Praj Industies (PRAJIND) provides turnkey plants and equipments for fermentation and distillation systems used in bio fuels processing (primarily ethanol related). It sells it products domestic Indian markets (about 70% market share), South East Asia (about 50% market share), and Europe (about 30% market share). It has been attempting to diversify in Brazilian and North American market but is still in very early investment/growth phase.
In addition to geographic diversification, it has also attempting at product diversification. It has begun working in other areas like Brewers, Agro Chemicals, Bio Chemicals, and Health and Wellness Products,
Praj Industries is small cap company. My objective here is to understand, if it will fit in my long term buy and hold portfolio. I like it because of very low debt.
The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends. All the data below is from 2000 to 2009.
- Revenue: Increasing trend since 2000 with average growth of 43% (SDev. 48%). Based on first nine months, I expect this to reduce for year 2010. Neutral Observation.
- Earnings per share: Overall acceptable increasing trend. Average growth of 41% (SDev. 104%). Extremely high variability and has possibility of negative growth. Not a good observation.
- Net cash flow from operations: Overall an increasing. Has been above net profit. However, has dropped below reported profits. Not a good observation.
- Profit/Loss from operations: Overall increasing trends in profits from its operations since 2001. Good observation.
- Reported net profit: Overall an increasing trend since. Good observation.
- Gross margins: Current GM of 22.2% is higher than historical average of 15.4% (SDev. 3.8%). Good observation.
- Operating margins: Current OM of 23.2% is higher than historical average of 15% (SDev. 4.4%) and increasing trend. Good observation.
Quality of Dividends
In this part of my analysis, I am trying to understand dividend growth rate, consistency, and ability of the corporation to demonstrate sustainability. In is also an indirect way to gauging management’s policy vis-à-vis sharing of profits with common shareholders.
- Dividend per share: Chart 3 shows dividend growth from 2004 onwards. Neutral observation.
- Payout factor: This has been less than 30%. The most recent annual report, management mentioned they will restrict dividends to maximum of 30% of profits. This shows intention to share profits but not all of them. Good observation.
- Dividend growth rate: The dividends have not grown at sustained year-on-year basis. i.e. there has been a high level of variability. Overall, on the basis of last five years, the dividends have grown at an average of 37% (SDev. 57%) which is a tad less than overall EPS growth rate of 41% (SDev 104%). Neutral observation.
- Ratio of cash from operations to reported net profit: It has been more than 1.0 until 2007. Dropped below in 2008 and 2009. Not a good observation. However, when you include cash flow from sundry debtors, this ratio is more than 1.0.
- Ratio of profits from operations to reported net profit: This ratio is more than one. Good observation.
- Ratio of Cash from operations to total debt: Practically a zero debt company. Good observation.
Dividend Cash Flow vs. Risk Free Savings Cash Flow
Why should I take risk if I can get a same or more cash flow by putting my capital into any risk free savings, fixed deposits, or any such risk free accounts? Therefore, I try to understand how dividends will affect my cash flow in 10 years of time period. The baseline assumptions are (1) the stock’s dividend yield is 2.2% at current price of Rs 83.00; and (2) savings interest rate is 7%.
- Best case scenario: considering average dividend growth rate of 57% for last five years, the dividend cash flow will be 9.96 times the cash flow from savings interest at the end of 10 years.
- Worst case scenario: considering low end of the expected dividend growth of 12%, the dividend cash follow will be 0.5 times the cash flow from savings interest at the end of 10 years. Note: this includes only dividends and not capital appreciation.
- For dividend cash flow to be equal to savings cash flow the stocks buy price should be Rs 39 (or 4.9% yield). This assumes conservative average dividend growth rate of 12% for next 10 years.
Expected Beta-based Volatility
I measured Beta for this stock’s risk (or price movement) relative to the S&P CNX NIFTY (or index movement). Here, I am trying to understand how a stock price behaves relative to the market.
- The stocks three year Beta value is 1.05, while it is 1.38 for last one year. This means this stock has high volatility w.r.t. S&P CNX NIFTY index.
- If I buy this stock, I should expect high degree of volatility.
- Note: I am not calculating beta-based expected return. This is because; it gives an impression to readers that I am using this parameter to calculate my potential capital appreciation. In true sense, the only reason I use this parameter is to understand volatility. This helps me set an expected on fluctuations. It helps me gauge how it behaves relatively to my objectives of 12% to 18% target. I have made a note of this, and I will discuss in the future post.
Fair Value Calculation
The next step is to estimate the fair value so that we can understand return characteristics for this investment.
- NPV price based on 15 year DCF: Rs 72.1
- Average high yield price calculated based on past 9 years: Rs 68.2
- Pricing relative to 9 year average PE ratio: Rs 57.0
- Pricing based on PE ratio of 12: Rs 83.3
- Graham number: Rs 61.4
The range of fair value is calculated as Rs 63 to Rs 68.
- In the recent past, Praj Industries has remained focused only on ethanol end market segment. It has achieved leading market position in India and South East Asia, and to a certain extent in Europe. It rode the ethanol craze of 2000s. One of the biggest growth driver has been regulatory diktat of using upto 10% of ethanol in automobile fuels in different countries.
- While I believe there will be more and more countries to join this bandwagon, the growth for Praj Industries will slow down.
- I am intrigued by its decision to invest in Brazilian market. I believe the barrier to entry is very high for it to make any meaningful returns. E.g. I would not go to China to open a manufacturing shop, or oil refinery in Middle East. One of the primary reason Praj wants international diversification is improvement in profit margins, which it could achieve in developed markets (but not in emerging economy). US and Europe can provide improved margins. Again, exchange rate driven growth? If yes, I do not expect long term sustainable growth.
- It’s margins have improved, but I believe it will get capped very soon. When and how much, I do not know.
- Instead, I like the company’s recent moves to diversify its product base. This is likely to provide long term growth potential. It still remains to be seen, when these efforts will bear fruits. In my viewpoint, this is a very positive move.
- Contrarily, I like Praj’s financial position. It has an enviable zero debt, good cash flow (including sundry debtors), and managements profit sharing ideology.
- One the great positives about the company is, I like management’s ability to use capital very cautiously.
Praj Industries has a good management that focuses on capital usage and control growth. It has remained focused in its core area, and has not gone on the growth binge beyond its expertise. I have very positive opinion about its product diversification efforts. Furthermore, the zero debt and good cash flow makes be want to buy shares for this company. I expect (1) intermediate term challenge of maintaining its earnings and dividends; and (2) high volatility. At present, it is trading at 21% premium to my fair value buy range. I will wait for price to be in buy range, until then it remains on my watch list.
Disclosures: No position at the time of this writing.
Disclaimer: This analysis is in the context of my long term buy and hold investment philosophy. It is in accordance with my investment objectives and my personal risk profile. If you intent to use this analysis for your own investment decision, then please make sure it meets your own objectives and your own risk profile.
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