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