July 9, 2007

VST industries

VST is involved in the manufacturing and marketing of cigarettes. It is the second largest cigarette-maker in India with 12 brands in its portfolio. The company is an affiliate of British American Tobacco (BAT), UK, which holds a 32.16% stake in the company. Some of the major brands of the company are Charminar, Charminar Special Filter, Charms Mini Kings and Charms Virginia Filter. Its products are targeted at the lower-end of the market and have dominance in the small sized (less than 60mm) micro segment. The company is dependent on ITC for the supply of tobacco. Though the major chunk of revenue comes from sale of cigarettes, it is also in the business of selling unmanufactured and cut tobacco.
In order to establish its presence in unrepresented geographies, the company has last year launched a new brand, 'XL Filter' in large parts of Tamil Nadu and the hill states of the North East. In 2005, the company also launched another new brand, 'Shaan', which has garnered 4% share in the micro segment.

The company is a debt free company with almost 200 Crs in cash and investments. The company has been consistently been profitable with net margins increasing from 5-6% to almost 15% now. The Return on capital is consistently above 25%+ and excluding the low yielding investment, the company enjoys very high return on tangible capital. The company has been working with Negative working capital for some time and this seems to be increasing too.

The company has strong competitive advantage due to the nature of the product for which users have a very high brand preference. Competition is limited to ITC and the unorganized sector at the low end. As a result the company has a strong free cash flow and high return on capital

Topline growth is low due to high excise and price sensitivity at the low end. Also the company is not clear of how it will use the excess cash and there is always a risk that the company may simply blow away the surplus cash.

At 58Cr net profit and 200Cr cash on the books, the company can be conservatively valued at 1100-1200 Cr (at 15 times PE of Free cash flow) which is at 50% discount to the current market cap. The company can grow at a 4-5% topline via new product introductions and price increases. The net profit has grown at a much higher rate of almost 20% for the last 10 years and a 6-7% growth in the future should look achievable. This level of growth and the high ROC can easily justify a PE of 15.
In addition, the company has a dividend of almost 20 Rs / share which is almost a 50% payout ratio .

Relative valuation
ITC is the largest player, but it has several businesses and hence it is diffcult to compare the financials. However a segment based analysis shows that ITC has around 17% post tax margins and around 110% return on capital. In comparison VST has a 15% net margin and more than 100% return on capital. ITC is curently commanding a PE of 20.

Godfrey philips is the second largest cigarette manufacturer. It had a net profit of around 87 Crs and has an adjusted cash and equivalents of approximately 200 crs (net of debt). The company sells at a PE of around 15-16 (net of cash). In comparison VST sells at an adjusted PE of around 7 and this could mainly be due to the slightly lower growth rates than ITC and Godfrey philips.

The company is a slow grower and the unit volume are more or less stagnant. The free cash flow for the business is equal to the net profit and the return on capital is also high. The balance has a lot of surplus cash and this should increase in the coming years. The catalyst for unlocking value could be higher dividend, better growth rates in the topline or continued good performance of the topline and bottom line.


RaviAranke said...

VST and cigarettes in general, is a no growth business. The
demographic head wind is against it and even the bottom of pyramid (lower economic class) has moved to Gutakha.

I wish management could do some financial engineering to unlock the value. This is a classic debt capacity bargain that Prof. Bakshi refers to.

With 58 Cr of PAT (and I think it would grow slightly as they took 9Cr hit for VRS), the company could easily support 200 Cr of debt. Add that to 200 Cr of cash on the books. The company can do a massive dividend / buy-back worth 2/3rd of outstanding stock. (current market cap ~ 600 Cr)

Besides, adding debt and reducing cash might make a tobacco company safer. The main risk in tobacco is litigation risk. If there is low free cash lying around there is that much lower motivation for lawyers.

Philip Morris stock became a super performer by huge dividends and stock buybacks. I will wait and watch for buy-back announcement by management. That would be a clear buy signal.


Rohit Chauhan said...

Hi ravi
internationally i consider litigation a major risk for the tobbaco business. the odds of that happening in india are definitely lower (which does not say much for our legal system).
i am looking at VST a graham play. the management seems to reasonable in terms of the dividend payout.the dividend payout gone up 10 fold in the last 6 years. the risk is ofcourse that the excess cash could be wasted or would just lie around. so i agree financial engineering could be a trigger for the stock. however i am taking a cue for the dividend policy of the company and assuming that they will try to return excess cash to the shareholders.
also i think BAT-UK has a 30% holding in the company and that could be positive in the long term

RaviAranke said...


Dividend yield is nice to have. However, at present, you can get generous dividend in floating fund with zero risk so that won't be an attraction /trigger till you move to low interest environment.

I agree with you that management has been raising dividends and this is good sign.

Overall, the stock looks somewhat undervalued and one can certainly buy it for Graham's cigar butt(Pun intended) portfolio.

Also, if I may invoke the dreaded 'land bank' argument, VST seems to be sitting on some good land in Hyd. Type 'VST, Hyderabad' in Google Earth.

A bit of motivation on Management part can do wonders.

Rohit Chauhan said...

hi ravi
i am not looking at VST as a dividend yield play. I am looking at the dividend history as an indication of the desire of the management to return extra cash to the shareholders.
the company sells at around 6-7 times cash flow if you exclude the cash on the books. I think the market is already pricing in the risk of management wasting the cash or letting it idle. The core business is however generating almost a 100% on the invested capital. I would assume that it would be worth far more than 6-7 times earnings.
it is by no means a slam dunk , however i see good upside odds versus downside odds.
it looks like a cash bargain, prof bakshi talks about - if you can estimate cash flow then you figure out how many years out the company will have cash more than the market cap (in this case around 6-7 years)
actually i got the initial idea of VST from prof bakshi interview
and i did not know about their land bank ..but i am not taking that into account .
and i completely agree if the management were to do some financial leverage then the stock could take off