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Safal Niveshak StockTalk: Bata India

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Manish Sharma.

“Putting ideas on paper forces you to think things through.” – Shelby Davis Sr.

There has been a lot of interest among investors about Bata India stock (Bata henceforth). This analysis is a basic attempt to understand the key dynamics of the business and the possible weaknesses or competitive threats that might affect the performance of the company. Normal disclaimer that goes along with all the reports of StockTalk apply here as well; please do your own due diligence.

Macro Overview of Footwear Industry
Before looking into the performance of the company, let’s take a brief look at the overall industry framework in which the company operates.

The Indian footwear market is currently growing at a rate of 12% per year. Of the total market size, 40% is in the organized segment also known as branded segment, and rural market accounts for 75% of the overall consumption.

Thus, the industry is dominated by unorganized players and rural market is holding fort. Nevertheless, with 40% of the market being controlled by organized players, footwear is the second most organized retail category in India, after watches.

Here are some other key stats…

  • India’s per capita shoe consumption has gone up from 1.4 shoes a year in 2004 to 2.2 shoes per year in 2010, so the market is definitely in a growth phase
  • India is the second largest footwear manufacturer in the world after China
  • The overall footwear retail market (in terms of value) is classified as follows:
    1. Men’s footwear accounts for 48%
    2. Women’s footwear accounts for 41%
    3. Children’s footwear accounts for the remaining 11%

About Bata India
Bata is a name that needs no introduction to Indians. The company has established itself as India’s largest footwear retailer. Bata India Limited (Bata) is a 52% subsidiary of the Netherlands-based Bata BV.

It is one of the largest footwear manufacturers in India and sells a wide range of canvas, rubber, leather, and plastic footwear. The company has a licensed capacity of 628 lakh pairs per annum spread across its five manufacturing units at Batanagar (Kolkata), Faridabad (Haryana), Bataganj (Bihar), Peenya (near Bangalore), and Hosur (Tamil Nadu). The company has one tannery at Mokameghat (Bihar).

As per its latest annual report, the company is relying mostly on domestic leather for production and imports constitute a very small part of raw materials.

Bata sells over 50 million pairs of shoes every year. South India is a major market for Bata, from where it earns around 40% of its revenue. The company is the market leader in South, with 16% share of the organized footwear market. Of the overall revenue, it derives nearly 85% through retail networks, 14% from non-retail channels (dealers/institutional/industrial sales) and remaining 1% through exports. Thus, the domestic market is the mainstay as far as revenues are concerned.

Here is the category revenue break-up:

  • 70% leather and leather alike footwear
  • 19% rubber/canvas footwear
  • 7% plastic footwear and
  • 4% accessories, garments, etc.

Bata is earning a major chunk of its revenue from leather products that is a high margin business as compared to rubber sandals and hawai chappals. This augurs well for the company. Accessories and garments have been recent additions, but it is unlikely that this category will grow considering the huge competition already present in the market.

Of the total revenue earned from leather footwear:

  • Men’s segment contributed 40-45%
  • Women’s segment 25-30%
  • Kids segment 11-13%
  • Sports segment 15% (approx.)

The executive shoes range for men’s segment has helped Bata in taking the pole position in organised shoes category. But the company lags its competitors in the kids’ and sportswear segments. It is trying to increase its market share in the women’s segment, but it will not be a cakewalk given the competition in this category as well.

According to market studies, nearly 75% of the market for women and kids’ footwear is unorganized. In its 2011 annual report, Bata India’s Chairman also stated that the organised footwear brands have less penetration in the ladies footwear segment mainly due to the complex buying behaviour of Indian women. As such the business model is unlikely to change easily.

Marketing Analysis
Bata being a retail company, it is better to make an attempt to assess the company’s strength on Kotler’s 4Ps of marketing – Product, Price, Place and Promotion.

Product: Bata has positioned itself as a one-stop family store for all footwear and related products. It provides to vast consumers various footwear lines under both international and national brands such as Hush Puppies, Marie Claire, Mocassino, Ambassador, Comfit, School, Quovadis, North Star, Scholl’s, Weinbrenner, Bubble Gummers, Baby Bubble, and Power.

Since shoe is a need-based product, there will always be a demand. But of late there is more effort on the part of company to focus on the premium range considering the growing consumerism. Although Bata does not enjoy the kind of monopoly it had during the late 1980s, considering its long history, high brand recall and extensive product portfolio, it is one of the formidable players.

Price: Bata has adopted a multi-pricing strategy by providing to its customers a value proposition strategy. It has moved away from the classic ‘Bata Pricing’ approach because it is now targeting the high-end customers along with the middle-class segment that is its main target audience. The present pricing approach where Bata is promoting various sub-brands under its umbrella brand has helped in projecting it as a family brand as well as a fashion brand.

Place: Bata has a strong distribution network, which is one of the strengths of the company. It has a retail network of over 1,200 stores and around 30,000 dealers. The company is on an expansion spree. In the last five years, it has opened 350 stores and renovated 200 existing stores. The company has also decided to be more visible in shopping malls, open up to the franchisee model and also create the shop-in-shop experience in multi-brand stores.

Promotion: Bata does not promote much by advertising. The selling & distribution expenses don’t account for a major cost. Unlike its competitor brand Liberty that has enrolled Hrithik Roshan for brand endorsement, Bata is not following that approach for promotion as of now. Thus, it is saving on exorbitant TV advertising cost.

Bata is mainly promoting through point-of-purchase material. It has revamped its stores to look more contemporary, shedding its age old image. It is also re-positioning itself as a market-driven, fashion-conscious lifestyle brand with an emphasis on service and production.

Financial Analysis
As seen from the table below, there is constant improvement in financial profile of the company driven by steady increase in Sales at an average annual rate of 16%. There is also a sustained improvement in net profit margins, which increased from around 5% in 2007 to over 9% in 2012. This has led to sharp increase in profits that jumped up nearly 4 times in these last 5 years (2007-12).

Between 2007 and 2012, Bata employed an average capital of Rs 4,327 million in the business and earned revenue of Rs 10,047 million.

And though the profits have grown at an average annual rate of 29% between 2007 and 2012, profit growth has not been steady all these years.

The net profit growth dropped to just 10% in 2009, and then it shot up over the next two years, to finally see a fall in 2012. It will be interesting to see how the company fares in the current slowdown (2013).

Nevertheless, as mentioned in the annual report, Bata has taken the following actions to improve its margins:

1. Cost rationalisation: Bata’s margins have improved because of rationalisation of employee cost, closing down of non-performing stores, and through outsourcing of several functions.

2. Outsourcing: Over the last 5-6 years, Bata has increased the outsourcing of labour-intensive work while retaining machine related operations. Increasing focus on outsourcing of labour-intensive operations has led to rationalization of employee cost and continuous improvement in profitability.

3. Business restructuring: Bata launched a massive restructuring exercise in the year 2006. It closed down 363 cash-drain stores and remodelled about 300 stores in the last 5 years. As a result, revenue per store increased from Rs 50 lakh in 2006 to more than Rs 100 lakh in 2011.

In addition to these factors, significant value was unlocked from the exit from the real estate project at Batanagar, Kolkata.

Capital Management

  • Bata has achieved growth in profitability without diluting equity or by incurring debt.
  • Entire capital expenditure in 2010 and 2011 has been funded through internal accruals.
  • Bata also had cash and bank balances of Rs 156 crore at the end of 2012.
  • Current ratio has shown consistent improvement; it was around 2x in 2012
  • Being a retail business, the inventory comprise mainly of finished goods. The growth in inventory is not very alarming and is keeping in tune with the sales growth.
  • The current production is comfortably below the installed capacity, so no major capex is expected soon.
  • There is a small contingent liability of Rs 47 crore that has declined from Rs 64 crore from the corresponding two years.

Return on Equity
Charlie Munger, Vice Chairman of Berkshire Hathaway has said the following on the importance of return on equity on shareholder return…

If the business earns six percent on capital over forty years and you hold it for that forty years, you are not going to make much different than a six percent return.

With increased profitability, little capex requirements and dividend payments, Bata has managed to increase its return on equity from 20% to 25%.

Further, the Du-Pont analysis shows that Bata has not relied on financial leverage to increase its ROE.

It has gradually increased its net margin to improve its profitability, which is a good thing. Net profit margin acts as a safety cushion; the lower the margin, the less room for error.

Since margin has gone up, the asset turnover remains stable. The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover (for most businesses; either it’s a high margin business or a high volume business).

Nevertheless, an asset turnover of around 3x augurs well for the company.

So Far So Good
While, all the financials and business performance discussed so far indicate a positive story for Bata, it’s important to note that things were not so hunky dory always.

Bata has had a history of losses and the company came out of woods not once but twice.

First time in 1996, Bata achieved a turnaround by posting a positive bottomline of Rs 4 crore. Earlier, the company had decided to wean away from traditional strongholds in the middle and lower footwear segment to woo the premium segment…a strategy that backfired resulting in the huge losses.

In order to cut its losses, the company even sold off its corporate headquarters for Rs 19.5 crore.

Then, the company again suffered a series of losses. For three successive years (2002-2004) it posted net loss of Rs 74 crore, Rs 26 crore and Rs 63 crore respectively. Sales suffered due to workers’ agitation at its factory in Batanagar over the issue of wages.

The company had to weather serious labour issues. In the three rounds of VRS offered around 2004, Bata reduced its employee count by 1,600. Apart from VRS, a turnaround strategy was undertaken which included focus on mass consumption products, flexible marketing, tighter cost controls, and better asset management.

Key Challenges
Here are the key challenges worth noting in case of Bata’s business…

  • Highly competitive industry characterized by strong presence of the unorganized sector and intensifying competition in the organized segment, likely to keep margins under pressure.
  • Significant price volatility in raw materials, especially in imports due to recent rupee depreciation, which may affect margins if the company is unable to pass on the increase in raw material prices to the customers, especially in the low-end segment.
  • It is also facing stiff competition from imports from countries like China, Indonesia, Thailand, Vietnam & Brazil, because their products are more competitive as compared to India.
  • Bata also faces headwinds with the entry of MNCs in the domestic market. Already many international brands are available in India after the opening of FDI in retail. International brands like Clarks, Pavers and other players have been making their presence felt at malls, high street locales, and airports and also online. India is on the cusp of consumption growth, recent slowdown notwithstanding. Bata has been trying to push its premium range and this strategy will be tested severely with the onslaught of FDI in retail.
  • It is often seen that many retail players often struggle to strike a balance between increasing their bottomline and maintaining volume growth. Uncertain business and economic environment, drying up of capital inflow and ever increasing competition collectively pose serious challenges to the established players in the market.

100% of the information you have about a company represents the past, and 100% of a stock’s valuation depends on the future.

Ideally, I would have liked to end my analysis over here. I am with Asif here who while reviewing Gruh Finance did not elaborate much on valuation part.

After all, we are putting a statutory warning at the start and not giving a valuation target can be the ideal way to prevent any biases creeping into the mind of investors regarding evaluation of the stock.

But still, I have tried to value Bata’s business, and you may consider this the trickiest part of my analysis.

But first I would digress a bit.

Warren Buffett wrote the following in his 1993 letters to Berkshire shareholders – “There’s no business like shoe business.”

This was in the context of the purchase of Dexter shoes that Buffett made this statement. He further wrote to the shareholders that I can assure you that it is a business that needs no fixing; it is one of the best-managed companies that Charlie and he have had seen in their business lifetimes. Berkshire paid US$ 433 million for Dexter Shoes. Rather than use cash, Buffett used Berkshire Class A stock to fund the purchase.

But, 15-years later (2008), this is what Buffett said about Dexter…

To date, Dexter is the worst deal that I’ve made. What I had assessed as durable competitive advantage vanished within a few years.

Now I am not comparing Dexter Shoes with Bata. The point I am trying to make is that everybody, even the investing greats, can be wrong in their judgement of business. And it is sometime difficult to assess the future performance of even a simple business.

Anyways, Bata is currently trading at Rs 815 (as on Sept. 2), and with shares outstanding of 6.4 crore, it has a market capitalization of around Rs 5,200 crore.

After deducting cash value of Rs 154 crore, we get an Enterprise Value of around Rs 5,050 crore. With profit before tax (PBT) of Rs 250 crore, we get a pre-tax yield of 5% (250 divided by 5050).

This is half of the yield available on the benchmark Govt. bond at present. Also, at current price level, the P/E ratio comes to around 30x, which is again on a higher side. Price-to-Free Cash Flow is also around 40x.

Overall, the stock seems fairly rich in valuation on traditional parameters. In fact valuing the stock on the basis of last 10 year average EPS, we get a figure of around Rs 330 per share. However, it must be noted that past figures would have been affected by macro environment like interest rates, low market base etc.

I have not used traditional DCF and Dividend Discount Model. The company has started giving dividend since 2007 and it is too short a period to assess the longevity of dividends.

Also, the company is in an expansion mode and so it is better to reinvest the capital into the business and earn superior returns for shareholders. Also the trouble with discounted cash flow or dividend discount is that most of the value is from year four or five into the future and not the next few years.

It is difficult enough to predict future especially for a growth business like Bata. Changes in the assumptions for the later years can substantially alter today’s value.

Disclaimer: I, Manish Sharma, am not invested in Bata shares, but I wear Bata shoes so I might be biased in my analysis. 🙂

Readers are advised to do their own independent assessment before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.

Safal Niveshak StockTalk: Gruh Finance

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Asif Nadaf.

1. About Gruh Finance
Gruh Finance (formerly Gujarat Rural Housing Corporation Limited) was set up in 1986 by HDFC with the objective of providing institutional structure to rural housing finance. HDFC owns around 60% stake in the company and provides it equity support. Gruh’s major focus is to provide home loans to individuals and families for purchase, construction and extension. It also provides loan for repair and renovation of houses. The company has a distinct target market segment, which complements HDFC’s market.

Association with HDFC
HDFC helps GRUH in many ways which include enabling funding at competitive rates, operational support, management support, operating policy, lending policy, loan sanctioning norms and loan schemes. GRUH benefits immensely by using well-established stringent credit appraisal and monitoring systems and processes, strong risk management systems and efficient recovery mechanisms of HDFC.

Although both GRUH and HDFC operate in the same industry, GRUH focuses primarily in the rural and semi-urban markets. This segment is distinct from HDFC’s target segment. GRUH also cross sells HDFC products.

Nature of Industry
There are three types of industries:

  1. There are industries where only one or two players take away most of the profit eg. Google, Yahoo or NSE and BSE
  2. There are others where nobody makes profits e.g. Airline industry.
  3. Finally, there are industries where every player makes money. Housing finance (HFC) is one of them.

The success of an HFC is very much dependent on two things, as aptly described in the book “The Richest Man in Babylon” – Safety of principal and safety of interest.

Safety of principal is dependent on nature of collateral and value of collateral. Safety of interest is dependent on nature and ability of borrower to make timely payments.

Any HFC faces three broad risks:

1. Market risk is the risk of losses in positions arising from movements in market prices. HFCs face two broad type of market risks. There is adverse movement in price of collateral and high loan to book value (LTV).

After a loan is given, the value of collateral diminishes. For example, a bank gives a home loan of Rs 30 lac and after some time, the value of home declined to Rs 20 lac. In India, given that property prices have continued to rise in the past, HFCs have not faced risk on this account..

LTV is the ratio of loan given against the value of the collateral. The lower the ratio, the lower the market risk. In simple words, the market risk for an HFC reduces when the gap between the market value of collateral and loan taken is large. For example, if for a property worth Rs 50 lac a loan of Rs 20 lac is given, the market risk is low. On the other hand, if for a property worth Rs 50 lac, a loan of Rs 48 lac is given, the market risk is high for the HFC.

In case of Gruh Finance, the LTV is less than 80% for approximately 78% of the properties financed so far and LTV greater than 85% exists only in case of 4% of the properties financed. Therefore, the overall market risk remains low for the company.

2. Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs.

Credit risk could be mitigated by stringent credit appraisal of the borrower by HFCs. Credit appraisal looks for ability and willingness of borrower to make timely payment.

Non-performing asset (NPA) is a measure of strength of credit risk policies and processes.

An NPA is defined as a credit facility in respect of which the interest and/or installment of principal has remained ‘past due’ for a specified period of time. In India, an asset is considered an NPA when the HFCs do not receive interest and/or principal for a continuous period of 90 days. If a borrower stops payment of EMI for 3 months, the bank considers the loan (asset) as non-performing.

For Gruh Finance, asset quality remains above industry average due to low gross non-performing assets (Gross NPA) and low Net non-performing assets (Net NPA).

3. Operations risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

Examples of operational risk include fraud by employees, theft of information, hacking damage, third party theft and forgery, account churning, damage to assets due to disasters, system failure, accounting errors, and negligence. Correct operational risk policies and processes increase asset quality and decreases non-performing assets as seen above.

The profit and NPAs of two HFCs are quite depended on processes and policies defined for each of the above risks. HDFC is the best amongst housing companies for managing each of the three risks. Gruh, being a subsidiary of HDFC, has simply copied the processes and policies for managing the above three risks from its parent.

2. Checklist
I’ve analyzed GRUH by answering a few important questions that span its:

  1. Business performance,
  2. Financial performance,
  3. Management quality, and
  4. Competition.

Before we move ahead, here are the symbols that I’ve placed against each checklist point and that will tell you at a glance whether I have a positive or negative view on that particular point.

   Indicates my positive view

   Indicates my negative view

Let’s get started.

A. Business
1. Can I, in simple words, explain what the company does?
Yes. Gruh is a housing finance company where HDFC owns a 59.7% stake. Its major focus is to provide home loans to individuals and families for purchase, construction and extension in rural and semi-urban India. It also provides loans for repair and renovation of houses. The success of HFCs is highly dependent on managing market risk, credit risk and operational risk. The policies and processes covering these three risks determine both safety of principle and adequate returns.

2. Does the business have high uncertainty?
The inherent nature of Gruh’s business is not uncertain. Once a loan is given, it keeps receiving EMIs for the duration of loan which is usually between 10 to 20 years.

3. Has the business got an enormous moat?
Gruh has a weak moat. However, an HFC’s business comes under the service sector and there is scope for number of players to operate with decent profit. One moat here is switching cost. One incentive to switch to other HFC/bank would be lower interest rate. However, the interest rate of HFCs/banks do not differ significantly to offer this incentive. Also, a borrower who wants to transfer loan to other HFC/bank has to put in lot of efforts in doing the paper work. The pain of going through this paperwork during the switch does not compensate with the gain to be received by extra savings to be made by lower interest rate.

The second advantage for an HFC like Gruh is that the policies and processes designed to manage market, credit and operational risks differ from HFCs to HFCs. Gruh has stringent policies and processes for lending, copied from its parent HDFC, which are best in the industry.

4. Does the business generate strong free cash flow?
Yes. Since Gruh does not have to invest in any plant and machinery and also does not have to hold any receivables or inventory, whatever cash it generates from operations is almost free cash. Most of its assets are free cash and book value closely resembles liquid assets.

As can be seen for the year 2013, the fixed asset of approximately Rs 12 crore is very low compared total asset of Rs 5,600 crore. It means whatever profit after tax is generated (Rs 42 Cr in 2008 to Rs 146 Cr in 2013) is almost free cash.

5. What is the bargaining power of suppliers and buyers?
Gruh borrows from various entities – National Housing Banks, commercial banks, debentures, etc. – to meet its short-term and long-term borrowing requirements. Since the rate of interest charged by all HFCs/banks are not significantly different, the rural and semi-urban borrowers do not have bargaining power.

B. Financial Performance
6. Does the business have a consistent sales and profit growth history and is there room for future growth?
Gruh has an excellent track record of financial performance…

  • Both gross and net NPAs have been one of the best (lowest) in the industry.
  • Net interest margin is high compared to peers
  • Loan assets have been increasing steadily over the years.
  • Average annual growth in Profit after tax has been 28% for the past 6 years, which is quite robust

As far as the future is concerned, given the continuous demand for new residential housing in semi-urban and rural India, I do not see mush problem on the growth front for Gruh, though growth may not be as high as in the past owing to the higher base.

7. Does the company have a good dividend history?
Good enough. In terms of dividend payout (amount of dividend paid as percentage of net profit), Gruh has averaged around 60% over the past 10 years, which is a good payout.

8. Has it got a high and consistent return on equity?
Yes. A company’s return on equity is akin to you earning a certain amount every year on your investments (no paper profits but actual dividend and interest income plus any profit on sale of investments). Looking that way, Gruh’s average return on equity of 27% is a good number. This is reflective of the good yield its investments have earned for it over the years, which has largely been a result of an overall good performance by the stock market.

C. Management Quality
9. Is the management known for its capital allocation skill and integrity?
Being a HDFC group company, there is no doubt that Gruh has a management that considers integrity as a core business value. As far as capital allocation skill is concerned, that is reflected in the good 27% average return on equity the company has earned over the years.

As can be seen, the retained earnings is approximately 60% and balance is distributed as dividend.

10. Has there been any substantial equity dilution in the past?
No. Gruh had seen a 30% increase in its outstanding equity shares in the year 2006-2007. This was on account of rights issue in the ratio of 3:10

11. Are management’s salaries too high?
During the latest year, the Managing Director was paid gross remuneration of Rs 1.7 cr. This is around 1.19% of the company’s net profit and thus not a big figure.

12. What has the management done with the cash in the past?
Gruh has, over the last ten years, distributed around 40% of earnings as dividend and balance was reinvested in the business. The average return on equity has been around 27% and it has increased over the year. It means the, management does not hesitate to return the money to shareholders in the form of dividend, instead of employing them in business when returns are not going to be good.

D. Competition
13. Does the business face high competition?
As of now, not much, as there are not many big players catering to the rural and semi urban market. However, when these markets grow in future, many big players would enter them to gain market share.

14. Has the management focused on market share or profitability in the past?
Looking at good capital allocation decisions, decent return on equity, high asset quality and low NPAs, the management as focused exclusively on profitability.

3. Future Prospects
Gruh operates in seven states – Gujarat, Maharashtra Karnataka, Rajasthan, Madhya Pradesh, Chhattisgarh and Tamil Nadu. The bulk of revenue comes from Gujarat and Maharashtra. These two states accounts for 76% of its loan portfolio. Gruh has a total of 134 retail offices and employees strength of 517 in these seven states.

There is enough room for growth for the company in the future. Gruh has the financial strength and support of its parent HDFC to expand and establish branches in remaining 21 states. Looking at India’s growth story, the future growth in housing finance would come from rural and semi–urban market and Gruh is well establish to take advantage of this opportunity in future.

4. Risk Statement
Gruh’s business, when purchased at a good buying price can provide a great amount of stability to an investor’s portfolio. The one risk that remains very high is the price paid to acquire stocks.

I am not sure after the retirement of Mr. Deepak Parekh, how the new head of HDFC and Gruh would be able to carry the legacy forward. Remember what happened to Infosys after Mr. Narayan Murthy retired; he had to be called back to lead the company after the gap of seven years. Essentially, the company is too much dependent on the vision and management skills of its founder.

5. Financial Snapshot

Disclaimer: I, Asif Nadaf, have no position in the company or in any company related to the promoter group. Readers are advised to do their own independent assessment before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.

Safal Niveshak StockTalk: Godrej Consumer Products Ltd.

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Abhishek Jain.

About GCPL
Godrej Consumer Products Limited (GCPL) promoted by Godrej group is a household and personal care products company. Godrej group owns around 64% of equity and the company is professionally managed. Through international acquisitions, the company has built a sizeable international presence in Africa, Latin America, Indonesia and the UK. Its overseas businesses now account for 40% of revenues.

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Over the past decade, GCPL has evolved from a domestic market soap manufacturer to a diversified emerging market MNC. The proportion of soaps in GCPL’s consolidated revenues has reduced to ~20% in FY13 from 63% in FY05.

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Safal Niveshak StockTalk: TCS

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Nishanth Muralidhar.

About TCS
Tata Consultancy Services (TCS) is one of India’s leading IT services companies, with the backing of one of the most valuable brands of India – the Tata Group. It is India’s biggest IT service company by employee headcount, as well as the biggest by revenues currently. TCS was also the first IT company in India to achieve revenues of US$ 10 billion.

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Safal Niveshak StockTalk: Cairn India

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Sridhar V. Sridhar owns the stock, so the following analysis may be biased. Be careful!

Cairn India is one of the largest independent oil and gas exploration and production companies in India. It, along with its joint venture partners, account for more than 20% of India’s domestic crude oil production.

The company is primarily engaged in the business of oil and gas exploration, production and transportation. Its average daily gross operated production was 205,323 BOE (barrels of oil equivalents) in FY12-13. The company sells its oil to major refineries in India and its gas to both PSU and private buyers.

Business overview
The oil exploration and production business is a high-risk venture globally, and investors need to be aware of this.

The business involves bidding for projects based on initial assessment of potential resources, which may or may not materialize or get fully exploited.

In layman terms, it is difficult to assess with precision as to exactly how much oil exists below the ground. However, players having the right skills and technical know-how have a reasonable estimate of the resource potential, and how they can exploit it.

Further, it’s a highly-capital intensive activity, where the gestation period of a project can range anywhere between 7-12 years or more.

Nature of industry
As mentioned above, the business itself is challenging because it’s a long-gestation activity, highly capital intensive, requires high technical skills & project experience, etc.

Further, revenues are subject to two factors – the amount of output and oil price.

The government may have certain restrictions on the amount of output, and it may also impose royalties on the producer.

Further, oil prices are benchmarked to international oil prices, hence there is oil price risk plus foreign exchange conversion risk in a company’s dealings with customers.

In simple terms, revenues are linked to international oil prices quoted in US dollar per barrel, and gets converted into Indian rupees, thereby getting exposed to oil price and forex risks.

Key players: ONGC is the leader in the Indian oil & gas exploration and production industry. Then, there are companies like Oil India, Reliance Industries, Essar Oil and several other players.

Cairn is not an oil marketing or distribution company, hence we are not discussing about HPCL, BPCL, etc. here, though these companies also might have exploration arms/units.

Exploration and production companies are also referred to as upstream oil companies, and marketing/distribution companies are known as downstream. (I tried my best not to use such complex terms -but if you read them elsewhere, this might be of help :-)).

Competition: Competition comes from large players such as ONGC, RIL, etc. However, crude oil being an essential commodity with more demand and limited supply in India, these companies can be expected to have a stable pricing.

Petrol, diesel, LPG and kerosene are subsidized in India, and the subsidy burden is taken up by ONGC, the largest exploration and production behemoth in India.

Private players are not affected by this subsidy burden, hence those including Cairn, RIL, etc. have a significant edge over PSU players.

Cairn is contributing to about 25% of the domestic consumption as per recent estimates.

A major portion of our oil supply is from imports and predominantly from Middle Eastern countries such as Iraq, Saudi, Qatar, and Kuwait.

Paying for oil increases the import burden and also widens the Current Account Deficit. The situation worsens when the payment has to be made in US dollars because the rupee deprecation increases the outflow of foreign exchange.

Hence, the Indian government is taking steps to encourage domestic production and aiming to have a better energy security for the country. This is a positive for players such as Cairn, ONGC, and RIL.

Entry barriers: The industry has high entry barriers given the huge upfront costs required (that run into billions of dollars), uncertainty about reserve potential and actual results, environmental and social impact, permissions or approvals from Govt., royalty to Govt., etc. Some point are discussed below under the “Moat” heading.

Cairn’s financial performance
1. Growth in Revenue, Profits: Before you start questioning the numbers, remember that Cairn is relatively a new player in the oil and gas space. And this business takes several years to break even, and profits come in after this stage.

This is the cause for the change from negative to positive numbers during 2006, 2007 and later periods.

All figures in Rs Crore except %; FY change in 2008 has been incorporated in FY09

As the business has gained stability and with steady growth in the number of wells and output in Rajasthan, the potential for growth is high.

Cairn’s sales and profit growth have been excellent over the past 2-3 years, and we can expect moderation in future. But I hope the consistency would remain.

I don’t want to paint a rosy picture, but if some new production happens, and if government gives approvals for higher output in future, we can expect accelerated growth for the company.

Even if we take a conservative 15-20% annual growth in sales, it would add consistent earnings to the company’s cash reserves.

The company’s margins are pretty high, since the project is now commercialized and is in a steady growth state.

2. Returns on Equity/Capital: Cairn’s ROE and ROCE during FY12 were 16.4% and 18.1% respectively. I did some calculation based on March 2013 results and the ROE comes to around 25% for FY13.

We still need to wait for the annual report to get a better insight into this. However, looking at the past trends, I see improvements though it may not confirm the rule book.

The opportunity for returns to improve is high, and if you understand this business, Cairn has crossed the introductory, exploration stage and is in the production and commercialization mode in many wells across Rajasthan Block.

Given the long-term nature of the business, the growth will continue for several years until it reaches a saturation point.

3. Moat: You might think that a moat is irrelevant here given that this is a commodity-oriented business.

Of course, Cairn deals with a commodity, but think of it as a toll-bridge, or a company selling products that must be purchased for essential needs. If you want to use petrol, diesel, LPG, kerosene, petrochemical products/byproducts, etc…you will somehow end up buying this commodity which is short is supply.

Moreover, this is not like other commodities which can be recycled and reused.

Once you use it, it’s exhausted – it’s a non-renewable resource. Whether you drive a car or two wheeler, you will be paying for fuel. And similarly for cooking gas, inverters, generators, and machinery (factories), you will be using fuel that is derived from crude oil.

We cannot go back to “bull and cart” era and neither can we do without fossil fuels, as solar, wind and other forms may not replace traditional fuel so quickly. So there is a demand and it is durable and sustainable.

Secondly, not every company can get in to oil and gas exploration. The Rajasthan block that is explored by Cairn and ONGC in a 70-30 Joint Venture is one of the biggest resources in India (probably KG basin might get closer to it).

How many companies in India can set up a block like Rajasthan or the KG basin, which requires enormous investments that are in the range of billions of dollars?

Finding a block itself is not easy, and if you found one you need multiple approvals, environmental clearances, huge capital, employee base, etc. So there is a hurdle/wall which makes it difficult for several competitors to enter.

4. Potential: The Rajasthan basin is estimated to have over 7 billion barrels of oil per day, and Cairn is currently producing roughly 200,000 barrels per day. So there’s a huge growth potential ahead for the company.

5. Debt/Leverage: Cairn is debt free and is capable of generating a stream of free cash flows in future.

How’s the management?
Cairn’s management quality is sound and consists of a strong team of technical and managerial personnel.

Last year there was some news on management changes when Rahul Dhir left Cairn to pursue another assignment. However, with the entry of Vedanta, the results have been positive as they retained the same brand, experts, technicians, and managerial personnel.

So, despite the entry of a new promoter, the business model and its functioning are running well.

If you are not a great Vedanta fan, you don’t have to agree with me, but Cairn’s functioning style is completely different from those of Sterlite, Hindustan Zinc, Sesa Goa, etc.

What’s the valuation?
A. DCF (using free cash flows): Rs 385

Historical Cash Flows: This is just to understand the past trends and have a base to start with.

Note: The year 2008 has been left blank because due to the FY change in 2008, the numbers are incorporated in year 2009. For example the financial year ending in 2008 December has been extended to March 2009 and has been incorporated in 2009 figures. Prior to 2008, the company’s financial year ended in December. The cash flows in the past have been inconsistent due to the development stage of the projects.

A brief of my assumptions are below.

  • Free cash flow (or Owners Earnings) from 2013 (estimated) till 2022 have been considered. Stage 1 Growth: 15% (for years 1-5). Stage 2 Growth: 10% (for years 6-10) – based on production growth trends
  • Discount rate: 15%
  • Terminal growth rate: 5% (after 10 years)

Here are the FCF estimates for the next ten years…

The present value of future cash flows and terminal value comes to Rs 385.

B. Dividend Discounting & Terminal Book Value Method: Rs 330

Key assumptions:

  • Book Value Growth: 7.3% (average of last 6 years)
  • Current Book Value: Rs 253 (consolidated for 2011-12)
  • Estimated Book Value as of Year 10 is based on 7.3% growth over 10 years.
  • Risk Free Rate: 7.3% (10 year govt bond yield as on June 14, 2013)
  • Dividend: Based on dividend for 2012-13 being taken as a conservative figure for future years. Not a good estimate, but on a conservative basis we can expect dividends to remain constant or grow gradually

All figures in Rs Crore except %

C. Relative Valuation method: Rs 570
Production assumptions under this method are:

  • Rajasthan – 180,000 barrels of oil per day (bpd)
  • Ravva – 21,000 bpd
  • Cambay – 4,500 bpd

Other assumptions:

  • Oil Price: $80 (Cairn sells at 10-15% discount to brent, and a lower price to account for commodity cycle risk)
  • No of production days: 300 (assuming lower working hours, holidays, etc)
  • US-INR Rate: Rs.54

Disclaimer: Most of the above analysis involves estimates about future business environment, which may or may not materialize, hence readers are requested to do their own due diligence.

Final Intrinsic Value
In summary, here are the approx. intrinsic valuations calculated as per various methods…

  • Discounted free cash flow – Rs 385
  • Dividend discount & terminal book value – Rs 330
  • Relative valuation – Rs 570

Based on these, the fair value range for Cairn’s stock comes to around Rs 365 to Rs 425 per share.

Assuming a margin of safety of 30% to the average of this range, the safe purchase price for Cairn is Rs 275.

Don’t ignore the risks!
Crude oil price dependence: Cairn’s revenue is based on crude oil prices, and any decline in oil prices can impact the revenues.

Foreign currency risk (Rs. Vs $ rates)

High cost of exploration: This can be a challenge if there are unexpected costs that add up making the project less profitable.

Judgment of reserve estimate: The approach taken by Cairn in judging estimate has been reasonable or on the conservative side.

Govt. approvals/permissions: This is an integral part of the business, and also serves as a Barrier to Entry. Given that we are an energy-deficient country the Government realizes the importance of exploration and has been encouraging the sector. However, getting timely approvals can be a challenge. If the business plans and execution is good then getting these approvals in place should not be an issue though it can be time consuming.

Potential shale oil supplies: Recently the US as well as other countries have initiatives shale gas exploration, which is a different method of exploration that is expected to bring in new supplies. Sale exploration involves fracturing from rocks below the surface. If there is a bumper output from shale production, oil prices can decline, and competition may arise. However, the above is mitigated to an extent because shale exploration process is highly complex, expensive and the costs involved will motivate suppliers to price oil higher, because the process is currently more expensive than conventional exploration. (I’m not an expert in this – someone from oil industry can comment on this.)

Demand: Some industry experts view that demand may reduce or saturate, and there are talks about shale boom leading to high supply-low demand situation. But if we look at India itself, which is within our Circle of Competence, the demand for fuel is very high – be it for petrol, diesel, gas variants, etc. I recently heard from local autowala that CNG prices have been increased on various occasions. And they still have to use it as CNG has fitted vehicles are becoming common.

Challenges and barriers mentioned above such as high cost, uncertainty, environmental or social issues, royalty fees, etc. are sometimes discouraging many global players in to venture in to this space. Nevertheless Cairn, BP and several other are exploring select pockets of opportunity.

Recent developments
The company’s Chief Executive P. Elango recently said, We plan to drill more than 450 wells in Rajasthan block over a three year period, a significant increase from the current rate of 25 wells drilled in FY2013.

“The Rajasthan block’s current production is at around 175,000 bpd (barrel’s per day). We expect to exit FY2014 with a production in the range of 200,000-215,000 bpd.”

Cairn’s current production comes from five fields – Mangala, Bhagyam, Aishwariya, Raageshwari and Saraswati. The Mangala field, the management has said, is producing at plateau rates of 150,000 bpd.

Aishwariya commenced production in March and is expected to ramp up to approved rate of 10,000 bpd over the next few months.

Bhagyam, the second biggest oilfield behind Mangala, is expected to ramp up to the approved rate of 40,000 bpd by the second half of current fiscal.

Disclosure & Disclaimer: I, Sridhar V, hold Cairn as part of my personal portfolio and may have recommended to others. Readers are advised to do their own independent assessment and take professional advice before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.

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Safal Niveshak StockTalk: MCX

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Sunny Gupta.

Most tribesmen reading this would know about the business moat (read how a business moat looks like) and its importance, and how identifying businesses with strong and durable economic moat is key to investment success (when properly combined with other important ingredients like margin of safety).

It is also evident that businesses that possess strong and durable economic moat tend to have little competition, high margins (or return on invested capital, ROIC), low working capital needs and low to zero debt.

[Read more…]

Safal Niveshak StockTalk: Amara Raja Batteries

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Read any legendary investor on his key rules of picking up great stocks, and a parameter that will stand at the top of the list will be to seek out companies that have no or less competition, and operate in an environment that allows for steady and rising sales, profits, margins, and return ratios.

Such companies are far and few to be found in a hyper-growth, hyper-competitive, and hyper-entrepreneurial market like India.

Amara Raja Batteries Ltd. (ARBL) seems like one of those companies on the face of it. But does it really pass the test of a safe, profitable business from key angles that a sensible investor would look from?

What about the valuations? After all, even if a business is good, what determines an investor’s long-term returns is the price at which he buys that good business.

Let’s try to find all this by understanding ARBL’s business, the industry it operates in, factors that are working well for the company, and ones that can go wrong.

First, the Business
ARBL is India’s leading industrial and automotive battery maker, and is a joint venture between the Galla family (26% stake) and the US battery major Johnson Controls (26% stake).

It is the second largest manufacturer (after Exide) of valve-regulated lead-acid batteries (VRLA; also known as “sealed battery”) in India, and finds companies from the automotive (~50% of total revenue) and industrial (~50% of total revenue) sectors as its key customers. Its key battery brands include Amaron, PowerStack, Quanta, and PowerSleek.

As per its FY12 annual report, ARBL had…

  • 46% share of the Indian telecom batteries market (28% five years back)
  • 32% of UPS market (23%)
  • 26% of four-wheeler market (23%)
  • 19% of four-wheeler aftermarket or replacement market (12%)

In order to understand ARBL’s business deeper, it’s important for us to understand the nature of the oligopoly or duopoly market, which is characterized by just 2-4 firms competing against each other…like the Indian industrial and automotive battery market where ARBL and Exide are the two dominant players.

One of the economics models that studies the duopoly market is called the “Bertrand Model”, which suggests that, in a game of two firms, each one of them will assume that the other will not change prices in response to its price cuts.

In other words, firms compete by setting prices simultaneously and consumers want to buy everything from a firm with a lower price (since the product is homogeneous – like a car battery – and the consumer does not incur any costs in searching for the products).

If two firms charge the same price, consumers demand is split evenly between them.

Now, while this is not true of the Indian industrial and automotive battery market as of now – Exide has a much greater market share than ARBL – things are definitely looking to head in that direction. If t his were to really happen, it will be great for ARBL given that its market share will increase at the cost of Exide till both companies have an almost 50% share.

A crucial assumption of the Bertrand model is that both firms have the same constant unit cost of production, so that marginal and average costs are the same and equal to the competitive price.

My analysis of operating and margins of both ARBL and Exide suggest that thing do fit into these assumptions, as both companies have almost identical average operating and net margins over the past 5-6 years (though ARBL has witnessed some weakness off late owing to higher Lead prices, which I will cover later).

Now, from duopoly, let us understand a bit about oligopoly that also characterizes a very few firms competing against each other.

Here are a few key characteristics of the oligopoly model (text in italics is as per Wikipedia), and how the Indian automotive and industrial battery market stacks up on each of them…

1. Ability to set price: Oligopolies are price setters rather than price takers.

This seems to be working for ARBL and Exide, though only to a limited extent. As I will discuss below, the companies have not been able to pass through the entire raw material price hike to customers…and especially over the past 2-3 years owing to some squeeze from its large customers, especially in the automobile industry.

2. High entry and exit barriers: The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms.

This is true for both ARBL and Exide. These two have been leading the industry for years now, with no meaningful competition from any other player.

Just ask yourself – in car batteries, you must have heard of just two brands – Exide or Amaron – and throughout the past.

3. Number of firms: “Few” – a “handful” of sellers. There are so few firms that the actions of one firm can influence the actions of the other firms.

This is also true of the Indian automotive and industrial battery market, where both ARBL and Exide seem to be tip-toeing the line, depending on what the other is doing. First ARBL caught up with Exide in terms of branding and reach…and now Exide is doing in terms of capacity expansion and technology upgradation.

4. Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits.

This is great news for both ARBL and Exide. Given their relationships with leading automotive and industrial consumers, quality of their products, and the relatively low price of their products (compared to the consumer’s total product cost; a car battery costs just Rs 3,000-5,000), they are in a great position to earn good profits over the next many years.

5. Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm’s market actions and will respond appropriately.

It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining how to achieve his or her objectives.

For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold existing prices constant.

Again, this is true in case of ARBL and Exide as we will understand in the analysis below.

6. Non-Price Competition: Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition.

True again for ARBL and Exide. Both these companies have maintained prices close to each other’s products and largely compete on branding and special schemes for distributors and direct consumers.

Now, while this is great for ARBL because Exide will not be able to outperform it in terms of margins and growth in the long run, the negative side is that even ARBL won’t be able to lead the changes in the market for long, and neither outperform Exide on profitability on a sustainable basis.

In fact, despite the big difference in their respective revenues (ARBL is 50% of Exide’s sales), their margins are almost similar and return ratios also tend to move in tandem.

Overall, being in an oligopolistic market can turn out to be a huge positive for ARBL in the long term, but with the limitation that its only competitor Exide is not going to sit quietly.

Anyways, let’s now turn to how things are going specifically for ARBL as of now.

What Looks Good?
Here are a few factors that are working out fine for the company as of now…

1. Sales & profit growth: The duopoly nature of the market has benefited ARBL as it just has one competitor to fight, which it has done bravely over the past five years. This is given that, while Exide has grown its sales and profits at average annual rates of 16% and 34% respectively over the past five years, the growth for ARBL has stood at 22% and 61% (though on a lower base).

Rising earnings serve as a good catalyst for stock prices, which has been highly true in the case of ARBL. So it’s important to seek companies with strong, consistent, and expanding profits. Also, more important than the rate of growth is the consistency in such growth. While ARBL’s profit has grown in spikes over the past few years, I won’t consider it too volatile for discomfort.

As per some estimates, the Indian battery market is worth Rs 100 billion, with the automotive battery segment accounting for over 65% of the overall market value. While VRLA batteries have a 25-30% share, lead acid batteries dominate the market with a 70-75% share.

The market is growing at an average annual rate of around 15%, which I believe is going to provide enough growth opportunities to ARBL. The company has set its eyes on Rs 40 billion in sales by FY16, which seems quite achievable as it needs to grow at just 10% to achieve that.

Unless raw material prices don’t play spoilsport, I don’t see any issues in ARBL also growing its profits at a decent pace during this period.

2. Moat: While both ARBL and Exide have moats around them – brand recognition, stickiness in demand, distribution, and steady client relationships – ARBL has done better to grow its moat over the past few years.

This is clearly seen from the company’s steady gross and net margins (at 32% and 10% respectively in FY13), even in the face of rising cost of raw materials – which is Lead in this case.

Lead is the biggest raw material for battery companies, and forms around 85% of ARBL’s total operating costs…and 60% of sales. The rising prices of this commodity has been a tad negative for the company in the past as it has been unable to pass on the entire cost hike to customers given the slowdown in overall demand, and steady competition from Exide.

Exide is better placed on the raw material front. Lead forms less than 70% of its total operating costs and 45% of sales. This is given the company’s secures a part of its lead requirement from its captive smelters, which ultimately help it benefit on the cost front.

Anyways, the reason ARBL has not seen a major dent in its margins despite higher raw material prices is because of a steady decline in its sales and marketing costs, which stand at under 7% of sales currently, down from 11% a few years back. A declining sales and marketing as percentage of sales also gives an indication of expanding moat as the company is spending less to not just cover its turf but also grow its business steadily.

Finally, I did some scuttlebutt among my friends, a few car dealers, and on the Internet on ARBL vs Exide. The former (ARBL) seems to be winning hands-down in terms of user experience, and price versus value equation.

So the brand moat certainly seems to be working for ARBL, as seen from the faster growth in its sales volumes – 25% average annual growth in units sold during FY08 to FY11 – as compared to just 10% for Exide, though the latter’s volume sales are three times of the former.

3. Capital efficiency: ARBL’s deepening moat is also visible from its steady and marginally higher return on equity, which stood at 27% in FY13, up from less than 20% six years back. During the same period, Exide has seen its return on equity decline from 20% to 18%.

Overall, the capital allocation track record of ARBL has been good in the past, with steady and high return on equity, no acquisitions, and reasonable dividends (payout has averaged 15% over the last five years).

When assessing companies on these parameters, especially RoE, it pays to look at consistency. ARBL scores well on this test, plus its RoE is now better than the industry (Exide).

The low capital intensity of the battery industry has also helped ARBL in earning good returns in the past. The company, for instance, spent a total of Rs 460 crore as capital expenditure during the six year period of FY06 and FY12. Against this, it earned revenue of Rs 2,360 crore in FY12.

4. Balance sheet strength: ARBL, like Exide, also has a clean balance sheet with negligible debt. The entire capacity expansion over the past few years has been funded through cash generated internally, plus the company has also been left with steady positive free cash flows (at least over the last five years).

The batteries industry also has a small working capital cycle, which is seen in case of both ARBL and Exide. ARBL’s average receivable and inventory days have stood at 56 and 47 over the past five years (as compared to 30 and 75 respectively for Exide).

So, if you were to go by Warren Buffett’s rule of seeking out companies with conservative financing, ARBL will clear the test – on both fronts of clean balance sheet, and steady positive FCF.

What Can Go Wrong?
1. Overconfidence in its abilities: The biases that we individuals suffer are also imminent at group and corporate levels. This can especially be said of companies that have witnessed a recent spurt in growth and that too against the tide of slowdown in its consumer industries.

I see ARBL sailing in this boat, and it comes our clearly from the company’s FY12 annual report (the latest available), where the management writes – “We have created a business plan with stretch targets. We are confident that we will be able to catalyse growth and meet aggressive targets through stronger capabilities.”

While there’s no doubt that the company finds itself in a good position as of now as far as its capacities and future demand assumptions are concerned. But if the slowdown in automobile and telecom industries were to persist for some more time, it can create some problems for the ARBL.

We already saw some hints of that in the just concluded FY13, when margins came under some pressure as the company was not able to pass on the hike in Lead prices to consumers, owing to slowdown in demand plus increased competitive pressure from Exide.

2. High Lead prices can play spoilsport: A large part of ARBL’s sales and profit growth over the past few years have been driven by volumes – more batteries sold – than better prices.

So, between FY04 and FY11 for which data is available, while ARBL’s volume sales grew at 36% per annum, selling prices improved by just 3% per annum. This is despite that Lead prices rose by 18% per annum during the same period (FY04 to FY11).

So a clear-cut pricing power is not seen for the company, which is largely the case of competition from Exide, which sails in the same boat.

Anyways, a sharp rise in Lead prices can negatively impact ARBL’s profits and margins going forward, especially given that Lead forms around 80% of the company’s total operating costs and thus has a great bearing on margins.

What is more, the impact of higher Lead prices will be greater on ARBL than Exide, as the latter has its captive smelter capacities at its service that help it absorb some of the price hike.

What about the Management?
Given ARBL’s performance over the past few years, and especially the stability in its margins and return ratios, I am comfortable with the management’s execution capabilities and capital allocation skills.

However, there are two things worth mentioning about here…

  • ARBL’s Managing Director Mr. Jayadev Galla’s salary in FY12 was around Rs 17 crore, which was almost 10 times the salary earned by the MD of Exide, a company more than twice the size of ARBL. In fact, even the MDs of ARBL’s two big customers – Maruti Suzuki and Tata Motors – earn salary of Rs 3 crore and Rs 4 crore respectively, despite that these companies are much-much bigger than the former. This is a clear case of excessive compensation in ARBL.
  • Just to mention, the company’s management has a stake in Andhra Pradesh state politics, given that the MD’s mother is a minister in the state government. 🙂

Read through the Comments sections below for some more risks associated with ARBL, and a few corporate governance issues that cast doubts on the management.

I find it easy to value companies that have simple businesses and simple balance sheets.

Of course, there is a great probability that whatever valuations I work up won’t come out right (that’s the most interesting part about valuations :-)), but still I’ve tried to assess ARBL’s valuations.

I am not explaining how I arrive at these different valuations, as the calculations are all there in the excel sheet I shared earlier…just that I have done some slight modifications here and there in my valuation calculations to adjust for the sound business quality and competitive moat of ARBL.

So here are my valuations for ARBL based on different methods…

  • Average P/E Ratio Valuation – Rs 180
  • Earning Power Value – Rs 280
  • Discounted Cash Flow – Rs 320
  • Historical Earnings Growth – 325
  • Sustainable Earnings Growth – Rs 330

Some assumptions I have used for DCF calculations are:

  • Growth in FCF – 15% for first five years, and 10% for next five
  • Discount rate – 12%
  • Terminal growth rate – 2%

Based on this, my fair value estimates for the stock stand at Rs 250 to Rs 290.

On the face of it, ARBL looks fairly valued at this point in time, unless and until you want to be brave and buy the stock without any consideration for what Ben Graham said were the three most important words in investing – MARGIN OF SAFETY. That could be dangerous!

Anyways, just one more thing about ARBL’s valuations – the stock is currently trading at a price-to-earnings (P/E) multiple of 15x as compared to Exide’s 20x. In fact, ARBL has always traded at a discount to Exide largely on the back of the latter’s better-established presence in the industry.

However, if you were to consider the last few years’ P/E charts for both the companies, the discount is reducing. This is not just because Exide now commands a lower P/E multiple as compared to its past, but also because ARBL’s base P/E multiple has also risen to cover the gap.

Till ARBL does not do something really foolish, continues to be a simple business like it is now, and maintains a good growth record and clean balance sheet, I see the gap reducing even further. This could provide a fillip to the stock’s long-term returns, but only if you buy it after taking into account sufficient margin of safety.

You see, sensible investing is always about using “folly and discipline” – the discipline to identify excellent businesses, and wait for the folly of the market to drive down the value of these businesses to attractive levels.

You will have little trouble understanding this philosophy. However, its successful implementation is dependent upon your dedication to learn and follow the principles, and apply them to pick stocks successfully.

Never forget that, as an investor, it’s important to focus on decisions and not outcomes.

When I combine ARBL’s business quality with its valuations, I get a good business at fair valuations, which leads me to wait for a lower price before I can own the stock.

You don’t have to agree! 🙂

In the Comments section below, let the tribe know of your own analysis of ARBL…and also share your feedback, if any, on my report.

Before I close, here’s some information about the upcoming StockTalk reports.

I have received an amazing response from tribesmen for the proposal to collaborate to write StockTalk.

Based on the responses I have received and with a view to cover companies from diverse sectors, here is the list of upcoming StockTalk coverage so that you are prepared with your own analysis to participate in the discussion. This covers the next six months’ coverage…

If your name is in the list, please send me an email at vishal[at], so that I can contact you directly to discuss the report format, deliveries etc.

If you chose to write a StockTalk but don’t find your name in the list above, please don’t feel bad as I will include you in the next list after this six months period is over.

StockTalk 2.0: Let’s Do What Buffett Did

In an interview with Warren Buffett in 1993, Adam Smith, author of Supermoney, asked how the small investor can find good investment ideas.

Buffett said, “I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities, and that bank of knowledge will do him or her terrific good over time.”

Smith asked, “But there are 27,000 public companies! Where should one start?”

Buffett replied, “Well, start with the A’s.”

Fifty years ago, when Buffett was starting out as a new investor, he was not the go-to guy if you wanted to sell your company or raise capital for your failing bank.

[Read more…]