Sunday, March 30, 2014

Tata Elxsi - high tech history but lots of uncertainty

TATA Elxsi was formed in 1989 and has Subramaniam Ramadorai in common with TCS. It was setup as the Indian arm to manufacture multi-processor based computers. Wikipedia claims that the TATA group was a venture investor in Elxsi in the US as well.

The company does 2 things - software development & services and systems integration. Over 90% of the revenue comes from the software development & services division. I fail to understand how this company does not have a conflict of interest with TCS. Even though the company claims it is the embedded product design arm of the TATA group (77% or so of the revenue of the company is in this basket) - TCS does the claim to do something similar in the TCS Embedded Systems group.

Saturday, March 29, 2014

State bank of India (SBI) - massive branch network but the operations could be better

BSE: 500112|NSE: SBIN|ISIN: INE062A01012

The socioeconomic impact of State Bank of India (SBI) has been staggering and cannot be overstated. It is the backbone of the Indian economy and the equivalent of the "too big to fail" banks in the US sub-prime crisis. As always that comes with lower efficiency but the Indian economy and banking system would be far worse off had it not been for SBI.

Thursday, March 27, 2014

Housing Development Finance Corporation - High quality home loans, insurance, banking, asset management at a high price

BSE: 500010 | NSE: HDFC | ISIN: INE001A01036

For those interested in learning how to analyze complex companies this is a good example. It is primarily a home lender than owns asset management businesses, a bank, insurance companies, a BPO company and publishing companies!

There are several ways of doing this. The most common being taking the public shareholding and subtracting that from the market cap. Then valuing the rest as a running business. In this approach the issue is that you first need to have a opinion on the underlying stocks. Fortunately we have already reviewed the largest underlying which is HDFC Bank. The unlisted insurance companies and GRUH (listed) are yet to be covered but do not form a large part of the earnings.

Wednesday, March 26, 2014

Alstom T&D - bogged down by low capex and very expensive

BSE: 522275 | NSE: ALSTOMT&D | ISIN: INE200A01026

Alstom global provides capital equipment for thermal power, renewable power, transmission and transport. This particular subsidiary designs and manufactures a range of electrical equipment for the high voltage and ultra-high voltage electricity transmission industry, provides substation automation solutions, network management services, and services & maintains capital assets sold earlier. Given the massive shortfall of electricity in India - at first glance this is an infrastructure play and should be hitting it out of the ballpark - and it was for many years but off late has lost the financial edge.

A capital equipment business is very scary from an operating leverage perspective. You have your team and assets lying waiting for the next order. If the order book dries up or execution is slow or the customers start delaying payments life becomes very challenging.

Domestic T&D market is around 80K Crores. 43% of it in 2012 was serviced by imports despite overcapacity in the Indian producers. Exports from India stand at around 18K Crores for T&D and have been growing slowly at 9.7%.

1. How good is the moat?

Grade B moat
  • Brand: Alstom is a massive global player and so the technology front is taken care of. That comes at the price of being exposed to foreign exchange risk. It has about 19% of the market and is the market leader in India. They also export over 10% of the revenue.
  • Sales & Distribution - All customer are industrial customers and seems like lots of government customers. Replication for a large corporation should not be such a big deal.
  • Pricing power - very low. Most of the products being won on pricing will be proprietary technology else might be hard to price. Company claims they lost lots of orders due to low prices.
  • Performance during recessions - very poor. Overcapacity in the sector in 2012 capacity utilization in the sector was 70% and capacity was expected to increase by more than 50% up to 2014-2015. Since then the economy has taken a nose dive and capital investments are slow.
  • Employees - 3597 employees. Seem to be stable. No competitive advantage seems to be here. Same with Vendors - not much covered here.

2. Risks

  • Technology license fee is rising - it has become 30.9 Crores in FY 2013 from 18.7 Crores in FY 2012. This may be a source of related party transactions where the pricing may not be in the interest of all shareholders
  • FX risk: Exports have become higher than imports in FY 2013 but still due to services and fees expenditure the company is still a net importer.
  • Debt - Debt to EBITD is at 1.48 times - which is a bit high. Not too much risk but I am worried about this due to the operating leverage situation described above.
  • Transparency risk - I don't understand why listed overseas companies want to maintain listed subsidiaries in India. The royalties, trademark fees, and buying prices of imports from parent companies or their vendors/affiliates is something which is a bit of a black box.
  • Customer creditworthiness - should be good as typically large state owned companies. Sometimes might have issues with large levered private companies.

3. Financials

  • CFO is actually leading net income which is great.
  • Stock options - Company claims parent company is providing stock options in the parent and not charging the subsidiary. Again this sounds slightly weird. Why would the subsidiary not be charged?
  • Exceptional items are small - profits on sale of land
  • Inventories in FY2013 have ballooned to 20% of sales from 10.7% a few years earlier. This again points to the slowdown in the customer pipeline.
  • ROE < 10% - has been going down since December 2008
  • Debtors % of sales stands at 50%+ - which is a very bad situation. Means average payment terms are 6 months. This drives up capital intensity and massively brings down ROE/ROCE.
  • Needless to say working capital consumption is much higher than where I would be comfortable
  • Dividend % of earnings is erratic - currently is 59% - the company is trying to keep up the dividend while the profits are falling.
  • No goodwill to talk about.

4. Soft factors

  • Shareholding - promoter shareholding is how 80% which needs to be 75% or below by SEBI guidelines and the promoters are wanting to keep the company listed.
  • Director shareholding - is not disclosed. Which is not a good sign
  • Growth - so far the company size has been contracting. Its multiple is probably high because the market expects that electricity transmission and distribution equipment market will pickup

5. Pricing

  • I really don't understand why project companies like Alstom are trading at such high multiples. Maybe the market is expecting them to hit it out of the ballpark once a new government is in place.
  • Overall the stability of earnings of this company is a big concern along with ballooning pending payments from customers. Pricing is also very expensive at 5000 Crores+ of market cap for just 107 Crores of TTM earnings. No value here.


Monday, March 24, 2014

Axis Bank - High quality, conservative (with blemishes) but there's value here

BSE: 532215|NSE: AXISBANK|ISIN: INE 238A01026

Used to be UTI bank - and probably one of the safest in terms of their gross NPAs. Tier 1 capital ratio is better than even HDFC bank at 12.23% at the end of the last financial year.
I compare all banks to HDFC Bank as in my opinion that is the bank to emulate. Interestingly Axis beats HDFC Bank on the employees front as well. Lets get straight into the details ...

1. How good is the Moat?

Grade B+ moat

  • Customer loyalty: Similar to HDFC. Customers are unlikely to switch to unknown names due to trust issues but among the big 5 or 10 banks competition is fierce.
  • Product: Nothing special. All banks offer similar products.
  • Sales and distribution: This is the core of any retail bank. Axis has 2321 branches and 12328 ATMs as of Dec 2013. Branch network on an annualized basis is expanding at around 25% per year. This network is the most valuable resource after the employees of the bank and is used to distribute third party products (MFs, Bancassurance, etc.) for a fee - I love that kind of income as its fairly risk free.
  • Vendors: For a bank vendors are depositors. Deposit % of total borrowings stands at 85.1% which is excellent but a bit behind HDFC at 88% or so
  • Employees - Profit per employee is 0.15Crores better than HDFC Bank at 0.10Crores or so. Business per employee is 12.15Crores - far better than HDFC Bank at 7.5Crores. This shows in the employee cost being 7.9% of sales versus HDFC Bank at 9.8% of sales. This also shows that the average compensation of a Axis employee is 7.7Lakhs/year verus 6.1 Lakhs/year for HDFC Bank. Axis wins hands down on this one.
  • Performance during recessions - as covered in the article on HDFC Bank the domestic credit to GDP ratio is very low at 51% as per the world bank. So I would not worry too much about the sales growth part. The issue is asset quality where this bank is slightly weaker than HDFC Bank.
  • #1 concern is the proprietary trading profits of 700+Crores - Even though this is positive in FY2013 it could very well be negative. Unless the bank is purely engaging in true arbitrage positions this is a VERY Bad sign. Retail banks should not be allowed to have proprietary trading operations. What slowly happens is that in the bull run years these desks generate money by being levered and being exposed to market beta. Management continues to allow them more and more risk until the big crash takes everything with it. It has been seen time and again on wall Street. This why I am a support in part for bringing back the Glass–Steagall act.
  • Overall B+ moat as asset quality concerns are slightly higher than HDFC Bank and the proprietary trading cowboys!

2. Risks

  • Proprietary trading - This is the #1 source of risk and can take an institution down.
  • Cost cutting to get business - even though the bank is more efficient on the employee front - they are giving out cheaper loans with higher NPAs showing that they are taking higher risk with lower returns. They are also taking money from the market at higher interest rates. Need to improve the NIM.
  • Customer concentration risk - 27% or so of the lending is retail loans which is mostly housing loans. Corporate credit is about 50% of the advances - unfortunately not much detail is given about these loans and their concentration and this worries me a bit.
  • Asset quality risk - gross NPAs for HDFC are at 1% whereas Axis has them at 1.42%.

3. Financials

  • Foreign exchange risk at a sophisticated bank like this seems to be hedged but I am still uneasy because of the prop desks. I have not been able to find how much risk the prop desks are allowed to take.
  • Employee Stock options: I am a supported of ESOPs in small degrees. In large degrees they make the management team take large risks not commensurate with the returns. Annually the bank issues about 0.6% of options. There are options pending for exercise in the money for about 2.4% of the total stock. They use the intrinsic value method with reasonable assumptions on the black scholes model.
  • Margins are hovering between 13% and 15% which is healthy for this bank
  • Dividend % of earnings is healthy as well around 18%
  • Net interest margin is at 3.53% which is much weaker than HDFC Bank at 4.5%
  • Cost of deposits is 5.9% versus HDFC Bank at 5.5%
  • Average interest on advances is 9.7% versus HDFC Bank at 10.8% - this is where Axis is loosing out. Their loans are cheaper than HDFC Bank with a higher NPA %. I am guessing they are using more people to address
  • Advances per branch are around 101 Crores which is marginally higher than HDFC at 97 Crores
  • Well capitalized as per Basel norms. Typically have maintained this and should not be a problem unless of course NPAs go out of control or prop desks go bonkers.

4. Soft factors

  • Promoters are SUUTI, LIC and General insurance company along with 4 others. They have recently offloaded their stake
  • Over 40% was owned by foreign institutional investors at 31st Mar 2013 - now I think it should be over 50% after the stake sale. This should hopefully ensure good corporate governance. Will also cause volatility on the stock.
  • I have been unable to find the director shareholding in the bank.
  • Index % - Axis bank is 1.8% of the SENSEX and 1.5% of the NIFTY. It is also part of several other indices.

5. Pricing

  • Bank is trading at around 11.5 times trailing 12 months (TTM) earnings. If it were to grow earnings at 15% for 6 years and then 10% for 6 years and 5% a year thereafter this price would be a good one to get in. So far this has happened and if the bank is able to capitalize on this position it could be a good long term value investment at 1390 per share or 65,100 crores of market cap.
  • Price to book - Around 2 times book. This should probably be looked at in terms of earnings as the returns on equity fairly robust.
  • On a relative basis the bank is far cheaper than HDFC trading at 21+ times earnings. I agree it should trade at a discount to HDFC due to gross NPAs and prop trading but this difference is a bit too high.

Saturday, March 22, 2014

Interpreting reports #1: Revenue & the importance of accuracy

Revenue is the lifeline of any business in the world. Unfortunately many companies end up making it look better by "managing" the financials. In this blog I would like to cover some of these technical aspects of sound investing. Detection & correct economic interpretation is the biggest strength of the astute investor and the easiest determinant of inflated revenue numbers is comparing cash flow from operations (CFO) to net income. Of course creative accounting can doctor CFO itself and we need to protect against that as well. In an ideal simple company cash flow from operations should be net income + depreciation assuming that the customer and vendor transactions are done on time, the customer and vendor payment terms are the same and inventory is being managed well.

Overstatement of revenue can be done in many ways some of which are:
  • Creating the invoice without having the customer's consent
    • Cases where this can happen: 
      • invoicing before shipment
      • Shipping goods/services without the customer wanting them
      • Backdated contracts or early revenue recognition on a contract
    • Losses: Leads to tax losses if the customer does not accept it in the future as invoices cannot be cancelled at will. There are several laws at play.
    • Detection: CFO vs net income.
  • Recognizing revenue before shipment/customer quality approval
    • Detection: Large increases in un-billed receivables.
  • Invoicing/recognizing 100% of value when <100% of the costs have been incurred
    • Detection: CFO vs net income. Secondly revenue recognition should be done after all the costs have been recognized. Read the revenue recognition policy in detail. Also look for previous quarter costs shown as 
  • Rejected goods lying with customers pending for rejection
    • Detection: This is very hard to detect and needs to be determined by looking into the history of customer claims, warranty claims, old rejections, etc. from the statements. 
  • Wild customer payment terms:
    • Increasing payment terms from 2 weeks to 6 months might increase sales drastically for customers but leads to interest loss, high recovery risk etc.
    • Detection: Debtors % of sales should be around 8% ideally - this shows a 30 day healthy payment cycle
  • Creditworthiness of customers
    • Detection: Very hard to determine but generally I try to avoid companies with higher than 15% debtors % of sales. Try to also avoid large credit exposures of the company to single customers - anything over 15% with a single customer is a company to stay away from. In addition to credit risk this will cause too much negotiation power with a single customer. For capital goods and long term service providing contracts customer financing situation needs to be studied. Again data on this might be scarce but needs to be dug out.
  • Sales to affiliates and group companies
    • Typically group company revenue is subtracted out but for example sales to the overseas or local parent might be done on varying payment terms and costing.
    • Detection: Unfortunately no annual report is going to say I sold for cheap and with a 6 months payment term to my majority shareholder's private firm. So the best tools we have are debtors% of sales and CFO vs Net income
  • Barter or stock transactions with customers:
    • For a detailed account on this please read the Financial Shenanigans book listed in the references but sometimes barter transaction values maybe inflated and revenue recognized.
    • Detection: Read the financials, annual reports, news and media releases carefully for this action.
  • Revenue recognition policy - needs to be deeply and carefully read by the investors to see if something does not sound right to you.
  • Revenue can be "managed" by with-holding revenue recognition for future quarters
    • Detection: Recognition of revenue from old work done, large margin changes across quarters or years without fundamental reasons. Large CFO vs Net income changes across quarters or years.
  • Marking up inventory at "maximum retail price" as it is in the finished goods yard or a fictitious completed service bucket
    • This may not be the sales price. Typically this reduces the cost side but in some creative cases it can be used to affect revenue as well. 
    • Detection: Read the inventory valuation sections carefully. Large negative adjustments to CFO due to increased inventories when payable's are not rising.
  • Cash flow from operations can itself be changed by wrongly recognizing investing cash flow as operational cash flow. Sometimes such transactions can be recognized as revenue as well so that the CFO and Net income are not too off from each other
    • Detection: Careful reading of the statements
So as we know there is no replacing careful reading of the information being given out by the company - annual reports, quarterlies, news releases, information given to the exchange, etc.

Keep a lookout for this space for more on how to be careful while reading financials & reports.


Financial Shenanigans by Howard Schilit

Friday, March 21, 2014

Reliance Industries Limited - Massive, diverse and as big a conundrum

BSE: 500325 | NSE: RELIANCE | ISIN: INE002A01018

Needless to say this company has been the poster child for rapid growth and shareholder returns. Today its a huge conglomerate which still generates most of its revenue from refining. Given the size it might be hard for the company to grow like it did the in the past. This also makes it a challenge for me to do justice to this massive company in one little piece. The company claims they want to be a top 10 player in the hydrocarbons space and I think they will achieve that given the history of business execution excellence. Given that buffet is holding Exxon Mobil stock the refiners are likely to be a good long term bet as long the execution is excellent.

1. How good is the moat?

Grade B moat.
  • Scale is the biggest factor in the moat. The company is the largest private sector refiner in India. India is likely to require massive refining capacity and the plastics consumption in India is likely to go up rapidly.
  • Exports are a large part of the moat - largest exporter in India. 64% of the revenue comes from exports. Going to 116 countries. 89% are petroleum products and balance 11% are petrochemicals. 
  • Refining margins are driven by the crack spread which is driven by refining capacity globally. This is the part where the moat looks weak as most refining companies cannot control their margins because of the product being a commodity.
  • Performance during recessions - The demand for its petrochemicals and petroleum products is fairly inelastic but in the global market the spreads might be thinner. 

2. Risks

  • Overcapacity in the refining space may put pressure on the margins
  • Given the fall in the rupee I would have expected Dec 2013 margins to be significantly higher as the import side is hedged by increases in prices to the Indian market and the export margins should be higher. Financials show only a small increase.
  • Increased capital expenditure leading to no growth in earnings - in FY 2010 revenue was almost half and the profits were higher! My concern is that the higher capital investments and revenue are not leading to higher profits.
  • Lots of cash on the balance sheet is invested in various instruments. These may or not not be good investments. This entire cash and investments portfolio is funded by debt.
  • Retail and telecom businesses are being invested in - businesses that the company has little experience in.
  • Upstream assets are limited for crude and downstream sales stations are missing due to subsidized gas sales by government companies.

3. Financials

  • FX exposure - despite the massive export of refined products from imported crude the company is a net importer. These import costs I suppose are passed on to the customers.
  • Returns are worse off than BP or Exxon - and both those companies trade significantly cheaper than Reliance. Also reliance financials are stated in a currency that has 8% inflation - after this adjustment the returns are dangerously low at the moment.
  • Margins also concern me - as the net margin of BP and Exxon are significantly more than Reliance.
  • Cash flow from operations is actually higher than net income, which is a first.
  • Company claims to be net debt free after offsetting cash and current investments against debt. This is probably being done to remain liquid in order to execute rapid investments once the opportunity arises.
  • Focus on returns on capital is not very high - the company talks about shareholder returns more than returns on capital employed.
  • There are 35K Crores of assets in the "Other" Category where the return on capital is around 1% before tax. This is 19% of the net worth of the company invested in low output assets.
  • Inventory % of sales is around 13% which is high but has been the case for years and should not be a case for too much worry. 
  • Of the 4 segments - Petrochemicals, Refining, Oil and Gas and Others - Petrochemicals as the best pretax return on capital employed - which is 14% or so.

4. Soft factors

  • Shareholding: 45% or so owned by the promoter group - rarely does the promoter group in India own less than 50% - but given the size of this company this is not much of a concern. All directors hold a good amount of shares in the company
  • Large share buyback program done by the company shows that the promoters and management believe in their investments.

5. Pricing

  • You can buy this company today for the same price as you could in July of 2007. Normally for a company with such a great track record it would be a screaming value investment. In this case however in July of 2007 the company's returns on equity with north of 15% and the margins were north of 9%. Today the margins are around 5% to 6% and the return on equity is around 11%.
  • The right price to buy this is hard to judge. The conundrum is between the stellar track record of this company and the off late not so great financial performance. Given the complexity and the risk this might not really be a value investment.
  • That said this could become the largest retailer in the country and a top 10 hydrocarbon company. Growth is imminent but the risk surrounding the company is high. Once the retail and telecom businesses stabilize this can be looked at again.
  • Bottom line: I don't understand the risk well.


Wednesday, March 19, 2014

Siemens Ltd. – high technology capital goods marred by slow Indian economy

BSE: 500550|NSE: SIEMENS|ISIN: INE003A01024

The parent company has been around since 1847 - a 100 years more than the independent republic of India's history.

This particular listed subsidiary is involved in the energy, industry, healthcare and infrastructure sectors. The entire sales cycle depends on the capital investment in the economy. Returns on equity used to be high From FY2005 till FY2011 after which the ROE has taken a sharp dip - since economic growth in India slowed down.

1. How good is the moat?

Grade B moat.
  • Brand - The brand is rock solid and has been around for years. Globally is well respected and known.
  • Product competitiveness - Few companies are competing in some of the areas and many in others. Overall needs to compete with several large companies for the market from all over the globe - Europe, US, & Asia. Siemens holds a lot of technology which might be of use in some areas - but in the Indian market buyers might step down to slightly older technology that is off patent for lower prices.
  • Sales and distribution - Relative to the competition no real competitive advantage in this area.
  • Employees - cordial relations with unions. HR processes are robust and well developed.
  • Net imports stand at 3000 Crores+ or over 26% of revenues - fall in INR values will hit profitability severely. Some of its competition in the Infrastructure space have setup local plants
  • Performance during recessions - This may be a big issue. A great management team & a great company when up against a bad business market is always going to end up losing the battle to the bad business market.

2. Risks
  • Largest risk is low capital expenditure in the economy will have adverse impacts of the cash flow
  • FX risk has already hit margins. Indian rupee is likely to decline against the dollar by the inflation rate difference between India and the US every year (FX interest rate parity)
3. Financials
  • CFO has lagged net profit by over 50%. Reasons a manifold - provisions reductions, etc.
  • Inventories - Have more or less fluctuated between 8% and 15% of sales
  • ROCE - Has gone down from over 30% to 4%
  • Dividend % of earnings - over 100% in the latest year. The company has tried to keep up the dividends through declining profits
4. Soft factors
  • Shareholding
    • Promoter group owns 75%. Has gone up from 55% or so in Sep 2010. This is the driver for the stock holding its value within 5% of the Sep 2010 prices. It is weird why this is happening given the decline in earnings.
  • Director shareholding - Negligible. Not a great sign.
  • Indices - BSE 200 Index, BSE Capital Goods Sector Index, BSE National Index, BSE Power Index, CNX 200 Index, CNX Infrastructure Index, CNX MNC Index, NSE CNX 100 and S&P CNX Nifty Index
5. Pricing
  • Market cap is around 24300 Crores with earnings of only 194 Crores. Dec 2013 is nothing very different. The company therefore is trading at 125 times or so earnings. Probably a bit too high at this point - not a value investment.
  • Price to book is around 6 times. For a company in this engineering sector this metric might not be very relevant
  • Only point going for the pricing maybe that the parent increased its stack back in 2010-2011.

Tuesday, March 18, 2014

ITC Limited - Smörgåsbord of quality, ethics and pricing?

BSE: 500875|NSE: ITC|ISIN: INE154A01025

Contrary to popular belief ITC is still largely a tobacco company with over 75% of the profits coming from the tobacco business. I still dont know who really owns the company. Financial performance is brilliant. The national public health foundation is running cigarrette ads which dont seem to be hurting ITCs financials. Also there is the ethical angle on this company - which is complex due to their cigarette activities being balanced by their hugely successful CSR activities.

1. How good is the moat?

Grade A+ moat.

  • Cigarette business is rock solid. They have over 80% market share and no new entrants into the industry are allowed. FDI is also banned. Nothing better than this moat. Question is can they export the cigarettes?
  • The company has over the years smartly built many businesses around the original tobacco business and brought tobacco revenues to 42% in FY 2013 from 79.4% in FY 2003 or but profit % from tobacco are still is 75% in FY 2013 down from 90% in FY 20013. The quest really remains whether this company can transform itself to become a proper FMCG player outside of tobacco. The company has made a huge effort in this regard.
  • Brand - in the Cigarettes space it has an over 70% market share where the moat is great but in the rest of the areas there might be an issue.
  • Sales & distribution: 100K markets directly serviced & over 20 Lakh retail outlets. Probably one of the biggest FMCG retail networks
  • Vendors - Innovations like e-Choupal enable ITC to procure agri products at very low prices while benefiting the farmers
  • ROE - The Return on equity on the cigarettes business is over 90%, Agri is 26% and the rest are pretty much not so great use of capital
Segment ROE % of revenue % of Capital
Cigaretts 94% 41.6% 27.6%
Other FMCG 0% 21.2% 16.7%
Hotels 1% 3.0% 18.9%
Agri 26% 21.0% 9.5%
Paper&board 9% 13.2% 27.4%

2. Risks

  • The cigarettes business still is growing but is likely to abate at some point due to the health organizations chasing the business. By the time that happens maybe the other businesses would not have picked up.
  • Rapid regulatory changes could hurt the cigarettes business giving ITC not enough time to recoup.
  • I think the hotels, agri, FMCG and other businesses might be a good way to advertise the cigarettes which again brings to fore the ethical question.

3. Financials

  • FX exposure - the business overall is a net exporter of about 5% of revenues. It does repatriate about 1000 Crores of dividends to overseas shareholders making it only a 2% to 2.5% net FX earner - of course the dividend sent overseas does not impact the company performance.
  • CFO and Net income are within 3% of each other.
  • Stock options dilution - This is a bit of an issue with the stock. They do recognize the black Scholes value of the options but whether they market to market the option dilution later is yet to be seen. Volume of options granted in FY2013 will cause dilution to the tune of around 1.1%. Which is high but not a game changer.
  • ROCE is consistently high
  • Debt is zero
  • Working capital is marginally negative - but this contains a provision for dividends which if taken out working capital would be less than 3% of sales. Very efficient!
  • Dividend % of earnings is very high - over 50% in all years - even 100% in some years. Basically the company needs to find good avenues for utilizing the capital. Hotels seems to be not a great way of utilizing the capital - unless they are a real estate play.
  • Not much goodwill on the balance sheet to be worried about.

4. Soft factors

  • Shareholding
    • I have no clue who the promoter is. The largest shareholder is listed on the annual report as Tobacco Manufacturers (India) Limited. This company cannot be found on the MCA website.
    • British american tobacco holds 30% of the company and currently claims to not want to increase its stake as per the news story linked here
  • Some reports suggest that the global tobacco industry is growing at 4.5%.
  • Ethics - is investing in a tobacco company irresponsible? Given the huge activism against the industry its probably seems irresponsible but the question really is that if we stop investing in these companies does that stop people from smoking? I will leave that thought for you to answer and the experts to ponder.
  • Growth - the agri business can grow. Cigarettes growth will have to come through exports. 

5. Pricing

  • Very hard to price as the growth of the cigarettes business is what is going to grow the bottom line and the overhang on that is hard to predict - per capital consumption in India is low but the public health administration in India is trying their best to get people to quit. Even if we assume that the company is able to grow bottom lines by 20% for 10 years (which is a very aggressive assumption) and then 10% after that the valuation would enable us to buy the stock at a 20 times multiple or so. For this to be a value investment I would say it would need to trade at 15 times or so.
  • Price to book is fairly irrelevant with such a high dividend % of earnings, no debt and ROE.

Sunday, March 16, 2014

HDFC Bank - Excellent Bank but too rich for now

BSE: 500180|NSE: HDFCBANK|ISIN: INE040A01026

Highest quality bank in the country. Has growth net income by 30%+ year on year for over 4 years. Lowest gross NPAs in the country among the big banks at 0.97%. Dec 2013 quarter NPAs are slightly higher at 1.1% which still keeps it among the top banks. Very few things would keep me up at night about this as a company.

1. How good is the moat?

Grade A moat
  • Customer stickyness: The brand is strong but customers are unlikely to shy away from shifting to another big name bank.
  • Sales pipeline: Very strong but nothing special relative to the competition. In fact I would say HDFC is less aggressive than for example Kotak.
  • Scale: This is one of the big banks with a good brand along with SBI, ICICI, Kotak and others. The Bank has over 3000 branches in over 1800 cities with more than 28.7 mil customers which is over 2% of the Indian population. Is in the top 3 by net income, top 4 by revenues, top 2 by net profit margins.
  • Lending safety: This is where HDFC Bank scores its grade A moat. Their discipline in getting what they want as security and loan safety is the highest. I have never heard of anyone saying HDFC dropped some loan requirement to close a deal - whereas people will always say that about some bank or the other.
  • Growth: India's domestic credit to private sector as a % of GDP in 2012 is abysmal at 51% as per world bank data. Most of the developed world is over 100%. Which means that the credit market has lots of growth left. The question for banks is how to tap on this growth without loosing your shirt. I think HDFC Bank is poised to take the maximum advantage of this situation.

2. Risks

  • Macro-economic risk: Runaway inflation could hurt the entire banking industry.
  • Banking to small transaction size consumers could raise costs
  • 57K Crores of unsecured advances - around 1/4th of the advances are listed in this section. Not many details are provided and this worries me.

3. Financials

  • Capital adequacy ratio is over 16% & Tier 1 capital is over 11%.
  • Net interest margin of 4.5%
  • Commission and brokerage as a % of revenues has fallen by 1% or so over the last 5 years
  • Deposit % of total borrowings is 88%+ which is very high - and very healthy.
  • 2 Subsidiaries - both seem to be profitable. Size is very small and probably dont play a major role currently for this business
  • No insurance exposure

4. Soft factors

  • The growth of the company has been stellar. EPS has grown faster than the ROE itself - showing that there was excess capacity that was used to deliver the EPS. Further room for growth is massive as credit is still scarce in India.
  • Shareholding: 
    • Company was originally floated by HDFC which in turn was floated by ICICI.
    • In this case the promoter so as to say is not a family or a set of individuals but an organization
    • Overall ADS depository JP Morgan owns 16 % which I presume is equity swap holdings overseas. Further FII holdings are 34% - over 50% holding is FII. Capital flows to india will be driving this stock.
  • Employee relations - are good. The HDFC jobs are coveted but not as much as the foreign banks yet.
  • Index % is 4.8% or so.

5. Pricing

  • This is highly tricky as its the first company I have seen that has been able to consistently grow earnings faster than the ROE %.
    • Is there room to grow? A resounding YES!
    • Can it keep the efficiency up at these levels? Probably.
    • Growth has slowed down in FY2014
  • We can safely expect this bank to grow earnings 20% for the next 5 years and maybe 10% per year for a few years after that.
  • The current price of 21.3 times Dec 2013 numbers is a bit too rich - might be a value investment anywhere around 14 to 15 times earnings. At current prices the investors still might make good returns as this is the darling of the markets but is not a value investment at this price.

Friday, March 14, 2014

Tata Consultancy Services - Excellent performance & A Grade moat but slightly rich

BSE: 532540|NSE: TCS|ISIN: INE467B01029

This is the poster boy for the TATA group and the entire country of India - in terms of the scale, growth and return on capital. I have always been curious to know what makes this engine such a superstar company.

1. How big is the moat?

A Grade moat

  • Traditional thinking will tell you that an IT client will move from one provider to another overnight but it seems that TCS is beyond that. They have consistently grown the client base and the revenue. Their revenue from repeat business is 98%+ which is excellent.
  • Scale obviously gives TCS a huge moat in India & globally. By revenue its around the 10 Bil mark making it about the 2nd largest company in the IT services space after IBM and parallel to accenture - not including the Microsoft consulting division.
  • Between the largest players shifting is probably possible and the space is likely to become more competitive.
  • Margins for TCS are larger than Accenture, EMC and IBM which are other IT services companies in its league globally - probably because of its being headquartered in low cost India.
  • Brand: Global footprint has been established and now the company is reporting good numbers on diversity and global presence. They will have to shed the low cost brand to being a global high quality player brand rapidly.
  • Performance during recessions - during recessions the company has been able to grow its revenue on the back to outsourcing from clients to reduce costs. So far the strategy has worked out.
  • Moat is A grade because the company does not have a proprietary product and can be replaced with IBM or Accenture or Infosys or Wipro or others by customers.

2. Risks

  • Size has become large and finding large growth opportunities will be difficult
  • Talent turnover is a huge issue but the safeguards in place are good too
  • Protectionism in the US
  • High exposure to banking and financial services - is a double edged sword - slowdown risk but increased regulation means more business for TCS
  • High cash on balance sheet might be used to make high value acquisitions - the TATA group has fallen for this before - where it worked out for TATA motors but didn't so much for TATA steel
  • Another double edged sword is the exports angle - FX exposure

3. Financials

We are basically trying to see if the financials are presenting an accurate picture of reality and if that reality shows that this is a great business.
  • Very consistently high ROE - at 36% or so
  • No debt
  • Cash Flow from Operations is lagging net income as debtors rise when there is revenue growth. High debtors is a concern here as they stand at 22% of annual revenues which indicates a 2.5 months payment cycle which is not a very comfortable position to be in. Also debtors are 36% of equity and 44% of invested capital. 
  • Un-billed revenue - there is revenue that has been recognized but not billed capitalized on the balance sheet to the tune of 3000 Crores+. This could be a source of risk if customers end up not paying for it.
  • No inventory to really talk about
  • Over a billion dollars of cash on balance sheet
  • Loans and advances to related parties are not large but don't sound befitting to the reputation of the TATA group.
  • 35% to 50% of the earnings have been paid out as dividends
  • Overall other than a few small issues financials look great.

4. Soft Factors

  • Promoter shareholding has been around 73% for a while
  • FIIs hold 16% of the stock so volatility is to be expected
  • Sources of growth - given the size of this company growth has to slow down at some point. So far they have been able to defy gravity. 
  • The stock is the largest component of the Sensex and will probably be highly correlated with the Index. 

5. Pricing

This is a tricky one. The moat is A (not A+) but the management performance is stellar. Currently trading at 19.5 times Dec 2013 quarter annualized and 24.1 times TTM. Price to book for such a high ROE business is not relevant. The question here is that if we assume that after the growth abates this stock will trade at around 10 times earnings it will have growth at 30% per year for 8 years to give you a net 20% return with a final revenue almost 2 times that of IBM. If the final P/E is 15 it would give you a 20% CAGR with 3 years of 30% growth and a revenue number about half that of IBM. The margin of safety is low so I would hold at this price and be buying around 17 times earnings.

Thursday, March 13, 2014

Bayer Cropscience - Good quality but expensive for now

BSE: 506285 | NSE: BAYERCROP | ISIN: INE462A01022

I came across this company while looking for companies making household products that I know about. I had seen Baygon bottles with the signature Bayer plus sign and was sad to find out that Bayer sold the brand to SC Johnson.

This company has been around forever since 1892 - started as a pesticide maker. It was a shocker to me to find out that this company gets 60%+ of its revenue from trading operations!

Bayer globally has 19% of the crop protection market and is number 1 or 2 globally. There are 6 companies that globally control this space. 

Crop protection market in in India is 3.8Bil USD of which 50% is exported. Bayer market share of this is around 13%. Export % of sales is around 16.9% - so Indian market local share of business is 23% or so and export from india share of business is around 4.6% or so.

Sector should be kept in mind as is likely to be growing for many years due to population increases and increasing demand for food.

1. How good is the moat?

B+ category moat.

  • Products: 3 major products - Active ingredients (25%), Formulations (59%), & seeds (14%). With increasing generics product replication is becoming easier
    • Active ingredient - is the substance that is biologically active. A generic typically contains the same active ingredient as the branded product. There are few new active ingredients coming to the market.
    • Formulation - Final product that contains the active ingredient and other supporting chemicals. Final use product.
  • Brand - the brand is great but will be unable to drive pricing. The brand definitely makes it easier to make the sale.
  • Sales & distribution - team size of 3000 and reach is humongous. Replication is not possible but a bit expensive.
  • Recession performance - Agriculture is required for survival and food is not in abundance in India yet.

2. Risks

  • Large Cash on balance sheet could be invested in unproductive assets
  • Growth is not commensurate with the invested capital outlay
  • Dividend % of net profit is around 14% of operating profits after tax which is low
  • Agriculture growth in India is not much and this company is currently a net importer. Exports are unlikely as the parent may like to export from the mother plant.

3. Financials

  • Debt: ZERO. Company over the years has paid down the debt.
  • Foreign exchange exposure (FX): Imports are around 650 Crores and exports are around 491 Crores. making the net FX exporsure to be 5.8% of revenues. Fall in INR will have a negative impact on this stock but not by much.
  • CFO vs Net income - this is a problem on this stock. Given the global footprint I would have expected this to not be the case but the working capital has gone up.
  • Overall Return on invested capital (after subtracting cash) is large probably due to the large trading gross margin which is 30% and consumes little capital. I cannot test this hypothesis as the previous annual report from 2008 does not provide the revenue split.
  • No large goodwill issues

4. Soft factors

  • Promoter group shareholding is 71% or so
  • Employee relations seem to be cordial
  • Growth: Sources of growth are limited - other than increasing adoption of products, increasing market share and general growth. All 3 look hard to do but the company has done it. Overall crop protection market is likely to grow at around 10% to 12% as per reports.

5. Pricing

  • Current ex of cash trading at P/E of 17.5 times earnings. Given the growth to be limited and relatively no export opportunities I might stay away from this for now. Maybe if it was trading at around 12 times or so it might be interesting
  • Price to book is probably not the right metric for this kind of a company


Wednesday, March 12, 2014

Bajaj Auto - great company but a tad bit expensive!

BSE: 532977 | NSE: BAJAJ-AUTO | ISIN: INE917I01010

Has been a household name forever (has been around since 1926). Used to make scooters and transformed itself into the most profitable 2 wheeler company. The auto industry has slowed down tremendously and the big giant Hero Honda split into Hero Motocorp and Honda continued with its Honda motorcyles.

1. How good is the moat?

Grade A Moat.

  • Brand: Replacing the Bajaj name in Indian households would be probably a very long and expensive activity. They have also been able to price their products above the Hero products and have greater margins.
  • Product replication is not the big deal here. The issue is the replication of the dealer network, brand, sales pipeline - which other than Honda Motorcycles and Hero Motocorp no one else has. They so far have the most successful export strategy in the 2W and 3W segment. Even the 3W brand is impeccable.
  • Sales & Distribution: Massive dealer network with over 3750 rural outlets, 500 dealers and 1600 service centers - unlikely for a new entrant to replicate rapidly.
  • Pricing power - I don't understand why but Bajaj auto since its remake as a motorcycle manufacturer has been able to price their products over the competition and still make sales. Even though 9 months ended December 2013 sales numbers are down 9.9% the value of the sales has remained constant and the profits have gone up by 8.9%!
  • Depreciated assets - Also the plants and equipment have been around for years and are fully depreciated. Replication of these assets will be an uphill task.
  • Performance during recessions: This is likely to be a concern and is one the big reasons for the stock taking a beating. Taking a bet on it is akin to believing that 2W and 3W sales will catch up either in India or abroad. The good news is that 30%+ of the revenue comes from exports FY2013 - which means that this company can catch up there even if the Indian economy is sluggish.
  • Innovation - some amount of innovation is being attempted with the 4W cheap vehicle to replace the 3W market and the small car market. This is like having a option that could end up far in the money.

2. Risk factors

  • Market recovery: 
    • If there is no recovery in the 3wheeler market (sales are down 20% this YoY) then 3W capacities might take a beating
    • If there is no recovery in the motorcycle market in India
    • If the export growth is unable to counter the fall in market size in India
  • Saving grace:
    • Ability of the company to increase prices and get away with it
    • Presence in the high end segment - and possibility of absorbing this technology and exporting these products
    • Presence in many export markets: Europe, Indonesia, Africa (Nigeria)
  • Strained employee relations - Bajaj Auto has faced lots of unrest at its plants at Chakan and Pune. This could be a concern when capacity utilization is required to meet market demand.
  • Capacity utilization - is low. Total installed capacity was 5.4mil units at the end of FY2013 of which 

3. Financials

  • Cash flow from operations has lagged net income by an average of 13% or so over the last 5 years which is largely due to the investment income. Not a cause for concern.
  • Exceptional items - small changes due to currency hedges - expected due to the exports exposure.
  • Inventories are maintained between 3.5% and 4.3% of sales which is very healthy. News reports suggest that dealer inventories are high. Feb sales were down by 6% YoY so this is to be expected.
  • Inventory valuation is not much of a concern as the absolute value of the inventories is low
  • ROCE track record: Has been always over 19% and for the past 4 years has been over 38%. Exceptional record.
  • Debt - company has ZERO debt which reduced risk massively. Cash rich. Cash reserves are over 4,500 crores invested in bonds, debentures, commercial paper, mutual funds, etc.
  • Trade receivables - are very low: 3.5% of sales. Working capital is negative (payable are more than receivables + inventory)
  • Dividend % of earnings - Around half the earnings are paid out as dividends annually.

4. Soft factors

  • Shareholdings: 
    • Promoter shareholding - Over 50% - which is good in this case.
    • FII holdings are high at 16% - so expect volatility
    • Retail investor base is over 15%
  • Employee relations is a large source of risk and the company need to fix this or might cause severe losses.
  • Growth - sources are mainly export at this point. But buying this stock means betting on the Indian economy to do well and for people to buy more motorcycles. The 4W project might be an interesting source of growth as well.

5. Pricing

  • Currently trades at around 17 times earnings which is typically what it has traded at for the past 5 years consistently. I would not buy at current levels as a value investment but would be buying this stock anywhere under 15 times earnings.
  • Price to book currently stands at around 5.9 times which is cheaper than historic trading but that is clearly because there is growth overhang. I would not read much into the Price to book of this stock.

Tuesday, March 11, 2014

Muthoot Finance - incredibly cheap!


India is voracious consumer of gold and thus the world's largest lender against gold is in India. This company is like a large professional bank that has a very liquid and easily measurable collateral. NPAs thus are irrelevant. Moat is not super great but still good. Price seems cheap even though the stock is up 65% from just 2 months ago!

1. How big is the moat?

B+ Category.

  • Brand: While searching for a loan typically you go for the cheapest - the only factor here is that these are gold loans against the family jewelry. For which you might consider a known name & trust. The fact that Muthoot claims to be around since 1887 is a big factor.
  • Distribution: This is a huge competitive advantage and there is room for growth in the North, east and west as the south already has a lot of reach.
  • Vendors & employees: There doesn't seem to be much that cannot be replicated here.
  • Resilience to downturns: I would expect more loans to be taken out against gold and jewelry during downturns so economic downturns does not seem to be a huge risk.

2. What are the risks?

  • Revenue growth: Overall credit access is low so opportunities for growth are humongous. In fact the 5 year growth in revenues from FY 2008 to FY 2013 has been a whopping 14 times or 70% CAGR! That sounds too good to be true to me.
  • Collateral risk: Most banks suffer massive collateral risks in terms of loan to value (LTV) ratio risk due to fluctuation and the complexity of liquidating the collateral. For a gold loan lender 60% LTV statutory limit is very safe and liquidating the collateral is very simple relative to liquidating a real estate collateral. Recently the LTV has been increased to 75% - increasing the LTV is a double edged sword - increases risk but increases the ability of the company to lend.
  • Theft: Of collateral by various agencies is something I am worried about and the company ofcourse claims its a fool proof system but I find it hard to believe how this is managed across 4000+ branches.
  • >25% fall in the value of Gold in INR - is extremely unlikely as the insatiable appetite for India to consume gold is unlikely to abate. And inflation ensures that the value of Gold in INR is typically rising over longer periods. In case this does happen it could wipe out the company.

3. Financials

  • Capital adequacy ratio - is greater than 20%  - which is far better than for example HDFC bank (which is probably the best managed and most conservative bank in India).
  • If the claims about the gold backing each loan are correct the the NPAs probably dont matter but the gross NPAs are high at 1.99% - almost 2 times the HDFC Bank gross NPAs (~1% )
  • Return on Equity has been high - over 30%. Latest 9M ended Dec 2013 the annualized ROE is around 19% or so which is lower than earlier but still better than most banks. It is higher than all large banks other than HDFC in the country (which has an ROE of around 20.5%)
  • In short given the risk reward it might be better to buy Muthoot finance than bank stocks. Yes HDFC Bank is a better company probably but that trades at 94 times earnings versus Muthoot finance currently at 7.9 times earnings!
  • Dividend % of net income - around 19.3% which is a healthy percentage to payout and ensures that profits are shared with shareholders routinely.

4. Soft factors

  • Promoter shareholding: Promoter family owns over 80% of the company.
  • FIIs own 10%+ which will lead to large volatility but that is a good thing for value investors.
  • Matrix partners has a large position and own 2%+ of the company

5. Pricing

  • If we take the reduced earnings of the 9M ended Dec 2013 and annualize them we get 798 crores of PAT for FY 2014. Today the stock trades at around 8 times that as total value which seems cheap to own
  • Price to book - Relative to the gold loan industry the price to book is expensive at 1.54 times book (Dec 2013 book value) as most gold loan lenders trade under 1 times book but that is because this company's margins are higher and its ability to lend while keeping the capital adequacy ratio in control is high. Relative to high quality banks like Axis or HDFC the price book is cheap (both Axis and HDFC trade at over 1.95 times book)
  • Bottom line I would have this stock in my portfolio at 172 INR/share

Sunday, March 9, 2014

Titan Company Ltd

BSE: 500114 | NSE: TITAN | ISIN: INE280A01028

A darling of the value investors - even my grandfather owned this stock and through growth became one of his good picks. Its come into the limelight again as the gold imports ban in India seems to have hit margins. I think this is a special situation and cannot continue for long. Plus the pricing power in the hands of Tanishq is large enough to counter the drop in margins.

1. How big is the moat?

A+ Moat.

Needs little explanation. Jewellery is around 80% of revenues and Tanishq is unlikely to be replaced in the largest jewelry market in the world - India. 65% of the organized sector of the watches market is with Titan. Yes watches are rapidly being replaced by phones but as an ornament they still will continue to exist. The weddings industry in India will always continue to consume jewelry and is unlikely to abate in demand.

2. Performance during recessions

Unlikely to be hit. From 2011 till 2013 sales growth was a tremendous 24% when the economy was slow. Also this is likely to become the top Indian luxury stock over the years where the consumers are wedding buyers. Wedding buyers tend to be irrational and emotional leading to massive profits for Titan.

3. Financials

  • CFO vs Net Income: 5 years net income and 5 years CFO is within 2% of each other.
  • Inventories stand at 30% or so of sales value for the past 5 years which is very high - but in a high value retail business that is probably ok.
  • Inventory valuation: Inventories are marked up for finished goods which is a little bit of a concern as discounts may not be factored in.
  • Margins: Net margin has gone up from 3.9% to 6.6% whereas operating margin has stated between 8.6% and 9% which basically means that the margin increase has been due to higher revenues from the same fixed asset base.
  • Return on equity/invested capital: Very high!  ROE has gone up from 29% 5 years ago to 37% last year. The company is virtually debt free with 1100 crores of cash which if subtracted from the Equity will give a ridiculously high ROIC.
  • Debt: Zero
  • Receivables - Stand at 1.5% or so of sales - which is excellent.
  • Working capital - stands at around 3% or so of sales - which is a sign of a very well run company
  • Dividend % of earnings - 30% which is ideal. Shows that the money is being sent back to shareholders and a good percent is reinvested. In this case has been used to pay down debt.

4. Soft factors & growth

  • Promoter shareholding - This is a TATA company and is likely to have great corporate governance thus this factor does not matter much. TATA group owns 25%+ and so does Tamil Nadu industrial development corporation.
  • Employee relations - The company reports manhours of training per head at 10 plus hours per year and 259% of the contractual employees being upgraded for skills. No cases of unrest. This sounds excellent.
  • Growth - Titan is continuously adding brands, stores and increasing international presence in various countries. Growth in India might be slow for the next few quarters until the gold ban is lifted but is definitely going to go up.
  • Is a huge position for Rakesh Jhunjhunwala - so as far as cloing goes might be a 

5. Pricing

I started writing this blog at the wrong time. Should have started 3 months ago! But still at 254 I think this is a good long term Value stock.