Summary: Electrosteel Castings at present levels is a good buy, irrespective of the present macroeconomic situation. If the situation turns better, this company is going to give decent returns. Personally, this company has been one big turkey in my investment portfolio from the last year, but this failure has taught me something that is far more valuable more than what I lost. I learnt that he reported numbers can hide as much as they show. For this company, this meant that the company will turn from a net borrower to a net payer in terms of debt, and all this money will come from present assets as there is no potential upside to its operational performance (because company is operating at over 95% of its production capacity, with no investments in captive capacity expansion). At this juncture, I have to decide if this is a company I have to opt out of but based on the below analysis, this is the level at which I should have entered the company to begin with.
My Holdings
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My Present Holdings |
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| Avg. Purchase Price | Holding period | Highest Purchase Price | Lowest Purchase Price | Unrealized Profit/Loss |
| 31.02 | 9-12 months | 33.3 | 27.35 | (40.21%) |
About Electrosteel Castings
The products and services provided by Electrosteel include Ductile Iron Pipes, Ductile Iron Fittings, and Special Products called Electrofresh Plus. Besides it undertakes Turnkey Projects. Ductile Iron Pipes have application in water conveyance. These pipes are used for over-ground pipeline installations and are available in various lengths, diameters, thickness and pressure handling capacity. Electrosteel’s Engineering Procurement and Construction division undertakes end to-end solutions for water and sewerage projects. .
Electrosteel Castings’ Ecosystem
Electrosteel Castings sells pipes that transport water. These are used in projects like irrigation, drinking water and sanitation/drainage systems. The company used to buy iron and made pipes out of it. The business is sustainable, bot not overly profitable as the scope for differentiation is little. The only way to increase profit was to lower costs and go for economies of scale. In order to reduce costs, in the past years the company has bought an iron ore mine to be able to extract cheap iron and has bought a coal mine to get cheap coking coal for the blast furnace used in such extraction. It also developed a power plant to generate electricity for its own use, as such a source will be cost effective.
The customers of Electrosteel Castings execute projects in which they need these pipes from the company. Most of such projects are in the social sector as the main use of Pipes is to transport power. The customers, thus, are mostly government. That means that the risk of a default in payments from the customer’s side is minimal, and that guarantees the profits in the business. On the other hand, most of the sale depends on the project lifecycle and project commencement and that is hampered by the general economic condition of the country.
In order to explore other markets, the company has started a) exporting to other countries and b) bidding for water and sewerage projects on a turnkey projects. For the purpose of export, the company has opened up its subsidiaries in various countries. For the purpose of executing turnkey projects, the company has started a new construction division for the same.
All said and done… Everything revolves around Pipes. The company has been making them and selling them for over 50 years no€w, and knows in and out of the business. It has made some though investments to minimize its costs and that has helped the company its performance in the past. This ecosystem rewards efficiency, and Electrosteel knows that.
Electrosteel Castings’ position in its ecosystem
India currently produces about 500,000 tonnes of DI pipes per year and Electrosteel Castings produced about 270,000 of them last year. Electrosteel, thus, is a giant in its ecosystem in India. However, that stability comes with a price. The company’s fortunes fluctuate with the fortunes of its ecosystem. This is evident from the fact that in 2008 when the world economy was last at its nadir, the company earned only 1 Rs per share. Immediately before that year and since that year, EPS as hovered between 3-4 Rs per year.
Among the metal pipe making companies in India, Electrosteel stands as 6th largest in terms of average sales in last 3 years. The company also has a sizeable controlling stake in Lanco Industries which is 9th in the list (more on that later). Together, these 2 companies are 4th largest in the country. There are over 40 listed companies in India making Metal Pipes and this makes this company a big player in the wider ecosystem as well.
| Company Name | Avg Sales of Last 3 FY |
| Welspun Corp Ltd. |
6516.1 |
| Jindal Saw Ltd. |
5491.3 |
| P S L Ltd. |
2942.7 |
| Surya Roshni Ltd. |
1957.8 |
| Maharashtra Seamless Ltd. |
1941.4 |
| Electrosteel Castings Ltd. |
1731.2 |
| Man Industries (India) Ltd. |
1667.1 |
| Ratnamani Metals & Tubes Ltd. |
932.9 |
| Lanco Industries Ltd. |
714.1 |
| Good Luck Steel Tubes Ltd. |
561.5 |
Above nos are from standalone financial statements.
Company’s Investments are of Importance
As mentioned earlier, the company is all about pipes. The company has invested heavily in backward integration and has bought coal mines, iron ore mines and invested in power plants. Apart from this, the company also knows that price differential comes from economies of scale. In this regard, it has invested in other Steel and Pipe making companies vz: Electrosteel Steels and Lanco Industries. The company considers these 2 companies as associate.
Ideally when we have JVs/Associates, the company adds the line items of the balance sheet and Profit/Loss statements of the JV/Associate with the parent company’s respective statements, in the proportion to which they are owned. Elecrosteel, however, takes a different approach and considers these 2 Associates as investments and mentiones them in its investments section. For the purpose of this analysis, we will consider the same.
As per the last balance sheet, the company’s total investments in these 2 companies were valued as follows:
- Electrosteel Steels is valued at 722 Cr., with a holding of 700000000 shares (P90 of Annual report)
- Lanco Industries is valued at 151 Cr. with a holding of 19301218 shares (P90 of Annual report)
Thus, together these 2 companies are valued at over 870 Cr. and that translates to a value of 22 Rs per share (on a diluted basis). That indicates that as of right now, the share price of the company is less than the amount of investments it is holding. Or in other words, if I buy 100% of the company at 20Rs per share, I will get 22 Rs. per share as investments on an immediate basis without doing anything else.
However, we will be mistaken. As of today, the share price of Electrosteel Steels is down to about 6.7 Rs per share and that of Lanco is down to about 25.9 Rs per share from a value of over 10Rs and over 40Rs. respectively during March 2011. Also, out of the 70 Cr. shares of Electrosteel Steel that Electrosteel Castings own, about 50Cr. are pledged by the company to the lenders in favor of securing financial assistance to Electrosteel Steels (P93 of annual Report, in the foot notes). This means that these shares will have to be given to the folks carrying debt of the company, and that may be necessary when the going is bad for the company. Given that Electrosteel Steels’ shares are falling, it can be assumed that the times are bad and it may be a necessity to let go of Pledged shares.
Thus when one values these holdings at current market price and for the no. of shares held and not pledged, we see that the updated amount of holdings are equal to about 183 Cr:
- Electrosteel Steels is valued at 134 Cr., with a holding of 200000000 shares (P90 of Annual report)
- Lanco Industries is valued at 50 Cr. with a holding of 19301218 shares (P90 of Annual report)
Thus, the company’s present Marketable holdings are over 690 Cr. less than what they are reported, at present market rates.
For the analysis below, we are going to understate the Cash and Marketable holdings by this amount o 690Cr.
Also for the analysis below, I am going to use the Consolidated Financial statements.
Reported Financial Performance:
The in the last FY2010-11, the company’s total revenue and PAT increased on a YoY basis.
Below is a high level view of the company’s finances as reported in its annual report. It can be seen that the profits have fluctuated rapidly in the last 3 years (consolidated).
| FY |
2008-09 |
2009-10 |
2010-11 |
| Net Sales (Rs. Cr) |
1977.14 |
1610.96 |
1904.26 |
| Reported pat (Rs. Cr) |
122.3 |
206.55 |
162.27 |
| Average Net Worth (Rs. Cr) |
1297.63 |
1510.81 |
1683.63 |
Reported Free Cash Flows to Equity Owners
Along with the above finances, one can look at the below measures from the company’s annual financial statements (consolidated).
| FY |
2008-09 |
2009-10 |
2010-11 |
| Cap Ex |
195.46 |
91.29 |
38.3 |
| Dep + Amortization |
53.4 |
53.51 |
55.88 |
| Absolute change in Non-Cash W/C |
-160.35 |
171.83 |
-99.86 |
| Total Increase in Debt |
258.54 |
197.8 |
340.76 |
| Total Increase in Deferred Tax Liability |
17.04 |
9.92 |
-2.95 |
One can see that the company has invested heavily into Capital Expenditures 2 years ago but has not done so recently. As per the company’s annual report, one can infer that this was for increasing the capacity of is DI Pipe making plant and for buying coal mines. The evidence is shown too when the capacity of the DI Spun Pipe factory increased from 250,000 tons per year, to 280,000 tons per year. That was a good decision as the company itself knows that increasing capacity is the key to cost reduction.
The company has financed the Capex using Debt as there has been a similar increase in debt in 2 years ago as well. The company has continued to borrow more debt in the las t2 years, even though it has not invested in CapEx, and that is perplexing. With increasing interest rates, that is going to put some pressure on its cash flows.
The company’s Working Capital status also fluctuates rapidly on a year to year basis, and that has to be normalized.
When I normalized the above factors and calculated the FCFE, I get the following data (all amounts in Rs. Cr.):
| Average last 3 FY Sales | 1830.79 |
| Net Profit (latest) | 162.27 |
| Cash Value + Marketable Securities | 788.10 (ignoring the 690 Cr. calculated above.) |
| Latest FCFE after Normalization of Debt and Capex | 200.68 |
| Latest FCFE before Normalization of Debt and Capex | 406.24 |
| Average FCFE after normalization for the past 3 years | 293.26 |
| Average FCFE before normalization for the past 3 years | 359.03 |
| Trailing 4 Quarter Profit | 140 |
One can see that the company’s last 3 year’s Average Free Cash flows on a normalized basis are more than the latest reported profit. This is primarily because the company has been borrowing more debt and that is considered as a cash flow to equity.
This indicates that the company has been returning a lot more money to its shareholders in the immediate past.
Why is the share price experiencing a free fall?
When I invested in Electrostel Castings about an year ago, I saw that the share price was about 33-36 Rs per share. Then I saw the cash holdings of about 22 Rs per share and a lot of positive free cash flows and thought, “Wow.. This is a great value investment. I cannot go wrong with this one.”
The price remained stable for a few months but then started falling and went down to as low as 16 Rs per share. That was a loss of over 50%. In the last few days the price has again stabilized on these levels.
Initially I thought that I was right but the market was wrong. But I should’ve known better. Below are the risk factors of the company:
- Nature of Investments getting killed: 60% of the company’s investments were made in other Pipe/Steel companies. When the market turned bad due to economic situation, these companies lost a lot and that meant their bad performance directly reduced the asset quality of Electrosteel Castings. Other 20% of the company’s investments are in Mtual funds and that meant that when the market turned bad, these lost as well. For te purpose of a new analysis now, I have reduced the investments in associates by 690 Cr (calculated above) and have reduced the value of holdings in Mutual funds by 150 Cr (about 50%).
- Screwed on Debt side: The company has taken a lot of debt in the last few years, and these fixed obligations have to be paid now. As per the annual report (P88), most of these have to be paid from this financial year. The company has issued 100Cr. debentures on 11.8% interest, and it has to pay 33Cr each from March 2012. Then the company issues 200Cr debentures at 9.15% and it has to pay the 200Cr back in Feb 2013. So net-net, the company has to pay back 33Cr debt in FY 12 and 233 Cr in FY 13. Apart from this, the company has borrowed 510 cr from foreign institutions and in the last one year alone the Indian currency has depreciated, and hence the debt value appreciated, by about 15%.
The company has to pay all this back. It cannot pay back by borrowing more (as new debt will be more expensive due to present interest rates and foreign currency exchange rates). It cannot raise new equity as existing equity holders have already been hammered. It has to pay all this from its cash and marketable holdings and that means that it cannot invest in capacity. Alternatively, it can pay back from its profits and that will mean that future payments to equity holders will be hampered.
All this would not have been an issue if the company was to make higher sales. But tat won’t happen either, atleast due to increased production. That is because it is not investing in Capacity.
- No Capacity Expansion: In the last year, the installed capacity of DI pipes of the company was 280,000 tons and the company made over 270,000 tons. That means its production is already running at over 95% capacity. Unless it increases the capacity more, the chances that it will increase the turnover (and hence grow) are minimal. Also, since metal prices are to be muted for some time, the chances that turnover will increase due to price are minimal too.
- More Equity Dilution coming up: To boot, the company has issued warrants that can be converted to equity in the coming years. This information is conveniently placed in the Notes to Accounts (Page 107 of Annual report, point 22). This means that we will see that there will be 3.3 Cr more shareholders (about 9.3% more) than what they are and so whatever the company earns, that will be split amongst these many shareholders more.
All said and done, I know now why more knowledgeable shareholders have been selling off their holdings when I was buying.
I know my investment earlier was bad. The share price was to go down from the levels I was holding. Now I need to answer, is it worthwhile to continue holding at present levels or should I get out of the company immediately. In other words, are there chances that the price will go down further or will they go up a notch from these levels, thereby reducing my damage.
To answer this, I need to understand how the numbers change from the reported nos.
What happens now?
To analyze the company’s performance in the worst case scenario I am making the following assumptions:
- Company’s operational performance remains the same as the rolling 4 quarters. Thus the profit for FY 12 changes to 140Cr instead of 162 Cr.
- Company’s cash holdings remain the same, but marketable securities are reduced by 840 Cr (690 for 2 associates, and 150Cr for investments in mutual funds). This reduces Net Worth by the same amount.
- Company has to make a net debt payment of 100-300 cr per year in the coming years (33 Cr in FY 12 and 233 Cr in FY 13, foreign currency borrowings). The company makes this complete payment from its cash holdings, as the profits are not good enough to pay for this.
- The total no. of shareholders are inclusive of all present and potential dilutions (i.e. including those 9.3% additional share holders).
- The company is unable to borrow any more debt for the coming months and is a net debt payer.
Based on above, the updated nos become as follows:
| Net Profit (latest) | 162.27 Cr |
| Cash Value + Marketable Securities | 508.10 Cr. (ignoring the 860 Cr. for investments, and 130 cr for debt payments.) |
| Average FCFE | 105 Cr. (assuming company pays 100Cr debt this year 300 cr next year) |
| Total no. of shares | 381927488 (14.4% more than the present no. of shares) |
Above are just a set of indicative numbers in the most stressful situation. Various scenarios yield different numbers, but in no scenario the numbers are anyways better than the present reported nos. from annual report.
It should be noted that if the company’s performance on sales/profit front had chance of improvement, the numbers would have been much better. But due to no investments in capacity improvement, the company may not gain much due to improved production and so it has landed itself in a situation where it has to pay much more than it will earn.
Ownership Structure:
48.46% of the company is in the hands of its promoters. This is a high concentration given the fact that the owners are not spending on capacity improvement but are spending on cost reduction and are borrowing along their way. If an external corporate raider has to buy the company, it will be very difficult for it to do so as it has to buy over 50% of the company, and that means it has to buy all the non-promoters.
To that effect, I believe the concentration of ownership of the company is not ideal.
Return on Net Worth:
The PBIT/Avg. Net Worth for Electrosteel Castings was 19.5% 6 years ago. It was 18.04% in the last FY. In this time, the lowest it got to was 6.9% in 2008 but apart from that it did not go below 18% anytime.
Based on this statistic alone, one can say that the company HAS GOT the formula to make good money in general economic conditions and is using that formula wisely. This is consistent with my assumption of same operational performance to continue in the next year.
Value Judgment:
Based on the above altered numbers of cash/profit/FCFE/no. of shares, we can arrive at the following data.
| Company | Electrosteel Castings |
| Latest BSE closing Price |
18.55 |
| P/E Reported |
4.3 |
| Cash value in Rs. per Share after all adjustments |
13.3 |
| Updated FCFE value in Rs. per share |
2.74 |
| (P-Cash)/Updated FCFE |
1.7 |
| P/Updated Avg. Net Worth after all reductions |
0.8 |
| Current Assets > Current Liabilities |
TRUE |
| Current Assets > Total Liabilities |
False |
| Interest Coverage |
3.59 |
At 33 Rs per share, the company was definitely not worth a buy. But now if I buy a share at 18.5 Rs per share, I am getting risk free cash back of about 13.3 Rs. For the remaining price, I am getting back 1.9 times the prospective free cash flows of the company. For a company that has been and should be operationally profitable, that is a cheap price.
The company had to be beaten down for its prospective bad performance. But given that the company has good working capital condition and has good history of performance, it is likely that the company will live to see another day and will thrive the day after. Moreover when the metal prices turn for the better, the company will reap in more profits and its investments will pick up and so everything will fall back in line.
The way I see it, there is no major downside from the current levels.
Verdict:
Investing in Electrosteel Castings is relatively less risky at present levels. For a patient investor who is willing to look longer term, this is a good opportunity. The stock looks undervalued from its reported performance, but is not undervalued a lot. For a new investor looking for 2 yrs timeframe, I would recommend look at this stock as an “accumulator” which means I suggest to keep on accumulating this stock on these levels with hope of a very good payback then.
Personally, I have unrealized losses in the scrip but I am not going to sell at present levels.
Personal Note on Electrosteel Ccastings
When I first analyzed Electrosteel Castings, I only took a note of its finances and on the basis of free cash flows, I concluded that the company is great to invest in. Due to reasons mentioned above, I was wrong. And How!
Lessons learnt:
- Looking at Notes to Accounts are more important than they seem. Sometimes a lot of potential risks are hidden there.
- For a medium sized company, a good performance in the immediate past may be an indicator of a bad performance in the immediate future.
- A company heavily invested in other units of its own industry is riskier to invest when economic environment is turning bad.
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