Saturday, 10 March 2012

Applying Capital Allocation Framework: Part 2

In the part 1, I discussed the two building blocks of capital allocation framework  i.e. conviction rating and valuation rating and then drilled down to constituents of conviction rating i.e. business quality, fundamentals, growth prospects and management quality. I illustrated the process with the example of Cera Sanitaryware. For reading Part 1 click here

Following is the overall score rating on Cera on business quality and fundamentals. 

Business Quality: 1.64

Fundamentals: 2.06

Now moving on from there, let's look at other two attributes of conviction rating i.e. growth prospects and management quality. 

Growth Prospects (weightage -30%):

Opportunity Size: This is one the most crucial parameter in the longer term as it determines the outer limit of scalability potential of a company. To give an example, Gillette has opportunity size of selling more than 3 billion razors, considering population of men around the world and hence if caught in early stage, such company can easily grow 100x . In terms of opportunity size, Cera can be considered to have a very large opportunity size considering more than 300 million households (and growing) and replacement demand that can be generated for their products. Hence Cera scores very well on this count Score:9

Ability to scale up: 
Even though opportunity size is the first and foremost requirement for scalability, not all companies in the same sector can scale up at same rate. Ability to scale up is the other part of equation that needs to be right to achieve sustained growth. A very interesting article by Mr.Rahul Saraogi about "scalability is not accidental" desribes factors impacting scalability. Let's look at some important measurable factors that reflects on ability to scale up. 

Industry Growth: Huge population and lack of sanitation facility for a huge section of society combined with growing replacement demand is going to drive the growth of sanitaryware in India. It is estimated that sanitaryware market is likely to grow in the range 13-15% for at least next 5-7 years and probably there after too! Score:8

Company Growth:Typically, Cera has grown much faster than industry in last many years and this trend is likely to continue as, company has expanded its distribution network and now planning to undertake a brand building exercise. Moreover rising income of middle class is spurring demand for stylish yet affordable sanitaryware and Cera is a major player catering to this market. Cera has grown its topline at CAGR 20% and bottomline at CAGR 45% as compared to industry growth rate of 15%. Score:9

Ability to fund growth: A key attribute of competent management is how well company manages its balance sheet and growth simultaneously. In addition to sustainable business economics, it requires reasonably measured approach from management (without being too aggressive or too conservative!) about growth. Cera has managed this aspect very well as it has grown its topline and bottom line at breckneck speed without leveraging its balance sheet. In fact, Cera has reduced its debt to equity ratio from 0.63 to 0.34 and long term debt/equity ratio from 0.41 to 0.15 in last 5 years while maintaining 20%+ growth rate. Unleveraged balance sheet will mean that Cera can continue to scale up without diluting equity for a long time to come. Score:9

Total Score in ability to scale up: (9+9+8)/3 = 8.67

Average Score = (9 + 8.67)/2  * 30% = 2.65

Management Quality: Even though, in the capital allocation framework 25% assigned to this attribute, this can make or break your investment. An intelligent management with wrong intentions can jeopardize the expected returns. Even though it is very difficult to measure attributes defining management quality, Mr. Donald's framework provides a reasonable clue to management quality and makes one look for usual suspects for camouflage/window dressings and danger signs. 

Type of Management: Cera was established  by Mr.Vikram Somany, a first generation entrepreneur. He is still heading the company, however, his son Mr.Vidush somany has started taking over operational responsibilities and is spearheading growth initiatives. However, company is run as family business and not much of professionalism seems to have been brought. Score:7  

Management Drive: Cera has embarked on a vision to be "total home solution provider" in the longer run and company is diligently working towards it by increasing its product offerings. One such initiative is to start a faucet ware plant whereby becoming "total bathroom solutions" provider. This indicates company is diligently  working towards its vision. Company has ability to think differently and implement it if felt right. Cera was the first company to use natural gas in manufacturing and was instrumental in launching "snow-white" range of products. It has also consistently gained market share from a new entrant to 20% of organized segment. Management has given indications that Cera will attain 25% market share by 2015. All these actions demonstrates that management has drive to take Cera to newer heights.  Score:9

Management Depth: As mentioned earlier, company is primarily run as family business and apparently and second line of executive management is mainly on the operational side. Strategic decision making still seems to be family's prerogative. However, company seems to have created robust organizational framework to take care of operations of the company. Score:7 

Management Integrity & Compensation: In general, there is no negative aspect relating to management integrity is found. There is neither significant related party transaction nor any warrant issuance/conversion at discount to market price. Moreover study of last 4 years' AR suggests that there is no auditor difference noted in their audit report. On the remuneration side, total remuneration of directors and its relatives was 4.68 crores which is 17.3% of its total earnings. This is higher than average and hence can be considered slightly negative. Score:7

Disclosure Norms & Regulatory Compliance: Cera has decent record in terms of disclosure norms and company's AR includes all necessary information. Management discussion and analysis portions are fairly elaborate   giving a good insight into industry structure, company's performance and measures undertaken during the year. Company has complied with all regulations and there is no stricture/order passed against company's management. Overall, a decent record in this area. Score:8

Shareholding pattern: Promoters hold 55% in the company representing decent holding. Moreover, recently promoters have bought shares from the market which will increase their stake further. Thus, promoters of the company seems to have enough confidence in company's earning power over a period of time. Score:8

Average Score = (7+9+7+7+8+8)/6 * 25% = 1.92

Conviction Rating for Cera = Business Quality Rating + Fundamental Rating + Growth Prospects Rating + Management Quality Rating 

Conviction Rating for Cera = 1.64+2.06+2.65 +1.92 

Conviction Rating = 8.27

Valuation Rating:

Price to Earning Ratio (TTM basis): on trailing twelve month basis, Cera is trading at P/E of 9.05 and considerably lower than its peer HSIL which is trading at P/E of 12.5. This difference is more glaring if one considers the fact that Cera is much less leveraged and has substantially higher return ratios and profit margins than that of HSIL. Score:8

Price to Book Ratio: on TTM basis, Cera is trading at P/B of 2.5 which is slightly on the higher side. However, P/E * P/B is still 22.5, the upper limit suggested by Ben Graham for conservative investors. HSIL is trading at P/B of 1.35 much less than that of Cera. Score:7

PEG ratio: PEG ration indicates how attractively a stock is valued compared to its growth record. PEG ratio below 1 indicates an attractive proposition as valuations may not have caught up with growth rate. On a 5 year average growth rate basis, Cera's bottom line has grown CAGR 24%. Based on TTM P/E of 9, PEG ratio works out to be 0.37 which is much below 1. Moreover, based on management guidance and industry growth rate, Cera is likely to grow at at least 20% for next few years hence PEG ratio of 0.37 incorporates substantial margin of safety. Score:8

Net working capital + Investment - Long term debt as % of Market cap: This measure is indicative of how much money is surplus with the company after meeting long term liabilities. Actually, this is one of the parameters to assess the liquidation value of a company as the value has higher certaintly of realization even in the worst case scenario. Cera has long term loan of 16 crores while NWC + Investment (at lower of cost or value) is 65 crores. Hence NWC + Investment - Long term debt as 49 crores. This represents roughly 18% of market cap. Even though there is no guideline available for this measure, a positive number more than 10% of market cap can be considered very good. Score:9

Discount to Intrinsic Value: Based on discounted future cash flow analysis considering very conservative FCF growth rate of 10% for 10 years,terminal growth rate of 3% and discount rate of 12%, intrinsic value of Cera is close to  550 crores giving margin of safety of 50%. Even if we consider 10 disastrous years for Cera and 5% growth in FCF, intrinsic value of 400 crores giving margin of safety around 30%. Thus current market value provides significant protection to downside. Score:9 

Valuation Rating = (8+7+8+9+9)/5  = 8 

Now based on conviction rating and valuation rating, let us arrive at composite rating. 

Composite Rating = 0.6 * Conviction Rating + 0.4 * Valuation Rating

Composite Rating = 0.6 * 8.27 + 0.4 *8 = 8.16

However, let me warn you that this is not the end of the process. One has to repeat the whole process for all the stocks in one's portfolio to arrive at relative standing of each stock as compared to others. If we come out with rating for all the stocks in the portfolio and potential new buys, it becomes easy for us to allocate capital based on this rating instead of groping in the dark or relying on gut feel. 

During the whole process, I felt, at times, that assigning ratings to some of the parameters became slightly subjective i.e. is P/B of 2.35 a rating of 7 or 6? Does higher management remuneration deserve   rating of 8 or 7? I was not too sure and went ahead with assigning rating based on my limited understanding from reading of AR of various companies and industry average numbers. 

However, the biggest positive of the whole exercise was it made me think! It made me look into lot of areas where danger signs would have existed that I might have overlooked. That is where I think its true value lies.              

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