AuthorRohit Chauhan

About
Bharat Electronics Limited (BEL) is the largest defense equipment company in India catering to Defense services electronic requirement. BEL enjoys near monopoly status in supplying high-tech defense products like radars, sonars, communication equipment, electronic warfare equipment to the armed forces. Other division manufacturing civilian products supplies communication equipment to the telecom industry, voting machines etc.

The defence sector contributed to 76% of the revenue and the rest was from the civilian sector.

The company has a government mandated near monopoly for the defence sector business. In addition foreign vendors as a part of localization are required to source from BEL

Financials

The company has shown considerable improvement in financial performance. Topline has grown by 10% p.a for the last 5 years. The net profit has however grown by almost 20% p.a during the same period.

The higher bottom line growth has been driven by an increase in net margins from 10% to around 17% in 2008. Total Asset ratios have improved from around 8.2 to around 9.2 in 2007. The Wcap is negative or zero and the inventory turns have also improved 2.1 to 3.3. Only the recievables ratio has dropped from 3.1 to 2.5 in 2007.

The management seems to be aware of this and in 2007 has indicated that this was mainly due to incomplete projects and should improve in the current year.

The company is a cash rich company with cash net of debt of around 2200 Crs which could improve further in the current year.

The ROE seems to be steady, however net of cash it has been improving and the Return on incremental invested capital has gone up a lot.

Positives
The financials have improved substanially in the last 5 years. The net margins and Return on capital has gone up. The company has considerable cash on books. In addition the company spends almost 3-4% on R&D.
The company has introduced almost 25 products and systems in 2007. The company plans to continue this pace of new products in the future too.
The company has an order book of almost 90000 million in 2007 which is equivalent to 3 years of revenue at the curent rate.
The company will also benefit from the mandatory offset clause where in foreign vendors have to procure some portion of the contract from BEL.

Risks
The margins have gone up from 10% to around 17% in the current year driven by Raw material cost reduction. I am not sure how sustainable this improvement is. The long term average is still around 10-12 % and the current rise could be temporary.
The defence spending dropped around 1996-1998 time period and the net profits were low during that period. It looks unlikely that the government would drop defence spending now, however the risk remains.
Competition is very low in the defence sector, however the other segments do have some competition.

Competitive analysis
BEL is one of those rare companies which have very substantial competitive advantages. These advantages are government mandated and I find it diffcult to see how these will go away. Across the world there is a preference for domestic companies for defence contracts, more so in india.

Valuation
With an assumption of current growth and margins, the Intrinsic value comes to around 2100 Rs/ share. However a senstivity analysis of margins and topline gives the following numbers
Topline – 10%, margin – 10-12 % (long term average): 1650
Topline – 14%, margin – 10-12% : 2200
Topline –14%, margin – 17% : 3300

The central point for the intrinsic value seems to be around 2000-2200.

Conclusion
The company seems to be trading at 30-40% discount to instrinsic value. This is however not a sexy company. This is a company with substantial competitive advantages and will continue to be very profitable. However I don’t expect the market to suddenly discover this company and give a higher valuation. Most likely one can expect decent returns in the long run.

I got the below comment and thought of posting on it.

Rohit,
I am not sure if abandoning HPCL is such a good idea right now. You can buy good stocks at bargain only during distressed times. First crude prices will definitely go down. its just a temporary blip and secondly government cannot afford to shut down these PSU oil companies. Definitely PSU oil companies are not a long term bet for me..but for the short term ..i guess there is an excellent opportunity as of now. I know i can be wrong.

Selling is always a difficult decision especially if the underlying assumptions change. I personally analyse my stocks every quarter and more frequently if the underlying situation changes. In case of HPCL, I was banking on two key points
– Margins will not deteriorate drastically and maybe improve a bit in the next 2-3 years as other initiatives from the company bear fruit.
– market would realize that the company sells at 20-30% of asset values and will reduce the gap

Clearly the spike in Oil prices has invalidated the first point and the second may not happen soon due to point 1. I rarely make sell decision by short term drops in price. If the intrinsic value of the company is steady or growing, I will hold on to the company for a long time.

In case of HPCL, my key concern is that the intrinsic value of the company is being destroyed on a daily basis and at a very rapid rate. Time is not on my side in this case. The current oil price may turn out to be temporary. However I am not willing to bet on that as, the longer the oil price remain high, the more the company will bleed.

Finally an investment idea needs to be compared with all the other options or ideas. As of now, I can see other ideas which are better from a risk reward perspective and hence I decided to move out from HPCL.

I had written the post below on 20-May. Since then the government has started thinking of raising the fuel prices. Note the word – thinking. The decision to raise prices is easier said than done. Even if the prices are raised, the haemorrhaging of the oil companies will reduce only partly.
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I had written about HPCL earlier see here and here

The key elements of the investment thesis was as follows

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

The key unsaid assumption was that oil would not spike sharply. Oil prices are now at 130 usd a barrel (double the levels at the time of the analysis) and show no signs of coming down. In addition , I also read the following report – oil firms weeks away from bankruptcy. Now I do not believe the oil firms will go bankrupt – technically speaking. It is in the interest of the government to keep these companies alive. However the future looks bleak for these companies for the following reasons

1. Oil prices are unlikely to come down anytime soon. So the only way the government can sustain these companies is by issuing oil bonds. To raise cash, these companies will have to sell the oil bonds at some discount , incurring losses.
2. The government is unlikely to compensate these companies fully, wanting to keep the deficeit under control. As a result expect these company to incur losses for the forseeable future. In such a scenario, I am not sure how much these companies can invest in profitable growth and other assets.
3. These companies will increasingly look like the State SEB and other power companies in the long run – forever subsidsing the consumer due government pressure and unable to grow the business or invest in it.

Key learnings

1. I was clearly wrong about point 2 in the thesis. I never expected the oil prices to spike to 120+ (if i knew, oil futures would have been a great investment) . I never expected this government to remove the subsidy (and the next government wont do that either – it is not in their self interest). However the price spike in crude will be devastating to the oil companies.
2. Ignoring key pyschological principle – self interest combined with a crude price shock. Individuals and goverments take actions which are in their personal interest. Which political party is ever going to increase fuel prices and risk losing elections. I expected the government to behave in the way it is now. However self interest combined with high crude price will hurt the companies big time. As long as the prices were 100 usd or lower, the situation was bad, but now it is dire for these companies.

The loan waiver was still a one time event (hopefully). However the above subsidy is ongoing and will hurt the oil companies in the long run (in the short run they will be compensated via oil bonds and other mechanism). The above thesis was reasonable for moderately high crude prices. However the current price shock could drive the networth to zero.

Disclosure – I am exiting my position at a small gain. HPCL has not been a big position for me. The risk reward situation was good initially. However with the oil prices shooting up, I think the risk is not commensurate with the return.

Added note : In life there is no free lunch. Till date the government has subsidized fuel by gouging the oil companies. That well is now dry. Eventually all this subsidy will have to be paid by someone. It will likely come through taxes and higher inflation (most likely a combination of both).