CategoryIndustry analysis

This is a complex industry with some of the largest public companies in india. It would be difficult to cover the entire industry in detail in a single post. I would however try to cover the critical components of the industry and try to explore one of the subsets of the industry in this post

The industry can be roughly be split into 3-4 groups

Refining companies – This would include standalone refining companies like RPL, MRPL.chennai petroleum etc and other vertically integrated companies like IOC, HPCL and BPCL which have their own refineries. Refineries are capital intensive businesses with high economies of scale, low differentiation in the product and competitive advantage being mainly with the low cost producer. In addition refineries are cyclical in nature with their margins driven by the price of crude

Marketing companies – There are no stand-alone marketing companies in india. Most of the companies like IOC, BPCL HPCL and now reliance are a combination of marketing companies (through retail outlets) and refineries supplying the marketing companies.

Marketing companies have more pricing power, some level of branding and less cyclical in nature. However in india as the retail price is controlled by the government, companies having the marketing division (HPCL, BPCL, IOC) etc do not have control on their pricing and typically have to bear losses which at best is mitigated through oil bonds.

Gas – These include companies like GAIL, Gujarat gas, Indraprastha gas etc. This is one the fastest growing sub-sectors in the oil and gas industry. With India trying to reduce its reliance on oil, there is a lot of focus on switching to the gas fuel.

In addition pricing for gas is not tightly controlled by the government. As a result most of the companies have fair amount of pricing power. As the industry is characteristed by entry barriers in the form of pipelines and licenses in specific markets. At the national level the market has been controlled by GAIL. However the government has opened the sector to compeitition and the common access guidelines provide access to the national gas pipelines controlled by GAIL.

The sector is however growing rapidly with a lot growth coming from industrial consumers and some cities switiching to CNG for vehicles.

Lubricants – These are some standalone lube companies like castrol. However for most of the companies this is an additional product which is produced and supplied through the same supply chain (Petrol pumps) or through retail outlets.

This sector is characterised by high competition with the industry growth dependent on the growth of the automotive sector. The last 2-3 years have been better in terms of the growth. However the sector characterised by poor pricing.

In the rest of the post I would cover the refining sector. I will cover the other sectors in future posts.

Porter’s 5 factor Industry analysis for refining companies

Entry barriers

The industry has moderate barriers characterised by economies of scale. Larger refineries with latest technologies which can process varying types of crude tend to have higher GRM (gross refining margins). For ex: the new RPL refinery is to have the latest technology with the capability to process heavy and sour crude oil(HSCO) and as a result could have margins as high as 10 $ per barrel.

Rivalry Determinant

The rivalry in the industry has been low till now as the industry was tighlty regulated by the government. The level competition would increase in the future, with reliance and other MNC becoming more aggressive

Supplier power

Supplier power is high as the net margins are strongly dependent on the price of the crude. Due to crude price volatility and supply risks, a lot of the indian companies are integrating backwards into E&P activities

Buyer power

Not too critical for most companies as refining operations are a part of the complete supply chain, with the refining operations supplying the product to the marketing company. However in case of standalone companies (which may no longer apply) long term contracts have to be signed with the marketing companies. The margins in such cases are dependent on such long term contracts.

Substititute product

Although gas , solar power etc exist as substitiutes , none of them are big enough to impact the demand of the petroleum products.


Company details

The key companies in this sector are MRPL, Kochi refineries, RPL (IPO), Chennai petroleum and Bongaigaon Refinery. Most these companies have benifitted with the high crude prices and are currently operating a high capacity utilisations. A few thoughts on these companies are below

RPL – the major points are coevered in this article. In addition, the pricing of the IPO at 60 would be on the higher side and as suggested in the article would account for the positives of the project being priced in. As an aside, considering the good deal which reliance is getting , I would like to look at RIL (it seems after all the demergers, the cross holding creation has started again in the new companies).

In addition, chevron has picked a stake too.

MRPL – The company has been turned around in the last 2 years and has now become profitable. It is now running at high capacity utilisation 119% (10 mmt capacity) . The financial numbers are much better now (see here) and the company has turned around after receiving capital from the parent (ONGC). The company is now valued at a PE of 9. Considering that the petroleum prices are at a high and any further expansion of earnings would come with further increase in refinery capacity, I think the company is fairly valued ( most of refinery companies are experiencing a cyclical high in terms of earnings).

Bongaigaon Refinery – This is a small refinery (2.1 MMT) with majority holder being IOC. It is running at fairly high capacity utilisation (100% +). The company is valued at a normalised PE of around 10 (based on average of last 5 years of earnings). Again the last year’s earnings seem to be at a cyclical high (GRM – gross refining margins were almost at 10 dollars last) and this year there has been a 50% drop in profits. Also further expansion will come only through capacity expansion, so the earnings / Free cash flows could be subdued for some time. However among all the refinery companies, this one is worth further analysis.

There are industries with stable pricing power like FMCG companies (to a certain extent), cylical pricing power like cement, steel and other commodity companies which depends on the demand and supply conditions and then there are companies which have a business model where the price is always dropping. A few industries, which come to mind are the computer industry (Dell, HP etc), semiconductor industry, memory (moser baer) and even electronics.

These industries are not even like airlines where there is a certain cyclicality of pricing. In the above industries, there is a relentless race to the bottom. Its almost a given. A PC now is around half the price of a PC in 2000 (maybe lesser), but it is 5 times or more powerful. So you have a scenario where the product keeps getting better and the price keeps falling.

So even when the revenue is increasing, the margins and profits may be shrinking. So what does it mean for an investor?

1. To be competitive all participants in the industry must constantly spend huge sums on new technologoies, equipments and other cost reduction options. So effectively the earnings are overstated for these companies, as depreciation is way to lower than the obsolence in the industry.
2. Due to poor pricing power, any drop in the demand has a severe impact in margins (see samsung results here). Companies like Intel which have a monopoly in the processor business have also taken huge hits when the demand has dropped.
3. Sudden shifts in technology can destory the exisiting product lines and put the company at risk. Even small shifts can hurt these companies badly (nokia got hurt and lost market share when the preference moved to clamshell phones in 2004/2005.)

In the end I would value these companies at low multiples if I can forsee the future of the company and figure out that the company would do well for quite some time.

As an example, look at Moser baer. This company has grown a lot, but at the same time operates in a falling price environment and needs constant investment into capital equipment. As result the company has had to add capital to the business. I am not sure if this business would really have any free cash flow.

Found this article on cnet.com on the trend in IT outsourcing industry in the near term

Almost $100 billion in outsourcing contracts will be up for grabs in the next two years, and big players including Accenture, Electronic Data Systems and IBM could feel their grip on the market weaken due to more competition from offshore companies.

My personal view point is that indian IT services companies like infosys, wipro etc will continue to gain market share and will show high growth for the next few years. Will the profit margin hold at the current levels. I think odds are against it. With the kind wage pressures already being felt and with dollar / foreign currency risks etc, I think the odds are that margin would come down over a period of time. More likely that the margins would drop by a few points every year till stabilise at 8-10 % (or maybe a bit higher). The key variable would how long will this take ? frankly I don’t have an idea. But I think it would be key variable for the current valuations to hold. If the slide is fast, then it would be difficult for the current valuations to hold up.

I have been reading shankar’s blog and left a few comments on his post about valuing a financial institution (like a bank or FI etc).

Shankar left me the following comment

Rohit, help me in arriving at a sustainable valuation model for banking sector. Debt recap / NCA will not work here. I can only think of P/E ratios but then this works on the whims and fancies of interest rates. Any guesses?

Its always easier to figure out what does not work v/s what does. That said, I have tried to come up with a valuation approach for banks and such lending institutions.

So here goes –

To start with let me try to list the reasons why valuing a bank is different from any other business

• Role of cash: Cash for a bank is equivalent to raw material and is used for creating the Product – Loan / mortage etc. For other businesses, cash serves as a lubricant (for lack of better word) to run the business. Hence for most businesses, cash is held for liquidity purposes. For banks, cash or equivalents is held as a raw material itself.
• Free cash flow: Free cash flow (after considering Capex) can be calculated easily for most businesses. Difficult to do for banks as their assets are not really the building / equipment etc. Assets are mainly the loans/mortages/ investment made out of cash. A business in absence of opportunities can return the cash to the shareholder. For a bank, the amount of free cash is not dependent on the opportunities itself. A bank has to maintain certain liquidity based on statutory requirements such as the risk profile of the assets.
• Role of book value: for most businesses, book value is an indicator of money invested. But may not be a big indicator of the instrinsic value. For banks, book value (net of impaired assets) is much more important indicator of intrinsic value
• Risk: Bank by their nature are risky businesses (I have read comments by buffett / munger to that effect). Any business which has a leverage of 10:1 (which banks do), can fall apart quickly due to mangerial mis-steps

My typical approach (which in my opionion is not sufficient) to value banks has been

• P/B ratio – I try to look at the relative valuation through this ratio. A high quality bank (in terms of operational efficiency, NPA etc like HDFC bank) would sell at higher P/B ratio. It is important to figure out the correct book value (preferably book value net of impaired assets)
• Long term return on equity – Higher the better, provided the bank is not making risky loans
• % of Net interest income to total income – Would want fee based income to be a higher proportion of the total income. Fee based income is typically less volatile and has low risk.
• Operational efficency – higher the better
• Presence of competitive advantage through – Distribution network, brand and quality of management etc which will allow the bank to earn higher than average ROE without undue risk

So effectively I do not have a quantitative (discounted cash flow type) approach to value banks. However I have tried to use a relative valuation approach. At the same time, according to me banks are risky businesses. One can never be sure what is the risk in the loan portfolio / derivative portfolio of a bank (you just have to trust the management). As a result I try to look for a higher margin of safety. I typically try to buy only when the bank seems to selling between 1-2 times book value provided the bank is looking good on the other factors.

Please share your approach/thoughts on valuing a bank. It would help me/others in developing a better approach to valuing a bank or any other financial institution.

Found an interesting view on indian economy from the ‘Morgan stanley GEF’ website

Some interesting observation in the article

We believe that a large part of the recent growth in industrial production and to a lesser extent services sector growth has been driven by cyclical global factors. A sharp fall in real interest rates since 2000 has encouraged both the government and households to borrow aggressively.

And

Acceleration in consumption growth has largely been driven by a rise in borrowing rather than income growth. Strong domestic consumption has been one of the key factors pushing the combined growth of industry and services sectors, which has averaged 9.3% over the past four quarters.

Second, rapid growth in leverage is also resulting in more credit risk in the financial system. Our banks team sees a rising credit risk building in the system as Indian households have leveraged significantly above the fair level that is supported by the current trend in per capital income. The central bank also relayed similar concerns.

The above makes you think about the valuation of banks which are showing strong profits and very low NPA. For Ex: ICICI bank has brought down NPA from 4%+ to below 1%. What are the kind of risks these banks have on their balance sheet due to their aggressive retail loans ? Somehow retail loans are now seen as low risk, high return and high growth area for most of the banks. As a result there has been a substantial growth of the retail portfolio. Maybe the overall risks are low (atleast the market has priced the bank stocks accordingly). The problem with bank loans is that these problems can remain hidden for a long time. As buffett as ‘Its only when the tide goes out, that you realise who has been swimming naked’

I was reading a research report on the sugar industry. The industry is a classical commodity industry with following characteristics

• Unbranded commodity product sold on basis of price
• Pricing depends on demand supply situation in the industry
• Highly fragmented industry
• Raw material (cane) pricing controlled by government and margins highly dependent on the Raw material prices

Lately the industry has been on an upswing, with demand exceeding supply and average inventories are down. As a result all the sugar companies have seen explosive profit growth (high operating leverage). Most of the sugar companies have very high debt levels ( > 2:1) and are in the process of raising equity to reduce it to manageable levels or working down the debt. At the same time as the capacity utilization is high, new capacity will have to be added through fresh equity or debt.

The industry is fairly cyclical with last few years being unprofitable for most of the companies. Lately however there is being a turnaround and most of the companies are selling at a PE of 6-7. The research report are bullish and predict a re-rating. I disagree with this analysis as it is simplistic and ignores the cyclical nature of a commodity business. Typically a cyclically business sells at a low PE at the peak of the commodity cycle and high PE at the bottom of the cycle .

I have simulated a commodity business cash flow and done a DCF analysis and the results the DCF model throws up confirms the above analysis ( the analysis can be downloaded here. The analysis has several assumption, but depicts a commodity business and shows inter-relationship between the cyclical earnings and PE).

I think the market is valuing these commodity businesses (sugar, cement) correctly and the analyst are being too optimistic in their appraisal and simplistic in their analysis. A few odd companies like balarampur chini or Ambuja cement may be different (due to a sustainable low cost position) , but the rest of the industry seems to be fairly priced

I was going through a report on the Retail industry specifically the Lifestyle / Garment (Non – Food sector).

Key points and my thoughts

· There are about three main publicly listed companies – Pantaloon, Trent, and Shopper’s stop
· All companies showing rapid growth (50 %+) and expected to show it for the next 2-3 (or more) years due to new stores being opened and share of organized retail rising ( current 3-4 % may go up to 7-8 %)
· All companies have raised debt or equity to fund expansion . In addition all the three do not have excessive debt and should be able to grow easily

· Margins are competitive ( 7-10 % OPM) and Net margins in the 3-4 %. For companies which have higher % of in-store brand , the margins are higher.
· New formats coming up such as central from Pantaloon ( A form of Superstore), Big bazaar (For groceries etc ) which have been fairly successful. Other companies in the space are also expanding through similar formats ( Trent has launched its hypermarket – Star India bazaar )

Positives

Strong growth in the sector due demographic changes in India ( Young middle class is now shopping more in such places)
A few successful formats are coming up which are driving growth
Development of organized retail will improve / streamline supply chain and help in developing the sector further

Negatives

· Competitive advantages depend on economies of scale / Brand and location advantages. Companies like Pantaloon if they can achieve scale would be able derive these advantages and face foreign competition. Companies which do not scale up or develop a niche will have a tough time facing foreign competition

· Foreign competition – Walmart / Carrefour are expected to enter the market. Their huge expertise and deep pockets cannot be matched by Indian players. Also reliance and other large industrial houses may enter the sector (Will the existing players get wiped out or relegated to niches ?)

· Valuation – Currently all the companies are trading at PE of 40-50 which reflect the opportunities ahead. But somehow the market is not considering the risks to these companies from expected competition

An important sector to follow, but not worth investing now as there is no margin of safety in the valuations (which reflect great times ahead, but no risks at all)