December 1, 2010

Continued analysis – Hyderabad industries

Statutory warning – Long post detailing further analysis of the company. Can knock you off to sleep – please be seated while reading :)

I described my process of analyzing two companies from the sector – construction material, in an earlier
post. At the end the analysis, the only conclusion I reached was that the companies were still attractive enough to continue my analysis and invest more time in them.

I had a look at visaka industries and for non quantitative reasons have decided not to go further with it. The main reason is management. I am not comfortable with the open ended risk of the investment in the power plants at a cost of 5000 crs. I do not have clarity on it and hence in view of a risk which I cannot evaluate, I decided not to pursue the analysis any further.

We can debate back and forth on this, but my personal approach is to look at it as a binary decision. If I am not comfortable with the risk, I tend to quickly move on. There is no point in doing some fancy calculations here. I may have missed quite a few opportunities in the past, but this approach has also helped me avoiding risks which I don’t understand. I would rather commit the error of omission than the error of commission.

Hyderabad industries
I have initiated a deeper analysis of Hyderabad industries now. The performance of the company has been good, but unspectacular in the last few years. Ofcourse one cannot expect spectacular performance in a commodity and mature industry such as building construction material.

The company re-structured in 2004 and has since then been doing fine. The company has been able to maintain a net margin in the range of 6-9%, ROE in excess of 15% , a top line growth of around 10% and a bottom line growth in excess of 15%. It is important not to take 2009 as a representative year in making these calculation, as margins were far above average in that year and these margins are already trending down in the current year.

Rough cut valuations
Once I am comfortable with the fundamentals of the company, my next step is generally to do a very rough cut, fundamentals based and price based valuation (see page – other valuations in my valuation template).

The reason for a two fold check is to quickly see if the fair value of the stock is below the current price and then to compare the current valuations (current PE) with the valuations in the past (around last 10 years). The past history of the valuations allows me to look at how the market has valued this company in the last 10 years. In addition, when you compare these valuations with the fundamental performance, you tend to get a lot of insights into how the market looked at this company in the past (more on it in the next few paragraphs)

The normal earnings of the company can be taken as around 40-50 Crs over a business cycle. So one can very roughly value the company at around 400-550 crs.

The last ten years of valuation shows the company’s PE has ranged between a low of 4 and a high of 10-12 (ignoring the extreme low valuations of 2008-2009 when everything crashed). These valuation levels have to be compared with the earnings of the company which have been very volatile.

It is obvious that the company saw rapid price increase in 2004-2006 when its fundamentals improved and saw a PE of around 10 times peak earnings. After 2006, the margins started dropping due to higher capacity and so did the stock. The stock price did not recover till late 2009 when the fundamentals started improving again.

The current valuations and price may appear as bargain based on the recent history, but looking back a few years, it does not look like a no-brainer.

A 20% price drop from here could make it a very compelling buy.

Question – what if the price runs up and I miss the opportunity?

Response – Well that’s the risk of being patient. I would prefer the price to come to me, rather than chase it. If not this company, then there are 5000 other companies to look at !

Checklist analysis
At this stage, even if I am not completely bowled over by the price, I will perform a checklist analysis on the company. I have listed various checks on the accounting, business model, management factors in my valuation template, which I run though to find any specific red flags.

Some of the key highlights of the checklist review
- Company has around 35 Crs of contingent liabilities (taxes etc). This translates to around 6 months of annual profits. Nuisance, but not too much to worry about
- The company has a foreign exchange risk due to import of asbestos which accounts for around 50% of total raw material costs.
- No specific accounting red flags

Competitor/ industry analysis
The next step for me usually is to analyse the industry and competition and see where the company stands viz-a-viz other companies. This industry is partly fragmented, but the top 4 players account for almost 65% of the market share.


The top four players are
Hyderabad industries
Visaka industries
Ramco industries
Everest industries

On checking the fundamental performance of all these companies, it seems that their average ROE is in the range of 13-20% range. The debt varies from 0.4 (for visaka) to .75 for ramco industries. Sales for the top 4 companies have grown by an excess of 20% and bottom line by around 10-15% range. These are not exact numbers, but they paint a decent picture of the industry.

Some key takeaways are
- The ROE for the industry over a business cycle is around 13-15%
- The topline for the industry is growing (as expected), however competition has ensured that profits have not grown as fast
- The net margins for the industry are in the range of 6-7%.
- No specific company has a breakaway performance from the rest of group, yet Hyderabad industries and Visaka seem to have slightly better performance and low debt levels
- Small amount of industry consolidation seem to be happening as the top players are growing faster than the market.

In summary, the industry leader – Hyderabad industry is only slightly better than the other competitors and seem to selling at cheaper levels.

Multiple model analysis
I have borrowed this approach from Charlie munger, who has stated that one should apply various mental models from multiple disciplines to improve decision making. For example – economic models of demand and supply, psychological models etc.

A few key takeaways for Hyderabad industries
- The demand and supply elasticity for the industry is high. In plain English that means that any drop in demand will cause commensurate drop in price which is bad for profitability
- Competitive advantage in the industry is weak and limited to brands, distribution network and to sourcing from the production side.
- Management seems to be rational and has disposed off weak businesses in the past.

Inverting the problem
What will cause one to lose money on this idea? I always ask myself this question to find disconfirming evidence. I can think of two points
- Demand supply situation worsens with new capacity. This would cause price to drop and a lowering of profitability. 2009 profitability was much higher than average and reversion to mean will not be good for the stock
- Industry is cyclical and hence net profit and stock price may trend downwards in the subsequent months (capacity addition or surplus capacity is available)

Final conclusion
I could go on and on in terms of further analysis, but in interest of keeping the post to a reasonable size, let me summarize my thinking till now

The sector seems to have above average profitability over a business cycle. In the recent past, the margins and hence profitability were above average and hence the stocks in this sector appear very cheap.

It is important to value stocks in this sector based on normalized profits and make a decision based on that value. The past few years of data shows an average margin of around 6-7% for most companies – except for extreme demand collapse or shortage conditions. In view of this, Hyderabad industries seems to have fair value in the range of 500-550 Crs for the company. At current price, it is at a discount of around 40% to fair value.

I do not have a position in this stock and will continue to analyse further and may or may not take a position. The above analysis was for illustrative purpose only and if needed, to put you to sleep :) …sweet dreams !

14 comments:

Vic said...

Thanks Rohit for the analysis, it didn't put me to sleep at all..i.e. you could have written further. :-)

Vikas

Kunal Vassa said...

Rohit,

Whats your call on ramco industries?
Good management group, diversified business, good yields and moreover it has investments in quality stocks whose market value for more than its market cap...

- Kunal Vassa

Anonymous said...

nice analysis. At what price would you be comfortable to buy it ? Also can you throw some more light on charlie munger's mental models & his book Charlie's alamnac ?

Regards

vinayak

Ramanand said...

Hi Rohit,
Nice to follow through with your detailed thoughts. May I ask what kind of red flags do you look for in a company's accounting books?
Also, when you see a company and try to judge its prospects what are your typical sources of information?

Thanks
~Ramanand

Somenath said...

Hi,
I am trying to find Charlie's book - "Poor Charlie's Almanack" in india for past one month without success.

Can anyone help me where can I find it?

Regards,
Somenath Paul

rajsmusings said...

Hi Somenath,

It's almost impossible to find in India. I have tried my best and failed. Finally i got it from US. May be i can help. Which city do you stay in ?

Regards
Raja

rayhaan said...

hi rohit, saw the link l8er in the post(sorry 4 d goofup,but still cant c any sign up button, it surely doesnt luk mobile friendly).just had a few questions-
Q.do u think it's a gud idea 2 have a luk at money matters.? I mean as long as the a/c is alright and no serious liability is imposed on the firm, it might still make a gud investment right?
Q2.pls have a look at empire industries.i mean crisil like numbers and probably quality 2!
P.s speaking of crazy situations , u might like to have a look at dhandapani finance,its an nbfc trying 2 go thru a deep cdr. Even though the chances of a bankruptcy are there, it might just prove to be a multibagger if the cdr goes through without hurting the shareholders too much , in this age of bailouts who knows? (i believe the results of the cdr process should be out in december.Btw i shot them an email seeking various details of the restructuring and they shot 1 right back asking me my client id/portfolio no. Is it a gud idea to give it away? In case u r wondering ,the co. has come under new management) . Really eager to hear ur views.tc

Somenath said...

I stay in Pune.

Rohit Chauhan said...

Hi vikas
i feel asleep while writing :)

rgds
rohit

Rohit Chauhan said...

Hi kunal
I did not dig deep into ramco. found hyd industry to be decent, but did not realise ramco has investment more than mcap. will look into it

rgds
rohit

Rohit Chauhan said...

Hi vinayak

any price of 380 or below. ofcourse this is not set in stone ..it can go up and down based on the company's fundamentals

charlie's book is a great book ..an absolute must read. i have read it 2 times and i think i will do it a couple of times more

rgds
rohit

Rohit Chauhan said...

Hi ramanad
difficult to list all red flags in a single comment. i have a list which i go through ..like depreciation policy, revenue recogonition, bad debt write offs etc

my sources are annual reports, any thing i can find on google and beyond that there are some smart investors i talk to usually ..so check with them

after reading all this, i take a cup of coffee (dont drink) and just think :)
rgds
rohit

Rohit Chauhan said...

rayhaan
can you split your comment a bit ..and write in english :) ..couldnt understand it

rgds
rohit

Mitesh Take said...

hi,
Rakesh Jhunjhunwala has invested in Visaka on 22-Apr-2010 at price Rs.151.75 . see bulk deal