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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Nice to know someone has conviction in Crompton. One concern I have is share pledging. Do you see this as a major issue?
Vishal Khandelwal says
Not really Salil, as the promoter – Avantha Group – is looking to fund its power projects using money raised by pledging shares. The balance sheet is strong so I won’t be much concerned here, till they misuse the money.
Segment-wise EBIT margins are for standalone or consolidated? Because on a consolidated basis, company’s EBIT margins always hovered around 10-12% and in FY 2012 it dropped to 5.5%. Hence wondering how segment wise EBIT margins are way higher than for company as a whole!!
One good thing about crompton’s acquisition is it never raised equity in the last 10 years and bought all of them through cash generated internally.
Vishal Khandelwal says
Then how do you explain discrepancy??
Arun Ramakrishnan says
In this tough macro environment, the firesale of pledged shares is leading to some very distressed valuations in midcaps and smallcaps. As Lynch once remarked, people should have the stomach to tolerate a 50% loss in their scrip due to such extreme events 🙂
Thanks to Vishal for picking up ideas that are kinda contra in nature.
Manish Dhawan says
good work with the analyses. however just couldn’t ignore the underlying tone of managements disgust for being in a bad industry. to quote Warren Buffet, ” When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact “.
Capital goods business would always feel the heat from countries with better technology and cheap(er) labor force. Its a never ending battle, something like berkshire hathaway textiles.
I believe what not to do is more important than what to do in Investment. I am staying away from this counter.
Crompton Greaves is way too complex company with 3-4 business verticals whose future business performance is difficult to predict with high degree of certainty or probability. Another things promoters holding is only about 20 % excluding pledged share (1- 2 years back it used to be above 40 %). If promoters themselves don’t have faith in the business any amount of analysis does not work in indian conditions due to poor regulation and implementation of corporate governance issues. My limited understanding of indian market says that in more than 95 % cases in indian market if promoters holding is less than 40 % (except may be Tata group companies or Banks) companies stops working for shareholders benefits and promoters start milking the company at the expense of shareholders and putting it as some forex loss or restructring loss etc (examples are plenty like Suzlon, Punj lyodd, Crompton Greaves, opto Circuit, Pantaloon etc to name a few all of them are considered companies with sound fundamentals only few years back) . Most of indian promoters is capable of destroying a great business into a junk business for their greed in small amount of time. So my advise please dont touch any company having pledged share by promoters because in long run it is not likely to give good investment return.
SG Jaclyn says
Pledging by generic outlook appears to bad activity similar to using complex derivatives. But some of the pledging activity by the promoter may simply be to get cash which can be used purposefully. I have seen the instance of Godrej Consumer Products promoters pledging their shares during the 2008 period and probably subscribed to the rights issue which was on at the same time. In a years time period they were able to use the borrowed money to the maximum benefit. So each transaction should be judged objectively. That doesn’t mean, I vouch for what the CG promoter has done.
SG you may be correct and this special case may fall under remaining 5 % cases (or it just case of good luck like wockard scenario etc). But getting good investment return probability is very less in such scenarios after investment. Another thing a company share price can fall upto 50 % due to business reasons or macro situations but share price of company falling from 400-500 levels to sub 100 levels means some serious unfair practice by company promoters and top management unless major change in technology etc makes the company product or services unsuitable for current market. I am of the view that in a company where promoters holding is less than say 20 % , without taking into confidence more than 80% shareholders, they should not have any rights to take a decision on restructuring etc which can have serious financial considerations for majority shareholders. In USA and other developed capitalistic market usually if promoters and top management under performs for 2-3 years they usually thrown out of the company or they exist their business gracefully by selling but in india promoters try to stick with the companies even if they no longer suitable to run the business or worst still try to steal from company at the expense of majority shareholders and dumping losses unto them.
Doesn’t Crompton needs too many things to go right for itself?
I started looking at the business since it was being thrown away by many investors but found that there were too many moving parts for my liking, making predictability that much harder
Though in a different sector (but still depending on the return of the investment cycle), I prefer something like a Voltas which at least in my mind is more surer of delivering and improving on previous years growth numbers as the tide turns
Vishal Khandelwal says
Thanks for sharing your view, Rishit.
Overall the analysis seems to be thorough but i have few doubts about the assumptions taken.
For calculating intrinsic value, last 3 year FCFs have been averaged, but in my opinion 2010 and 2011 were best years of crompton greaves in terms of earnings and cashflows. So are we taking right assumptions for calculating future valuations? In my opinion, crompton greaves might prove to be right and might come out of distressed situation with flying colors in coming years but the clarity on their core business is still doubtful in current scenario.
Valuation is perception based, and I think its still not undervalued to be lucrative buy keeping all considerations in mind.
Vishal Khandelwal says
Thanks for your view, Vikas. All valuations, as I have always maintained, are wrong. 🙂
I am assuming 6-7% net margins in long term with 10% growth in sales…In this case stock might yield 8-10% returns in the long term.This is just my amateur estimate.
What is the reason Google Finance quotes EPS as 0.61 and P/E as 156.79 ?
Vishal Khandelwal says
They may be right SP as the latest year has been pretty bad for the company owing to restructuring losses. Regards.
Caution! You have given an outright sales pitch here.Such articles will suck you back into the guessing game.
Vishal Khandelwal says
Not one, there are two sales pitches here – 🙂
1. My research on Crompton, which is a worthless pitch until the buyer (reader) does his own research.
2. Lessons from Graham are still valid today, which is the worthwhile pitch and I would love if my reader buys into it.
As far as getting back into the guessing game is concerned, well I have held on to my anchors tight and they won’t allow me to get sucked anymore. 🙂
Whatsup Prahalad says
there is a big differentiator.. that is “Peak energy” The day’s of Cheap energy are over which is a big game changer…
Wealth has been defined in terms of “Energy consumed”
Two people travel from point A to point B
The amount of energy consumed for travelling from point A to Point B determines the wealth of a person..
Similarly the basic needs are “Food clothing and shelter”
but the wealth of the person determines the amount of energy consumed for these basic activity.
Every one aspires for being wealthy.. but with the direct correlation of wealth with energy .. populous nations like China (1.35billion) and India (1.2Billion) aspiring for US (315 million)Standards of living will put a very large strain on the world wide energy situation..
In this race to be wealthy.. the real problem is the reduced availability of abundant energy sources..
look at the energy density of petroleum with other sources of fuel.
There are skeptics who say.. there is no “peak oil” but look at the news in the media..
– Saudi Arabia plans to become a 100% renewable energy nation
If you have a natural spring next to your house.(oil for Saudi’s) .which provides you with pristine drinking water..
Would you: Dig a hole 200ft deep to extract water and then filter it for making it fit for drinking? NO!! (why build acres of solar farms which need to be maintained physically? from dust and debris and energy density of solar is equal to rounding error of oil..)
(oil in saudi fields are depleting.. but if they announce it.. they will be hard pressed to sell the remaining oil.. who will invest millions of dollar to setup a refinery if there is no availability of oil 10yrs hence?..)
(would you buy a car if the govt announces fuel rationing will start from 2020??)
Everybody must have seen the panasonic advertisement “Little less is always better”
A Consumer Goods company with a tag line “A Little less is always better”!!
The fact is we are already passed from an “energy abundant world” to “Energy deficient world”
which means we are past “Peak prosperity”
Please visit the following “Peak prosperity” site and must see the “Crash course”
Pls read the following article about german army report.
The original German Army report: (Germany is one nation which has the maximum percentage of its energy needs being supplied from renewable’s)
Univ of Calif SantaBarbara report: Peak Energy Climate Change and collapse of global civilization
As much as I like what Vishal is doing with his life and most of all sharing his wisdom/insight..
The real problem is a future is an “Energy Deficient” world.. and CG inspite of being the best will have to scale down. hence an avoid
What we really need to work on is a sustainable development (not GROWTH but DEVELOPMENT i.e. Zero Growth but development)
for India.. unfortunately .. keeping the “Peak energy” under wraps.. and assuming a “everything is fine” attitude/fascade
the industry(business) and the govt is doing a disservice to the public of India.
we need to break away and do radically different things and come out with solutions.. else we will get a “hand me down” idea from the western world.. where they will hold all the cards..and we will end up being their consumers..
I personally have moved from IT to living in a farm next to a water body.. trying my hand at farming,biogas and investing
Dear Sir – Given that a specific company is being discussed, your expounding the virtues of renewables is similar to spam. I am sure even you do not appreciate spam whether it is on a site like this or in your email. May I humbly request you to not do this to other members of the tribe. I am sure your noble work will be recognised and humanity will greatly benefit from your insights.
Your analyses is comprehensive and well referenced to Graham.
The brand is definitely strong as regards consumer durables and the demand for consumer durables should structurally grow. Unfortunately capital goods is going through a tough time and if this continues for some time (which it seems would) acquisitions and therefore profitability would be a drag. Thankfully the acquisitions were not leveraged buyouts which would have made the balance sheet very heavy at the wrong place !! Also the acquisitions seem to fill the gaps in the product offering which should benefit once demand revives.
I personally think the share at this price is worth buying but keep a watch for any increase in debt and corporate governance issues (like buying a aircraft).
Reni George says
Good evening to you,
Here i have just concluded merging 4 years balance sheet of crompton greaves and you have completed the full analysis.
Thakur eee no cholbe…..Joking
Any research done more is welcome,this would give me a more insight.
Another of graham’s great calculation was the net of net.
So if that was to be calculated then the per share price of crompton would come around Rs.28/Share
Well its really hard to find companies right now that are net of nets……that would come down during extreme pessimism……
Well lets wait and watch…..by the way as per my calculation ,I won’t mind an investment,but would still wait and have a watch
Thanks and Regards
Reni George says
Good Evening to you
On thing I would like to ask to you that if the Cash flow of the company is negative after
(a) Cash Flow from Operations
(b) Cash Flow from Investing Activities
Then What is the need to pay Dividends, you could avoid that,You could see that the Cash Flow turned negative 48.97 Crores after the above mentioned cash flow after that they borrowed
729.33 Crores in way of long term borrowings and out of that 102.52 Crores was paid as interim dividend and 16.75 as Dividend Tax.
This is akin to taking a Personal loan and going on a Roman Holiday
Thanks and Regards
Your analysis is good. But as per current environment margins of company for next 2-3 years will remain suppressed and so NPM would be in range of 3-4%. Is it worthwhile to give company a p/e multiple of 14-15 when industry growth will be below par for next 2-3 years?
Looking at other comments and since most are soundbites without competing analysis … I shall also add my two bit. Net Cash Accruals fell off sharply in FY11. And after that it has been a downhill story.
If you see how the stock has performed, the all time high was in early Dec 2010, around 340 odd. Someone who was tracking the company and the sector could have ideally shorted seeing and interpreting limited quarterly financials data and would have been in the money like anything now … oh St Hindsight!
It is still trading at ~ 1.8x book in a sector that is so cyclical that I doubt we have seen the depths yet.
I would prefer to make 20% in BHEL any day than 200% in CG. Look at the directors’ “commission” – far too generous in my view 🙂 It is another point why non-executive directors should earn a commission when they are more or less a fiduciary for the other shareholders and earn a fixed sitting fee anyway.
Who cares? “Mummy I want to look slinky on the golf course, damn the shareholders ….”
Vishal : I happened to stumble on to your blog as I was working on a different analysis (SENSEX P/E vs returns). So far your blog has been a very interesting read. Quick question on your analysis, for the PE based on avg. 3 year EPS , are the EPSs adjusted for inflation ? and also do you think 3 year is a sufficient historical time frame (compared to the 10 used in the Shiller method)
My personal opinion is that CG would find it tough to upscale its size & business to reach the goal set by the Avantha Group.
The main issue I see hereby is that the owner with maximum nos of share is more busy in cutting ribbions, appearing on TV and travelling with young girls than running the company. Unlike other group companies like ADAG, Birla, Tatas, Future Group, Fortune Group, Caryles group etc the owners if not everyday but focus maixmum time in strategy formulation & its implementation. But in CG, the owner is a couch potato, what he does best is hire an outsider and give him power & target to achieve.
If you were to run CG in Rs. 14.5 Crs annual salary, for a signed term of 3 years with target of 1st year complete restructuring, 2nd year profit across all SBU’s and 3rd year another overseas acquisition then would you honestly do this job at Rs43.5 Crs or make a fraud, eat company’s money and run after an year with Rs. 35 Crs with salary & subsequently join some other MNC at annual paypackage of Rs 18-20 Crs?
Who cares what Avantha or Thapar wants, what matters most is what people want !!
Samja Kya! This Frenchie is going to pull off every Indian’s undie in this company.
Your confident on this company Paid has been Paid.that is it out performed Nifty.But it under performed in wide margin to it’s own competitor HAVELLS. Refer this.
Post demerger which one has more potential for growth?