CategoryCompany analysis

I received an analyst report on Indraprastha gas (see here) from uresh patel yesterday. The report has a sell rating.

Normally once one has made a decision and proclaimed it in public (via a post in my case), it is diffcult to accept information which goes against your conclusion. With that in mind, I have been trying to look at the report as objectively as possible and see if it refutes my assumptions.

On a broad basis the following points are made by the analyst for the sell recommendation

1. IGL has substantial margin risk as it is supplied gas on a subsidised basis. However the subsidized gas is 40% of the total supply. I have taken this scenario into account in my valuation and worked out the DCF calculations with the operating margins dropping from 40% to 32% by 2010 and net margins dropping to 14 %. Gujarat gas which is a similar company has net margins of around 11%, has a much larger commerical customer base and hence taking Gujarat gas a base case, I have assumed IGL will have a slightly better pricing power. So I agree with the analyst on the margin risk and impact on the net margins.

2. The analyst highlight risk to the topline due to competiton. I could not find any specific competitors who are planning to enter the delhi market. I could be wrong on that. In addition, IGL is planning to expand into noida and gurgaon. They are also exploring markets in haryana. These plans are very crucial for the company. If the company were sit tight and do nothing in terms of growth, then the topline will stagnate or even decline in face of competition. I find that hard to believe in case of IGL which has clearly stated aggressive plans in the PNG segment and new markets. In addition they have the cash to do so. So I am not sure why IGL will not have topline growth or choose not to do so. However any growth

3. Margin risks due to diesel pricing – The analyst have analysed the margin risk due to diesel prices falling from here. I have no opinion on this factor as I cannot predict what will happen to petroleum prices. This is a wild card and could hurt margins for some time. As a result I see this as a risk, but cannot evaluate it and predict it. In addition, the analyst case is based on the scenario that oil prices will drop in the future and hence that would reduce the discount and hurt margins. I am sure if anyone can predict that.

4. Regulatory risk – I missed this out completely. On reading the report, i think this could be a key risk going forward. One has to look at the petroleum sector and now cement to get a feel of it.

I think the key difference between my analysis and the one in this report is the difference in the expected topline growth. I have assumed a topline growth of greater than 10% due to the new initiatives. The analyst has assumed less than 10%. As a result my intrinsic value estimates are closer to 150-160. However if the growth comes lesser than 10%, then instrinsic value drops to 100-110. This is without even considering the regulatory risk. Any adverse development on that front could cut down the intrinsic value further

I would be analysing my assumptions further and would take a decision based on that.

Indraprastha gas ltd (IGL) is currently the sole provider of CNG and PNG in the NCR region. IGL was promoted by GAIL and BPCL ltd in 1998. It currently operates 146 CNG stations in the NCR region. In addition the company is setting up PNG infrastructure to supply Natural gas to commercial and residential consumers.

As per the Supreme Court directive all buses, commercial vehicles and Light good vehicles have to run on CNG. In addition there is a substantial cost advantage of running cars and 3 wheelers on CNG. As a result there is now a trend of private cars converting to CNG. These factors ensure a high level of demand stability for IGL and reasonable growth prospects due to continuing conversion of cars to CNG and due to growth in PNG consumers.

In addition IGL is now expanding into the adjacent areas of noida and ghaziabad. It is also doing a feasibility study in haryana.

IGL’s CNG sales is less than 50% of its compression capacity. As a result IGL has substantial operating leverage and would be able to grow revenues with low capital expenditure.

Competetive advantage
IGL is currently the sole provider of NG to the transportation sector and to commercial and residential consumers. The gas industry all over the world is characterised by local monopolies. Typically there is a single company supplying gas to the final consumers, as it is not viable to have two competing pipelines in a given geographic area. As a result IGL would likely remain a monopoly in the NCR region. In addition GAIL which can be a strong competitor is actually a promoter of the company.
The company is one of those rare cases where there is a substantial monopoly and a government/ court mandated requirement of its product. This gives the company a substantial visibility of demand.

Financials
The company has had a ROC of 25%+ since inception. In addition like other gas companies it has a very low working capital requirement. The NPM margins at 19% are twice that of other gas companies such as gujarat gas. Also the company has zero debt and a small amount of cash on the balance sheet which will grow due to strong free cash flows. The main investment of the company is mainly fixed assets which is mainly the gas infrastructure.

Valuation
The company has an EPS of around 9.5 and the FCF (free cash flow) is around the same amount. As a result at the current price it sells at around 11-12 times free cash flow. A company with such strong competitive advantage, high ROC and good growth prospects of 8-9 % per annum , can conservatively be valued at 16-18 times PE. As a result the company is selling at 30-35% discount of conservatively calculated intrinsic value

Risk
The key risk for the company is the supply risk. IGL gets 50% of gas at APM rates. On checking I found that the APM price for gas are around 40-50% lower than market rates. As the government plans to bring market based pricing for gas in due course of time, the gas cost for IGL would increase in the next few years. The net margins for the company, which are at 20%, would reduce when this happens if the company is not able to pass the complete increase to the consumer.

Additional points
The current price seems to discount the above scenario. I personally feel that IGL would be able to pass some of the price increase, although there would definitely be some impact to the net margins. This would not necessarily impact the absolute profits, but could result in slow down of the growth in net profits.
Assuming that 3-5 years later IGL starts paying market price as per govt policy, the gross and net margins will drop for IGL. Taking GGCL NPM of 11% as the base line ,IGL can have a NPM of 13-14 % due to better retail mix and higher pricing strength. Also some amount of cushioning will happen as volumes increase.

Comparitive valuation
In comparison with guj gas, IGL has higher margins and better ROC. Also IGL is 20% cheaper than Guj gas. Against a NP of 90Cr for Guj gas, IGL will have rough profit of 130 Cr. Also mcap for both companies is same. By comparitive valuation IGL should be valued same as Guj gas , if not more.

Blue star india is primarily in the commercial air conditioning and refrigeration business. The three main business segments are

1.Central air conditioning: This is the main business for blue star. It accounts for 70 %+ of the company’s revenue, has been growing at 25 % and has a pre-tax ROCE of almost 60 %. Blue star is fairly dominant in this sector and has a good market share of almost 30%. This sector is dependent on industrial demand, IT/ITES sector and retail. Lately the industrial sector, IT/ITES and retail sector have been boyant due to which Blue star has a good backlog of orders.

2.Cooling products: This comprises of Window, split A/c and other retail products such as water coolers, cold storage etc. This is a fairly competitive segment with strong brands such as carrier aircon and other vendors. This segment had a good volume growth and revenue growth of 30%. However as this segment is competitive, the pre-tax ROCE is at a respectable 15%.

3.Professional electronics and industrial equipment: This segment had a good growth last year on a small base of 60 Crs. The segment is small accounting for less than 10% of the total revenue. The pre-tax ROCE is high at almost 70%+.

Key competitive strengths
Blue star has key advantages via a strong brand in its key segments. It has a good reputation in terms of project execution and after sales service for the institutional segment. There is certain amount of lockin once a customer (especially if it is an institutional one) has selected and installed a blue star system. Subsequent orders would likely be for the same vendor. Due to high market share, blue star has certain demand and production economies of scale, which allows it to be a low cost provider. The central air conditioning segment is project driven, where project skills, experience and scale matters as the margins are fairly low (pre-tax margins were < 10 %) and hence a company has to be efficient to be a profitable business.

Problems areas
The company has performed well on most parameters such as revenue growth, NPM, ROE etc. However for the last 1-2 years, the free cash flow of the company has been dropping. The current year’s FCF was around 40 % of the operating profits. The main culprits have been account recievables and inventory. The recievables ratio has dropped from 6 to 4.9 and the inventory ratio has dropped from 9 to 7.9. The drops are not alarming and are still good in an absolute sense. However they need to be watched closely to see if the growth is not coming a high price (write-offs of bad debts and inventory later)

Valuation
Assuming (a big assumption though), the company can manage its Working capital, the Net profit can be taken as Free cash flow. The last year EPS (post split) was 5.8. The current year EPS should come be conservatively at 7. Using a DCF (with various assumptions) I would value the company roughly at 140-160 Rs/ Share. My personal opinion is that the stock is fairly priced.

Disclosure : I have owned the stock for the past few years.

Analysis date: Aug 2006

Kirloskar oil engines, a company from the kirloskar group has two main business segments

Engines: This business segment accounts for almost 80 % of the revenue and is the main business segment. This business caters to the farm sector, power sector, industrial machinery, Construction and material handling equipment. In addition the company has contracts/ relationships with OEM manufacturers, the armed forces and has its own service dealers and service personnels. The company has products in a wide HP ranges and has technical collaborations too. The highest volume comes from the small engines segment followed by the medium engines.

Autocomponents: This business segment accounts for the balance 20% and had an above industry growth due to capacity constraints. In addition the company has OEM relationships with some prominent companies such as maruti, sundaram clayton etc. The main products are valves and bearings

Other business: Some other minor businesses such as manufacturing grey iron castings, trading, power generation and sales (which is under review due to dropping sales)

The Company has benefitted from the recent improvement in the capital goods sector and upturn in the power sector. The period from 1996 to 2001 such low growth (20% in almost 6-7 years). Due to the improvement in the business climate the topline and margins have improved dramatically in the recent past. The company is seeing good volume growth in its core business and has also delivered good performance in the export sector which crossed 100 Crs this year.

Due to the nature of the industry (capital goods) with limited and large buyers, and due to cyclical nature the topline and margins are also cyclical. The NPM has fluctuated between as low as 2-3 % to 15 % in the recent past. I would put the average NPM at 6-7 % over a complete business cycle.

The company has become fairly efficient with the Fixed asset turnover ratios expanding from 4-5 to 7-8 in the recent past. Wcap ratios have gone through a dramatic improvement and is now almost 14. This freeing up of the capital has raised the ROE from 8-10 % to almost 30% +. In addition on a total capital base of 795 Cr, almost 500 Crs is investments.

This 500 Crs of investment at market value is almost 1000cr which translates into almost 95 Rs/ share (net of debt)

Valuation: The last year Netprofit is almost Rs 10 / share (net of exceptional items). With almost 95 Rs / share of investment, I would value the stock at approximately 350 Rs / share (max). There are various assumptions behind this valuation, namely

1. Rs 18/ share for current year’s earnings are during a cyclical high. The average earnings are more like 14-16.

2. Rs 95/ share of investments is not really realisable as a major part of this investment is in other group/ JV’s, which are unlikely to be sold off soon.

3. The company has some competitive advantage such as customer relationships, some economies of scale etc. But in the end it is in a cyclical industry with moderate to weak pricing strength and hence I would not accord the core business a PE multiple of more than 16-18.

On running various filters in icicidirect, I was able to list a few companies which were worth further investigation.

My approach was to do a preliminary analysis and reduce the list further to a few more interesting opportunities.

I am listing the companies and my analysis. This analysis is a bit dated as I did this analysis during the aug/sept time frame and have not looked at the recent price for these companies

1. Merck : Indian subsidiary of the american MNC. The american parent has a 100% subsidiary too which could be getting all the new products from the parents portfolio (and I guess special treatment over the listed subsidiary).

The company is selling at approximately 5 times earnings after adjusting non operating income and cash on books. The company has a high ROE of 30 % and low growth of 4-5%. The actual ROE on tangible equity is 60% +.

The company has a Pharmaceuticals and chemicals business. It has recently sold its life sciences business and has approximately 3370 million on its books (Rs 200/ share).

The topline is expected to drop due to the sale of the life sciences business. The pharma business has a growth in single digits and the next years earnings could be 10-15 % over the earnings of 2005 (current year earnings are not comparable due to the sale of life sciences division)

This company is a value play. The management does not seem to be very shareholder friendly. It remains to be seen, what the management will do with the huge cash it has on its books . Will it try to buy out the indian shareholders at an unfair price like a few other MNC’s have done in past? Can happen.

I would estimate the intrinsic value conservatively at 700-800 Rs per share. However it is quite likely that the valuation gap may take a long time to close due to poor growth prospects and a management which may be indifferent to minority shareholders

2. Swaraj engines
The company showed up in my list as the PE seems to be 4-5. However after adjusting for the bonus issue, the actual PE is 14. Also the company has low growth, high debtors position and is mainly supplying to sister companies. It is a small cap company too. I do not see much value in this stock and decided to give it a pass.

The other stocks which I will detail in subsequent posts are

Grindwell norton
Revathi CP
Kirloskar oil engines
Hindustan inks
Tube investments
Neyvelli lignite
Gujarat gas

Please do not take the above list as a recommendation. This above post is just for analysis and I may or may not have invested in any of the above stocks

I came across this post on sundaram clayton which got me interested in the checking on the company. On reading the annual report, this is what is found

• sundaram clayton is in the business of auto-components – namely brakes and into aluminium castings
• The company has a revenue of 5360 million rupees, NP of 534 million rupees
• An average of ROCE of 20%+ with average Debt/equity ratio below 50 % (except current year where ratio is close to 50%)
• Healthy NPM of 8-10% consistently across the years
• Sundaram clayton is also know for its six sigma initiatives and has received several prefered supplier awards over the year

The company has several subsidiaries with a few associate companies too. The rough back of envelope calculation is as follows

The biggest holding is TVS motor company at 57%. A rough valuation is 16000 million (current year NP*12). The value of the holding is conservatively at 9120 million.
All the other subsidiaries are small with combined net profit of roughy 130 million. I would value is not more than 2000 million with Sundaram clayton value not exceeding 1500 million ( a very rough valuation).

So the total value of all the holding seems to be around 10620 million. With around 1090 million as debt and 25 million as cash , I would put the net value of these investment as 9600 million. The stock sells at 885 per share and with 18.9 million outstanding shares, the equity value is 16726 million. Back off the value of this investments and the company is valued at around 7100 million.

So with current EPS of 28, the PE comes to around 12-13.

Now all the above calculations are very rough. But it seems to be that the company is undervalued.
Although my initial analysis has not turned up anything negative, I would still not commit money to the stock as I still have figure out the following

• The catalyst which could unlock the above value.
• A more detailed analysis of the industry dynamics as there seems to be new competition coming up in the same segment as the company (there is mention of this in the management discussion)

I came across a few research reports on exide industries and liked what I saw . In a nutshell

• Exide industries is in the business of  Automotive batteries with brands such as Exide and Standard furukawa.
• Exide supplies to OEM customers in cars ( Maruti, Hyundai, Ford etc), 2 wheelers ( Bajaj, Honda etc ) and has now made an considerable in roads in the tractor segment too. It has a very high market share of around 80%+ in the OEM segment
• Exide has a dominant position in the replacement market ( 60%+) market share and a strong brand and extensive distribution network ( Read  competitive advantage )
• Exide has a strong balance sheet with ROE in high teens and consistent topline and bottomline growth inspite of increases in lead prices ( lead account for around 65 % of Raw material costs )
• Exide seems to have a reasonable pricing power due to its strong brand and is a preferred vendor for a number of OEM customers
• The company is now expanding into the export market ( which accounts for only 5 % of the topline currently )
• The next few years look good for the company as the Automotive sector ( cars, CV and 2 wheelers) has seen good growth and as the replacement cycle is around 18-24 months, strong demand from the both the OEM segment and replacement segment  should kick in.

A few negatives

• Lead pricing would have an important bearing on the margins going forward. However over the next 2-3 years the impact of higher lead prices could be reduced if Exide is able to pass through the cost increases.
• Valuation – The company is priced at around 15 times FY06 earnings. For me it is on the higher end of the price range. If I am able to get more comfortable and confident of the  business (need to read about other companies in this industry), then 15 times FY06 earnings may have a margin of safety. But for the time being, I am still evaluating and trying to get my arms around it.