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.