One of the companies I have invested in since last year is Swaraj Engines Ltd. It is a small cap stock with a market cap of RS. 490 cr as of close of day, 3 August 2012.
- Manufactures and supplies tractor engines for Mahindra & Mahindra’s “Swaraj” brand of tractors.
- Indian agriculture sector has low levels of mechanization, there should be steady demand over long-term with government support for minimum prices for farmers, credit availability and schemes like NREGA which are diverting traditional farm labour into government projects.
- Financially well run – Zero debt, cash on books of close to Rs. 150 cr, this is more than 30% of today’s market cap of Rs. 490 cr, 5 year average RoE of around 30%, high capacity utilization, good working capital management
- Trailing P/E ratio of 9.4 times FY12 earnings which is lower end of historical price band
- DCF analysis for the very worst case gives valuation which works out to 10% lower than a stock price of around Rs. 395.
- Possible weak monsoon may give a great opportunity to pick it up very cheap and hold for the long-term. Keep your eyes focused on Swaraj Engines.
Company – Qualitative analysis
Punjab Tractors Ltd. (PTL) was the owner of “Swaraj” brand of tractors and also had a stake in Swaraj Engines Ltd. (SEL). “Swaraj” tractors have a long history being one of the earliest homegrown tractor brands in India. PTL had a bad phase from 2003 onwards. In the June 2007 quarter Mahindra & Mahindra (M&M) bought PTL. M&M thus acquired PTL’s shareholding in SEL.
The main business of SEL is manufacturing of tractor engines ranging from 20 to 50 horsepower (HP) capacity and it supplies them solely to M&M. As on date more than 200,000 Swaraj Tractors fitted with engines produced at SEL are in the field as per the company website.
Breakup of sales for FY12
The bulk of SEL’s revenue comes from selling engines to M&M for the “Swaraj” brand of tractors. The next head of revenue is from hi-tech engine components supplied to SML Isuzu (erstwhile Swaraj Mazda) for assembly of commercial vehicle (CV) engines.
Installed engine capacity on double shift basis used to be 42,000 engines per annum till a couple of years back. SEL undertook a capacity expansion programme in two phases. The FY12 Annual Report mentions that the first phase of capacity expansion to 60,000 engines is near completion. The next phase of expansion will take capacity to 75,000 engines per annum by December 2012. SEL manufactured 55,000 engines in FY12 compared to 43,413 engines in FY11. Assuming a base of 60,000 engines per annum as capacity, the capacity utilization works out to 92% for the year gone by.
Breakup of cost of raw materials for FY12
I have attempted to understand SEL’s ability to protect their margins. With the recent changes in accounting rules, it is not possible to have analysis for FY12 because companies are no longer bound to give the number of inputs that they purchased in different input categories. Nevertheless there is data for years before that. I have indexed all output and input prices per unit respectively to 100 for the base year ending FY2000. Subsequent data points reflect progressive changes in per unit prices over till FY11.
As you can see, SEL has been able to increase per unit prices of engines sufficiently to cover the price rises in inputs. One exception is the cost of flywheels which is on a trajectory of its own. The consolation is that it makes up around 5% of input costs. I have skipped “Others” category solely for the reason that data for it is not provided in the Annual Report. It is not possible to provide “Others” for the reason that it must be made up of a range of multiple small contributors.
Since SEL sells all its tractor engine output to M&M, we need to look at competition faced by M&M. According to a February 2012 ICRA report, the competitive position in the tractor market is as follows:
A research report mentioned that M&M has increased market share over last 5 years in all regions in India save North where it has marginally declined.
The M&M company website has this to say about “Swaraj”,
We acquired Swaraj when it had under 5 percent market share and turned it around in less than two years, growing its market share to more than 12 percent.
As mentioned above the Company increasing its total installed capacity to 75,000 engines per annum. The entire capex of Rs. 94 crores for the proposed expansion is being met from internal resources. There has been no need for debt to finance this expansion. SEL’s growth plans depend wholly on M&M’s tractor business.
Industry growth drivers
Some of the tractor industry growth drivers in the last few years have been:
- Govt. support for crop prices
- Social schemes like NREGA which are providing alternate employment to farm labour and thus reducing available manpower for agriculture
- Increased mechanization
- During the last few years there has been increasing use of heavy horsepower tractors in infrastructure projects for haulage.
- Increased NBFC credit availability
The growth in tractor sales from FY05 to FY12 is as follows. There has been a compounded annual growth rate of more than 12% over this period. There is a moderation in FY12 with only a 2% growth rate over the previous year (FY12 data is annualized as the report only mentions 9 month data till December 2011)
Source: Department of Agriculture, State of Indian Agriculture 2011-12
|(in %)||June 2012|
Promoters include M&M which holds 33.22% and Kirloskar Industries which holds 17.39% respectively.
Prominent institutional investor holding shows Reliance Capital Trustee holding 9.4%, SBI MF holding close to 3.1% and RBS holding 1.4% as per June 2012 shareholding pattern records filed with the exchanges.
- Theoretically M&M could squeeze margins in SEL and keep greater profits in the parent company rather than the associate company and get a higher multiple on the profits. The recent squeezing of Mphasis’ margins because of pressure from HP which has control over Mphasis is a good example of this type of risk. In SEL’s case, there is protection because Kirloskar Industries is a co-promoter of SEL and a situation like this would be against its interest, hence reducing the risk of this happening.
- Bad monsoons spell reduced demand for tractors. M&M is the biggest player in tractors. SEL will surely be affected if there is a dry monsoon season.
Company – Quantitative analysis
I like the company’s annual report for regularly displaying a 12 year snapshot of performance indicators. Incidentally I have noticed that a lot of companies that I have analyzed which seem to be steady performers have multi-year snapshots like this. Does it say something about a company’s long-term vision and learning from past mistakes? Because it takes guts to show the good with the bad. What do you think?
In SEL’s case there was a bad patch that the management could have chosen to forget about. But we get to see it.
Figures are in Rs. cr.
|Revenue 5 yr CAGR||28%|
|EBITDA 5 yr CAGR||25%|
|PAT 5 yr CAGR||29%|
|EPS 5 yr CAGR||29%|
|Operating cash flow||50||31||37||32||39||14|
|Free cash flow to firm (FCFF)||19||25||35||30||37||12|
|Cash + Investments||151||132||113||74||46||7|
- 5 yr EPS CAGR is 29%, is in line with Revenue CAGR, SEL has not diluted equity in this time span.
- 5 yr Avg. RoE is 25%.
- 5 yr avg. free cash flow to firm (FCFF) of Rs. 29 cr per year
- Dividend paying company, has increased dividends as Rs. 5, Rs. 8, Rs. 10, Rs. 13 over the last 4 financial years respectively, dividend yield at current market price of Rs. 395 per share is close to 3%
- Cash of close to Rs. 150 cr, this is more than 30% of today’s market cap of Rs. 490 cr
- Tight working capital management.
An approximate idea of a trailing P/E band for SEL is possible if we look at the table below.
|P/E at close of FY||9.6||12.3||9.6||5.6||19.0||11.8|
Figures are in Rs. cr.
|Enterprise Value (EV)||345|
|Cash adjusted P/E ratio||6.5|
|Cash / Market cap||30%|
At yesterday’s closing price of Rs. 395 per share SEL trades at a trailing P/E ratio of around 9.4. If you drop FY08 which was a year of extraordinary valuations for most stocks, it still trades at the lower end of the historical P/E range.
A simple DCF analysis for a worst case could be conducted.
- Assume that they make a FCFF of Rs. 29 cr a year for perpetuity. This is last 5 year average FCFF value. Why this worst case is because SEL has only improved its cash flows over the last 4 years. If you strip out the FY12 capex of Rs. 30 cr you get a higher average FCFF of Rs. 35 cr a year.
- Take a small growth rate of 3%.
- Assume a discount rate of 15%.
- An FCFF of Rs. 29 cr yields an enterprise value (EV) of Rs. 249 cr. Add cash of Rs. 150 cr and you get a equity value (no debt to be subtracted since SEL is zero debt) of close to Rs. 400 cr.
- If you take an FCFF of Rs. 35 cr yields an enterprise value (EV) of Rs. 300 cr. Add cash of Rs. 150 cr and you get a equity value (no debt to be subtracted since SEL is zero debt) of close to Rs. 450 cr.
- This compares with a closing market cap of Rs. 490 cr.
Stock price performance (indexed to 100 at Jan 2006)
- SEL has a simple business model. It is a supplier to M&M, an entity which is also a part owner. M&M is a dominant player in its area of tractors.
- Major demand has origins in agriculture sector which is gradually getting mechanized, other sources of demand like non-agriculture use of tractors are emerging.
- Financially strong, zero debt, high RoE business, strong free cash flows, capex programme underway which can be funded internally
- It is trading at a reasonable valuation.
- Tractors showed a good correlation with rainfall during monsoon season in India till FY09. Post 2007 they showed divergent behaviour. In FY11 even with bad rainfall there were good sales for tractor makers. Monsoon in FY13 is showing signs of weakness and it may affect tractor sales for all players and by extension Swaraj would be affected to some extent.
- Recent news reports suggest that tractor makers are doling out freebies. This is something that has not happened in the recent past suggesting pressure on tractor sales.
The stock may correct given weak tractor demand in short-term. It might give a good opportunity to enter gradually over the next 6 months to 1 year. A company like SEL should be a good investment to hold in your portfolio for the long-term. At the current price I would HOLD it. At any price in the range of Rs. 320-400 per share (20% down from here) it looks like an attractive BUY.