CategoryCompany analysis

I had written about Lakshmi machine works earlier here. I would recommend reading the earlier post, especially the comments. The post and comments were right in the middle of the financial crisis. The stock was quoting in the 500-600 range and went down to the low 400 range in the subsequent weeks. At that price, the company was selling for slightly over cash on the books and the market was assuming that the company would go bankrupt soon.

I distinctly remember the comments and a few emails I received on this idea. The general theme was as follows
– The near term outlook for the company is horrible. As a result one should wait till the outlook is clear and then buy the stock.
– The company is barely making any profits and could be in financial trouble if the textile business shrinks further.
– The stock market gurus and pundits are advocating caution and I would prefer to wait (close to the first point).

My logic at that point can be summarized as follows
– The near term outlook was terrible and hence the stock was available at a bargain. Stock don’t sell at throw away prices if the near term outlook is great. The key point to analyse was how the company will do in the long run – that is after the downturn is over
– The company had a 60% market share in the industry and is one of the dominant players in india. They had a very strong balance sheet and good management. The company had a much higher probability of surviving than the other smaller players. On the contrary, I would say that a recession wipes out the weaker players and the stronger ones gain market share and strength due to lesser competition.
– If you listen to gurus and pundits, and don’t do your own thinking then you are likely to be in trouble anyway.

The post of LMW received a big number of hits and I think a lot of people found the company attractive.

I bet you would be thinking that I am busy patting my back !. I am not. In hindsight (which is 20/20), I think I was not aggressive enough and did not commit enough capital to the idea. I was personally quite confident of this company and a few others and still bought very cautiously. The caution had more to do with my extreme risk aversion and less with a specific idea. Anyway, I am working on that.

Let’s look at how the company performed in the last 2 years
– The topline of the company collapsed by 50% in the last 2 years
– The bottomline of the company came down by 60%+
– The return on capital has dropped, but is still at 50%+ levels (excluding surplus cash)
– Fixed asset turns dropped from around 4.1 to 2.5
– The company is still working capital negative (operations generate working capital instead of consuming it)
– Net margins have dropped from 10%+ to around 8% range (excluding other income)
– Net cash on the books (excluding customer advances) increased from 250 crs to 520 crs and total cash from 670 crs to around 830 Crs.
– The management has indicated plans to develop some land in Coimbatore (a real estate venture). This is a bit of a bouncer !

So what grade do we give the company ? I would say A and no I am not out of my mind.

In case of LMW one has to distinguish between the factors which cannot be controlled by the management (external environment and demand) and which can be controlled (their own cost structure and profitability).

The topline and bottom line dropped as expected (which is why the stock was selling for 500 and discounting this performance). However the management did a decent job of controlling the costs and still managed to generate profits during the downturn. There are very few companies which can remain profitable in face of a 50% drop in topline with a profit margin in the 10% range.

Where do we go from here?
The stock is now selling at around 2400. The company has announced a buyback to use up the extra cash, which is a good sign though not a great timing. The current price is partly discounting the expected good performance of the company.

If you assume a net margin of around 8-9% and topline growth of 10%, then the fair value can assumed to be around 2900-3100 range. The stock is slightly cheap, but not a bargain at current levels.

Balmer lawrie is a decent size holding for me and hence I make it a point to review the annual performance in detail. The annual report for the company was published recently and I have been looking at it. Following are my thoughts on the performance of the company –

I have written about the company here earlier. The company has been doing fairly well and the management has been moving the company in the right direction. The changes are not obvious from the overall results, but if one analyses the individual businesses of the company, the picture turns out to be much better.

Let me list some statistics (for last 6 years) of each of the SBU of the company and then give my thoughts on it
Industrial packaging (steel drums/ barrels etc) – Revenue growth per annum: 14%, Profit growth: 29%, Average ROCE: 18%+
Greases and lubes – Revenue growth per annum: 19%, Profit growth: 26%, Average ROCE: 15%+
Logistics (the largest division in terms of bottom line) – Revenue growth per annum: 8%, Profit growth: 19%, Average ROCE: 150%+
Tours and travels – Revenue growth per annum: 11%, Profit growth: 14%, Average ROCE: 30%+
Others (tea, leather chemicals etc) – Revenue growth per annum: -5%, Profit growth: negative, Average ROCE: negative
Overall company – Revenue growth per annum: 11%, Profit growth: 30%+, ROCE: 25%+

A few key points stand out
– The management is moving the company out of the unprofitable lines and investing into profitable businesses. They could move faster, but I still appreciate the performance as they are operating in a PSU environment with unionized labor.
– The management has improved the Return on capital for the good businesses too in the last 5-6 years. For example – logistics, travel etc have seen improvement in capital returns
– The management has paid off all the debt and has surplus cash of almost 300 crs on the balance sheet
– The management has raised dividend rapidly in the last 5 years and the current dividend is almost 4% of the CMP.

I personally think that the management has done a fairly good job of delivering good performance in tough business segments.

A few more points –
– The company has a few JVs (joint ventures) also. One of the JV (TSL) had a fraud and misreported the results for the last few years . As a result Balmer lawrie has prudently written off the investment in the JV. This has depressed the company’s profit for the year.
– The company is investing in the logistics business by opening new CFS. In addition the company has exited most of its unprofitable tea business in UK and hopefully will do so in india too.

The company should be able to make a net profit in the range of 130-140 crores for the year (including JVs). I think a conservative estimate of fair value for the company is around 1300 Rs/ share.

Perception driven investing
There is a lot of perception driven investing in the market. A lot of investors, including me, make decisions based on certain pre-conceived notions. A few of these notions are true, but some are just assumptions which have never been validated.
– PSUs do not make good investments: The assumption is that the PSU label means a poorly run government company which is always losing money. This is however always not true . There are several profitable and well run PSU such as Concor, BHEL etc.
– MNC are attractive investment: The assumption is that the MNC subsidiaries are run by well educated and professional managers. Hence they are good investments. The reality is that these companies are fairly well run, but not for the benefit of the minority shareholders. There have been a lot of instances where the top management has stiffed the minority shareholder to benefit the parent company
– Small and mid caps are risky: All stocks are risky if you don’t know what you are doing. Even walking in the house is risky, if you close your eyes when doing so.
– Rohit is smart, handsome and good looking: This is not a perception, but absolute truth 🙂 even if no one including my wife refuse to agree with it.

Balmer lawrie has suffered from a PSU discount and has always sold below fair value. At the same time it has given 35%+ returns per annum (including dividends) to shareholders who have been diligent enough to evaluate the company beyond the labels and patient to hold on to it for the long term.

I think it is important to check one’s assumptions and perceptions before making a decision. You may be surprised by what you find – that is other than the last point about me, which I can assure you is not a perception but absolute reality 🙂

A disclosure first – This is a completely borrowed idea. I originally saw this idea on Ayush’s blog and started investigating it on my own. I had some discussions with him on the phone and liked the story behind the company.

The idea is a borrowed one, though hopefully the thinking is not (Ofcourse if the idea succeeds it would become my original idea as i would conveniently forget the source in due time 🙂 ). I personally have no qualms of borrowing ideas from other smart investors like ayush (would highly recommend following his blog), though I will provide due to attribution to the original idea if I post about it.

I will not repeat some of the analysis here as ayush has done a great job of it. You can find the analysis here. Let me add some additional thoughts to the analysis

Competitive analysis
The Company has been able to sustain a fairly high growth and profitability for the last 8-10 years. The company currently enjoys a 35%+ market share in its business niche which is characterized by a large number of players from the unorganized sector.

The company has been expanding rapidly and is now enjoying the benefits of scale in production and sales. The Working capital turns have been going up steadily over the years which is an indication of the operating leverage (Fixed asset turns have not increased as much due to constant capacity addition). The company is now one of the largest company in its sector and is now exporting almost 57% of its total turnover. An effective sales and marketing organization is required to develop and sustain an export business as it requires a close relationships with the OEMs (tyre manufacturers and other users of rubber)

The competitive intensity from any large players is likely to low as this is not a big and attractive segment for any big player. The company enjoys a substantial competitive advantage over smaller player due to economies of scale, customer relationships, strong sourcing network (for waste rubber) and ability to invest in research.

Risk
The main threat is low cost import of tyres from china which can hurt the OEMs directly and Gujarat reclaim indirectly. In addition this is a very competitive industry with a lot of competitors and it is unlikely the company can earn very high profits for a long time.
The price of rubber also plays an important part in the profitability. As the price of virgin rubber has increased, the substitution by reclaimed rubber has gone up too. The substitution effect may slow down once the price of rubber starts dropping.

Competition
The company does not seem to have any major listed competitors, though there seem to be a lot of smaller competitors. A company like Indag rubber is not really a direct competitor even though they operate in the tyre industry. Gujarat reclaim provides cheap substitution of a raw material used in tyres, whereas indag provides a substitute for the end product – tyres itself (via re-treading).

Valuation
The fair value of the company can be estimated to be between 1700-2000 with an assumption of 8-9% net margins and growth in the range of 10-11 %. The company is selling at a decent discount to fair value and would be quite attractive if the price drops below 800.

Disclosure: I have a position in the stock. Please read disclaimer at end of the blog.

About
Shakti Met Dor is a leading manufacturer of steel doors since 1995. The company was established primarily to manufacture steel doors, windows, and other building material products to cater to the construction industry. Shakti has expanded its facility to 180,000 Sq.ft of manufacturing and warehouse space capable of producing 300,000 doors and frames. Shakti has seven sales and marketing branches across the major metropolitan cities in India.

Financials
The company is in a niche business and has done fairly well in the last 8-10 years. The ROE has been maintained in excess of 20% with the recent drop due to new CAPEX and higher receivables. The Debt levels have gone up due to the new capacity and due to high additions to accounts receivables in the current year.

The inventory turns has remained at around 10 turns per year and the working capital turns in range of 3.5-4 which seems the reasonable. The total asset turns are at 2.3 which is likely to improve to around 3 with the capex being completed in the last one year.
The one key area of concern is the increase in accounts receivables which is now at around 150 days. I think this needs to be watched closely over the next few years.

Positives
The company operates in a profitable niche and has been able to scale up well in the last few years. The company has been able to deliver a topline growth in excess 20% in the last 10 years and bottom line growth (inspite of the recent drop) in roughly the same range.

The company has recently completed its capex cycle and with the growth in the construction, IT and other user industries, should be able to grow well. In addition the profit margins are likely to improve in the next few years, if the company is able to reduce the debt load and control the raw material costs. The improvement is not a given, but based on the past performance likely to happen.

Risks
There are several key risks in the business. The number one risk is the delisting plan of the company (see here). The management plans to delist the company and has offered around 195/ share. The management holds 56% of the company and needs 34% more to delist. Around 100 shareholders (including the promoters) hold around 90% of the company. I do not have details of these shareholders, but if the management has an informal agreement with them, then the delisting may happen at the proposed price. The minority shareholders holding 10% of the stock will not matter much in the reverse book building process.

A consent order was passed by SEBI on non-compliance of the company of the Substantial Acquisition of Shares and Takeovers Regulations in June 2010. It seems the promoters were acquiring the shares from the market since 1998 and have not disclosed it. This information is missing from the annual reports till 2008-2009. I think this does not inspire confidence

The other risk is the increase in the accounts receivables. This may not be as much as risk as the last quarter of 2010 has seen a sudden increase in topline and hence the year end numbers could be inflated due to that. However one has to watch this number closely as the debt more than 6 months doubled in 2009 and the total debt has increased further in 2010. This increases the risk of bad debt write-offs in the future.

Management quality checklist
– Management compensation: On the higher side. Management compensation is around 12% of net profit
– Capital allocation record: Has been sensible and good till date.
– Shareholder communication – Not good. The management has not been transparent in their communication (see the point on risks above)
– Accounting practice – Seems fine for most part with all the mandatory disclosures in the latest AR.
– Conflict of interest – None in the notes to account. However see the risks section for such incidents.
– Performance track record – Good from a business performance perspective. Corporate governance standards have not been satisfactory.

Conclusion
I started this analysis a few days back and was impressed with the fundamentals. On looking through the BSE filing, I noticed the delisting notice from the company and was thinking of this as an arbitrage or long term opportunity. However the nature of the shareholding (thanks to ninad for pointing that out), I have concerns on how the delisting will work out for the minority shareholder. In addition, some of the past actions do not inspire confidence.

As I discussed in the last post, my valuation template has a checklist which I go through before doing a more detailed analysis on the company. On running through the checklist, I have come across the risks mentioned earlier in this post. I am not too comfortable with those risks and hence inspite of good fundamentals have decided to drop this idea.

Note: If you hold the stock and don’t think the above issues are material enough, it may be so. However I am more conservative and don’t want to put my money on the line to test it out.

About
Sesa goa ltd is the largest private sector iron ore producer and exporter. It has access to 240 Million Mt of ore with mines in Goa, Karnataka and Orissa. The company achieved a turnover of around 5221 crs in 2009 with a net profit of 2710 Crs. The company exports almost 85% of its production to china

The company has three divisions with Iron ore accounting for 85% of the revenue, Pig iron representing forward integration represents 12% of the revenue and rest is accounted by Metallurgical coke. The company is principally a mining operations and logistics company.

Financials
The company achieved a topline growth of 30% and a profit growth of around 16% in 2009 inspite of the severe recession in Q3 and Q4 of the financial year. The company was able to achieve this performance due to the increase in volumes and pickup in demand in china, which account for 84% of its total volume.
The company has around 4000 crs in cash and equivalents on an asset base of 4800 crs. This translates to a stated ROE of 60% and 300% on the invested capital.
The company has a 10 year topline growth of almost 35% per annum, with majority of the growth coming in the later years. The net profit has grown by an even higher rate, with the last 5 year CAGR coming to around 33%.

Positives
The company has clearly been able to manage the business well during the downturn. It has been able to keep costs under control and maintain its profit levels. The company has a very strong balance sheet with a lot of surplus cash to re-invest in the business.
In addition, over a 10 year period the company has become fairly efficient and profitable. The net profit margins are close to 50% as the mines are owned by the company and the business enjoys considerable operating leverage (overheads do not increase in proportion to volumes).

Risks
China accounts for almost 84% of the total demand for the company. China currently accounts for almost 40%+ global steel production and hence the demand supply situation in china will have huge impact on the fortunes of the company.
In addition, iron ore export is a sensitive topic and the government can and has imposed export tariffs to favor the domestic steel industry. This can impact the net profit levels of the industry and the company in particular.
Finally, the company at the current rate of production (without growth) will exhaust the reserves in around 16 years. As a result the company needs to constantly explore and add to existing reserves on an ongoing basis. The cash on the books is not really free cash as it will be required to sustain the business in the future.

Management quality checklist
– Management compensation – Fairly low, based on the size of the company. Good for the shareholders.
– Capital allocation record – This is difficult to evaluate as the company has kept the dividend low and retained most of the profits which is now held as cash and equivalents. It remains to be seen how the capital will be deployed. The management has stated that the intention is to acquire mining assets with the excess capital.
– Shareholder communication – The shareholder communication is actually quite good. I have rarely seen Indian companies (outside of some IT companies) discuss their operations with honesty and detail. The company has actually detailed all the risks to the business quite clearly and with complete honesty.
– Accounting practice – appears conservative.
– Conflict of interest – doesn’t look like conflict of interest, but a 1000 Cr intercompany deposit with a fellow subsidiary is not something good over time.
– Performance track record – good in terms of operational performance. Capital allocation (investing the surplus cash) performance needs to be seen.

Valuation
Sesa goa is a mining company and it would be silly to value this company using a PE approach or Discounted cash flow. I have seen valuations where the company is said to be cheap as it sells at a PE of 13-14. That is stupid. The simplified equation should be
Company value = value of current reserves + future value from reserves to be added.
The company achieved a profit of around 130 crs per Million MT of ore . As the existing reserves are around 240 Mn MT, the asset/ cash value of the company is around 19000 crs (if the company were to develop no new reserves). This is the current cash or baseline valuation of the company. If the company sells below this price, it’s a bargain as it was in early 2009.
The company currently sells for 30000 crs which includes the value the company will generate through additions to its reserves and new mines. I need to evaluate the average reserve additions over the years to get a sense of the company’s capability to add to its reserves.
My current thought is that the company seems to be fairly valued till I can get a better sense of how the reserve addition will work out in the future.

Conclusion
The company is performing fairly well and has a strong balance sheet to support additions to ore reserves. At the current price however the company does not look undervalued to me. In addition there was a recent FCCB conversion which has added to around 3% to the equity base. Finally there seems to be some fraud investigation going on regarding the company. I have not been able to find much in terms of details and not sure how it impacts the company.
The company was bargain at any price below 200.

Lakshmi machine works
LMW reported Q3 results recently and overall the result are as expected. I have analysed the company earlier here . The company had a terrible 2009 and reported an almost 60% drop in profits. This was expected in view the recession in all the developed countries.
The topline growth and the profits have now started recovering and are back to around 50-60% of the pre-crisis levels at around 30 crs per quarter. It will ofcourse take a longer period (I don’t know how long) to reach the pre-crisis levels and surpass it. Overall the company is performing as I thought it would.

You can find the detailed analysis here – look for the file valuationtemplatelmw.xls. Finally, I think the intrinsic or fair value of the company has remained unchanged.

IT results – Infosys, NIIT tech and Patni
I have a holding in all of the above companies, though I have been cutting the position size for some time now. Most of the IT companies have declared their Q3 results and it has been mixed bag overall. I am reviewing the result for the three companies I hold.

Infosys had a small drop in the topline (1%) and and similar drop in the bottom line. They have reported a small (around 8%) growth in the net profit for the first 9 months of the year. The company has almost 13000 crs of cash on the books and continues to earn a high return on equity and a much higher return on tangible capital (building , receivables etc). The company has given a guidance of a small growth for the rest of the year and has yet to give a guidance for 2010. The stock price currently is discounting some growth for the next few years. My own estimate of fair value is around 2600-2800 and hence I have been reducing my position in the stock.

NIIT tech reported a 7% drop in topline on YOY basis and 2% increase on QoQ basis. The net profit went up by 10% on QoQ basis and doubled on an annual basis. The increase has been mainly due to reduction of the hedge losses. If one were to eliminate the impact of the hedges on topline and bottom line, the revenue and net profit are more or less flat. The company has reduced the impact of the hedges on the balance sheet and in the investor call have indicated that they will keep a limited currency hedge going forward – some return of common sense there. The company expects moderate growth going forward. I have also revised the fair value of the stock upwards by around 10%. My personal estimate of fair value for the stock is around 240 rs.

Patni reported results which are in line with that of the industry. It reported a 3.3% growth in topline on QoQ basis and a 8.9% drop on Yoy. The net profit dropped by 17.2 % on YoY and now stands at around 171 crs. The company should be able to deliver to deliver around 500 crs in terms of net profit in 2009 and carry around 2000 crs of cash on the books by the year end. The company also completed a successful buyback during the early part of 2009 at an attractive price. The company results are not great, but more or less in line with the industry and as per expectations. I have revised the fair value of the company upwards by around 5%. My personal estimate of fair value for the stock is around 530.

I think on an overall basis, the IT companies I hold have performed as per expectations. In addition, they are now showing signs of growth for 2010. At the same time the valuation of these companies reflects that and more. As a result the stock price for most of these companies is now much closer to the fair value and I have started reducing my position size as the prices keep rising.

Container corporation of India (CONCOR)
The company reported a 5% growth in topline in the current quarter and a flat bottom line. The company has achieved a 10% growth in topline for the first 9 months and 5% drop in the profit for the same period. The company has two business segments – exports and domestic. The company provides containerized transport for exported goods, mainly out of ports and also provides for domestic transport of goods, mainly through rail services. As expected the export part of the business has shown a drop in profitability due to the slow down. The company has been able to reduce the impact by improving the performance of the domestic business.

CONCOR is a great business with enormous competitive advantage, conservative and good management and good growth opportunities. The company should start growing again once the export business recovers. The company however is not cheap and sells close to its fair value.

Additional note : I am not buying any of the companies reviewed in the post. If however the stock price keeps rising, I may start reducing my positions further.

Warning: Parts of this post are boring as I would be discussing about Hedge accounting, reserve adjustments etc. However if you are invested in IT stocks, I would recommend you to get a good understanding of these concepts as they are now critical to understand how the company is doing.

Results summary
The company had an average performance for the year 2007-08. The ROE was maintained at 30% level. The sales growth was lower at around 6% (reduced partly by the rupee appreciation) and the net profit growth was around 3%. The net profit margins were maintained at 14.3%. The operating margins also held steady at 19%.

The key segments of BFSI, Insurance and travel now contribute to more than 80% of the revenue. Europe continues to the major geographic segment with the contribution to revenue at 50%. The other performance parameters such as % revenue from top customers, no. of new customers etc showed decent improvement.

The company completed the accquisition of ROOM solutions during the year. This business was not profitable during the year as it is in the investment mode as per the management. In addition the company made another small accquisition of Softec in the airline IT solution space. Thus the company is pursuing a strategy of both organic and inorganic growth in the focus verticals, especially in Insurance and transportation.

The positives
The company did not perform as well as the tier I vendors. However the company is now pursuing a strategy of focusing on key verticals. It is growing through accquisitions in these verticals and accquiring the required IP and customers via these accquisitions. This strategy makes sense for mid size companies such as NIIT tech, which cannot compete with the Tier I companies on scale alone.

The company maintained its margins and ROE inspite of the slowing markets and currency fluctuations. The company performed as expected and as the valuations are currently discounting a terrible performance, the stock price did not suffer.

The cash and equivalents for the company now stand at 220 Crs which is almost 30% of the mcap. The company continues to sell at around 2.5 times earnings (or slightly higher than book value), which means the market expects the company to be out of business pretty soon.

The negatives
The volume growth for the company was poor for the year 2007. The company is definitely not performing as well as some of the Top tier companies.

The accquisition for ROOM solutions was done at 100 Crs. The company is currently making losses. NIIT tech Management has paid quite a bit for the company and must have seen a lot of value. I hope they are right. Although subsequent poor performance of ROOM may not hurt the company a lot, it would definitely put the capital allocation skills of the management into question. I would personally rethink my entire thesis about the company if the accquisition turns out to be a dud

The performance of the accquisition is more critical than it seems on the face of it as the company has a large cash holding. This cash holding would grow further in the future and the management would be looking at new accquisitions with this cash. A poor track record would hurt the performance in the long run.

The accounting
The company accounted a forex loss of around 6.7 Crs in the P&L account with net impact of +.8 crs ( still trying to figure how they arrived at this number).

Now for the dry part,
The company maintains effective and non-effective hedges. The effective hedges are used to hedge the revenue and recievables. The company booked a loss of around 15.5 crs against reserves in the year 2008. These reserves have increased to around 65 Crs in Q12009. So if the rupee remains at the current levels, the company will close the hedges (which cover 27 months of revenue) over the next 27 months and take a loss of 65 Crs on the P&L account.

So the question is – Has the company already incurrend a loss of 65 Crs ? Yes and No. If the company were to close the contracts then it will have to account for the losses. However NIIT tech is not in the business of derivatives. These derivatives and contracts are used to hedge forex revenues. It is possible that the exchange rate could go in the opposite direction and the losses could worsen or they could go in the intended direction and the company could make profit and come out smelling roses.

The valuation impact
How should one account for forex gains/ losses? I think it would stupid to consider these losses as an ongoing one and capitalize it.

For ex: 2008 net proft was 137 Crs. So would you net the above loss of 15 Crs and say the Net profit is 122 crs and use this number for the final valuation ?

I would rather do the following

Say we take the appropriate PE as 15. The value of the company is 137*15= 2055. I would net off 15 crs from this value to arrive at the final value of 2040 Crs. I would apply the same logic if the company made a profit.

Over the long term, I think the forex gains or losses should be a wash (net impact should be minimal). Unless the treasury department is foolish (which doesn’t look likely) or very smart, the hedges should end up serving their purpose of reducing the impact of exhange losses or gains.

Ofcourse I am assuming the company will not start looking at Forex hedges and derivatives as a source of profit. That is a different ballgame completely. If the company gets in exchange speculation (and some companies have tried that stunt), I will take a very dim view of it.

The employee benefit (AS15) impact is not too high for the year and hence I would not concern myself too much about it.

Reading up

I am currently reading AS30 standard to get a better understanding of the new accouting standard for mark to market accounting. It is quite a dry read. However if you are interested in understanding the accounting and results of IT companies, then it is important to understand these standards. I would say, that if you are into fundamental analysis, the understanding all the AS standards is crucial.

Ofcourse reading AS standard is as entertaining as getting your dental work done. But investing is not always fun ..is it ? 🙂

I have still not changed my mind about the company. The market expects a far worse performance and as long as the company can do better than what is expected, the returns for an investor should be good.

The analysis for NIIT tech is uploaded here. Earlier posts on NIIT tech here, here and here