The Growth Conundrum

As a long term investor, one should be concerned with two things while buying a stock,

• Quality of the Business
• Price at which one buys the stock

Courtesy of internet, screens, forums, list of bloggers on this blog the the chances of you coming across good businesses and stock ideas is pretty high (serendipity). So without much effort the first point is taken care of.

It is on the second point that divergence appear amongst investors, and it appears more so in case when we are talking of stocks on high growth path.

For last few days I have been struggling to solve this problem of "what price to pay for growth" until i bumped onto one of the blogs of Aswath Damodaran ( If anyone wants to learn valuation, please go through his lectures. They are free and brilliant). The link to these blogs are here and here

Based on the blog I ran the test on 5 companies, who meet probably all criteria of a quality business. These were: Amara Raja, Astral Poly, Atul Auto, GRP and Kaveri Seeds.

Before, jumping to conclusions of the test let me first share the methodology here.

Step: 1 : Find out the enterprise value of the stock ( Mcap+Debt- Cash)
Step: 2:  If we assume that company doesn't do any growth going forward then it can pay the entire income out to stockholders as dividends and as interest to lenders.In this case, operating income from the most recent period will be cash flow each year in perpetuity. The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place.By doing this we know what is the value of assets which company holds now.
Step 3: This involves calculating the value of assets which are required for growth. To calculate this we would need the following inputs

• Expected growth rate: I have assumed 25% for all the 5 companies
• Expected Return on Capital: I have taken average last 5 years as an indicator for this.
• Length of Growth: I have assumed 5 years,since all of them operate and have strengths to deliver growth for long periods.
• Reinvestment Rate: For a company to grow it needs to reinvest money it earns into business which can be calculated as Reinvestment Rate= Expected growth rate/RoC

Once we have this data in place we simply to a DCF for 5 years, with operating income of each year being reduced by the reinvestment amount required.

Step 4: The difference between EV(Step 1) and Value of Assets( Step 2) gives us the price which we are paying for growth.
Step 5: Comparing price found in step 4 with value of assets for growth( Step 3) will give us an indication whether this stock is overpriced/cheap/fairly valued.

The results of my analysis courtesy Prof. Damodaran are given below. Also attached is the link for excel sheet with all calculations. It is a modified version of what Prof. has shared on his blog. 
 

Inputs	Amara Raja	Astral	Atul Auto	GRP	Kaveri
Growth Rate	25.00%	25.00%	25.00%	25.00%	25.00%
RoC ( Avg. 5 years)	31.00%	21.80%	30.00%*	29.40%	20.00%
Growth Period	5	5	5	5	5
Cost of Capital	15.00%	15.00%	15.00%	15.00%	15.00%
Stock Price	239	310	114	1603	1073.00
Outputs ( In Crs)
Enterprise Value	3918	727	121	269	1361
Value of Assets in Place	1442	322	107	159	427
Value of Assets for Growth	1107	149	80	116	159
Price Paid for Growth	2476	405	13	111	934
Price Paid/Value	2.24	2.71	0.17	0.96	5.89

* For Atul Auto RoC is average of last 3 years.

The link for the excel sheet is here. One can modify all the input parameters into the sheet to see at what price/growth rate/RoC does a stock become overvalued or cheap.




Has this solved my conundrum? Yes, but i have fallen into another conundrum of a few biases :(. More on that later

Till then Happy "growth" Investing.

Regards,
Saurabh
PS- Invested in Atul Auto, GRP & Kaveri Seeds, although all are very small positions as of now.

JB Chemicals: Cash is King

In a rising market such as what we are witnessing today, it becomes increasingly difficult to find good stocks which are cheaply available. 

For me one of the resorts in such a run up is to find statistical graham style cash/debt- capacity bargains (Explained brilliantly by Kiran here: Debt Capacity Bargain) and one of the stocks which has popped up is JB Chemicals (JBC). 

Business of JBC:  JBC was founded by Mr. J.B.Mody and is one of the oldest branded generic drug manufacturers in India. Some of its well known brands are metrogyl, rantac, nicardia etc. JBC also does contract manufacturing with specialty in lozenges and supplies them to various geographies.

Like a typical branded generic play JBC is a good but not great business. The same can be concluded if we look at its RoE & RoC figures, which are in range of 16 to 18% consistently.

The company becomes interesting when we consider that they have recently sold off their OTC business of Russian & Other CIS countries. Sales from this division were around Rs.200 Crs and PAT of around and company received Rs.1200 Crs for the same out of which Rs. 320 Crs was paid as dividend.

At present cash position of the company is as follows:

Cash & Investments= 560 Crs

Less Debt               = 80 Crs 

Balance                 = 480 Crs

Present market cap of the company is around Rs.637 Crs, which means we are getting the whole business for around Rs. 157 Crs or around Rs. 18.

Excluding the CIS business JBC had sales of around Rs.635 Crs in FY 12 and if we assume a nominal growth of 10% & lower end PAT margin of 10%, we get EPS of around 7.5 which means we are effectively buying the company at P/E of 2x, which is much lower than P/E assigned to other comparative companies.

So, it is clearly established that on a valuation front the company looks deep into cheap territory. 

However, there are certain pitfalls one needs to check to ensure that such ideas don't become value trap. Let’s have a look at them

A) Is the management efficient in capital allocation or will they blow away the cash they have got :

Few indicators for this are

• RoE & RoC
• Sales to Free cash flow
• Past usage of cash
• Dividend Payout ratio

1) RoE & RoC- Both look decent but not great which can be expected from a branded generic drugs manufacturer.

	FY12	FY11	FY10	FY09	FY08
RoE	67	16.5	16.5	14.79	11.15
RoC	8.33	17.62	16.59	18.03	10.11

2) Sales to Free Cash Flow- This looks healthy. Any company able to convert around more than 10% of its sales to cash is doing good business. I have not taken this for FY 12 as they comprise of income due to asset sale.

In crs	FY12	FY11	FY10	FY09	FY08
Operating cash	879	133	109	98	38
CAPEX	80	33	12	15	28
FCF	799	100	97	83	10
Sales	797	854	716	670	558
FCF/Sales	-	11.71%	13.55%	12.39%	1.79%

3) Past Usage of Cash: If the company has been generating cash as indicated above it is important to look has the company blown away cash in the past. This can be checked by looking at Dividend Payout ratios, whether they have done unrelated diversification or any special payouts to promoters etc. The same can be checked by again looking at cash flow statements to see if there are lots of investments and if yes where are they going. Similarly is money being constantly used for large CAPEX’s etc can be seen from the cash flow statement.

If we look at AR’s of last 5 years, Dividend Payout Ratio is has been consistently in range of around 13-15% for which is an ok indicator.

The company also doesn’t seem to be very aggressive in CAPEX, or forming subsidiaries or investing in JV’s.

This gives comfort that they will probably not blow away cash in random unrelated things.

B) Integrity of management/Aggressive Accounting- Company is in business for 50 years and there are no as such litigation's/problems evident. Also, spoke too few people in industry who have say management is honest though not the most efficient.

To check for aggressive accounting we looked at cash from operations and PAT for last 5 years. Most of the times there is not much divergence here, which indicates fair accounting by company.

In Crs	FY12	FY11	FY10	FY09	FY08
PAT	677	139	118	25	45
Net Cash flow from operations	879	133	109	98	38

C) Indication of management on future business plans- As per AR of FY12, company has indicated that they want to focus only on pharma segment with more focus on domestic business. They are not is a hurry to use the cash till they get the right opportunities. They are specifically looking to increase product penetration and also get approvals for few other geographies.

Conclusion: JBC looks like a decent bet to me for medium to short term, wherin I expect the valuation gap to close. Although, one needs to keep a track on how does the company plan to utilize the cash? Another point to be noted is that when one looks at cash/debt capacity bargains it is better to have multiple bets.

Regards,

Saurabh

PS- Have initiated a starter position. Also as stated earlier I am invested in other cash/debt bargains like Mazda ltd and Piramal Enterprises ltd