CategoryInvestment ideas

I had written about HPCL earlier (see here). To recap, my main thesis was as follows.

HPCL now sells at around 9000 crores. The EV is around 10000-11000 crores at best. The replacement value of the assets is around 25000-30000 crs. The company is selling at 25-30% of replacement value, which can reduce due to the following reasons

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.

So what is the situation now ? Well the company is selling at around 400 Rs/ share and the gap has now reduced to around 40% of replacement value. It is easy to declare that the original thesis has been validated. However although I think that the above reasons are still valid, they are not responsible for the reduction in the gap. I expected these reasons to play out over 1-2 years. However in the current bull run, each and every listed stock is rising almost every other day. HPCL is no different. That said, I am not complaining if I have been lucky.

These are interesting times in the market. The market is now at a PE of almost 27. Almost 1000+ stocks are now at a 52 week high and any stock which one could have picked in the last 6 months has risen. I cannot speak for others, but for me it is time to be cautious. Frankly I am having diffculty finding good ideas. It has almost become like searching for a needle in a haystack. However for me doing nothing is better than doing something stupid.

Disclosure: I have a position in the stock. As always please see the disclaimer too.

For sake of disclosure, let me say that I have started exiting my position in MRO-TEK. The stock is almost at 95 and has shown an 80% rise in the last one month. It is now above my calculation of intrinsic value for the stock.

I can see the thrill of momentum investing – instant gratification. In spite of the thrill, I am not planning on changing my approach which I understand well, and have become comfortable with, over the years. In general I have seen my picks rise and approach intrinsic value in 1-2 years. That allows me to analyse the company in detail and build a decent position. Sometime I have been able to even average down on the stock as the price went lower and I developed a better understanding of the company.

A case like MRO-TEK is not really suited to my style of investing. Too soon, too fast. If the stock moves up very fast, I lose interest if it crosses my buy levels as I cannot complete the analysis and would hate to create a big position without understanding the company in depth. This approach is ofcourse contrary to most investors. However I do not have such an approach for the sake of being contrary or just because it is a smarter approach. It is just that with my time constraints and risk aversion, I prefer to analyse a company in detail before I invest in it.

Will the stock go higher …? I have no clue and am not planning to play the stock on that.

As always, please read my disclaimer

I generally select and buy stocks where the general enthusiam for them is very low. None of my picks shoot up after I have bought them and so when a few did in the last few months, it was a new experience for me.

One such pick was MRO-TEK. I started looking at the Company a few weeks back when the stock was at around 52 per share. My analysis was as follows

About
The company is primarily into end-to-end solutions and hardware/products-provider in data communications, data access and networking fields, offering a wide range of sophisticated LAN/WAN products.
The company has a JV with RAD corporation and a few other technical collaborations. The company had a split of 30-70 of manufacturing v/s trading a few years back. In the recent years, the split has reversed to around 70-30 in terms of revenue

Performance
The company has had very erratic performance. The projections which the company made at the time of the IPO in 2000, were never met (by a huge margin). Since then the performance has been one step forward and one step back. The ROE has fluctuated between 5 and 15 %. Topline has also fluctuated and has grown by 9% per annum and the Net profit has also grown by roughly the same amount.

The margins have held steady at 9-10% and the asset turns have improved from 1.2 to 2.6

Positives
The company has maintained its margins and improved its efficiency ratios. Wcap ratio has improved from 1.5 to 6 due to improvement in inventory and recievable turns. The company has freed up cash and as a result has no debt and almost 40 Crs of cash on the balance sheet.
The company recently completed a buyback program using the surplus cash. The promoters have also been increasing their holding % in the last few years. The company has been paying a decent dividend with a DPS/EPS of around 30-40%.

Negatives
Although the management appears rational, pro-shareholder and is trying to create value, their performance has not been up to the mark. Reading the annual report reminds me of kids in school, who study hard and have the right work ethic, but still manage to flunk one or two subjects each year.
The company operates in a very competitive field with competition from likes of CISCO and LUCENT etc. This industry involves a lot of new technology, high R&D expenditure and high rates of obsolescence. MRO has only recently started investing in R&D and till recent past was mainly a distributor of networking products.

Conclusion
My personal estimate of intrinsic value was around Rs 90/ share. At 52 / share, the company was not a screaming buy, but worth creating an initial position.
I am not too optimistic on the long term economics of the company as this is a very small company in a fast paced and competitive industry. As a result it is diffcult for the company to operate at the top end of the product range and make good margins. Due to my lack of confidence on sustained good performance I conservatively estimated the intrinsic value at around 90 /share

Post script
Once I complete the analysis, I write a single page note detailing my investment thesis. This is more to record my thoughts at the time of the decision. It is useful to keep such notes as I can check them again later and check if my assumptions were true or not.

I had written on Ashok leyland earlier.

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

I recently got this email from Vishnu

I have been going through Eicher JV deal with VOLVO. It would be great if you can share your opinions.

Story:
Eicher is stepping down its Commercial Vehicle and Component business into a JV with VOLVO which is paying 275 million USD in CASH and 75 million USD in terms of VOLVO’s truck distribution business in the JV.

Valuations:
Cash(VOLVO) is paying 1045
VOLVO India Truck distribution 142
TOTAL VOLVO Share (45.6%) 1187
EICHER Share in JV (54.4%) 1416.070175
Eicher Market cap 1314
* All figures are in Crores (INR)

I have already shared my opinion on the above opportunity with him. What struck me was that the deal involved the Commercial vehicle business and the deal was valued at approximately 2000 crs. Eicher motor’s CV business had a PAT of roughly 62 crs (pretax – 82 Crs) and hence the private market value (the amount that a private investor would be willing to pay for the company, in its entirety, were it not public) seems to be around 25-30 times earnings

So Ashok leyland can be valued at 70-90 Rs/share by the above metric. My own conservative estimate was around 60/share.

Whats the point of this analysis ? well private market valuation is another approach to valuation. It may be more than your own estimate as it may include controlling premium. However if you can find the private market value to a business you are looking at, it helps in calculating the intrinsic value.

In case you are wondering if I really benifited from my research, I did not completely. I have this tendency to do detailed analysis and build my position over a period of a few months especially if the price drops reaches or drops below 50% of my estimate of intrinsic value. Ashok leyland is around 54 now, so basically the price went up before I could go beyond my initial position. That unfortunately has happened several times this year.

Why should a quick price increase be unfortunate? Well that’s another post for this wacky idea.

I received the following email from sanjay shetty and decided to post it as he has asked a very important question on valuation. I have done some work on it on my own and have put the results in the worksheet – Quantitative calculations.xls

You can download is from here or use the download link in the side bar. Please see the tabs – Maintenance capex and FCF anal.

My responses are in italics. There is a follow up question from sanjay on maintenance capex. I will post on it in detail shortly with an example. If you have looked at my valuation templates, you may have noticed that I use FCF based on maintenance capex for valuation purposes

Hi Rohit,

I’ve been viewing your blog, after your comment on my blog (http://indiainvestor.wordpress.com).

I had a few questions for you.

What methodology are you using to value companies in India?

DCF, comparitive or relative valuation, sum of parts etc. I try to value a company based on multiple approaches and also depending on the nature of the company

Are you using a Discounted Cash Flow method to calculate Intrinsic value? If so, are you checking the Free Cash Flow, how are you calculating it?

yes, i use free cash flow. I however do not use capital expenditure directly. I use maintenance capex needed to support unit volumes or competitive position (maintenance capex). Difficult for me to explain in brief. i have a few excels uploaded in my google group explaining the calculation.

I’ve see most of the companies I’ve analyzed seem to be blowing enormous amounts of cash, with almost negative free cash flow which is worrying. –

I think the key point is whether the capex is maintenance or for growth / accquisition. Let’s take a short example. If a company earns 5% on capital , and has 10% margins (asset turn is 0.5). Then to grow by 5%, the company will use all its free cash flow. Also 5% growth is roughly inflation, so in this case the company is using all its free cash for maintenance capex
In case of a company growing by 20% and 10% margins (asset turns is 2), growth of 5% requires only 50% of the netprofit . The rest is cash flow which company can use to aqcuire other companies, give dividend or build assets. This is the case with grindwell norton. Grindwell has low FCF as it is investing the surplus cash in assets to increase volumes.

Hope the above clarifies .i have tried to provide a quick explaination and have left a few things out (like adding back depreciation)

Take for instance Grindwell Norton, which you’ve recently mentioned on your blog, Every thing seems rosy however Free Cash Flow is the concern.

I have taken out the detailed calculations by sanjay and put the final computations

Free Cash Flow
Mar’ 02 29.178
Mar ’03 21.802
Mar ’04 17.149
Mar ’05 18.481
Mar ’06 3.121

The worrying fact about this company is the amount of cash it’s blowing, though currently it’s Sales, ROIC etc. are all healthy and growing.
Free Cash flow growth is actually going from bad to worse. I’m calculating Free Cash Flow as Net Cash from Operations minus Capital Expenditure which is Purchase of Fixed Assets.

I invested in Gujarat gas back in 2003 and exited my position by 2006. I recently read the following post on ranjit’s blog. As Gujarat gas is one of his top 5 holdings, I decided to re-look at the company to see what I am missing out as I had exited my position sometime back and did not feel that the company is under-valued.

I found the following positives

– Gujarat gas now sources almost 95% of its gas requirements at market prices now and has been able to maintain the operating margins. In 2003, a substantial portion of gas was procured at subsidized rates and hence there was a risk of margin reduction. The company has been able to manage the transition very well.
– There has been a substantial reduction in the transmission income. The company has managed this well by expanding the other lines of revenue
– There is substantial expansion in progress at Vapi and Jaghadia. Vapi will contribute to revenue in 2007
– Gas volumes, no. of retail customers and bulk customers are all increasing at a heatlhy rate. This should provide good growth over the next few years
– The CNG business is now in growth phase and should provide for healthy growth of revenue and profits.

Overall the company is firing on all cylinders. It also has expansion plans in place and is investing heavily. I have updated my company analysis (valuation template-gujgasaug2007) and uploaded the same. The earlier analysis of the company from 2003-04 is also uploaded in the valueinvestorindia google groups.