This posting is slightly modified version of the thread that I initiated on Amara Raja Batteries Limited on valuepickr. Even though, over three years, I have been experimenting with various value investing approaches like deep value investing (cash bargains/debt capacity bargains), growth for free and great businesses at reasonable price, I am slowly realizing why Mr.Buffet puts so much of importance on the idea of "durable moat". In my investment journey, though very short by any standards, I am starting to get a "feel" that investment in business with durable moat at reasonable price may give much higher return than buying reasonable businesses at great prices (to read more on sources of durable moat sources of durable moat). Hence, I have been looking to re-balance my portfolio with companies that either have durable moat and are trading at reasonable price (25-30% discount to conservatively calculated intrinsic value) or companies that have a possibilTity to create sustainable moat over next few years and are available at reasonable bargain price (40-50% discount to intrinsic value). Even though ARBL came to my radar around April 2012 (earlier post on Value Picks in turbulent times), as I dug deeper, my conviction level on ARBL went up considerably.
I tried to put on skeptics hat and tried to put hole into the story, but could not find any major ones. Then i posted the idea to valuepickr community members (a very vibrant and dedicated community towards value investing to say the least!), essentially seeking views of the community members on what can go wrong. And till now many of very senior members have opined that it is indeed a good business with possibility of having durable moat. So here is the story of Amara Raja.
Commpany Profile:
Amara Raja Batteries Limited (ARBL) is one
of the largest battery manufacturing company in India. It has two divisions
namely automotive and industrial. ARBL has very popular brands like Amaron,
Powerzone and Quantas and very wide distribution network of 274 franchises
across the country.ARBL is promoted by Mr.Ramchandra Galla. Jhonsons Control,
world's largest automotive battery manufacturer, holds 26% in the company. ARBL
has grown from strength to strength over the years and has successfully
challenged the monopoly position of Exide in India. ARBL was the first company
to introduce advance technology VRLA in India giving exide run for the money in
Industrial segment and capturing growing telecom tower market.
Business Environment:
ARBL caters to two main segments namely automotive batteries and industrial
batteries. In India, branded battery segment is duopoly with Exide and ARBL
dominating the market. Even though Exide garners larger share in automotive
market due to its relationship with two-wheeler and four wheeler OEM, ARBL is
fast catching up. Over the years, vehicle owners are slowly shifting focus from
unbranded battery to "proven and branded" automotive batteries which is helping
both Exide and ARBL. Considering the duopoly nature of the business and
perecieved value of the "brand", there is moderate pricing power. Typically,
companies are able to increase prices with some lag to raw material (mainly lead
which constitutes 60% RM cost) price.
Automotive segment
Exide is present in all the segments of automotive batteries namely four
wheeler OEM, four wheeler after market, two wheeler OEM and two wheeler after
market. ARBL is present in all except two wheeler OEM which it is trying to get
foothold in next 2 years. ARBL commands 26% in four wheeler OEM, 34% in four
wheeler after market and 24% in two wheeler after market. It has marquee client
list like Maruti, Honda, Hyundai, GM, Mahindra, Tata, Chrysler, Swaraj, Ashok
Leyland and many other names
Industrial Segment
ARBL has developed a fairly robust product portfolio catering to needs of
various industry including telecom, power, railways, oil & gas and UPS. ARBL
introduced VRLA technology in industrial battery segment by leveraging its
colloboration with Jhonsons Control. This move changed the competitve landscape
by making a big dent in Exide's monopoly. This early advantage was carefully
scaled up by ARBL. As a result, now ARBL has become market leader in telecom and
UPS sector with 46% and 32% market share. To give some more perspective: Over
50% of Indian railway's two and three tiered AC coaches are powered by ARBL
batteries
to summarize on the business side
- battery manufacturing is relatively simple business (for sure no rocket
science!)
- It is a steady and scalable business. every 3-4 years these batteries needs
to be replaced and so the demand for the product is definitely going to go up
only as they sell more batteries
-Operates in duopoly with moderate pricing power and competitive environment
is benign
- Has strong brands such as Amaron, Powerzone and Quantas with well
established distribution network across the country. In my opinion business that
combines brand, reach and pricing power is very likely to qualify as high
quality business.
Financials and Fundamentals:
I am not posting numbers here as 10 year financials are available on its
website itself.
If we look at 10 year history, following can be inferred.
Profit & Loss:
- ARBL has grown its topline and bottom line have grown at CAGR 30% and 40%
respectively even though from a lower base in 2001-02. In last 5 years ARBL has
grown CAGR 18% on both topline and bottom line. Even though topline has grown
consistently in all 10 years, bottom line degrew in two years 2003-04 and
2010-11.
Balance Sheet:
-Very good management of balance sheet inspite of very high growth rates.
Current debt to equity stands at 0.1 while the highest debt to equity was 0.95
in 2007-08. It has also managed its working capital needs well as its net
current assets/sales dropped from 0.43 to 0.22. ARBL holds roughly 300 crores as
cash on its balance sheet which is deployed in bank FD and liquid funds.
Cashflow:
ARBL has been generating positive operating cash flow for last few years and
is typically slightly more than its net profit. Moreover, if we take into
account depreciation as maintenance capex, company has been generating
substantial free cash flow. ARBL is paying small part of this FCF as dividends
while the larger part is redeployed in business for growth. I have no quarrels
with this as management is generating very decent return on the capital and as
Mr.buffet puts it the best business to invest in is the one where large amount
of incremental capital can be deployed at high rate of return.
Ratios:
As warren buffet puts it, any business in the long term can not grow its
value at higher rate than return it generates on its equity (ROE) and hence it
is the single most critical parameter. ARBL has fairly decent trackrecord on
this front. It has improved its ROE from 4.5% in 2001-02 to 29% in 2011-12.
Moreover, Since 2006-07, ARBL has consistently generated ROE in excess of 20%.
Similarly, ARBL has been able to expand its net profit margin from 4.6% to 9.1%.
Both these indicates improving quality of business.
Management Quality:
As I went through ARBL's annual reports, I was impressed. ARs are exhaustive
and gives a good sense of where business is going with clear articulation of
future course of action. Moreover accounting is standard and I was not able to
find major objectionable points.
Actually, if one goes through AR 2008-09, their treatment of forex losses indicate that company follows fairly conservative accounting practices. In FY 08-09, company had incurred forex losses of 33 crores (both cash loss and notional) due to unprecedented currency movement. As the forex movement was very sharp and unprecedented, AS-11 was relaxed to allow companies to book forex losses spread over next 3 years, however management decided not use this relaxation and booked whole loss in FY 2008-09 itself, impacting its bottomline considerably. This surely indicates, that company strives to provide "as is" picture of its business in its books too.
Management is doing a great job in terms of
disclosures. Moreover, Jhonsons Controls 26% equity gives me lot of comfort on
corporate governance front. In general, my sense is that ARBL management is
competent and transparent with no major negatives.
Valuations:
ARBL is currently trading at TTM P/E of 12-13 times which is fairly decent
considering impressive historical growth rate, ROE of more than 25%, free cash
flow generation and simple, steady and scalable business run by reasonably good
quality management. Management has given guidance of 15-20% growth in bottom
line which if we take on its face value, we are talking about forward P/E of
12. In terms of margin of safety, on a very rudimentary basis, if I assume 10%
FCF growth rate for 10 years, 3% terminal growth rate and 12% discount rate,
typical margin of safety is around 25%. However 10% growth rate is conservative
considering past track record, size of the opportunity and growth plans. I do
feel it is a high quality business and hence intrinsic value is going to grow
considerably due to inherent quality of business.
Risks:
- Significant rise in lead price is one of the key risk as it directly impacts ARBL's margin. ARBL's competitor (Exide) has its captive lead smelter capacity which typically helps Exide reduce its lead cost. Thus Exide will be able to absorb rise in lead price more effectively with lesser "pass through" to end user. It will be difficult for ARBL to increase price in absence of price increase from Exide in after market segment and hence its margin may get impacted in that particular segment.
- Another threat I see is when Exide starts cutting its margin to improve its market share or stop eroding its market share. Even though, it is a distant possibility, it can not be ruled out.
Scuttlebutt:
As we all must have replaced battery one time or the other, I thought it is relatively easy to do a small scuttlebutt to find out whether story has any holes. I went around to various mechanics/garages/ battery dealers (independent and not Exide or Amaron) asking them that I need to replace my battery for the bike, which one should I buy? and to my utter surprise a large majority suggested Amaron ( I expected equal divide between Exide and Amaron). I probed most of them further about why not Exide? they said Amaron batteries last longer, slightly cheaper and comes with higher warranty. Many of valuepickr members too received similar feedback in different parts of the country. So on the ground, things gel in with the story.
Moat:
For any battery company to succeed, they must create reach across the country not only in cities but even in rural areas as vehicle population is spread all across the country. Moreover, being a critical component, people do prefer brands that are proven. Amaron, Quantas and Powerzone are very very strong brands. It takes years to nurture a strong brand and wide reach. A key attribute of such "moat" is pricing power. Consider this fact, lead prices have increased at CAGR 16% in last 10 years. Lead constitute 60% of the cost of battery. And yet, ARBL has improved its net margins from 4.6% to 9.1%. Thus, clearly company is able to pass on the price increase either through moving up value chain or increasing prices! Another feature that is often downplayed is the technological edge that ARBL has due to its strategic partner Jhonsons Controls International (JCI). JCI has been instrumental in developing cutting edge technology giving longer life time, better performances and newer applications for many years and has strong R &D focus. Instead of fighting Exide on price front, ARBL has smartly leveraged this advantage to dent big holes into the monopoly of Exide by taking away large market share.
In all, I think ARBL is a high quality business having reasonable moat (and likely to build sustainable moat) which is simple, steady and
scalable, run by efficient and reasonably ethical management, available at a decent valuation.
