Friday, 29 June 2012

Hindustan Zinc: A Value Play or Value Trap?

In this post I am going to share my confusion and dilemma on one idea that appears to be a good value play but may turn out to be a value trap, if value is not shared with the shareholders by the management. 

I am talking about world's largest integrated producer of zinc and second largest producer of zinc in the world. HZL operates Rampura Agucha mine in Rajashtan that has world's largest deposit of zinc and lead. It is the lowest cost producer in the world due to integrated nature of its operations, higher concentration zinc/lead in its ore and highly efficient operations. HZL's cost of production was roughly USD 800/ton in FY 11-12 while world average is around USD 1300. So is HZL a pure commodity play or a business surrounded my strong moat? My answer is that it is surely a business surrounded by strong moat but fortunes of the business are closely linked to commodity cycle. 

Now let's look at cursorily at HZL's  10 year historical performance on P&L, balance sheet and return ratios. 

P&L: HZL's top line grew 1650 crore in 2002-03 to 12000 crore in FY 11-12, registering CAGR of 22%. However, bottom line for HZL grew by staggering 45% in last 10 years taking net profit from 142 crores to 5526 crores.  Revenue growth was led by both volume increase as well as higher price realization from zinc. An extraordinary performance on the bottomline was due to operating leverage kicking in a big way. NPM for the company increased from 8.6% to 45% due to streamlining of operations, increased integration in terms of mining and refining and operating leverage. 

Balance sheet: It is a squeaky clean balance sheet with hoards of cash lazing around there! And like in any wonderful business, the difficulty is always to find avenue to deploy more and more cash in a profitable manner. HZL has no debt and has been that way in last 10 years except in 2003-2006 where, company took some debt (debt/equity of 0.3-0.5). As per FY 11-12 numbers, accounts receivable and inventory together amounts to less than 10% of revenues, indicating very high operational efficiency for the company (or may be very favorable business conditions!). So Currently company is sitting on cash pile of roughly 18000 crores all invested in liquid mutual funds and fixed deposits.

Cash flow and return ratios: Like  all successful natural resource companies, it is a company with very high free cash flow. In FY 2011-12 company generated around 5000 crores of free  cash flow after providing for maintenance capex. Company has ROCE of around 22% even after 18,000 crores of cash sitting in balance sheet earning paltry 10% pre tax! In terms of actual capital employed for operations, company had ROCE of around 48% in FY 2011-12 and has remained in the range of 50% for last 5 years. 

Now, let's do the valuation based on back of the envelope calculation. Currently company is trading in the range of 50,000 crores market cap. Now if we deduct cash and cash equivalent of 18000 crores, HZL is available at roughly 32000 crores net of cash.  

It is important to understand that earning power of the company is dependent on price of zinc, lead and silver and refined metal production for each one of them. In FY 11-12, average price realization for zinc, lead and silver were USD 2098/ton, USD 2269/ton and USD   1200/Kg. USD-INR average for FY 11-12 was 47.95. Production of refined zinc, lead and silver was 759,000 tons, 99,000 tons and 242 tons respectively. For commodities, taking one years' profit or price realization for predicting future cash flow is not appropriate considering cyclical nature of commodity price. In order to arrive at expected price realization for zinc and lead, let me take last 5 year's average price realization for zinc and lead as benchmark. However, story is slightly different for silver. Silver has got rerated in last  3 years and hence I do not think 5 year historical average is good approximation for next 5 years. Based on this approach, average 5 year price realization stands at USD 2132 and USD 2205 per ton for zinc and lead. For silver, I think current price level (you can call this gut feel or speculation!) is appropriate benchmark i.e. roughly USD 1000/Kg for average price realization for next 5 years. If we put all the information together along with current capacity of refined metal production of  759,000 tons of zinc, 100000 tons of lead and average 400 tons of silver (Fy 12-13 350 tons and increasing to 500 by FY 14 and steady thereafter), total revenue realization will be roughly 11000 crores at exchange rate of 48. If we take profit margin of 45%, roughly 5000 crores shall accrue from operations as net profit. This in my opinion a reasonably conservative scenario because of the assumptions like no significant increase in refined capacity, for 5 years commodity up-cycle does not play out, rupee strengthens to 48 etc. 

According to FY 11-12 annual report, HZL possesses mine reserves of 25 years and more exploration work is going on. So one can expect that at least for 20 years HZL will be able to produce at current capacity without depleting its resources. Even if I do not factor in price increase equivalent to world average inflation and consider constant price for 20 years, IRR for investing 31000 crores against 5000 crores of cashflow for 20 years works out to be 16% which is very decent. This does not take into account further cash accumulation and 8-10% return on this accumulated cash.

Now let's look at the upside 

- If HZL decides to deploy 18,000 crore capital in productive assets and especially in mining and natural resource area, it is possible to earn 25-30% return on capital employed. This will mean additional 5000 crores flowing in in addition to HZL's operational cash flow with annual cash flow amounting to  roughly 10,000 crores, making it a huge cash generating machine. Now thus accrued cash earns only 10%, and at  constant price and output, on 20 year basis IRR is 29%. 

-If there is commodity up-cycle in between, and company has invested idle capital in projects generating reasonable returns, or company ramps up its production from current capacity (a very likely scenario considering past track record) it will amount to substantial returns. 

Down side

- Let me be devil's advocate and assume that commodity market plunges and average price realization for zinc lead and silver is at USD 1000/ton, USD 1000 /ton and USD 500/kg and investment on balance sheet earns 8-10% return only. In this case also, on 20 year basis (resource base is equal to 25 years of current production if they don't find any additional zinc/lead resource.), one would typically be able to earn 10-12% IRR. 

So looks like an opportunity where there is significant upside possibility with very limited downside.  So what makes me think that HZL can be a value trap?

- HZL has always been generating considerable free cash flows over the years and hence the staggering pile of 18000 crores has been built up slowly. This is truly worrisome. management should have either deployed cash effectively to generate better returns or should have returned it to shareholders either as dividends or through buy-backs. Management has not done either of them, a clear danger sign. Dividend payout has been paltry 6-8%. This is peanuts for such high free cash flow generating company. 

- Management, in other instances, has used cash on balance sheet of group companies to make large purchases and thereby deploying cash in unrelated and probably pricey acquisitions. A case in point Sesa-Goa's cash reserves were used to acquire stake in cairn India. 

- I get a feel (though i have not done analysis to support this!) that management sometimes carry out restructuring among group companies so as to extract maximum benefits for the promoters and probably at the expense of the best interests of minority shareholders. 

If management engages in such activities, value realization for minority shareholder may not happen and it can fall into value trap! To be fair to management, HZL has been a great value creator. As per HZL's FY 11-12 AR,  Rs.1000 invested in HZL stock at the end of FY 02-03 would have grown to roughly 90,000, a 90 bagger in 10 years! So, what's my take? I am not too sure.  I am sharing my dilemma here and I will highly appreciate your views on the same.

Monday, 11 June 2012

Dissecting Return on Equity: Few Insights from Britannia and Titan

As mentioned in earlier post on significance of return on equity, ROE is one of the most important parameters signifying sustainable competitive advantage of the business and hence investment attractiveness of the company. However, as I dug deeper and gained more insight into the subject, I found that relying just on ROE number may be misleading. It is very important to understand what drives change in ROE and how good is the quality of ROE. In this post, I will try to illustrate the point with two examples. What is common in both the examples is that if one looks at ROE of the company, it has moved in a band has remained in that band. However, in one case, business quality has deteriorated while in the other, business is clearly on the upswing. However, had one relied on just ROE number, one would not be able to get a realistic feel of changing business environment. 

Let me start with defining ROE in terms of equation as suggested in Dupont formula 

ROE = Net profit margin *  Asset Turnover ratio * Equity Multiplier 

So ROE = (Net Profit/Total Revenue) * (Total Revenue/Total Assets) 
              * (Total Assets/Total Equity) 

So now, it is clear that three parameters drive return on equity, we can dissect ROE of any company in three components and look at what is driving ROE. This dissection of ROE will help us gain insight which can reveal interesting information about changing business environment for the company. 

Let's take first an example of Britania Industries.

Britannia Industries: Britannia Industries is India's leading food products company having formidable brands such as Good Day, BourBon, Little Hearts,  Marie Gold and Treat in biscuit segment and strong brands in dairy products such as Cheese, Butter, Spread and Yogurt. Let's see what has happened to ROE of the company. 


So on the first glance it appears that Britannia has increased its earning on its equity hence each dollar put in as equity by the company is earning 41 cents in 2010-11, up from 18 cents in 2006-07. Typically this would suggest that company's business is getting stronger and "moat" around its business is growing. However, let me dissect ROE further into its three core components.

            2006-07 2007-08 2008-09 2009-10 2010-11
    Profit/Revenue (1)   
    Revenue/Assets (2)   
3.24 2.91 3.55 4.12 4.98
    Asset/Equity (3)  
    Return on Equity (1*2*3)   

Above analysis, indicates that for Britannia, NPM has been fluctuating and has declined substantially in 2009-10 and 2010-11 from 4% to 2.6-2.8% which indicates deteriorating business conditions. On the other hand, company's  Asset/equity ratio has increased substantially from 1.33 to 2.9 indicating substantial increase in debt/equity ratio and hence leveraging. Thus increase in ROE for the company seems to have been contributed to a large extent by leverage and higher asset turnover to a smaller extent. Thus, it is reasonable to infer that in spite of increased return on equity, Britannia's inherent business condition is worse than that of 2006-07. 

Titan Industries: Titan is India's largest watch maker and world's fifth largest watch maker. Titan is perceived as benchmark of quality blended with style in Indian watch industry. Titan has also created immensely popular brands such as Fast-track and Raga catering to youth and effluent class respectively. Titan has entered into branded jewelry segment with "Tanishq" brand, which proved to be an run-away success. It also started "Titan Eye" division catering to style conscious youth by creating a range of stylish eye wear. Let's understand how Titan's business has undergone change and why "wholesome" ROE may not adequately reflect changes in business environment but dissecting ROE into its base components will give a insight into how business fundamentals are changing. 


If we look at ROE for last 5 years for Titan, it appears that Titan is operating in a business environment which is stable till 2009-10 (except in 2008-09) and ROE has remained in the range of 30-34% barring 2010-11 when ROE jumped substantially. This gives an impression that Titan operates in a business environment that is neither improving nor deteriorating substantially. Now let's see how drivers of ROE has changed over a period of time. 

            2006-07 2007-08 2008-09 2009-10 2010-11
    Profit/Revenue (1)    
    Revenue/Assets (2) 
4.17 5.22 5.71 6.13 6.6
    Asset/Equity  (3)  
    Return on Equity (1*2*3)   

Above table clearly indicates that Titan's ROE is incrementally contributed from expanding margins and higher asset turnover. A combination of margin expansion and higher revenue generation/rupee of asset on the book is helping Titan improve its return on equity. However in terms of overall ROE number, this effect is muted as company is consistently reducing debt (reducing leverage) which offsets the effect of increase in margin and asset turnover on ROE number. Expanding margin and increasing utilization of asset for revenue generation and that too consistently, indicates company's improved  business fundamentals which one would fail to notice if the focus is on just "ROE" number. On the other hand company has reduced its debt substantially over a period of time, which has strengthened its balance sheet

To put it differently, had Titan maintained debt/equity at a level prevailing in 2006-07, company's ROE would have looked liked as below


Thus, even though Titan's business environment and fundamentals have changed significantly they are so "jumbled up" that overall ROE number would not help investor decipher such changes. 

It is therefore critical to dig deeper into ROE number and understand drivers of ROE which will truly reflect the changing business environment and contributory effect of each component of ROE.