Ben Graham, the Father of Value Investing, writes the following at the start of Chapter 37 of Security Analysis…
In the last six chapters, our attention was devoted to a critical examination of the income account for the purpose of arriving at a fair and informing statement of the results for the period covered.
The second main question confronting the analyst is concerned with the utility of this past record as an indicator of future earnings.
This is at once the most important and the least satisfactory aspect of security analysis. It is the most important because the sole practical value of our laborious study of the past lies in the clue it may offer to the future; it is the least satisfactory because this clue is never thoroughly reliable and it frequently turns out to be quite valueless.
These shortcomings detract seriously from the value of the analyst’s work, but they do not destroy it. The past exhibit remains a sufficiently dependable guide, in a sufficient proportion of cases, to warrant its continued use as the chief point of departure in the valuation and selection of securities.
In other words, while a company’s past track record may give you no clue about its future, it remains a sufficiently dependable guide for selection of stocks.
Graham then goes on to explain the concept of “earnings power”, which he says has a definite and important place in investment theory. He writes…
It combines a statement of actual earnings, shown over a period of years, with a reasonable expectation that these will be approximated in the future, unless extraordinary conditions supervene.
The record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle.
This is where I start my analysis of Crompton Greaves, India’s leading manufacturer of power transmission and distribution equipments, and also a household name for its fans and light bulbs.
Crompton Greaves has been part of my portfolio for more than a year now.
If you look at the company’s last few quarters’ results, it might seem like a bad decision to hold on to the stock or to even think of adding more.
After all, here is a business that is loss-making at this point in time and has been weak and inconsistent for the past many quarters.
If the business’s poor performance is not enough, there are concerns that the current French CEO is leading the company to even worse times. To top it all, the management’s decision to buy a private jet costing Rs 270 crore in 2011 (which they sold off later at their purchase price) is still fresh in investors’ minds.
If that was not enough, the company’s non-executive vice-chairman sold his entire holding in the company after he stepped down as its Managing Director on June 2011.
Anyways, thanks to all these concerns, the stock is on its way down…and is currently trading at the same level as in May 2009, and March 2007.
The stock’s P/E based on its past 3-years average EPS is around 15 times (assuming a marginal loss in FY13).
Anyway, coming back to earnings power, here is how Crompton’s 10-year net profit chart looks like…
Now, if I am looking to invest first time in Crompton Greaves, and see this chart as the first financial indicator of the company, I may not look further and drop the company from my radar…especially after knowing that it has posted a net loss in the latest nine-month period.
But given that I have some ideas about the strength of Crompton’s brand name in the power transformer industry and also its rising clout in the consumer durable industry (fans and lights), I will try to figure out whether the company can return back to normalcy as far as its profitability is concerned.
Here is a past record of PBIT margin (a measure of profitability) for Crompton’s key segments…
This shows me a good picture of the company’s past profitability, which has been in a rising trend expect for the last two years.
Even when I consider the last two years, the PBIT margin of each segment was above 10%, which is a good number for most industries in such bad times for business.
Now, considering the company’s great past track record in terms of profit growth and profitability (margins), and the weak last two years, how much confidence should I put on the company’s earnings power, or the ability to earn at least the highest earnings of the past in the future?
Well as Graham writes, it would depend on how the past has been.
Look at the performance of two companies that Graham writes about. Let’s call them Company A and Company B. Here is a chart comparing their past EPS numbers…
As you can see from the chart above, the average EPS of Company A for a 10 year period has been US$ 4.36, while the same for Company B is higher at US$ 4.75.
So which company has a better earning power?
This is what Graham wrote…
The average earnings of about $4.50 per share shown by Company A can truly be called its “indicated earning power,” for the reason that the figures of each separate year show only moderate variations from this norm.
On the other hand the Company B average of $4.75 per share is merely an abstraction from ten widely varying figures, and there was no convincing reason to believe that the earnings from 1933 onward would bear a recognizable relationship to this average.
When I re-look at Crompton’s past 10 years’ EPS, and exclude the last two years, I see a gradual rise without any major aberration. This creates a sense of trust in the company’s future, that its earnings power has the capability to return to normalcy after the current state of weakness.
But can past indicate the future?
In order for a company’s business to be regarded as reasonably stable, it does not suffice that the past record should show stability. The nature of the undertaking, considered apart from any figures, must be such as to indicate an inherent permanence of earning power.
Thus, as is stresses upon, a company’s quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
So what does the quality of Crompton’s business tells me.
I look at the following key ratios to assess the quality of the business. Again these numbers are from the past but tell me a lot about how good or bad the business quality is.
- Crompton’s debt to equity ratio has average 0.6 times over the past 10 years. The number was less then 0.3x in the latest year FY12.
- The company’s debt burden ratio (debt to FCF) has been under 3x (excluding two years with negative FCF), which again adds to my comfort on the balance sheet front.
- Net current assets (Current Assets – Current Liabilities) have been comfortably greater than the total debt, which suggest enough liquidity available to the company.
- Excluding the impact of acquisitions, if I look at the company’s standalone 10-years EPS growth, it has clocked an average annual rate of 62%. Even after removing the very low base of the first of these ten years, and looking the last 9-years performance, growth has been strong at 38%.
- The company has recorded no net loss over the past 10 years. There has been a loss in the first nine-months of this year, but given that engineering companies have a generally strong fourth quarter, the company can turn out a small profit for the full year FY13.
- As for free cash flow (FCF), the number has been negative in just two of the last 10 years.
- Working capital situation is comfortable. Inventory days are at 40 days while debtors repay in about 100 days, which are again good numbers for a capital goods company. What is more, there is a history of minimal doubtful debts, which means the company has recovered all money from its customers.
- Cash is not too high on the balance sheet, but enough to repay its entire short term borrowings.
- Return on equity and return on capital employed have averaged around 28% over the past 10 years.
One concern that most people have with Crompton is its series of acquisitions over the past eight years, starting from that of Belgium-based power transmission equipment major Pauwels Group.
The company then acquired Microsol of Ireland in 2007, Sonomatra of France and US based MSE Power Systems in 2008.
As far as my understanding goes, Crompton has not overpaid for any of these acquisitions. The chief reason the company has acquired overseas is to bridge the gap in technology and product portfolio that it had with its MNC peers in India like ABB, Siemens, and Areva T&D.
The acquired companies have contributed tremendously to Crompton’s growth and profitability. The company’s subsidiary revenue has, for instance, grown from Rs 16 billion in FY06 to around Rs 50 billion in FY12 (average annual growth of 20%).
More importantly, the operating margins of these overseas businesses have improved from around 5% in FY06 to around 11% in FY11.
Even if you were to look at the company’s balance sheet, as we have discussed above, it has not been burdened by these acquisitions.
Goodwill on consolidation of subsidiaries is currently Rs 588 crore, which is not a large part of the company’s total asset (Rs 8,765 crore) or equity base (Rs 3,611 crore).
So far so good.
Now what ails Crompton?
Let me now talk a bit about some concerns Crompton faces in the short to medium term.
The company, in the latest quarter ended December 2012, incurred non-recurring (or one time) restructuring costs of around Rs 200 crore. This includes Rs 120 crore of employee cost liability owing to laying-off employees in its Belgium plant, and Rs 80 crore of other restricting costs.
The company reduced these costs from their operating profits, which ultimately led to a net loss.
The management has indicated that the restructuring is complete and the Belgian operations are expected to stabilize this quarter onwards.
My concern relates to the timing of the actual pickup in business for the company’s Belgian and other international operations, which have been reeling under pressure owing to extremely weak economic conditions out there.
Then, the situation in the Indian power transmission and distribution market itself needs to improve for the company to see a good revival. Order intake over the past few quarters has slowed down, and this will revive largely in line with the overall recovery in power and industrial spending.
Crompton’s return to any stable earnings power hinges on these two events panning out positively.
One positive fallout of the restructuring of the international business, as the management thinks, is the huge savings in costs in the future and thus higher profitability.
I would however wait for costs savings to actually start benefiting the margins before being happy about this fact.
Anyways, despite the weak situation in Crompton’s power business, one thing working positively for the company is the sustained growth of its consumer goods business, and the tremendous improvement in profitability this business is seeing. Crompton is gradually expanding capacity here, which will aid future growth.
Graham strikes again!
Coming back to Graham’s Security Analysis and what he says there about earnings power, one thing that will play a big role in whether Crompton is able to see a strong revival in its earnings power is the company’s “pricing power”, if there will be any.
If I were to read its FY12 annual report, the company is finding it difficult to pass on the rise in raw material prices to end consumers, largely due to weak demand.
Here is what I read in the annual report, which says it all about the pricing pressures in the industry…
In the last eighteen months, power equipment prices came under severe pressure with many Chinese and South Korean manufacturers attempting to increase capacity utilisation by offering rock-bottom quotes to major global customers. The good news is that such intense competition may have passed. Buyers have understood which players can deliver quality, and those who cannot.
Equally, it is important to note that no power equipment manufacturer or solutions
provider will enjoy the kind of prices and margins that were the norm for half a decade leading up to FY2010. Companies will have to be more productive and competitive; and focus on bundling equipment as a part of selling end-to-end solutions. Your Company is no exception to this reality.
While I like Crompton’s honesty in accepting that it is no exception in the price war that the power equipment business is seeing, I am worried that it may take some time for the company to return to normalcy as far as its earnings power is concerned.
But again, here is what Graham writes in Chapter 38…
We must consider such indications as may be available in regard to the future selling price of the product. Here we must ordinarily enter into the field of surmise or of prophecy. The analyst can truthfully say very little about future prices, except that they fall outside the realm of sound prediction.
So without looking at the future and whether Crompton will continue to face a better or worse pricing situation, let me value the stock considering just its past numbers, and some estimates on cash flows.
- Based on DCF, after assuming 6-8% growth in FCF over the next 10 years and keeping a discount rate of 14%, I get a intrinsic value of Rs 76 for the stock.
- Graham’s valuation gives me a value of Rs 117.
- Average P/E ratio valuation is around Rs 260
- Earning power value is around Rs 77 (assuming average earning power to be average of last three years EPS)
Based on this, and assuming a 25% margin of safety to the average of low (Rs 90) and high end (Rs 135) of the fair value range, I get to a comfortable buying price of about Rs 85 for the stock. This is around 8% lower than the stock’s current price.
Purely from a Grahamian perspective, Crompton scores well in terms of expected return to earnings power, has good enough liquidity on balance sheet, and valuations based on both P/E and P/BV (price to book value) are low.
I believe Crompton will enjoy at least an average future if not a great one, and the valuations seem to be discounting all that.
Now, can valuations get even cheaper? How I wish I had some predictive powers!
Anyways, given its product portfolio, strong brand name, technology bought through acquisitions, and safe balance sheet, it is reasonable to expect that Crompton will continue to survive and will participate in the good and bad times in the future.
Coming to the concern about the current CEO who investors worry is trying to make the future worse for the company, I will rather go by what Buffett says – it’s better to bet on the long-term strength and prospects of the horse (business) than the jockey (management).
Of course you still need to worry about the management’s integrity while choosing a stock, but I see Crompton as a much lesser evil among scoundrels hiding inside India Inc.
Rest, it’s your call.
By the way, let me know in the Comments section below the concerns that I may have missed out on Crompton, and that can jeopardize the company’s future and earnings power.
One technical concern you may have is regarding the promoter’s share pledging, but that’s not really a big concern. Anything else?
Disclaimer: I have a decent history of making mistakes as far as stock analysis is concerned. So please don’t believe that this time will be any different, and thus take your own call. It’s after all your money. Don’t put me in the line of fire in the future, whether you lose 10% or 50% in the stock discussed.
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