CategoryInvestment ideas

Basket Bet

By Rohit Chauhan
In Investment ideas, Risk management
June 22, 2020
4 Min read
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B

I wrote the following note to my subscribers on a recent position we have initiated. Specialty chemicals and Pharma is currently among the few sectors which have caught the fancy of the markets. I think these sectors do have the potential for above returns in the long term, though not every company will benefit equally from the tailwind.

The success or failure of each company will come down to the unique advantages/ competencies built by the management and their execution going forward. In addition to that, each company faces idiosyncratic (fancy word for unique) risks with FDA audits being one of them.

As a result, a single company bet can lead to losses even if rest of the sector does well

In order to mitigate this risk, I have taken a basket bet approach for the portfolio. This is also due to the fact, that one cannot estimate such risks ex-ante (before the fact). Diversification across the sector reduces, though does not eliminate the risk.

Pharma Sector bet

This is different from our usual transactions. This transaction is part of a sector bet. I am betting on the pharma sector for the following reasons

  • Several companies in the sector have been investing in R&D across a wide range of products such as Finished generics, API, Biosimilars and new dosage forms. As these investments have a long gestation period, the result is not fully visible in the P&L statement yet. We are now at the cusp of seeing the result of these investments, which have been made over the last 5+ years
  • Several companies have been investing on the front end (marketing) for the US and other markets. This allows the company to have a better control on the supply chain (with better margins) and work directly with customers. However, building the front end takes time and we are seeing early results of that.
  • The industry went through a growth phase till 2015, when it was hit by a mix of issues. The industry was hit by FDA audit failures which resulted in a loss of revenue for companies which failed the audit. At the same time, there was a consolidation of buyers (companies which buy pharmaceuticals for hospitals and pharmacies) which resulted in higher pricing pressure. This caused a drop in the growth and margins for the industry resulting in re-rating of the sector.
  • The industry has since then improved its processes and has a much better record of passing FDA audits. In addition to that, companies continue to invest in these processes to improve their compliance rate.
  • Several companies in the sector are now expanding beyond the US (and India) into other countries such as the EU, Japan and Africa. This should provide further growth opportunities for the sector.

We have an option to bet on a single company to play the above theme, but the risk of FDA audit and higher pricing pressures in some product segments continues to be high. I want to take advantage of this long-term tailwind and growth opportunity, but at the same time reduce the risk of failing an FDA audit.  Hence my plan is to go ahead with a sector bet where we will spread out our capital across a few attractive ideas.

I have not decided the number of companies or the size of the bet yet.

The ideas in this bucket – which I will call the pharma bet (PB) could be rotated in and out with a much higher frequency compared to other positions in our portfolio. I have been studying the sector for some time now and like a few other companies in this space. My plan is to add companies some of which could be long term plays whereas others could be more tactical in nature.

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A contingent stock

By Rohit Chauhan
In Investment ideas, Uncategorized
March 8, 2014
7 Min read
5 comments
A

A few disclosures – This is a borrowed idea. I will not use the word steal, as I got it from a friend J

This idea was published by Ayush on his blog (see here) and then he mentioned it to me via an email. I was intrigued by the extremely low valuation (which is not obvious) and some medium to long term triggers.

I started looking at the company in the month of December, and before I could create a full position, the stock price ran up. Inspite of the run up, the company is an interesting, though speculative opportunity.

Another disclaimer – I hold a small position in my personal portfolio, but as it is a speculative idea, I have not added it to my family or the model portfolio.

The company

The name of the Company is Selan exploration and it is an E&P (exploration and production) company. The company has five oilfields – Bakrol, Indrora, Lohar, Ognaj and Karjisan

As part of the NELP policy, the company has the rights to explore and develop these oil fields. The company was among the first private sector players to get the rights to do so and if successful in finding oil and gas reserves, they have to pay a certain level of royalty to the government. In addition, the entire production of the company is taken up by the government or PSU under the production sharing contracts

The E&P business

The basics of exploration and production are actually quite simple to understand – The government grants the license to explore and exploit a specific area which may be rich in hydrocarbons, under a specific contract. The company winning the contract then undertakes exploration of the area using various advanced technologies such as 3D seismic surveys and exploratory drilling to identify the size of the reserves and the best location to drill wells to exploit these reserves.

Once the reserves are delineated (identified), the company applies for the various clearances (such as environmental) which once approved, allows the company to drill production wells. Although the technology is quite advanced and allows a company to identify deposits accurately, it is not a precise science and hence a certain percentage of the wells may turn out to be dry wells (not enough oil in that particular location). These dry wells have to be abandoned and the cost has to be written off (similar to a product which fails in the market).

The productive wells, once online produce oil and gas which is transported via pipelines or other means to oil refineries.

The problems

Let’s start with the problems which have caused the stock price to stagnate over the last few years. That will also give us an idea of the medium and long term triggers for the company.

The company was granted the exploration rights in the 90s and has been able to increase the production from 62000 BOE in 2004 (barrel of oil equivalent) to roughly 2.82 Lac BOE in 2009. I described the process of license, survey, clearances and approvals to get to the final production stage of drilling the production wells and pumping out the oil.

As you see from the process, we have government involvement at each step and anything where the government is involved means lack of clarity and uncertain timelines.

As has happened for multiple sectors in the economy, the clearances for drilling production wells came to a halt in the last four years. Due to the nature of oil exploration and production, the current wells start getting exhausted in time and if you are not drilling new wells, the overall production starts dropping.

In case of Selan exploration, production dropped from 2.8Lac BOE in 2009 to 1.64 Lac BOE in 2013. The revenue dropped from 99 Crs to around 97 Crs in 2013 and the net profit was roughly the same (at around 45Crs)

A mumbo jumbo of terms

Before I get into what is the opportunity here, let’s talk about a few terms for the Oil and gas industry. For starters, barring Selan and Cairn (I), I don’t think the PSUs in this sector are worth considering as investments. These companies are run as piggybanks by the government to subsidize fuel in the country. It is debatable on how good that is for me as a citizen, but I am clear that it is a disaster for a shareholder.

If you want to understand how the industry works (without the chaos of government interventions), you may want to look at US and Canada based companies such as Chesapeake, Devon energy or Exxon Mobil. If you are looking at a pure play E&P Company, there are several small companies such as Novus energy or Jones energy.

Why bring up these non Indian companies? Any US or Canada based company has to declare several key parameters which help an investor to analyze an exploration company. Some of those parameters are

2P reserves (proved and probable reserves)

Operating netback per BOE : revenue minus cost

NPV10: DCF valuation of the reserves (revenue based)

EV/BOED: Enterprise value/ Barrel of oil equivalent in reserves (valuation measure)

Cost curves, EUR, Exploration cost and well IRR (for each field)

Current oil flow rate (BOED) to understand the current revenue levels

You can find the definitions easily by doing a Google search for these terms.

So which of this data is provided by Selan exploration? None!

Are they doing anything illegal? No, because I don’t think there are clear disclosure norms on the above for Oil and gas companies in India (none that I could find). In comparison, Cairn (I) has more disclosures and communication.

The thesis
In absence of this disclosure, why even bother and move on to something else? That is a valid point and hence I have called it a speculative bet as I am making it with minimal information.

What do we know here?

For starters, it seems that the company has 79.2 Million (7.9 Crore) BOE of reserves in two fields alone (Bakrol and Lohar). The company sells at around 1.2 dollar/ BOE (EV/2P) versus 5.5 for cairn (I). Comparable companies in the US/Canada sell at around 8-12 dollar/BOE. Of course the foreign companies are not comparable, due to a very different regulatory environment.

In addition to this valuation gap, we are not even considering the potential reserves in the other fields (which seem to be bigger than the ones in production). So we are talking of a situation where the market is valuing the company based on the current production rate (Which is suppressed due to lack of approvals) and is not giving any credit for its reserves.

The company is able to generate a pre-tax profit of around 70 dollars / BOE versus 10-25 Dollars for the US/ Canada companies. The huge difference is due to the fact that Selan produces mostly oil compared to oil and gas in case of other companies.

So the company is very cheap based on known reserves and is also quite profitable. In addition the company has spent close to 65 Crs in the last three years on exploration expense (remember the surveys to find the oil and gas reserves?). Once it starts getting the approvals, it can start drilling the wells and start pumping out money …sorry oil.

So why is this still speculative or contingent? It is contingent on the company receiving approvals – Which is seems to be getting recently based on the update in the latest quarterly report. These approvals are based on the whims and fancy of our government and one can never be sure what will the scenario be next year.

Why is it speculative – because there is so little disclosure and we are using the reserve numbers from a past annual report? We do not have any clear updates in the latest reports and so it is like driving with a foggy windshield window.

I have taken a small bet on the company to track the company and may buy or sell in the future based on new developments. As always, please do your homework and make your own decisions.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog

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Analysis: Supreme industries

By Rohit Chauhan
In Investment ideas, Uncategorized
September 18, 2013
7 Min read
17 comments
A

About

Supreme industries is a leader in the plastics processing industry and processed around 2.45 Lac metric tonnes in 2012. The company processes polymers and resins into various plastic products. The broad verticals for the company are as follows
  • Plastic piping including CPVC pipes
  • Consumer products such as molded furniture
  • Packaging products such as specialty and cross laminated films
  • Industrial products such as Industrial components and Material handling products
  • Construction business wherein the company has developed a corporate park on some excess land in Mumbai
The company has around 22 plants across the country which has helped it in reducing the transportation cost for the products (an important factor for operating margins).
Financials
The company achieved a topline of around 2900 Crs and is expected to close the current year at around 3500 Crs. In addition the company earned a profit of around 240 Crs (8% Net margins) and should be able to achieve a single digit growth during the year. The lower growth in net profits is due to lack of sale of commercial property in the current fiscal.
The company has been able to maintain an ROE in excess of 25% for the last 6 years. The debt equity levels have dropped from around 1.5 to around 0.6 during this. The company has also been able to improve the asset turns from around 2.5 in 2007 to 3.5 in 2012 as a result of an improvement in working capital turns (mainly driven by lower receivables as a percentage of sales).
The company has also improved its net margins from around 4% in 2007 to around 8% in 2012 driven by an improvement in overhead costs and depreciation as % of sales.
Positives
The company operates in a commoditized industry and as a result several products of the company earn low margins. The company is now focused on developing new products (called valued added products) such as CPVC pipes, cross laminated files and composite cylinders which have a higher operating margin (17%) than the other commoditized products such as molded furniture. The company plans to increase the contribution of these value added products to around 35% by FY15 and expects to improve the overall operating margins to around 15-16% levels
The company has a wide distribution and production network and well established brands in the plastics product space. The management has been able to use these assets effectively in entering higher margin products while exiting the commoditized segments at the same time.
The per capita consumption of plastics is around 7 kg versus almost 30-70 Kg in other countries. As a result, the industry is likely to see sustained growth for sometime as the per capita consumption increases with a rise in the income levels. In addition to the demand tailwind, companies like supreme are likely to benefit further as the industry continues to consolidate and the market share shifts to the organized players.
Risks
The company operates in a highly fragmented and commoditized industry. Although the company has been able to maintain the margins and a high return on capital by constantly introducing higher margin products, the moat or competitive advantage is not deep.
Brand name and a wide distribution network provide some level of competitive advantage, but the resulting moat is not wide and deep. As a result the company will have to constantly innovate to keep the return on capital high. The profitability could get hurt if there is a rapid commoditization of the various segments.
Competitive analysis
The plastics industry is a fragmented industry with a large unorganized sector, especially in commoditized products. The company has different competitors in each segment of operations.
In the case of PVC pipes the key players are finolex, chemplast sanmar, Jain irrigation, astral poly etc. In the packaging products there are around 6-7 large players and several un-organized ones. In consumer products nilkamal and Wimplast are the two key players. Finally in the industrial component segment there are a wide range of players ranging from Motherson sumi to Sintex industries.
Most major players earn an ROE of around 13-14%, with high leverage , except for astral poly which has an ROE of around 22% with low levels of debt (due its focus on a high margin and high growth product – CPVC pipes).
Overall the industry does not have high return on capital- due to the commoditized nature of the products. Supreme industries has been able to break away from the pack due to a portfolio approach to products (exit low margin products and move into high margin ones).
Management quality checklist
–          Management compensation – compensation is around 5% of net profits. This is on the higher side, though not excessive
–          Capital allocation record – The capital allocation record of the company has above quite good in the last 6-7 years. The management has been investing in high return projects and has also used some of the cash flow to reduce the level of debt. The ROE as a result has improved from the 20% levels to 30%+ levels in 2012
–          Shareholder communication – adequate. Management provides decent amount of disclosure in the annual reports and also conducts quarterly conference calls to discuss about the performance.
–          Accounting practice – appears conservative
–          Conflict of interest – none appear to be of concern
–          Performance track record – the management has been fairly transparent about its performance goals (growth and return on capital) and has been achieving them consistently in the last few years. In addition the management has been in this business for the last 40+ years and understand it very well.
Valuation
A discounted cash flow with conservative assumption of around 7-8% margins and 15% topline growth (10% volume growth + 5% inflation) gives a fair value in the range of around 530-570 per share. The growth assumption appears to be conservative as the company has delivered a 12% volume growth in the past. The risk is mainly around net margins which could come under pressure if there is faster commoditization in the industry.
The company has sold between a PE of around 8-9 and 18-20 in the past. The current PE of around 15 is at a midpoint and as a result the company does not appear to be overvalued.
Finally the company has shown a higher growth and Return on capital as compared to almost all other players in the industry (except astral poly) and hence has a higher PE (but not much) than others.
In summary the company does not appear overvalued and may be undervalued by around 30-35% from its fair value.
Conclusion
Supreme industries operates in a growth industry (due to increasing demand for plastic products) where the average profitability is quite poor. The company has been able to perform better than the other players by being focused on the newer and higher margin products. The management is as focused on ROC (return on capital) as on growth as compared to several other players who are pursuing growth at low returns.
Inspite of the above average returns and competent management, the company is unlikely to enjoy very high valuations like the FMCG industry as the overall profitability of the industry is low and the pricing power of branded products not very high. Supreme industries appears to be modestly undervalued and the returns are more likely to come from a consistent increase in profits than from revaluation by the market.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Value trade: Infinite computer ltd

By Rohit Chauhan
In Investment ideas, Uncategorized
March 10, 2013
6 Min read
13 comments
V

In an earlier post, I discussed about a new mental construct – value trade. This is basically an investment operation where one buys a super cheap stock in the hope that it will become merely cheap (as my good friend neeraj puts it).
The idea is to buy a stock which is selling at dirt cheap price due to various short term reasons such as selling pressure, unexpected bad results or sheer neglect. The hope is that the market will get over this extreme pessimism (temporary) soon and will price it at slightly more reasonable levels (though still cheap). 
In such cases, I am out as soon as the stock recovers (as I have done with some ideas in the past – Globus spirits).
About
Infinite computers is a 1400 Cr IT services company. The main business segments of the company are application management services, infrastructure management services, Product engineering services and a new division – Mobility solutions.
The application management services involve the usual ADM and other support services. This is the bread and butter of the Indian IT industry. This segment contributed to around 68% of the revenue for the company and is characterized by repeat revenue, moderate levels of margins and high levels of competition
The infrastructure management services contributed around 16% of the revenue and is similar to the application management services in terms of profitability and competitive pressures. These two segments are being commoditized across the industry and the days of fantastic profits are gone.
The product engineering services involves some kind of IP based revenue sharing model. I could not find any revenue data for this segment, but based on the other segments would assume around 14-15% of the total revenue.
The mobility solutions segment is a new segment referred to as Infinite convergence solutions. This is a messaging platform (details here) acquired from Motorola and supports around 100 Mn+ global subscribers.
Financials
The company has grown from around 350 Crs in 2007 to around 1400 Crs for the year 2013 which translates to around 25% CAGR growth.  The net profit for the company has grown from around 3 Crs to around 120-130 Crs for the current year.  The net margins have improved from around 9% to around 11% levels, mainly due to a small reduction in the manpower cost (as % of sales)
The company has been able to deliver an ROE of 20%+ in the last five years. In addition the company been able to maintain receivables at around 25-30% of revenue which seems reasonable for a company of its size.
The company is a debt free company and has around 130 Crs cash on the books (30 % of market cap). The management has been investing capital into the business, has a 30% dividend payout ratio and the rest has been accumulated as cash on the books. In addition, the company also did a small buyback in the last one year.
Positives
The company has a very strong balance sheet and good returns ratio. The management has invested capital sensibly in the past and has a reasonable dividend policy in place. In addition, the top management is a buyer of the stock at the current levels (though one should not read too much into it)
The company has a high level of repeat business, which provides a high level of confidence to the sustainability of the revenues.
Risks
The company has been able to grow the topline and profits since 2007 and now has considerable cash on the books. At the same time, the company was not very profitable from 2005 to 2008 (average 2-4% margins) and had a very low topline growth of around 5% per annum during this period.
The company operates in a highly competitive, global and fragmented industry – IT services. The industry is facing commoditization and is very likely to have lower profitability in the future. The company is focused on the telecom industry which has its own competitive pressures with the additional risk of a very high proportion of revenue from the top 5 clients. This exposes the company to a high level of topline and profit risk, if there is any loss of  business from the top few customers.
Finally, the company is also expanding into the product space which is a high risk, high return kind of a business. The company has invested in excess of 80 Crs on various product related businesses and these intangible assets may incur a write down if these ventures were to prove unsuccessful.
Catalyst
In case of a long term idea, a buy and hold strategy works quite well as the company is growing its intrinsic value. In case of mid cap IT companies, the economics of the industry over the long term is not very clear (atleast to me). As a result, the returns have to come over the next 9-12 months and this is usually driven by a catalyst.
In case of infinite computer solutions, the 2013 profits have been a bit suppressed by the forex losses and once this headwind dies down , we should see a better growth in the net profits. A consistent dividend payout of 30% – growing with the profits should serve as another catalyst.
What can go wrong?  A loss of any of the top 5 customers would hit the topline and profits. A sudden slowdown in north america would impact the company as this region accounts for almost 80% of the revenue. If any of this happens, the stock is likely to drop in the short term
Finally, if the management does an overpriced acquisition or has to write down the intangible assets, the market is not going to like that.
Conclusion
The company sells at a PE of around 4 and an EV/EBDITA of 1.7 (after excluding cash). At these levels, the market believes that the company will soon be out of business. The company does face multiple risks (which company doesn’t), but none of the risks appear to be fatal. In addition, as far as I can tell, the management seems to be doing a good job of managing the business and a fair job of allocating capital.
If one believes that the company is not going out of business, then one does not need any fancy calculations to realize that the stock is cheap.
Why a value trade?
I am not comfortable with the economics of the IT services industry. This industry is commoditizing and the wage arbitrage game is slowly coming to an end. The super high returns on capital are likely to trend down – as has already occurred for several mid cap companies in this space.
At the same time, I cannot resist an undervalued stock which can deliver above average returns in the medium term (9-12 months).
Note: This idea was emailed to me by chaitanyya and it is not an original idea. I have a small starter position and will add or reduce based on the price and performance of the company.  Please do your own due diligence.
Disclaimer : Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

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Triveni turbines limited – Waiting for growth

By Rohit Chauhan
In Investment ideas, Uncategorized
December 10, 2012
5 Min read
10 comments
T

About
Triveni turbine is a Bangalore based company in the business of manufacturing and servicing steam turbines upto 30 Mw. In addition the company has a JV with GE (general electric) for turbines in the range of 30-100 Mw.

The company has around 2500 turbine installations globally and is a market leader in India in the sub 30 Mw range with a market share of around 55%.

Steam turbines have multiple applications such as co-generation, captive power plants, and Industrial drives and in ships. The company supplies industry specific turbines to multiple industry segments such as sugar, cement, steel, chemicals, municipal solid waste and textiles.

Financials

The company was spun off from triveni engineering in 2011, which also has a sugar, water management and gears business. The turbines business has grown from around 280 crs in 2006 to around 670 Crs in the current year at a CAGR of around 13%. PBT has risen from around 37 Crs to 140 crs in the current year at a CAGR of 20%+.

The company has been able to maintain an operating margin of roughly 25% during this period and a return on capital in excess of 100%. The company is able to earn such a high return on capital due to negative working capital and high operating margins.

Positives

The company earns a very high return on capital which points to the presence of a sustainable competitive advantage. It enjoys a very high market share in India and is now expanding into export markets too

The company also has the following four growth engines working for it

–      Industrial demand for power via captive power plants. Additional demand from co-gen opportunities
–      Service demand from the install base and for turbines of other manufacturers.
–      Demand from the JV with GE in India and abroad for the 30-100 Mw range
–      Export demand for sub 30 Mw product range

In addition to the above growth opportunities, the company is currently running at around 40-50% of capacity and can expand sales with minimal capex.

Risks

The key risk for the company is a delay in the revival of the capex cycle. The investment cycle has slowed down in India and in the export markets. As a result the company has struggled to grow the topline and profits in the last 2 years. If the capex does not revive, the company could face stagnant profits for some more time.

Competitive analysis

The key competitor for the company in India is Siemens. However companies like Siemens and BHEL have a very wide range of products and are not as focused on a single product in a narrow range (below 30 Mw). Most companies in this sector enjoy a decent return on capital and hence triveni turbine should continue to earn a high return in the foreseeable future.

Management quality checklist

–          Management compensation : reasonable at around 1-2% of profit
–          Capital allocation record : In the short operating period as an independent company, management has used the free cash to pay down the debt and the company should be debt free by the end of the year
–          Shareholder communication – fairly good. The company shares adequate details via the annual report and quarterly investor updates and conference calls.
–          Accounting practice – appear conservative
–          Conflict of interest – none

Valuation

The company is currently selling at around 20 times earnings. On the face of it, this does not appear to be cheap. At the same time one has to look beyond the raw numbers. The topline and profits for the company have stagnated in the last 2 years with a complete collapse of investment demand.

During this period, several capital goods companies have made losses and have seen their working capitals blow up. During one of the worst downturns in the sector, the company has remained solidly profitable and continues to operate with a negative working capital.

In addition the company expanding its export business has a thriving and growing turbine services business and should see additional revenue from the JV with GE. We may not see a PE expansion as the company is already operating very efficiently, however as the topline and profits start expanding, we should get a return commensurate with the growth.

Conclusion

The company operates in a niche and has a sustainable competitive advantage due to its customer relationships and service network. In addition the company has formed a JV for the 30-100 Mw range which should enable it to expand the target market for its products.

The company’s performance has stagnated in the last 2years due to the macro economic conditions. However the long term prospects remain intact and the company and its stock should do well in the long run.

Disclosure: No position in the stock as of writing this post

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog. 

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For the patient investor: ILFS investment managers

By Rohit Chauhan
In Investment ideas, Uncategorized
November 10, 2012
5 Min read
18 comments
F

About
IL&FS investment managers is a private equity/ fund management company promoted by ILFS (50.5% ownership). The company is in the business of raising funds from investors (institutional – both in India and abroad) in the form of individual fund offerings.

These funds have their individual mandates such private equity investments, infrastructure or real estate type investments. The company is responsible for investing the funds, managing the risks of individual investments and then finally working out exits from these investments. The company has been fairly successfull in managing the funds, generating 20%+ returns on most of the funds in the past for the fund investors.

The main source of revenue for the company is the fixed 2% management fee on these funds and an override on the returns over a threshold (a percentage of the gains made, above a threshold)

Financials

The company has delivered a 35% growth per annum over the last 8 years. The company earned around 225 Crs in 2012.

The company has grown the net profits at around 40% over the same period and made around 74 Crs in 2012. The main cost for the company is compensation for the employees and overhead expenses incurred on launching and operating the funds. The company has been able to maintain net margins in excess of 30% in the last 10 years.

Finally, the company has been able to maintain a high ROE of 30%+ and if one excludes the excess cash on the balance sheet, the ROE would be in excess of 50%.

Positives

The business requires minimal incremental capital to grow. The main assets of the company are the brand, its relationships with clients and the skills/knowledge of its employees.

The company needs very little capital to grow (some extra office space and maybe a few computers) and hence the entire profit is truly free cash flow. The company has consistently maintained a high dividend payout ratio in the past (over 50%) and used the excess capital to acquire a new fund (saffron) in 2010.

The company has a long operating history in raising and investing funds in various opportunities in India with good results (returns in excess of 20%). As a result the company has a good reputation with current and potential investors which should help the company raise additional funds from the clients in the future.

Risks

The company operates in a very competitive environment with minimal entry barriers. The company now faces stiff competition from a large number of Indian and international competitors such as hedge funds and other private equity funds. This has resulted in higher competition for raising India specific funds and investing the same in attractive opportunities (businesses) in India. This could result in lower returns for the fund investors and hence lower income for the company in the future.

The slowdown in the investment cycle, recent actions by the government such as the GAAR fiasco and other global macro-economic factors have made it difficult for the company to raise new funds. In addition the exit timelines for the fund investments have increased due to weak stock markets, resulting in lower returns for the fund investors. All this has impacted the revenue of the company which depends on the volume of funds managed (AUM) and the carry (excess returns over a threshold). It is unlikely that the investment cycle will turn around quickly, due to which the company may face a longer period of low revenue growth or even de-growth over the next few quarters.

Management quality checklist

Management compensation: fairly high at 25% of revenue. However this kind of compensation is typical of the industry.
Capital allocation record: extremely good. The company has maintained a very high dividend payout ratio and has indicated that they will dividend out almost the entire profits to the shareholders.
Shareholder communication: Quite good. The company provides adequate details of the business in its annual reports and conducts quarterly conference calls to keep the shareholders updated on progress.
Accounting practice: conservative
Conflict of interest: none

Valuation

The company is currently selling at a PE of around 7 which is on the lower side of the past PE range of the company (6-23). A company earning an ROE of around 30% and with a 15%+ growth prospects can easily support a PE of 15 or more. The company thus appears undervalued by most objective measures.

Conclusion

The company has performed extremely well in the past and has rewarded the shareholders well. The period from 2003-2008 was a bull market for private equity and stock markets resulting in high returns for the company’s funds. This resulted in good profits and high growth for the company.

The markets have slowed down considerably since the 2008 financial crisis and the Indian government has made it worse in the last few years. As a result, the company has struggled to raise new funds which is needed to drive the topline and profits for the company. It is likely that the company will take a few more quarters before it can raise and deploy new funds and a result the topline and profits could stagnate for some time.

The long term prospects of the company are good, though it will take time for the company to start growing again. This would test the patience of most investors.

Disclosure: No position in the stock as of writing this post
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog
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Analysis : OIL India

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
February 27, 2011
5 Min read
15 comments
A

About
Oil India an E&P company (oil exploration and drilling) which came out with an IPO in 2009. The company is a category – I, miniratna which allows them operational flexibility from the government (atleast on paper). The company operates mainly in the north-east with additional fields in Rajasthan and a few JVs in the foreign markets such as Iran, Sudan and Venezuela.

Financials
The company has delivered fairly good results over the last few years. The company has been able to deliver an ROE in excess of 20% from 2003 onwards (the year from which the results are available). If one excludes extra cash on the balance sheet, then the return on capital is in excess of 50%. The company is debt free and has excess cash to the tune of 30% of its market cap.

The company has delivered a topline growth of around 15% per annum for the last 8 years and net profit growth of 24% per annum during the same period. The company had a topline of around 8859 Crs and profit of 2610 Crs in 2010. The company has been able to generate a net margin in excess of 25% and fixed asset turns in the range of 1.7-2. The company operates with low working capital requirement and has also operated with negative working capital for a couple of years.

The company has been able to invest the internally generated cash to acquire new assets (exploration blocks in India and abroad) and thus maintain and grow its oil reserves at a decent rate.

Positives
The company has a great balance sheet. It has almost 9000 Crs of excess cash on its balance sheet. This cash can be used by the company acquire oil assets and thus grow the business.

In the oil and gas business, the only way to grow the business is to continuously acquire rights to new oil fields and carry out exploration (read drilling) activities. The nature of the business is such that a few of the exploratory wells will be unsuccessful (no oil or gas), but the successful ones will more than cover for it and more. In addition new technologies such as 3D seismic surveys help the companies in finding attractive places to drill so that the chance of finding oil or gas is higher (and lower the chance of drilling a dry well which is literally a sunk cost).

The company has been able to grow its oil reserves from 33 MMKL to 38.3 MMKL and gas reserves from 29.1 MMKL-OE to 37.9 MMKL-OE in the last 5 years. Higher the oil reserves, higher the oil & gas which can extracted and hence higher the topline and profits.
In addition to the above positives, the company has been able to improve its return on capital by increasing the total asset turns from around 0.95 in 2003 to almost 1.7 in 2010. The company also pays almost 35% of its profits via dividends

Risks
So whats not to like in the company? On the face of it the company has great margins, high return on capital, great balance sheet and good growth prospects (India needs more oil and gas).

There is one word for the key risk – Government of India. Currently OIL India shares almost 33% of the fuel subsidy with the rest being borne by the downstream company. If you have been following the news lately, you must noticed that oil recently crossed 100 $ a barrel. The state owned oil companies as a whole are losing money at the rate of almost 1lac crore/ annum (no it’s not a typo).

The India government has two options – raise the price of fuel or pay for the subsidy through the budget. The government may raise fuel prices by a bit, but it is a politically difficult decision. The other option is to take the subsidy on the budget and blow a hole in the deficit. The third option can be a mix of these two options and to get the upstream oil companies to share the loss.

If the downstream companies such as IOC, HPCL are bleeding money, how likely is it that the government will allow the upstream companies like ONGC and OIL to make decent profits? What stops them from increasing the subsidy burden?

The last time oil prices crossed 100$/ barrel (2008), the company was able to maintain the margins and the subsidy burden did not hurt the margins. So we have some level of comfort from the recent history, though the price spike was for a short period. We do not know how the government will react if the oil prices remain elevated for a long period of time.

Conclusion
I currently have no position in the stock. I am not able to evaluate the above risk. It may just be that I am over estimating the risk. At the same time one has to consider the possibility that oil could remain over 120 levels and the government may decide to increase the subsidy sharing, driving down the company’s profits.

If the above risk materializes and every other analyst is screaming a sell on the stock – it may be a good time to buy.

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Quick analysis – Amara raja battery

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
February 20, 2011
2 Min read
11 comments
Q

I am currently in the process of looking for new ideas and have shortlisted a few. I have done some preliminary analysis and these ideas have made through the initial filters. However, these ideas need deeper analysis to make a final buy decision. I am discussing one such idea in this post – Amara raja batteries

Amara raja Batteries
The company is the no.2 batteries manufacturer in india and supplier to the industrial, automotive and telecom sectors. The company also has a strong presence in the after market with the amaron product range.

The company has grown its topline at 25%+ per annum and its net profit 20% per annum. This growth has not been a smooth upward trend. The company had a drop in profitability during the 2003 to 2005 time period. The company has managed to pay off most of the debt it acquired for adding capacity and now has a debt equity ratio of around 0.1

The company has maintained a return on capital in excess of 20% in the last 5 years, however the period from 2000-2005 was a period of poor returns due to lower margins and requires more investigation on the causes of the poor performance. The asset turns of the company has improved steadily from 2000 onwards.

The company has been expanding its retail distribution and is also expanding its relationship with various OEMs. The company is focusing on expanding its relationship with 2 wheeler OEMs now.

The company has done well over the years and provided good returns to the shareholders. The company has provided almost 36% annual return over the last 10 years, excluding dividends. This return has come partly through PE expansion during the period (from 4 to around 10 now) and the rest through an eightfold increase in the net profits.

In summary, the company is atleast worthy of a more detailed analysis.

IT companies
I have exited all my holdings in the IT industry. I have had positions in Infosys, patni and NIIT tech at various points of time. I have exited these companies mainly for valuation reasons. I personally feel that the risk reward for IT companies is not attractive at currently valuations.

If the prices were to drop to 2008 levels (when midcaps were selling for 2-3 times earnings), I will not hestitate in creating new positions again.

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Analysis : Noida toll bridge

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
January 9, 2011
6 Min read
23 comments
A

I typically have a look at my current positions every 6-12 months independent of the quarterly/ annual results. This allows me to evaluate the company independent of the recent results (which would bias my thinking)

About
The Noida Toll Bridge Company Limited was incorporated as a Special Purpose Vehicle for the Delhi Noida Bridge Project on a Build, Own, Operate and Transfer (BOOT) basis. The Delhi Noida Bridge is an eight lane tolled facility across the Yamuna river, connecting Noida to South Delhi.

The company initially had financial issues after the toll bridge was completed as the initial traffic projections did not materialize. The company had a highly leveraged structure (high debt) and hence had to get the debt re-structured. In addition the company also raised equity in 2006 to improve the debt equity ratio.

The company has since then paid off substantial amount of its debt and has a low debt to equity ratio of 0.3:1.

Business model
The business model of toll bridge is quite interesting to say the least. The initial capital investment is fairly high in an infrastructure project. Once this capital is invested, the ongoing maintenance and operational costs are very low and most of the incremental revenue flows to the profit.

However if the initial revenue projections do not materialize, then the debt load can crush a company, which occurred in case of noida toll bridge, due to which the company had to undergo the re-structuring. The company was thus able to buy time for the traffic projections to come through. The toll bridge now handles around 105000 vehicles per day (ADT or average daily traffic) which is around 45% of the rated capacity.

Current financials
The company had a toll revenue of around 71 Crs in 2010. The company is also able to sell rights for outdoor advertising around the bridge and was able to earn around 8 Crs from it. There is some miscellaneous income of around 5-6 Crs in addition to the above.

The company was able to make a net profit of around 28 Crs on the above revenue base. The company has an operating expense of around 30% of which the main heads are staff costs (salary) at around 8%, depreciation at around 6% and O&M (operating and maintenance) costs at around 8.6%.

The depreciation expenses are bound to remain fixed as there is not much addition to the fixed assets. A portion of the O&M expenses are now paid as a fixed charge to a 51% subsidiary and are not based on the traffic volumes. The salary costs and some other expenses such as legal fees, travelling expense etc are variable and are bound to increase over time.

The company thus has around 40-45 Crs of pretax profits available to service the debt. The company has been paying down debt which now stands at around 145 Crs in the latest quarter. At the current profit levels, the company should be able to payoff its entire debt in less than 3 years (though it may not happen due some of the re-structuring clauses).

The valuation model
Noida toll bridge may be one of the easier companies to model to arrive at a fair value. The average daily traffic (ADT) has grown at around 15% in the past. One cannot assume that the traffic will continue to grow at that pace, however one can easily assume that the traffic will atleast grow at 3-5% annum till we reach the 100% capacity of the toll bridge.

The average fare per vehicle is around 19 Rs. One can assume atleast a 5% increase in the fare over time (slightly less than inflation). These two figures – ADR and average fare can be used to estimate the toll revenue.

The current operating costs are a mix of fixed (depreciation) and variable (staff and other costs) expenses. On an optimistic note, one may assume that these expenses may go down as percentage of revenue. However if one, wants to be conservative, then the expenses can be assumed to be around 30-35% of the revenue.

There are two additional factors to consider in the valuation. The first factor is the advertising revenue which the company can earn with minimal expenses. In addition to this, the company also has a leasehold title to around 99 acres of land which was awarded by the government as compensation for shortfall in the revenue. The company estimates this title to have a value of around 300 Crs. I have personally not ascribed full value to it as I don’t have an idea on the status of this leasehold title or what the company plans to do with it (which the company describes as a risk)

The risks
Noida toll bridge was assured a 20% return on the cost of the toll bridge through toll collection and development rights for 30 years. In the initial years, the traffic projections did not come through and hence the actual returns were much lesser than the assured returns. The shortfall in the returns has been accruing to the company and one way of compensating the company would be to extend the 30 year operation period for the company. In other words, the company may be allowed to run the toll bridge for a much longer period.

The leasehold title is definitely a risk for the company. Anything related to land always has some kind of political risks.

One irritant for me is the staff cost. The staff cost for the company is way too high. The company has around 15 employees and wage bill of almost 6 Crs. The key management personnel (CEO and a manager) are paid a salary of around 4Crs. I think the compensation costs of the company are high.

Finally, the company will generate quite a bit of cash flow once the debt is paid off. It is not clear what the company intends to do with the excess cash, though the company has started paying dividend in the current year

Conclusion
My own valuation estimate is around 50-55 Rs per share with an assumption in traffic growth of 5% and fare rate increase of around 3-5% per annum. You have two options – either take my estimate on face value, or you can use the assumptions I have provided to estimate the value on your own.

My personal preference is to consider a range of assumptions for traffic growth, fare rate changes and cost parameters to arrive at a range of fair value.

Noida toll bridge has a much higher probability of increasing revenue, though anything can happen to prevent it (such as people will start walking instead of driving). On the flip side, there is a limit to the growth and upside as the maximum capacity of the toll bridge is fixed and once that is reached, further increases will be limited to fare increases only.

At current prices, I am not buyer of the stock as it is not very attractive yet. I have small position in the company. As always please read the disclaimer before making a decision to buy or sell the stock.

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Stock analysis : FDC ltd

By Rohit Chauhan
In Company analysis, Investment ideas, Uncategorized
August 9, 2010
6 Min read
9 comments
S

About
FDC is an Indian Pharmaceuticals company with an operating history of more than 50 years. The company is into formulations, synthetics, nutraceuticals and bio-tech with a focus on therapeutic groups of ORS, opthalmologicals, dermatologicals, Anti-biotics, Cardio and diabetes. The company has several well known brands such as electral, enerzal etc.

Financials
The company has maintained an ROE in excess of 20% for the last 10 years. In addition the company is conservatively financed with zero debt and excess cash position during the same period.

The company has maintained fixed asset turns (sales/ fixed asset) at the same levels by investing in fixed assets in line with the topline growth. The working capital turns (sales/ working capital) have improved from around 5 to 9+ levels in the last 10 years. This improvement has been driven mainly by an improvement in receivable turns (sales/ account receivables).

The net margins have improved from the 15% levels to 20% levels mainly due to drop in raw material prices.

Positives
The company has maintained a high ROE with a very conservative balance sheet. The company has maintained excess cash and financed growth with the free cash flow generated from operations.

The company has also been able to maintain a topline and bottom-line growth in excess of 15% in spite of high competition and change in the operating environment (changes in patent laws in 2005).The company announced a buy-back in 2008 and has been able to use the excess cash to reduce the number of outstanding shares.

The company has a consistent track record of introducing several new products every year and currently spends almost 3% of sales on R&D which is a crucial investment in the pharma business.
The company is conservative in other aspects of the business such as foreign acquisitions (none) or expanding in the foreign markets (exports are 10% of total turnover).

Risks
The company operates in a business characterized by a high level of competition from domestic and deep pocketed global pharma companies. Although company spends a substantial amount on R&D, global players such as JNJ spend in excess of 10% on R&D. As a result the R&D spend of the company is small by most standards and can be utilized only to develop the off patent molecules in the form of generics for the local and export market.

This is a very competitive business with low to moderate profitability and several other domestic pharma companies such as a CIPLA or Dr reddy’s have a major head start in the space (they are almost 10 times the size of FDC)

In addition the company is also into the consumer health space which is closer to FMCG than pharma products and requires a different set of skills and focus.

Competitive analysis
The industry is characterized by a large number of domestic and foreign competitors. India, China and other BRIC countries are the major growth areas now and all the major companies are now targeting India for growth. The market is already experiencing a high level of competition and activity. One indicator is the number of new product launches and corresponding marketing and sales cost.

The generics opportunity in the export markets of US, Europe and Japan is big with thin margins and high levels of competition.

In case of a drug coming off patent, the pricing typically drops off by more than 60% in the first year and by almost 80% by the third year of patent expiration. As a result these are high risk – high return, limited duration type of opportunities.

Management quality checklist

– Management compensation – Management compensation seems reasonable at less than 3% of net profit.
– Capital allocation record – Fairly good till date. The management has kept the ROE high, inspite of high cash levels. In addition the management has also used the excess capital to buy-back shares which is a sensible decision.
– Shareholder communication – Very sketchy. The mandatory disclosure in terms of the balance sheet, P&L and other schedules are as per the standards. However the company, like other mid cap companies, is very sketchy and does not provide enough discussion on the subjective parts of the business. It gives a very generic overview of the business and has not discussed the plans for the future in detail. If you compare with the annual reports of other pharma companies like Dr reddy’s, the differences are glaring. I can live without too much detail for a steel or a cement company as the numbers give a good picture, but for a pharma or IT company the subjective details are important to evaluate the future of the company. This is a big negative for me.
– Accounting practice – Seems ok. Nothing out of the ordinary
– Conflict of interest – Related party transactions seem fine. I could not find anything out of the ordinary.

Competitor analysis (top 2-3 competitors)
The main competitors for FDC are the domestic pharma companies such as Dr reddy’s, Cipla, Sun pharma and Ranbaxy. These companies are much larger than FDC and are not strictly comparable. At the same time, competition in the pharma industry is by segment. The term pharma is too broad for comparison. If one has to compare competitors, it would be by therapeutic groups such as anti-bioitics, cardio-vasculars, opthalmologicals etc.

FDC has a leading position in some segments such ORS and a few leading brands such as ZIPANT-D SR, 1-AL etc.

The net margins for FDC are comparable to the other top companies and the ROE is also in the same range of 20%+. The overall business risk to FDC is much lesser as the company has not expanded aggressively in the foreign markets. Conversely the returns and growth have been lower too compared to the other aggressive competitors such as Dr reddys, SUN pharma etc.

Valuation
A DCF calculation with a net margins of around 16-18% and 10-12% growth (both assumptions are conservative based on past history), gives a fair value of 120-140 per share. The company would be a good value below a price of 70 per share or if the company started doing far better than the assumptions in the above valuation.

Conclusion
FDC has been a conservatively managed company which has done fairly well in the past 10 years. The company has expanded mainly in the domestic markets and is now expanding slowly into exports via new ANDA filings. The company is likely to maintain a 10-15% growth in line with the market growth with some additional growth coming from exports.

As an investor, I would expect the company to give me moderate returns at low risk. I don’t think the company can be a multi-bagger in the short to medium term.

Disclosure : I have position in the stock. The above analysis is not to recommend the stock. So please do your own homework on it.

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