21. Pioneer Invest Corp - Harshit Taunk

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IMT Nagpur 2008-10 Page 1

EQUITY RESEARCH REPORT ON GREAT OFFSHORE


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APPROACH TO FUNDAMENTAL ANALYSIS FOR

COMPANY VALUATION

SIP project report submitted in partial fulfillment of the

requirements for the PGDM Program

By

HARSHIT TAUNK

08FN047

Supervisors: 1. Prof. H. Virupakshi Goud

2. Prof. Ravindra M. Gadgil

3. Mr. Syed Sagheer

Institute of Management Technology, Nagpur

2009


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ACKNOWLEDGEMENT

I wish to express my deep sense of gratitude to those who generously helped me to

complete the project with the wealth of their knowledge and expertise.

I am sincerely thankful to Mr. Gaurang Gandhi, MD, to provide me opportunity to share

corporate experience at PINC.

My special thanks to Mr. Syed Sagheer, Senior Analyst for his continuous valuable and

productive guidance for this project.

I would like to express my profound gratitude indebtedness to Prof. H. Virupakshi Goud

and Prof Ravindra M. Gadgil faculty guides for their valuable guidance and

encouragement throughout the project.

I would like to express my profound gratitude indebtedness to Prof Vishwanath for his

valuable guidance and encouragement throughout the project.

Lastly I will like to thank my friends and family for supporting me for completing the

project and Almighty for his blessings.


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Contents

Executive summary....5

Introduction...8

Objectives of the study11

Concepts Introduced in the Study ......12

About Pioneer Investcorp.....22

Exploration and Production industry...23

About Great Offshore..32

Swot analysis of Great Offshore..34

Proposed methodology.35

Calculations and Tabulation..36

Conclusion.39

Recommendations.39

Limitations.39

Bibliography..40


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Executive Summary:

The project is in equity research. It is an approach to Fundamental Analysis to company

(Great Offshore Ltd.) valuation using Discounted Cash-Flow (DCF) model.

Investors always look for recommendations and suggestions from their brokers who have

their own set of analysts. These analysts track companies and sectors so as to take a call

for lucrative investment options for their clients. To accomplish the same, fundamental

analysis coupled with the relevant macro-economic factors are considered.

Fundamental analysis deals with evaluating the fundamentals of a company and involves

analyzing its financial statements and health, its management and competitive

advantages, and its competitors and markets. Fundamental analysis is a long term

perspective and different from technical analysis which is based on investors sentiments

and current market and stock prices movements.

Every sector is affected by some macro-economic factors more than other sectors. The

changes in any of these factors would have a bearing on the final call (buy/sell/hold)

taken by the analyst.

A Top down approach is used in the project for all information available, including

macroeconomic data, to make an investment decision. In general, fundamental analystslook first at the current macroeconomic conditions, because for them the decision to

invest depends mainly on what stage of the business cycle the economy is heading and

which industry is expected to perform well in the forecasted economic environment.

Then analysts try to find the best companies in these industries. The stock selection

process is based on the idea that the stock of the selected company must outperform its

peers in the industry and the industry must outperform other industries. Valuation is the

process of determining the intrinsic value of common stocks. The commonly accepted

theoretical principle to value any financial asset is the discounted cash flow methodology.

An asset is worth the amount of all future cash flows to the owner of this asset discounted

at an opportunity rate that reflects the risk of the investment. This fundamental principle

does not change and is valid through time and geography. A valuation model that best


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converts this theoretical principle into practice should be the most useful. Valuation

requires an estimate of the present value of all expected future cash flows to shareholders.

In other words, it involves looking into an uncertain future and making an educated guess

about the many factors determining future cash flows. Since the future is uncertain,

intrinsic value estimates will always be subjective and imprecise. Better models and

superior estimation techniques may reduce the degree of inaccuracy, but no valuation

technique can be expected to deliver a single correct intrinsic value measure.

In efficient markets price should equal intrinsic value, but fundamental analysis assumes

that value and price can deviate. It is too simplistic to assume that markets are always

efficient so that prices adjust to intrinsic value instantly.

Discounted cash flow (DCF) valuation models recognize that common stock represents

an ownership interest in a business and that its value must be related to the returns

investors expect to receive from holding it. A business generates a stream of cash flow in

its operations and as owners of the business; shareholders have a legal claim on these

cash flows. The value of a stock is therefore the share of cash flow the business generates

for its owners discounted at their required rate of return. DCF calculation involves

dividing the free cash flow to the firm (numerator) with the appropriate cost of capital

(denominator).

Estimating FCFF involves forecasting many components like revenue, depreciation,

taxes, operating expenses etc. Risk is the main concept behind the required rate of return.

It is commonly accepted that the discount rate for risky assets consists of two parts: a

risk-free rate that compensates investors for the opportunity of investing in a risk free

asset, and a risk premium compensating for bearing additional risk. The required rate of

return is therefore mainly a function of perceived risk; it translates the markets risk

preference and perception of risk into stock prices. CAPM is used for the calculation of


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the cost of equity whereas the cost of debt has been averaged out over a period of 3 years.

The determination of various costs ( equity and debt) involves assumptions like a

terminal growth rate of around 4 %, market risk free rate of around 6.5 7 %.India is

heavily dependent on imports to meet the growing demand for petroleum products and

possesses an annual average growth rate of between 6-7% compared to a world average

of 1.54%. The country is currently the 11th largest consumer of oil/gas and forecast to be

the fifth largest consumer within the next 20-years. Oil consumption is expected to grow

rapidly from a current level of 2 million bo/d to 3.2 million bo/d by 2010 and with the

country responsible for importing around 70% of its hydrocarbon requirements, the

Government recognized the need to adopt a comprehensive approach to tackle its energy

security needs and embarked on a programme to overhaul dramatically the petroleum

sector in the mid-1990s.

Realizing that an increased level of exploration activity supported by large scale capital

investment was necessary to expand domestic exploration and production, the

Government drafted an internationally competitive fiscal regime and formulated the New

Exploration Licensing Policy (NELP). As a result, ONGC and OIL had to compete with

private sector companies to obtain exploration licenses (as opposed to receiving them on

a nomination basis) and with no compulsory state participation, a level playing field was

provided for the first time between private and public sector companies. As such, India

has been rewarded with a number of significant gas discoveries in recent years which

could potentially transform the countrys energy landscape.

The company under research for the project is Great Offshore. It is India's prominent

integrated offshore oilfield services provider offering a broad spectrum of services to

upstream oil and gas producers to carry out offshore exploration and production (E&P)

activities. From drilling services to marine and air logistics, from marine construction to

port/terminal services and beyond, Great Offshore meets a wide gamut of the offshore

requirements of an E&P operator. Since commissioning its operations in 1983, Great

Offshore has serviced major E&P operators in India as well as in the international waters

of the North Sea, the Middle East, South Africa and South East Asia with its state-of-the-

art vessels that include exploratory rigs, offshore support vessels, anchor handling tug


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supply vessels and a construction barge. They also provide port and terminal support

services through a fleet of harbor tugs.

Introduction:

In his book Capital Karl Marx (Marx, 1887) uses a remarkably simple equation to

explain the capitalist system: M-C-M. In words, the capitalist starts with Money (M),

converts it into Capital (C) by investing it and ends up with More Money (M) that is in

essence the investment process. Investing is essential for the functioning of the capitalist

system. Investors provide money to entrepreneurs that build businesses to produce goods

and services demanded by society. In return for providing capital, the investor is

compensated with a share of the profits of the business.

An investment can therefore be defined as the current commitment of money for a period

of time in order to derive future payments that will compensate the investor for (1) the

time the funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of

future payments or risk.

Valuation is the first step toward intelligent investing. When an investor attempts to

determine the worth of her shares based on the fundamentals, it helps her make informed

decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in

a sea of random short-term price movements and gut feelings.

For years, the financial establishment has promoted the specious notion that valuation

should be reserved for experts. Supposedly, only sell-side brokerage analysts have the

requisite experience and intestinal fortitude to go out into the churning, swirling market

and predict future prices. Valuation, however, is no arcane science that can only be

practiced by MBAs and CFAs. With only basic math skills and some diligence, any Fool

can determine values with the best of them.


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Before you can value a share of stock, you have to have some notion of what a share of

stock is. A share of stock is not some magical creation that ebbs and flows like the tide;

rather, it is the concrete representation of partial ownership of a publicly traded company.

If XYZ Corp. has 1 million shares of stock outstanding and you hold a single, solitary

share that means you own a millionth of the company. Why would someone want to pay

you for your millionth? There are quite a few reasons, actually. There is always going to

be someone else who wants that millionth of the ownership because they want a millionth

of the votes at a shareholder meeting. Although its small by itself, if you combine that

millionth with about 500,000 of its friends, you suddenly have a controlling interest in the

company. That means you can make it do all sorts of things, like pay fat dividends -- or

merge with your company.

Companies buy shares in other companies for all sorts of reasons. Whether its anoutright takeover, in which a company buys all the shares, or a joint venture, in which the

company typically buys enough of another company to earn a seat on the board of

directors, the stock is always on sale. The price of a stock translates into the price of the

company, on sale for seven and a half hours a day, five days a week. It is this information

that allows other companies, public or private, to make intelligent business decisions with

clear and concise information about what another company's shares might cost them.

A share of stock is a stand-in for a share in the company's revenue, earnings, cash flow,

shareholders equity -- you name it, the whole enchilada. For the individual investor,

however, this normally means just worrying about what portion of all of those numbers

you can get in dividends. A share of ownership entitles you to a share of all dividends in

perpetuity. Even if the company's stock does not currently have a dividend yield, there

always remains the possibility that at some point in the future there could be some sort of

dividend.

However, a company can also simply repurchase its own shares using its excess cash,

rather than paying out dividends to shareholders. This effectively drives up the stockprice by providing a buyer, as well as improving earnings per share (EPS) comparisons

by decreasing the number of shares outstanding. Mature, cash flow-positive companies

tend to be much more liberal with share repurchases as opposed to dividends, simply

because dividends to shareholders get taxed twice. Securities research is a discipline


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within the financial services industry. Securities research professionals are known most

generally as "analysts," "research analysts," or "securities analysts;" all the foregoing

terms are synonymous. Securities analysts are commonly divided between the two basic

kinds of securities: equity analysts (researching stocks and their issuers) and fixed income

analysts (researching bond issuers). However, there are some analysts who cover all of

the securities of a particular issuer, stocks and bonds alike.

Securities analysts are usually further subdivided by industry specialization (or sectors) --

among the industries with the most analyst coverage are biotechnology, financial

services, energy, and computer hardware, software and services. Fixed income analysts

are also often subdivided by asset class -- among the fixed income asset classes with the

most analyst coverage are convertible bonds, high yield bonds (see high-yield debt), and

distressed bonds (see distressed securities). (Although technically not securities,syndicated bank loans typically fall within the domain of fixed income analysts, and are

covered, as if they were bonds, by reference to the industry of their borrowers or asset

class in which their credit quality would place them.)

In the broadest terms, securities analysts seek to develop, and thereafter communicate to

investors, insights regarding the value, risk, and volatility of a covered security, and thus

assist investors to decide whether to buy, hold, sell, sell short, or simply avoid the

security in question or derivative securities (see: derivative). To gather the information

required to do so, securities analysts review periodic financial disclosures (such as made

by United States-listed issuers to the S.E.C. and India-listed issuers to the SEBI) of the

issuer and other relevant companies, read industry news and use trading history and

industry information databases, interview managers and customers of the issuer, and

(sometimes) perform their own primary research.


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Objectives of Study:

Equity research is one of the most critical lines of business in the financial services

sector. Any long term and thoughtful investment decision should be preceded by a

thorough study and research about the prospective company and this can be accomplished

by fundamental analysis followed by the use of tools to zero down to a target price for the

share.

With this study one can get adequate exposure to the subject so as to enable the student to

improve and build his/her understanding in some of the most critical and important

concepts of finance.

The main objective behind carrying out this study was to find out the fair value of the

listed entity i.e. Great Offshore, and to issue investment rating to its share for the

investors based on which they can take a wise decision on their investment in the

companys equity.

This project is a tool to bring in more clarity on certain concepts like Fundamental

analysis for company valuation, Discounted cash flow, cost of capital to name a few. The

study not only strengthens the understanding of some of the accounting concepts but also

lends a practical approach to the whole learning.

It certainly enables one to relate theoretical concepts to the practicality of accounting and

valuation practices of the financial services.


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Concepts Introduced in the Study

There are two major types of analysis for predicting the performance of a company's

stock - fundamental and technical. Fundamental research is done by analyzing

companies financial information and current news flows whereas latter looks for peaks,

bottoms, trends, patterns, and other factors affecting a stock's price movement and then

making a buy/sell decision based on those factors. It is a technique many people attempt;

though very few are truly successful.

Fundamental analysis is used in this study.

Fundamental Analysis:

The underlying theme in fundamental analysis is that the true value of the firm can be

related to its financial characteristics -- its growth prospects, risk profile and cash flows.

It is the examination of the underlying forces that affect the well being of the economy,

industry groups, and companies. As with most analysis, the goal is to derive a forecast

and profit from future price movements. At the company level, fundamental analysis may

involve examination of financial data, management, business concept and competition.

At the industry level, there might be an examination of supply and demand forces for the

products offered. For the national economy, fundamental analysis might focus on

economic data to assess the present and future growth of the economy. To forecast future

stock prices, fundamental analysis combines economic, industry, and company analysis

to derive a stock's current fair value and forecast future value. If fair value is not equal to

the current stock price, fundamental analysts believe that the stock is either over or under

valued and the market price will ultimately gravitate towards fair value. Fundamentalists

do not heed the advice of the random walkers and believe that markets are weak-form

efficient. By believing that prices do not accurately reflect all available information,

fundamental analysts look to capitalize on perceived price discrepancies.

Any deviation from this true value is a sign that a stock is under or overvalued. It is a

long term investment strategy, and the assumptions underlying it are:

(a) The relationship between value and the underlying financial factors can be measured.


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(b) The relationship is stable over time.

(c) Deviations from the relationship are corrected in a reasonable time period.

Valuation is the central focus in fundamental analysis. Some analysts use discounted cashflow models to value firms, while others use multiples such as the price earnings and

price-book value ratios. Since investors using this approach hold a large number of

'undervalued' stocks in their portfolios, their hope are that, on average, these portfolios

will do better than the market. Fundamental analysis serves to answer questions, such as:

Is the companys revenue growing?

Is it actually making aprofit?

Is it in a strong-enough position to beat out its competitors in the future?

Is it able to repay its debts?

Is management trying to "cook the books"?

The various fundamental factors can be grouped into two categories: quantitative and

qualitative. The financial meaning of these terms isnt all that different from their regular

definitions. In our context, quantitative fundamentals are numeric, measurable

characteristics about a business. Its easy to see how the biggest source of quantitative

data is the financial statements. You can measure revenue, profit, assets and more with

great precision. Financial statement analysis is the biggest part of fundamental analysis.

Also known as quantitative analysis, it involves looking at historical performance data to

estimate the future performance. Followers of quantitative analysis want as much data as

they can find on revenue, expenses, assets, liabilities, and all the other financial aspects of

a company. Fundamental analysts look at this information for insight into the

performance of the firm in the future. They don't ignore the company's stock price; they

just avoid focusing exclusively on it. The following information is presented in most

financial reports, note that the order in which these are presented might vary-Summary of

the previous year, Information about the company in general, its history, products and

line of business, Letter to shareholders from the President or the CEO, An in-depth
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discussion about the financial results and other factors within the business, the complete

set of financial statements (balance sheet, income statement, statement of retained

earnings, and cash flow statement) etc.

Two Approaches to fundamental analysis are top down approach and bottom up

approach. The top down approach is a process by which one examines a particular

investment opportunity. First, one examines the general economy, then a particular

industry and, finally, individual firms within a particular industry. It assumes that both

economy/market and the industry have a substantial impact on individual stocks. In

contrast to the top down approach the bottom up approach analyzes the individual

companies to find undervalued stocks, regardless of the economy/market and the

industry.

within these industries, these macroeconomic factors should be considered before

industries are analyzed. When investors examine the economy as a whole, they must

examine certain factors that affect monetary and fiscal policy. Fiscal policy initiatives

such as tax credits or tax cuts can encourage spending, while added taxes reduce

spending. Both have an effect on the economy. Government spending also has an effect

on the economy, a strong multiplier effect. Monetary policy has an effect on the

economy. A restrictive monetary policy reduces the growth rate of the money supply. It


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reduces funds for working capital and expansion projects. This will cause interest rates to

increase; this inhibits borrowing and therefore reduces economic growth. Another

important factor to examine is the inflation rate, which has a negative effect on

investment and on exchange rates. It is important to examine all of these factors because

it is very difficult to conceive of any industry or company that can avoid the impact of

macroeconomic development that affect the total economy. Once an investment specialist

has chosen a country to invest in, he or she must determine how the portfolio will be

weighted. The investment specialist should underweight a portfolio in a country, which

has a bad economic outlook, and overweight it a country that has a strong economy.

An industry's prospects within the global business environment will determine how well

or poorly an individual firm will fare, so industry analysis should precede company

analysis. This step includes the process of scanning the economic environment forindustries that exhibit stability and growth potential. Investors may examine taxes on

goods in a particular industry, import quotas, government intervention in the market

place, the stage of the industry is in the business cycle, whether the industry is

"internationalized", and whether it is dominated by a monopoly It is just as hard for a

company to perform well in an unfavorable industry as for an monopoly. It is just as hard

for a company to perform well in an unfavorable industry as for an industry to flourish in

a poor economy. After finishing the first two steps an investor can analyze and compare

individual firms' performance within the entire industry using financial ratios and cash

flow values. There are many techniques for looking at particular companies. Investors

may use a quantitative approach, a qualitative method, or a mixture of both. The different

models for security analysis will be discussed in the next section. After a particular

company has been chosen to invest in, the investor should use common sense: Do not

invest in an industry that exhibits poor attributes or in a company that is going bankrupt.

With this said, asset allocation is a subjective process.

Turning to qualitative fundamentals, these are the less tangible factors surrounding a

business - things such as the quality of a companys board members and key executives,

its brand-name recognition,patents or proprietary technology.
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The Concept of Intrinsic Value:

One of the primary assumptions of fundamental analysis is that the price on the stock

market does not fully reflect a stocks real value. In financial jargon, this true value is

known as the intrinsic value.

For example, lets say that a companys stock was trading at Rs20. After doing extensive

homework on the company, you determine that it really is worth Rs25. In other words,

you determine the intrinsic value of the firm to be Rs25. This is clearly relevant because

an investor wants to buy stocks that are trading at prices significantly below their

estimated intrinsic value. This leads us to one of the second major assumptions of

fundamental analysis: in the long run, the stock market will reflect the fundamentals.

There is no point in buying a stock based on intrinsic value if the price never reflected

that value. Nobody knows how long the long run really is. It could be days or years.

This is what fundamental analysis is all about. By focusing on a particular business, an

investor can estimate the intrinsic value of a firm and thus find opportunities where he or

she can buy at a discount. If all goes well, the investment will pay off over time as the

market catches up to the fundamentals. The big unknowns are:

1) one doesnt know if the estimate of intrinsic value is correct; and

2) one doesnt know how long it will take for the intrinsic value to be reflected in the

marketplace.

Discounted cash flow model:

The purpose of DCF-Valuation is to determine the value of a company in terms of its

future cash flows. The cash flows are adjusted with certain items (e.g. those not related to

companys core businesses or those with no cash effect) in order to make sure the flows

reflect the actually generated cash as good as possible. In simple terms, discounted cash

flow tries to work out the value of a company today, based on projections of how much

money it's going to make in the future. DCF analysis says that a company is worth all of

the cash that it could make available to investors in the future. It is described as


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"discounted" cash flow because cash in the future is worth less than cash today.

The underlying idea of DCF-Valuation is to compute the fair value of a company i.e. the

intrinsic value of the companys share. The potential of the share price (which the

investors are particularly interested in) is then computed by comparing the fair value with

the current market price of the company's share.

As an investor, one has a lot to gain from mastering DCF analysis. For starters, it can

serve as a reality check to the fair value prices found in brokers' reports. DCF analysis

requires one to think through the factors that affect a company, such as future sales

growth and profit margins. It also makes one consider the discount rate, which depends

on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All

of this will give an appreciation for what drives share value, and that means one can put a

more realistic price tag on the company's stock.

Basic formulation of Discounted cash flow valuation is as follows:

Free cash flow to firm is discounted with WACC to the Year 0 (the forecast year) in

order to get the present value of free cash flows. Cumulative discounted free cash flow is

a yearly item in which all the forecast years discounted cash flows are summed up.

Hence, the first item is the sum of all forecast years free cash flows at present value

terms. Value of equity FCFF is divided by the number of shares outstanding to get the

fair value of the companys share. EBIT is adjusted with Taxes and Share of associated

companies profit/loss in order to get Operating cash flow - the figure that reflects the

cash actually generated by the company much better than the EBIT.


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Operating cash flow is adjusted with Total depreciation to get Gross cash flow. This has

to be done because depreciation has no cash effect and thus does not really reduce the

cash generated.

Gross cash flow includes cash tied up in investments. Hence, Change in working capital

and Gross capital expenditure have to be subtracted from it and Increase in non-interest

bearing liabilities added to it in order to get Free operating cash flow.

Change in working capital appears in the calculation as minus-signed if more capital is

tied up in the business than in the previous year. Gross capital expenditure in turn is the

cash used for investments during the year. Increase in non-interest bearing liabilities is

plus-signed, since it has an opposite effect than Net working capital.

Other items include extraordinary items, which have cash affect even though they are not

important in an operational business sense.

Interest bearing debt, Cash at bank and Investments' share price impact are to be

added/subtracted from the Cumulative discounted cash flow so that the result of the

valuation is Value of equity, not Value of firm. All items except for EBIT, Share of

associated companies profit/loss and Taxes on continuing operations the model

calculates automatically. Thus, you can freely change EBIT, Share of associated

companies profit/loss and Taxes on continuing operations.

How to Value Stocks: Cash Flow-Based Valuations

Despite the fact that most individual investors are ignorant of cash flow, it is probably the

most common measurement used by investment bankers for valuing public and private

companies. Cash flow is literally the cash that flows through a company during the

course of a quarter or the year after taking out all fixed expenses. Cash flow is normally

defined as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Interest income and expense, as well as taxes, are all tossed aside because cash flow is

designed to focus on the operating business and not secondary costs or profits. Taxes

especially depend on the vagaries of the laws in a given year and actually can cause


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dramatic fluctuations in earnings power. For instance, early in a company's life, it usually

loses money. When the company starts to turn a profit, it can often use those losses from

previous years to cut its taxes. That can overstate current earnings and understate its

forward earnings, masking the company's real operating situation. Thus, a canny analyst

would use the growth rate of earnings before interest and taxes (EBIT) instead of net

income in order to evaluate the company's growth. EBIT is also adjusted for any one-time

charges or benefits.

As for depreciation and amortization, these are called non-cash charges, as the company

is not actually spending any money on them. Rather, depreciation is an accounting

convention for tax purposes that allows a premium to its shareholder equity -- a number

that it accounts for on its balance sheet companies to get a break on capital expenditures

as plant and equipment ages and becomes less useful. Amortization normally comes inwhen a company acquires another company at as goodwill and is forced to amortize over

a set period of time, according to generally accepted accounting principles (GAAP).

When looking at a company's operating cash flow, it makes sense to toss aside

accounting conventions that might mask cash strength. Cash flow

is most commonly used to value industries that involve tremendous up-front capital

expenditures and companies that have large amortization burdens. Cable TV companies,

for instance, reported negative earnings for years as they made huge capital expenditures

to build their cable networks. However, their cash flow actually grew; huge depreciation

and amortization charges masked the companies' ability to generate cash. Sophisticated

buyers of these properties use cash flow as one way of pricing an acquisition, thus it

makes sense for investors to use it as well.

The most common valuation application of EBITDA, the discounted cash flow, is a

rather complicated spreadsheet exercise that defies simple explanation. Economic value

added (EVA) is another sophisticated modification of cash flow that looks at the cost of

capital and the incremental return above that cost as a way of separating businesses that

truly generate cash from ones that just eat it up.

Investors interested in going to the next level with EBITDA and looking at discounted

cash flow or EVA is encouraged to check out the bookstore or the library. Since

companies making acquisitions use these methods, it makes sense for investors to


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familiarize themselves with the logic behind them as this might enable a Foolish investor

to spot a bargain before someone else.

Applicability and Limitations of DCF Valuation

Discounted cash flow valuation is based upon expected future cash flows and discount

rates. Given these informational requirements, this approach is easiest to use for assets

(firms) whose cash flows are currently positive and can be estimated with some reliability

for future periods, and where a proxy for risk that can be used to obtain discount rates is

available. The further we get from this idealized setting, the more difficult discounted

cash flow valuation becomes. The following list contains some scenarios where

discounted cash flow valuation might run into trouble and need to be adapted.

(1) Firms in trouble: A distressed firm generally has negative earnings and cash flows. It

expects to lose money for some time in the future. For these firms, estimating future cash

flows is difficult to do, since there is a strong probability of bankruptcy. For firms which

are expected to fail, discounted cash flow valuation does not work very well, since we

value the firm as a going concern providing positive cash flows to its investors. Even for

firms that are expected to survive, cash flows will have to be estimated until they turn

positive, since obtaining a present value of negative cash flows will yield a negative1

value for equity or the firm.

(2) Cyclical Firms: The earnings and cash flows of cyclical firms tend to follow the

economy - rising during economic booms and falling during recessions. If discounted

cash flow valuation is used on these firms, expected future cash flows are usually

smoothed out, unless the analyst wants to undertake the onerous task of predicting the

timing and duration of economic recessions and recoveries. Many cyclical firms, in the

depths of a recession, look like troubled firms, with negative earnings and cash flows.

Estimating future cash flows then becomes entangled with analyst predictions about

when the economy will turn and how strong the upturn will be, with more optimisticanalysts arriving at higher estimates of value. This is unavoidable, but the economic

biases of the analyst have to be taken into account before using these valuations.


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(3) Firms with unutilized assets: Discounted cash flow valuation reflects the value of all

assets that produce cash flows. If a firm has assets that are unutilized (and hence do not

produce any cash flows), the value of these assets will not be reflected in the value

obtained from discounting expected future cash flows. The same caveat applies, in lesser

degree, to underutilized assets, since their value will be understated in discounted cash

flow valuation. While this is a problem, it is not insurmountable. The value of these

assets can always be obtained externally2, and added on to the value obtained from

discounted cash flow valuation. Alternatively, the assets can be valued assuming that they

are used optimally.

(4) Firms with patents or product options: Firms often have unutilized patents or

licenses that do not produce any current cash flows and are not expected to produce cash

flows in the near future, but, nevertheless, are valuable. If this is the case, the valueobtained from discounting expected cash flows to the firm will understate the true value

of the firm. Again, the problem can be overcome, by valuing these assets in the open

market or by using option pricing models, and then adding on to the value obtained from

discounted cash flow valuation.

(5) Firms in the process of restructuring: Firms in the process of restructuring often sell

some of their assets, acquire other assets, and change their capital structure and dividend

policy. Some of them also change their ownership structure (going from publicly traded

to private status) and management compensation schemes. Each of these changes makes

estimating future cash flows more difficult and affects the riskiness of the firm. Using

historical data for such firms can give a misleading picture of the firm's value. However,

these firms can be valued, even in the light of the major changes in investment and

financing policy, if future cash flows reflect the expected effects of these changes and the

discount rate is adjusted to reflect the new business and financial risk in the firm.

(6) Firms involved in acquisitions: There are at least two specific issues relating to

acquisitions that need to be taken into account when using discounted cash flow valuationmodels to value target firms. The first is the thorny one of whether there is synergy in the

merger and if its value can be estimated. It can be done, though it does require

assumptions about the form the synergy will take and its effect on cash flows. The

second, especially in hostile takeovers, is the effect of changing management on cash


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flows and risk. Again, the effect of the change can and should be incorporated into the

estimates of future cash flows and discount rates and hence into value.

(7) Private Firms: The biggest problem in using discounted cash flow valuation models

to value private firms is the measurement of risk (to use in estimating discount rates),

since most risk/return models require that risk parameters be estimated from historical

prices on the asset being analyzed. Since securities in private firms are not traded, this is

not possible. One solution is to look at the riskiness of comparable firms which are

publicly traded. The other is to relate the measure of risk to accounting variables, which

are available for the private firm.

The point is not that discounted cash flow valuation cannot be done in these cases, but

that we have to be flexible enough to deal with them. The fact is that valuation is simple

for firms with well defined assets that generate cash flows that can be easily forecasted.

The real challenge in valuation is to extend the valuation framework to cover firms that

vary to some extent or the other from this idealized framework.

About Pioneer Investcorp Ltd:

Incorporated on Jan. 23, 1984 Pioneer Investcorp Limited is an India-based company that

provides investment banking and financial advisory services. The Group's principal

activities are providing Project and Financial Advisory Services and Financial Solutions

for Corporate and Industrial Houses Development Projects. The Group's financial

services include Investment Banking, Research for Equity markets, Brokerage for Debt,

Equity and Derivative Markets, Portfolio Management Services (PMS), Insurance and

Risk Management Services, Private Placements of Bonds and Equities, Term Loan and

Debt Syndication and Commodities Trading. It operates under three segments: Advisory

& Merchant Banking, Income from Securities/Investment and Equity Brokerage and

related income.


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A registered merchant banker having Category-I registration from SEBI, the company

offers formulating capital structure, raising capital, debt restructuring, project financing

and other corporate advisory services like private placement of equities and other

domestic and foreign securities.

The Companys wholly owned subsidiaries include Infinity.Com Financial Securities

Ltd., Pioneer Wealth Management Services Ltd., Marine Drive Investments And Trading

Company Pvt. Ltd., Pioneer Investcorp International Ltd. and PINC Fund Advisors LLC.

In FY08, the corporate finance and advisory business exhibited a 217% increase in

revenues through a combination of high-value advisory services and finance structuring

of mid-cap companies. The company and its subsidiaries now cover all areas of the

financial sector other than foreign exchange services.

Exploration and Production industry:

The oil and gas exploration and production industry consists of about 7,000 companies

with combined annual revenue of around Rs890 million. Major companies include

Murphy Oil, Chesapeake Energy, Devon Energy, Anadarko Petroleum, and Occidental

Petroleum. Other companies include the exploration and production divisions of

integrated companies such as Exxon Mobil, Chevron, and ConocoPhillips. The industry

is moderately fragmented: 10 percent of companies generate 60 percent of revenue. A

fast-track approval mechanism was also established to help accelerate and streamline the

licensing process, thereby removing the prolonged bureaucracy that had long been

associated with contract signature. The outcome has been highly successful: since the

launch of the First Licensing Round under the NELP in January 1999, four further rounds

have been concluded, giving rise to 110 contracts (40 deep water, 32 shallow water and

38 onshore) being awarded over the last six years compared to only 22 contracts in the

preceding ten years.


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Source: E&P spends survey

This industry segment doesn't include transmission, refining, or retailing of petroleum

and natural gas products.

Competitive Landscape:

Demand is driven by economic activity, population growth, and energy efficiency for

residential, industrial, and transportation uses of oil and gas. Profitability of individual

companies is driven by the success rate of new wells drilled and the ability to increase

production from existing wells. Large companies are advantaged by access to capital,

including the ability to buy or merge smaller companies. Small companies compete by

focusing on, and developing expertise in a few geographic areas. The industry is capital

intensive: average annual revenue per employee is about Rs5 million.

Oil and gas compete with other energy sources, such as coal, nuclear power, and

hydroelectric power, for industrial and home heating applications. Renewable fuels, such

as ethanol and biodiesel, and hybrid-electric cars, which use stored electricity from


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batteries instead of or in addition to gas or diesel, are emerging alternatives for

transportation applications.

There has been a substantial increase in per capita consumption of energy in developed

nations due to increase in industrialization and consumerism. This has cascaded with the

emergence of new industrial powerhouses like China and India.

Types of offshore vessels:

Rigs

Offshore Rigs (oil rig/platform) are assets which house workers and machinery used for

extracting oil from the seabed. Rigs can be classified as deep water rigs and shallow

water rigs. Various types of rigs are:

Jack Up Rigs

These are the most commonly used rigs for drilling. This device moves from location to

location on its hull, towed by support vessels like Anchor Handling Tugs (AHT) and is


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lowered onto the drilling location using columns/legs, which touch the seabed, using a

hydraulic or electrical system. Once the columns are properly secure, the JR can be

lowered or raised depending on the drilling depth required. JRs (jack up rigs) usually

operate in shallow waters (upto 500 ft.). Globally, there are 426 JRs in operation and

most of these are >25 years old as they were built in the 80s during the oil boom. There is

an estimate of 84 JRs to be added over the next 5 years worth USD9bn. However,

demand should be sustained due to replacement and increase in exploration sites. JRs

command day rates in the range of USD70-180k/day depending on the depth to which it

can drill.

A jack-up rig

Semi Submersible Rigs

These rigs are based on a platform which has sufficient buoyancy to be stable and yet

float on the sea level. The rig is towed by support vessels like AHTs to the desired

location and then the hull is submerged below the water level to enable the rig to operate.

The rig is held in place by anchors/rope. It is used for deep water drilling and can go upto

10k feet. The demand-supply skew in this asset class is the highest due to increasing deep

water drilling. Currently, there are ~170 SS in the market operating at above 90%

utilization. There are an estimated 49 such rigs worth USD25bn under construction and

expected to commence operations over the next 5 years. However, due to buoyant

demand of such deep sea rigs, day rates are not expected to soften. These rigs command a

day rate in the range of USD 290-340k/day.


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Semi-submersible rig

Drill Ships

Drill ships are maritime vessels fitted with drilling apparatus. They are used in deep sea

drilling upto 12k feet, often in turbulent waters as they are positioned with a dynamic

positioning system (DPS) to enable accuracy of drilling at the offshore location.

Currently, there are ~40 drill ships operating in the market and another 32 DS of

USD19bn are expected to join the existing fleet in the next 5 years. DS command a day

rate in the range of USD280-330k/day.


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Offshore drilling ship

Platform Supply Vessels:

A Platform supply vessel (often abbreviated as PSV) is a ship specially designed to

supply offshore oil platforms. These ships range from 65 to 350 feet in length and

accomplish a variety of tasks. The primary function for most of these vessels is

transportation of goods and personnel to and from offshore oil platforms and other

offshore structures.
http://en.wikipedia.org/wiki/Oil_platformhttp://en.wikipedia.org/wiki/Oil_platform


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A PSV

Apart from the above types of vessels there are also other types of offshore vessels like

fire fighting supply vessels, construction barge and multi role supply vessels etc. which

are more of support vessels.

Offshore drilling can be done in the shallow waters of the continental shelf or in deep

seas. In shallow waters up to 500 feet, a drilling rig, such as a jackup rig, is towed to the

drilling site and part of the platform sunk to the bottom. Legs are lowered from the upper

platform to the sunken platform and the upper platform is then jacked up to the desired

height above the water. Drilling is then conducted in a manner similar to onshore drilling.

In deeper waters, submersible rigs or deepwater drill ships may be used.

Demand and supply:

As the demand for oil and natural gas increases in the midst of increased consumption by

the ever so burgeoning world population, there will be a higher pressure and subsequently

higher demand for E&P activities. This increase in the E&P activities will lead to higher

demand for rigs/OSVs and other such vessels.


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On the supply side, the role of efficient and productive shipyards is critical, as these

shipyards around the world are the ones to build such vessels.

Demand and supply equation


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Demand supply dynamics

Source: http://energy.ihs.com/Resource-Center/Whitepapers/

Usually three shifts of crews are on for the offshore rigs two living aboard, the third

ashore. The shifts are rotated in two-week intervals. Large rigs can have as many as 200

workers living aboard. Wells require periodic workovers to maintain production levels.

During service, a workover rig or a smaller service unit is used to raise and lower

equipment into the well. Sand, rock, and other debris can be removed from the well using

oil- or water-based mud or nitrogen foam pumped into the well under high pressure. In

some instances, wells can be drilled nearby and water or a gas (carbon dioxide or

nitrogen) can be pumped in to drive the petroleum or natural gas toward the production

well.


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About Great Offshore:

Great Offshore is India's prominent integrated offshore oilfield services provider offering

a broad spectrum of services to upstream oil and gas producers to carry out offshore

exploration and production (E&P) activities. Great Offshore Ltd. is Indias second largest

company in the offshore services space with a fleet of 40 assets. From drilling services to

marine and air logistics, from marine construction to port/terminal services and beyond,

Great Offshore meets a wide gamut of the offshore requirements of an E&P operator.

The company has a total fleet of around 60 vessels of different types.


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Since commissioning its operations in 1983, Great Offshore has serviced major E&P

operators in India as well as in the international waters of the North Sea, the Middle East,

South Africa and South East Asia with its state-of-the-art vessels that include exploratory

rigs, offshore support vessels, anchor handling tug supply vessels and a construction

barge. We also provide port and terminal support services through a fleet of harbor tugs.

GOF is scouting for inorganic growth opportunities after the potential acquisition deal of

an offshore company (Cayman based Sea Dragon Offshore, according to media reports)

did not go through. It has also diversified its earnings profile by garnering a large marine

construction mandate. These moves showcase the companys strategy of diversifyingrevenue flows and participating in a fast growing offshore market.

Background:

Great Offshore Ltd (GOF) commenced operations in 1983 as an offshore division of

Great Eastern Shipping Co Ltd. In 2006, Great Eastern Shipping demerged its offshore

operations to form GOF. The company started with a couple of assets and various JVs to

form Indias largest offshore services company by number of vessels. It has a fleet of 40

assets, which include a Drill Barge, jack up rig, 7 PSVs, 11 AHTSVs, 3 AHTs, 2 Fire

Fighting vessels, 1 MSV, SV, heavy lift vessel, construction barge and 11 harbor tugs. Of

the total fleet of 40 vessels, all 7 PSVs, 4 of its AHTSVs and 2 FF vessels are deep water

assets. Six of its total 25 OSVs are deployed in international waters in the North Sea,


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Russia, Middle East and W. Africa while the remaining are in the domestic space. As a

logical extension of its offshore services, GOF ventured into marine construction

business in 2002. Of late, the same has gained traction with a large order from ONGC.

Swot Analysis:

Strengths

Large fleet size of 41 vessels in an attractive offshore space.

Buy back of shares at an average price of Rs 564 in July'08.

85% of the contracts are long-term with the contract period up to 5 years, indicating

more stability in revenue.

Diversification into marine engineering and port services is expected to contribute

nearly 10% and 15% to the total revenue in FY10E and FY11E.

Weaknesses

34% of the fleet is more than 20 years old.

As 85% of the fleet is on long-term contract. It may not be able to get maximum benefit

from spurting rates in spot markets.

Any major dry docking expense for its fleet may dampen profitability.

GOL is subject to exchange rate risk as its business is dollar dominated.

Opportunities

GOL may consider an acquisition or order new assets.

Securing more orders in the newly diversified sector.


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There is a natural entry barrier as the order book of most shipyards is running full till

FY12.

Threats

Damage to its rigs, which are old, will dampen revenue.

Delay in new deliveries (as proved recently by the withdrawal of the contract by ONGC

due to failure of GOL to deliver the rig named Samadh Shikhar).

Re-pricing of assets at lower than existing rates or major fall in spot market rates will

affect its revenue.

Proposed Methodology:

The offshore services sector is thoroughly studied at a macro level and then a micro level

study of the company is done. For this the financial statements like the balance sheets,

income statements (etc) along with its annual reports, and transcripts of the conference

calls with analysts are analyzed. The various financial ratios would enable us to gauge the

efficiency of the company on various important aspects.

Overall, the company level study would help in understanding the business model and the

current health of the company vis--vis the industry peers.

Then the forecasting of future cash flow for the forth coming years would be done

factoring in various factors which would impact the performance of the company ex. - the

delay in the delivery of a jack-up rig will impact the revenue for FY10 for Great Offshore

and this has to be considered while projecting revenues for FY10.Using DCF, the present

value of the company is determined and subsequently the intrinsic value of its share so as

to give a buy/sell recommendation.


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Calculations and Tabulations:

For finding out FCFF, we use the following formulae:

Free cash flow = NOPAT + Depreciation - Capital Expenditure (+) Increases

(Decreases) in Working Capital Investment

Where NOPAT = Net Operating Profit after tax = Earnings before Interest but after

Taxes

= EBIT (1- Tax rate)

EBIT = Revenue - cost of goods sold - operating expenses - depreciation

Estimation of cash flows requires NOPAT, Capital Expenditure and Net working capital.

In calculating NOPAT, interest is not deducted because the discount rate, WACC,

incorporates after-tax cost of debt. Tax rate is of approx.10.42 %.

Beta was calculated using the formulae:Co Variance (Sensex, stock)/Variance (Sensex)

The cost of equity was determined using CAPM model and was found out to be15 % and the cost of debt (after tax rate) was calculated as 6.71 %.

Assuming a terminal growth of 2 %, the terminal value was calculated using theformulae:

(CFFY11 * 1.02)

11.83 % - 2 %

Calculation of change in working progress:

Mar 08 Mar 09 Mar10E Mar 11E

Receivables 1748 2207 2646 3116

(+)Inventories 78 81 110 121(+)Loans,advc and deposits 1563 1048 1310 1688

Current assets 3389 3336 4066 4925

(-)Liabilities 1971 2301 2767 3059


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1418 1035 1299 1866

Change in WIP -383 264 567

Key Ratios Mar 06 Mar 07 Mar 08 Mar 09E Mar 10E Mar 11E

EBIDTA margin (%) 42.45 46.50 49.33 48.01 42.00 43.00

Net profit margin (%) 24.99 24.94 27.03 19.76 16.09 20.19

EPS basic 24.09 37.10 53.31 53.31 46.88 69.29

Diluted EPS 24.09 37.10 52.17 52.17

Capital employed 7870.60 12034.70 15750.80 21830.23 25566.21 25526.15

ROE 18.80 23.51 22.87 18.71 14.93 21.85

ROACE(%) 20.95 22.49 23.36 20.36 18.24 22.02

ROANW(%) 18.80 23.51 22.87 18.71 14.93 21.85

Sales/Total Assets 0.49 0.48 0.47 0.42 0.43 0.51

Debt/Equity 0.72 1.21 1.07 1.53 1.43 1.44

Current Ratio 2.05 1.46 2.68 1.74 3.58 4.26

Recievable (days) 78.81 77.72 85.55 87.00 87.00 87.00

Inventory (days) 12.67 8.31 7.66 7.00 8.00 8.00

Payable (days) 185.79 203.54 192.89 200.00 202.00 203.00


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Net working capital (days) 102.24 45.02 197.04 85.11 295.99 357.72

P/E 11.24 7.52 5.41 5.96 6.11 4.13

EV/Sales 3.44 3.01 2.27 2.58 1.74 1.24

EV/EBIDTA 8.11 6.47 4.59 5.38 4.15 2.89

Mcap/Sales 2.74 1.83 1.39 1.15 0.96 0.81

P/BV 2.11 1.77 1.24 1.12 0.91 0.90

Sales Growth(%) - 49.88 28.12 24.13 19.92 17.75

(Rs mn.) FY09 E FY10 E FY11 E

NOPAT2150 2662 3504

Depreciation1489 1692

1710

Capex + Maintenance exp. (7930) (3130) (400)

Change in Working Capital 383 (264) (567)

FCFF -3908 960 4247

Beta 1.00

Debt/Equity 1.62

WACC 11.83%

Terminal Value 44072

PV of Terminal Value 31513

Sum of PV of FCF 309

Fair Value 31822


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No. of shares outstanding 37.10

Target Value 388

(Detailed calculations are in the Excel sheet)

Conclusion:

Thus we have successfully arrived at the target price of the scrip of Great Offshore. We

see that the current market price of Great Offshore share is around Rs 353 (as of 27th

May

2009) with a PE multiple of around 6x which is 9x lower than the historical PE multiple ,

and hence we may conclude that it is under priced at the current market price levels. One

can expect the prices of this share to rise in the near future once the demand for oil in theinternational market picks up.

Recommendations:

According to the current market price levels and the calculated target price, we

recommend a BUY on Great Offshore.

Limitations of the study:

Any equity research report work requires lots of information about the company

under research which is not readily available to the common investors. Some

information which brings in more depth and accuracy in the estimation of the

future cash flows has to be availed only by contacting the concerned authorities of

the firm (e.g. expected capex or future revenues from a particular contract). The

information contained in equity research report has been obtained from sources,

which are believed to be reliable, but the accuracy or completeness of the contents

cannot be guaranteed. This study was carried out under such limitation being an

internship project.


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Assumptions taken for carrying out certain calculations like that of the cost of

equity (using CAPM) are open to modifications as these may not be completely

accurate.

Any investment recommendations in this report contain a high degree of risk and

a prospective investor is encouraged to review in detail the companys prospectus

and/or other additional information.

Bibliography:

http://www.greatoffshore.com

Bloomberg

http://www.investopedia.com/university/dcf/dcf2.asp

http://www.rigzone.com

http://www.douglaswestwood.com

Investment Valuation by Ashwath Damodaran

http://www.bseindia.com

http://www.investmentcommission.in/oil_&_gas_exploration.htm
http://www.greatoffshore.com/http://www.investopedia.com/university/dcf/dcf2.asphttp://www.rigzone.com/http://www.douglaswestwood.com/http://www.bseindia.com/http://www.investmentcommission.in/oil_&_gas_exploration.htmhttp://www.investmentcommission.in/oil_&_gas_exploration.htmhttp://www.bseindia.com/http://www.douglaswestwood.com/http://www.rigzone.com/http://www.investopedia.com/university/dcf/dcf2.asphttp://www.greatoffshore.com/

21. Pioneer Invest Corp - Harshit Taunk

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