November 22, 2010

Construction material companies – Visaka and Hyderabad industries

I recently came across this industry as this sector seems to have been beaten down by the stock market. The stocks in this sector are selling at PE of 5 and below. Anything cheap always catches my eye!!

So if the stocks seem so cheap, one should sell his house, his cows and everything else and load up on these stocks? Not really. A low PE does not always mean undervalued and vice versa.

About the Industry
The construction material industry includes cement, steel and various other raw materials required to make a residence. However, I am specially referring to companies such as Hyderabad industries and visaka which are mainly in the business of cements asbestos and other fiber based roofing sheets and flat products such as pre-fab panels and boards

These products are mainly used by the poorer sections of the society in roofing their houses as they move from a tiled house to a better constructed and durable house. In addition the pre-fab panels and boards are used as partitions and in other applications where plywood or particle boards are used. So these products are mainly a substitute for these wood based products.

The macro opportunity
I think it is obvious that there is a macro tailwind behind the industry. The rise in the per-capita income, especially in the rural areas, is resulting in investments in better housing. The rural poor tends to improve the quality of shelter and the graduation is from thatches and tiled roof to better roofs such as asbestos or GI roofs. In addition the government also has several housing related schemes for the rural areas, so there is definitely ample demand in the sector.

A growing demand and large opportunity may be a good starting point for an attractive investment, but it is not always the case. A good investment needs to satisfy several additional criteria.

The industry economics
We now come to the more crucial aspects of the industry. The industry topline is likely to do well (other than the issue of the asbestos ban - more on that later) due to the growing demand, but that need not translate into a bigger bottomline or higher net profit.

Although the industry is characterized by a large number of companies in the sector, the top 4-5 companies account for almost 60% of the market share. The top 2 companies – Hyderabad industries and visaka account for 35% of the market share alone. So the industry is not too fragmented.

At the same time, one can see that the entry barriers in the industry are low. It is not too difficult to setup a plant (takes around a year to do so). The main barriers are mainly the marketing, distribution and branding of the product. However as the product is mainly regional in nature (due to high bulk), a company can build capacity in a small region and build out its sales and distribution network in the region at a reasonable cost.

In addition, although brands could make a difference, I don’t think brands enjoy too much pricing power in the industry. The financial results of the companies show that margins are highly dependent on the demand and cost factors such raw material pricing. A company with powerful brands and high pricing power will have stable margins over a business cycle. That does not seem to be the case with this industry.

Raw material such as asbestos and cement account for more than 55% of the total cost of the product. Transportation and fuel account for further 10-15% or more of the total cost. As a result the industry has been impacted by the rupee-dollar rate (asbestos is mainly imported) and other raw material based cost factors in the past (2008 being one such year).

The industry also has competition from substitute products such as GI roof and other materials and so the demand depends on the price of these substitute materials too.

Due to the part commodity nature of the industry, there is a lot of competition between the multiple players in the industry and hence one cannot claim there is a high competitive advantage for the main players in the industry.

Performance of the top two players

Hyderabad industries
Hyderabad industries is a C K Birla group company and has been in this business for 60 odd years. The company has one of oldest roof brands called charminar.

The company used to have a loss making division –heavy engineering till 2004 and as a result was not a profitable company. This division was sold off in 2004-2005 and the ample cash flows during that year were used to reduce the debt. The company has been able to bring down the debt equity ratio from 1.3 to 0.3. The total asset turns have remained steady at around 2.1, with substantial improvements in debtor turns and additional investments in plant capacity to meet the growing demand.

The net margins of the company has ranged between 5-7% in the last 5 years, with last year’s margins in excess of 12%. The margin improvement has been mainly due to reductions in manpower and interest costs.

Finally the company has been able to grow the topline at around 12-13% and bottom line at around 20%+ levels in the last 6 years.

Visaka industries
Visaka industries is a Hyderabad based company and has been in the business for the last 20 odd years. In addition to the roof and other building material segment, the company also has a textile products division which accounts for 20% of the revenue and is a fairly profitable division in itself.

The company has improved the ROE from 15% levels to 20%+ levels in the last 6 years. The improvement has been mainly due to a slightly improvement in fixed asset turns and an improvement in debtors turns (debtor as % of sales has reduced). The net margins have held steady between 6-7% with slight drop in interest and manpower cost, being offset by increase in raw material costs.

Although the company has been able to bring down the debt to equity ratio over the years, the overall debt has gone up as the company has used a combination of debt and profits to expand capacity and put up new plants across the country.

The company has been able to grow the topline at 20%+ levels and the profits at 30%+ levels.

My current thoughts
The entire post till now has been a narration of the facts and past performance. The past performance of an industry has to be used as a starting point of our analysis to think about the future economics and performance of the industry (not the next quarter!).

It is quite obvious that the companies in this industry do not enjoy a great competitive advantage from current and future competitors. As a result it is unlikely that the industry as a whole would enjoy very high returns as seen in 2009, over a period of time. The high demand is already driving a lot of capacity addition in the industry (both visaka and Hyd industry are adding capacity) and this will have a depressing effect on prices.

In addition, if the demand slows down or if there is any other hiccup, the margins can drop even further. If one looks over the last 6-8 yrs, it looks reasonable that these two companies are likely to make around 6-7% margins over the entire business cycle and an ROE in the range of 10-14%.

If one takes visaka as an example, it seems to be selling at around 5-6 times 2009 cash flow. Hyderabad industries is selling at around the same valuation levels too.

Are these levels cheap? Now that is difficult to say, though prima facie it appears to be so.

Current conclusion
I am still in the process of studying and analyzing these companies. I have on purpose written a post in the middle of my analysis to show my process of evaluating stock ideas and arriving at a decision.

I have already completed the quantitative part of the analysis and read up the annual reports of the two companies. I have completed around 70% of the analysis and 50% of the thinking. At this stage if I have not rejected the idea, I will proceed with my valuation template (download from here) and start a structured thinking process to arrive at a conclusion.

I have several questions in my mind which I need to resolve –
- Visaka industries is planning to invest 5000 Cr in power project. How does that change the risk?
- Hyderabad industries and visaka have had poor profitability in the past (2007-2008 and earlier) when the capacity ran ahead of the demand. Are we in that phase already and likely to see depressed profitability in the coming quarters?

The annual reports and the numbers are always the easier part and only a guide to make a decision. If the past numbers alone were sufficient, then the whole work of fundamental investing could be converted into an automated program. Fortunately for my style of investing, it is not likely to happen anytime soon.

Additional disclosure: I do not have any position in the stock. As I continue with the analysis, I may decide against creating a position due to various qualitative factors. Please make your own decision before buying these stocks.

12 comments:

Pradeep said...

Hi Rohit,

That was a wonderful post. I have a few queries:

- A lot of what you mentioned above also seemed qualitative to me but you specify that you have completed the quantitative part of the analysis. Can you explain what these two parts are?

-To what extent of detail do you go in annual reports. Do you read it fully from page 1 to last page? Also do you read only last years or 3-4 years reports (again fully or specific parts)?

Wonderful post and gives very good idea as to how one must think of investments.

ramurthy said...

rohit,
I dont think asbestos sales will grow significantly.people with thatched roof will only think of concrete houses even though very small and not asbestos(also it is banned in many countries for health reasons)

JAISHRIKRISHNA said...

very nicely written as always, i would like to add that as the stock price is falling the div. yield of these co's is getting better, would like to know that will cash and cash equivalents on the balance sheet will be considered by you while taking a firm decision, its very hard to find value in current market, but do these stocks offer value or they are value traps is to be seen, frankly speaking i was considering buying Visaka on every red day, but as you have started evolving into this sector, i will be very much glad to know the outcome of your final analysis.

Warm Rgds,

Manish.

Arjun said...

Is there any reason why you did'nt consider Ramco industries?

Rathin Shah said...

Refer:
http://www.bseindia.com/xml-data/corpfiling/AttachHis/Navin_Fluorine_International_Ltd_151110.pdf

Hi Rohit,

Navin Flourine had announced a buy back (3.3% of the total equity). BB price is 400/- vs. CMP of 280/-. I can't handle special situations correctly, so required your help on this. What do you think?

Regards
Rathin

Mohit Rathi said...

It is specifically mentioned that Charminar enjoys good sales and prices due to its brand explicitly in Hyd Inds AR and implicitly in Visaka's AR.

I will buy Hyd Ind if the yield goes above 4.5%. Right now am going to apply all I got in MOIL IPO. What is your opinion on that?? I think its a no-brainer.

Regards
Mohit

Rohit Chauhan said...

hi pradeep
if you look at the first page of my template..i cover the numbers there. thats quantitative part. doing DCF and other valuation are also quantitative

all the rest is qualitative analysis. on the AR is read for last 10 yrs for every alternate year. will cover most of the report and in the earlier years i will look at the director's report, MD&A and look at the p&l, balance sheet, cash flow and the schedules

rgds
rohit

Rohit Chauhan said...

hi ramurthy
true ..agree with you. only issue is whether companies will make money or the profits will be competed away

rgds
rohit

Rohit Chauhan said...

Hi jaikrishna
i consider cash and equivalents too..but ofcourse thats just one piece of the puzzle. i will be posting rest of the analysis soon

rgds
rohit

Rohit Chauhan said...

hi arjun
no reason ..will look at it soon

rgds
rohit

Rohit Chauhan said...

hi rathin
the buyback is very small ..hardly 3% and will use up a small part of excess cash. i had a look at the company based on rayhaan's comment and i dont like the company one bit.
also with a 3% buyback its not really an arbitrage situation as you will be left the most of your holding after the buyback and then have to figure what to do with it

rgds
rohit

Rohit Chauhan said...

Hi mohit
i havent looked at the IPO ..i generally avoid IPOs ..some of them can be attractive, but most are overpriced. i dont know about MOIL though

rgds
rohit