Value Investing Contest Winning Entry #4: Gabriel India Ltd.

This report was prepared by Venkat Sivagnanam, 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.

I started to screen for a quality business which I understand and has long-term competitive advantages and potential to generate free cash flows for at least the next 20 years to come.

With this in my mind, I decided to focus on automotive industry in India as it is going through a domestic slump and has been in the news for bad reasons (high-interest rates, inflation, low sales etc.). It is not unusual to find an under-valued and reasonably strong business in a sector that is undergoing a temporary slump or recession.

I restricted my screening to automobile sector. Further, within the automobile sector, I decided to focus or limit my screening to the automotive components/products suppliers, rather than vehicle manufacturers/OEMs.

This was based on the hypothetical scenario that increasing competition amongst major OEM brands, vying for their share in the lucrative, growth-oriented, long-term Indian auto market, would help the quality auto component suppliers to not only increase their sales volumes but also gradually expand their profit margins possibly for over next 10-15 years (assuming that Indian auto market may mature by 2030).

This increase in profitability may be from economies of scale and maximum capacity utilization, brand-equity and quality driven price premium, and also due to simple supply-demand mismatch in favor of the auto suppliers.

My screening process, within the auto ancillary sector, was narrowed to those companies that have earned return on equity (ROE) of 15% of more, grown through internal accruals (with low debt levels and negligible equity dilution), and sound working capital management.

The screening process led me to Gabriel India Ltd. (GIL).

Business Description and History
GIL was incorporated and listed in 1961 and 1978, respectively. It is a flagship company of Anand Group which is a leading auto components supplier to major auto OEMs in India. It is a market leader in Ride Control products (shock-absorbers/shoxs & struts) in the country or simply put, like Xerox being synonymous with photo-copying, GIL is synonymous with shock-absorbers and struts in India.

Today, GIL has seven manufacturing facilities and four R&D centers spread across the country. The fourth R&D center is a new state-of-art-tech-centre for two-wheelers set-up in Hosur (opened in Dec. 2013). The company supplies ride control products across automotive sector: 2 and 3-wheelers, passenger cars and commercial vehicles.

The company has technology tie-ups with KYB Corporation, Japan, KYBSE, Spain and Yamaha Motor Hydraulic System, Japan for passenger cars and two wheeler applications. It also has capabilities to develop proprietary products and solutions in-house, thanks to its state-of-the-art R&D centers and 50+ years experience catering to Indian market.

Its website says…

The market leader, Gabriel delivers one shock absorber every second. With close to 300 models, the company offers the most diversified basket of products to its customers supplying to every major vehicle manufacturer in the country across segments. As the leading OEM supplier in the country, Gabriel holds a 45% share of the Passenger Vehicles segment, 19% of the Two-wheeler segment and over 80% of the Commercial Vehicles Segment. Gabriel leads in the Aftermarket as well and exports ride control products to several developed markets in the US, Europe, Australia and the Asia-Pacific region.

~ Excerpt Source

Competitive Analysis

• Substitution Threats (Very Low): There is no real threat of substitution for this product. For example, if market for electric car or solar cars gain traction and the traditional petrol or diesel car market shrinks, it may be disrupt and badly affect the suppliers of car engines, engine parts and engine oils (e.g., Castrol). However, this may not be the case for many basic parts such as shock absorbers, wheels, brakes, gear systems etc..
• Bargaining Power of Suppliers (Low): GIL’s suppliers, mainly steel sheet companies, do not enjoy sufficient bargaining power as steel is almost a commodity and there are lots of suppliers and huge idle capacity in the domestic market. From the financial analysis of the company, one can see that GIL enjoys a trade credit period of 80 days on average (FY13).
• Bargaining Power of Customers (Average to Moderately High): GIL’s customers have average bargaining power as there are few strong competitors of GIL looking forward to win new orders and secure long-term supply contracts from marquee OEM brands and to maintain their market share. The company faces strong competition in the two-wheeler segment. However, it has a good track record of quality, 50 years of market experience, just-in-time delivery systems, patents, culture of innovation with strong R&D capabilities, and tech tie-ups making it as a preferred supplier of OEMs. Shock absorbers and struts are an integral “quality” element of any automobile and they are essential for driver and passenger comfort (as immediately felt by the customer during test drives) and safety. Hence, the OEMs can’t compromise on the quality of Shoxs. GIL’s average receivables collection period is only 40 days and this is very comforting.
• Threats from New Entrants (Low): Manufacturing of ride control products require proprietary rights and design knowledge. Also, to supply this to OEMs one needs to have a proven track record of quality. New entrants can be pressurized by the existing players through under-pricing, economies of scale, close client relations and efficient/innovative products.
• Competitive Rivalry (High): GIL has competition, mainly from Munjal Showa and Endurance. Both these companies are catering to 2-wheeler segments. For example, Munjal Showa mainly supplies to Honda Motors and Hero Motocorp. Munjal has a market share of 60% in the 2-wheeler segment and hence dominates this segment. This can be attributed to its position as the sole supplier of shocks to Hero Motocorp which is a leading motorbike company in India. Though this is positive, Munjal’s concentrated customer base is a big risk, especially when Hero performs badly Munjal will inevitably so. Munjal has technology tie-up with a Japanese company. Endurance serves 2-wheeler segment of Bajaj Auto and it’s an unlisted entity (so no much data available). In fact, during last fiscal Munjal Showa (with RoE of 22% with zero debt) has outperformed GIL (with RoE of 16% with debt), thanks to Hero Motorcorp’s 55% market share in 2-wheeler segment. Also, Munjal’s second important customer is Honda Motorcycles and Scooters India (HMSI) which has out-performed Hero Motocorp and Bajaj during the recent difficult times (Read here).

Moat and Growth Opportunities
GIL has a diversified customer base involving all major auto players except a few like Hero Motorcorp. This diverse customer base will act against the competition and protect GIL from the risk of client concentration as faced by Munjal Showa or Endurance.

Though GIL earns 50% of its revenues by selling to 2-wheeler segment, it has only 20% market share in this segment. This means that GIL has room to grow in the 2-wheeler segment and increase its market share by competing with Munjal Showa. Also, Munjal Showa’s close association with Hero Motorcorp may make its competitor Bajaj to prefer GIL and Endurance for its shock absorbers supplies as it grows.

GIL has clients such as Piaggio, Kinetic, TVS and HMSI in its roster list. It has recently opened a 2-wheeler shocks R&D centre to innovate and develop custom-made products for its clients. All these points augur well for GIL’s future growth in the “semi-defensive” 2-wheeler segment.

The company owns several patents, has technology tie-ups with three different foreign partners and constantly innovates its products. It has 80% market share for commercial vehicles segment and 45% share of the passenger vehicles segment. Clearly, except for the 2-wheeler segment, GIL has a strong market position and dominance.

Its diversified customer base across passenger cars, commercial vehicles and 2-3 wheeler segments are provide the company with a strong moat, apart from its patents, quality, client network, learning curve and innovation capabilities.

Various market studies show that the Indian automobile industry’s long-term prospects are still intact and it will grow at 9% annually until 2020 and beyond. This will invariably help the auto components suppliers as well to grow around the same rate (if replacement market and exports are included then the growth may be in double digits).

Financial Analysis
Annual reports starting from FY06 are accessible from the company website and hence financial analysis data is restricted to last 8 fiscal years, i.e., from FY06 to FY13.

Financial Picture from FY06-FY13
GIL revenue and net profit growth trend since FY06 till FY13 is shown in Graph 1 below. During FY08 and FY09, there was a slight dip in sales which was due to global economic crisis. However, FY09 onwards, sales have more than doubled (2.2x) and have grown at a CAGR of 17.6%. Net profit during the same period has grown by 6x (CAGR of 44%).

This tremendous growth has been due to GIL’s operating leverage as can be gleaned from the Table 1 (Installed Capacity Vs. Production).

Sales growth (in volume as well as value) and better utilization of capacity resulted in the increase of profitability; net profit margin has peaked up to 5% during FY12 from 1% level of FY09. The company has reported a RoE of above 15% since FY10, with a very healthy 25% and 28% in FY11 and FY12 respectively.

Clearly, from DuPont analysis (refer Table 2) one can see that this was achieved from expanding net profit margin and uptick in assets turn-over (thanks to increase in sales and capacity utilization).

Prior to FY10, the RoE and RoCE was well below 15%, even dropping to paltry 1% during FY07 (without considering other income). If we see this financial picture as an emerging movie, the first half seems horrible (FY06 to FY09) where as the second half is more interesting to watch (FY09 to FY13).

As the company starts to operate to near 100% capacities and as domestic vehicle sales continue to grow, the RoE and RoCE will expand further and stay near or above 20% levels. The management has to be careful not to allocate capital as it did in the pre-FY10 scenario and has to constantly strive to increase shareholder value by adding new capacities or new production facilities judgmentally after thorough market demand analysis/forecast.

Latest Trends
GIL’s FY13 results are a good indicator of how the company performed during a difficult global and Indian macro-economic environment.

From FY12 to FY13, sales growth was only around 9% whereas net profit dipped by 28%. This was mainly due to raising raw material and other expenses combined with a dwindling vehicles demand in India leading to a net profit margin de-growth by 100 basis points (1%).

As of FY13, GIL’s debt-to-equity ratio and interest coverage ratio are at comfortable levels of 0.6 and 4.5 respectively. Quick ratio of 0.5 is not of big concern for the company as it enjoys Rs 137 crore of float (trade creditors) and has only Rs 49 crore of short-term debt, and Rs 15 crore of maturing long-term debts vs. a comfortable Rs 100 crores of cash flows from operations.

High number of payable days (80 days) and relatively low receivable (45 days) and inventory days (50 days) also show that the company’s products are much sought after. This point is further evidenced by the gradual decline in receivables days over the last eight years. GIL’s current ratio of 1.1 is a result of efficient working capital management. In fact cash conversion cycle for the company has been in the range of 5 to 15 days only in the last 5 years.

All these pointers indicate that the company’s financials are pretty good and the competitive advantages enjoyed by it are reflected via floats, payable days being twice that of receivable days, efficient working capital management, short cash conversion cycles, high cash flows and low debts levels.

Table 1: Production capacity (in Million units) of shoxs and struts
Vs Actual Production from FY06 till FY13

Table 2: DuPont Analysis for Gabriel

• Expiry of patent rights: Company is constantly innovating to overcome this problem
• Any dispute with technology partners: Has 3 technology tie-ups and also intensively working on developing its own products through its in-house R&D
• Any serious quality issue can lead to cancellation of supply contracts: Intensive testing and quality control is done to ensure quality. In some production facilities client concentration risk is there, for example Gurgaon plant for Maruti Suzuki and Sanand plant for Tata Nano. If the OEMs have any strikes or model failure etc. it will badly affect the average capacity utilization of the company and hence can cause serious dent in profits.
• Competitors can come up with better quality products: GIL is trying to outcompete through innovation and client relationship management.
• Interest rate sensitivity of auto market can lead to economic cycle dependent growth: overall long-term growth seems intact thus can average out short-term slumps in growth.

Valuation
When I started analyzing the stock, it was quoting Rs 22 per share. As of date (3rd April 2014), it is quoting at Rs 30 per share.

GIL generated a free operational cash flow of Rs 2.7 per share (after deducting for depreciation) in FY13, which was a considerably a bad year. Rs 2.7 is a conservative estimate. And, if we consider that the cash flow increases at 10% YoY for the next 7 years (as per market studies of Roland Berger Consultants and Booz Allen), then by 2020, the free cash flow per share will be Rs 4.8.

I will be happy to earn 15% return on my invested capital and this translates into (Rs 4.8 / 15%) = Rs 32 per share as the value that I would consider paying for GIL.

Using DCF method (7-year CAGR of 10%, terminal growth of 2% from 8th year and a discount rate of 15%), the intrinsic value comes to Rs 28 per share and after adjusting for outstanding debt and contigent tax liabilities it would drop to around Rs 24 per share.

Averaging the first estimate of Rs 32 and DCF estimate of Rs 24, I get a fair value estimate of Rs 28 per share. Kindly note that if one is satisfied with 10% discount rates (in parity with long-term AAA bond yield rates), the valuations will inch further higher.

Given the strong likelihood of auto sales picking from the current levels and staying sound during the next 7-10 years and beyond, the company can benefit from its market leadership, economies of scale and pricing power, leading to higher free cash flows and hence, much higher intrinsic value than currently estimated.

Disclosure: I, Venkat Sivagnanam, am not invested in the stock.