Date: June 7, 2011
BSE SCRIP Code: 500575
Website: www.voltas.com
CMP: Rs 163/Share; Value: Rs 173/Share
Wait - Voltas is available at small discount of less than 10% to its value. I would suggest that though its a wonderful business to grab a pie of wait for the price to tumble to Rs 130/Share
Background
Voltas, a Tata group company, has been in business for 50+ years. It has 3 business units - Electromechanical projects and services (61%), Electrical projects and services (10%) and Unitary refrigeration (29%). The Electromechanical projects and services unit undertakes projects for urban infra (airports, ports, MTS, etc.), commercial complexes (hotels, malls, etc.) and healthcare customers. They essentially design and install end to end cooling, refrigeration and allied systems. Recently, they have undertaken some of the most prestigious projects in India, Singapore and Middle East - Burj Khalifa, Ambani's pad, etc to name a few.
Electrical projects and services design and install machinery for a industrial users such as textile mills, power transmission companies, mining companies, etc. They also have Material handling equipments (Cranes, Forklifts) as part of their offering. Additionally, they have developed expertise in water and sewage management.
Unitary refrigeration / Air conditioning division provides cooling and refrigeration solutions to retail as well as industrial users. Earlier, they targeted only industrial users but later on added the retail portfolio and since then have developed a large distribution network of 5,000 dealers. Currently, they are the leaders in this segment by recently overtaking LG.
Voltas has strong skills in the areas of cooling and refrigeration and have diversified into allied engineering space. One great thing about their business is that they do not require huge amounts of capital to run the business. The electromechanical and electrical businesses (representing 3/4th of the business) are project based business and get paid in advance before commencing work. These businesses do not require much inventory and assets. The unitary refrigeration unit however has to procure and manage inventory as well as invest in building factories. Given the share of this business is about 30%, overall capital requirement is quite low.
Stock analysis using value investment technique attempts to answer a few important questions. Only when the answers lead to the conclusion that it makes absolute sense to buy this stock, should an investor do so. Else, wait for the right price. Primarily, the attempt is to project future earnings with some degree of uncertainty and conservatism and then discount it to present to assess whether it is available at significant discount to its value. I rely on annual reports (usually go through previous 5 years ARs), investor calls, business outlook presentations and other announcements made or published by the company.
Industry, Company, Management
Q1: What are the prospects of the industry?
Each of the segment has unique characteristics and prospect. Electromechanical segment's fortune is linked to commercial and infrastructural investments. Given the stage in which Indian economy is that, domestic market will continue to grow. Voltas is also quite active in Middle East, particularly Abu Dhabi and Qatar. Though, there is political unrest in most of ME but Abu Dhabi and Qatar are quite insulated. So there are no immediate worries and given Qatar will host 2022 WC these places will see a lot of commercial activities. Overall, the market should continue to grow at historical rates.
Electrical segment is dependent on expansions and replacement in user industries - Mining, MHE, Textiles, etc. Machinery segment is one of the first industries to show both downturn and upturn. So there will be ups and downs in this segment. Voltas is working on winning African markets which is a good strategy given the large potential of Minerals in Africa. Overall, this segment will grow at rates similar to rate of Gross Capital Formation. However, going forward Voltas will face shortage of quality manpower. They have been indicating that as an issue repeatedly in their annual communication to shareholders.
Unitary refrigeration business is on a comparatively faster trajectory. The market is evenly split between industrial and retail users. Retail penetration is low 2.5% compared to 25% in China. Given that middle income group is fast moving up the consumerism curve, the expected rate of growth will continue to be high. For industrial users, Voltas has a range of offerings including water coolers and chillers. There is nothing that suggests slowdown in industrial segment either.
Q2: How is Voltas placed compared to rest?
Voltas has been winning prestigious projects in the market it is competing. Middle East market is quite competitive and attracts several global players. Voltas has been able to utilize India's low cost capability. Much of design and engineering work is outsourced to India center. So, over the next few years Voltas will retain its competitiveness.
In the engineering segment, Voltas is not a leading player. It competes with several domestic as well as foreign players in India which is its major market. Management has indicated cost pressures and growing competition as a concern going forward. African inroads should be a good strategy for Voltas to up topline and margins.
In unitary refrigeration, smart management has catapulted Voltas to the number one position. It has overtaken LG in tonnages sold. Given their strong experience in air conditioning and strong network of 5,000 (and growing) dealers Voltas will continue to lead the pack. But margins may be lower compared to competitors who have a wider range of offerings for dealers and consequently more bargaining power with dealers. Additionally, a shift towards lower margin Window ACs, as more and more non metro population shops for air conditioners, will also erode margins going forward.
Q3: How about management?
Voltas is a classic case of what a good management can do to a business. Not so long back Voltas was languishing in early single digit profit margins and early double digits return on capital employed. Its only in 2005-06 when new management took over following mass exodus of legacy managers and started pushing the company for growth and profits. They started SWIFT initiative: S - Smart Thinking; W - Winning Attitude; I - Initiative and Innovation; F - Flexibility; and T - Teamwork. In one of the interviews, Sanjay Johri, MD of Voltas, said that 'we hire for right attitude and train for right skill'. The management of Voltas is quite audacious. Back in 2005 when Voltas netted Rs 14 bn in Revenues, they set a more than aggressive internal target of Rs 100 bn by 2011. Though, they could not achieve this target but registered Rs 52 bn (3.7x) in 2011. They did not go for any major acquisition which would have added ~Rs 30 bn to the topline. Management has been quite realistic about business prospects and have not misled investors by painting rosy picture. Sanjay Johri, 57, has been appointed MD last year and I believe good things will continue under his leadership.
Historical Performance
Q4: How much cash do they earn and how do they use their earnings?
Exhibit - Historical Performance
Let us consider the period from 2006 to 2010 (2011 Balance Sheet not published yet). During this period, Voltas earned Rs 802 Cr for its shareholders
- Rs 642 Cr (includes funding changes in WC and maintenance capex) as operating cash profits
- Rs 160 Cr as dividends and interest from investments in the form of non-operating income
During this period, it repaid Rs 88 Cr thus bringing down Debt/Equity to 8%.
It ploughed back 17% of the shareholder earnings (Rs 134 Cr) and returned the remaining to its shareholders. Break-up is as follows:
- Growth Capex: Rs 134 Cr
- Dividends: Rs 193 Cr (goes to shareholders)
- Liquid Investments: Rs 131 Cr (goes to shareholders)
- Cash Accretion: Rs 257 Cr (goes to shareholders)
Q5: Has it been growing and profitable?
Voltas has been growing and profitably so as can be seen during 2006 to 2011:
- Net Sales grew at 23%
- EBIDTA margins averaged 9%
- Operational Cash Earnings averaged 5%
- ROCE (EBIDTA/Capital Employed) of 47%
- ROE (Cash Earnings / Net Worth) of 34%
Voltas is a great business. It does not require a lot of capital and hence even a margin of 5% on Revenues translates into attractive earnings for shareholders.
Future Estimates
Q6: How fast and profitably will it grow in future?
Electromechanical and Electrical segments closely follow the gross capital formation in the economy. At the moment, the outlook for capital formation seems reasonably bright particularly in the geographies Voltas has exposure to - India, Qatar, Abu Dhabi, KSA. Given strong order book and outlook at the moment, management believes that for the next 5-7 years growth momentum will continue. However, there could be some constraints in terms of manpower availability and inflationary pressure on input materials driven by oil price which is expected to be volatile at the moment. The unitary refrigeration segment will grow at a higher rate on account of increasing consumerism. Hence, for the foreseeable future (say next 7 years) following are assumed:
- Net Sales to grow at 13% (previously 19%)
- EBIDTA margins at 8% (previously 7%)
- Operational Cash Earnings at 5%
- ROCE at 34-35%
- ROE at 24-25%
During this period, it is assumed that, Voltas will
- Continue with low Debt levels; it, however, is likely to do a major acquisition but one can't be certain about it
- Re-invest 15-17% of capital to sustain growth
- Return remaining to shareholders, i.e., 83-85%
Q7: Future earnings projections
Exhibit: Future estimates
Valuation
Q8: What is the value of Voltas shares?
Finally, the million dollar question. I use discounted cash flow to equity owners method. In other words, how much cash the company is capable of paying its shareholders in future and when discounted to present whether this is significantly higher than the price paid today. I find several merits in this method. It allows me to assess the actual cash company will pay in future for the price I pay today. This is strictly an earnings based technique and does not take into account liquidation value of assets. In India, it is anyways difficult for shareholders to liquidate assets and collect their share (refer to BIFR process). This is a very useful technique for long-term investors and recommended by most value investors who invest with long-term horizon. In the short-term (less than 2 years), however, this analysis will seldom correctly predict share price movements.
I use 12% for discounting future cash flows. Why 12%? Because, interest rates in the Indian market are comparatively high (7-10%) and to account for the volatility in earnings.
For terminal value, I am assuming a growth rate of 5% given the nature of business. Finally, I am adding back Cash-at-hand (Rs 550 Cr) and investments (Rs 450 Cr) to discounted cash flow to equity holders to arrive at the final value of shares. It must be noted that Voltas has investments in Lakshmi Machine Works which at cost is only Rs 6 Cr but now has grown in value to Rs 120 Cr.
Exhibit: Valuation
The following emerges:
- Discounted value of future equity earnings: Rs 4720 Cr
- Present cash and liquid holding: Rs 1010 Cr
- Value of Voltas Equity per Share: Rs 173
- Current Market Price (1st June, 2011): Rs 163
- Margin of Safety: 6% (much less than recommended 25%)
- Target Price for Acquisition: Rs 130 @ 25% Margin of Safety
- Likely return over 5 years holding: 13% per annum
Don't buy, WAIT!
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