November 16, 2011

Applying models to real life

As an armchair investor, I usually analyze companies and their economic models through their annual reports and other published documents. This is a top down approach and does not involve any grass roots analysis or any kind of investigation at the ground level. At the end of the day, it has a virtual feel to it.
I recently met a distant relative, who is in the transportation business – mainly long distance trucking and started talking with him about the economics of his business. He mentioned a few key points of his business
-          The pricing in the business is very volatile in nature. He was able to get good pricing (rate per tonne) during the 2004-2008 period. The rates collapsed during the 2008 -2009 period. Rates have recovered since then, but are still not anywhere near the peak levels.
-          The current rates are slightly above break even. He is able to make good profits in a few months, but ends up giving back (looses money) part of it in the other months.
-          He had contracted with large companies via fixed rate contracts and got killed by these contracts during the downturn due to low utilization (A truck under a fixed rate contract cannot be hired out). At present, he has inflation related pricing clauses, but is unable to enforce them due to severe competition.
-          The trucking business is driven by vehicle finance from banks and NBFCs. Large companies like TCI are able to negotiate rates and payment terms with them. However as a small operator, he is unable to do so.
-          The current ROC in the business is an anemic 10-13% of capital. At the same time there is a lot of stress. Due to these factors a lot of small operators are exiting the business and he is planning to do the same.
I started thinking about the economics of the business and did a mental exercise of applying the porter’s five factor model to the business to see how the facts fit the model
a.    Entry barriers: This business has low to nonexistent barriers to entry. A typical truck costs around 22-29 lacs (total cost) and one can easily get a loan of around 20 lacs. So anyone can enter this business with a starting capital of 7 lacs. In addition, one does not need any specialized skills in this business (beyond a driver’s license and a transport permit). Finally, there is an open market for trucking service (via brokers) and any operator can contract out his vehicle (if he accepts the offered price)
b.    Buyer power: Buyer power is quite high in this industry, especially with large companies. A large cement or steel companies drives a hard bargain with the transport operator as trucking, atleast at the small scale is a commodity product.
c.    Supplier power: Supplier power is quite high too. A small transport operator has to deal with large banks or NBFC for finance and with Tata motors or Ashok Leyland for the trucks. It is easy to see the lack of leverage in this unequal relationship. Fuel is the biggest variable cost, which also is priced by the government.
d.    Substitute product: Although there is not much substitution for road transport, multi-modal transport is now becoming a viable alternative. Large operators like GATI, concor or gateway distriparks now offer a combination of road and rail transport and thus provide a cheaper option. This has now started to hurt the smaller operators
e.    Competitive intensity: This is very high in the industry. As it is easy to add capacity (does not take much to buy trucks or divert it to a more profitable routes), pricing is driven by demand and supply. Due to the highly fragmented nature of the industry, most of the small operators are price takers and are not able to earn an attractive return on capital
It is also clear that the industry is now consolidating with the exit of the smaller players. In a commodity industry, the pricing is driven by the lowest cost operator. In the trucking industry the large operators (especially multi-modal transporters) have some leverage with the suppliers and are able to drive costs down (due to scale) and thus earn an attractive return on capital.
One added reason for doing this mental exercise is that I did a short project with Tata motors in their heavy vehicle business as a management student in the late 90s. The economics for the small operator had started deteriorating then and has now become worse due to the entry of multi-modal transport operators.
At the end of the conversation, I did not want to advise my relative that he should exit this business as it would seem presumptuous (what would an armchair investor know?). However, I am guessing that he has arrived at the same conclusion without using the fancy models and would be exiting it soon.
In the end, I think it was a good learning experience for me. The trucking business reminds me of the following quote by warren buffett
‘When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’


Amit Bagaria said...

HI Rohit, i comepletely agree to your analysis..

infact before i came into the field of investments, i was somewhere in close contact with the small scale trucking industry. A few observations:

a) a lot of politicians funding in done in this feild because at small scale most of business dealings are done in cash

b) between very small players and between big multi modal players, there are also few players who owns limited trucks but do subcontract work to all these small players and operate that way.. and they do make decent money.

c)labour issues are big challenge in this industry.

I completely agree to you that this is a typical commodity industry where the guys with large capacities only make some money.

Happy Investing

Manish said...

Dear Rohit,

I am closely associated to truck business since last 15 years(I work with truck manufacturer selling trucks) and I completely agree with your analysis.

This business has perfect combination of factors associated with businesses with bad economics:
1. Low or no entry barriers
2. Almost no pricing power
3. High leverage
4. Highly fragmented market'
5. No bargaining power with supplier as well as customer.
6. Higher fixed cost putting barrier on exit

So even for Big operators things are good while going going is good but during downturn aggressive (greedy) big fleet owners may also get wiped out due to high working capital needs and intense competition from other big fleet owners for business and price pressure from large customers under cost cuttings drives.

Overall its recipe for bad business economics.

Nice Analysis keep it up.

Anonymous said...

there are many more examples like this with paltry ROCs,in which we often found our acquaintances involved in...

Sachin Purohit said...

Hey Rohit..How do you read the possible divestment of promoter's stake in Gujarat Gas? Firstly, what is not known is whether they intend to completely walk out of this business or they intend to just bring down their stake to 51% and still control this company. If they are planning to get out of it completely, GAIL and Reliance are the most probable candidates to purchase their stakes. Both case, this business might get ruined.

Not able to make up my mind as to whether to step up my buying while its stock price is plummeting.

Anonymous said...

Hi Rohit:
Your post resonates with discussions I have had with relatives. One of them is in the cloth retail business - with wafer thin margins, competitive intensity, inventory risks etc. Overall a business with no competitive advantage. Many times they keep doing the business out of sheer history - grandfather, father, 12 years in the business etc.

I had an unrelated question on Crisil. Can you comment on it's valuations & what range you would consider increasing it? Regards, DI

Rohit Chauhan said...

Hi amit
i am sure you would have a better understanding of the business due to closer contacts. from what i could gather , it is a very tough industry for all but the large or connected operators


Rohit Chauhan said...

Hi manish
i worked with telco for a short period and saw the same dynamics. the only point i would disagree is the 'greedy' point - i would say all business men are greedy - i mean everyone wants to make the highest return possible. however the poor economics of the indstury means two steps forward and 1.8 steps back


Rohit Chauhan said...

Hi sachin
i think if GAIL buys the stake it would be a positive as GAIL can provide a better supply of gas and at better prices.

I am not sure about reliance as i dont have confidence on their corporate governance.

i dont think the business will be impacted, however the quality of management will impact if the gains will come to shareholder

at the current prices, i am not a buyer ...there is cheaper stuff available


Rohit Chauhan said...

Hi anon
you hit the nail on the head - tradition. that is usually the case for staying in a business with poor economics

as for crisil - i think it is fairly value. i have not bought anything for some time. at the same i think i have been too conservative with this company which has constantly surprised me on the upside