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.

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