Monday, 30 April 2012

Mazda Limited: Engineering A Value Play

In my last post, I wrote about Mr.Pabrai's book Dhandho Investor (Click here to read) and Mr.Pabrai's insistence on making an investment only if it presents an opportunity where Heads you win but Tails you don't lose much. And coincidentally, as I was running through my value screen, spotted a very interesting opportunity befitting this philosophy. 

Mazda Limited is a custom engineering company that is engaged in business of  manufacturing vacuum system and associated equipment, evaporator systems and air pollution control equipment. Since last 4 years, it has also diversified into food business catering to market for instant drink powders, food essence and food colors with brand name of BCool.  However, custom engineering business remains company's main stay as it derives more than 90% of its revenue from engineering business. Mazda has technology tie-up with Croll-Reynolds , a world leader in customized vacuum system design. Croll-Reynolds also holds 6.8% stake in the company (earlier 11%) and has a nominee director on the board. Mazda also claims to be the only company in India to offer one of the world's largest test facility to simulate actual operating conditions. Being a chemical engineer and having worked on process side, I feel this may be a big advantage as simulating actual operating condition will be very useful in optimizing the vacuum system performance and reduce steam consumption to minimum level. As far as my limited understanding, not many players in India have such state-of-the-art set up. 

Mazda Limited is promoted by Sorab Mody and has scaled up significantly in last 10 years. It has grown it's revenue from 12.63 crores in March 02 to 89 crores in March 11, achieving CAGR of 21%. Similarly, net profit has grown ten fold (after deducting extra ordinary profit made in FY 11 on sale of valve division) from 0.86 crore to roughly 9 crores , CAGR of 26%. It is important to mention here that Mazda operates in highly specialized business of custom engineering which is less competitive than general engineering business. Moreover, it is an asset light business which derives its value from intellectual inputs (i.e. design of vacuum system and evaporators which is proprietary/customized). This is clearly reflected in ROCE/ROE performance of the company. Mazda has consistently achieved ROCE in excess of 25% for last many years. ROE of the company has remained above 22% for last several years. High ROCE/ROE indicates that company operates in niche business and can generate superior returns on capital/equity employed. Another glaring fact  is that large part of company's growth has come from shareholder's equity as Mazda has consistently maintained very low debt to equity ratio (less than 20%) throughout 10 year period. Currently, it is a debt free company. 

In 2010, company sold of its valve division to Circor India Limited (subsidiary of US based Circor International) for 22 crores. According to AR for FY09-10, Mazda's valve division had turnover of roughly 10-11 crores (based on equipment wise revenue break up on page -37). Circor International is a fairly large company with its flow technology division having annual revenue of around USD 265 million in 2011 (it has two other divisions as well). A US company of this size buying a division indicates  high level of quality standards/manufacturing practices adopted by Mazda. For the above mentioned deal, Circor India paid 2 times revenue for buying out valve division of the company. Mazda received 18.7 crores as upfront payment while remaining money is to be received in June 2012 (roughly 2.5 crores after working capital adjustment). 

Now, let's look at Mazda's valuation. Currently company's market cap is around 39 crores. Based on September 2011 half yearly filings, Mazda has 13.37 crores in investment (all of it in mutual fund) and cash and cash equivalent of 4.04 crores. Mazda will receive 2.5 crores in June 2012 from Circor India. In all company will have cash and liquid investment of roughly 20 crores. This means, market is assuming discounted value of future earning at 19 crores (Market Cap - liquid investment- cash). According to 9 monthly data, Mazda has net profit of 6.72 crores, amounting to annual profit of 9 crores. Mazda has expanded its capacity by 15-20% and hence FY 13 profit is likely to be at least 20% higher (even though this year, company's margin has been substantially lower than last two years and if it improves in FY13, profit can be significantly higher). Hence likely payback for the investment net of cash+ investment is going to be 2 years. This is a base case scenario, in my opinion, and fairly lucrative one too!

On the other hand, let's assume that company is for sale, what value its peers/competitors will be willing to pay to acquire the company? If I assume company will receive at least as good valuation as that of its valve division, i.e 2x revenue (which in my opinion is conservative as vacuum/evaporator business is less competitive than valve business and possess characteristics of niche business. Moreover, there is substantial real estate value to its factories located in Ahmedabad), FY13 projected revenue of 108 crore (1.2*90 crores due to 20% capacity addition), company will be valued in the range of 200-220 crores. This is 5.5 times current market capitalization! 

So what's the deal? If I win (if things go better than expected or market bridges the gap between intrinsic value i.e. close to private value of the company and price) I can get 4-5 bagger . If I lose (no growth, margin at current levels only), I am making investment having payback of 2 years (not bad by any standards!). 

However,as in any investment thesis, one has to take  facts and figures with a pinch of salt! So let me show you some areas where things can go wrong...

Negatives:
  • Promoters have low shareholding (34.19%) which may expose them to hostile take over (even though chances are very less due to un-leveraged balance sheet)
  • Mazda's competitive edge is largely dependent on design/know how of Croll-Reynolds. If things go wrong and technology transfer arrangement is discontinued, company may face uphill task of developing intellectual capital comparable to that of Croll-Reynolds .
  • Mazda has diversified into food business, which, inherently is a low profit margin business. If company is not able to manage this diversification well and allocates inordinate capital for expansion, company's prospects will be negatively impacted. 
And finally, some icing on the  cake...

Positives:

  • Promoters have been slowly buying stock from the market which indicates their belief in future prospect of the business (most recent acquisition at price of Rs.86, not too far from current price!)
  • A large part of the export revenue (80%) is derived from Croll-Reynolds. Croll-Reynolds have bought equipment worth 15.5 crores from Mazda in FY11 up from 6.53 crores in FY10. This may indicate Croll-Reynold's confidence in the company.
  • Management has consistently maintained/increased its dividend since last 10 years. Moreover, management rewarded shareholders when they received proceeds from the sale of valve division by declaring interim dividend. 
  • Management has clearly indicated in ARs that they are operating in custom engineering business which has limited competition. They also indicated that company possesses pricing power which will help it protect its margin in case of increase in raw material costs. This affirmation validates the premise that Mazda possesses sound business economics. 

In all, Mazda represents an investment opportunity to buy a niche business with pristine balance sheet and high ROCE/ROE at dirt cheap valuation where probability of permanent loss of capital is minimal while potential upside can be significant.

Disclosure: Views expressed in this post are individual and shall not be construed as buy/sell investment advice. All the readers are strongly encouraged to carry out their own due diligence. 

Tuesday, 24 April 2012

The Dhandho Investor: Heads I win, Tails I Don't Lose Much

Recently, I finished reading veteran value investor Mohnish Pabrai's highly acclaimed  book Dhandho Investor: The Low Risk Value Method to High Returns. Mr.Pabrai started managing money in 1999 with Pabrai Investment Fund and has generated compounded annual returns of close to 18% net of all expenses for 12 years. Thus, he has vastly outperformed the S&P and DJIA. 

Dhandho Investor is a thoroughly enjoyable read as Mr.Pabrai very succinctly illustrates how age-old approach of Gujarati and Marwari community to doing business deeply ingrains value investing philosophy. The book starts with how the first Patel family migrated from Africa to USA, decided to enter into motel business which is relatively simple to understand and operate (Investing in existing business, Investing in simple business). Motel industry was going through a tumultuous phase (Invest in distressed industries/businesses) and motels were available at dirt cheap rates for buying presenting enough margin of safety. Moreover, the value proposition on the table was so good that bet will result in to multi-fold returns on success while the downside was capped (Heads I win, tails, I don't lose much). So, Mr. Patel decided to take a plunge and put up entire chunk of saving to finance owner's equity, while rest of the money is lent by banks (Few Bets, Big Bets). Once he is successful in his venture, his relatives also follow same model and copy his strategy, which turn out to be a great success for them as well. 

Key elements of Dhandho framework as outlined in the book are as below. 

  • One should invest in existing businesses with long history of operations that has established business model. This will allow investor to analyze the past performance of the business, its profitability and cyclical nature of business. It is much safer to invest in existing operating business than investing in a start-up.
  • One should invest in business that is simple to understand and operate. Mr.Pabrai suggests that even though, methodology for arriving at intrinsic value is quite simple, it is not easy to arrive at intrinsic value of business. With an example, he illustrates that even for a simple business, intrinsic value will have range of estimates depending upon assumptions taken to arrive at intrinsic value. If the business is not simple and is fast changing, estimation of intrinsic value will have far more diverse range and prone to sharp change in intrinsic value. He suggests staying with businesses that are very slow changing as one can, with reasonable certainty, predict future cash flow for next 8-10 years.
  • According to Mr. Pabrai, investors must continuously scan  businesses and industries under distress. This is essential for getting into great businesses at bargain price, as many a times, market only factors near term negatives in the industry or business while losing focus on long term drivers of the value creation. In general, market does not like uncertainty and hence perceives lack of certainty as risk thus bringing down the price of the stock well below its long term intrinsic value. Thus a business/industry in distress may provide a good entry point for an investor
  • Investors shall make investment choices that exposes him to situations where loss on downside is minimal while potential upside is multi-fold. He call this strategy  "heads I win, tails I don't lose much". Typically these opportunities are surrounded by high uncertainty but low risk and clearly reflects mis-pricing by the market. If investor creates a portfolio comprising of handful of such businesses, he will be able to obtain very high returns with minimal risk. A key to identify such opportunities is to find businesses which are surrounded by uncertainty/fear and understand various possible outcomes and assign probabilities to such outcomes for such businesses(which requires primary understanding of the business and industry.) including probability of permanent loss of capital. 
  • When investors identify a bet where odds are overwhelmingly in his favor, one must bet big as opportunities which passes all criteria of Dhandho framework ( simple, existing business having strong moat, available at substantial discount to intrinsic value and exposing one to very high potential upside) are very rare. This strategy is essential for maximizing one's returns. In other words, he suggests that developing a focused portfolio comprising of small number of stocks is the best approach to maximizing returns from value investing. He suggests "Few Bets, Big Bets, Infrequent Bets". 
  • As a disciple of Mr.Buffet, Mr. Pabrai stresses importance of "moat" or "sustainable competitive advantage" and "margin of safety" as central thesis of investment. 
  • As a value investor, I have struggled to understand how long one should hold onto a business, in case if the price does not approach intrinsic value (as perceived by investor) even after a year or two. He suggest, from his experience, 3 years is reasonable time frame. In his experience, most of the market anomalies are taken care of in around 3 years. Hence if in 3 years, price does not approach intrinsic value, it is better to get out of investment as opportunity cost of holding onto such investment may be very high. He also gives rationale behind time frame of 3 years. He very interestingly points out that as value investor, buying a right business is like penetrating a "chakravyuh", however if one does not have exit strategy (i.e. to sell) in place, result may be sub-optimal. 
  • Finally, he has an opinion on crucial question for individual investors on whether to invest in index fund or run an actively managed portfolio. Mr.Pabrai, suggests that he would prefer passive investment in stocks selected based on "magic formula" designed by Joel Greenblatt rather than investing in index fund. I am not too sure if that is the right approach as I have not delved into how exactly "magic formula" works. 
In all, Dhandho Investor is worth every penny due to Mr.Pabrai's grasp of the subject, fresh perspective that he brings to central ideas of value investing , crystal clear thought process (no ambiguity at all!) and writing style that truly caters to individual investors. 

Strongly Recommended!

Thursday, 12 April 2012

Piramal Healthcare- Gazing Through Crystal ball- Part 2

In the Part-1 of this post, we reviewed three different businesses of PHL namely CRAMS, critical care and research division. As described in the earlier post, I have tried to be as conservative as possible while trying not to be projecting doomsday scenario at the same time. So let's do a small recap of revenue and investment projection for three businesses discussed in Part-1

Custom Research & Manufacturing: Assuming PHL is able to grow business at least as well as industry (historical data suggests that they have out performed industry), in 2016-17, one can expect revenue of INR 3500 crore with investment of roughly 1300 crores. 

Critical Care: One of the leading players having entire range of product portfolio and sales and distribution network, PHL shall be able to clock revenue of around  1500 crores with estimated investment of 1000 crores. 

Research Division: A business which is exposed to positive black swan. However, while counting for revenue, I have tried to derive expected value  based on actual receivable benefits in immediate future only (e.g. only upfront payment for out-licensing deal is considered, rest of the elements are not considered). Based on this, I arrive at revenue estimation of around 2100 crores with investment of 800 crores. 

So now moving on let's analyze rest of the three business namely OTC, NBFC and real estate private equity. 

OTC Business: PHL's OTC business comprises of 7 brands such as i-pill (emergency contraceptive pill), Lacto Calamine (skin care), Saridon (headache), Superactiv complete (nutrition supplement), itchmosol ( itching), Triactiv (nutrition suppliment) and Polycrol (acidity). Some of these products such as lacto calamine, Saridon and i-pill are household names. OTC business in India is expected to grow at 16-18% in next few years and will reach size of around USD 10 billion  from current size of roughly USD 2 billion. 


OTC business is driven by two things, building brands and distribution network. Both these activities will require substantial investment. Once the brands are well established and availability of the product is ensured, sales will be driven by "pull" rather than "push". In my opinion, PHL's portfolio of  brands can be categorized as follows 

Strong brands: LC, i-pill, Saridon and Superactiv 

Moderately strong brand : Polycrol 

Weak brand: Itchmosol and Triactiv  

So if we consider that PHL has 4 strong and 1 moderately strong brand out of 7 brands and financial capacity to make large investment in brand building and distribution network, it can grow at probably 25% CAGR in terms of revenue (OTC business is likely to grow at 16-18%). This will mean annual revenue of around 700 crores (taking 225 crores as base in FY 12). PHL has indicated investment of around 2500 crores in OTC considering inorganic growth. Even though, I have not considered inorganic growth in CAGR projections, to be on the conservative side, I will keep investment number at 2500 crore. 

NBFC Business: PHL has entered into NBFC business and started lending money. According to PHL, they would like to attain asset under management of around 6000 crores in next 5 years. As we do not have any benchmark in terms of past performance in this business for PHL, i would like to take management's guidance on its face value. Moreover, the target set by the management seems to be achievable compared to market potential of NBFC and niche area that they want to target such as real estate, education and hospitals. All these sector are currently not served by existing NBFC players (to the best of my knowledge)

In order to derive at revenue generation for NBFC, I have tried to look at other NBFCs such as IDFC and Shriram Transport to understand the ratio of revenue to AUM. In case of IDFC, 5 year average revenue/AUM is around 25% while that of STFC is around 14.5%. I will take lesser of the two and assume 15% revenue/AUM ratio which will mean revenue stream of around 1000 crores   from NBFC operations. Management has guided that investment required will be around 1000 crores. I will stick with management's number. 

Real Estate PE business:  Let me be candid here and admit that I do not know how to value (or predict revenue) for real estate PE firm. I believe that typical valuation of a PE firm is around 4-5% of Fund Value, however I do not know either the methodology or has grasp of the business to give any insight. Management has guided that they will invest roughly 1000 crores and manage funds of around 13,000 crores. So how should I value this business? After pondering over this, I decided to not put any revenue number and assume that by not valuing this business I am providing for "margin for error" in my estimates for other businesses. What I will do is, I will not count revenue from this business while will consider investment of 1000 crores in this business in the investment section. 

So at the end of the whole exercise, my conservative scenario, following are revenue and investment numbers. 

Revenue (in Crore): 3500 (CRAM) + 1500 (critical care) + 2100 crore(research) 
                            + 700 (OTC) + 1000 (NBFC) = 8800 Crores

Investment (in crore): 1300 (CRAMS) + 1000 (critical care) + 800 (research) + 
                               + 2500 (OTC) + 1000 (NBFC) + 1000 (real estate PE)
                              = 7,600 crores

PAT Estimates: 10 year average PAT for PHL's pharma business was 10.4%. However, in next 5 years, PHL is going to have tax shield of loss making research division which is going to bring down PHL's tax rate to 7-8%, less than average tax rate for last 10 years. Reduced tax burden shall translate into higher profit margin however, I am not accounting for that as I believe lower margin in initial years in OTC business may counter the upside.

For NBFC business, 5 year average net profit margin for STFC and IDFC is 18.7% and 25%  respectively. 

So I am assuming combined PAT as 10% of revenue (which in my opinion is fairly conservative). this will bring PAT to roughly 900 crores. 

Number of shares outstanding: 

After buyback, as on date, number of shares outstanding are 16.72 crores. 

PHL has total cash equivalent of 

Vodafone investment = 6600 crores (10% return on investment post tax which is much lower than management guidance)

Abbott Deal receivables: NPV of receivables is around 5000 crores 

Hence total cash available for deployment is roughly 11600 crores. Out of this, investment requirement will be around 7600 crores. 

This will leave 4000 crores of cash surplus plus free cash flows generated from 2012-2016. PHL may decide to partially retire debt out of this proceed. PHL management has clearly indicated their preference for buy back over dividend payout due to tax advantage. Hence, I see very high chances of second round of buy back by PHL. In my opinion PHL will buy back when the price of the stock is subdued. Hence let me assume PHL offers to buy back shares at Rs. 600 and allocates roughly 2000 crores for the same. This will mean extinguishing 3.33 crores shares. After second buy back, total shares outstanding around 13.39 crores. 

Thus, estimated EPS for PHL in 2017 will be PAT/outstanding shares = 900 crores/13.39 crores  = 67.2 

Valuation: Let me confess! This is the toughest part for me. I do not know how market will look at PHL five years down the line and what valuation it will assign to the company. The inference that I derive from my above analysis is: 
PHL's revenue will likely to have grown at CAGR 34% in 5 years and PAT (barring one time profit) at much higher rate. I think, if PHL is able to come near to expected numbers, considering valuations of peers (most of them have traded at 20-25 P/E), PHL's historical P/E (around 20-25) and clean balance sheet, P/E multiple of 15 seems reasonable. In my opinion, if PHL trades at P/E of 15, it will mean market is still circumspect about PHL's management ability or future growth prospect. However, I will  go with P/E of 15. 

If I apply P/E of 15 to EPS of 67, it will will give value of share around 1008. Thus from current price of 455, it will be return of CAGR 17%. 

To me, 17% is a base case, conservative and quantifiable estimate for return. In addition to this, Investor is exposed to following upsides. 

  • PHL is able to successfully complete phase-3 trials for its lead molecule P-276 which will open up a new vista for the company. If they are successfully able to commercialize this molecule, as intended by management, PHL will be in a different league altogether. 
  • PHL's molecules for Merck and Eli Lily moves forward in trials and if any one of them gets commercialized,  value of royalty, milestone payments and marketing rights will be substantial.
  • PHL is able to move some of the current molecule till phase-2 end. They will represent significant out-licensing value. (P1446 (likely to move to phase-2 in 3-6 months) and P2745 (phase-1 likely to be completed by end 2012)) 
  • As per management's guidance (management has track record of meeting their targets by and large) PHL is able to grow inorganically and achieve much higher growth rate than estimated in my analysis. 
  • PHL's margins improve due to increased income for R&D which is a high margin business. 
  • Last but not the least, market values PHL at least in line with their peers. 
On the downside following risks


  • It is not able to run NBFC business properly and is not able to achieve profitability as projected.
  • I have assumed complete loss of capital for PHL (i.e. investment of 1000 crores) 
In all if I am getting a chance to partner is a business where the management is flush with money, has excellent track record, top management is transparent, ethical and competent, I am able to see at least 17% compounded return in 5 years and exposed to large positive black swans, I would grab it with both the hands.


Update: PHL has received approval for BST-cargel in EU countries. It has also applied for approval in Canada and will approach authority in India post EU approval.

Disclosure: I have position in PHL. Views expressed in this post shall not be construed as investment advice. Readers must do their own due diligence before taking investment decision

Monday, 2 April 2012

Piramal Healthcare: Gazing Through Crystal Ball - Part I

In value investing, gazing through crystal ball is highly injurious and rather considered to be poles apart from the basic tenets of value investing. However, in certain situations such as unknown and unknowable events (UU events), it is important to not be bogged down by the sheer scale of uncertainty and think simple and straight to make sense of the fluid situations. It is very much possible that some of the outcomes may vary considerably from assumptions, however, at least the whole exercise leads to a structured thought process that may give some "sense" on the probable outcomes.

Success of the whole process will depend on focusing on conservative outlook rather than going gung-ho about the growth or taking management's estimates (which, many a times are very aggressive) on its face value. As described in my earlier article "Piramal Healthcare: In the territory of unknown and unknowable", PHL is surrounded with a lots of uncertainty about how future will pan out for the company. This post is a modest attempt to wade through numerous uncertainty to derive some "feel" on how future might look like 5 years down the road. 

Even though I have tried my best to derive numbers based on some of the published information on industry growth rate, past track record and some of the activities happening in the same space/sector, at some places, I have put numbers based on my "hunch", which inherently is subjective. Again numbers that are arrived at are not sacrosanct and are just very broadly indicative. The core principle still remains that it is better to be approximately right than precisely wrong.