Recent analysis

17May10

I have been trying to look at some good companies in the 1000-4000 crore market cap range which are undervalued. The reason being I have invested in two microcaps (Ador Fontech and Patel Airtemps) whose valuations I am kind of comfortable with but not with the underlying business itself to hold them for the long term. I wanted to diversify in terms of market cap and invest in undervalued good mid caps. But I have not met with success so far.

2 companies I analyzed but did not pull the plug:

ARBL:

ARBL is in the battery business and competes with Exide and Sukam in the organized segment. The company has grown at a CAGR of 50% in last 4 years, has average ROA of 11-12% and ROE of 24-25%. I liked the business which the company was in. Selling car batteries constituted some portion of the business and other portion depended on selling batteries to industries like IT, Power, Telecom etc. It has a wonderful brand Amaron with, I believe, a very good brand recall. This company came into my radar since it was available at a TTM P/E of less than 10. I completed a very basic 1st level DCF analysis (which I do conservatively by cutting the rate of growth by half and reducing margins reasonably etc). I just assumed that the future will be worse off than the present. However I was disappointed with the result. The company did seem to be correctly valued. The value which I got from my valuation exercise matched the market cap. I then realized that the sudden drop in P/E of this company (Exide is at 18 P/E) is due to sudden drop in lead prices, a significant component in batteries, which has lead to super normal profits. So chucked this investment.

Rolta India:

Rolta is in a “sexy” business of geospatial software and related stuff. They operate in a niche area of defense software, infrastructure software, Geospatial information systems etc. I could tell this company is, at a basic level, similar to BEL since these software tenders are preferred to be given to local vendors due to the confidential nature of defense/government stuff etc. I did feel that this is a considerable moat around the business.

Fast facts: Sales CAGR for last 5 years is 27%, PAT margins close to 30%, Average RONW at 17% to 21% in last 10 years, D/E of 0.6

The company is available at a P/E of 8-9 and hence I got interested in this business. Obviously I did not have any clue about this seemingly tech arena but was willing to learn if my 1st cut DCF analysis told me that the company was significantly undervalued.

However this valuation exercise did teach me how deceptive P/E ratio can be. The valuation exercise told me that the company seems to be valued correctly. I did not understand how the P/E can be so low for a company growing at such a fast pace and generating above average returns.

The key is to figure what has been the “cost” of the growth. The company’s FCF’s have been negative for quite some time. I did an analysis of the fixed assets growth of the company. Over a 10-20 year period, the company has invested 90-95 Rs in fixed assets for every 100 Rs increase in sales. In last 5 years, this ratio has gone up and the company has invested 130 Rs roughly for every 100 Rs increase in sales. The tougher part is I excluded FY2009 in all my calculations since in that year, it increased its net block by 100%!! Including FY2009 investment meant the company has invested close to 200Rs for every 100 Rs increase in sales over 10-20 years. However its not right to add FY2009 investment in the analysis since the benefits of that investment would not have translated into sales.

The significant uncertainty is this:

-Why did the rate of addition of Net block  go up from 90-95Rs to 130 Rs in the last 5 years?

– What will happen in the future?

I obviously did not have an answer to any of these two questions.

But one can wonder how can a company, which needs so much FA investments, survive? That is partially possible because it is generating returns on those invested assets i.e. PAT of 30% is not a joke and helps a lot in generating supernormal CFO but the problem is all that CFO ends up in FA investments for future and leaves little room for FCF. (Compare this to Infy which did not have to invest in FAs and hence had high FCFs).

Maybe it is a “growth” company and stuff, but I do not know how to value it then anyway. So let this pass too. But the significant learning is to not just look blindly at P/E, which is a static measure, but to see how much money a business can generate over a period of time.  The change in assumption from 90-95 Rs in FA investment to 130 Rs in FA investment to 180 Rs in FA investment gave me answers that the company was 60% undervalued, correctly valued to 30% overvalued. And the past trends did not help me fix the right number for investment needed in FA. (I guess its here I need to dig deeper now to figure out the difference between growth CAPEX and maintenance CAPEX and how these two play a role. This exercise is not completed. I want to understand how these various valuation methodologies join hands.)

PS: I did a rough cut 10 min basic DCF on ABB limited and found that I would invest in the company only if it falls by 80%. I do not know whose valuation is wrong. But a 50 P/E for a 6000 crore revenues company does not seem to be very low.

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4 Responses to “Recent analysis”

  1. 1 vasant

    I thought your analysis on ARBL will be peppered with some more analysis …after all you know the company well isnt it? . But as you rightly pointed out, the Co’s bottomline is clearly linked to the ‘Lead’ costs which is its key raw material input. Sometime back i had invested in Graphite India and learnt quickly how the stock’s beta (volatility) gets affected by this factor.

    As far as ROLTA is concerned , I have invested very recently as I find the Geospatial mapping area quite promising ( I hv been involved with this technology on some project and so could relate to it)

    Good Analysis. Hope to see more

  2. Hi Vasanth,

    Thanks for commenting! Though I have worked with ARBL on a project, the work involved analyzing various other sectors and industries rather than ARBLs core business. All I do know is that the management is very good and ethical in their dealings and have a long term focus. I would definitely like to invest in ARBL but at a market cap of around 1100 crores.

    What is your insight on the Geospatial space? Is it a technology which is changing very fast and is the business asset intensive?

    Rolta is actually not a stock which is not known that much. In its recent concall, the following analysts participated:

    Mr. Kunal Sangoi Edelweiss Capital
    Mr. Abhiram Eleswarupu BNP Paribas Securities
    Mr. Pratish Krishnan Bank of America – Merrill Lynch
    Mr. Vihang Naik Motilal Oswal
    Mr. Nitin Padmanabhan Centrum Broking
    Mr. Yash Gadodia ICICI Direct
    Mr. Dipesh Mehta Khandwala Securities
    Mr. Pranav Bhardwaj Mata Securities
    Mr. Nimit Shah Harley Securities

    Its a pretty big number. I am yet to read the transcripts. Would study this space further.

  3. Hi Pradeep,

    In ARBL’s valuation, what else have you seen beyond the lead cost and the P/E ratio? Ofcourse all this goes into your DCF.

    I glanced through their numbers on moneycontrol and noticed they have showed tremendous debt reduction discipline. In Mar 2008, debt on books was 316 crs and in Mar 2009, debt on books was 285 crs. Notice that at 285 crs they paid 20.6 crs in interest expenses. Now in FY2010, adding up the interest – we have just about 7.8 crs; which means ARBL would have reduced debt from 285 crs to about 100 crs when they release their B/S for FY 2010. The point I see here is a very informed management – a crucial factor in evaluating a ‘value buy’.

    Regarding lead prices, most companies almost always adjust their sale prices upon any price rise in raw materials – ARBL is no different. The operating margin of the company has been 15.4-16.4% for the last 3 years. While FY10 seems to be higher (arnd 19%), in the long run the number should be around 15%. The Op. Profit is a major valuation tools esp. when you use ROIC.

    I shall look at ARBL tonight to see if there is any hidden value that we haven’t unearthed. Keep up the good work.

    Regards,
    Shankar

  4. H Shankar,

    I did not observe the debt reduction aspect in the B/S. Thanks for bringing it up. The management definitely seems to be doing a good job. However the reason I did not take a call then is that I did not find it undervalued or to have a margin of safety (once we consider the average operating margins as 15% and average PAT as 10%). I plan to do a valuation once again and go through the business in more detail.

    There are also a few things one needs to keep in mind. I observed these from the A/R which I just glanced through in 10-20 mins. They have 2 segments: Industrial batteries and Automative batteries. The former has grown at 25% CAGR and has contributed significantly to the company’s growth. It contributes 50% to revenues and Automotive contributes 50%. Automotive, my guess, grew at 8-10% CAGR. The automotive growth is inline with the car sales CAGR in India. In the Industrial growth arena, 60% was through telecom towers battery sales and the growth also has been significantly from this business. I am not sure, but I think this part must slow down in the future. I did not do a detailed analysis but I am not sure how many more telecom towers have to be built in India. So growth will slow down in the future. Their other significant area is supplying to IT offices. You can have a look at their A/R. Their MD&A is very good!

    I have been trying to develop a better valuation model than what I have been using, in which I found some conceptual flaws. I will try to value ARBL again once I get sometime off work. Thanks for commenting. Guess you have started blogging once again after sometime. Please keep up the good work and continue blogging.


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