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

Fooled by Politicians

I had been following Times Now on the recent CWG mess quite regularly. The editors did a good job of making the right noise day in day out on why CWG was in a mess. Fingers were pointed at the Organizing Committee and whosoever connected with it. Quite a few interviews were done on the general rut - accountability, responsibility, nation, pride, etc.

But something was quite startling about it. How politicians were able to fool the situation and were able to manufacture consent. Every time a question was asked on what happened in the past, they would deflect it to future selling a rosy picture. Invariably people fell for that. Q: Mr Kalmadi, its a shame that the games village is not ready and athletes have started pouring in. How do you explain this? Why was work not done in time? To such questions Mr Kalmadi would take a very measured, always works, approach. Firstly, he'd say that it is not a matter of concern (DENIAL) as we have stepped up our preparedness. No one is complaining and athletes are having a good time. (After having denied the history, he'd deftly take a futuristic stance that obviously no one can say with certainty will happen or will not happen). Let me tell you Mr Such & Such that we'll deliver an excellent games (SOLD A ROSY FUTURE). And the athletes and the officials and our countrymen will have a great time. Ah! this completely shuts out further allegations. So next question logically would be - Do you still expect the games will go on as planned. Here the politician (Kalmadi in this case) has won the battle. He has quite successfully sold the idea of a brighter future and no more is he going to be pained by questions on roof leaking, dogs found sleeping on the bed, paan stains on the floor, shit in shit pot and everywhere else ... Having successfully fooled the audience, he'd now move to seal the debate. To the question whether the games will go on as planned, he'd say definitely two hundred percent. There is no question about that. Wah! a victory. Editor having fallen for the bait would now defer their judgment call to the 'let the games begin' day. Everyone is assured that the games will start as planned.

Compare this to others managing the games but playing the support role and not really at the helm. Rather, what separates a Kalmadi from the Balbir Singh, Mehnot, etc of the world. A Balbir Singh or a Mehnot sometimes fall for the bait and answer the question that media prompts them to. They get into explanations. So Mr Singh, dogs sleeping on the bed what do you have to say? Mr Singh would respond, well MCD should have taken care of this but its a minor problem (DENIAL, but after ACCEPTANCE). Wrong strategy surely. If Kalmadi were to respond, he'd say that we have a week to go and let me assure you it will be a stray dog free games and our countrymen, athletes, officials are going to enjoy this game. Ah! victory again.

Why management consulting interventions fail?

Why management consulting exists at the first place? The reason for consulting to exist is very fundamental to human nature. You'll agree that our mind is not programmed to do an objective evaluation of ourselves. For example, take up the task to describe yourself in one sentence. You'll find very difficult to answer this question. Ask a friend of yours the same question. She'll find it difficult too. Now ask her to describe you in a single sentence. This, she'll not find as difficult. Certainly, she has less information about you still she is able to assess you better. Take this example to an organizational set-up. Here, managers know much more about the existing ways of working but seldom are they able to objectively evaluate areas of improvement. Because they have biases about own processes and systems. Like your friend, here the consultant (rather a seasoned one) is of help as she'll be able to objectively diagnose and bring out problems for everyone to view objectively. That's precisely the reason why consulting exists.

So, why then does it fail on most occasions?

The key reasons why interventions fail also happen to be very fundamental in nature. To understand this we need to visit the process of consulting. Client hires a consultant for a defined scope of work. Consultants start work by appointing a project manager to coordinate activities. Once identified, they start the fact finding mission by speaking to managers in the organization and analyze data to understand the situation at hand. Then, they formulate their findings and validate the same with employees / managers. Post which they present their findings to the top management / steering committee. Upon approval from the steering committee, they start work on formulating changes required in processes, strategy, organization, etc. As a final step, they present the change imperatives to the steering committee. Most often, if the work is up to standard, the steering committee accepts the recommendations and reaffirms its intention to get the changes implemented. At times, it also initiates search for the project manager to initiate changes.

All this seems pretty much the right thing to do. Then why does it fail. To understand this lets revisit the process. A careful thought would surface the lack of involvement from the client team. Here is a team who has to implement but has not been involved all through. The team is not bought-in. All this while, client team has either provided data or set-up meetings but has never done the thinking-through. Now, for someone who has not participated in the process, it is very difficult to accept and implement changes as envisaged. Even if an honest attempt is made, multiple roadblocks surface, that consultants had not envisaged, to disengage the team. Once disengaged, it can never hit the road running.

Unfortunately, most consulting firms operate in a manner that does not adequately involve the client team. And the client team is then given the responsibility to build a home they never dreamed of. Do you think, one can ever build a home without first dreaming about it.