The Little Book That Builds Wealth - Chapter2

In this chapter Pat explains how it is important for us not to understand the factors that create a moat for a business.  Some companies may be performing good in a tough industry and be better than others. But that does not make them stalwarts and create competitive advantage.  It is always better to have an average company in a great industry  than one that is the number in a tough industry.  Even though companies in  tough business may perform great in short term, in long term others will catch up and bring their profitability down.
Size does not matter.  It could be a small cap company that has virtually no competitors or it could be a very big company but with no pricing power.  In India when Bharti Airtel started even though it was a small company, it had virtually no competitors and it had good pricing power.  Compare that to the Bharti Airtel today.  There are too many players now and everyone is trying to drive down the prices so much that  there is hardly any profitability.  There is no pricing power for Airtel.  There is no differentiation in perceived quality for the customer if they move from Airtel to say Vodafone. If they increase price, customer will switch.

So, great products, great size, great execution or great management does not create a competitive advantage. Then what should we look for to identify companies with great competitive advantage?  As per Pat, they are

• Intangible assets like brands, license, patents etc. which keeps the competitor from copying. Some examples of brand are Maggie, Nescafe etc.  Coal India with mining license is a good example.  
• High switching cost.  It is difficult for the customer to switch to a different product.   Eg. Microsoft.  If company has to think of changing its operating systems or office products, it is very difficult to do as they have to train everyone and also worry about their compatibility with other companies in the business world with which it interacts
• Network effect -  Most recent example of this is Facebook.  Why is Facebook more popular than google+.  The answer is because 'Its popular'.  If all your friends and relatives are already in Facebook, why would you open your account in google+.  Also, if you already have Facebook where all your friends and relatives are there, would you create another account in google+ and maintain both?
•  Cost advantage - Company has some structural cost advantage because of which it provides products or services at a cheaper cost than any competitor. 

What is an Investment ?

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When it comes to investment, many of us are not sure as to what is considered as an investment.  For some, buying gold or real estate is an investment and for some buying a car or an insurance plan is an investment and for others stocks, mutual funds and fixed deposits are considered investment.

Most of us in India put our money in fixed deposits or into real estate.  Many of us buy gold especially those that have a girl child.  When it comes to other investments like stocks or mutual funds  some consider it as gambling and  sure way to lose some hard earned money.  When they hear someone talk about PE, Book Value, Earning growth etc. they look like the Taare Zameen Par kid who sees only dancing numbers and does not understand anything.  I will first attempt to make it clear as to what is considered an investment and then we will see each investment class.

As per dictionary.com,  investment means the investing of money or capital in order to gain profitable returns as interest, income, or appreciation in value.  So, if something you bought diminishes in value the moment you walk out of the door after purchase, it cannot be called an investment. Things like car, bike or any expensive consumer goods that we buy just for use by us cannot be considered an investment.  Their value neither appreciates nor does it provide any income after you buy it.  However, if you have bought them to get some investment return, then it can be considered as an investment.  For example, if  you bought a car to be used as a call taxi, it can be considered an investment.

Listed below are some of the most common asset classes in which investments are made other than running your own business

• Real Estate and Property
• Fixed Deposits
• Precious metals and gems
• Insurance
• Equity/Stocks
• Mutual Funds
• Bonds
• Currency
• Commodity
• Collectibles

In my next post, I will cover each asset class that I have listed.

The Little book that builds wealth - Chapter1

I am currently reading a book called The little book that builds wealth by Pat Dorsey.  This is a very good book for those who are interested in understanding what are economic moats and how you can identify them.  He also provides ways to value them. I intend to provide a commentary on every chapter that I read and summarize some of my thoughts.

In Chapter1 he explains about what is an economic moat and why it makes sense to own businesses with economic moats.
Companies with economic moats will generate handsome profits for a very long time and that is what makes them valuable. Return on capital is the best way to judge if the company is profitable and shows how good the business is taking investment money and  earning returns on it. Economic moats protect the company from competition thereby enabling them to maintain their high profit levels and thereby increasing shareholder value.  Companies with competitive advantage have better margin of safety as they can afford to sometimes make mistakes but still be able to comeback to normal profitable levels because of structural advantages.

The chapter does not clearly explain what is an economic moat. It just gives some examples of how a Honda commands more price than Kia and also about how Coke or McDonald's could sometimes mess their  strategy but still comeback.  Some Indian examples I can straight away think off is how Titan can charge more price for their watches than other watches like say HMT or how a Ray Ban glass is more expensive than any other unknown branded glass.

Ador Fontech

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Overview:

Ador fontech is a company of Ador group which was incorporated in 1980.  It is a supplier of products, solutions and services that help in conservation of resources by many manufacturing, mining and many other industries.  They sell welding alloys , equipment and other heat and wear resistant products.  Current market cap is around 142 crores.  The do fabrication and repair welding jobs which is what most manufacturing companies will resort to during bad times to prolong the life of their assets.  Most of its revenues come from domestic with overseas contribution a very low percentage (below 10%).  Current repair welding market is around 450 crores and  Ador Fontech  is number two player.  EWAC (L&T subsidiary) and Diffusion are the competitors.  EWAC is the top player in this segment.

Financials:

Balance Sheet:  Company has very good balance sheet and it is Debt free for the past 5 years. Out of total 51cr of capital, around 14cr is spent on fixed assets (27%),  7 cr on working capital (14%) and around 30cr (59%) is held as investments and fixed deposits which shows that there is very little capital requirement.

Profit and Loss: Current revenue is around 147cr.  Out of the total revenue 57% comes from selling equipment,  34% from selling other products like electrodes, flux wires and wear parts.  Remaining  9% comes from services and others. From the revenues, 40 cr is spent ton fixed costs (26%) and 79cr (51%) goes towards variable cost.   Operating income is the main income for this company.  Other income is  about 1.9 cr which is around 7% of the operating profit.  There is no significant interest payment by the company as it is debt free.  The tax rate is at 33% and  the depreciation is around 8%.

Cash flow: Average cash from operating activities is around 11.5 crores. Cash flow has consistently increased over the years. On an average around 1 cr is spent on capex and that leaves us a free cash of around 10 .5 cr every year. Company has increased its service center capacity in Nagpur recently.

Ratios (5 Years):

Operating profit margin and the net profit margin has been expanding over the years.  Average operating margins are around 14.5% and net margins are around 9.3%. The margins have improved due to the sales mix having more services/solutions than trading which was higher in the previous years.   Return on networth is around 33% and Return on capital (before tax) is around is 53%.   Average inventory turnover  is at 11.5 times and debtor turn over is around 9 times.  Asset turn over is at 7.2 times.  Operating Cash flow to Net profit ratio is at 69%.   Around 70% of the earning are retained by the company and remaining 30% are paid as dividends.  Interest coverage is not significant for this company as it is debt free.

Growth (5 Years):

Networth growth is 33%. Revenue growth is around 16%.  Operating Profit grew by around 28% and the net profit grew by around 38%. All growth rates seems healthy.  Net profit grew more than the growth of networth which is a good sign.  Sustainability of the same may be difficult.

Moat Rating:  No Moat

Brands, Licenses, Patents   - They have some industrial certifications and also partnership with repair solutions/product companies which can be considered a very fragile moat.

Switching cost  - None

Network effect - None

Cost leadership  - Not sure.

Management quality/Corporate Governance:

Promoters hold around 35% stake in the business.  Management has been pretty decent in terms of capital management.  They have consistently increased dividends which shows that they do not want to hoard capital.  If we  look at last 5 years, this business had generated around 54 crores.  Out of this around 14 crores was distributed as dividends and remaining 40 crores was retained.  Net profit of the company was 5.12 cr in Mar 07.  The net profit was 18.36 in Mar 11.  So we can assume that this additional 13.24 cr of profit was generated by this retained capital of 40 cr.  This gives a RONW of around 33%.   Maintaining this margin in a tough industry shows that management has been running this company efficiently.  Annual report did not suggest any evidence of siphoning cash to the promoter entities.  Managing director's salary was around 3.8% which sounds reasonable for the performance provided.  Shareholders communication seems to be adequate for company of its size.

Peer Comparison: 

EWAC is the market leader with around 250 cr of sales and Ador does around 150 cr.  Diffusion is a smaller player with around 60 cr of sales.  This is a small market with 3 organized players.  Market is not very big for bigger players to enter.  If the market size gets larger more players could enter.  EWAC and Diffusion are private players so number are not available for comparison

Positives:

Low working capital and fixed asset needs which would mean that low reinvestment requirement to fuel growth

Fixed Costs are lower than flexible costs

Good use of incremental capital investment to generate superior returns

Repairs and fabrication demand should be better during slowdown and high interest rate scenario as companies would try to stretch the life of their asset which augurs well for Ador fontech.
Promoter has been increasing their stake in the recent years which shows confidence in business.
Niche market with strong client relationships and partnerships with solutions providers for high end welding which has better margins.

Risks:  

Business risks: Raw material price increase and their inability to pass on the cost to customer is one significant risk.  Capex cycles are cyclical and that could impact the revenue of the company.

Forex Risk : Company imports leaves are around 25% and exports are below 10% and provides some natural hedge to their imports.  Rupee depreciated could increase the cost of good and impact margins.

Unfair Competition:  Ador fontech is engaged in repair solutions and this is different than just selling products.  This is a small market with few organized players.  Low end welding is commoditised but high end welding requires skills and knowledge and quality which has better margins.

Management Risk:  Management has been doing a good job so far with the capital.  They have been shareholder friendly in paying back the shareholders.  Management could invest capital into unprofitable/mediocre investments which may bring down ROCE and RONW.  Management has been slow in sales growth and this could lead to revenue stagnation faster than expected.

Valuation:  

Company is available at  EV/EBIT of 5.38 times and EV/Operating Cash flow of  8.14 times.  If we compare this to a bond we get a earning yield (EBIT/EV) of 18.58%  compared to 8.5% for GOI bond.  Current dividend yield is around 3.1%.   So either the market is considering this profitability to be unsustainable or  the discount could be because of this being a small cap.   Given that the average PBIT for the past 5 years is around  16.6 cr the earning power value (EPV) for this stock with zero growth is Rs 138 cr (16.6/12%)  if we consider the cost of capital of 12% for this company.  This business is available at  140cr which is fair value for the stock.  Ador being a small cap company and infrastructure companies that it services would only grow, it has very high probability for growth.

Decision:  

Ador fontech seems to be a well run company with good balance sheet and satisfactory returns on capital invested.  This being a  small cap company, it does not get the attention that is generally given to the medium and large caps.  Business does not have any moat at all and the margins could be under pressure during bad times.  Given the business performance in the last 5 years a, Ador Fontech looks fairly priced at current price of 80.55. Long term investors can invest in this stock at this price looking to add more if the price falls as it would only increase its margin of safety and make it more attractive