Comprehensive analysis of the business model of AIA Engineering and the opportunities and threats the company faces in the long run.
Statutory Warning: This is not an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I own the stock, and thus my analysis is bound to be biased due to liking tendency, endowment and commitment biases. And, of course, my analysis could be wrong. I have been wrong many times in the past.
AIA Engineering (AIA) is the second largest manufacturer of high chrome metallurgy products in the world, behind Magotteaux from Belgium. Together, these two companies account for over 80% of the market share and the rest is controlled mainly by Chinese manufacturers. The company was set up in 1979 as Ahmedabad Induction Alloys (thus the acronym AIA). In 1992, it formed a joint venture with Magotteaux, which lasted till 2001.
The products AIA manufactures include grinding media, liners, diaphragms, and vertical mill parts, all manufactured in high chrome metallurgy (collectively referred to as “mill internals”).
These products are used in the process of grinding and crushing of limestone, coal and ore at cement, mining and thermal power plants, which is a very crucial part of the production process, given that it has a direct bearing on cost and quality of the final output.
Unlike conventional grinding media, AIA manufactures high-chrome grinding media, which, as the company says, is technologically more advanced and helps in relatively higher output for the user industry. Also, high chrome metallurgy offers a lower wear rate, compared to conventionally used parts of manganese steel, hyper steel and forgings.
AIA’s products form a small component of grinding cost for its customers, but are essential for continuous production. What is more, given that failure or non-availability of such products can lead to complete halt of grinding operations, its user companies must have continuous, long-term relationships with established suppliers. And AIA, as I mentioned, is the second largest in the world and with a dominant position in the Indian market.
The global market for Mill Internals for mining and cement sectors is estimated at 3 million tonne (valued at around Rs 125 billion) and growing at 4-5% per annum.
Apart from new demand, a large part of the growth of high chrome products is also coming from the replacement market.
In fact, a significant portion of AIA’s business is derived from replacement demand as over a period of time, mill internals witness substantial wear out. While mill internals like diaphragms and liners take something like 2-3 years to wear out, parts like grinding media wear out continuously thereby necessitating regular replacements. With increasing wear out, the grinding operations become less efficient thereby adversely affecting the final output. A replacement of mill internals is thus required.
AIA currently has a capacity of 260,000 MT and is pursuing capacity expansion program to reach 440,000 MT by March 2016, which will make it the largest player in the industry, surpassing Magotteaux. A large part of its growth is focused on the mining segment where the company has found success in taking away market share from Magotteaux.
As per its FY14 annual report, the addressable market opportunity in the replacement demand of mill internals is around 1.5 million tonne annually. Against that, not more than 20% has been converted into the high chrome use, which suggests great headroom to grow for AIA.
Even when it seems that the era of super-cycle for commodities has come to an end, and that capacity addition plans for many companies are being put on hold, AIA’s prospects are more closely linked to the capacity utilization of the mines and the subsequent replacement demand which has held up well.
In FY14, India formed around 25% of the company’s total sales, with the rest 75% coming from the international markets.
Let me now analyse AIA’s business using a set of question to test the underlying business and management quality.
- Is the Business a Monopoly or Commodity?
While trying to identify great businesses, it’s important to seek out companies that have no or less competition, either due to a patent or brand name or similar intangible that makes the product unique.
While AIA may look like any other capital goods company that caters to a specific niche market, it’s important to understand that the business operates in an oligopoly market, i.e., a market or industry dominated by a small number of sellers (here, just about two of them). The pricing power of an oligopoly is not as strong as a monopoly, it’s not weak as well. AIA enjoys a strong bargaining power against its clients, given its high-end products and their critical nature to clients’ operations.
The benefit of this is seen from a continuous rise in AIA’s gross margins over the past few years, with the same improving from around 37% prior to FY08 to 44% in FY14. While I do not have comparable margin performance for Magotteaux, AIA seems to be scoring better here owing to its low cost of operations.
- Does the company have pricing power?
AIA has raised prices in the past, but the rise has just about matched the inflation rate, or around 7% annually between FY05 and FY14.
Given the oligopoly structure of the industry and the fact that mill internals are a small portion of the user company’s total cost of operations (around 2% for a cement company and 6% for a mining company), AIA is in a sweet spot to raise prices in the future, at least to keep pace with inflation in material prices.
It’s also important to note that, over the past 2-3 years, AIA has made deep inroads into Magotteaux’s market share in the mining industry through competitive pricing, which has hurt its margins a bit. With a firm presence in the industry now, and given the critical nature of its products, margins have a good probability of rising even further.
- Has the earnings growth been strong?
Rising earnings serve as a good catalyst for stock prices. So it’s important to seek companies with strong, consistent, and expanding earnings (profits). AIA has grown its gross and net profits at an average annual rate of 36% each over the past ten years. While growth slowed down during the period FY10 to FY12, it has picked up pace again over the last two years, especially after the company has moved aggressively in the mining sector. With new capacity coming on stream, and a great move towards high chrome components, the probability of growth remaining good in the future seems high.
- How profitably have retained earnings reinvested?
Apart from seeking a company that has been growing its earnings well, it’s also important to study if the company is investing its retained earnings (earnings after dividends) profitably. A great way to assess this is by assessing the return on equity. AIA’s average ROE over the past eight years has been around 21%. While this has reduced to an average of 18% over the past five years, rising pricing from the mining products business, subsequently improved margins, and lower incremental capex will ensure a stable to higher ROE in the future. The best part is that AIA’s ROE is driven largely by its net margins and not financial leverage (remember the Du Pont ratio?), which talks a lot about the management’s good capital allocation record.
- Is the company conservatively financed?
It’s important to seek out companies with conservative financing, which equates to a simple, safe balance sheet. Such companies tend to have strong cash flows, with little need for long-term debt. AIA stands good on this front, with negligible borrowings (Rs 75 crore, as against equity of around Rs 1,945 crore) and strong free cash flow generation (Rs 330 crore in FY14). Also, as far as its ongoing capacity addition plan is concerned, almost the entire requirement of Rs 650 crore is being funded through internal cash generation (the company generated Rs 465 crore cash from operations just in FY14).
- Does the company stick with what it knows?
Like you as an investor must stick to your circle of competence, a company should ideally invest its capital
only in businesses within its circle of competence. AIA stands good on this factor as well. The company is spending its entire energy in making deep inroads in the mining sector’s requirement for high chrome mill internals, which has paid great dividends in recent years. As I mentioned above, the company has strong cash flows, which are easy to waste away if the management has loose hands. This is not in case of AIA, as the management has been extremely prudent in managing its cash and spending it wisely on things it knows best.
- Does the company need to constantly reinvest in capital?
Companies that consistently need capital to grow their sales and profits are like bank savings account, and thus bad for an investor’s long term portfolio. While searching for potential wealth creators, it’s important to seek companies that don’t need high capital investments consistently. AIA is one such company. Apart from its investments in capacity expansion from time to time, the company has fared decently on the working capital part as well. Its receivable days have dropped from 100+ four years back to 75 in FY14, while inventory days have dropped from 75 to 62. The declining need for incremental capital is again reflected in its clean balance sheet and rising free cash flow generation.
- How has the management fared?
Extremely well. While AIA’s ROE in the last 3-4 years has taken a hit due to slowdown in the cement industry and competitive pricing as an entry strategy in mining, the long term track record of the management on the capital allocation front has been respectable. What is more, for all the value he has helped create over the years, the company’s founder and managing director earns an annual salary of just Rs 85 lac which is lower than what an experienced stock analyst working with a brokerage and writing a report on this company would earn. The management has remained focused on AIA’s core competency of mill internals, which also talks a lot about their mindset.
- What are the risks to the business?
While AIA seems to be in a sweet spot to capture higher market share in the mill internals business and also has a good growth opportunity ahead, there are some risks that the company faces, though not all of its own creations.
One of them in foreign exchange volatility that has hit the company in the past as well, given that a large part its revenues come from international markets.
For instance, in FY13 and FY14, the company had to incur loss on forex fluctuation of around 3-4% of its sales, which is a big number. As revenues from international business grow larger in the future, and if the currency markets remain volatile, this loss figure can also widen thereby hurting the company’s profitability.
At the current price of Rs 1,040, the stock is trading at a price-to-earnings multiple of around 22x its trailing 12-months EPS of Rs 46.4 per share. This is higher as compared to its average P/E of around 18x over the past three years. If I were to do a reverse DCF calculation, it seems that Mr. Market is assuming around 30% annual growth in cash flows over the next 10 years to justify the current stock price.
So the valuations don’t seem mouth watering at the current levels, though this is rarely expected of a high quality business like AIA’s.
In all, AIA is a great business, no doubt about that. The management also has a record of clean governance and good capital allocation. Considering this, and your own analysis of the business and its future prospects, it’s up to you to decide how much you would want to pay for the stock, which should also factor in adequate margin of safety. The idea should be to understand the business first, and then value the stock using simple variables, possibly without using complex calculations. The ultimate idea should be to focus on the decision you’ll be taking and not on the output of mathematical models.
P.S. Click here to download the past few years’ annual reports of AIA Engineering.
Statutory Warning: This is not an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I own the stock, and thus my analysis is bound to be biased due to liking tendency, endowment and commitment biases.And, of course, my analysis could be wrong. I have been wrong many times in the past.
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