Maruti Suzuki - How Much to Pay?

BSE: 532500

website: www.marutisuzuki.com
CMP: Rs 1175/Share; Value Rs 1250/Share

Very strong company, but available at a small discount to value. May be we should wait! 

Company
Maruti Suzuki is a leader in passenger vehicles in India. It has been in business for long and has transformed the four-wheeler scenario in India. Currently, it has 45% market share in the passenger vehicle segment. It has a dominant position in the entry level segment. The company's value proposition is low cost of ownership and fuel efficiency. It has set up a large dealer and service network covering 668 and 1395 cities respectively. This gives them a unique advantage to tap rural market which now accounts for 20% of their total domestic volume. They have outstanding service network and have been rated the best for 11 continuous years by JD Edwards. As an erswhile Maruti owner (and now Tata) myself, I can vouch that they are very strong on service and cost of ownership. These propositions are difficult to beat. Most players struggle to deliver a reliable sales and service network. Maruti's incoming supply chain is also quite strong. They have been able to develop suppliers in close proximity, again an advantage very difficult to implement.
Though their product portfolio spans entry level to sedans they are the strongest in the small / economy segment with 80% market share.
Historical
During the 6 year period 2006-11, Maruti has hardly raised any debt and funded all its requirements through internal accruals amounting to Rs 11,300 Cr. Roughly half the accrual was used for funding growth capex and the remaining was either distributed to shareholders or retained as liquid investments. The capex deployed earned 24% returns after accounting for depreciation. 24% is a high return given the quantum involved and Maruti has done well to allocate its capital.
Exhibit: Historical

During this period,

• Sales grew by 25% yoy
• Operational Cash Earnings averaged 9.6%
• ROCE averaged 34%

Estimates
Maruti, today, is USD 8 bn in Sales. From here, how big can they grow? And what are the risks facing Maruti?
Well, the most potent risk Maruti faces is competition risk. Market risk is negligible in the long run. As still per capita ownership is low. Maruti already is tapping the rural base which currently contributes 8% to its topline. But real threat can come from new car launches by competitors. However, this threat is most likely to realize in the premium segment where currently Maruti has only 3-4% share. In the economy segment where customers are price and value conscious, Maruti has a great brand recall. Many foreign players have struggled to parallel the sales and service network that Maruti has been able to create and that will be a source of competitive advantage for Maruti in the years to come.
I have used rather conservative estimates on growth and earnings to estimate value of Maruti shares which are as follows:

• Sales growth at 8% for the next year (2012) and 13% from thereon for the next 6 years
• Operational Cash Earnings to be lower by 1.2% (88% of current levels)
• Company redeploys 66% of internal accruals and keeping in line with Capital structure will not use debt for funding investments
• Capex rate is Rs 1,150 Cr for 1 L cars including engine and allied capacities (at present, company invested at a rate lower than Rs 1,100 Cr per 1 Lakh cars for new capacities)

Exhibit: Estimates

Valuation
What is the value of Maruti shares? As always I have discounted cash earnings to shareholders to estimate value. I have also assumed terminal growth rate of 5% for Maruti. And, further assumed the returns on additional capital deployed to halve once growth phase is over.
Exhibit: Valuation

Applying some of the above assumptions, the following emerges:

• Value of Maruti shares: Rs 1,250/Share
• CMP: Rs 1,175/Share
• Margin of Safety: Slim 6% (much higher than 25%)
• Expected returns over 5 years: 13% yoy

I must submit that I bought some Maruti shares at Rs 1,100/Share (12% margin of safety, which is high than recommended levels) and was hoping it drops further. But shares started inching upwards and market didn't give me further opportunity to accumulate. So from my side, its a waiting game.

Oshkosh, US - Defense Trucking

Date: 20 June, 2010
NYSE: OSK
website: www.oshkoshcorporation.com
CMP: $27/Share; Value: $35/Share

Buy - Leading player in each of its segments and one of the most successful suppliers to US Defense for 80 years, OSK is available at about 30% discount to its Value

Company
Oshkosh is Wisconsin based specialized utility vehicle and body parts manufacturer for several end user segments such as defense, construction, fire and emergency and waste collection. Oshkosh has been in business for 80 plus years and has been a key supplier to the US Defense since then. It is a premium player in each of the segment it operates in, viz., Defense, Access Equipment, Fire & Emergency, and Commercial. Originally, it was a supplier to US Defense and later on acquired related businesses and expanded its presence to other segments. It offers a wide range of extremely useful products - we may have seen them in operation multiple times but may have only seldom noticed.
For US Defense, it manufactures those kewl (slang for ultra cool) looking severe duty heavy and medium payload trucks. These trucks help in moving troops and material (missiles, fuel, tanks, ammunition) safely with surety at war and war-like locations. In 2007, it acquired JLG, a leading manufacturer of aerial work platforms and tele-handlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights. Through this business, now it has a global presence in access equipment. The fire and emergency segment manufactures firefighting vehicles and equipment, aircraft rescue and firefighting vehicles (used during emergency situations), snow removal vehicles, ambulances and other emergency vehicles. The commercial segment manufactures rear and front-discharge concrete mixers, refuse collection vehicles, concrete batch plants and vehicle components for ready-mix companies and commercial and municipal waste haulers.
It has been winning business from US Defense (over 50% revenue generator currently) for over 80 years. In FY 2009, they won a $5.4 billion contract from US Defense by beating other leading players such as BAE, Mercedes, MAN Group, etc to it. They quoted $400 million lower than the nearest competitor and still made money on that contract. One of their core strengths - moat as some call it - is engineering and innovation and that allows them to develop a repertoire of proprietary parts at competitive costs. It is because of this moat were they able to quote lower and still made money. Another key strength, in addition to their strong relationship with the US DoD, is flexible manufacturing systems. Most were doubting their ability to deliver such a large order within contracted timeline. But showing great flexibility they shifted part of the work to facility for access equipment and delivered before timeline.

Management

Oshkosh was led by Robert Bohn till Dec 2010. In Jan, Charles Szews took over. Szews has been part of the leadership team and was the COO when Bohn was the CEO. Szews has been involved in the company's new business development efforts, mergers and acquisitions as well as long-term strategic initiatives. He also had a significant role in building the company's international footprint and global procurement supply chain. Currently, major business for Oshkosh comes from US and Canada. However, in order to continue growing business they will need to win in global markets. In this endeavour, Szews's focus will certainly be useful.

Historical

In the last 10 years, Bohn transformed Oshkosh from a $400 Mn company into a Fortune 350 player. Over the last 6 years - 2005 to 2010 - Oshkosh delivered some fascinating results while sailing through tough environment on the way. Not so long ago, 2007-08, they seemed running out of gas with high levels of debt and macro-economic uncertainties facing them. But they did managed to salvage the situation with the record order win and delivering the same by marshaling all they had.

Exhibit: Historical

During the 6 year period of 2005 to 2010, Oshkosh

• Grew sales at 35% yoy
• Maintained EBIDTA margin of 11%
• Delivered ROCE (EBIDTA/Capital Employed) of 20%
• Delivered ROE of 23%

Oshkosh's strategy during this period was focused on growth and it invested a substantial share (90%) of its earnings and borrowings for making strategic acquisitions.

You would notice a sharp decline in PAT in 2009. This is because Oshkosh charged asset impairment of $1.19 Bn considering the prospects of newly acquired JLG business which declined significantly in that year. This, however, does not bother me. Because, one, Oshkosh cash earnings were highest at $899 Mn in that year and secondly, the prospects of JLG has not deteriorated much. In 2010, JLG posted $3 Bn in revenues similar to what it used to when it was bought.

Estimations

Going forward, Oshkosh is likely to continue on its growth path. US DoD requirements will not come down significantly in the near future because of prevailing geopolitical situation. Recent crisis in Middle East further adds to the demand for Oshkosh's products. Access Equipment segment has picked up from record decline. Oshkosh has a global footprint in this business which will not only help it grow this business but also grow other businesses in foreign markets. Emergency and Fire and Commercial also have strong long term prospects. I expect Oshkosh to invest a substantial share of earnings and borrowings for strategic acquisitions going forward. Additionally, I have (as usual, conservatively) assumed the following for projecting future earnings:

• Sales growth as 8% yoy as against 35% during 2005 to 2010
• Return on new capital to be lower by 2% from historical averages
• Redeployment rate of more than 80%
• Company to constantly work towards reducing Debt levels as indicated in their communication to shareholders

Exhibit: Estimations

Valuation

Now the question is how much should we, as value investors, pay for owning shares of Oshkosh. At current debt levels and earnings, Oshkosh earns $420 Mn per year for its shareholders. On the conservative side, it earns (taking out the impact of record order of $5.4 Bn in FY 2009) $250 Mn per year for its shareholders. If Oshkosh does not make any acquisitions or redeploys earnings to fund future growth, I will value its equity at $27/Share, i.e., ($250/12% + $370)Mn / 92Mn Shares. Sure, its worth more as Oshkosh will continue to make acquisitions and grow profitably.

Exhibit: Valuation

I have made the following assumptions:

• Its terminal growth rate will be 3%
• All $370 Mn are available to US Shareholders as cash as large share of business happens in US and Canada

The following emerges:

• Value of Oshkosh Equity at $35/Share
• CMP of $27/Share
• Margin of Safety of 25% (equal to recommended value)

Buy - Definitely a great business to buy at such discounts

Prism - Cement, Tiles and RMC

17 July, 2011
BSE 500338
website: www.prismcement.com
CMP: Rs 49/Share; Value: Rs 65/Share

Buy: Its a decent business but likely to get under stress because of aggressive growth pursuits. Currently sitting at just about the right discount to its value but who knows it could be available at even cheaper valuations.

Company
Prism Cement earlier had three companies which they now have merged into one. Its a Rajan Raheja promoted company and has been around for xx years. Prism Cement is into Cement, TBK (Tiles, Bath and Kitchen) and Ready Mix Concrete businesses.
Their cement business is one of the finest in India. Prism Cement is, I think, the most efficient cement manufacturer in the country. Their specific consumption for power and coal are the lowest, or one of the lowest in the country. They do not have captive power plant so buy from power producers. Purchased power is costlier compared to captive power but lower specific norms keeps the power costs down. It has a good brand recall and primarily sells in under-developed markets of Bihar, Jharkhand, Madhya Pradesh and West Bengal. Another advantage they have is their ability to sell in markets closer to manufacturing location (Satna, Madhya Pradesh). This has helped them keep their lead distance low, 275 km, and consequently freight expenses, a very heavy contributor to cost structure.
They have been doing quite well in the TBK business as well. They have grown their business at very high rates (+25%) over the last 5 years. Their tiles are the most recognized in the country and sell under the brand name of Johnson Tiles. Their tiles are recognized by international quality rating agencies and they are the only Indian company to have that distinction. They have a very strong distribution network of 2,000 dealers and sub-dealers.
Ready Mix Concrete (RMC) business is a growing business for Prism contributing 25% to their net revenues. They are the third largest in the country in this segment. They have 80 RMC units and cover about 30 cities at present. This business does not require a lot of cash and return on investment is around 15-16%.
Management
Prism is promoted by Rajan Raheja. Back in 2008, I was researching cement companies and had met analysts from brokerage firms. There was this analyst I really liked who also happened to work with Rajan Raheja at Prism. His view was that he is a very very patient and long-term guy. For cement business, its really a bonus where one has to go through good and bad times to make money. Raheja has a fairly competent team managing these business units. But again, not much is published information on the management. Rajan Raheja has been talking about becoming a 10 Mn T cement company for about 3 years now so growth is certainly in his plans.
Historical
The three business segments got amalgamated into one only last year hence consolidated financials are available for FY10 and FY11 only.
Exhibit: Historical

Following emerges from historical financials (I am also adding bits from earlier annual reports from Prism Cement) - (a) Cash reserves have been exhausted for funding capacity additions; (b) Company has taken new Debts to fund the same and growth capex in other businesses. It is likely that Company will continue to add Debt to fund other planned expansions like they did recently.

Outlook and Estimates
Long term outlook for cement in terms of demand is quite positive. Long term it'll continue to grow at 9-10% on a national average basis. In the markets Prism is present, given current levels of penetration future demand may even be higher than national average. In anticipation of future demand, companies have recently added capacities and consequently margins will be depressed in the near term. Margins in cement industry follow cyclical patterns and bounce back after lows. What is worrying me most is that the company has started work on a new greenfield project of 4.8 Mn T in South (for hedging against regional fluctuations as presently they are in eastern and central parts of India) of India. Prism has recently added 3.6 Mn T (full operations not realized yet) at the same location, Satna in MP. They have done a commendable job of adding this capacity at $60/T which is $30-35/T lower than replacement costs. But in doing so, they now have a debt position of Rs 1100 Cr against NW of Rs 700 Cr. Further to make matters worse, the additional output has to be sold at higher lead distances which consequently will increase freight and negatively impact margins. Back of the envelop shows that they will have to travel 60% longer distances (sqrt of 6Mn T/2.5 Mn T) and hence their margins will be lower by Rs 180/T or about 70-75% of long-term EBIDTA margins in that market. Ideally, I would have liked had they paid off the Debt and then added capacity. So if they proceed with the 4.8 Mn T expansion as planned they could be in trouble with more Debt and this may provide investors a better value opportunity in 12-18 months - But who knows how prices might behave then!
Both TBK and RMC businesses are operating in favourable markets. Markets for these are likely to grow at 15% in the foreseeable future led by some fundamental drivers - increasing housing & commercial construction and benefits of RMC over on-site mixing. Both these business do not require much capital to run and generate strong returns on capital. Given their relatively strong positions in these markets, I do not see much concern in growing profitably.
But value investors must always look at conservative scenarios. So I am lowering profitability and growth assumptions to reduce margin of error in making investment decisions.
Exhibit: Estimates

Valuation
For valuation purposes, I have assumed the following:

• Company goes ahead with its plan to add greenfield capacity of 4.8 Mn T post which there will not be any further addition
• TBK and RMC businesses will grow at 5% on a terminal basis. Given their expected contribution in later years, terminal growth rate for the entire business will be 3.5%
• Unquoted investments at 80% of cost and liquid and quoted at market value

Exhibit: Valuation

The shares are valued just about the right discount of 25% to its value. But I do expect more stress for the business going forward. As value investment technique requires one NOT to SPECULATE, I can't say for sure whether prices will be more attractive during difficult periods (next 12-18 months). My strategy will be to  buy this scrip now and when prices go down buy some more at far greater discounts.

Cisco: Why Does It Make Sense?

June 14, 2011
website: www.cisco.com
CMP: $15/Share; Value: $21/Share

Strongly advise Cisco, it is rare that such blue chips are available at large discounts but such are the whims of markets

Whats Cisco Into?
Cisco Systems is the world’s largest networking company and about 9 times the size of its nearest competitor Juniper Networks. The company designs, manufactures, and sells IP-based networking and other products related to the communications and IT and provides services associated with these products and their use. Cisco provides a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world. The firm’s products are designed to transform how people connect, communicate, and collaborate. Cisco’s products, which include primarily routers, switches, and other advanced technology products, are installed at large enterprises, public institutions, telecommunications companies, commercial businesses and personal residences.
Historical Performance
Exhibit: Historical Performance

During the previous 6 years, FY05 to FY10 Cisco has grown its business primarily led by acquisitions. During this period

• Sales grew at 11%
• Average EBIDTA from operating sources was 26%
• Operational Cash Earnings post maintenance capex was 28%
• Average ROCE (EBIDTA/Capital Employed) stood at 23%
• Average ROE stood at 33%

Quite impressive for a company of its size.
During this period,

• Cisco earned $ 55.8 Bn for its shareholders
• Raised $ 16.7 Bn through Debt

And

• Used $20.3 (28%) Bn for funding growth and acquisitions
• Repurchased stock worth $32.8 Bn (45%)
• Parked $19.5 Bn (27%) in Liquid Investments 

Cisco has a massive and strong balance sheet with ~$40 Bn in Cash and equivalents. It has started paying Dividends which at current prices yield 1.5% - Not bad!
Management
John Chambers has been at the helm since 1995. He has developed Cisco into a world-class firm under his leadership. Recently there were concerns about the succession plan. Cisco has about 6 executives who are CEO ready. But the problem it seems is that Chambers has announced that he will continue to run the company for another 3 to 5 years. It will be difficult to retain top talent for that long. And recently two of them quit to join other firms. Investors also want to see change at Cisco sooner than later. I don't know when the change will happen but two things gives me confidence. One, Chambers will not do much wrong till he is around and secondly, it has a strong line of CEO ready executives. So whenever it happens, it will be a positive discontinuity.
Prospects
Cisco is in a growing segment. Requirements for data transfer is only going to penetrate deeper going forward. New technologies will keep emerging so that more and more people and businesses can be on the network. Gartner, Datamonitor and like estimate significant growth in opportunities like global mobile video and cloud services. Cisco has operations in several emerging economies that are under-penetrated and expected to grow at significantly higher rates.
Recently, Cisco's margins were down - gross margin for Q3FY11 at 61.3% was lower than historical lowest for full year at 63.9% in FY09 since FY03. The two key areas that have been the biggest source of deteriorating gross margin are the switching and government businesses. The switching market is in transition as customers are moving up from 1G to 10G. For Cisco, this transition has meant customers moving from its erstwhile Catalyst 6500 product to the newer Nexus product. There was a glitch in this transition and Cisco acknowledges that Nexus has under-performed expectations. In response to that and increasing competition from HP it launched a series of new products. It has been one of the largest product refresh in its history. Cisco is ready as before to grow switching business. Another concern it has is cut down of government's budgets. But in order to bring in long term efficiency government will be forced to go in for increased digitization. Though, the present might appear bleak the outlook is surely encouraging.
I have used very conservative assumptions to project Cisco's financials.
Exhibit: Projections

Some of the key assumptions for making projections are

• Capital turnover rate of 60% as against 75% which means slower growth on new acquisitions
• Sales growth of 5% as against 11% during the previous 6 years
• Operating Cash Earnings at 24% as against 29% in the past
• Dividend growth rate of 10%; little is known about this at present

Valuation
Cisco is in the habit of repurchasing shares ($32.8 Bn during FY05-10) . Even in the ongoing FY, it has repurchased shares upwards of $5 Bn. I think investors should be neutral to repurchases. The reason being that though repurchasing increases stake it reduces claim to cash. Another aspect that I think makes sense to highlight is that not all cash and equivalents that Cisco carries on its books are lying in US. Part of the cash when repatriated to US will attract taxes. The impact of the same I have not worked out but I am assuming that through restructuring US investors will continue to have claim on a large portion of it.
Exhibit: Valuation

I have assumed that terminal growth rate is 0% which means that no new investment / acquisitions will be made to grow business. I have also assumed that company will return all that it earns to shareholders post attaining terminal growth. These are indeed conservative assumptions. Additionally, I have assumed that no repurchase will be effected. Even if it is done, shareholders should be neutral towards this.
The following appears basis above assumptions:

• Cisco's equity value at present is $83 Bn
• Cisco has cash and equivalents of upwards of $40 Bn
• Per share basis, Value is $21
• Margin of Safety is 30%, much higher than recommended 25%

Very Attractive Opportunity to Buy Shares of a Very Strong Company

JK Lakshmi - Cementing Growth

Date: 10 June, 2010

BSE: 500380

Website: www.jklakshmi.com

CMP: Rs 45/Share; Value: Rs 83/Share

Must Buy: A growing mid-cap cement company available at 45% discount to its intrinsic value

Industry Prospects:

Cement industry growth practically mirrors GDP growth. And the simple reason is its end usage - housing for retail segment and construction for commercial segment. Indian Cement industry has been growing at a percentage or 2 higher than reported GDP numbers. Though, in our country GDP estimates have been found to be incorrect sometimes but cement output is tracked closely by CMA and is generally accurate. In the long-term, Cement will continue to grow at 7-8%. We are still far behind on per capita consumption compared to China leaving room for demand.

JK Lakshmi:

JK Lakshmi is owned by Lakshmipati Singhania group, one of the leading industrialists from India. JK Lakshmi has been in business for about 30 years. And has seen some tough times during downturn (early 2000s) largely because of imprudent financing decisions. Since then they have been prudent with their financing decisions. I had met the CFO once and he did acknowledge that because of financial imprudence they went through a rough patch and now have been prudent on that front.

In cement industry, the key to success are

• Economic capacity
• Proximity to market with regional presence
• Low energy cost and consumption norms

JK Lakshmi is quite a popular brand. They sell primarily in Rajasthan where they have their manufacturing facility. Slowly, they are expanding their regional footprint. They already have a split grinding unit in Gujarat and another one in Haryana and are now planning a greenfield capacity in Chattisgarh (good market to be in). JK Lakshmi has economic capacity units, in fact has one of the largest single location unit. Their specific consumption norms are in line (or slightly more) with other efficient players. Their per unit cost of energy is low as they have secured low rate contract for supply of electricity and have captive power plants totaling 66 MW.
They have also diversified into RMC (Ready Mix Concrete) business. RMC is very popular in US and other developed economies. But in India its in nascent stage. It is being used for commercial and residential constructions chiefly in urban settings. Its a good business with long-term prospects.
Historical:
Exhibit: Historical Financials

JK Lakshmi has been ploughing back a large share of capital to improve capacity and operating efficiency. They have made the investments wisely and have earned decent returns on capital employed. For instance, during 2006 to 2010, they ploughed back Rs 545 Cr. EBIDTA since then has gone up from Rs 128 Cr in 2006 to Rs 434 Cr in 2010. Even considering EBIDTA at historical long-term average of Rs 600 / T, Company has additionally earned Rs 150 Cr on Rs 545 Cr invested, more than 25% ROCE.
Projections:
Exhibit: Future Estimates

It is assumed that the proposed greenfield capacity of 2.7 Mn T will come in line during FY 13. Hence, FY 14 starting, the company will benefit from the new capacity. For Value Investment analysis, I have assumed the following:

• Future EBIDTA / T to be less than Rs 600/T (as against Rs 1300/T at peak and Rs 500/T at its most depressed)
• Depreciation for the new asset will continue at rates similar to existing assets. Given, a large part of JK Lakshmi's capacity has and will come in line recently, this is a conservative assumption
• I have assumed that beyond 8 Mn T total capacity (post Chattisgarh unit in FY 13), there will not be any further addition for the period under consideration. This also is a conservative one as the company will continue to improve capacities through equipment balancing.

Valuation:
Exhibit: Valuation

JK Lakshmi at current prices is available at $46/T as against replacement value of $100/T. Though, this is a huge discount but while using Value Investment technique, I rely on earnings rather than anything else. Above analysis indicates the following:

• Equity Value of JK Lakshmi: Rs 1000 Cr
• Or, Per Share basis: Rs 83/Share
• CMP: Rs 46
• Margin of Safety: 45% (much above recommended 25%)
• In 5 years, Rs 100 investment should grow to Rs 320

Strong Buy: Share Prices are down on concerns over over-capacity and that is why market provides an opportunity to buy a good company at a discount.

Voltas: Is it a Cool Value Pick?

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!

Why Ceat Tyres is a Value Pick at Rs 100/Share?

Date: June 1, 2011

BSE SCRIP Code: 500878

Website: www.ceattyres.in

CMP: Rs 100/Share; Value: Rs 210/Share

Lap Up - Ceat Tyres available at 50% discount to its value at current prices. I would strongly recommend this Stock  for its solid business history and high brand recall

Background

Ceat Tyres is the fourth largest tyre manufacturer of rubber tyres in India. It manufacturers the widest range of tyres for vehicles which includes both 2 wheelers and 4 wheelers as well as off-road vehicles. It is in business for 50+ years. It has a very high brand recall in the Indian market and has also emerged as a leading exporter of rubber tyres from India.

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 opportunity. Warren Buffet waited for more than 5 decades to buy Coke. Expected life of Indians almost certainly do not permit us to wait that long! So, what are the questions and answers to these.

Industry, Company, Management

Q1: What are the prospects of the industry?
Rubber tyres is a derivative industry of automobiles. As long as automobiles are there, they will be required. In my opinion, we need not be too worried about rubber tyres. They will be around for a few decades if not more. The technology is quite established and likelihood of path-breaking research is unlikely. Currently, there are no research that predicts switching to alternative materials for producing tyres. Globally, the industry is dominated by a few strong players. India is no different. Indian tyre is dominated by Apollo, JK, MRF and Ceat which together form a large share of both OEM and Replacement markets.

Q2: How is Ceat placed compared to rest?

Ceat currently has a market share of 11% and recent data suggests that it has been able to improve it by a few basis points thus indicating that it has grown faster than the industry. Ceat has a high brand recall. I quite like the new advertisement - 'Roads are full of idiots". Quite catchy.

Q3: How about management?

It is a RP Goenka group company. Though, I do not have a first hand account of the management and there is not much reported either I do believe that they are quite low profile. They are a 17,000 Cr (USD 4 billion) business group but one has not seen them too often doing or talking about non-business stuff.

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 2007 to 2011. During this period, Ceat earned

• Rs 655 Cr (105 + 21 + 131 + 232 + 166) in operating cash (includes funding changes in WC)
• Rs 52 Cr as dividends and interest from investments in the form of non-operating income
• Rs 118 Cr from sale of a land parcel in 2008

And, spent

• Rs 124 Cr for upkeep of assets (maintenance capex)
• Rs 328 Cr as interest on Debt (average interest charge of 9.7%)

Hence for shareholders, it earned Rs 373 Cr

• Rs 203 Cr (Rs 655 Cr less Rs 124 Cr less Rs 328 Cr) through operations
• Rs 170 Cr (Rs 52 Cr as non-operating income plus Rs 118 Cr from exceptional items)

During this period, it borrowed Rs 496 Cr at Debt/Equity of 133% (Rs 496 Cr / Rs 373 Cr). Put together, Ceat had Rs 869 Cr at its disposal.

It ploughed back 85% of this capital (Rs 742 Cr) and returned the remaining to its shareholders. Break-up is as follows:

• Growth Capex: Rs 742 Cr
• Dividends: Rs 26 Cr (goes to shareholders)
• Investments: Rs 93 Cr (goes to shareholders)
• Cash Accretion: Rs 8 Cr (goes to shareholders)

Q5: Has it been growing and profitable?

Ceat has been growing and profitably so as can be seen during 2007 to 2011:

• Net Sales grew at 13%
• EBIDTA margins averaged 7%
• Operational Cash Earnings averaged 5%
• ROCE (EBIDTA/Capital Employed) of 16%
• ROE (Operational Cash Earnings / Net Worth) of 25%. This was higher at 27% if non operating income is included

The reason why I am saying it is a profitable business inspite of a meager looking 5% operational cash earnings is the high Capital Turnover ratio of 260%. Rs 100 invested as capital will generate Sales of Rs 260. Even a low margin of 5% on Sales makes it 13% on Capital and even more on Net Worth as Return on Capital exceeds Cost of Debt (10.7%).

Future Estimates

Q6: How fast and profitably will it grow in future?

I don't think so that this industry which has been growing at faster than GDP rate will slow down. Underlying factors are quite fundamental - Middle-Class boom and high reliance on Road Transportation or rather under-developed Railways network.

From Ceat's perspective, however, I am making an adjustment in its historical growth rate of 13% it recorded during the previous 5 years. Ceat, in 2008, received Rs 118 Cr from sale of land. This is an exceptional item and non-recurring in nature. Hence, I am taking out the effect of Rs 118 Cr from historical growth and assuming the resulting growth rate to continue in future. Had this transaction not happened, Ceat would have earned only 68% (Rs 255 Cr) of Rs 373 Cr for its shareholders. Which means less capital available for deployment and eventually lower growth rate of 9% (68% of 13%).

Hence, for the foreseeable future (say next 7 years) following are assumed:

• Net Sales to grow at 9%
• EBIDTA margins at 7%
• Operational Cash Earnings at 5%
• ROCE at 15-16%
• ROE at 26%

During this period, it is assumed that, Ceat will

• Lower Debt/Equity to historical levels of 1.20 or less (which at the moment is high on account of recent capacity expansion)
• Re-invest 85% of capital to sustain growth. Given focus on growth in Annual Reports, it is very likely Ceat will continue to re-invest high share like before.
• Return remaining to shareholders, i.e., 15%

Q7: Future earnings projections

Exhibit: Future estimates

Valuation

Q8: What is the value of Ceat shares?

Finally, the million dollar question. I use discounted cash flow to equity owners method. In other words, how much cash the company will and is capable of paying its shareholders in future and when discounted to present is this amount significantly higher than the price paid for the shares. I find several merits in this method. It allows me to assess what the company will realistically pay me at future times for the price I pay today. This is a strictly 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 important 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. Warren Buffet uses a rate of 10% because he says he is highly certain about future cash flows estimated by him. Since, I am a beginner and need to test my method over a period of time, I use a higher, 12%, rate.

For terminal value, I am assuming no growth situation and all 100% earnings will be returned to shareholders. This is a very conservative assumption as even after 7-8 years, Ceat will continue to reinvest and grow. Finally, I am adding back Cash-at-hand (Rs 48 Cr) and Liquid portion of investments (Rs 68 Cr) to discounted cash flow to equity holders to arrive at the final value of shares.

Exhibit: Valuation

The following emerges:

• Discounted value of future equity earnings: Rs 603 Cr
• Present cash and liquid holding: Rs 116 Cr
• Value of Ceat Equity per Share: Rs 210
• Current Market Price (1st June, 2011): Rs 100
• Margin of Safety: 52% (much more than recommended 25%)
• Likely return over 5 years holding: 30% per annum