CategoryInvestment ideas

About
Bharat Electronics Limited (BEL) is the largest defense equipment company in India catering to Defense services electronic requirement. BEL enjoys near monopoly status in supplying high-tech defense products like radars, sonars, communication equipment, electronic warfare equipment to the armed forces. Other division manufacturing civilian products supplies communication equipment to the telecom industry, voting machines etc.

The defence sector contributed to 76% of the revenue and the rest was from the civilian sector.

The company has a government mandated near monopoly for the defence sector business. In addition foreign vendors as a part of localization are required to source from BEL

Financials

The company has shown considerable improvement in financial performance. Topline has grown by 10% p.a for the last 5 years. The net profit has however grown by almost 20% p.a during the same period.

The higher bottom line growth has been driven by an increase in net margins from 10% to around 17% in 2008. Total Asset ratios have improved from around 8.2 to around 9.2 in 2007. The Wcap is negative or zero and the inventory turns have also improved 2.1 to 3.3. Only the recievables ratio has dropped from 3.1 to 2.5 in 2007.

The management seems to be aware of this and in 2007 has indicated that this was mainly due to incomplete projects and should improve in the current year.

The company is a cash rich company with cash net of debt of around 2200 Crs which could improve further in the current year.

The ROE seems to be steady, however net of cash it has been improving and the Return on incremental invested capital has gone up a lot.

Positives
The financials have improved substanially in the last 5 years. The net margins and Return on capital has gone up. The company has considerable cash on books. In addition the company spends almost 3-4% on R&D.
The company has introduced almost 25 products and systems in 2007. The company plans to continue this pace of new products in the future too.
The company has an order book of almost 90000 million in 2007 which is equivalent to 3 years of revenue at the curent rate.
The company will also benefit from the mandatory offset clause where in foreign vendors have to procure some portion of the contract from BEL.

Risks
The margins have gone up from 10% to around 17% in the current year driven by Raw material cost reduction. I am not sure how sustainable this improvement is. The long term average is still around 10-12 % and the current rise could be temporary.
The defence spending dropped around 1996-1998 time period and the net profits were low during that period. It looks unlikely that the government would drop defence spending now, however the risk remains.
Competition is very low in the defence sector, however the other segments do have some competition.

Competitive analysis
BEL is one of those rare companies which have very substantial competitive advantages. These advantages are government mandated and I find it diffcult to see how these will go away. Across the world there is a preference for domestic companies for defence contracts, more so in india.

Valuation
With an assumption of current growth and margins, the Intrinsic value comes to around 2100 Rs/ share. However a senstivity analysis of margins and topline gives the following numbers
Topline – 10%, margin – 10-12 % (long term average): 1650
Topline – 14%, margin – 10-12% : 2200
Topline –14%, margin – 17% : 3300

The central point for the intrinsic value seems to be around 2000-2200.

Conclusion
The company seems to be trading at 30-40% discount to instrinsic value. This is however not a sexy company. This is a company with substantial competitive advantages and will continue to be very profitable. However I don’t expect the market to suddenly discover this company and give a higher valuation. Most likely one can expect decent returns in the long run.

I got the below comment and thought of posting on it.

Rohit,
I am not sure if abandoning HPCL is such a good idea right now. You can buy good stocks at bargain only during distressed times. First crude prices will definitely go down. its just a temporary blip and secondly government cannot afford to shut down these PSU oil companies. Definitely PSU oil companies are not a long term bet for me..but for the short term ..i guess there is an excellent opportunity as of now. I know i can be wrong.

Selling is always a difficult decision especially if the underlying assumptions change. I personally analyse my stocks every quarter and more frequently if the underlying situation changes. In case of HPCL, I was banking on two key points
– Margins will not deteriorate drastically and maybe improve a bit in the next 2-3 years as other initiatives from the company bear fruit.
– market would realize that the company sells at 20-30% of asset values and will reduce the gap

Clearly the spike in Oil prices has invalidated the first point and the second may not happen soon due to point 1. I rarely make sell decision by short term drops in price. If the intrinsic value of the company is steady or growing, I will hold on to the company for a long time.

In case of HPCL, my key concern is that the intrinsic value of the company is being destroyed on a daily basis and at a very rapid rate. Time is not on my side in this case. The current oil price may turn out to be temporary. However I am not willing to bet on that as, the longer the oil price remain high, the more the company will bleed.

Finally an investment idea needs to be compared with all the other options or ideas. As of now, I can see other ideas which are better from a risk reward perspective and hence I decided to move out from HPCL.

I had written the post below on 20-May. Since then the government has started thinking of raising the fuel prices. Note the word – thinking. The decision to raise prices is easier said than done. Even if the prices are raised, the haemorrhaging of the oil companies will reduce only partly.
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I had written about HPCL earlier see here and here

The key elements of the investment thesis was as follows

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

The key unsaid assumption was that oil would not spike sharply. Oil prices are now at 130 usd a barrel (double the levels at the time of the analysis) and show no signs of coming down. In addition , I also read the following report – oil firms weeks away from bankruptcy. Now I do not believe the oil firms will go bankrupt – technically speaking. It is in the interest of the government to keep these companies alive. However the future looks bleak for these companies for the following reasons

1. Oil prices are unlikely to come down anytime soon. So the only way the government can sustain these companies is by issuing oil bonds. To raise cash, these companies will have to sell the oil bonds at some discount , incurring losses.
2. The government is unlikely to compensate these companies fully, wanting to keep the deficeit under control. As a result expect these company to incur losses for the forseeable future. In such a scenario, I am not sure how much these companies can invest in profitable growth and other assets.
3. These companies will increasingly look like the State SEB and other power companies in the long run – forever subsidsing the consumer due government pressure and unable to grow the business or invest in it.

Key learnings

1. I was clearly wrong about point 2 in the thesis. I never expected the oil prices to spike to 120+ (if i knew, oil futures would have been a great investment) . I never expected this government to remove the subsidy (and the next government wont do that either – it is not in their self interest). However the price spike in crude will be devastating to the oil companies.
2. Ignoring key pyschological principle – self interest combined with a crude price shock. Individuals and goverments take actions which are in their personal interest. Which political party is ever going to increase fuel prices and risk losing elections. I expected the government to behave in the way it is now. However self interest combined with high crude price will hurt the companies big time. As long as the prices were 100 usd or lower, the situation was bad, but now it is dire for these companies.

The loan waiver was still a one time event (hopefully). However the above subsidy is ongoing and will hurt the oil companies in the long run (in the short run they will be compensated via oil bonds and other mechanism). The above thesis was reasonable for moderately high crude prices. However the current price shock could drive the networth to zero.

Disclosure – I am exiting my position at a small gain. HPCL has not been a big position for me. The risk reward situation was good initially. However with the oil prices shooting up, I think the risk is not commensurate with the return.

Added note : In life there is no free lunch. Till date the government has subsidized fuel by gouging the oil companies. That well is now dry. Eventually all this subsidy will have to be paid by someone. It will likely come through taxes and higher inflation (most likely a combination of both).

About
Maruti Suzuki is india’s largest car company with brands such as Maruti 800, Alto, Swift etc. The company sold around 760000 cars in FY08 and currently holds a 50%+ market share

Financials
The company has achieved a 10%+ growth for the last few years. In addition the ROE has been 20%+ for the last few years and net of cash the ratio is upwards of 50%. The net profit margins have gone up from 5.8% to 9.8% in the current year. The company is a zero debt company and has almost 3000 Crs + cash and investments as of 2007.

In addition the efficiency ratios have improved from 2003 onwards. The company is now working on 0 Wcap. The recievables ratio is up from 14 to around 19 (2007). The total asset ratio has improved to around 5.

The company has thus improved its profitability and asset turns in the last few years. The improvement in net margins is really commendable as this has happened in times of rising raw material prices and higher competition.

Positives
Maruti is one the most well know brands. I really doubt if there is an indian who is not aware of maruti suzuki (rather their cars).

The company has a strong balance sheet, great brands and has been able to add new successful models consistently in the past few years. In addition the company now has full support from the parent for new models.

In addition to the above the company has the largest dealer and service network.

Risks
I see competition as the biggest risk. There will be swings in the demand. However as India prospers, the unit volumes are bound to go up. However with China and India being the high growth markets globally, there is bound to be intense competition in this sector. This could have an impact on the margins going forward.

The risk to margins is not from the pricing alone. Higher competition means, shorter product cycles and hence the amorization of the development expenses is now over shorter period. Case in point – The Company has rightly hiked its depreciation rates.

In addition during the year 2000-2002, the company had quite a stumble. The company was suddenly faced with slowing demand and increased competition. As a result the company made its first loss in years. However the company has learnt from it and has become far more efficient.

Competitive analysis
The firm has competitive advantage from a high market share and well know brands. The high volumes drives economies of scale for the company in manufacturing, purchasing, distribution and such scale driven activities.

In addition the company has increased the lead by expanding its distribution networks (more dealers), opening new service centres and by expanding into allied services such as insurance and used car sales. All this results in higher customer lockin and more repeat business.

Valuation
It is quite apparent that the company has considerable competitive advantage. However what is not easy to figure is how competition will increase and impact margins in the future.

With an assumption that the margins will remain between 7-9% (which is slightly higher than the global averages) and a 8-10% growth, and CAP of 9 years , the intrinsic value comes to around 1200-1300. I think the growth and CAP assumptions are reasonable. However the net margins are a wild card.

Added note: A 6-7% margin assumption would give an intrinsic value of around 1100.

Conclusion
The company sells at around 40% discount to the above intrinsic value. However I still have my doubts on the net margins. As a result although the company appears undervalued at current prices, I do not have any investment in the company. I would be prefer to have a higher discount to intrinsic value to make a commitment in order to reduce the downside risk from net margins.

Disclaimer – I may change my mind based on new information and may invest in the company. I may however not post when I do so. So as usual please make your own decision and read the disclaimer.

There has been quite a lot of discussion on this investment idea. You can check the comments for that.

A few key points in the valuation of the company are as follows. I have uploaded the valuation (valuationtemplatev3NIITtemp.xls) based on the factors below in google groups. Please note that this is a rough back of the envelope calculation (see net impacts section of the spreadsheet) and may be off by 10-20%.

Impact of ESOP – This can be computed and I have detailed my logic in the comments. It is not completely accurate. However considering that ESOP’s account for 6-8% of the company’s current Mcap, a 20% errror would not amount to more 2-3% error in the computation of the intrinsic value. That is an acceptable error for me (although you would flunk a derivatives class for that error) as It would not change my overall conclusions.

Tax impact – I do not have the exact numbers on what the changes are. However for NIIT the current tax rate is around 15%. The average tax rate for Corporate india is around 25%. I have assumed that NIIT would be paying the average rates from 2010 onwards. You can see the impact of the tax changes in valuation excel I have uploaded in google groups.

US slow down and dollar depreciation – cannot really compute the impact. The downside is limited due to the fact that NIIT tech has 30% revenue from US. However that does not mean than Europe and Rest of world are immune from a US recession. I have taken the impact of a slowdown and dollar depreciation by considering that the net margins will drop from 14.5% to around 7.5% in the next two years. It could drop below that too …although the probability is low (my guess is good as anyone else). As a result of this the net profit could drop from around 130 Crs in 2007 to 90 Crs in 2010.

Forex hedge – The company does not have large hedges. So I do not see any open risks from hedges (such as the one which hit hexaware). However one cannot rule out such a risk in the future

ESOP computations – See section ‘options’ in the uploaded excel

Basic logic is as follows (which differs from the text book approach). This approach may have flaws and I think it is overly conservative.

i do not consider just the granted options alone. I consider all options already granted and to be granted. As the options approved by the board will be granted in the future and that would then dilute the shareholder’s equity in the business
a) Adjusted mcap = current price * (all options+issued stock).

Options which lapse can be re-issued to new employees, so lapsed options should not be netted out.b) value lost due to free options to employees – The option price is given in balance sheet (ESOP are not free to shareholders)
so reduction from intrinsic value = total options to be issued or exercised* option pricenet intrisic value = DCF based intrinsic value – cost of optionsso based on above i now compare adj mcap with net instrinsic value. If the adj mcap is 50% or below Net intrinsic value, then it is a buy for me.

Finally a correction – As pointed by others in the comments, I have calculated the net cash incorrectly. Post accquisitions and net of debt the net cash could be around 200-250 Crs (what are a few crores here or there 🙂 ?). Luckily that does not change the final conclusions much for me.

Please feel free to leave a comment for me if you find errors in my valuation.

Please read disclaimer at the bottom of the page. In addition I have a position in the stock.

Note: The analysis below is dated end of march – beginning of april. The stock has had a major jump since I started analysing the company. In interest of disclosure, I have a position in the stock. So please take this as a biased analysis. In addition I do not know if the jump in price is temporary and the price will fall again or it will continue rising. So as usual, please do your own analysis, read my disclaimer below and don’t blame me if your decision is based on my analysis alone. In summary – I am not recommending anyone to buy or sell the stock.

About
NIIT technologies is a 900 Crs company. It is a spinoff from NIIT ltd and is in the business of ITES and BPO. The company has 50% of revenue from Europe, around 30% from US and the rest from Asia, and other parts of the world

The company has a focus on a few key verticals such as BFSI (more in insurance), Transportation and retail services. The company has done a few targeted accquisition (such as ROOM solutions) in the above verticals in the last few years. In addition the company has signed a few JV’s too in the past. The company thus seems to be following an organic and in-organic path to growth

Financials
The company has done well in the past few years with ROE increasing from 17% to 30%+ in 2006. This has been driven by improvement in margins from 6% to around 12-14% in the recent years.
The revenue has also grown from around 500 Crs in 2004 to around 1000 odd crores in 2008 (expected). This translates into a revenue growth of around 18% p.a. The Net profit has grown from 33 Crs to around 110 Crs in 2007.

Positives
The company has a cash balance of almost 250 Crs (2007) which could rise to 350 odd crs (approximate). This would account for more than 60% of the market cap of the company.The company has almost 50% revenue from europe and thus is less exposed to the dollar risk and recession in the US.
In addition the company seems to be growing well, improving margins and increasing scale. At the same time the revenue from top 10 clients as a % of total revenue seems to be coming down, which is a good thing.
The company has a repeat business of almost 89% which shows good stability of revenue.

Risks
The obvious ones – US dollar, global slowdown etc etc.
The non obvious – The company is mid-tier ITES company. It still does not have the scale of the tier I vendor. However if the company focusses on the specific verticals and scales up in those verticals, then this disadvantage could be eliminated
In addition the company is pursuing accquisitions also. This is always a riskier way to grow.

Competitive analysis
The ITES business depends on the following key factors
a) scale : NIIT seems to be building scale in specific verticals. This would be the key to the company’s future
b) Customer lock in: This seems to be working for the company as the repeat business is fairly high

The other factors such cost advantage, overall scale etc is no longer a key differentiator as all ITES companies have this advantage and it is now considered as a minimum requirement in this business.

Valuation
The company sells at 1-2 times Net profit (Net profit is equal to free cash flow here) if you take out cash. The market is pricing NIIT tech with a view that the company will be out of business by 2010.

Conclusion
Short the company shutting down by 2010, it cannot think of any other justification for such valuations.
Dollar depreciation, US slowdown and increase in taxation rate can hurt margins. However ITES companies have some flexibility and control on the net margins through variable pay, utilization etc. So even if the margins drop by 50% to around 6-7%, the company will still sell at 4-5 times PE which is still quite low.

In summary, the market is pricing NIIT tech to be out of business in the next 1-2 years. That is a very low probability event in my view

I am finding more ideas in some sector/ sub-sectors than others. Such as,
– IT midcaps
– MNC Pharma
– Auto components
– Auto OEM

For some reason, valid or otherwise, most of the companies in these sectors have been beaten down. The reason range from genuine concerns (US recession, Rupee appreciation etc for IT sector) to investor apathy (MNC Pharma). My approach in such cases is to list all the companies in the cheap sector, filter the most attractive ones and invest in all of them.

For example, I can see the following attractive ideas in IT Mid cap space

– Patni computers
– NIIT technology
– Zensar
– Hexaware
– Sonata
– Aztec

I have not done a detailed analysis on these companies yet and may discard a few. However I do feel that there is too much pessimism around these sectors. It not surprising that the market has beaten down these sectors as during bull runs, most investors prefer high growth companies and avoid companies which show low growth (even if they have a high Return on capital)

High PE v/s Low PE stocks – Most of you must have noticed that stocks with high PE or high valuations are getting hit harder when the market drops. This does not mean that these companies are over-valued or will do badly. If the analysis is correct and the companies does well, then investors in these companies should do well in the long term. However you have to be comfortable with the high volatility in the stock price. In comparison the low PE stocks, of which not much is expected, don’t drop as much during market drops. However they do not gain as much during the rise too.

update : 03/04
blog.rcfunds.com (referred to in the comment on this post) is also my website. I eventually plan to migrate this blog to that website. however my new website is still beta. I need to improve the look and feel of that website. As a result i have not publicized it, thinking no one will notice it. I guess i was wrong. Anyway, i will be posting my posts on both locations at the same time.

I had written on Allahabad bank earlier. I mentioned the following as a key risk

The biggest risk for the bank is political interference. As the majority shareholder is our government, you can never be sure what hairbrained scheme they will come up with. In the past there have been loan melas, loan writeoff etc. This has reduced in the last few years, but you never know.

Well, the risk has materialized. The FM has announced a loan waiver for small farmers to the tune of 60000 Crs. Forget about the fact that this money may never reach the farmers, a part of this money could come from PSU banks like Allahabad bank which has a 55% Government holding.

The bank has a 7000+ cr loan portfolio for the agricultre sector. The best case scenario is that the government would compensate the banks completely for this waiver, but I think that is unlikely. A probable scenario is some losses on this portfolio. A 10% loss on this portfolio would be a 20% hit to the Networth of the Bank. In addition PSU banks could get poor valuations going forward as the market will not trust that the government would not pull off a similar scheme again in the future.

This case is different from HPCL (see analysis here). In case of HPCL, the subsidy is priced into the stock. Any positive development such a moderate price hike would help the company. In case of allahabad bank, this risk is not priced into the stock.

As of now, I am not sure how this will play out. I generally do not concern myself with price movements. However a fundamental development such as the one above is different. I may be wrong on this one and this development in the short term, may not impact the company. However this is definitely a moral hazard for banks in the long run. Rural borowers may start expecting such writeoffs again in the future. Net Net, I am not interested in risking my capital to find out.

Disclosure : I have maintained a small position in the stock as the stock seemed undervalued, but not by a big margin. However I am now planning to exit the stock completely.

About
GSK consumer is a 1300 Cr consumer goods company with well known brands such as Horlicks, Boost, Maltova, Crocin etc. The company is a part of the Glaxo smithkline group which specialises in pharma products

Financials
The company has done well for the last 5 years after a dip in performance in 2001-2002. The company topline dropped by 12% in 2002 and the bottomline by 33%. The company has since then recovered the topline growth to around 10% per annum and Net profit growth to around 12-15% CAGR.
The RONW/ROCE have improved to 20%+ levels due to improvement in margins and Asset turns. The company has no debt and an approximate cash of 300 Crs.

Positives
The company has strong brands, well established distribution network and a high market share in its category (around 70%). In addition the company has cash of 300 Crs on its balance sheet.
The management has been a rational allocator of capital. They have maintained a dividend payout of almost 35%. In addition the management executed a buyback in 2006 of around 125Crs using up the excess cash. The current cash on the Balance sheet is for acquisitions and to grow the business.
The company plans to introduce 2-3 of its international brands in the couple of years such as sensodyne, breathe right etc.

Risks
This is a single product company. Crocin and Iodex brands are not owned by it. The company only distributes it for the parent and gets a fee for it. As a result topline and bottom line is based on a single product category and it can get hit again as in the past by a drop in the demand or competition or both.

The company has plans to acquire new brands and businesses, but it remains to be seen how that will play out.
In addition it remains to be seen if the Global brands to be introduced in india would be successful or not.

Valuation
The company current sells at around a PE of 13.5 (after taking out the cash). A rough calculation (ROE = 20%, growth around 7-10% and CAP of 8-10 years) would give an intrinsic value of around 3000 Crs. This valuation does not include upside from Global brands or any accquisition. Those would be icing on the cake, but I would not value them as yet.

conclusion
The company seems to be undervalued by 20-30%. In addition the upside from introducing global brands or any acquisition is not included in the calculation. So that could be a positive upside (or a negative if it fails). I find the investment idea good, but not mouth watering. Would like to wait and watch

Disclaimer : I don’t hold the stock (as yet). In addition I may change my mind at any time on that and may not put that on the blog. So please look at the disclaimer below and take your own decision.

I am analysing some of the following stocks in detail as these stock have passed my initial filters

Concor
Balmer Lawrie
GSK Smithline consumer

Disclosure – I have owned Concor and Balmer lawrie for the last few years and currently re-analysing the stocks. So my analysis could be biased. I would be posting the analysis soon.

In addition Mid-caps and some value stocks have now become even cheaper. Some companies now sell for almost or slightly less than cash on the balance sheet. I am now finding quite a few ideas to work on and hoping that the cheap would get cheaper.

In addition I am reading the following books and have found them to be good. I would definitely recommend reading both the books

More than you know by Michael J. Mauboussin
Margin of safety by seth Klarman