CategoryCompany analysis

I received a list of companies to analyse based on my earlier post. In order to do a better analysis, I am trying to club all the stocks from the same industry. As there are several cement companies in the list, I decided to take a stab at the cement stocks first.

My earlier analysis of the cement industry is here and here. In addition I have analysed the industry and updated my analysis in the file business analysis in the google group. Please have a look under the column commodity – cement.

The cement industry is a cyclical commodity industry where the profit and return on capital is dependent on the demand cycle picture. From the mid 90’s to 2002-2003 period, there was an excess of supply and hence prices were depressed. Most companies had poor to non-existent profits and accordingly the stock prices suffered. Since 2003, the demand has increased rapidly and so have the prices. The profit margins are now in excess of 20% for some companies and ROE in excess of 40% for companies such as ambuja cements. I personally think these are fairly high returns for this industry and the best of the companies in the industry would earn around a max of 20% over a business cycle.

Valuation of cement companies should not be done on the basis of peak earnings alone. This holds true for most commodity companies. Case in point – sugar companies. In 2006-2007, these companies appeared cheap based on their peak earnings. However when the cycle turned downwards, the stock prices got wacked. The economics of the cement industry are not as bad (there is lesser government intervention), however the valuation approach should be similar to the sugar industry. One has to be careful in extrapolating the peak earnings and assuming that the stock is undervalued.

Due to the cyclicality and commodity nature of the industry, analysis and valuation of cement companies is more diffcult as one has to figure out where the industry stands in terms of the business cycle . High returns can be made if one can predict the key turnaround points in the business cycle.

Mysore cement –
This is an interesting company. The company was taken over by the heidelberg group and made a tender offer to buy shares from the public at 54 Rs/ share in 2006 . SEBI directed the group to set the price at 72.5 per share. This was recently overturned by SAT and the heidelberg group can now initiate a tender offer to buy the shares from the public at Rs54 per share.

In addition the company alloted 66.5 Million shares at Rs 54 per share in 2006 to the group. This capital was used to pay off the accumulated debts and wipe out the accumulated losses. The company has also become profitable from 2007 since the new management took over.

In addition a recent news, indicates that indorama cement would be merging with mysore cement taking the capacity to 2.8 Million tonnes. The company further plans to expand the capacity to 5.9 Million tonnes.

The financial look good, with the company solidly in the black, no debt and cash of almost 180 crs on the books. The impact of the new management can clearly be seen from the P&L account, balance sheet improvement and aggressive plans of the company to expand capacity through mergers and greenfield projects.

So if everything is so good, then one should go and buy the stock? I would hold on that before I can figure out the following
– Cement is a cyclical industry. Currently the industry is on an upswing and hence all cement companies are making good money. How will mysore cement fare when the cycle turns south (supply exceeds demand)
– What is the cost structure for mysore cement? Cost is critical in a commodity industry such as cement.
– Future plans of the management. Scale is important in the industry. Mysore cement is still at 2.8 Million tonnes and even after capacity expansion would still be one of the smaller companies

One interesting development is the tender offer. The stock is quoting at around 30 Rs and the tender offer should be around 54 Rs. The stock may be a good arbitrage opportunity, even if the long term prospects of the company needs a more thorough analysis.

Ambuja cements
Ambuja cements has been one of most profitable cement companies in india and has made money even during the downturns. They have the highest net profit margins in the industry at 30% and ROE of almost 40%. Net profit margins have grown from 10% to around 30% and the profit as a result has grown by 8 times in the last 5 years.

The company sells at around 560 Crs/ Million tons of capacity compared to say 170 Crs/ Million tons of capacity for Mysore cement. The difference is high and understandable as Ambuja cement is a well run company with huge capacity and a very efficient cost structure.

The company is currently selling at a PE of 7 based on last year’s net profit numbers. Based on normalised profit margins of around 12-15%, the company is selling at a PE of around 12-13. I would say the company is undervalued by 20-25% at best.

If you believe that the net margins are sustainable, consider the following fact : Net margins in 2003 and before were around 10% and have expanded to around 30% in the last 2 years.

Grasim, ACC, Ultratech etc
Grasim has a blend of cement, VSF and other businesses. The cement business seems to be doing well in line with industry. The other companies such as ACC and ultratech have also been performing well in the last 2-3 years. Most of the top cement companies now have margins in the range of 18-22%, ROE in excess of 30% and high profit growth rates in excess of 20-30%.

The valuations of these companies are fairly close. Most of these tier I companies are selling at 7-8 times profit in comparison to the smaller companies which are selling at 4-5 times or lesser.

I am reaching the following conclusions after looking at the complete sector

– The cement industry has enjoyed very high growth rates and great profits for the last few years. The profits margins are not sustainable. New capacity, cost pressure and competition are bound to drive the margins to long term averages of around 10-12% in the next few years
– Most of the companies appear undervalued in terms of the last 2 years profits. However on the basis of normalized profits they are selling at 12-13 times earnings. At best, these companies appear undervalued by 20-25%. There may be a bit of undervaluation, but not by a huge amount.
– Considering the level of undervaluation in some sectors such as pharma, IT etc and the better economics enjoyed by those industries compared to Cement, I am personally not too keen on investing in the cement sector. If I had to pick up one cement company to put my money in for the long term, I would prefer ambuja cement (if I had to that is !!)

My notes on Allahabad bank

About
Allahabad bank is one of the oldest banks in India with over 2000 branches. The bank’s branch network is predominant in UP, Bihar and other northern parts of the country. The bank also has 47 specialised branches for various business activities such as Industrial finance, Collection service, Treasury management etc. The Bank is a PSU bank
The bank was a basket case a few years back. I was reading a research report when the bank came out with an IPO in 2002. The bank had NPA of 10.5% which was actually a reduction from 15.1% in 1998. So technically the bank had a zero networth till 2002. The bank has improved its performance since then.

Financials
The Bank has improved its financials substantially in the last few years. The following Key parameters of the Bank have shown improvements from 2002 to 2007

ROE – 11.2 % to 22%
CAR – From 10.5% to 13%
Net NPA – from 10.5% to 0.9%
ROA – From 0.6% to 1.3%
Absolute Net NPA – from 1160 Cr to 315 Cr
Credit deposit ratio – from 48% to 65%

Income growth has been 15%+ for the last 5 years
Net profit has also grown by 20%+ per annum over the last 5 years

The following financial numbers have remained stable or not shown much of an improvement
Other income as a percentage of total assets
Provision ratio has dropped to 70%
Yield on asset – In line with fall in rates over the past few years.

Positives
– The key indicators such NPA, ROE, CAR, ROA, Credit deposit ratio, income and netprofit growth are good for the bank.
– The bank has been expanding its branch network and also getting into the international markets. In addition the bank has kept its NPA’s low in percentage terms and absolute level.
– The bank is also increasing the other income component. The other income which comprises of fee income, trading etc has grown at a much faster rate this year as compared to the Net interest income.
– Operating costs as a percentage of total income has dropped mainly due to reduction in manpower costs. The bank has thus become more efficient in the past few years.

Risks
The biggest risk for the bank is political interference. As the majority shareholder is our government, you can never be sure what hairbrained scheme they will come up with. In the past there have been loan melas, loan writeoff etc. This has reduced in the last few years, but you never know.
In addition the NPA are controlled. However the bank operates in UP, bihar etc. There is a small risk of the rise in the NPA.

Comparitive Valuation
The bank is currently selling at a PE of around 5 and a P/B of around 0.9. On a comparitive basis SBI sells for a PE of around 17 and P/B ratio of around 2.5. SBI is a bigger bank, but on Key parameters such as ROE (around 18% ) , Growth rates (net profit around 8% for last 5 years) etc is not much better than Allahabad bank.

The other top notch bank HDFC is priced at around 35 time PE and P/B of around 6.5. On certain parameters such NPA and growth the bank is ahead of Allahabad bank, however ROE is higher for Allahabad bank. Finally the market recognizes the qualilty of HDFC bank’s management and performance and has priced it accordingly

Conclusion
Allahabad bank is one those non-glamorous, dull stocks. However key to investing is not how sexy the stock is or how much sizzle it has, but whether you can buy a stock at a discount to intrinsic value.
Personally I feel the stock is a bit undervalued, however I have yet to make up my mind on it . I don’t see an immediate catalyst to unlock the value, however if management continue to perform as it has in the past 4-5 years, the returns should be decent.

Please see disclaimer

About
SF(sundaram finance) is an NBFC promoted by the same group which controls companies such sundaram clayton etc. The company is the business of hire purchase and leasing in the automotive sector. In addition the company has subsidiaries for housing finance, asset management, Infotech, insurance etc.

Financials
The company reported a consolidated revenue of 1100 crs with a growth of around 25%. The company has had decent topline and bottom line growth in double digits for the last 5-6 years. The ROE has improved around 10% to almost 15% now. The company also has extremely low NPA of around 0.5% and CAR ratio in excess of 12%.
The company has AAA ratings and has been able to get funding from banks and other institution at competitive rates.

Positives
The company is a well managed conservative company. It has show good growth in the last 5 years, with a decent ROE and low NPA. In addition the company has a strong brand name in its segment and a good distribution and marketing infrastructure which is important in the hire/purchase and lease business.
In addition the company is now expanding into new growth areas such as home finance, asset management and insurance. Several of these subsidiaries are now doing well and have turned profitable in the past few years

Risks
The core business of the company is still hire purchase and leasing in the auto sector. The auto sector has been in a growth phase in the last 5 years. As a result the company has been able to show good results and low NPA. However a downturn could slowdown the topline and bottom line and also increase the NPA’s.
The company is expanding into various financial services such as insurance, housing finance, infotech etc. These businesses are still new and have just turned profitable. However there are still risks in these businesses till they mature.

Valuation
It is important to do a sum of part valuation of the company as the company has several subsidiaries, JVs and associates. A conservative valuation would give the company a value of approximately 2000 Crs which is a 35% discount to the current mcap of 1275 Crs. An optimistic valuation would give a value of 2700 Crs which is more than double the current mcap.
To put it differently, the current mcap accounts for the parent company only and all the JV’s, subsidiary and associates are available for free.

The caveat however is that the investments in associates are mainly in group companies and it is unlikely that these holding would ever be sold. The company would be able to get good dividends from these holdings, but the full value is not likely to be realised.

About
Ashok leyland is a 7500 Cr company in the automobile industry. It is the no.2 manufacturer of commercial vehicles in india. It has a 28% market share in commerical vehicle and is no.1 in the bus segment. It has a current capacity of around 80000 vehicles which would be expanded to 100000 vehicles in the next 1-2 years. The company has 6 plants at Ennore, hosur, Alwar and Bhandar and is putting a new plant in Uttaranchal.
The company has the following product segment – Buses, trucks, defence, spares, services and now the company is entering into design and other OEM services.

Financials
The company has doing well inline with the commerical vehicle industry. The turnaround in the sector performance has happened from 2002 and the industry has seen good growth since then. ALL (ashok leyland Ltd) has seen its revenue increase by 23% per annum since then and profits increase by 25%+. The company has become more efficient as its return on capital has increased from 15% to 25%+. The net margins have gone up from 3.8% to 5.2% during this period. The increase in ROC has come from better utilization of assets which have increased from 1.9 turns to 3.6 turns.
The company has used the free cash flows to reduce debt from a ratio of 0.75 in 2003 to 0.36 currently. Net of cash and cash equivalents the company is a zero debt company.

Positives
The financials of the company has improved a lot during the last 5 years. The company has used the upcycle to improve the balance sheet and make a few strategic acquisitions.

The company has acquired the truck Business of Avia in Europe and would be selling around 1000 trucks per annum (not sure of the exact number). In addition the company has agreed to purchase DTE in the US which provides testing services to OE manufacturers in the US. The company also has a JV with in UAE to build bus bodies in the UAE. The above acquisitions and other service initiatives should add value to the company and reduce the cyclical nature of the business.

In addition the company has been a good allocator of capital in the last 5 years and has a resonable dividend payout of almost 50%.The current management team seems to be more aggressive and focussed on doing well. The company has managed to increase its market share in the last 2-3 years too.

Risks
The business is cylical and during the down cycle there is considerable margin pressure. In addition the company has turnaround its performance during the last 5 years of boyant demand. However it still remains to be seen how the company will do during the down cycle.
Competition in the Commercial vehicle segment is now increasing due to the entry of foreign players and this could increase the pressure on the margins, especially during a down cycle.
The management is currently expanding capacity. However a drop in overall demand could depress profits in the short to medium term due to this excess capacity. However this risk is on the lower side and could be mitigated by increasing exports.

Valuation
The company sells at a PE of 12. The current EPS is around 3.3 per share. The company can be expected to grow at 10-12% over the next few years. In addition the company has some competitive advantage such as a known brand name (especially in the south), long operating history and experience in the market, rational management and a decent distrubution/ service network.
The company can be valued at around 16-18 times PE and given an intrinsic value of around 60 Rs/ share.

Conclusion
The company seems to be undervalued, but it is still not a screaming buy. A 10% drop in stock price could make it a good buy. In addition the company is selling close to its 52 week lows due to the slowdown in the CV sector. A further drop in the share price could present an attractive opportunity.

I received a few comments on my analysis of Cheviot company. Thought of posting it on the blog as they add to the analysis of the company.

Prem Sagar said…
Rohit,
Do you know what the mgmt intends to do with the huge investment portion?
from their last 5 yrs, I see no huge capex and I dont think the mgmt has any plans to invest huge sums into the same business to increase sales or to enter into new avenues to explore new possibilities. So as of now, the investment portion is just sitting on their books without any plan for it, but merely compounding it.
do you think they would do better if they disburse a part of it to shareholders or buy their own shares back?and the industry itself is struck severly by strikes and I can see several instances of strikes for this co alone. and the whole industry doesnt look enticing.
Assuming that the investments are discounted, would you be willing to buy such a co at 2 times?
4/11/2007 12:25:00 AM

Rohit Chauhan said…
Hi prem
very valid concerns. as far as strikes are concerned, i would not be too worried as the company has been able to manage the financial impact of such strikes in the past. unless the company has some very serious labor issues in the future which shuts down the plants for a very long time, i dont think these labor issues should harm the long term economics of the company
the capex needs of the company are low and hence i expect the cash to increase. i have seen no evidence of the management wasting the cash till date. they have given a bonus, decent dividends and seem to be accumulating cash. need to see how the cash gets used. buyback is unlikely as the no. of shares is low (0.45 crs).
cheviot is a graham play and a portfolio of such companies should do well ..although individually a few of them may do badly
4/11/2007 04:06:00 PM

khali_pili_lafda said…
Hi Rohit,
First off great effort on this blog. My observations on Cheviot are below.
1. Jute prices are on the decline on a global scale and may exert pressure on profit margins for Cheviot over the next few years given that export orientation of company has increased.
2. Historically the P/E has always been below 6. Cannot figure out why the markets are unwilling to give Cheviot credit for performance.
3. Company has a lot of cash on hand (Rs543M) with only 4.5M shares outstanding. May be diversifying into Tea – read this online? Saw a spike in Capex in 2003.
4. Labor issues have already been highlighted by you but given that Cheviot operates in West Bengal, labor laws and strikes can be particularly harmful and unpredictable.
5. With only 4.5M shares outstanding – it raises a liquidity red flag since trading may be controlled by a select syndicate. On Apr 12th only 485 shares changed hands although Mkt cap is over 100 crores.
Niraj
4/12/2007 02:35:00 PM

Rohit Chauhan said…
Hi niraj
great comments.my thoughts on the points raised by you
1. i also noticed that jute prices (raw material) is decreasing. i think that is a plus for the company as it improves the net margins for the company (the company sells valued added jute products)
2. i think the historical PE is low because of the various factors in your and prem’s comment. small cap, illiquid stock in an unglamorous industry with labor issues
3. i am not sure that the company has diversified into tea. the 2003 increase in gross asset was a revaluation which was reversed in 2004. i checked this in annual report. the capex for last 5 years has been roughly equal to the depreciation
4.agree with you. however i feel that labor does not represent a threat to the long term economics of the company. it can cause short profits to suffer. although a serious labor trouble could impact my assumption. frankly it would be difficult to evaluate this risk objectively
5. this could be the reason for the low valuation

I am currently analysing Cheviot company (for company website see here).

The valuation is as follows

No. of shares outstanding – 0.45 Cr
Price per share – 228
Mcap – 103 Cr
Investment/ cash on book – 63 (last year)+ 10 Crs (this year) = 73 Crs
Net value = 103-73 = 30 Crs
Current year expected NP = 23 Crs

The company seems to be priced for 1-2 years earnings. The market seems to valuing the company with a horizon of 1-2 years and expects the company to be out of business after that !!.

Background

Cheviot company is a West bengal based company into the manufacture and sale of Jute based products. Almost 70% of the sale is export and the rest is domestic (Page 6 of Annual report).

The company has been in business for more than 100 years and is currently the most profitable in its industry (the jute industry as a whole is sick and incurring losses). The company has two manufacturing units, one at Budge budge and the other at Falta. The unit at Budge budge is having some labor trouble which may impact the Topline for the company.

Financials

The company has had a ROC of almost 20%+ for the last few years (if one excludes cash). The company has been consistently profitable and has good free cash flows ( equal to net profits).

In addition, although the volumes have come down, the company has moved up the value chain and has been able to improve realization for the end product (Raw material cost as % of Sales has been coming down over the years). The topline has increase with a CAGR of 6% for the last five years whereas the Net profit has increased by 15% CAGR over the same period.

The company has almost 73 Crs cash on book which has been invested in mutual funds and other liquid investment.

Risk
The indian government has made jute the mandatory packaging material for food grains and sugar to support the industry. In addition the government also provides marketing assistance for the export market which is received as a credit. Thus the industry is surviving based on this support from the government.
The company currently has labor unrest in one of its units which may impact the short term profitability. In addition, this industry is marked by labor issues and strikes.

Conclusion
In my view, the strike could impact the topline for a quarter or two, but it is not a long term risk. In addition, the company has been concentrating on the export market and as a result could continue to do well.

The market is currently discounting all the above issues and more and pricing the company for bankruptcy, which does not seem probable.

I got the following comment on my previous post on Indo nippon electricals

Hi Rohit,
In the absence of latest annual reports, it is difficult to evaluate this.

What is the catalyst that you have in mind which will unlock the value or force the reevaluation?

Earnings are not growing significantly where they would make the market to take notice. In the absence of takeover attempt, it might be a long time (years!) for market to re-evaluate the price.

Some months ago, I had made a purchase of Kothari products (pan parag fame). Its book value is more than the market cap. Tobacco business is a cash minting machine. That’s all the analysis I did at the time of purchase hoping that somehow market will recognise the Graham bargain.

However, later I noticed that the promoters own more than 80% of outstanding shares. There is no incentive for the current owners to reward shareholders. There is no way for a hostile takeover. Ergo, the value trap stays as is. I have moved on in due course – hopefully, wiser.

Best Regards,Ravi

I decided to post my thoughts on ravi’s comment. I have posted on value traps earlier here

i agree, value trap is always a concern in such situations. i have also invested in kothari products in the past (see post here) with a clear understanding that the underlying business was at best stagnant and the value unlocking would happen if the management did something about the cash. After holding the stock for more than a year (with a small gain), I realised that the management was not interested in any value enhancing measures. On the contrary there was a lot of apathy towards investors. The management had not bothered to update its website with the latest results and there was no way to access their annual report. As a result, I bailed out.

Indo nippon electrical has similar risks. However there are some key differences

1. The underlying business for Indo nippon is healthy and has a small amount of growth
2. The management has been pro-shareholder in the past and has given bonus shares and decent dividends in the past
3. The management has been very rational and efficient user of capital and has kept the return on capital fairly high.
4. They have updated their website with the latest annual and quarterly results

Value unlocking can happen via various actions on part of the management. In case of Indo nippon electricals I expect continued decent performance and passage of time to unlock the value.

However due to the concern of value trap, I have classified this idea as a graham idea. The key approach in such kind of investing is to invest in a group of such stocks (more than 10-15) where the entire group could do well, with some indivdual stocks performing well and some performing poorly. In contrast, focus investing which involves investing heavily in a select few stocks would not work in the above kind of idea. However with valuations being high, I am not able to find too many good ideas in which I can invest heavily.

see here a post on value traps and critical thinking titled ‘Value Delusions and Strategic Thinking’ by rick. he discusses about value traps and how to avoid them towards the end of his post.