Special Situation - Indo Asian Fuse Gear

I had earlier written a  post on a special situation arising due to the large difference in valuation of DVR & normal shares of Tata Motors & Pantaloon Retail. Recently i have come accross more ideas which fall under the special situation category rather than normal equity long ideas. There is a certain element of unpredictability in special situations which really can't be put into numbers, so you end up making a buy/pass call based on assumptions which themselves may go against you turning your whole analysis wrong. So please go through the following analysis carefully and make your own buy/pass judgments as even i have limited experience with them.

On 23rd July French company Legrand announced that it would buy Indo Asian Fusegears 's Switch gear business for  a sum of 600Crs. The break up of the deal is as follows:

   

     1. Amount to be paid for Switchgear Business : 495 Crs

     2. Amount to be paid as non compete fee : 35 Crs

     3. Amount to be paid as non compete fee to promoters : 35 Crs

     4. Amount to be paid to promoters for Indo Asian Marketing : 35crs

So this works out to 530 Crs to the company(shareholders) and 70 Crs to the promoters . The board of directors of Indo Asian Fusegear has already approved the sale, which is subject to regulatory approvals. Now lets do the math and see how much cash may eventually hit the company's book. 

  Amount paid by legrand to company = 530 Crs

  Tax to be paid to govt.(not sure about the %,assume worst case 30%) = - 159Crs

  Total debt on companies books(as of Mar 2009 ) = -128Crs

  Total cash on companies books(as of Mar 2009) = Rs 13.2Crs

  Remaining Amount with company = 256 Crs or  Rs 167/sh

The company is now available at a Marketcap of 225 Crs (Rs140).The above calculation has a few assumptions like,the debt is as of last years Balance sheet and there is a chance of it going up or down(most likely up). The same argument applies to the cash balance. I have also assumed the worst case Tax at 30% since i am not too sure about this one but there is a chance it can be between 20-30%. So as per my calculations at the current price the market seems to be valuing the company at a 10% discount to its expected cash on books and completely disregarding the remaining business of Indo Asian. Lets take a brief look at the various segments of the company & its financial performance till date to understand why this may be the case.

Indo Asian Fusegear operates in the following business segments:

1. Switchgear : This was the segment that was sold to Legrand for the above mentioned amount.This includes MCBs, HRC Fuses, Feeder Pillars, RCCBs, Distribution Boards, Switches etc. This division had Revenue of 206Crs & Profit of about 31 crs in Fy 2008-09(need latest Annual report for latest figures).

2. Lighting  : This includes Compact Fluorescent Lamps, Fluorescent TubeLights and Luminaires etc. This division had Revenue of 28Crs & Loss of about  2.5crs.

3. Cable and Wires: This includes Wires and Cables etc. This division had Revenue of 26.7Crs & Loss of about  2.25crs.

As its obvious from above, the Switchgear business was the key revenue & profit contributer for Indo Asian a trend visible all the way from 2006-10. The Lighting business was profitable till 2008 & went into losses last year.The Cable & Wires division didn't figure in Annual Reports till 2008 & looks like a new division & it is also loss making. The Lighting business is also very competitive as per the Annual report.  Assuming the Lighting & Cable/wires divisions return to profitability in the near future, we can look at revenues of about 60Crs & profit of about 4-6 Crs(Assumption based on 2008 profits they could very well continue making losses too).  Further the management plans to pursue opportunities in the areas of advance lighting systems (LEDs),  products  for  energy  management  & conservation. This could be the key to its future prospects as getting into Advanced Lighting systems will require the company to make acquisitions or incur Capex all of which will require a good proportion of the cash it will get from the deal. The Management has also said they will consider a special dividend from the proceeds of the sale.

Risks
 

1.First of all, a lot of the figures used in the calculations above especially the balance sheet items are from FY 2008-09 as that is the latest available. The main unknown is the total debt on the company's books. If it turns out to be significantly higher than 128Crs the cash & hence valuation of company reduces.

2.There is uncertainty regarding the prospects of the remaining divisions as to their latest performance. They are mostly loss making going by last year's performance.

3.The management doesn't score very high on corporate governance as per my understanding from the annual report. One of the concerns i found was a lot of Related Party Transactions with the relatives & family members of the promoters. Also the management hasn't paid any dividend till date which implies they may not quite be shareholder friendly.

4.The management hasn't shown anything to write home about w.r.t capital allocation so far. There is a chance that they may pay a small amount as dividend or do a share repurchase & invest the bulk of the cash into new businesses which could lead to value destruction if it doesn't work out.

Conclusion

The market is Valuing Indo Asian Fusegear at more than 10%+ discount to its expected cash reserve post the deal. The key here is simply how the company will utilize the cash, will they pay a huge dividend or invest the bulk of it or use a part of it for share repurchase .So a lot of unknowns &  uncertainty about the possibilities have resulted in the current valuation. I personally would prefer a share repurchase over dividend as this would avoid the unnecessary dividend distribution tax of about 16-17%. Although the management has already committed to paying a special dividend & also to get into the advance lighting systems business but the proportion of cash  for the same is unknown.It would be good if the company also repurchases some stock with a part of the money which is the best possible use of the cash given their capital allocation record. So a high Uncertainty but not necessarily a high risk special situation,would be interesting to see how it turns out. I am sure i would have missed some finer/obvious details, hence i  invite views.

Disclosure: Long Indo Asian Fusegear. Please read the Disclaimer

Swaraj Engines Update

I recently received the Annual report of Swaraj Engines for the year 2009-10. For a small cap company like SEL and in general for most Small & Micro caps there is so much information & insight one can draw from just the Annual Report. Further, SEL's website is pretty basic & worthless giving you hardly any idea about the company. A couple of readers were eager to know if it is the right time to invest in the stock after the recent run up in the prices. This post is an update on the performance of SEL in the last year & other insights if any that i was able to glean off the Annual report.

Performance in FY 2009-10

SEL registered total revenue of 295Crs last FY ,a growth of 37.34% Y-O-Y and it clocked Net profit of 37.35Crs an impressive 75.5% growth Y-O-Y. Net profit margin was 12.66% as compared to 9.9% last year. Return on Equity was a record high in 7 years at 30.4%. All this was mainly due to the fact that the company sold 39143 engines(28539 last year) a record high of all time and first time going above 100% capacity utilization of 36000 in recent years. More importantly the Free cash flow was 38.21 Crs after another year of abysmally low Capex of around 2Crs . So in the past 3 yrs Free Cash Flow has always been higher than the Net profits , that is a positive for me as very few companies are able to do that. So overall it was a great year for SEL and the management seems to be bullish about the long term prospects of the tractor industry without giving any specific guidance for the short term. The sales for Apr'10 were 41% higher than the previous year as per the annual report. As i mentioned in the previous post the number of farmers per tractor in India is quite a  bit above the global average and hence the long term story looks good .Although it can be hard to predict the short term trend given the vagaries of the sector. 

Valuation 

At the current Market price of 423 the stock is trading at a P/Ex of about 14 TTM and P/BV of 4.24 which on the face of it looks just about fairly valued. However the latest balance sheet shows that SEL's cash reserve's have grown over last year and it stands at 114.1 Crs(Cash & short term Investments). This is almost 22% of the current market cap & hence deducting the cash on books form the market cap the  new numbers for P/Ex & P/BVx are 10.9 and 3.3 respectively. Now the valuation appears more reasonable from a long term view. However i would like to buy under a P/Ex of 10 to get a margin of safety and this translates to a price of about 390. So personally i would buy more if the stock corrects to below 390 levels. One reader also asked me about the kind of returns one can expect in 3yrs or so. Honestly i don't have the answer and it all depends on how SEL performs as simple as that.As i am not buying at dirt cheap prices i expect SEL to be a compounder and not a multibagger(if everything goes as expected). So over the long run if bought at a reasonable price the returns will mirror the company's growth in profits(true for any stock in my opinion).

Other Observations

1. One of the risks that i seemed to have overlooked which i learnt through comments & discussions with others is that over 90% of SEL's revenue comes from M&M the parent company. This can both be a negative or a positive. There is a chance that the margins will come under pressure as it can't bargain much with M&M. However so far this hasn't been true and there hasn't been any drop in margins(it actually went up last year). Margins have stayed in the range of 10-13%. The positive is that they can have stable & predictive revenue and an efficient operating cycle(lower inventories,receivables etc). The latter is already reflected in the pristine Balance sheet & good cash flows.

2. A couple of senior officials of M&M led by Mr Pawan Goenka have been appointed to the board of SEL recently. Also there have been rumors about M&M's intent to buy out the stake of Kirlosker Oil Engines Limited in SEL. I believe all of this sends a strong signal about M&M's plans for SEL. Ever since M&M took over PTL the fortunes of SEL have turned around and the company has performed very well. It would be good for SEL if M&M can also use its facilities to manufacture other engines like for LCVs. This would remove its dependence on the Tractor Industry.Even otherwise the prospects appear good. SEL would soon need to undertake Capacity expansion given the rate at which they are growing. This can be easily funded through internal accruals given the cash on books & strong cash flows.