Sell Torrent Pharma

I had earliest posted about torrent pharmaceuticals here  and initiated a small position.  One of the exist criteria mentioned in that post was the balance sheet getting weaker and exposing the company to leverage risks.  Recently the company has acquired the some of the brands from Elder Pharma for domestic and Bangaladesh market.  Company is paying around 2000cr towards this transaction.  Based on what I read in some of the reports the company is paying around 5X sales and this seems to be an expensive acquisition to me.

Investment Checklist - Part2

Courtesy 1shots/freedigitalphotos.net

In my previous post on Checklists here, I provided an overview on the checklists and the benefits of using them.  In this part, I have listed the checklists I follow while analyzing a security for potential investment.  As I mentioned, every investor may have a long or small checklist based on their need and its more of an individual preference.  Indian companies are notorious for corporate governance and one needs to be very diligent in their evaluation exercise.  As I mentioned before, it is the safety of the investment and its downside  that is more important than the upside.  Our idea is to reduce the errors of commission than committing errors of omission.

Investment Checklist - Part 1

Picture courtesy 1shots/freedigitalpohotos.net

Checklists are basically tasks/checks that are jotted down in orderly way to make sure that all the items mentioned have been done or covered.  Checklists are used for managing very complex systems or procedures where things are not left to the memory of the person that is executing the task or following the procedure.  Checklists are very commonly used by pilots while flying aircraft and now checklists are slowly being used by health care industry as well during surgical procedures as well as in ICUs.  Checklists have not only helped in saving many human lives but also has helped in cutting down cost and improving quality.  

Open Ended Questions to Management

Picture Courtesy pakorn / freedigitalphotos.net

While reading the Investment Checklist written by Michael Shearn,  I came across an interesting list of open ended questions that can be asked to the management of a business. He recommends asking open ended questions to the management than asking close ended ones as open ended ones tend to give more insight about how the manager takes decisions.  Also he recommends that hypothetical questions should be avoided as they do not guarantee how the manager will actually act when such situation come.  

Useful Links for Business Analysis

I found this useful link from investopedia to understand some the industries and their metrics.

http://www.investopedia.com/features/industryhandbook/

Key Metrics on 25 Industries by Forbes

This is a very useful slide presentation provided by Forbes on metrics on 25 industries.  While this may not list all the metrics, they could be useful to analyze where the company you analyze stands with respect to the industry.

http://www.forbes.com/2010/06/29/best-in-class-financial-metrics-entrepreneurs-finance-sageworks_slide.html

Stock Analysis - Torrent Pharmaceuticals

Business Overview:  

Torrent Pharmaceuticals is a Pharma company having presence in Indian and global markets.  It manufactures both branded and unbranded generics and has a small exposure to contract manufacturing.  It sells branded generics in India and sells both branded and unbranded generics in overseas markets.  As of 2013, domestic revenues contribute about 32% of total revenues and international revenue contribution is around 57%. Contract manufacturing and other form the rest of the revenue.

Their product key segments are Cardio Vascular (36%) followed by , CNS and Gastro Intestinal (18%) segments.  Other major areas include Anti Infective(9%) and Anti Diabetic (8%)

Torrent is now 17^th by turnover and has around 5 brands of top 300.  5 years back they were 16^th by turnover and had around 6 of top 300 brands.  They are present in Brazil, Germany and US.  Entry in US market was late but this market is growing to be a significant one for them.  They have presence in Europe and other emerging countries as well.

While the domestic operations are very profitable, the overseas operation performance has been lackluster and the profit always fluctuates.  They seem to always have good revenue growth overseas but the profitability is always inconsistent suggesting margin pressures.  They are expanding their footprint into global markets and are investing aggressively into many countries.

             Financials:

Company has employed debt at reasonable levels and has debt to equity ratio of 0.35 as of Mar 13.   On consolidated basis, company employs around 819 cr on Net Block and around 150 cr of net working capital to generate a revenue of 3211 cr which is pretty good.  It generates operating profit of 692 Cr from this capital deployed on core business and this looks impressive.  Company always has been generating good amount of free cash flow on regular basis except for last year when the free cash flow was negative because of high inventories and receivables.  Company has been investing aggressively into global businesses but they are not consistent in terms of profitability.  Consolidated profits has always been lower than stand alone profits showing that they are making losses in their overseas operations.  Despite all these, the return ratios and metrics are pretty impressive for the company.  It has an average ROE of around 30% and given the capital retention ratio one can expect a growth of around 16%.  Companies return on reinvested capital has been very impressive with a 5 year average of around 31%.

Investment Rationale:

Company has the potential to grow for some time at around 15%  due to various reasons ranging from expansion in global markets and domestic markets to the amount of products they have in pipeline given the numbers of products that are going off patent until 2016.   Company has been spending consistently on R&D to keep its product portfolio growing. 

Company is available at a reasonable valuation of around 15 time EV/EBIT(average)   basis.  Assuming a growth of 15% for 5 years and terminal growth of 4% afterwards and a discount of 12%, this stock has a fair value of Rs 562 and at current price of Rs 459, it provides a margin of safety of around 18%.  On PE basis it had valuation range between 7 times and 17 times and currently it is available at the high PE range of around 16.  

Any buy at a price with around 25% margin of safety would be great.  As of now I will wait for the price to decline to 425 or below for accumulation.

            Risks:

Currency risks due to exposure to global currencies may impact the profitability of the company as global revenues are almost nearing 60% of the total revenues.

Global operations may make big losses and may not turn out to be profitable as the company expects due to competition from other players.

Margins may contract in the global markets due to competition and changes in government policies.

Working capital requirements may increase in some countries due to long time for payment.

Product launches could be delayed due to longer approval cycles.

Drug price control revised by the government last year may bring in more products of the company under max price ceiling and that may affect margins in domestic market.

Quality issues could result in product return which could affect the profitability.

            Exit Criteria:

Company does not grow on average at 15% as per assumption and likelihood of future growth in this range is very bleak.

Balance sheet structure gets weaker with increased debt exposing the company to leverage risks

Prolonged decrease in the free cash making ability of the business

Company price grows more than the intrinsic value and priced over value by 25%

Return on reinvested capital falls below the bond rate.

Investing is not for the weak hearted

Image courtesy of Nutdanai / FreeDigitalPhotos.net

This year has been an absolute nightmare for investors in general.  While the Sensex stocks which is just 30 stocks index has held its ground better, overall stock market has lost anywhere around 15% to 25% depending on the market cap.  For example, if you look at CNX Midcap index, it has lost about 18% as of date since the beginning of the year.  Bond investors were not safe either. Due to rupees free fall, RBI has taken some drastic measure on liquidity which made most the yields shoot up driving the bond prices down.  Even money market liquid funds reported negative returns in the last week.  Anyway, who said investing is easy?

While the stock index has been down 18% to 25%, some individual stocks have been down 50% or more in some cases.  A correction of this kind would make may investors lose sleep and that is the reason there is very minimal retain participation recently.  Why do majority of us cannot handle this while some of the investors like Warren Buffet or  Mohnish Pabrai can handle even 50% contraction with ease?  To understand this we need to get into biology a bit. 

Thoughts on Engineers India and BHEL

I frequently visit Vishal's blog named safalniveshak.com which is a very good site with lot of great information. Recently Vishal had posted about 6 questions for investors about BHEL, Engineers India and SAIL and I replied to those questions in his site. I do not hold SAIL, so my reply was only for BHEL and EIL. I am posting my reply below as well. This will service as a good reference for me few years from now to see if things pan out the way, I have replied. Please feel to post your comments.


1.Are these companies (BHEL, Engineers India) really going to die?

I do not think so because of the three reasons

• They both have very long operating history and they have survived all kinds of business and macro cycles that happened in the past 
• Both are considered as the best in trade as far as the business they operate in goes. There are very few companies that match their ability and scale. Most of them are price takers. 
• Strong Balance sheet with insignificant or zero debt 

Joel Greenblatt and Bruce Greenwald class notes

I found this very valuable resource on Joel Greenblatt and Bruce Greenwald's class notes.  It is very useful for seekers of value.  The link may not work at times as they keep updating it.

Best way is to search for the word VALUE VAULT VIDEOS AND BOOKS  and it site and you will get to the page

Joel Greenblatt and Bruce Greenwald's Videos and Notes

Ador Fontech Qtrly Update - Dec 2012

I wrote about Ador Fontech here .  Company came out with their quarterly results for Dec12 qtr.  On YoY basis, sales fell by 15%  and the operating margins fell by whopping 62%.  Gross margins fell from 47% last year to 42% and operating margins fell from 18% to 8%.  Overall it has been a disappointing quarter.  This has been the worst quarter in a long time.  Hope this is just an exception.  Stock reacted by going down around 12%.  Bought some more at Rs.78.  Need to keep track to see if this is a temporary down phase or a permanent change in business prospects.

Ador Fontech

Image Courtesy: fotopedia.com

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