Monday, 30 April 2012

Mazda Limited: Engineering A Value Play

In my last post, I wrote about Mr.Pabrai's book Dhandho Investor (Click here to read) and Mr.Pabrai's insistence on making an investment only if it presents an opportunity where Heads you win but Tails you don't lose much. And coincidentally, as I was running through my value screen, spotted a very interesting opportunity befitting this philosophy. 

Mazda Limited is a custom engineering company that is engaged in business of  manufacturing vacuum system and associated equipment, evaporator systems and air pollution control equipment. Since last 4 years, it has also diversified into food business catering to market for instant drink powders, food essence and food colors with brand name of BCool.  However, custom engineering business remains company's main stay as it derives more than 90% of its revenue from engineering business. Mazda has technology tie-up with Croll-Reynolds , a world leader in customized vacuum system design. Croll-Reynolds also holds 6.8% stake in the company (earlier 11%) and has a nominee director on the board. Mazda also claims to be the only company in India to offer one of the world's largest test facility to simulate actual operating conditions. Being a chemical engineer and having worked on process side, I feel this may be a big advantage as simulating actual operating condition will be very useful in optimizing the vacuum system performance and reduce steam consumption to minimum level. As far as my limited understanding, not many players in India have such state-of-the-art set up. 

Mazda Limited is promoted by Sorab Mody and has scaled up significantly in last 10 years. It has grown it's revenue from 12.63 crores in March 02 to 89 crores in March 11, achieving CAGR of 21%. Similarly, net profit has grown ten fold (after deducting extra ordinary profit made in FY 11 on sale of valve division) from 0.86 crore to roughly 9 crores , CAGR of 26%. It is important to mention here that Mazda operates in highly specialized business of custom engineering which is less competitive than general engineering business. Moreover, it is an asset light business which derives its value from intellectual inputs (i.e. design of vacuum system and evaporators which is proprietary/customized). This is clearly reflected in ROCE/ROE performance of the company. Mazda has consistently achieved ROCE in excess of 25% for last many years. ROE of the company has remained above 22% for last several years. High ROCE/ROE indicates that company operates in niche business and can generate superior returns on capital/equity employed. Another glaring fact  is that large part of company's growth has come from shareholder's equity as Mazda has consistently maintained very low debt to equity ratio (less than 20%) throughout 10 year period. Currently, it is a debt free company. 

In 2010, company sold of its valve division to Circor India Limited (subsidiary of US based Circor International) for 22 crores. According to AR for FY09-10, Mazda's valve division had turnover of roughly 10-11 crores (based on equipment wise revenue break up on page -37). Circor International is a fairly large company with its flow technology division having annual revenue of around USD 265 million in 2011 (it has two other divisions as well). A US company of this size buying a division indicates  high level of quality standards/manufacturing practices adopted by Mazda. For the above mentioned deal, Circor India paid 2 times revenue for buying out valve division of the company. Mazda received 18.7 crores as upfront payment while remaining money is to be received in June 2012 (roughly 2.5 crores after working capital adjustment). 

Now, let's look at Mazda's valuation. Currently company's market cap is around 39 crores. Based on September 2011 half yearly filings, Mazda has 13.37 crores in investment (all of it in mutual fund) and cash and cash equivalent of 4.04 crores. Mazda will receive 2.5 crores in June 2012 from Circor India. In all company will have cash and liquid investment of roughly 20 crores. This means, market is assuming discounted value of future earning at 19 crores (Market Cap - liquid investment- cash). According to 9 monthly data, Mazda has net profit of 6.72 crores, amounting to annual profit of 9 crores. Mazda has expanded its capacity by 15-20% and hence FY 13 profit is likely to be at least 20% higher (even though this year, company's margin has been substantially lower than last two years and if it improves in FY13, profit can be significantly higher). Hence likely payback for the investment net of cash+ investment is going to be 2 years. This is a base case scenario, in my opinion, and fairly lucrative one too!

On the other hand, let's assume that company is for sale, what value its peers/competitors will be willing to pay to acquire the company? If I assume company will receive at least as good valuation as that of its valve division, i.e 2x revenue (which in my opinion is conservative as vacuum/evaporator business is less competitive than valve business and possess characteristics of niche business. Moreover, there is substantial real estate value to its factories located in Ahmedabad), FY13 projected revenue of 108 crore (1.2*90 crores due to 20% capacity addition), company will be valued in the range of 200-220 crores. This is 5.5 times current market capitalization! 

So what's the deal? If I win (if things go better than expected or market bridges the gap between intrinsic value i.e. close to private value of the company and price) I can get 4-5 bagger . If I lose (no growth, margin at current levels only), I am making investment having payback of 2 years (not bad by any standards!). 

However,as in any investment thesis, one has to take  facts and figures with a pinch of salt! So let me show you some areas where things can go wrong...

Negatives:
  • Promoters have low shareholding (34.19%) which may expose them to hostile take over (even though chances are very less due to un-leveraged balance sheet)
  • Mazda's competitive edge is largely dependent on design/know how of Croll-Reynolds. If things go wrong and technology transfer arrangement is discontinued, company may face uphill task of developing intellectual capital comparable to that of Croll-Reynolds .
  • Mazda has diversified into food business, which, inherently is a low profit margin business. If company is not able to manage this diversification well and allocates inordinate capital for expansion, company's prospects will be negatively impacted. 
And finally, some icing on the  cake...

Positives:

  • Promoters have been slowly buying stock from the market which indicates their belief in future prospect of the business (most recent acquisition at price of Rs.86, not too far from current price!)
  • A large part of the export revenue (80%) is derived from Croll-Reynolds. Croll-Reynolds have bought equipment worth 15.5 crores from Mazda in FY11 up from 6.53 crores in FY10. This may indicate Croll-Reynold's confidence in the company.
  • Management has consistently maintained/increased its dividend since last 10 years. Moreover, management rewarded shareholders when they received proceeds from the sale of valve division by declaring interim dividend. 
  • Management has clearly indicated in ARs that they are operating in custom engineering business which has limited competition. They also indicated that company possesses pricing power which will help it protect its margin in case of increase in raw material costs. This affirmation validates the premise that Mazda possesses sound business economics. 

In all, Mazda represents an investment opportunity to buy a niche business with pristine balance sheet and high ROCE/ROE at dirt cheap valuation where probability of permanent loss of capital is minimal while potential upside can be significant.

Disclosure: Views expressed in this post are individual and shall not be construed as buy/sell investment advice. All the readers are strongly encouraged to carry out their own due diligence. 

31 comments:

  1. You have excellent skill in analysis.I saw this company in the start of January. After a small research thought of making a initial position but did not as other opportunities took my money away to them.

    After reading your analysis and conviction i am thinking of taking this business again into my radar..let me come back after i have done my analysis

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    Replies
    1. Hi Prabe,

      It will be indeed good to have the investment thesis for Mazda analyzed independently again as it may unfurl some negatives that I might have missed. I will look forward to your findings from the analysis.

      Best Regards
      Dhwanil Desai

      Delete
  2. Superb Post ........ Adding Mazda to my Watchlist ....... Thanks for sharing your knowledge ......

    Karun Sandha

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    Replies
    1. Hi karun,

      Thanks for the compliments.

      Best Regards
      Dhwanil Desai

      Delete
  3. Hi Dhwanil,

    Nice post. I have read all your posts and surely appreciate your insights.
    I have one question on Mazda.
    From the valve division sale, the company earned roughly 25 rs per share as a one time gain, but shared only 3.5 as special dividend. Do you know, if they have real good use of the retained money ? This retention of money looks like, will bring down their ROE for the next few years and like you mentioned they are already sitting on quite a bit of cash in comparison to their operations. Is that a reason market perceives them to investor unfriendly and hence the valuation ?

    Regards
    Raja

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    Replies
    1. Hi Raja,

      Yes, most of the time when value gets unlocked (such as from sale of a division/business/brand), market expects promoters to share the value creation with shareholders immediately. Contrary to that, promoters typically would like to chalk out plans to deploy cash either in existing business (through organic/inorganic route) or diversify in other businesses or siphon off cash (there are umpteen ways of doing this and market fears the worst)from balance sheet. Market does not like uncertainty and hence unless there is clarity about management's objectives and objectives' worthiness, market discount such companies heavily case in point being Piramal healthcare/ JB chemicals.

      In case of Mazda, As I understand, roughly 18.7 crores were received from sale of valve division (out of 22 crores, remaining tranche post w/c adjustment is due in June this year). They paid total dividend of roughly 3.5 crore (including special dividend), paid taxes of roughly 3 crores , invested 3-4 crores in expansion. So roughly 50-60% money are already utilized. Rest of the money is parked in liquid investment funds. Hence, I am not able to see any unethical/minority unfriendly behavior by the management.However, I agree with your point that if company neither distributes cash nor deploys it for productive purpose, ROE would come down. But at the current valuation, even considering dampened ROE, Mazda seems to be a bargain.

      Best Regards
      Dhwanil Desai

      Delete
  4. Great post. but how is low promoter holding a negative? That would make the chance of an open offer more likely, thus helping minority shareholders(am assuming no risk of tunneling here).

    Also, please display your RSS feed(to posts) prominently,for those who prefer that to email

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    Replies
    1. Hi Anandh,

      Typically, higher promoter shareholding shows confidence of the management in the business and it will align interest of promoters with minority shareholders. One of the downside of the low promoter shareholding is possibility of hostile take over. However, in case of Mazda, it has unleveraged balance sheet which makes hostile takeover a low probability event. On the positive side, if management decides to sell off its stake, as you mentioned, it will trigger, open offer which may be beneficial to minority shareholders as company acquiring management stake would like to have controlling stake and hence will be ready to pay higher price to minority shareholders.

      Delete
  5. Dear Dhwanil Desai,
    Just as I was surfing the net and I came across this artilcle.Not for the sake of cheap flattery I appreciate your article but it is
    well Reaserched and well balanced by exposing the STRENGTH AS WELL AS THE WEAKNESS OF THE company.
    The Technical aspect is as under:

    simple moving averages 30 days -> 92.07
    50 days -> 92.27
    150 days -> 86.98
    200 days -> 86.98
    it is poised at critical juncture which may give positive break out. 52 Wk High/Low 99.90/70.25 .
    Rest is all you have provided.
    With warm regards and due respect Vakharia M J

    ReplyDelete
    Replies
    1. Hi Mahesh,

      Thanks for your kind words.

      Delete
  6. What's your take on scalability,opportunity sizes execution ability of promoters?

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  7. Hi Dhwanil,
    post reading your take on mazda i did some of my own research and i noticed that if you observe power & fuel cost of company for last 10-12yrs its average around 2% of sales.
    now its a capital goods company, hence i believe 2% seems to be kind of aberration/weird/out of the sync to me.
    another thing i was trying to get historic price from BSE & Cline but some of it was missing, based on whtever data i could gather (apr-07 till date ) i tried making 1yr forward P/B band and saw tht it was always traded below book value. something to ponder about.

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    Replies
    1. Hi Sage,

      I do not think power & fuel cost of 2% is weird considering their nature of business. Mazda makes high value vacuum steam jet ejectors, evaporators, surface condensers and other vacuum systems. Typically, power or fuel consumption is more towards machining and tooling different components to required specification. Moreover many of the components may be procured directly from their vendors in finished form which needs to be assembled properly. I would logically assume the power/fuel will not be a significant component.

      Regarding historical price, I do not have record for historical price dating back to 10 years but as I glanced through their old ARs where they need to put monthly data on prices and compare them with forward P/E, I did notice that Mazda traded few times at P/E of 9-10 on forward basis. Moreover, I believe that companies evolve and market change view based on how well they evolve. So as long as they continue to perform well on all other ratios and EPS, i would not be too worried about historical performance as sooner or later market will bridge the gap between price and intrinsic value.

      Delete
  8. Hey Dhwanil,

    Great Post. Can you comment on Mazda diversifying into unrelated food business? Not sure, but would you be turned off as this is unfocused/unrelated expansion?

    Thanks,
    Sangram

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    Replies
    1. Hi Sangram,

      Yes, diversification into food business did create doubt in my mind when I analyzed this company. However following points helped me in assuaging my concerns

      - Diversification in food products business is not entirely unrelated to their core business i.e. vacuum systems. Typically concentrates manufacturing unit will have sophisticated vacuum systems at its heart in terms of process. Mazda used to supply these systems for such applications to their clients hence they are bound to get at least that part right
      - The entire business model is ultra asset light model with marketing their products through e-commerce only. Moreover, Mazda has not deployed large capital for such diversification except allowing its land and old machinery to be used.
      - Food dvision is showing steady improvement in performance on revenue and margin front consistently. This at least ensures it is not eating into the profits of engineering division.

      - It has focused on "private labeling" and food colors and essence which is less competitive and scalable without investing into creating reach through marketing/distribution network.

      All these considerations makes me feel that downside due to diversification may be limited. Moreover at this valuation, even diversification going wrong seems to be factored in.

      Delete
  9. Hey Dhwanil,
    Keep up the good work. Now it has become a habit to check your blog daily for any posts or updates. Had one question regarding Mazda ltd., Can you throw some light on the order book especially if you have interacted with the management after q4 or fy12 annual results.
    thanks

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    Replies
    1. Hi Kunal,

      Thanks for the appreciation. I have not interacted with management post FY 12 results and hence I will not be able to comment on the same. I do know that team at ValuePickr was trying to get in touch with management for Q&A. If I come across any updates will surely keep you posted.

      Best Regards
      Dhwanil Desai

      Delete
  10. i guess the margins are goin to be more or less strained in the next couple of quarters
    just thinking should not the cash and bank balances figure be 3 crores instead of 4.2 crores as fully 1.2 crores of it are deposits against bank guarantees?(not sure exactly what those guarantees are for..would like it if you could clarify)

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    Replies
    1. Hi,
      Frankly speaking I am not too sure about how margins are going to pan out in next 2 quarters. What I do know is that under worst case scenario also, there is very limited downside while If things work out well, It can give significant upside. So If one constructs a portfolio consisting of such stock which has limited downside and significant upside, results are going to be above average just based on laws of probability.

      With respect to Cash, I do agree that to be most conservative one can take 3 crores instead of 4.2 crores. However typically bank guarantees are issued as assurances to the clients and B/G are invoked only if there is failure to meet obligations. So If no such events happen for which B/G is given, 1.2 crore can be counted as cash available. But to be safe one can go with cash of 3 crores.

      Best Regards
      Dhwanil Desai

      Delete
  11. thanks for the clarification,
    i too agree with you that mazda has limited downside (and with special emphasis on paying the lowest price possible and appropriate diversification it should work out nicely)...thxfully mr.market seems to have discounted most of the negatives on this one(even if one assumes lower margins for the next couple of quarters) or if one would like too view it this way,you are paying less than 10 times last years operating cashflow of 5 crores(after deducting the valve sale of course) .
    however there has been one nagging concern i could not overlook
    as i look at the cashflow history stretching back ten years to 2002(according to moneycontrol),the operating cashflow has been pretty volatile and uneven to say the least( though i could not help being impressed by the fact that they have had just one year of negative
    operating cashflow) ,also the net profit figure too have varied widely over the years...is there something im missing out or does it have to with the business model
    would be really grateful if you could clarify this

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  12. DESAI JI..
    have a look(and maybe repond to the above)

    http://www.safalniveshak.com/forum/stock-ideas/mazda-ltd/#p241

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  13. Hi Dhwanil,
    Super facts and research on Mazda ! One question maybe you may know as to why Croll reduced stake from 11% to 6.5% odd ... ?
    austin.

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  14. Hi Austin,

    Frankly, I do not have any idea why Croll reduced its stake in Mazda. May be financial crunch for them as well. But just a guess here, no clues otherwise.

    Best Regards
    Dhwanil Desai

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  15. Hi Dhwanil,
    If someone has an engineering background or understands this industry well - would love to get a better understanding of outlook / competition in vacuum system business.
    Regards

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  16. Good report from ICRA which has upgraded rating today ...

    www.icra.in/Files/Reports/Rationale/Mazda%20Limited_r_11062013.pdf

    link for anyone interested ... like my previous post was directing towards, the business and industry info is not much ( even in this report ) and strong moat remains a question going forward... anyone know more about this ?

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  17. Based on sept '13 balance sheet, the company seems to have close to 38 cr of cur investment + cash less debt. Either this company is fraud or really cash bargain.

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    Replies
    1. Hi Anonymous,

      I recently met the Company management and it surely is not a fraud company. In fact they have long standing association with some very large MNCs like ABB/Siemens/Alstom/Alfa Laval. I also got an impression that company is very conservative in its approach towards business. Secondly, it is consistently increasing its dividend, pay 30% tax and still increasing its cash position which alludes that cash flows are for real and not "made up".

      Having said this, they are passing through a lean patch this year as the Capital goods sector is not doing great. So, in short term, there may be some pain. However, in terms of valuation, it is an interesting bet.

      Delete
  18. I have this in my watch list, I think its still a good buy although I am waiting for it to drop so I can add some. I think in the long term even if the market doesn't rerate the company I would expect > 20% return because of its ROE values which is actually not bad for me. Although I don't like companies diversing into other areas however I am biased towards food business. I think its a good long term business

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    Replies
    1. Hi Nirvana,

      Thanks for your comment. Mazda continues to primarily remain an engineering play as the food business is only a small part of it. I am not too sure how serious the management is about scaling up the food business. Secondly, the food processing business is very competitive hence the margin may not be high on sustained basis. Overall, I feel it's more of a value play and once the value catches up with intrinsic value, it's best to book profit.

      Best Regards
      Dhwanil Desai

      Delete