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.

http://www.amararaja.co.in/annual_reports.asp

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.

Psychology of Human Misjudgement and Investing - Part 1

I am sure many of you must have heard about Charlie Munger as vice chairman of Berkshire Hathway and astute value investor who is partner of warren buffet in Berkshire Hathaway. Warren buffet has publicly acknowledged the invaluable contribution that Mr.Munger has made towards the success of Berkshire Hathway. In a sense, Mr.Munger was instrumental in shaping Warren Mr.Buffet's philosophy of "paying for the quality". As Warren Buffet has put it, it is better to buy a great business at reasonable price than buying a reasonable business at great price. However in my opinion, Mr.Munger has made even greater contribution to the discipline of value investing by unfurling how  some very prevalent psychological tendencies contribute towards faulty and ill conceived decision making. I have gained immense insights about our psychological fallies  by reading Mr.Munger's transcript of Psychology of Human Misjudgement. In the essay, Mr.Munger has talked about 25 psychological tendencies/biases that is likely to result into human misjudgement. Most of these  misjudgements lead to faulty decision making without even realizing one has made mistake. I would like to talk about 8 such tendencies which are very prevalent and will try to put forward my point of views on how these biases will cause errors in decision making from investment perspectives. In the first part, I will discuss four tendencies namely reward and punishment super response, inconsistency avoidance, influence from mere association and excessive self regard. In the second part, I will focus on deprival superreaction, social proof, contrast misreaction and availability misweighing.

At the outset, I would like to mention that most of the points discussed here not my ideas and are merely my interpretation of Mr.Munger's essay on the subject. I would like to also mention that Prof. Sanjay Bakshi's hugely insightful lecture notes on this subject has contributed immensely to my understanding of the subject.  

Reward and Punishment Super response Tendency: In very simple words Mr.Munger is talking about power of incentives. According to Mr.Munger, incentives or disincentives are the most important in changing cognition and behavior. As he puts it " I have been in top 5% of my age cohort all my adult life in understanding the power of incentives and yet I have always under estimated that power". Out this enormous power of incentives, arises what is called "incentive caused bias" which drives a fairly decent and good intentioned person, consciously or unconsciously driven by incentives, to drift towards immoral/unethical/unprofessional behavior. Not sure how it works? Remember that insurance agent who sold you ULIP/guaranteed return plans laden with hidden charges, large upfront deductions and meagre insurance covers? What drove and still drives most insurance agents is the commission that they get on policy and ostensibly commissions were highest for ULIP plans. So a fairly decent guy i.e. insurance agent was driven by incentive of "maximizing his returns" without worrying about sub par returns to the policy holder! So how is it relevant in making investment decisions? 

My two cents:

• As Warren buffet puts it, "never ask a barber whether you need haircut". Be wary of trading calls/advise from brokerages/brokers as they would, almost always want you to trade more to earn more brokerage, even in situations when the best action is "no action".
• Management having high shareholding in the company has natural incentive towards value creation and sharing of value. Hence high management shareholding shall certainly be regarded as "positive" 

Inconsistency Avoidance Tendency: As Mr. Munger puts it, the brain of a man conserves programming space by being reluctant to change , which is a form of inconsistency avoidance. If we look at worldly wisdom, "first impression is the last impression" which is a combination of doubt avoidance tendency (another tendency discussed by Mr.Munger in his essay which leads to our habit of jumping to conclusions) and then ignore all the facts/incidences that are not consistent with the initial opinion formed. As lord Keynes put it " it is not intrinsic difficulty of new ideas that prevented their acceptance. Instead new ideas were not accepted because they were inconsistent with old ideas prevailing".  And Mr. Munger comes up with a wonderful metaphor that human mind works a lot like a human egg. When one sperm gets into human egg, there is an automatic shut off device that bars any other sperm for getting in. For human mind, idea is like a sperm which penetrates human mind and shuts off the mind from any other ideas. 

From these tendencies arises "confirmation bias". We tend to over weigh evidences that confirm with our conclusions and under weigh evidences that counter our conclusions/judgement. So how does it impact investment decisions? 

My two cents: 

• This is one of the most potent bias that has ability to cause us huge loss  financially! A typical situation would be to clinging on to stock which was   bought in the first places out of "misjudgements" or "mistakes". As time passes, contrary evidences emerge nullifying   one's investment hypothesis. However, driven by confirmation bias, investors under weigh contrary evidences and do not sell such "losers". Not only one suffers from "loss of capital" from such losers but also suffers opportunity loss (sometimes "huge" due to very attractive investment opportunity) from not liquidating such position and reinvesting it in much better opportunity. I. myself, has fallen into this many a times in the past. 

Influence From Mere Association Tendency: There is a typical tendency in most of us to associate one event with the good/bad outcome in spite of no causal link between event and outcome. Mr.Munger talks about this tendency at length giving various examples. Many a times when people are presented with four or five similar purchase, quite a few of them will select the item with highest price associating the "high priced" item with "highest quality" item even though there may be no causal relationship between price and quality. This tendency is also known as pavlovian association. Another typical example of such tendency is looking for patterns and trends where there are no such patterns/trends. Yet another pitfall that we experience is the extrapolating trends into future which is erroneous most of the times especially in predictions related to business/economics. Stereotypes is also the outcome of such tendency where we associate certain traits/observations with a set of people/communities/nationalities where actually there is no causal link between such traits and people/communities/nationalities and observations/traits may apply to only some identified people/communities/nationalities. 

My Two Cents:

• My hunch is that some good cash bargains  are created arising out of this tendency. A case in point: Piramal healthcare. Market typically views companies that hold large chunk of cash that it received from sale of asset/business/operations very negatively if proceeds from such sale is not fully shared with the shareholders and a large portion is retained with the company to be deployed in the business. This dislike arises from the fact that history is full of examples where in such situation dishonest or incompetent promoters either allocate this extra capital foolishly (by overpaying for acquisitions or unduly expanding aggressively) to generate  mediocre return on capital or stash away money into promoter's account through financial jugglery. However, market treats competent and ethical management (proven through track record) also with same stick and discounts it heavily to the extent that company is available for less than cash on its balance sheet! It is like getting a dollar worth of cash for 80 cents.... This happened with Piramal Helathcare when it sold of its domestic formulation business to Abbott for $3.7 billion by clinching jaw dropping deal. PHL management shared roughly 20% of the sale proceeds with shareholders through buy back program and rest of the proceeds it retained with the company to deploy effectively in existing and new businesses. Piramal management has exemplary track record of capital allocation and integrity over last many years, however market treated PHL in the same way as it would have treated a company of some third rate promoter! At one point in time, PHL was available at 70 cents for a dollar on a balance sheet with all fixed assets and operating businesses coming free on top! So market associated non deployment of cash immediately with "wrong intentions" of the promoter. I am sure if one understands that market has fallen for this "bias", one would be able to use the situation to take a great advantage out of such situations.
• Another example of such tendency is drop in price of all companies in a particular industry which is surrounded by negative sentiments or is in down cycle even though some the companies in the same industry may not have been impacted negatively and may actually be reaping positive results of such situations. 

Excessive Self Regard Tendency: Mr.Munger points out to the fact that most of us misappraise ourselves on the higher side on many of our abilities than objective assessment will reveal. A typical example he shares is that 90% of Swedish drivers consider their driving skills above average! Similarly, one typically values his/her possession more than realistic estimate of the value of possession. As Mr.Munger points out that man's possessions, once owned, suddenly become worth more to him than what he would pay if they were offered on sale to him and he did not own them! How about lottery ticket? Odds of winning a lottery for a randomly selected number is as good as (or as bad as!) the number "chosen" by the purchaser of the ticket. However, lottery company charges differently for randomly selected number versus a lottery ticket with a number "chosen" by the purchaser! They take take advantage of lottery ticket purchaser's excessive self regard in "choosing" a number which has more probability of winning....

My Two Cents:

• A typical folly arising out of this tendency is to over estimating the value of our holdings compared to intrinsic value of our holdings. This over estimation of our holding will not allow us to liquidate the position even when the price of the holding has exceeded its intrinsic value. This trap will lead to a situation where one holds on to investments where margin of safety no longer exist and by clinging onto such holdings one is letting go other attractive opportunities. Prof. Bakshi has suggested a wonderful antidote to this folly. Prof. Bakshi suggests that one should periodically liquidate the entire portfolio mentally to reassess whether one will invest in each holdings if it was a fresh investment decision! I have tried doing this, and let me tell you, it is a wonderful technique to avoid commitment/excessive self regard bis. 
• Most of us believe that we are better at the art of stock picking than our peers. So we will become "active" investors and make stock specific investments. However, if we analyze portfolio returns over a long period of time (which we often don't!),  we may find out that our track record does not support our assumptions of being "above average" stock picker! We may be under performing the index consistently and yet believe that we are good stock pickers! To avoid falling for this bias, one should maintain a close tab on the portfolio returns which if unsatisfactory, shall either resort to index funds or resort to "intelligent" investment adviser (by intelligent i mean an adviser who follows "value based" investment approach)

GSFC Ltd: A Peter Cundill Style Opportunity

I have completed reading "There is Always Something To Do: The Peter Cundill   Investment Approach" by Christopher Risso-Gill. Let me tell you, it is a remarkable book about a extra ordinary value investor. The book has been replete with "investment notes" maintained by Peter Cundill for his investment ideas.Investment rationale for many investment ideas is very succinctly presented with right perspective. Peter Cundill was one investor whose investment style largely resembled to the investing style of Benjamin Graham which relies heavily on tangible assets on book to ensure margin of safety in investment process. This analytical framework is the most conservative way of ensuring margin of safety as it ensures "safety of capital" in the worst case scenario, i.e. liquidation of a company. 

Before I start analyzing the company, let me give you some glimpse of Peter Cundill's investment style. Peter Cundill describes his investment style as "mostly Graham, slightly Buffet and little bit of Cundill". His investment thought process relied heavily on determining "liquidation value" of a company and if the company was trading below its liquidation value, he would seek to invest in a company. He would look for securities that were quoting below book value and carried assets on the books at substantial discount to its fair/market value. He would then determine the fair book value or liquidation value of a company and if the price is below "liquidation" value, he will seriously look at such companies for adding into his portfolio. In my opinion central premise on which Peter Cundill relied was that any business is worth more alive than dead. Based on this premise, if one buys into a business at price which is even lower than its liquidation value, it gives substantial margin of safety to investor. The only caveat here is that, business in which one is investing, should be a profit making venture and should not be burning cash. This approach worked so well for him that he generated 15.2% annual returns compounded over 33 years, a terrific record by any standards. Peter's focus on seeking margin of safety in tangible assets meant that he was insulated from vagaries of growth rates and free cash flows!

With this background, I will try to analyze GSFC Ltd and how it presents an opportunity that Peter Cundill would have surely looked at. GSFC limited is a public sector enterprise promoted by Goverment of Gujarat with the aim of producing complex fertilizers to meet the needs of agrarian economy. GSFC  mainly operates in two segments i.e. fertilizers and industrial chemicals. GSFC is the largest producer of Caprolactum (used for manufacturing of nylon), malamine and amonium sulfate in India. It is second largest producer of di-ammonium phosphate (DAP) in India. It also produces ammonia, nylon, ammonium phosphate sulfate, urea, argon gas and sulfuric acid. It has also entered into production of bio-fertilizers and water soluble fertilizers which is a value added product compared to normal fertilizers. 

I will do a very cursory analysis of P &L and return ratio here, as focus of the analysis is limited to ensure that GSFC's operation will not start burning cash fast enough to erode margin of safety. 

In Fy 2011-12, company reported revenue of 5680 crores and net profit of 758 crores. It increased its sales by 14% while its bottom line grew by 1% from FY 2010-11. In last 5 years company's sales has grown at CAGR 9% while its profit grew at CAGR 26% (mainly due to quantum leap in margins in last 2 years post nutrients based subsidy adopted from April 2010). GSFC's ROE has been oscillating between 17% to 30%. However post NBS, company is able to generate ROE that is much better than that of pre NBS era. It has very little debt on its books as per 2012 balance sheet. So essentially we are talking about a company that is practically debt free and generates reasonably good return on its equity. In each of the last 5 years, cash flow from operations has remained positive and generally in line with net profits. Thus, it is reasonable to conclude that GSFC is not going to be cash burning enterprise in near future. 

So now let give you a glimpse of key components of balance sheet for GSFC as on march 2012. 

Total Shareholder's Funds: 3517 Crores

Long term Debt              : 191   Crores

Total Liabilities              : 3708 Crores

Net Block                      : 1425  Crores

Capital work in progress  : 346   Crores

Investments                  : 433   Crores

Net Current Assets         : 1504  Crores

l

Let us first look at assets that can be easily liquidated and price can be estimated with reasonable certainty. In the entire exercise, even though, I have taken some benchmarks to decide realistic value for various assets/investments, I have tried to remain conservatively realistic on valuation. 

Net Current Assets: based on balance sheet of FY 2011-12, 

Current Assets- Current Liabilities = (3104-1611) = 1493 crores. 

Now we have to determine realizable value of net current assets if these assets are to be liquidated/sold off to some other investor. 

If we break down current assets it comprises of following components, its book value and realizable value based on certain assumptions.  

Asset/Liability Class	Value on Books	Realizable Value
Cash	897 Crores	897 Crores
Accounts Receivables	1426 Crores	1354 Crores (5% Write Off)
Inventory	642 Crores	515 Crores (80% of BV)
Other Current Assets	135 Crores	120 Crores (10% write off)
Short Term Loan	622 Crores	622 Crores
Accounts Payable	492 Crores	492 Crores
Other Current Liabilities	500 Crores	500 Crores

so realizable value of Net current Assets = (2886-1609) = 1277 crores

Now let's look at investments. 

Investments: 

Following link provides view of various short term/long term investments held by GSFC.

GSFC 2011 12 Investments

Non Current Quoted Investments:

Let us start with non current investment in quoted securities  and determine market value of non current quoted investments.

Security Name	No.Of Shares	Book Value (Cr)	Current Share Price	Market Value(Cr)
GNFC	3,07,79,167	58.39	84	258.5
GIPCL	2,23,62,784	36.50	65.75	147
GACL	16,55,040	8.27	122.95	20.35
Total				426

Total market value of quoted security is roughly 426 Crores at current market price. 

Non Current Unquoted Equity investments:

I have done analysis of conservatively estimated value of GSFC's investment in Indian potash limited, bhavnagar energy company, GSPC and GSPC Gas. I have not analyzed other investments as either they are strategic in nature (Gujarat Chemical Port Trust) or enough financial information is not available with me.

1) Indian Potash Limited: GSFC holds roughly 7.87% stake in Indian potash i.e. 11,25,000 shares in IPL, a flagship company promoted by various fertilizer companies and ministry of commerce for importing, marketing and promoting potash in Indian market. According to 2010-11 P &L available on its website, company made profit of roughly 375 Crores on turn over of 20,750 crores. According to FY 10-11annual report, basic EPS is Rs.263 . Even if we assume 10% growth in FY 11-12 and assign P/E of 6 on 2011-12 earnings, it will mean share price of 1740. GSFC's investment of 11,25,000 shares can be valued at roughly 200 crores against book value of 0.61 crores.

2) Bhavnagar Energy Company Limited: It is a 500+ MW lignite based power plant put up near Bhavnagar in Gujarat. BECL is promoted by various state PSU such as GSFC, GNFC, Gujarat Power Corporation Limited, Gujarat Mineral Development Corporation, GIPCL and GACL. Lignite for the power plant is going to be available for GMDC mine near Bhavnagar. GSFC holds 4% share in the company. BECL is at advance stages of construction and project is likely to be commissioned by end 2012. A comparable company for valuation shall be Navyeli Lignite corporation which operates 2750 MW of lignite based capacity and has market cap of 13670 crore valuing company at 5 cr/MW of existing capacity. On a similar matrix, BECL can be valued at roughly 2500-2700 crores. However considering the fact that for BECL project is under implementation and there is no track record of operations, one should consider at least 25-30% discount to Navyeli's valuation. Thus we shall assume 4 Cr/MW for valuing BECL. Hence valuation of BECL shall be around 2000 crores. GSFC's share of 4% will mean value of 80 crores. 

3) GSPC Limited: GSFC holds 2.35 crores share of GSPC at average cost of 64 rs/share (face value of 1 Rs). Total value of GSPC holding is 150 crores. LIC, SBI and IDFC acquired shares in GSPC at 810 rs/share (FV of 10 Rs) so effectively they acquired stake in GSPC share (of Fv 1 ruppe) at roughly 81 rupees. However, to be conservative, let us value GSFC's investment in GSPC at the book value i.e. 64 Rs/share. This will mean valuation of 150 crores for GSPC investment (same as value carried on book). 

4)GSPC Gas Limited: GSPC gas is now the largest City gas distribution operator in India with its wings spread across number of cities in Gujarat. GSPC gas distributes CNG and PNG in many parts of the state catering to natural gas needs of industrial, residential and commercial customers. GSPC Gas is promoted by GSPC. It is currently not publicly listed company. GSFC holds 91,78,800 shares in GSPC gas. According to 2010-11 annual report of GSPC Gas, company reported net profit of 148 crores in 2010-11 registering more than 400% growth in PAT with respect to previous year. If I assume modest growth of 15% in PAT, 2011-12 PAT of GSPC Gas would be around 170 crores. Based on FY 2010-11 report GSPC has issued paid up shares of 5.92 crores in 2009-10 and was under process to issue shares of 10 crores. Hence total paid up shares is likely to be 15.92 crores. Thus EPS of the company would be 170/(15.92) = 10.7. In terms of valuation, GSPC gas valuation can be done based on it's listed peers Gujarat Gas and Indraprastha Gas. GGL and IGL trade at trailing P/E of 15 and 11 respectively. GSPC gas being the largest CGD company and also being fastest growing CGD company can very easily command P/E of 12. Considering this, valuation of GSPC Gas share will be around 129. So total value of GSFC holding in GSPC Gas is around 129 * 91,78,800 = 118 crores.

Joint Venture Company:

GSFC and Coromandel International Limited (CIL) has established joint venture with tunisian firms Groupe Chimique Tunisian (GCT) and Campagnie Des Phosphate De Gafsa (CPG) to establish 360,000 tons of phosphoric acid plant in tunisia.This company is known as Tunisia Indian Fertilizer Company Limited (TIFERT). GSFC and CIL each have agreed to offtake 180,000 TPA of phosphoric acid from this new facility. GSFC has signed 30 year supply agreement with TIFERT. GSFC holds 15% equity in the project. GSFC has invested INR 120 crores in the project and holds 33,75,000 shares of 10 tunisian dinars each. Total project cost of this project is likely to be roughly USD 600 million i.e. 3000 crores. 

Phosphoric acid is a key raw material for manufacturing di-ammonium phosphate (DAP) a very popular phosphatic fertilizer in India. Indian fertilizer companies are facing severe shortage of phosphoric acid and they have to rely on very tight international market for procuring phosphoric acid. Almost all DAP manufacturers have indicated that lower capacity utilization of DAP plants are due to non availability of phosphoric acid. In such situation having 30 years supply tied up is a big strategic advantage. However, it is difficult to quantify such advantage and hence, to be conservative let us assume zero value for this advantage. Hence, value of GSFC's share will be at least equivalent to its book value i.e.  120 crores. 

Equity Trade Investment:

In addition to non trade investment in GACL, GIPCL and GNFC, company also has some investment in following companies. Table below represents market value and book value of these equity investments. 

Security Name	No.Of Shares	Book Value (Cr)	Share Price	Market Value(Cr)
Gruh Finance	1,00,000	.295	777	7.77
IDBI Bank	5,49,440	4.46	95	5.22
Manglore chemical	5,79,000	0.38	51	2.95
Total				15.94

Based on analysis of various type of current assets and investments,Following table summarizes and enlists realistic value of current assets and investments. 

Current Asset Name	Value
Net Current Assets	1277 Crores
Non-Current Quoted Investment	426 Crores
Stake in Indian Potash Limited	200 Crores
Bhavnagar Energy	80 Crores
GSPC	150 Crores
GSPC Gas	118 Crores
Tunisian Indian Fertilizer	120 Crores
Equity Trade Investments	16 Crores
Total	2387 Crores

GSFC's Current Valuation: At today's closing, GSFC's total market capitalization is roughly 2850 Crores. If we add long term debt of 190 crores, GSFC is available at 3040 Crores to a private investor. Out of 3040 crores, company has net current assets + investment of roughly 2400 crores. This implies that GSFC's fixed assets and future cash flow is available for 650 crores. 

Now fixed assets on depreciated basis is carried on company's books at 1425 crores while   capital work in progress is roughly 345 crores. So total fixed asset value on the books is 1800 crores. However, even if we only assign 650 crores ( roughly 35% of book value), investment made by a private investor at current marker price will break even. In my opinion, no sane person/entity will sell its assets at 1/3 of book value, unless company is under financial distress or assets on books are not likely to generate cash flow in future. In case of GSFC, neither of this is true. 

To put the things in perspective further more, if GSFC wishes to monetize only township land, (roughly 850,000 square yard and free hold of land is with the company) at prevailing market price (roughly 10,000/sq.yard)  it will fetch roughly 800 crores, far higher than value assigned to fixed assets of the entire company at current market price. This will leave Vadodara and Sikka plants available for free.

Thus there exist an opportunity to invest in one of India's largest complex fertilizer company at substantial discount to its liquidation value. I am sure, Peter Cundill would have grinned spotting such opportunities.

As icing on the cake, Fidelity Low priced stock fund holds 4.63% in GSFC. Fund manager of this scheme,Joel Tillinghast is noted value investor who follows investing style of Peter lynch and tries to buy "growth at reasonable price". He has achieved enviable record of generating compounded annual return of 14% for 23 years in Fidelity low price stock fund. Mr.Tillinghast has received best fund manager of the decade award in 2009 by highly prestigious Morningstar magazine. Fidelity low priced stock fund has increased its position in GSFC over last 3 years from nil to 4.63%. This further supports my hypothesis of GSFC's value proposition.

In all, I think, GSFC is a very good investment opportunity considering its leadership position in complex fertilizers, diversified product mix, very good return ratios, strong balance sheet and substantial margin of safety at current market price.

Hindustan Zinc: A Value Play or Value Trap?

In this post I am going to share my confusion and dilemma on one idea that appears to be a good value play but may turn out to be a value trap, if value is not shared with the shareholders by the management. 

I am talking about world's largest integrated producer of zinc and second largest producer of zinc in the world. HZL operates Rampura Agucha mine in Rajashtan that has world's largest deposit of zinc and lead. It is the lowest cost producer in the world due to integrated nature of its operations, higher concentration zinc/lead in its ore and highly efficient operations. HZL's cost of production was roughly USD 800/ton in FY 11-12 while world average is around USD 1300. So is HZL a pure commodity play or a business surrounded my strong moat? My answer is that it is surely a business surrounded by strong moat but fortunes of the business are closely linked to commodity cycle. 

Now let's look at cursorily at HZL's  10 year historical performance on P&L, balance sheet and return ratios. 

P&L: HZL's top line grew 1650 crore in 2002-03 to 12000 crore in FY 11-12, registering CAGR of 22%. However, bottom line for HZL grew by staggering 45% in last 10 years taking net profit from 142 crores to 5526 crores.  Revenue growth was led by both volume increase as well as higher price realization from zinc. An extraordinary performance on the bottomline was due to operating leverage kicking in a big way. NPM for the company increased from 8.6% to 45% due to streamlining of operations, increased integration in terms of mining and refining and operating leverage. 

Balance sheet: It is a squeaky clean balance sheet with hoards of cash lazing around there! And like in any wonderful business, the difficulty is always to find avenue to deploy more and more cash in a profitable manner. HZL has no debt and has been that way in last 10 years except in 2003-2006 where, company took some debt (debt/equity of 0.3-0.5). As per FY 11-12 numbers, accounts receivable and inventory together amounts to less than 10% of revenues, indicating very high operational efficiency for the company (or may be very favorable business conditions!). So Currently company is sitting on cash pile of roughly 18000 crores all invested in liquid mutual funds and fixed deposits.

Cash flow and return ratios: Like  all successful natural resource companies, it is a company with very high free cash flow. In FY 2011-12 company generated around 5000 crores of free  cash flow after providing for maintenance capex. Company has ROCE of around 22% even after 18,000 crores of cash sitting in balance sheet earning paltry 10% pre tax! In terms of actual capital employed for operations, company had ROCE of around 48% in FY 2011-12 and has remained in the range of 50% for last 5 years. 

Now, let's do the valuation based on back of the envelope calculation. Currently company is trading in the range of 50,000 crores market cap. Now if we deduct cash and cash equivalent of 18000 crores, HZL is available at roughly 32000 crores net of cash.  

It is important to understand that earning power of the company is dependent on price of zinc, lead and silver and refined metal production for each one of them. In FY 11-12, average price realization for zinc, lead and silver were USD 2098/ton, USD 2269/ton and USD   1200/Kg. USD-INR average for FY 11-12 was 47.95. Production of refined zinc, lead and silver was 759,000 tons, 99,000 tons and 242 tons respectively. For commodities, taking one years' profit or price realization for predicting future cash flow is not appropriate considering cyclical nature of commodity price. In order to arrive at expected price realization for zinc and lead, let me take last 5 year's average price realization for zinc and lead as benchmark. However, story is slightly different for silver. Silver has got rerated in last  3 years and hence I do not think 5 year historical average is good approximation for next 5 years. Based on this approach, average 5 year price realization stands at USD 2132 and USD 2205 per ton for zinc and lead. For silver, I think current price level (you can call this gut feel or speculation!) is appropriate benchmark i.e. roughly USD 1000/Kg for average price realization for next 5 years. If we put all the information together along with current capacity of refined metal production of  759,000 tons of zinc, 100000 tons of lead and average 400 tons of silver (Fy 12-13 350 tons and increasing to 500 by FY 14 and steady thereafter), total revenue realization will be roughly 11000 crores at exchange rate of 48. If we take profit margin of 45%, roughly 5000 crores shall accrue from operations as net profit. This in my opinion a reasonably conservative scenario because of the assumptions like no significant increase in refined capacity, for 5 years commodity up-cycle does not play out, rupee strengthens to 48 etc. 

According to FY 11-12 annual report, HZL possesses mine reserves of 25 years and more exploration work is going on. So one can expect that at least for 20 years HZL will be able to produce at current capacity without depleting its resources. Even if I do not factor in price increase equivalent to world average inflation and consider constant price for 20 years, IRR for investing 31000 crores against 5000 crores of cashflow for 20 years works out to be 16% which is very decent. This does not take into account further cash accumulation and 8-10% return on this accumulated cash.

Now let's look at the upside 

- If HZL decides to deploy 18,000 crore capital in productive assets and especially in mining and natural resource area, it is possible to earn 25-30% return on capital employed. This will mean additional 5000 crores flowing in in addition to HZL's operational cash flow with annual cash flow amounting to  roughly 10,000 crores, making it a huge cash generating machine. Now thus accrued cash earns only 10%, and at  constant price and output, on 20 year basis IRR is 29%. 

-If there is commodity up-cycle in between, and company has invested idle capital in projects generating reasonable returns, or company ramps up its production from current capacity (a very likely scenario considering past track record) it will amount to substantial returns. 

Down side

- Let me be devil's advocate and assume that commodity market plunges and average price realization for zinc lead and silver is at USD 1000/ton, USD 1000 /ton and USD 500/kg and investment on balance sheet earns 8-10% return only. In this case also, on 20 year basis (resource base is equal to 25 years of current production if they don't find any additional zinc/lead resource.), one would typically be able to earn 10-12% IRR. 

So looks like an opportunity where there is significant upside possibility with very limited downside.  So what makes me think that HZL can be a value trap?

- HZL has always been generating considerable free cash flows over the years and hence the staggering pile of 18000 crores has been built up slowly. This is truly worrisome. management should have either deployed cash effectively to generate better returns or should have returned it to shareholders either as dividends or through buy-backs. Management has not done either of them, a clear danger sign. Dividend payout has been paltry 6-8%. This is peanuts for such high free cash flow generating company. 

- Management, in other instances, has used cash on balance sheet of group companies to make large purchases and thereby deploying cash in unrelated and probably pricey acquisitions. A case in point Sesa-Goa's cash reserves were used to acquire stake in cairn India. 

- I get a feel (though i have not done analysis to support this!) that management sometimes carry out restructuring among group companies so as to extract maximum benefits for the promoters and probably at the expense of the best interests of minority shareholders. 

If management engages in such activities, value realization for minority shareholder may not happen and it can fall into value trap! To be fair to management, HZL has been a great value creator. As per HZL's FY 11-12 AR,  Rs.1000 invested in HZL stock at the end of FY 02-03 would have grown to roughly 90,000, a 90 bagger in 10 years! So, what's my take? I am not too sure.  I am sharing my dilemma here and I will highly appreciate your views on the same.

Dissecting Return on Equity: Few Insights from Britannia and Titan

As mentioned in earlier post on significance of return on equity, ROE is one of the most important parameters signifying sustainable competitive advantage of the business and hence investment attractiveness of the company. However, as I dug deeper and gained more insight into the subject, I found that relying just on ROE number may be misleading. It is very important to understand what drives change in ROE and how good is the quality of ROE. In this post, I will try to illustrate the point with two examples. What is common in both the examples is that if one looks at ROE of the company, it has moved in a band has remained in that band. However, in one case, business quality has deteriorated while in the other, business is clearly on the upswing. However, had one relied on just ROE number, one would not be able to get a realistic feel of changing business environment. 

Let me start with defining ROE in terms of equation as suggested in Dupont formula 

ROE = Net profit margin *  Asset Turnover ratio * Equity Multiplier 

So ROE = (Net Profit/Total Revenue) * (Total Revenue/Total Assets) 

                

              * (Total Assets/Total Equity) 

So now, it is clear that three parameters drive return on equity, we can dissect ROE of any company in three components and look at what is driving ROE. This dissection of ROE will help us gain insight which can reveal interesting information about changing business environment for the company. 

Let's take first an example of Britania Industries.

Britannia Industries: Britannia Industries is India's leading food products company having formidable brands such as Good Day, BourBon, Little Hearts,  Marie Gold and Treat in biscuit segment and strong brands in dairy products such as Cheese, Butter, Spread and Yogurt. Let's see what has happened to ROE of the company. 

2006-07	2007-08	2008-09	2009-10	2010-11
18.35	25.76	19.83	36.35	41

So on the first glance it appears that Britannia has increased its earning on its equity hence each dollar put in as equity by the company is earning 41 cents in 2010-11, up from 18 cents in 2006-07. Typically this would suggest that company's business is getting stronger and "moat" around its business is growing. However, let me dissect ROE further into its three core components.

	2006-07	2007-08	2008-09	2009-10	2010-11
Profit/Revenue (1)	4.26	6.28	4.02	2.65	2.84
Revenue/Assets (2)	3.24	2.91	3.55	4.12	4.98
Asset/Equity (3)	1.33	1.41	1.39	3.33	2.90
Return on Equity (1*2*3)	18.35%	25.76%	19.83%	36.35%	41%

Above analysis, indicates that for Britannia, NPM has been fluctuating and has declined substantially in 2009-10 and 2010-11 from 4% to 2.6-2.8% which indicates deteriorating business conditions. On the other hand, company's  Asset/equity ratio has increased substantially from 1.33 to 2.9 indicating substantial increase in debt/equity ratio and hence leveraging. Thus increase in ROE for the company seems to have been contributed to a large extent by leverage and higher asset turnover to a smaller extent. Thus, it is reasonable to infer that in spite of increased return on equity, Britannia's inherent business condition is worse than that of 2006-07. 

Titan Industries: Titan is India's largest watch maker and world's fifth largest watch maker. Titan is perceived as benchmark of quality blended with style in Indian watch industry. Titan has also created immensely popular brands such as Fast-track and Raga catering to youth and effluent class respectively. Titan has entered into branded jewelry segment with "Tanishq" brand, which proved to be an run-away success. It also started "Titan Eye" division catering to style conscious youth by creating a range of stylish eye wear. Let's understand how Titan's business has undergone change and why "wholesome" ROE may not adequately reflect changes in business environment but dissecting ROE into its base components will give a insight into how business fundamentals are changing. 

    

2006-07	2007-08	2008-09	2009-10	2010-11
30	33	29.4	34	41.6

If we look at ROE for last 5 years for Titan, it appears that Titan is operating in a business environment which is stable till 2009-10 (except in 2008-09) and ROE has remained in the range of 30-34% barring 2010-11 when ROE jumped substantially. This gives an impression that Titan operates in a business environment that is neither improving nor deteriorating substantially. Now let's see how drivers of ROE has changed over a period of time. 

	2006-07	2007-08	2008-09	2009-10	2010-11
Profit/Revenue (1)	4.1	4.30	3.96	5.09	5.95
Revenue/Assets (2)	4.17	5.22	5.71	6.13	6.6
Asset/Equity  (3)	1.74	1.47	1.30	1.1	1.06
Return on Equity (1*2*3)	30%	32.99%	29.4%	34.32%	41.62%

Above table clearly indicates that Titan's ROE is incrementally contributed from expanding margins and higher asset turnover. A combination of margin expansion and higher revenue generation/rupee of asset on the book is helping Titan improve its return on equity. However in terms of overall ROE number, this effect is muted as company is consistently reducing debt (reducing leverage) which offsets the effect of increase in margin and asset turnover on ROE number. Expanding margin and increasing utilization of asset for revenue generation and that too consistently, indicates company's improved  business fundamentals which one would fail to notice if the focus is on just "ROE" number. On the other hand company has reduced its debt substantially over a period of time, which has strengthened its balance sheet

To put it differently, had Titan maintained debt/equity at a level prevailing in 2006-07, company's ROE would have looked liked as below

2006-07	2007-08	2008-09	2009-10	2010-11
30	39	39.34	54.3	68.3

Thus, even though Titan's business environment and fundamentals have changed significantly they are so "jumbled up" that overall ROE number would not help investor decipher such changes. 

It is therefore critical to dig deeper into ROE number and understand drivers of ROE which will truly reflect the changing business environment and contributory effect of each component of ROE.