CategoryInvestment ideas

Part II of the analysis

Competitive analysis
The main competitors for the company are the other big pharma companies and the generic firms such as Ranbaxy, Sun etc. We can apply Michael porter’s five factor model to evaluate the company
Barrier to entry – All the segments of the company enjoy substantial entry barriers. The pharma and medical devices have formidable barriers in the form of patents and sales and marketing network. In addition any new drug or device requires substantial R&D expenses and infrastructure. The consumer segment has barriers in the form of Brands and distribution network
Supplier power – Moderate to low in this industry. Suppliers are mainly providers of basic chemicals or contract manufacturers. The value is derived from the IPR of the drug and not from the manufacturing.
Buyer power – Low in consumer goods. However in case of Pharma and the devices segments, national programs such as Medicare have a strong leverage and with escalating cost will attempt to drive down prices.
Substitute product – none
Rivalry – There is intense rivalry in the industry from other pharma majors who are attempting to develop a similar drug and especially from the generics where the price and profits drop by as much as 90% over the course of a few years as soon as the drug comes off a patent. In addition, the generic companies are constantly trying to challenge the patents too.

Management quality checklist
– Management compensation: The company has almost 215 Million outstanding options which would result in 2% dilution. The options do not appear to be excessive.
– Capital allocation record: Fairly good. The management has maintained an ROE in excess of 25%, low debt and a dividend payout of almost 40%. In addition, the management has been engaged in acquiring other pharma companies to pull gaps in its drug pipeline and added to it too.
– Shareholder communication: The shareholder disclosure is good with clear explanation of the benefits assumptions and IP R&D (in process R&D) calculations from the acquisitions.
– Accounting practice: The overall accounting seems to be conservative. However there are some areas of concern. For example – the company has assumed long term returns on plan assets of 9%. I think that is aggressive and could result in additional charges over the years. The IP R&D (in process R&D) charges do not appear to be excessive.

Valuation
The company has approximately 12 Bn of cash flow and is selling at around 13 times earnings. The company has shown a profit growth of almost 15% per annum with high degree of consistency. At the same time the company has maintained a high level of ROE during this period too. One cannot assume such a high level of profit growth in the future as some part of this has come from the increase in net margins. However with a conservative assumption of 6-7% growth, discount rate of 8% and CAP period of 10 yrs, intrinsic value can be estimated to be between 80-85 (PE of around 20).

The current valuation assumes a growth of 0 or worse and gives no value to the competitive advantage of the company. The company is currently selling at a 5 year low and appears to undervalued by comparative and absolute standards.

Conclusion
The company has performed well in the past in terms of fundamental performance. The sales and profits have grown at a double digit rate. In addition the company has a healthy drug pipeline at various stages of approval which could help in replacing the blockbuster drugs going off patent. The medical devices and consumer division provide stability to the earnings and help in reducing the risks of the pharma division.
The management has been a rational allocator of capital which is visible via the high dividend payout, above average ROE and sensible acquisitions. The company appears 20-30% undervalued compared to the intrinsic value which in turn can be expected to grow at 7-10% in the future.

A new addition: I have created a pdf version of the analysis. Please feel free to download and share with others

About
Johnson and Johnson (JNJ) is a US based pharma and healthcare company. The company has three primary business segments – consumer products, pharmaceuticals and medical devices.

The company had a revenue of 63 billion USD in 2008. The Consumer segment includes a broad range of products used in the baby care, skin care, oral care, wound care and women’s health care fields, as well as nutritional and over-the-counter pharmaceutical products. The Pharmaceutical segment includes products in the following therapeutic areas: anti-infective, antipsychotic, cardiovascular, contraceptive, dermatology, gastrointestinal,hematology, immunology, neurology, oncology etc . The Medical Devices and Diagnostics segment includes a broad range of products such as Cordis’ circulatory disease management products; DePuy’s orthopaedic products; Ethicon’s surgical care products ; Ortho-Clinical Diagnostics’ professional diagnostic products and Vistakon’s disposable contact lenses.

The company operates globaly in a predominantly decentralised structure with over 118000 employees.

Financials
The consumer segment had a global sale of 16 Billion in 2008 with a 10.8% growth. The company also acquired the consumer healthcare business of pfizer in 2007. The consumer segment had an operating profit of 16.7%, an increase of 1% over 2007.

The pharma segment had a sale of 24.6 billion in 2008, a decrease of around 1.2% over 2007. This business saw an increase in operating profit from 26.3% to 31% mainly due to writedowns in 2007.

The medical devices segment had sales of 23.1 billion with an increase of 6.4% over 2007. The operating profit increased from 22.3% to 31.2% in 2008 partly due to some litigation settlements in 2008 and some restructuring charges in 2007.

The company has maintained a high level of R&D investment (around 10% of sales or higher) during this period. This efficiency of this investment is evident from the drug pipeline of the company which consists of around 18 drugs filed or approved and almost 25 in the stage III trails.

On an aggregate basis, the company has has a very steady performance in the last 10 years and more. The ROE has ranged between 26-30% during this period. This improvement has been driven by an improvement in net margins from around 15% to 20%. The various asset ratios such as working capital turns has improved from low teens to around 30. The fixed asset turns has improved during this period too.

The company has maintained a healthy cash flow during this period and has had a dividend payout of almost 40% during this period. The balance cash has been used to pay off the small amounts of debt, invest in assets and make targeted accquisitions.The company is a zero (net basis) debt company and has a cash flow rate in excess of 10 billion per annum.

Positives
JNJ has several key positives as a business and over other pharma companies
– The company derieves around 30-32% of its revenue and around 40-45% of operating profits from the pharma business segment. Although the company faces the risk of its top performing drugs going off patent, the company has a healthy pipeline to manage this risk
– The company has a medical devices division which does not face the generic or patent risk of the pharma division and is fairly profitable.
– The company has a consumer products division with strong brands and an extensive distribution network which act as a hedge to the other segments.
– The company has a deep moat in all its business segments and sustaniable competitive advantage.
– The company has a decentralised operating structure with 250 operating companies across 57 countries across the the globe.
– The company has strong balance sheet and consistent cash flows. The net profit and cash flow has grown at around 16% per annum for the last 10 years. In addition the company has improved its ROE and other asset rations

Risks
The company faces the following key risks
– Several key pharma brands (in excess of 1 bn sales) such as risperdal and Topamax have lost patent protection in the recent and will face drop in sales and profits due to generics. Success of new drugs is not a given and only a few drugs in the pipeline may replace these blockbusters. In addition, there may be short to medium term dip before the new drugs replace the loss in sales.
– The global slowdown is likely to impact the topline and bottom line growth for the next 2-3 years
– The US market accounts for almost 14 bn in sales for the pharma division and 10Bn in sales for the medical devices division. Although I have not been able to find the numbers. the profitability of these divisions in the US is fairly high. This may be at risk due to the health care reforms in the US.
– The recession in the developed markets which account for major part of the sales and profit could keep the topline and bottom line subdued for the next few years.
– The company faces litigation risks related to product marketing, pricing, product side effects and patent issues. These risks are detailed over 3 pages of the annual report and are not easily quantifiable. The company has accrued liabilities against these risk and has stated that these risks in aggregate will not have a material effect on the financials.

next post : competitive analysis, management quality, valuation and conclusion

Lakshmi machine works
I have written on LMW earlier here. The domestic and export demand for the company has collapsed since then. The company is now running at 40% of its capacity. The company reported a 60% drop in topline and 76% drop in profits. Time to panic and sell the stock ? Not quite.

The market was pricing much worse earlier. For a period of few months, the company sold for almost its cash holdings without any value being given to any other assets.Now that the market has realised that the company is not headed for extinction, it has revalued the company to a certain extent.

At the same time, I do not have any illusions that the fundamentals of the company will suddenly turn completely. The company is in for some tough times till the demand returns back to the pre-crisis levels and accordingly the profit peak achieved over the last few years could take some time too.

However if one looks at the annual report, one can see that the company is doing a great job of managing the downturn. The company does not require much capex and has reduced the working capital too. The cash and equivalents are now up at almost 700 crs which comes to around 60% of the market. I personally don’t think the company is going bankrupt and hence plan to hold on.

Ashok leyland
I have written about the company earlier here and here. The company reported an almost 50% drop in sales and 80%+ drop in profits ( I like companies whose sales are dropping off the cliff 🙂 ).

If you are interested in the company, I would encourage you to see the latest presentation by the company here. The company has taken pains to detail out the problems and how they are coping with the recession.

Ashok leyland has also been hit severly by the downturn and credit crunch. Although the demand is now stabilizing, the current quarter and maybe the next will continue to be hit due to inventory liquidation. The company books sales when it sells to the dealers. The slowdown in the demand has resulted in high inventory with the dealers which needs to be worked out. The only worrying factor in the results is the loss of market shares in HCV, especially in the mid segment.

The company’s results will continue to be hit for atleast a few quarters due to the slowdown and due to the depreciation cost of the capex which was put in place for the expected demand last year. As in LMW, I don’t think the company is going bankrupt and hence plan to hold on. At the same time Ashok leyland is not as cheap as LMW

Hinduja global
I have written on Hinduja global earlier (see here and here). My main concern was the high cash holding of the company which is being maintained in foreign sub. The company has since then tried to clarify the above fact (details of the cash holding are provided in the last quarter’s result).

In addition the company came out with a higher dividend and fairly good results in Mar 2009. As a result the stock has almost doubled since then. In the current quarter, the company reported a topline growth of 30% and bottom line growth of almost 80%. The company continues to perform well. My hesitation in building a large position still continue to be the corporate governance issues, even though the company is cheap by objective standards.

Gujarat gas
I have written on gujarat gas earlier (see here ). The company reported Q2 numbers and i am fairly satisfied with the numbers. The company has been facing a supply issue due to lower level of supplies from two long term sources.

The Q1 results were hit considerably due to the above shortage. The company has been able to secure some supply in the spot market to meet some of the demand. The topline grew by around 10%, though the volume dropped by around 5% during the same period.The bottom line grew by more than 10% if one eliminates the one time gain in last year’s result.

The company is doing quite well and I expect the profit growth to improve once additional sources of supply are tied up. Finally, the company has declared a 1:1 bonus issue. This does not change anything fundamentally other than higher dividends in the future. However the market has reacted positively and pushed up the stock price.

Lets go over what the typical investor was thinking over the last 18 months, from the peak to the current recovery phase.

Jan 2008 – Whopee, I am getting rich. Just need to keep buying and selling and trading and I can retire! I am a genius!!!

March 2008 – I knew the market was overvalued, but then I am long term investor. So I am going hold onto my stocks during the this drop, maybe even buy more

Aug 2008 – The market is climbing again!! the bear market is over.

Nov 2008 – What happened ?!! oh boy, why did not sell in august. I have lost too much money. No point in selling

Feb 2008 – This is getting bad. Let me salvage whatever I can and move to fixed deposits. Even the CNBC guys are saying that

April 2008 – The market has risen a bit, but I am not worried. The market will drop once the election results are announced

May 2008 – The results were a surprise and missed the rally. I should have bought in Feb when the market was cheap. Let me wait

Jun 2008 – let me wait for the market to drop

July 2008 – Let me wait for the market to drop

….and the mental circus continues

I know I am exaggerating, but I know there are a lot of investors who went through the above mental roller coaster and will learn all the wrong things like

– The market is a casino and one has to be able to predict the market in advance to make money
– I should take more risk and should trade more frantically to make money
– One needs to be glued to the TV to make money
– All the losses are not my fault, though the gains were due to my brilliance

I have myself gone through some of the above emotions in the past. There is nothing wrong in experiencing all kinds of conflicting emotions during such volatile times. It will however not do an investor any good, if he or she does not learn the right lessons. Let me state a few things I learnt from bear markets in the past

– There is only one person to blame for your losses – you
– There is never a good or a bad time to buy stocks. If you can find a good company, which is undervalued, buying is a smarter decision than guessing what the market will do.
– Prepare in advance – I have been guilty of being timid in the previous bear market. During 2001-2003 bear market, I lacked the self confidence of investing a meaningful amount of money even though I realized that the market and stocks were cheap. The reaction is understandable if you are new to the market and have suffered losses. After the bear market ended, I realized my mistake and make a mental plan of how much capital I would commit when the inevitable downturn came. During the current downturn, I was prepared psychologically to go ‘all in’ when the valuations became cheap.
– Stop listening to markets forecast and silly predictions. They will cost you money in the long run
– Learn continuously. You may make money by luck in the stock market, but will not keep it.
– Stop looking backwards – I should have or would have done this, is not relevant. The question is – knowing what I know now, what do I plan to do?

VST
I wrote about VST a month back and got it perfectly wrong. The company has come out with a 60%+ topline growth and doubling of bottom line. I have not been find more details on the results, but need to figure out how the company has been able to increase topline so rapidly in a business with such a low growth.

Container corporation
The company reported a 10% topline growth and a flat bottom line. The bottom line is flat due to the 20% rise in the rail expenses. Although I don’t have the exact details, the rail charge hikes cannot be passed on the customers immediately and there is a lag in getting the price increase.
The overall results are good in view of the slowdown in the exim markets. Concor has been a long term holding for me and is a very profitable logistics company with a cash rich balance sheet, attractive margins and substantial competitive advantage.

Novartis
I wrote on Novartis earlier here. I have not completely exited the stock as I felt the buyback price was too low. The company has been able to increase the holding to 76.4% now. The company increased the topline by 7% and bottom line by around the same amount.
The performance is nothing out of the ordinary. The stock continues to be undervalued and will most likely remain so. The only upside is a possible buyback and delisting by the parent. However as there is no fixed timetable, it may not make sense to hold the stock for the long term. In my case, I will exit my position when I can find a better idea.

So how is your portfolio doing ?
I often get this question by email. The short answer is – as expected (around 10% in excess of the index returns). I started buying last year from march and went all in by Q4 of 2008. I have not been very active since the beginning of the year due to various reasons ranging from shortage of cash to lack of time.

I have been lucky that my wins generally end up more than compensating for my goof-ups. It is however difficult to know beforehand which idea would be a winner or a clunker. In the final analysis, though it is the portfolio performance rather than individual stock performance, which matters more.

NIIT tech
I have written on NIIT earlier (see here).

NIIT recently announced the Q4 09 results and published the transcript of their investor call. Some thoughts on the call

– Topline grew by 10% (excluding hedging losses), and operating margins increased to 22.3% from 19% (excluding hedging losses) for the quarter.
– The topline growth was around 5% for the year and the operating margins held steady. However the bottom line dropped by more than 10% due to the hedging losses.
– Hedging losses were around 22 Crs. This is the most ridicolous hedge I have ever seen. They had created a hedge for almost 2+ years of revenue at the rate of almost 41.6 Rs. I cannot understand why the management would have taken such a long hedge last year and assume that the currency would only strengthen.
– The company now has a hedge of around 1 year at the same rate and has mark to market loss of 199 Crs. The underlying earning power of the company is not impacted by this hedge, but some finance guys probably the CFO should be taken to task for such a hedge. The above losses have been booked against the reserves as per the new guidelines.
– The other key indicators such as new client additions (18 for the year), order intake (312 Mn usd), utilization etc have been healthy.

Overall, the results have been as expected and not really spectacular. However the current valuations continue to assume much worse and hence the stock continues to be undervalued. I have updated the valuation spreadsheet and uploaded it again(valuationtemplateNIIT2009).

I personally feel, that my net margin assumption of 7.5% may be too conservative and the company may be able to maintain net margins in the region of 10%. If that turns out to be the case, there could be a higher upside to the stock price.

Cheviot company
I have analysed cheviot company earlier. The main thesis behind this idea can be summarized as follows – the company net of cash and equivalents is selling at 1 or less times annual earnings.The company has an average earnings power of 14-15 Crs per year and can valued at around 200 crs (versus 80 Crs market cap).

I recently reviewed the annual report and did not like what I saw, mainly on how the company is using the excess cash. A few key points from my annual report analysis are

– The company recorded a topline growth of around 5% (inspite of a drop in volumes) and a bottom line which was flat or up a few percentage point (one needs to exclude the impact of other income which is mainly from equity investments and mutual funds). The same is visible in the cash flow from operations too.
– The operating and net margins from core operations has remained steady inspite of the turmoil in the export markets and other issues such as labor.
– The investments on books have dropped by 20 crs and there seems to be an unexplained loan/ advance of the same amount on the balance sheet. The company had invested the surplus cash in the equity markets and has seen a drop in the value of the holdings. The company also took some losses through the profit and loss statement due to the sale of some holdings.
– The outlook for the next year looks bad due to the high jute prices and recession in the global market. The bottom line and hence the stock price could remain depressed.

So why am I annoyed with the results
– For starters, the company has taken the surplus cash and invested in the equity markets. That does not seem to be their core skills. In addition, I don’t think they have done a great job of it anyway. The market value has dropped by 50%, which seems to be roughly in line with the market level. So the treasury department is barely keeping up with the market or earning a few points above it.
– The dividend payout has been reduced this year due to the drop in profits (from other income). I am fairly irritated by this reduction as the company is drowing in cash, does not have too much use for it in the core business and is investing it in the stock market (not too well )
– There is an unexplained 20 Cr advance to someone. There are no other details provided on this transaction. This is not a related party transaction, but at the same time I would prefer more disclosure.
– A donation of 3 Crs (LY 2.5 Crs) !!

I am annoyed mainly by the capital allocation skills being displayed by the management. They are holding excess cash and are neither able to deploy in the core business and at the same time not ready to return it to the shareholders.

I have been slow in learning this fact, but catching onto it – Managements which show poor capital allocation skills and hoard cash, destroy value and the market may never assigns a decent multiple to such a businesses.

I do not have plans to sell the stock, but plan to monitor it closely. If I don’t see an improvement or change in the capital allocation policy of the management, I may decide to exit the stock.

I initiated the analysis of Patni computers in my last post. The rest of the analysis follows

Competitive analysis
The IT services industry is a very competitive industry driven by scale, customer relationships and management quality.

I think there is a low level of differentiation in the industry (contrary to what each company claims in its annual report) and most of the companies provide a similar product.

There is a decent amount of lockin at the customer level. Most companies including patni have a high % of repeat business and are able to leverage these relationships and customer lockin to sell additional services. However there is a substantial amount of competition now and it is no longer a given that a company will always maintain the same level of engagement at a client.

Patni has had a high concentration of revenue from its top customers. This has however been reducing in the last few years which is a good thing.

Finally management quality is an important factor in the IT industry, which I evaluate in the next section

Management quality checklist

– Management compensation: The founders and executive directors are entitled to a pension equal to 50% of last pay after 62 yrs of age. I cannot fathom the logic of this compensation. The current value of this obligation is almost 35 Crs and increasing. This is around 1% of the company’s market cap. Although not a large amount by itself, I cannot see any precedent for this kind of compensation in any other company in the industry. The compensation for the top management including the founders is almost 8% of net profit. This level of compensation is quite high and above the industry average. In addition this represents a 50% increase in 2008, when the performance does not justify such an increase.
– Capital allocation record: average record. The ROE has been high and the management has not blown too much cash on accquisitions, but as other IT companies, the company is holding too much cash. In addition the dividend payouts are not commensurate with the profit levels.
– Shareholder communication – good and in line with other IT services companies
– Accounting practise – The disclosure levels are good, in line with other IT company. However the company has around 185 Crs of hedge related liability on the balancesheet. I have not been able to find the details, but I can also see a 144 crs hedge reserve. This looks like a writeoff of the hedging losses without passing it through P&L. This is aggressive accounting. On the other hand the company has also adopted AS30 (forex related accounting) in advance which is a positive. In addition the company has a translation adjustment of almost 110 Mn usd (500 Crs) in the GAAP statement. I have to evaluate how much of this loss will reverse due to forex changes and how much will have a pass through into the P&L statement depending on the nature of the derivative contracts.
– Conflict of interest and related party transactions – Nothing stands out in terms of related party transactions. As stated earlier, the compensation is quite high and the same is confirmed in this section too.
– Performance track record – average. The management has shown average performance in terms of the topline and bottom line growth. On absolute basis the performance is good, but average in comparison to the industry.

Valuation
The key to valuing an IT services company is to estimate its underlying earnings power. The net profit numbers for most companies has been fluctuating a lot due to forex changes. In addition, the current tax levels are too low due to imminent expiration of the tax holidays.

Patni had a forex gain of almost 103 Crs in 2007 and a loss of 83 Crs in the current year. The tax as a % of PBT has dropped from 16% of PBT in 2007 to around 5% in 2008. Clearly a 5% tax rate is not sustainable.

As a final adjustment to the valuation, one must also adjust the impact of the stock options (or RSU now). I have made the following assumptions in arriving at my final numbers (these can ofcourse be debated)

Tax as % of PBT = 25%
Future earning power = 7.5% of sales (7.5 % net margin) excluding the impact of forex. Current net margins are around 12-14%.
Cost of outstanding options = 152 Crs
Dilution due to options = 1.17 cr additional shares

If we consider the above assumptions, a PE of 14 (which is not aggressive for a company with 8-10% growth and ROE of 15%+) and cash on books of around 1300 Crs, the intrinsic value is 6000-6300 Crs.

Scenario analysis
The above valuation assumes a very modest topline growth (around 10% per annum) and a negative growth for net profits (due to falling net margins and higher taxation).

The company could get a better valuation if it is able to hold its net margins and reduce the forex losses. I think the performance risk for the company are low as the current market enviorment is as bad as it can get – drop in demand, forex losses etc.

conclusion
Patni is a decent undervalued idea. However due to the various management issues outlined earlier and average performance in the past, I will not look at the company as a long term holding. It would be good idea to hold the company as long as the undervaluation exists and then exit once the gap closes.

Disclaimer – I have a holding in the stock.

I will be publishing the analysis in multiple parts.

About
Patni is an IT services company similar to Infosys, WIPRO and other companies in the same industry. The company derieves a major portion of its revenue from the US. The main industry segments in which the company operates are Financial services, insurance, manufacturing and media.

The key feature of the business model is offshoring. Indian IT services company provide a cost advantage to the customer by executing the work in low cost locations such as India.

Financials
The company has been doing fairly well financially for the last couple of years. It has been able to maintain its ROE in excess of 15% over the past 5 years. The calculated ROE is depressed due to high cash on books (running almost 1400 Crs now). The company had a good topline growth till 2005, which slowed down in 2007 and 2008. However it has still been able to pull off a double digit growth for 2008.
The net margins has dropped from around 20% to around 13% levels due to forex losses. The net margins are not as high as the Tier I companies such as infosys, but still at healthy levels.
The net profit growth has been fairly erratic in the last few years due to the forex changes. However the profit has doubled in the last 5 years inspite of the major changes in the market such as recession, flucutations in the Rupee-dollar rates and increases in the salary etc.

Positives
The company has a fairly healthy cash flow and the same is visible via the strong level of cash on the balance sheet. The company has had a moderate growth in the topline and bottomline numbers.
The company is also growing faster in the non US markets and thus reducing the dependence and contribution of the US markets.
The company recently completed a buyback of almost 10% of its equity at around 210 Rs per share. Thus the company has been able to buyback its shares at a fairly discounted price and thus add value to the exisiting shareholders. This buyback is however partly offset by almost 1 Cr ESOP outstanding for employees which would increase the dilution.

Negatives
The are several negatives with the company. The company performance has been average and has not been of the level of the tier I vendors. As a result the company will not get the valuations of its more successful competitors. The company has had a decent performance, but on a comparitive basis it is poorer than the tier I vendors.

The other negatives is the stock options plan of the company. The earlier stock option plan was almost 5% of the equity. However in 2008, the plan was converted to a RSO (restricted stock options) plan with a strike price of almost Rs 2 / share. The irritating part is that the proposal was approved without the management specifying if the ESOP numbers will roll into the RSO plan. If that happen,I am looking at a reduction of almost 150 Crs (6-7 Rs/ share) in the value of the stock. This may not be huge, but it is irritating to see the company change the plan at the expense of the shareholders.

Risks
The company shares the usual risks faced by the other IT companies such as recession, protectionism in developed markets, cost escalation and competitive pressures from other IT vendors – both indian and foreign.

Next post : competitive analysis, Management quality, valuation and conclusion

Side note: I have a mirror self hosted copy of this blog. I recently changed the blog design and feel it is an improvement over the earlier design. Would appreciate your feedback on it. If this blog were to go down for some reason, then that would be place to go !! guys give that website some love too 🙂

About
Balmer lawrie is a diversified government owned company. It has the following diverse businesses
– Industrial packaging: Drums, barrels etc
– Logistics infrastructure and services
– Travels and tours
– Greases and lubes
– Tea
– Others

The company is a profitable PSU, a zero debt company and now has surplus cash on its books.

Financials
The financial performance of the company has been improving steadily from an ROE of 12% in 2004 to almost 24%+ in 2008. The Topline for the company (includin JV and Subs) has grown from around 1100 to 1788 in 2008 giving a CAGR of 10%. The bottomline has improved from 31 Crs to 99 Crs in the same time period indicating an improvement of profitability.

Positives
The topline has grown by 10%, however the netprofit for the company has almost tripled in the same time period. The company has now become a zero debt company (including JV and subs) now, with surplus cash on its books
In addition the company management realizes the importance of allocating capital . They have indicated that they are looking at exiting low profitability businesses like tea and invest in the more profitable ones. This is also visibile from the improvement in profits over the topline.
In addition the excess cash has been used to reduce the debt too.

Risks
Everything said and done, this is still a PSU. So there is always a risk that the government may do something stupid. However in the recent past the profitable PSU’s are being allowed to operate with autonomy (barring the Oil PSU’s). Still a risk exists.
Almost 60% of the profits come from the logistics and infrastructure serivces division. So any drop in profitability of this division could impact the company strongly.

Management quality
The PSU label seems to indicate that the management quality is poor. I think that would be as wrong as saying the MNC label indicates good management. Each company and its management should be evaluated based on its own merit.

Management compensation – Being a PSU, the compensation is a bit too low.

Capital allocation record – The management has had a good and sensible record of capital allocation. They ROE has been increasing steadily over the years due to the management focus on better performing PSU such as tour & travels, logistics and divestment of the poor performing businesses such as Tea (in UK), projects etc. In addition the management has reduced debt and also increased dividends.

Shareholder communication – Fairly decent. The management has regularly discussed the strenghts and weaknesses of each SBU, plans for each of the businesses and have been transparent on the downside risk of each business (may be a bit too pessimistic)

Accounting practise – Good. I don’t see any aggressive accounting.

Conflict of interest – None from the management. However the majority shareholder is the government. Till date there has been no interference.

Valuation
The company sells for around 3-4 times the cash flow for 2008-2009. With an ROE of 20%+, and a moderate 10% net profit growth, the instrinsic value seems to be around 1500 Crs or higher for the whole company.
An alternative approach to valuing the company would be to value each division individually as some have great economics such as the logsitics division and some horrible, such as the Tea division. The sum of parts valuation of the company is loaded in the google groups here

Conclusion
The company seems to be selling at greater than 50% discount to instrinsic value. It seems to carry a PSU discount to its valuation too. Finally, the company has a dividend yield of almost 5%+ and this dividend yield look sustainable too.

disclaimer : I have a holding in the stock.

About
Grindwell Norton Limited (GNO) is one of the subsidiaries of Compagnie de Saint-Gobain (Saint-Gobain), a transnational Group, with its headquarters in Paris and with sales of €43.8 billion in 2008.
The main business segments for the company are – Abrasives and Ceramics & Plastics

Financials
The company had a revenue of 523 Crs in 2008, showing a growth of 13% over the previous year. The company has shown a consistent growth in excess of 10% per annum for the last 5 years. In addition, the company has maintained an ROE in excess of 15% during this period. Inspite of the rise in RM costs during this period, the company has been able to maintain a net margin of around 10%.
The net profit has grown much more rapidly during this period. However due to the sudden slowdown in the economy, the company had a bad Q4 and has had a small drop in net profit in 2008.The company has no debt on its book and actually has some surplus cash.

Positives
The company is in a duopoly situation in the abrasives market. Along with carborundum universal, Grindwell is the only other major player in the market. In addition, the company has R&D support of its parent. The company has been investing in new facilities in India and is looking at growing the business.
The company has a wide range of products, good brands and a strong marketing, sales and distribution network.
Financially, the company has done fairly well in the past and has grown its sales and net profits are a decent rate, while maintaining a high ROE. The company has a dividend payout of almost 40% and has been investing the rest of the capital in the business.

Risks
The company faces the risk of imports from china and from the unorganized sector. In addition, the company had a bad Q4 in 2008 and will face a tough 2009. The company has Indian partners too, but still one cannot rule out the possibility that the MNC parent may try to buy out the minority holders cheap.

Competitive analysis
The key competitor for GNO for comparative purpose is CUMI (Carborundum universal limited). Although both the companies are in similar businesses, their profiles are quite different. CUMI has now expanded into the foreign markets with acquisitions and JV’s in the last 2 years. CUMI has also taken a substantial debt load (Debt equity now at 0.9:1) to fund these investments in acquisitions and new facilities.
In view of the slow down in sales, higher debt loads and higher RM prices, the Bottom line for CUMI has dropped by 20%+ in comparison to the 10% odd drop for GNO (excluding the one time income and charges).
CUMI now sells at around 11-12 time earnings (considering the debt) compared to 7-8 times for GNO. CUMI has higher upside due to its foray into international markets and new facilities, but also has a higher business risk compared to GNO.

Management analysis
I have added this new section to my analysis. This is necessarily a subjective exercise. I am looking at analyzing the management on certain parameters (details in a separate post)

Capital allocation – Management seems to be doing fine on this count. They have decent dividend payout and are not hoarding capital. Capital is being invested and the returns from invested capital have been good in the past.

Communication – Not good, nor bad. The management has discussed the plusses and minuses of the business briefly and could do a better job at it

Management compensation – The management compensation does not seem to be high. The MD is being paid at around 20 million per annum and there are no stock options for the management.

Related party transactions – Nothing odd in the section, except for some sales and purchases with associate companies. So no red flags here

Valuation
The company sells at an adjusted PE (net of cash and adjusted for non operating income) of around 8-9. The current EV is around 400 Crs. The company is going through a slow down and the current valuations are depressed. The company could see a growth of 15-20% in profits in the next 2 years.

The intrinsic value range is around 700-800 Crs for the company based on a growth assumption of 8%, net margins of 9% and CAP (competitive advantage period) of around 8 yrs.

Conclusion
The company is reasonably undervalued. This is not a stock or company which will give huge returns. The company has low business risk due to moderate competitive advantages in the business, strong balance sheet and decent market position. This is a moderate risk, moderate return stock.

Disclaimer
I hold the stock and hence the above may not be an unbaised analysis of the stock. Please read the disclaimer in blog too.