Friday, 21 September 2012

Amara Raja Batteries Limited: A Business Moving Towards Sustainable Moat?


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.

17 comments:

  1. Dhwanil,

    I am following your blog since some time and read all posts at valuepickr as well.
    Do you think this is the right time to enter this stock or one has to wait for 1-2 qtr to grab it.
    I am thinking to allocating 15% of my portfolio to ARBL.

    ReplyDelete
    Replies
    1. Hi Kushal,
      Your guess is as good as mine one whether prices will come down in next 1-2 quarters. However, I do see business doing reasonably well (15-18% topline and bottom line growth as guided by the management). And in my opinion, if it does perform the valuation gap between Exide and ARBL will narrow down which means some re-rating. So I feel, level around 370-380 is a good level to initiate a position.

      Best Regards
      Dhwanil Desai

      Delete
    2. Dhwanil,

      Thanks for reply.
      I already got some at 375 odd levels for long term.

      Kushal

      Delete
    3. I can see this scrip at 242 today, and didn't found it at 275 at anytime over the last 10 year. Am i missing something here ?

      Delete
    4. Hi Anon,

      The price is adjusted for bonus. I am talking about price before bonus. So bonus adjusted price of 137.5

      Best Regards
      Dhwanil Desai

      Delete
  2. Thanks for a wonderful post. I would like to enter ARBL if it comes down by a resonable percentage in the next 3 months

    ReplyDelete
    Replies
    1. Thanks Anon for the compliments.

      Best Regards
      Dhwanil Desai

      Delete
  3. Aditya Bob Mahendru22 September 2012 at 09:47

    Great post Dhwanil!! I have been following ARBL for some time and it looks great...healthy industry structure, good growth potential, and a sustainable moat. On valuations, P/E of 12 is quite attractive...considering Exide is at 25+. Even though Exide is the leader, the multiple for ARBL is quite low and is not justified.

    On risk from Exide that you have mentioned, that is a valid point. Exide has recently gone for capacity expansion...its margins had also come down in between due to shortages. With capacities in place, it would play aggressively in the marketplace. However, the industry structure is so healthy and with reasonable moat, ARBL should be able to perform well in time to come.

    ReplyDelete
    Replies
    1. Hi Aditya,
      I completely agree that industry economics does provide protection to downside/return ratios.

      Best Regards
      Dhwanil Desai

      Delete
  4. ARBL is really promising and U have made a case like coke and pepsi along with lot of other home made soft drinks ( Local Players ).
    Why not wait for the coke to come at reasonable price ( need Patience ) rather than betting on pepsi. Because
    1) the price war shall be tilted in the favour of the market leader.
    2) Is there any special strategy to disloge the msrket leader keeping the margins good . Because the market leader is getting ready for the price war and the benefit of this war shall go to the consumer and not to the company
    I have just got this analogy to simply the understanding please clarify.


    Secondly can U help me to analyse Navin Flourine International LTd
    Passing all the tests ( however Mcap is 300 Cr and Base group is arvind Mafatlal)
    I shall be waiting for the same
    Regards Vipin jain

    ReplyDelete
    Replies
    1. Hi vipin,
      If i understand your analogy correctly, u r suggesting that one can wait for Exide to come down and buy it. May be it makes sense to be with market leader when it is in unassailable position such Coke. However, in my humble opinion, Exide is surely not in such unassailable position as ARBL has managed to make inroads into all major segments where Exide was market leader and have gained sizable market share. As I understand from my analysis, part of the success is due to superior technology and part is due to tepid management response from Exide. So, my sense is that technology edge will remain with ARBL due to Jhonson's support. Exide management is getting its act together and fighting back. However, I do see room for both to grow and in terms of business/management quality, there is hardly any difference. However, valuation wise, there is a large gap. So from investment perspective it does make lot of sense.

      I have not looked at Navin Flourine closely ( though I think it can be debt capacity bargain), I will try doing it and come back to you.

      Best Regards
      Dhwanil Desai

      Delete
  5. What is your opinion on Balkrishna Industries? Can this be considered for long-term investment?

    ReplyDelete
    Replies
    1. Hi JB,
      Balkrishna is a niche business and has considerable moat, however the inherent characteristic is that it is an asset heavy business. Personally, I do not prefer asset heavy business because, if one looks at ROE, considering steady profit margin, the only way to maintain/improve ROE is to leverage balance sheet as Asset turnover will be in the range of 1.1-1.4.This means that in bad times, company may face tough time and balance sheet most of the times is leveraged. So, I personally would not prefer it. However, I must add here that it is business having good moat so in that sense quality of business is good.

      Best Regards
      Dhwanil Desai

      Delete
  6. Thanks for the nice analysis :-)

    How did you get past annual reports? I can only find the latest one. Did you perform your analysis based on latest AR and 10 year financials posted on the website?

    Also, what is the risk of losing Johnson's support? Have Johnson reduced their stake in the company in the past?

    I'm also a little concerned by the way price has run up from Rs 100 in Dec 2011 to 240 in less than 10 months!

    Regards
    Sunny

    ReplyDelete
    Replies
    1. Hi Sunny,

      Your blog is equally interesting. I also read last 3-4 years AR in addition to latest AR and 10 yr numbers. I got the ARs with the help of google! Even BSE website has last 3 years AR. In terms of losing Jhonson's support, risk remains. But what is the likelihood of risk being realized? I think it very less. Jhonsons Control is aggressively eyeing emerging markets for growth. In order to part ways with ARBL and still remaining in this market, will mean creating large reach which will take long time. Moreover, JC does not have direct experience of operating in Indian market and they will be pitted against well entrenched player like Exide. So unless something drastically goes wrong, JC would not like to move away from partnership. Secondly, JC has not reduced their stake over last 10 years.

      I think it is more important to focus on value than price as focusing on price will lead to anchoring bias. But yes, I too agree that at this price, there is a possibility of downside and margin of safety is deminishing. As you have rightly mentioned, 175 is a very attractive price to get in of create a large position.

      Best Regards
      Dhwanil Desai

      Delete
  7. I've posted some risks here...you may want to comment on them?

    http://prufolio.blogspot.in/2012/10/amara-raja-batteries.html

    ReplyDelete
  8. Hi Dhwanil,

    I have been following your posts for past week and have become a follower of your blog. I have investment in some of the companies like Mayur Uniquoters & Cera Sanitaryware that you have recommended. I am also studying Hyderabad Industries Limited and the company looks quite undervalued to me. I basically had 3 queries:

    1. Do you think at the price of around 250 - 260 it makes sense to invest in ARBL considering the valuations have increased considerably (P/E of 16 times on TTM basis)?
    2. Have you been tracking RS Software? What is your view on that company?
    3. Like you even I am working in a company, have monthly cash flows and a very small portfolio (spent my savings in marriage). What strategy would you recommend for people like us who have monthly cash flows and would like to invest regularly?

    Even I am an Amdavadi like you (although am living in Pune currently and visit Ahmedabad every weekend)and would like to meet you.

    Thanks,
    Ankit Gupta

    ReplyDelete