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A bear case on IT companies

By Rohit Chauhan
In Industry analysis, Uncategorized
October 19, 2010
3 Min read
18 comments
A

It’s not that I have always been a bear on IT companies. I have held NIIT tech, Patni computers and Infosys are various times over the last 5-6 years.

You can see my analysis of NIIT tech here and patni here.

The main reason for my bearishness is simply ‘valuations’. Mid cap companies like NIIT tech or patni and maybe a few others could be slightly undervalued (depending on your point of view), but I find it difficult to see the undervaluation in large caps such as Infosys which are selling over 30 times their current earnings.

A lot of the IT companies are priced for perfection which as we have seen never happens in reality. In the alternative universe of brokers and tipsters, the time to buy IT stocks was in 2000 and now and to sell was in 2008. We do not know how things will turn out in the future, but can clearly say from hindsight that 2000 was the time to sell and 2008 was a decent time to buy.

The advantage (or disadvantage) of having a blog for more than 5+ years is that all your past thoughts and statements are online and can be referred back at any time. In 2008, I felt that IT stocks, especially midcaps were extremely undervalued (some selling for PE of 2 or 3) and hence were a bargain. It was not a macro point of view, but based purely in valuations (you can read the post on it here)

Getting the timing wrong
My decision to start buying into some of the IT midcaps was based on valuations and a belief that the underlying economics of the IT service space was still attractive and the companies would continue to be profitable in the long run.

I had no clue that 2008 and 2009 would be such a disaster ( if I knew, I would have bought put options and retired by now 🙂 ). So clearly, in hindsight the best time to buy was 2009.

However one cannot make investment decision based on hindsight and so mere mortal like me (unlike some of the forecasting gurus ) have to base their decision on current valuations and expectations of reasonable business conditions in the future.

Still no idea of the future
As I have still do not have any special powers of knowing the future, my current view on IT stocks is centered on valuations and some of the long term headwinds faced by the industry such as
– Dollar depreciation : when and by how much …who knows, but more than likely to happen
– Increased costs : If you are an employed with an IT company, a point to remember is that everytime you get a good raise in salary, it comes from the bottom line (no there is no santaclaus paying for your salary)
– Intense competition: From other IT companies which is likely to drive down returns in the long run
– Host of other factors: regulation, slow growth in developed markets etc etc

The point is that the current valuations do not reflect these risks. Ofcourse you can make a point that current valuations for a lot of companies do not reflect the risk – but that is whole different story.

So what to do ?
Nothing much – sell if you think the stocks are overvalued and yes, be prepared to look like a fool if the stocks keep zooming up after you have sold. I have done that for most of my IT stocks and I am fully ready to look like a complete fool.

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A relook – mangalam cement

By Rohit Chauhan
In Company analysis
October 12, 2010
4 Min read
22 comments
A

I analysed mangalam briefly here and here and recently started analyzing the company again as I was looking at some other cement stocks. This is what I found –

The good
The company has a 2MT plant and supplies to the northern markets of Rajasthan, MP, Haryana and parts of western UP.

The company was a BIFR case till 2002-2003, but has been able to turn around the performance. The company has been able to maintain an ROE in excess of 20%. The topline has grown at around 10% and the net profits have gone up by a factor of 7 in the span of the last 7 years.

The company has been able to bring power cost as % of sales (power is a big component in cement) from 35% to around 24% levels. In addition the company has captive power plants and windmills, so it is not be exposed to fluctuations in power costs and cutbacks in the supply. The company now has a net profit margin in the range of 15-18% which is comparable to the other companies in the industry.

The company has excess cash of around 90 Crs on the books and is now planning a 1.75 MT brownfield project at the cost of around 800 crs. The total capacity should be around 3.75 MT by 2012, when the plant goes into production. In addition to the plant, the company is also setting up a 17.5 Mw captive power plant which should go onstream by the end of the current year.

The bad
The industry – cement – is a very cyclical industry and a pure commodity play. I really doubt consumers would pay too much premium for a brand. Pricing in this industry is driven by local/ regional demand and supply situation.

The upside is that the demand is growing rapidly, but at the same time there is quite a bit of supply coming online too. As a result pricing is unlikely to get too firm, with occasional dips on the way.

The ugly
The company board recently announced a merger with Mangalam timber (see here) in the ratio of 1:10. It may appear that the mangalam timber shareholder is getting hurt, but I would say they are not the only ones hurt by this transaction.

Unless you believe that the true value of mangalam cement is the current price, it is not difficult to see that the management is giving out quite some value to the Mangalam timber shareholders. The merger is in the ratio of 1:10 and if one assumes a fair value at around 400 rs per share (difficult to explain this valuation in single line, so just play along with me even if you don’t agree), the management is giving out 40 Crs in value for the sister firm.

One can debate whether the merger ratio is fair or not, but I find cannot understand the logic of the merger. Please don’t suggest that the management is building a construction company – that way a steel company should buy a car company and imply that they are integrating forward.

The management is allocating 40 Crs on behalf of the shareholders and should be doing so in the best possible opportunity which adds value. Is mangalam timber the best value??

Anyway, inspite of this merger the company will still not lose too much of its value though it definitely does not give confidence to a minority shareholder.

Conclusion
I still think the company is fairly undervalued and is selling at 40-50% below fair value. I do not have a position in the stock and will continue digging further before I make up my mind

As always, please do your own research before you make a decision.

Read on22 comments

It’s all warm, sunny and bubbly

By Rohit Chauhan
In General thoughts
October 5, 2010
2 Min read
26 comments
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Happy days are here again ! The index is at 20400 and will soon touch 22000 and then maybe 25000 or even 30000. The sky is the limit with India growing at 9%, and with a young population and all the other great factors working in its favor.

2008 was actually just a small bump on the way and the smart folks who bought during the downturn have made several times their investment. So the smart thing to do now is to load up on the small caps and midcaps as they have returned 100%+ returns in the last 2 years.

All the news channels are buzzing with hot new stocks and the smart thing to do is to watch these programs for tips and buy these stocks the next morning. The other day all those stock gurus and pundits were saying that now is the best time to buy as India has such a bright future ahead of it.

One should hold these stocks for a couple of days and sell it for a quick 10% profit. One only needs to do this a few times a year to make more than 100% on his or her investment. Actually, if you are really bullish, you should take on debt and dabble in options. Then the upside is unlimited and one should be able to retire in the next few months.

The problem with the news channel is that they don’t give the hottest tips. To get the hottest tips, one should join a penny stock service and use those tips to ‘play’ market. There is no time to waste on analyzing companies as most of these opportunities are available only for a short time and anyway who is planning to hold for more than a couple days ? So why bother !

It really does not matter that the IT stocks did badly after the 2000 bubble or the real estate stocks crashed in 2008. It is different this time!!!

Now is the time to get all excited and one should be fully invested, so that you don’t miss the opportunity of a lifetime. Heck, all my friends are making money and now my milkman and dhobi is in the market too!!

Note: If you are new to the blog, I hope you have realized that this is a sarcastic post and the exact opposite of my views.

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Review – Lakshmi machine works

By Rohit Chauhan
In Company analysis, Uncategorized
September 28, 2010
4 Min read
8 comments
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I had written about Lakshmi machine works earlier here. I would recommend reading the earlier post, especially the comments. The post and comments were right in the middle of the financial crisis. The stock was quoting in the 500-600 range and went down to the low 400 range in the subsequent weeks. At that price, the company was selling for slightly over cash on the books and the market was assuming that the company would go bankrupt soon.

I distinctly remember the comments and a few emails I received on this idea. The general theme was as follows
– The near term outlook for the company is horrible. As a result one should wait till the outlook is clear and then buy the stock.
– The company is barely making any profits and could be in financial trouble if the textile business shrinks further.
– The stock market gurus and pundits are advocating caution and I would prefer to wait (close to the first point).

My logic at that point can be summarized as follows
– The near term outlook was terrible and hence the stock was available at a bargain. Stock don’t sell at throw away prices if the near term outlook is great. The key point to analyse was how the company will do in the long run – that is after the downturn is over
– The company had a 60% market share in the industry and is one of the dominant players in india. They had a very strong balance sheet and good management. The company had a much higher probability of surviving than the other smaller players. On the contrary, I would say that a recession wipes out the weaker players and the stronger ones gain market share and strength due to lesser competition.
– If you listen to gurus and pundits, and don’t do your own thinking then you are likely to be in trouble anyway.

The post of LMW received a big number of hits and I think a lot of people found the company attractive.

I bet you would be thinking that I am busy patting my back !. I am not. In hindsight (which is 20/20), I think I was not aggressive enough and did not commit enough capital to the idea. I was personally quite confident of this company and a few others and still bought very cautiously. The caution had more to do with my extreme risk aversion and less with a specific idea. Anyway, I am working on that.

Let’s look at how the company performed in the last 2 years
– The topline of the company collapsed by 50% in the last 2 years
– The bottomline of the company came down by 60%+
– The return on capital has dropped, but is still at 50%+ levels (excluding surplus cash)
– Fixed asset turns dropped from around 4.1 to 2.5
– The company is still working capital negative (operations generate working capital instead of consuming it)
– Net margins have dropped from 10%+ to around 8% range (excluding other income)
– Net cash on the books (excluding customer advances) increased from 250 crs to 520 crs and total cash from 670 crs to around 830 Crs.
– The management has indicated plans to develop some land in Coimbatore (a real estate venture). This is a bit of a bouncer !

So what grade do we give the company ? I would say A and no I am not out of my mind.

In case of LMW one has to distinguish between the factors which cannot be controlled by the management (external environment and demand) and which can be controlled (their own cost structure and profitability).

The topline and bottom line dropped as expected (which is why the stock was selling for 500 and discounting this performance). However the management did a decent job of controlling the costs and still managed to generate profits during the downturn. There are very few companies which can remain profitable in face of a 50% drop in topline with a profit margin in the 10% range.

Where do we go from here?
The stock is now selling at around 2400. The company has announced a buyback to use up the extra cash, which is a good sign though not a great timing. The current price is partly discounting the expected good performance of the company.

If you assume a net margin of around 8-9% and topline growth of 10%, then the fair value can assumed to be around 2900-3100 range. The stock is slightly cheap, but not a bargain at current levels.

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