Vishal Khandelwal

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.

Valuations?
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]safalniveshak.com, 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.

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…] about StockTalk 2.0: Let’s Do What Buffett Did