Swaraj Engines (SEL)- Vantage Analysis- Part 2

In last post we looked at business of SEL from a perspective of Business Analyst.  Lets take this further now:

2) Vantage Point of Prudent Banker :

For a prudent banker, 3 risk factors need to considered which would be size of company, cyclicality of business and interest cover.

• Size of Company :: SEL is a small company, but as it is promoted by M&M and Kirloskar Group. The size risk thus takes care of itself. 
• Business Cycle:: The business is to an extent cyclical as it is directly dependent on the tractor demand. Tractor demand in itself is a function of agri spending, monsoons and various other factors.
• Interest Cover:: Calculations for this are given below
• Average cash flow (A)= 38 Crs, 
• Interest cover (B) = 3.5 x, due to cyclical nature of business,
• Annual interest payment which company can make= A/B=10.85 Crs.
• Assuming interest rate of 11%, company can easily take debt of around 100 Crs. This would be the safe debt capacity of the company.

Therefore, at Rs. 100 Crs the prudent banker can soundly sleep at home as we would have very low risk of company defaulting on its loan.

3) Vantage Point of not so Prudent Investment Banker:

An investment bankers eye will light up after looking at these figures:

Fig. in Crs	FY08	FY09	FY10	FY11	FY12
Cash	29	54	55	74	70
Investments	17	20	58	58	81
Total	46	74	113	132	151

The company has generating cash at a handsome rate, and for an investment banker SEL will be a good candidate for advising the company on some acquisitions or some exotic investment options. History, is filled with cases when sound companies have gone on to do some stupid acquisitions and have suffered due to them.

Thus, cash and its usage will be a key figure to monitor. What does SEL do with cash and how does it efficiently deploy this cash is something any investor should track and also try to check with management.

4) Vantage Point of a Value Investor: A value investor would like to buy a good business, run by good capital allocators and at the right price. He tries to buy stocks at price there is no value given to growth of the company. Also, he looks for catalyts which can re-rate the stock. Let us look at this one by one.

• Good Business: Is SEL a good business? It is a good business but not great on account of lowered pricing power. On all points such as ROE, low D/E, cash on books, management quality etc SEL does well. Its growth will be a function of tractor sales by M&M.
• Capital allocation: Till now SEL management has shown excellent deployment of funds, giving RoE of around 30% consistently. What needs to be tracked is how do they deploy the cash which the business is generating? Will the start selling engines to other companies, diversify or return it to shareholders?.
• Price:  The right price for a value investor is the intrinsic value of company. Unfortunately, this is neither a fixed number nor is there a standard method to evaluate this. Intrinsic Value is  usually a range in which the company becomes a good bargain. To find this range we can look at the following methods
• Debt Capacity Bargain:: The vantage view of Prudent banker is nothing but in value investing parlance Debt-Capacity Bargain (DCB) taught by Ben Graham. As per DCB, SEL becomes a steal when its Mcap is less then its Debt Capacity+Cash. This figure comes to Rs. 100 Crs+ Rs. 150 Crs= Rs.  250 Crs, giving me a price of Rs. 201. 
• Basic DCF:: Link to calculations here:: DCF-SEL. The intrinsic value by this method comes to Rs. 570 Crs. Adding cash of Rs. 150 Crs, M. cap comes to Rs. 720 Crs, translating into price of Rs. 580/-.  An analysis based on DCF can easily bias towards an optimistic view of the business. Assuming that these are optimistic projections, i discount this price by 25%, to arrive at CMP of 435.

• The range which we thus get is Rs. 202- Rs. 435. The present CMP is around Rs. 400. Whether a value investor will invest or not is a function of how much margin of safety he desires.
• Catalyst for re-rating:: Price of a stock is a multiple of  P/E and EPS.  A value investor will not just look at EPS ( which we have discussed above), but will also try to see if their is a way in which P/E can be re-rated. These in case of SEL could be 

1. Special Dividends/ Increased Div. Payout:: The pace at which SEL generates cash, could lead to this happening. They already have a healthy payout ratio of around 28%, which could further increase. 
2. Buy-Back of shares:: The best possible scenario for the minority investor. This will automatically increase the EPS and in absence of any other usage could be the best way to deploy the excess cash.

5) Vantage Point of a Short Seller: Famous Investor James Montier, says that people who short a stock are the most sound fundamental investors as they usually have unlimited risk. So let us try and understand why a person who shorts stocks might be interested in SEL.

• As Tractor business becomes more competitive M&M might be forced to reduce its margins. Since SEL has limited pricing power this would mean shrinkage in margins of SEL which would then make it a not so attractive cash generating machine.
• A slowdown in off take of tractor sales can lead to M&M demanding longer debtor payment periods from SEL. This will lead to a working capital gap being created. This will be either funded by cash which will reduce returns or by taking loans which will lead to financial expenses and lowered EPS.

This concludes my cloning of a great original post. 

Regards,

saurabh

PS- I am not invested, but keeping it in watch list for accumulation.