CategoryInvestment ideas

I received a few comments on my analysis of Cheviot company. Thought of posting it on the blog as they add to the analysis of the company.

Prem Sagar said…
Rohit,
Do you know what the mgmt intends to do with the huge investment portion?
from their last 5 yrs, I see no huge capex and I dont think the mgmt has any plans to invest huge sums into the same business to increase sales or to enter into new avenues to explore new possibilities. So as of now, the investment portion is just sitting on their books without any plan for it, but merely compounding it.
do you think they would do better if they disburse a part of it to shareholders or buy their own shares back?and the industry itself is struck severly by strikes and I can see several instances of strikes for this co alone. and the whole industry doesnt look enticing.
Assuming that the investments are discounted, would you be willing to buy such a co at 2 times?
4/11/2007 12:25:00 AM

Rohit Chauhan said…
Hi prem
very valid concerns. as far as strikes are concerned, i would not be too worried as the company has been able to manage the financial impact of such strikes in the past. unless the company has some very serious labor issues in the future which shuts down the plants for a very long time, i dont think these labor issues should harm the long term economics of the company
the capex needs of the company are low and hence i expect the cash to increase. i have seen no evidence of the management wasting the cash till date. they have given a bonus, decent dividends and seem to be accumulating cash. need to see how the cash gets used. buyback is unlikely as the no. of shares is low (0.45 crs).
cheviot is a graham play and a portfolio of such companies should do well ..although individually a few of them may do badly
4/11/2007 04:06:00 PM

khali_pili_lafda said…
Hi Rohit,
First off great effort on this blog. My observations on Cheviot are below.
1. Jute prices are on the decline on a global scale and may exert pressure on profit margins for Cheviot over the next few years given that export orientation of company has increased.
2. Historically the P/E has always been below 6. Cannot figure out why the markets are unwilling to give Cheviot credit for performance.
3. Company has a lot of cash on hand (Rs543M) with only 4.5M shares outstanding. May be diversifying into Tea – read this online? Saw a spike in Capex in 2003.
4. Labor issues have already been highlighted by you but given that Cheviot operates in West Bengal, labor laws and strikes can be particularly harmful and unpredictable.
5. With only 4.5M shares outstanding – it raises a liquidity red flag since trading may be controlled by a select syndicate. On Apr 12th only 485 shares changed hands although Mkt cap is over 100 crores.
Niraj
4/12/2007 02:35:00 PM

Rohit Chauhan said…
Hi niraj
great comments.my thoughts on the points raised by you
1. i also noticed that jute prices (raw material) is decreasing. i think that is a plus for the company as it improves the net margins for the company (the company sells valued added jute products)
2. i think the historical PE is low because of the various factors in your and prem’s comment. small cap, illiquid stock in an unglamorous industry with labor issues
3. i am not sure that the company has diversified into tea. the 2003 increase in gross asset was a revaluation which was reversed in 2004. i checked this in annual report. the capex for last 5 years has been roughly equal to the depreciation
4.agree with you. however i feel that labor does not represent a threat to the long term economics of the company. it can cause short profits to suffer. although a serious labor trouble could impact my assumption. frankly it would be difficult to evaluate this risk objectively
5. this could be the reason for the low valuation

I am currently analysing Cheviot company (for company website see here).

The valuation is as follows

No. of shares outstanding – 0.45 Cr
Price per share – 228
Mcap – 103 Cr
Investment/ cash on book – 63 (last year)+ 10 Crs (this year) = 73 Crs
Net value = 103-73 = 30 Crs
Current year expected NP = 23 Crs

The company seems to be priced for 1-2 years earnings. The market seems to valuing the company with a horizon of 1-2 years and expects the company to be out of business after that !!.

Background

Cheviot company is a West bengal based company into the manufacture and sale of Jute based products. Almost 70% of the sale is export and the rest is domestic (Page 6 of Annual report).

The company has been in business for more than 100 years and is currently the most profitable in its industry (the jute industry as a whole is sick and incurring losses). The company has two manufacturing units, one at Budge budge and the other at Falta. The unit at Budge budge is having some labor trouble which may impact the Topline for the company.

Financials

The company has had a ROC of almost 20%+ for the last few years (if one excludes cash). The company has been consistently profitable and has good free cash flows ( equal to net profits).

In addition, although the volumes have come down, the company has moved up the value chain and has been able to improve realization for the end product (Raw material cost as % of Sales has been coming down over the years). The topline has increase with a CAGR of 6% for the last five years whereas the Net profit has increased by 15% CAGR over the same period.

The company has almost 73 Crs cash on book which has been invested in mutual funds and other liquid investment.

Risk
The indian government has made jute the mandatory packaging material for food grains and sugar to support the industry. In addition the government also provides marketing assistance for the export market which is received as a credit. Thus the industry is surviving based on this support from the government.
The company currently has labor unrest in one of its units which may impact the short term profitability. In addition, this industry is marked by labor issues and strikes.

Conclusion
In my view, the strike could impact the topline for a quarter or two, but it is not a long term risk. In addition, the company has been concentrating on the export market and as a result could continue to do well.

The market is currently discounting all the above issues and more and pricing the company for bankruptcy, which does not seem probable.

I got the following comment on my previous post on Indo nippon electricals

Hi Rohit,
In the absence of latest annual reports, it is difficult to evaluate this.

What is the catalyst that you have in mind which will unlock the value or force the reevaluation?

Earnings are not growing significantly where they would make the market to take notice. In the absence of takeover attempt, it might be a long time (years!) for market to re-evaluate the price.

Some months ago, I had made a purchase of Kothari products (pan parag fame). Its book value is more than the market cap. Tobacco business is a cash minting machine. That’s all the analysis I did at the time of purchase hoping that somehow market will recognise the Graham bargain.

However, later I noticed that the promoters own more than 80% of outstanding shares. There is no incentive for the current owners to reward shareholders. There is no way for a hostile takeover. Ergo, the value trap stays as is. I have moved on in due course – hopefully, wiser.

Best Regards,Ravi

I decided to post my thoughts on ravi’s comment. I have posted on value traps earlier here

i agree, value trap is always a concern in such situations. i have also invested in kothari products in the past (see post here) with a clear understanding that the underlying business was at best stagnant and the value unlocking would happen if the management did something about the cash. After holding the stock for more than a year (with a small gain), I realised that the management was not interested in any value enhancing measures. On the contrary there was a lot of apathy towards investors. The management had not bothered to update its website with the latest results and there was no way to access their annual report. As a result, I bailed out.

Indo nippon electrical has similar risks. However there are some key differences

1. The underlying business for Indo nippon is healthy and has a small amount of growth
2. The management has been pro-shareholder in the past and has given bonus shares and decent dividends in the past
3. The management has been very rational and efficient user of capital and has kept the return on capital fairly high.
4. They have updated their website with the latest annual and quarterly results

Value unlocking can happen via various actions on part of the management. In case of Indo nippon electricals I expect continued decent performance and passage of time to unlock the value.

However due to the concern of value trap, I have classified this idea as a graham idea. The key approach in such kind of investing is to invest in a group of such stocks (more than 10-15) where the entire group could do well, with some indivdual stocks performing well and some performing poorly. In contrast, focus investing which involves investing heavily in a select few stocks would not work in the above kind of idea. However with valuations being high, I am not able to find too many good ideas in which I can invest heavily.

see here a post on value traps and critical thinking titled ‘Value Delusions and Strategic Thinking’ by rick. he discusses about value traps and how to avoid them towards the end of his post.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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