Vardhman Special Steels - Special Situation - Spinoff

So while researching the textile sector in general, i came across Vardhman Textiles and then its spinoff company which has just started trading (May 17th, 2012) called Vardhman Special Steels. And whenever i hear of a demerger/ spinoff, I stop and pay attention, especially after I read the book - You can be a stock market genius by Joel Greenblatt.

In this situation, i really have not looked at the business outlook of VSS in detail. The valuation is that attractive. And there are other factors too:

1. The stock is trading below its liquidating value as defined by Graham. The calculations are given below:

Figures in INR Cr.

Current assets


Current Investments                                18                       100%                         18
Inventories                                              95                       66%                           62.7
Trade receivables                                    105                     80%                           84
Cash                                                       87                       100%                         87
Loans & advances                                  16                        80%                          12.8

Fixed assets
Tangible assets                                        43                       15%                          6.45
CWIP                                                     8.6                      15%                          1.3
Long term investments                             81                       100%                        80
(debt mutual funds)
Loans and advances                                12                        15%                          1.8


Total                                                                                                                   353
Total current liabilities                              188                      100%                       188
Total non current liabilities                        93                        100%                       93

Liquidating value                                                                                                  72
Liquidating value per share                                                                                   38.7

2. The promoters are the biggest shareholders holding approx 75% of the shares of VSS. So their interest are aligned with the shareholders.

3. If that is not enough to convince you of the intent of the promoters, here's more good news. The promoters have lent the company INR 66 cr through their companies. From the latest balance sheet:

Short term borrowings

From related parties
- Vardhman textiles limited              29.8 cr.
- Vardhman acrylics limites              35.9 cr

So, the promoters do have a lot to lose if the company goes down. And the share price does suggest that it is going down.

4. Currently, around 11% of the shares are held by MFs. As generally happens, the institutional shareholders will exit the demerged company after the demerger. If that happens, as i assume it will in this case, the share price will go even lower.

5. If you insist, i will tell you a little about the earnings of the company. First it is not loss making. That should be enough. Maximum i will do is look at the ROE and cash flows.

Net profit margin: 4.9%
Net asset turnover: 1.87
Leverage: 1.48
ROE : 13.6%

Last year, on a net profit of 26 cr

CFO: 5 cr.

Operating cash flow was much below net profit, because of an increase in receivables and increase in "other current assets/ loans and advances."

- Increase in trade receivables is concern and one to look out for.
- Other CA/ Loans and advances consists of advance to suppliers mostly (13 cr. out of 16 cr.) So no problems there.

6. Currently, the stock is trading around 36. Me being a douchebag deep value investor, i will wait till i can get it for 70% of the liquidating value which is 27 (something to do with margin of safety). So i will wait for it to come to me. 

Venkys

Overview

Venky's is the largest and most diversified company in the poultry sector in India. Its business can be broadly classified into the following three segments. From the company's latest annual report:

1. Poultry and poultry products - top line contribution - 65%
The company's major business is poultry and poultry products which consists of production and sale of day old broiler and layer chicks, specific pathogen free eggs, processed chicken products and poultry feed.

Broilers are chickens raised specifically for meat production whereas layer chicks are raised for the purpose of eggs. Modern commercial broilers are specially bred for large scale, efficient meat production and grow much faster than egg laying hens or traditional dual purpose breeds.

The numbers in brackets show the percentage of the overall revenue for last FY (2011).

Products:
Chicks (18.9%)
SPF eggs (2.8%)
Grown up parents (0.4%)
Grownup commercial broiler (17.7%)
Grownup commercial layers (1.0%)
Poultry feed (8.8%)
Processed chicken (15.9%)

2. Animal health products - 9.5%
The company has its animal health products manufacturing facility in Pune

Products:
Animal health products - powder (6.9%)
Animal health products - liquid (2.8%)

3. Solvent extraction: Oilseed - 25.5%

Products:
Refined oil (9.2%)
De oiled cake for poultry (10.6%)
Misc (4.9%)

DuPont Analysis
Let's first start by understanding the overall economics of the business and then we'll get into the details of specific segments. As always i'll do a DuPont analysis and look at the ROIC numbers for the overall business to get a sense of its profitability and capital intensity over the last five years. The numbers are given below:

                                       2007          2008          2009          2010          2011          2012 (9 months)
Net margin                      2.76%        5.04%       3.57%        7.64%        8.48%        3.17%
Net asset turnover          1.72            2.00          2.18            2.28           2.13           1.47
Leverage                        1.99           1.89           1.68            1.51          1.47            NA

ROE                               9.4%         19.1%       13.1%         26.3%       26.6%         NA

First the net margin. The net margin has been fluctuating over the years due to the cost of raw materials. A majority of the cost (~60% of revenues) is constituted by raw materials which is maize or soya. Also the fluctuation in the net margin of the company with the fluctuation in raw material prices tells us that the company cannot pass on the entire cost increase to the consumers. The company in the past has been able to pass on the increased raw material cost but only with a lag. Also the poultry industry in India is highly competitive and this limits the ability of the company to effect price increase. Some source of comfort here should be that the company is the leader in the poultry industry and has built up a good brand name. Hence its bargaining power should be more than that of the other players in the highly fragmented industry.

Net the asset turnover. The company is not overtly capital intensive as can be seen from the asset turnover which has been above 2 for the past 4 years. The assets of the company include Breeder Farms, Hatcheries,  Commercial farms in Uttar Pradesh, Haryana, Punjab, Madhya Pradesh, Himachal Pradesh, Gujarat and Uttaranchal. It has its solvent extraction unit in Solapur, Maharashtra and Chicken Processing and Animal health products unit in Pune, Maharashtra. However, the capital intensity of the company might change in the future as can be seen by the decreased asset turnover in 2012. This is because the company has recently ventured into fast food restaurants under the brand name of Venky's Xpress which will require substantial capital expenditure. The company has outlined a capex of Rs. 250 cr. over the next 3 years. (http://investment.contify.com/story/venkys-india-to-invest-rs-25-bln-to-open-100-outlets-across-india-expects-break-even-in-15-months-2011-11-01)

ROCE
                               2007          2008          2009          2010          2011          2012 (9months)
NOPAT                 1,489         3,120          2,557         5,902         7,694        2,912
CE                          24,273      26,467        26,441       31,113       40,400      49,299
ROCE                    6.1%         11.8%         9.7%          19.0%       19.0%       7.9%#

# Estimated by assuming the fourth quarter NOPAT as the average of previous three.

These nos. are definitely not pretty. Except for 2010 and 2011, the there has been shareholder value destruction in the remaining years. Let look at the segment results to understand the overall performance a little better.

Segment Analysis
First lets look at the net EBIT margin and capital employed in the three segments separately.

Revenues
                                                 2011                                     2012 (9 months)                     Growth*
Poultry & poultry products        59,425                                  51,443                                    16.1%
Animal Health products             8,685                                    7,103                                      6.5%
Oilseed                                     23,485                                  19,424                                    17.8%

* Comparison of the first 9 months of 2012 to the same period last year.

EBIT Margin
                                                 2011                                     2012 (9 months)
Poultry & poultry products        15.4%                                   7.0%
Animal Health products             19.1%                                   18.1%
Oilseed                                     6.9%                                     4.9%

Capital Employed
                                                 2011                                     2012 (9 months)                     Growth
Poultry & poultry products        21,516                                  28,729                                    33.5%
Animal Health products             2,712                                    3,326                                      22.6%
Oilseed                                     6,360                                    5,337                                      -16.1%

Below are the EBIT/Capital employed (per annum) to understand the capital intensity of separate segments.

EBIT/Capital Employed
                                                2011                                     2012 (again projecting EBIT for full year)
Poultry & poultry products        42.5%                                   16.7%
Animal Health products             61.2%                                   51.5%
Oilseed                                     25.5%                                   23.8%


The results look especially terrible for the poultry and poultry products segment. The company has clarified in its latest quarterly report that - "During the quarter the poultry and poultry products segment registered lower profits due to higher cost of feed ingredients and lower realizations from sale of day old chicks and grown up birds." The products of poultry segment are commoditized expect for processed chicken which contributes 16% to the revenues only. So the fortunes of the company are necessarily tied to the poultry industry. Right now the company appears especially fragile as it is getting beaten on both the ends - prices and costs. Poultry products costs (RM costs) are up and the realizations are down. Over the next year, this is expected to change and hence the profitability is expected to go up. The company has grown revenues at a CAGR of ~20% over the last 5 years. Revenue during the first 9 months of 2012 increased at a rate of 15% and this growth is expected to continue. The cyclicality of the industry will make sure that the bottom line will fluctuate with the industry.

Valuation
On a PE basis, the company is trading at PE of 10.58 on estimated earnings of FY12 and at 5.4 on est. earnings of FY13. This might look on the higher side but keep in mind that this is a cylical company and the best time to buy might be when the PE is at its highest.
P/B ratio for the company is 1.31.

But as suggested by Warren Buffet these numbers might be illusory, the only real way of valuing a company is cash flow valuation. And on that basis, according to my model a fair price of Venky's is in the range of Rs 415-540. Here i have assumed a growth rate of 10% for the next 10 years and a terminal growth rate of 3%. The range of values represents differing scenarios for the capex of the company going forward.

Ess Dee Aluminium

I noticed this stock because the private equity firm Sequoia had bought a stake in the company which they later increased. So after doing a very superficial analysis, i bought some shares as the stock has been trading at its near lows.

Now since i'm analyzing my portfolio to see if i should keep this one. So here is the story:

Ess Dee Aluminium is a leading manufacturer of pharmaceutical packaging products with core competency in aluminum packaging. With a total 37,000 MTPA capacity, the company is the largest organized packaging player in India in this segment with a market share of approximately 20%. As far as i have been able to find out, Hindalco is its closest competitor with installed capacity almost one third of Ess Dee. The rest of the industry is mostly fragmented with smaller players.

So far they have done a good job up until FY 2011 that is. Their top line grew at a CAGR of 42% during the past 5 years. Lets do a DuPont analysis to understand the company a little better.

                                      2007                         2008                  2009*                2010#              2011
Net margin                    21.9                           22.8                   -5.29                32.54               16.79
Net Asset Turnover       0.61                           0.67                  0.74                  0.86                  0.75
Leverage                       1.23                           1.27                  1.82                   1.35                 1.31
ROE                             16.4%                       19.4%               -7.1%                37.8%              16.5%

* The figure is negative in 2009 because of the merger of India Foils (That is the reason of the current predicament of the company. More on that later)
# Again the abnormal profit in 2010 because of the tax advantage of the merger.

From the table above, it looks like the company has been able to maintain a ROE of 16%. We can see that the company is capital intensive by looking at the low asset turnover. I generally like a capital intensive company if it can generate more than a rupee for every rupee invested over a long period of time. That in itself is a truism, one may people often forget. Anyway to return to the story, the share price of the company were bid up to Rs 842 at its peak in Jan 2008. After than it declined to sub 150 levels in Dec 08. After that it again soared to above 500 levels in June-July 2010 and is currently trading at around 150. This case is a classic example of the boom bust pattern frequently observed in financial markets.

My first concern in buying the stock was to see if the company has a competitive advantage. This becomes even more important in case of capital intensive companies. After a lot of research into the business model of the company, i'm still not sure about that. The company sells a commodity product and hence it might be difficult to build a sustainable competitive advantage. However, there are a few positives about the company. It has been able to increase its earnings at such a fast pace in the past because of its hub and spoke model, about which you can read more at its website or the annual report. But that alone is not much of a comfort to me.

The recent downslide in the stock prices of the company has been mostly because of the declining earnings over the past 3 quarters starting in the first quarter of 2012. It seems likely that this would continue for the next quarter as well. The management has attributed this to some problems in one of its factories at Hoera, which was acquired as part of the India Foils acquisition. This is a major concern and there is not much clarity about its impact going forward. So i was about to give up on further research and sell my stock.

But then i did a simple cash flow analysis to find out what is the minimum price at which i will still buy the stock. In my modelling i have assumed a zero percent (that's right) growth rate for the next ten years and a zero percent terminal growth rate beyond that. I have taken the cost of funds at the higher end at 16%. And i'm getting numbers in the range of  120!! So, 120 should act as a floor for the stock price. Based on the current market price of 153, the market is currently assuming a growth rate of around 2% for the company over the next 10 years. (I'm assuming a conservative terminal growth rate of 1% in this case.)

Based on the above analysis i'm not selling my shares just yet. If i'm lucky and the stock moves down even further from the current levels, i might start buying more. Meanwhile i will wait for a little more clarity on the situation to decide on the future course of action.

A little more about Polyplex

In the last post i did not talk about one major risk factor for Polyplex.

If we look at the returns of Polyplex, the return on equity for the last four years have been 16.5%, 17.3%, 14.2%, 26.15% respectively. While this may look good at first sight, it is actually not. That is because the economics of the business are not that good. It is capital intensive industry with the returns on capital invested telling a better story than return on equity. For the last 3 years for which i have calculated the ROIC (using the Stern Stewart method), they are: 11.9%, 9.7% and 25.1%. The returns for the last year are a one off thing as explained in the previous post. So the company is not doing that good as i am certain that the cost of capital is more than the returns. Couple this with the excess capacity in the industry and you should get an idea as to why the stock is so undervalued.

Doing a simple cash flow valuation, i think a fair price right now for the company is around 360. Its market price is half of that amount because of the dismal returns which if they remain at past levels will be shareholder value destroying. Additional capital invested is not really adding commensurate additional shareholder value. And the company is investing a lot of capital - 1000 cr over the next 2-3 years. The company will have to increase the returns for unlocking shareholder value going forward. That can only happen by increasing the margins as asset turnover or leverage will only come down. Now that is a very tricky part - its difficult to increase the margins in an industry with overcapacity. On the positive side the company is investing in high value products such as thick film line in Thailand.

Having said that, there is still a high margin of safety. Patient investors with a horizon of 3-5 years can definitely go in but there is no quick buck to be made here.

Polyplex Corporation

So, i've been reasearching this company - Polyplex Corporation over the entire weekend. Yes thats how i spend my weekends , really sad i know.

The positives
Right now Polyplex would seem like a solid investment, the one Graham or any other value investor would drool over. Other people have written extensively about the positives, just have to look up on the net. So, what are the positives from a valuation perspective:

At the end of FY2011, the company had a cash of Rs. 8,608 mn
That works out to approx Rs. 269 per share.
The stock is currently trading at 190 per share. Need i say more.

But wait, there is more. On top of the cash, the company has MF investments of Rs. 284 mn, which works out to another Rs. 9. So only on cash and cash equivalents the company has an upside potential of 46%, its unbelievable.

About the company
The company is into manufacturing of PET films which are used predominantly in flexible packaging. It has manufacturing in India, Thailand, Turkey, China and a new plant coming up in the USA. India contributes for about 20% of the revenues of the company and the remainder come from outside of India. The industry is expected to grow globally at the rate of 8.7% pa till 2015. This story just keeps getting better and better. But i'm not done yet.

Last year the company's topline (operating) grew by 103% from 12,666 mn to 25,704mn. It had a positive CFO of 4,904 mn (growth of 98%).

The negatives
But failing miserably to work enough on the bear case with my last investment, this time i will be a little more thorough. So lets check out what might go wrong with the astonishing story above.

1. Let me start with a caveat. This is a cyclical industry and as with all cyclical stocks there is always the big risk of buying too soon. The topline growth of 103% was a one off case because of prices of pet films doubling in 2011. This happened because of many reasons. Quoting from the annual report of Polyplex:



Market Developments
Demand continued to grow despite the Economic Crisis in 2008-09.
There had been inadequate / delayed capacity additions.

Structural changes:
Closure of some old uneconomic lines.
Diversion of capacity from packaging to industrial segment as well as conversion of thin film lines into
intermediate and thick films for new applications.

New applications
Optical industry /Photovoltaic (PV)

So, dont expect the abnormal growth to continue. In 2012, according to analyst estimates, the revenue will be 24,577 mn. Since the company has already achieved revenues of 18,377 in the first 3 quarters, i will say that is a fair estimate.

In the next 2 -3 years, a downturn is expected in the pet films industry with capacity outweighing demand. Demand supply gap is expected to increase from 500 MT in 2011 to 950 MT in 2012 to 1300 MT in 2013 before moderating to 1100 and 800MT in 2014 and 2015. So expect prices and margins of the company to go down. More research is needed to determine exactly how low the prices will go but from what i've read the experts are saying that prices have bottomed. But i will take that with a pinch of salt based on the demand supply situated i've highlighted above.

Source: http://www.pcifilms.com/main.asp?selection=News&marker=223&subsel=Have%20European%20BOPET%20film%20prices%20bottomed%20out?

2. The second negative are the high capital expenditures of the company over the next two years. The company has outlined a capex of 9,976 mn over the next 2 years. Increasing capacity at this time might be risky with overcapacity in the industry and all. So expect the free cash flows of the company to be -ve. FCF has been negative for 2009, 2010 and it should be negative for the next 2 years as well.

3. Margins might contract in the future because of increase in raw material prices. The company's raw materials are crude related and with the prices of crude going up, this could reduce margins further.

Valuation
At price earning basis the company is trading at 2.58 on 2012 estimated earnings.
At price to book, it is 0.28 (thats right)

Other companies in this industry are trading at similar PE multiples, although on PB basis, i think poplyplex is the winner (sarcasm intended :)).

In my very humble opinion, they should be trading at slight premium to other companies in this industry. Allow me to explain why.

Jindal Poly Film is in the exact same industry as Polyplex. JPF is trading at a PE of 3.7. On a little more research, I found out that JPF has been investing a lot of cash from this business into their other businesses such as Power giving a middle finger to the shareholders. Same is true of Uflex although it is strictly not in the same industry as Polyplex. Polyplex on the other hand has been investing all the surplus to the shareholders. Given that they have a lot of cash at the moment and whether it would have been in the best interest of shareholders if they rewarded the shareholders through a buyback? Is reinvesting all that money the right decision. That is a question to which i dont have an answer. But based on the share price, market has not taken their decision to reinvest all the money very kindly. But in my opinion, reinvesting the money in the same business shows the management is committed to doing this and they are not using this as a cash cow for other  businesses.

So my dear friends, after all this analysis, i think i know which way i am heading. You can make your own decisions. Although if you do uncover anything i've missed here, please be so kind as to let me know. Any information will be much appreciated. Thanks.

Educomp solutions - great earning potential - not really

I think i was a little naive as far as my last investment goes. Since, i've sold all Educomp and happy to get out of it. The great earning potential of Educomp has been built on a very shaky foundation and i have reason to believe that the stock will go even lower. Much lower that most people believe.

I've been reading a book - Financial Shenanigans by Schilit. Basically the company has been very aggressive in revenue recognition. I have reason to believe that the primary segment of the company - Smart Class, is not doing that well. So they have started selling receivables through a complicated structure involving a SPV. Without going into the details, let me just say that this is one of the most apparent signs of declining revenues. At the same time, IMO the company has been foraying into a host of other things to make up for the declining revenues from Smart Class. They havent been very successful in this endevour as still more than 95% of the revenues come from Smart Class. Randomly diversifying into every sector in education just shows how desperate the company has become.