Value Investing Contest Winning Entry #6: Swaraj Engines

This report was prepared by Nishanth Muralidhar, 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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About the Business
The Indian tractor industry has 13 national and a few regional participants. The market share is, however, concentrated amongst the top-five manufacturers, who account for over 90% of total volumes.

India’s current tractor penetration is estimated at 20 tractors per 1,000 hectares of agricultural land. While this is close to the averages in some countries, the statistic belies the fact most of the land holdings in India are smaller than those in foreign countries. Also penetration numbers vary widely across states, with states like Punjab, Haryana or Western UP enjoying significantly higher penetration compared to the rest of the country. Some regions like Eastern Uttar Pradesh, West Bengal, Orissa, Madhya Pradesh, Karnataka and Andhra Pradesh have relatively low penetration levels.

Also, there exists headroom for growth of smaller horsepower tractors among small and marginal farmers. Further, even if tractor density was to remain constant, demand in the industry is expected to remain sound on account of shortening tractor replacement cycle.

Industry growth drivers are scarcity of farm labour, strong replacement demand, government support, increasing mechanization and exports (From ICRA 2012 Report).

Mahindra and Mahindra Tractors (M&M) is the market leader, having a share of 40% and has only one supplier for its ‘Swaraj’ brand of tractors – Swaraj Engines Ltd. (SEL).

SEL is a Mohali-based company originally established to manufacture engines for the erstwhile Punjab Tractors Ltd. (PTL). The company was a joint venture between PTL and Kirloskar Oil Engines Ltd. (KOEL). In 2007, PTL was taken over by M&M. Since then SEL has not looked back and has grown its market share to the current levels of 14%.

SEL’s Business Model
SEL manufactures diesel engines for the ‘Swaraj’ brand of tractors owned by M&M. It manufactures diesel engines, diesel engine components and spare parts. It supplies 5 types of engines, from 20HP range to 50HP range. It also manufactures high-tech engine components for Swaraj Mazda Ltd. (SML).

The company’s engine business constitutes approximately 95% of its product revenue. The remaining 5% represents value of hi-tech engine components being supplied to SML for assembly of commercial vehicle engines. The company has only one customer in the form of M&M. So SEL’s growth and shareholder returns depend entirely on the plans M&M has for the ‘Swaraj’ brand of tractors.

A couple of interesting factors that may be noted about SEL is the extraordinary strength of its balance sheet right from the beginning of its operations, and a very small cash conversion cycle. These are hallmarks of a great business, as we will examine in detail later on.

Financials

1. Size of Opportunity and Profit Pool: Given that the land under agriculture is not increasing in India, population is not decreasing, and manual labour is getting more expansive, mechanization seems the way to go. There is low penetration of tractors in India compared to the global average. The Indian tractor market is the largest in the world. M&M is the largest tractor company in the world by volume, and ‘Swaraj’ brand is number one in the country as per customer surveys (from M&M’s FY14 annual report).

Thus, given the potential opportunity and market leadership status, SEL is in a good position to grow manifold in the future.

2. Strong Return Ratios: Superb return on capital employed, averaging 24% over the past 10 years, and a debt free status, with healthy operating margins, are testimony that of the strong business model of SEL.

3. Free Cash Flow and Cash Conversion Cycle: SEL has been generating Free Cash Flow (FCF) more than its net profit over a ten-year period, which again is the hallmark of a well-run business (Positive FCF is very hard, not impossible, to fake over a ten-year period). SEL generates loads of FCF which enables it to undertake capex programs without resorting to debt. As always, cash used wisely is king.

Since SEL has instant payment terms with M&M, it has very small debtor days (15 days) and inventory days (27 days). This coupled with FCF generation are characteristics of a truly great business. Other businesses having this characteristic are Hero Honda, HUL, and VST Industries.

Balance Sheet
Debt free status, healthy return ratios, and good cash reserves all lead to the formation of a fortress like balance sheet. SEL’s cash and equivalents on balance sheet come to Rs 145 crore, almost 20% of the current market cap (as on 16th March 2014).

Very few businesses are able to maintain balance sheets like SEL. This is in no small part due to the instant payment terms with the single customer (M&M) and suppliers.

Dividends
For a small investor, one of the best ways to check corporate governance is to look at the dividend policy of the company. If a company with good FCF and consistent profit generation pays out liberal dividends, that is a very healthy company to invest in and SEL is one such company.

Now people can question that cash would be better utilized in growth opportunities, but cold hard cash is hard to conjure up unlike earnings or positive press releases. Dividend is the only thing that a company necessarily needs to write a cheque for, unlike paying its suppliers or obtaining payment from customers. SEL has had a consistent history of dividend payments over the past 10 years (except FY07) and that bodes well for shareholders.

Risks

1. Dependency on single customer (M&M) who is also a major shareholder is a risk. Conflicts of interest can arise if M&M squeezes the margins of SEL thereby leaving the shareholders high and dry. However, this situation has not arisen yet. If anything, M&M’s parentage has only benefited SEL, leading to better operational efficiency and margin expansion. As it is a “captive” manufacturing unit, it is able to pass on most cost increases to M&M.
2. Dependence on the monsoons is also a risk. A weak monsoon affects the need for tractors. As the monsoon weather is out of the hands of the company, it can be difficult to ramp up or down production accordingly.
3. Main raw material is steel, whose prices can affect the company adversely.
4. Competition from other tractor manufacturers, government interference etc, are also risks worth noting.

Valuations
We have established SEL as a first class business, with good management who is friendly to shareholders. Now the question is – is it available at an attractive price?

I believe that we must pay a fair price for a great business, but not overpay. Let’s take two separate methods of valuation – Earnings Per Share (EPS) growth and Earnings Power Valuation (EPV). All estimates below are taken conservatively. All figures are in Rupees Crore.

1. Earnings Power Valuation(EPV): SEL’s trailing 12-months PAT (Profit After Tax) is Rs 63 crore. Since it is in a cyclical industry, let us take a five year average of the PAT numbers and that figure so obtained is Rs 55 crore.

For such a company which has very good returns on capital, its intrinsic value is driven by its earning power (profits after taxes earned). Let us assume that SEL’s PAT stays at its current levels and there is no growth in the same. So the maximum multiple we would be willing to pay for it would be 12.5 times its current earnings power (12.5 is the inverse of Government of India bond yield of 8%, or 1/8). We would expect at the maximum a risk-free return from a company which does not grow its returns. And the best proxy for a risk-free return is the yield of the Government of India bond.

Thus, the EPV of SEL would be Rs 686 crore, which is derived by multiplying 12.5 with Rs 55 crore. As SEL is most likely to have consistent growth in its EPV as demonstrated from its operating history, we can assign a conservative multiple of 1.5 to its EPV. Then, the final EPV that we can pay for would be Rs 1,029 CR (686 * 1.5).

At current market price of Rs 660 (as on 16th March 2014), the stock is trading at a market capitalization of Rs 820 crore. So if we take EPV of SEL as Rs 1029 crore or around Rs 830 per share, this translates into a 25% upside from current price of Rs 660 (as on 16th March 2014).

2. EPS Growth Rate Valuation: SEL EPS has grown at a CAGR of 19.5% over the past 10 years. Let us assume the company can grow at half this rate easily, it gives constant annual dividend of Rs 13 per share and the P/E of the stock stays at 11 times trailing-12 months earnings.

SEL’s current EPS is Rs 51.2 per share. Applying CAGR of 10% for 10 years, the EPS at the end of 10 years will be 132. Multiplying the EPS by PE, we get the price at end of 10 years to be 132*11= Rs 1,452. For 10 years, the total dividends would be Rs 130 per share. Thus the total return would be Rs 1,452 + Rs 130 = Rs 1,582.

So if we buy SEL at current market price of Rs 660 (as on 16th March 2014) and sell it at a price of Rs 1,582 per share at the end of 10 years, the CAGR in price comes to around 9%. Remember, we have estimated a very conservative EPS growth rate for the company, and that there would be no P/E expansion, and no increase in dividend payout. If any one of these three factors exceeds our estimates, then the returns would be even higher.

Disclosure: I, Nishanth Muralidhar, hold shares of SEL. I might buy, sell or hold those shares as per my needs. I am not being compensated in any way, financial or otherwise for the writing of this report. Please do your own research and run your own calculations if you decide to invest. A good starting point for the research would be annual reports of both SEL and M&M. Remember, the risks, profits and losses arising from any investment decision in this company belong to you and you alone.