Surya Pharmaceuticals

According to an old saying, either you succeed or you learn. In case of Surya Pharmaceuticals I learned. Attractive valuations when we consider ratios such as P/E (~2), P/OCF and P/B (~0.4) and then there are some red flags.

Business:

The company has presence in presence in API (Active Pharmaceutical Ingredient, 53% of business), Menthol (46% of business), formulations (1%, new business line) and organized retail in pharmaceutical (new segment). Entry into formulation seem to be motivated by the expected sale loss in US due to patent expiry of some key drugs over the next five year. Menthol segment is expected to be strong given the high demand (more than supply), capacity expansion and strong position of the company (added some key customers such as Colgate, etc). Progress on the organized retail front seems to be encouraging at least on the face of it from the readings from annual report. Formulation is expected to grow, which again is a story that is easy to digest. All in all from a business point of view everything sounds perfect.

However, MD&A doesn't say anything about potential threats. I don't know whether this is a standard practice or not, but that sounds like a red flag. Any business has to have some threats to it.

Operating Cash Flow:

Operating cash flow calculation methodology of the company has changed from IFRS (till 2009-10) to GAAP in the current year. Cash flow according to IFRS in current year is negative due to huge outflow of interest (around Rs 109 Crores). As most of this interest (around 70%) is the interest charge of working capital loan, this should be accounted for as operating cash flows (even if we argue according to the spirit of it). Also, there was no explanation provided for the change in standards. Again a red flag.

Inventory:

Another glaring factor in the company's annual results is the bloating inventory (mainly work in progress inventory). Inventory has been consistently been high over the past few year, however, particularly in 2011 there was a 70% increase in inventory levels. High inventory and in turn high working capital has lead company to take working capital loans (around 70% of the loans are working capital loans). Again throughout the report, management doesn't mention any reason for increase in inventory. A potential red flag.

Reporting standards of inventory are doubtful. The inventory has been "physically examined and certified by the management" - according to a CA friend (Anandh Sundar), this is a clear red flag. Auditors don't want to take any responsibility for the inventory. Inventory accounts for a major percentage of book value of the company. With a low equity base (~30%) any major impairment in inventory can wipe off the equity.

However, there is a positive here as well that the working capital loan is secured by current assets which includes inventory. Thus, there is a possibility that physical examination of inventory would have been done by the bank providing working capital loan.

Final Statement:

In the end, I will avoid this stock for now. Will wait for some more clarity on the books. All these red flags might not mean anything and it turns out to be a great stock, or the red flags might be true and this turns out to be a messy stock - I am not in a mood to take the chances when there are some other good opportunities. Hope to find another one soon !

Tata Steel

I am looking at Tata Steel as two companies:- Tata Steel standalone and rest of the company. Roughly speaking, Indian operations (or more specifically Tata Steel) account for around 25% of the revenues of the consolidated company.

1. Tata Steel Standalone:

Business Logic:
Tata Steel has a production capacity of 6.8 Million tonnes per annum which is being augmented by a brownfield project in Jamshedpur (2.9 Million ton). The additional capacity is to be commissioned from this financial year. In addition to that, its Odisha plant will have a capacity of 3 Million ton, however that will be commissioned somewhere in 2014 or so. Capacity utilization at Jamshedpur plant during the last two years has been more than 100%.
Tata Steel has a strategy to become self sufficient in terms of raw materials and has been acquiring coal and iron ore mines across the globe - Mozambique and Canada are case in point. However, coking coal prices have been an issue in the Steel industry (Tata Steel has captive capacity of only 50% as far as coal is concerned and 100% in case of iron ore).

Steel prices (demand) might dip in Indian market due to inflationary pressures and rate hikes by RBI. However, on a longer term the, steel scenario in Indian market remains solid.
Tata Steel has been one of the low cost producers of Steel across globe and has an EBITDA margin of the range of 35-40%. These operational efficiencies might come in handy in the current periods.

Valuation:
Tata Steel currently commands a P/E ratio of 5.74 compared to that of 10.08 of SAIL, 5.55 of SAIL and 8.98 of Bhushan. The EV/EBITDA multiple of Tata Steel is 5.18 compared to 5.81 of SAIL, 4.75 of JSW Steel and 10.97 of Bhushan Steel. Thus, Tata Steel seems to be valued at par with the peers in Indian market.

However, market seems to have discounted the growth in the production capacity which is expected to has its impact starting this financial year.
I have done a DCF analysis with following inputs (these are very moderate assumptions, somewhat bearish only):
i) Revenue growth rate of 20% over next three years (this is due to the growth in production capacity, average growth rate for past four years has been 12.7% covering a period of recession) and then slowing down to 12.7% by year 6
ii) EBITDA margin to be 30% (company average is 38.1%) for first three years (even in FY11 Q2 EBITDA margin has been around 30%) and increasing to company average of 38.1% in next three years
iii) Investment as a percentage of sales being 20% for first three years and 15% for the next three
iv) Beta of the stock = 1.2, Risk Free = 10%, MRP = 10%
v) Terminal EV/EBITDA of 5.5 (equal to peers)

The fair price of stock comes out to be Rs 484.4 per share. It should be kept in mind that this is the value of only the Indian Steel operations of the company.

2. Tata Steel Europe:

European operations suffer from the problems of:
i) High pension liability - it is more than net assets of the company. Tata Steel Europe follows IFRS and thus doesn't recognize the pension liabilities on the balance sheet or any change in the same in P&L. The off balance sheet liability of Tata Steel Europe due to pensions is Rs 1,13,762.22 Crores, which is about thrice its assets. The only silver lining in this case is that it is a long term liability and might not materialize in near future and hopefully by its maturity TSE is able to turnaround its business.
ii) Non improving, rather deteriorating economic scenario in Europe.

TSE is tackling this problem by:
i) Cost cutting and mothballing / selling its non-profitable divisions
ii) Vertical integration to secure the supply of raw materials
iii) Trying to rationalize the pension plan

Growth Drivers:
i) Capacity expansion
ii) Increased focus on raw material security
iii) Anything positive from European operations and other Asian operations (not covered in this analysis) is a bonus

Risks:
i) Pension liability in Europe
ii) Increasing interest rates and raw material prices in India
iii) Contingent liabilities of around Rs 12,000 Crore (however, probability of these materializing seems remote)

Exit:
Even after assuming the European and other Asian operations to be of zero value, Tata Steel is undervalued. The exit price in the short duration is Rs 500 per share. It will, however, depend on the performance of European division. Anything positive out of the division and share price can attain new heights.

Gujarat State Fertilizers & Chemicals Ltd.

Business Aspect:

Products (Revenues):

Main products of the company include: DAP, Ammonium Phosphate Sulphate and Caprolactum

With the increasing push of Nutrient Based Subsidy, consumption of complex fertilizers will increase vis-a-vis Urea. CRISIL expects a growth of around 9% of DAP and 16% of other complex fertilizers. On that top of that, India is dependent on imports in case of fertilizers. With a weakening Rupee, the cost of import is to increase further and thus will help domestic industries. Weakening rupee will also increase cost of raw materials (Phosphorus and Phosphoric Acid are mainly imported). However, GSFC, according to its annual report has been hedged against any fluctuations in rupee depreciation.

There are only two producers of Caprolactum in the country. Caprolactum is required for Nylon 6 which is in turn required for the production of Tyre. With the supply demand balance in favor of GSFC, it is in a price setting position.

Raw Materials (Costs):

They Key raw material costs that are of concern to GSFC are Natural Gas and Phosphorous / Phosphoric Acid. Natural prices are relatively stable, however, they are expected to increase with producers such as Reliance pushing for deregulation. Phosphorous prices on the other end are very fluctuating and might be a concern in the valuation. With the deregulation in the DAP and other complex fertilizer prices, we can assume that GSFC in a better position to pass on these costs to farmers. Because of the strong farmer lobby in the country, these will be an increase in subsidy if there are any significant changes in the prices of raw materials. Thus, even though raw material prices might have some impacts on the EBITDA margins there is no major impact expected from this.

Regarding Valuation:

A 6 year DCF analysis of the company assuming following inputs:

Revenue growth of 8.8% (last year growth was 19%), EBITDA margins of 20% (last year was 26%), terminal EV/EBITDA multiple of 5 (as compared to peers; current is 3.5), Beta of the stock is 0.5, risk free rate = 8%, MRP = 10%.

This gives an upside of 30%.

Looking at multiples, the company has a P/E ratio of 4.5 which is quite low when compared to the peers that have the multiple of around 10. The company is high growth and is almost un-levered. These factors again warrant a high P/E ratio. The low P/E can be explained by three reasons:

1. Government is the major stakeholder

2. DAP has been a regulated product and thus margins were typically less. Also, complex products have been used in less than optimal proportion vis-a-vis Urea due to the erstwhile subsidy structure

3. Fluctuating raw material prices

Quality of results should not be doubted because of the clean annual report of the company and the fact that it is government owned and thus the incentive structure of the employees doesn't warrant any major wrong doing (inflating books, etc) on their part.

Growth Drivers:

1. Nutrient Based Subsidy

2. Supply deficient market

3. Farmer Lobby in the country

4. Presence in high growth products - supply is chasing demand

5. Presence in Oligopoly markets

Key Risks:

1. Raw material prices

2. Dependence on subsidies

3. Dependence on monsoons

Exit:

A 30% increase in price keeps the exit price at Rs 650 in case the underlying assumptions stay the same. However, as long as the company keeps on growing and is able to maintain its position in the individual product segments, one should keep invested in the company till it achieves a P/E of around 10.