Statutory warning – Long post detailing further analysis of the company. Can knock you off to sleep – please be seated while reading 🙂

I described my process of analyzing two companies from the sector – construction material, in an earlier post. At the end the analysis, the only conclusion I reached was that the companies were still attractive enough to continue my analysis and invest more time in them.

I had a look at visaka industries and for non quantitative reasons have decided not to go further with it. The main reason is management. I am not comfortable with the open ended risk of the investment in the power plants at a cost of 5000 crs. I do not have clarity on it and hence in view of a risk which I cannot evaluate, I decided not to pursue the analysis any further.

We can debate back and forth on this, but my personal approach is to look at it as a binary decision. If I am not comfortable with the risk, I tend to quickly move on. There is no point in doing some fancy calculations here. I may have missed quite a few opportunities in the past, but this approach has also helped me avoiding risks which I don’t understand. I would rather commit the error of omission than the error of commission.

Hyderabad industries
I have initiated a deeper analysis of Hyderabad industries now. The performance of the company has been good, but unspectacular in the last few years. Ofcourse one cannot expect spectacular performance in a commodity and mature industry such as building construction material.

The company re-structured in 2004 and has since then been doing fine. The company has been able to maintain a net margin in the range of 6-9%, ROE in excess of 15% , a top line growth of around 10% and a bottom line growth in excess of 15%. It is important not to take 2009 as a representative year in making these calculation, as margins were far above average in that year and these margins are already trending down in the current year.

Rough cut valuations
Once I am comfortable with the fundamentals of the company, my next step is generally to do a very rough cut, fundamentals based and price based valuation (see page – other valuations in my valuation template).

The reason for a two fold check is to quickly see if the fair value of the stock is below the current price and then to compare the current valuations (current PE) with the valuations in the past (around last 10 years). The past history of the valuations allows me to look at how the market has valued this company in the last 10 years. In addition, when you compare these valuations with the fundamental performance, you tend to get a lot of insights into how the market looked at this company in the past (more on it in the next few paragraphs)

The normal earnings of the company can be taken as around 40-50 Crs over a business cycle. So one can very roughly value the company at around 400-550 crs.

The last ten years of valuation shows the company’s PE has ranged between a low of 4 and a high of 10-12 (ignoring the extreme low valuations of 2008-2009 when everything crashed). These valuation levels have to be compared with the earnings of the company which have been very volatile.

It is obvious that the company saw rapid price increase in 2004-2006 when its fundamentals improved and saw a PE of around 10 times peak earnings. After 2006, the margins started dropping due to higher capacity and so did the stock. The stock price did not recover till late 2009 when the fundamentals started improving again.

The current valuations and price may appear as bargain based on the recent history, but looking back a few years, it does not look like a no-brainer.

A 20% price drop from here could make it a very compelling buy.

Question – what if the price runs up and I miss the opportunity?

Response – Well that’s the risk of being patient. I would prefer the price to come to me, rather than chase it. If not this company, then there are 5000 other companies to look at !

Checklist analysis
At this stage, even if I am not completely bowled over by the price, I will perform a checklist analysis on the company. I have listed various checks on the accounting, business model, management factors in my valuation template, which I run though to find any specific red flags.

Some of the key highlights of the checklist review
– Company has around 35 Crs of contingent liabilities (taxes etc). This translates to around 6 months of annual profits. Nuisance, but not too much to worry about
– The company has a foreign exchange risk due to import of asbestos which accounts for around 50% of total raw material costs.
– No specific accounting red flags

Competitor/ industry analysis
The next step for me usually is to analyse the industry and competition and see where the company stands viz-a-viz other companies. This industry is partly fragmented, but the top 4 players account for almost 65% of the market share.

The top four players are
Hyderabad industries
Visaka industries
Ramco industries
Everest industries

On checking the fundamental performance of all these companies, it seems that their average ROE is in the range of 13-20% range. The debt varies from 0.4 (for visaka) to .75 for ramco industries. Sales for the top 4 companies have grown by an excess of 20% and bottom line by around 10-15% range. These are not exact numbers, but they paint a decent picture of the industry.

Some key takeaways are
– The ROE for the industry over a business cycle is around 13-15%
– The topline for the industry is growing (as expected), however competition has ensured that profits have not grown as fast
– The net margins for the industry are in the range of 6-7%.
– No specific company has a breakaway performance from the rest of group, yet Hyderabad industries and Visaka seem to have slightly better performance and low debt levels
– Small amount of industry consolidation seem to be happening as the top players are growing faster than the market.

In summary, the industry leader – Hyderabad industry is only slightly better than the other competitors and seem to selling at cheaper levels.

Multiple model analysis
I have borrowed this approach from Charlie munger, who has stated that one should apply various mental models from multiple disciplines to improve decision making. For example – economic models of demand and supply, psychological models etc.

A few key takeaways for Hyderabad industries
– The demand and supply elasticity for the industry is high. In plain English that means that any drop in demand will cause commensurate drop in price which is bad for profitability
– Competitive advantage in the industry is weak and limited to brands, distribution network and to sourcing from the production side.
– Management seems to be rational and has disposed off weak businesses in the past.

Inverting the problem
What will cause one to lose money on this idea? I always ask myself this question to find disconfirming evidence. I can think of two points
– Demand supply situation worsens with new capacity. This would cause price to drop and a lowering of profitability. 2009 profitability was much higher than average and reversion to mean will not be good for the stock
– Industry is cyclical and hence net profit and stock price may trend downwards in the subsequent months (capacity addition or surplus capacity is available)

Final conclusion
I could go on and on in terms of further analysis, but in interest of keeping the post to a reasonable size, let me summarize my thinking till now

The sector seems to have above average profitability over a business cycle. In the recent past, the margins and hence profitability were above average and hence the stocks in this sector appear very cheap.

It is important to value stocks in this sector based on normalized profits and make a decision based on that value. The past few years of data shows an average margin of around 6-7% for most companies – except for extreme demand collapse or shortage conditions. In view of this, Hyderabad industries seems to have fair value in the range of 500-550 Crs for the company. At current price, it is at a discount of around 40% to fair value.

I do not have a position in this stock and will continue to analyse further and may or may not take a position. The above analysis was for illustrative purpose only and if needed, to put you to sleep 🙂 …sweet dreams !

I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!

So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.

About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards

These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.

The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.

A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.

The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban – more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.

Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.

At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.

In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.

Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).

The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.

Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.

Performance of the top two players

Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.

The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.

The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.

Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.

Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.

The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.

Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.

The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.

My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).

It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.

In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.

If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.

Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.

Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.

I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.

I have several questions in my mind which I need to resolve –
– Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
– Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?

The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.

Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.