Value Investing Contest Winning Entry #1: Balkrishna Industries Ltd.

This report was prepared by Ankit K, as part of the Safal Niveshak Value Investing Contest. None of the facts herein have been validated by Safal Niveshak. Also, please DO NOT treat this report as a “recommendation” from either the author or Safal Niveshak. Do your own homework.

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Company History and Business
BIL is a Siyaram Group Company with its history dated back to 1962. From setting up its first manufacturing unit in 1988, it has come a long way in becoming India’s leading exporter of “Off-Highway Tires”. It is an export oriented company with 90% of sales moving to different countries worldwide.

Highlights of the company’s business and financial strength are as follows:

• Widest and comprehensive product portfolio of over 2,000 SKUs and develop 100 to 120 incrementally per year.
• Current achievable production capacity is 166,000 MTPA (metric tonne per annum). It is to be enhanced to 276,000 MT by FY15.
• Market presence in more than 120 countries all over the world.
• Manufacturing facility at: Aurangabad, Maharashtra; Bhiwandi, Rajasthan; Chopanki, Rajasthan; Bhuj, Gujarat; Dombivali, Maharashtra
  

• Volume Trend(in Metric Tonnes sold)…
  
  2013-14E: As per management guidance in its corporate presentation

• FY13 sales Segment: Agriculture contributed 62%, OTR (Earth moving) market contributed 34% and 4% was contributed by other markets.
• Sales Channel: Replacement market (via distributors) caters to 81% of the sales. OEMs account for only 15%.
• On Going expansion at Bhuj: Setting up of a new manufacturing facility at Bhuj will augur incremental additions to capacity of 10,000 MT in FY13, 60,000 MT in FY14 and 120,000 MT in FY15. Investment in this facility is Rs 2041 crore up to September 2013, with Rs 850 crore being capitalized till that period.
• Distributor Model (replacement market): 80% of sales cater to replacement market. Replacement market is a more stable and high margin market compared to OEMs. In turbulent times of economic and global slowdown, it is the replacement market demand which continues to be resilient whereas the OEMs face pressure as we see dip in the sales of original equipments. Distributor model also helps the company to widen its geographical reach with minimum capital infusion as they work on “manufacture against confirmed orders” and hence do not require any warehouses to keep stocks. This policy not only reduces the fixed cost, it minimises the inventory carrying cost and sales & distribution cost considerably. Replacement cycle is also relatively small in case of agricultural and OTR market, thereby demand remains intact. Replacement cycle for agricultural tires is 2-3 years, while that of mining & construction is 9 to 12 months only. Due to the reasons as explained above, the company is being able to grow its exports in the market where global majors like Bridgestone, Goodyear, Michelin and Titan International find it difficult to strive. They face the problem of high labour and inventory cost. BIL also faces the challenge of high logistic cost, but it mitigates the same with very low labour and inventory cost. Hence, BIL has an operating margin of around 15%, while global tire makers operate at around 3-5% operating margin. Apart from that, the depreciating rupee going forward will make the exporting price even more competitive in the years to come.
• There has been no equity dilution in the last eight years. This is a good sign of a strong financial health of the company.
• Debt Equity Ratio has been consistently close to 1 for last eight years, but there is cushion in the debt service ratio.
  

Industry (Competition)
To begin with the industry structure we may note the following two quotes signalling broad nature of tire industry in US in the period of 1901 to 1930:

(..) an extraordinary burst of entry, with 249 firms entering between 1917 and 1922, and the number of tire producers peaked at 278 in 1922. Subsequently, the firm exit rate nearly tripled and the number of firms declined sharply despite robust growth in the industry’s output through 1929, when the number of producers dropped to 122. The number of producers fell even further after the Great Depression, reaching a low of 49 in 1950” (Buenstorf & Klepper, 2009, p. 1)

Klepper and Simmons (Klepper & Simons, 1997; 1999; 2000; Simons, 1995) underlined the peculiar durability of earliest entrants (early entry are defined the cohorts before 1917), which had a markedly lower exit hazard and persisted for many years thereafter. The age dependence of the hazard and the strong inverse relationship between the firm hazard and innovation are also in accord with the Evolutionary Industry Life Cycle theory. (Innovation and Industry Life Cycle: The Case of US tire Industry (1901-1930))

We get two strong points from the above quotes:

1. Historically, tire industry has a characteristic of concentrating in the hands of very few players.
2. Earliest entrants have a peculiar durability nature but innovation is very important to survive for many years.

BIL certainly has the signs of being one such player. Whether it will actually become such a player is an equation depending upon several factors. Only time will tell whether it will be able to succeed in it or not. It, however, is placed in a sweet-spot in terms of market and industry dynamics. It has its benefit both on cost side and demand side which gives an indication of a sustainable business model developing a strong economic moat. We can further satisfy the last comment with the following observations:

Intangible Asset or Brand: BKT tyres have been making inroads into newer geographies throughout the world. It is gradually creating a huge brand image of a company which sells high quality tires at significantly low cost. Though it is difficult to assign an economic value to this brand, but the industry dynamics and company’s product mix make it believable that the economic value of that brand has a tremendous potential to increase even more in times to come. Where major MNCs are facing margin pressure and capacity constraints, BIL is poised to make a leap forward.

Network Economics: The distributor model of operation is expanding the geographical reach of the company at a rapid space with relatively minimal costs as explained above. This network economics has a peculiar characteristic of increasing the value of the product with the increasing count of users (distributors and end users both). With more and more nations getting first hand feel of BIL products, the users are bound to increase if the quality remains intact.

Cost Advantages: Cost advantages can stem from broadly four sources:

• Cheaper process
• Better location
• Unique assets
• Greater scale

While it is difficult to comment on the process efficiency due to lack of data and no contact with the management, in relation to the foreign market it caters, BIL has an operating margin of 15%, whereas its MNC competitors have a low operating margin of 3-5%. The major cause for the same is the cheap labour cost and lower inventory cost of BIL. There is also a location advantage creeping up for BIL with its existing expansion facility at Bhuj. Bhuj is in the proximity of two large ports, Kandla and Mundra. The fact that company exports almost 90% of its products, logistic and selling & distribution expenses should reduce with this location advantage. Moreover time will tell if the economy of scale will work in its favour or not. Currently it does appear to be positive for the company as with increased capacity, more orders are met, and margins are expanding.

So, a wide economic moat seems to be present in this company which can be further substantiated by the following two charts:

Table 1 – Operational Performance

The product portfolio of other tire companies differ

Stock Performance

Image Source: Moneycontrol

Management Quality
Siyaram Group is a traditional Indian family-owned business. While there has been a remarkable operating performance by several Indian family-owned companies, there often has been a case of loose corporate governance as well. While it is impossible to predict about any future fraudulent corporate governance issues, we may run a checklist on capital allocation decisions of BIL as follows:

• Salary and perks to management: The managerial remuneration for FY13 has been around 6.5% of PAT. This appears to be a bit on the higher side. So, one should take into account this fact and asses the risks associated with it very carefully.
• Merging unrelated private companies into the company: BIL has four direct subsidiaries in the name of Balkrishna Paper Mills Ltd, Balkrishna Synthetics Ltd, BKT Exim Ltd and BKT Tyres Ltd. It also has three indirect subsidiaries in the name of BKT (Europe) Ltd, BKT Europe SRL and BKT USA (Inc). This leaves a possibility of some kind of adverse related party transaction, though none of such transactions found currently.
• Relatives without adequate qualification on the managing board: It is a family owned business and some sort of favouritism is evident in the membership of the board.
• Management trading in stocks of the company: Management ownership can be viewed below:
  
  Source: BSE website
  As we can see that there has been a steady control of management in the shares of the company, moreover there has been an increase in the shareholding in FY13. This should be considered as an encouraging sign, though it hardly changes anything on the business and financial front. On the whole we find it as a typical family-owned Indian business, so we need to take the corporate governance risks in mind while investing here. While there is no clear visibility of an adverse transaction, one must not take that for granted.

Risks

• Raw Material Prices: Tire industry is predominantly dependent upon natural and synthetic rubber. Rubber needs can be satisfied both indigenously and through imports. But as we see that cost of rubber consumed accounts for more than 50% of sales, variation in rubber prices would certainly affect the financial health of the company. The company though speaks about piling up rubber inventory in periods of suppressed prices. It is also to be noted that company has an advantage in imports as it does not have to pay duty on them, it being an exporting entity. We can look at the influence of import on the demand supply situation in last one year.
  
  In the last one year rubber prices were suppressed. Hence, we saw an uptick in margins. It will, however, be a real challenge to maintain these margins in periods of high rubber prices as the above data shows continuance of strong rubber demand.

• Concentration of Business in US and Europe: As per the company’s presentation, around 70% of sales in FY13 accrue from the US and Europe. It is imperative for the company to expand in other geographies as well to mitigate country risk. While the company has already started venturing into African and Asia pacific region, it continues to be vulnerable to slowdown in advanced economies.
• Foreign Currency Risk: While the company speaks of a hedging plan in place, there is still significant un-hedged foreign currency exposure in all the years of operation. That should be carefully monitored as well. The company though have managed to reduce foreign currency transaction loss from Rs 10 crore in FY12 to Rs 5 crore in FY13.

Valuation
FCF is futile here, as the company does not show any positive FCF in the last three years. But, we do get a sense from the annual report that working capital management has improved significantly in the last year, if that trend continues, we may see a positive FCF from FY16 onwards as by then the capex plan of Bhuj will take its full effect on the books.

Operating cash flow should improve with the reduction in inventories and receivables. With lesser capex requirements post Bhuj expansion, FCFF may turn positive from FY16. But to make an accurate assumption of the same as on date is impossible. So, we may look at the relative valuation multiples to arrive at the intrinsic value. The same can be understood below:

Source: Morningstar Website

A simplistic approach is followed wherein equal weights have been given to all the relative parameters and value has been arrived by using the average valuation multiples the stock has been trading for the last eight years.

A margin of safety of 30% has been taken for risks associated with the business and management. But, a wide economic moat seems to be there in the business model. Hence, I would suggest accumulating the stock at levels close to 300.

Disclosure: I, Ankit K, am long on the stock at Rs 280, so I may be positively biased towards it.

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Note: I will publish more winning reports over the next few days.