Last year I wrote about the business model of Shriram Transport Finance (STFC). You can read about it here. At that time I liked the business model of the company. But I did not purchase the stock. In the last few weeks the company lost 40% of its market capitalization. This piqued my interest and I took another look at the business. And this is the subject of this post.
Imagine that you are playing the game of snake and ladders. You start at square one and cruise your way to square fifty. On your next landing you get engulfed by a big snake and find yourself back at square one. This is what happened to the investor who purchased STFC in 2011. The price chart given below tells you the snake and ladder story. What happened?
Before analyzing the reason for the correction let’s look at STFCs sales and profit growth of its core CV business for the last five years. From the chart you can see that sales compounded at 10% and profits didn’t grow at all. Why did this happen?
In order to answer this question we need to look at the cost structure of the company. There are three components to STFCs cost structure (1) finance cost (2) operating expenses (3) provisioning. From the chart given below you can see that its finance and provisioning cost went up by a lot which resulted in zero growth in profits. Why did finance and provisioning cost go up?
Let us first look at why the finance cost went up. In order to control the inflation of food and other commodities, RBI had increased the repo rate by 3.75% in several rounds since March 2010. Repo rate is the rate at which RBI lends money to commercial banks in the event of any shortfall of funds. This increased the cost of funds for STFC and reduced its net interest margin. What is a net interest margin (NIM)? It is interest income less interest expense as a percentage of average earning assets. All else being equal higher NIMs results in higher profits.
In 2011 and 2012 more than 50% of STFCs operating income came from securitization. Since securitized assets qualify as priority sector lending, the banks were willing to take a lower interest rate and this resulted in higher profit margins for STFC. But in 2012, RBI changes its securitization guidelines. According to the new guidelines, for the loan to quality as a priority sector, assets should conform to a maximum interest rate of eight percent above the bank’s base rate. This reduced its profits margins. Also the new guidelines insisted pass through certificates (read it as middle man) which is not favorable for banks compared to the earlier bilateral arrangement (read it as no middle man). This reduced the overall securitization volume. You can read about the new guidelines here and here.
Before looking at why provisioning went up let us understand few things about provisioning. Given below is the income statement for banks A and B. From this can you tell which is the better bank? If you answered B then you flunked the provisioning test. You need more information about provisioning before coming to any conclusion.
Banks are in the business of giving loans to individuals and businesses. Some of its customers will neither pay interest nor principal for sometime due to tough business conditions. Banks will classify these loans as non performing assets (NPAs). Once the condition improves the customers will pay back the interest and principal. But if the condition doesn’t improve for the customer then he will default and the bank will write off this loan. The bank has to estimate how much loans will get defaulted and set aside some portions of its profits as provisions to cover future losses.
Take a look at the table with provisioning information. Bank A has an NPA of $500,000 and has provisions for $550,000. Even if all of its NPA turns sour, A is well protected as it has a coverage ratio of 110%. On the other hand B has an NPA of $2,000,000 and has set aside only $100,000. It’s coverage ratio is only 5% and even if 10% of its NPAs turns sour it is screwed. From this we can conclude that Bank A is better than B even though B has higher accounting earnings.
Now let us look at why STFCs provisioning went up over the last few years. STFCs customers operate commercial vehicles like trucks for transporting goods. For them to pay their interest and principal on time they need (1) to transport goods (2) cheap diesel prices (3) get better freight rates. But all of them had issues over the last few years and this resulted in higher provisioning. The next question is that how do we know if STFC has provisioned enough. For that we need to look at its net NPA which is gross NPA minus provisions. Any value under 1% is good and STFC has done an excellent job in provisioning.
The slowdown in Indian economy, lower freight movement due to restrictions on iron ore production and weak coal output coupled with high interest rates are major factors impacting the truck financing business in 2011-12. Your Company, having regard to long-term interest of the business, had consciously adopted more cautious, conservative and selective approach in terms of customer assessment, loan margins and disbursement, not perturbed by aggressive practices adopted by the competitors to grab business. All the aforementioned factors moderated the growth of the Company’s business for the year ended March 31, 2012. The suspension of mining of iron ore by order of the courts impacted business of transportation of iron ore leading to defaults and re-possession of certain specially built vehicles financed by the Company. As such, the Company has made higher provision and write off for the year ending March 31, 2012 compared to the last year. – 2012 Annual Report
Mr. Market is aware of higher financing and provisioning costs. And the recent crash didn’t happen because of this. It happened because of the mismanagement in handling one of its subsidiary business – Shriram Equipment Finance Company Limited. In the recent quarter its non performing assets went up to almost Rs 400 crores and it set aside Rs 235.75 crores as provisions. This wiped out its reserves and surplus which the company accumulated for over five years. This situation reminded me of Nassim Taleb’s turkey which was fed well for 999 days and was chopped on the 1000th day.
Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.* – The Black Swan
These provisions did not bother me much as the management is confident of collecting them. What bothered me was that the management was unaware of the situation until the last minute. The economy slow down was an ongoing thing and it didn’t happen all of sudden in the recent quarter. Had the management been awake then they would have noticed that a lot of NPA is about to move to the 180 days bucket. And informed the markets much earlier than waiting until the very last minute. By not doing this they failed couple of psychology tests: deprival super reaction syndrome and reason respecting tendency.
If I present this case to Sherlock Holmes what would he tell? The world is full of obvious things which nobody by any chance ever observes. Here are the obvious things that I can see.
(1) The management didn’t hide their screw up in the construction equipment (CE) business. They provisioned a loss of 60% instead of the mandated 20-25%. They are doing the right thing by being conservative and not worried about managing the short term earnings.
(2) People from the core business are getting involved to recover the money. This is not a write off situation and the management is confident in working with the customers and make them repay once the business picks up instead of repossessing the vehicle. They are holding on to the core mission statement of their founder. Also most of the customers are contactable. They are not going to lend more money to CE business until the situation improves. And they are going to come up with a strategy on how to take the CE business forward. Most likely they will lend only for equipments that have multipurpose use.
(3) Securitization is a high margin business. I don’t know if the company will be able to increase the volume in future. And I am not worried about it. This is because the company has adopted to the situation and is tapping funds from other long term sources like non convertible debentures. The company is used to handling these kinds of regulatory changes. During 1998-99 the only source of funds for the company was retail fixed deposits. At that time RBI put a rule telling that NBFCs cannot receive funds through fixed deposits. The company changed its strategy by building relationships with the banks.
(4) High NPAs over the last few years happened due to slowdown in the economy. Once that situation improves its customers will be able to pay interest and principal on time and this should result in lower NPAs. Recently the repo rates was cut by 0.50%. This will reduce the cost of funds and result in higher net interest margins. STFCs income statement has the power of operating leverage. What do I mean by that? On Rs 60,000 crores of asset under management, a 1% increase in net interest margin will result in pretax operating income of Rs 600 crores. After paying 30% taxes, this translates to an EPS of Rs 18.50.
(5) Despite of all the adversities the company focused on increasing its number of customers and branches. This will make life much harder for competitors to take away STFCs marketshare.
The overall pie of the commercial vehicle (CV) industry is growing. Also the preowned CV industry is highly fragmented with unorganized players controlling 70-75% marketshare. STFC is one of the key organized players and the leader in preowned 5-12 years CVs with pan india branch network. Also the construction equipment industry is at nascent stages and has a market size of Rs 40,000 crores. On top of this the company is successfully executing on its rural strategy. There are over 6 lac villages and the company has covered only 15% of them. So growing profits at 15% for a very long time is a very conservative estimate.
The Indian Commercial Vehicle (CV) Industry is the lifeline of the economy. Approximately 66 percent of the goods and 87 percent of the passenger traffic in the country moves via road. We expect India’s demand for commercial vehicles to remain strong. India’s stock of commercial vehicles is currently low at six vehicles per thousand people versus 11 for China and 48 for other Asian peers. The gap is expected to narrow down in the coming years in wake of GDP growth and increase in infrastructure spending. – 2011 Annual Report
After adjusting for the mismanagement in CE business the profits after tax comes to Rs 1,325 crores. Remember that the company is operating under tough economic conditions and we are working on depressed profits. So there is conservatism already built in my future projections. Let us assume that the company grows its after tax profit at 15% for ten years. This means its profit after tax after ten years will come to Rs 5,360 crores. At that point let us assume that the discount rate is 10% and the profits will not grow at all. This means that after ten years the company will be valued at Rs 53,600 crores. As of this writing the stock is selling at Rs 773 and this translates to a market capitalization of Rs 17,538 crores. An investor buying the stock at Rs 773 and holding it for ten years can expect to make a CAGR of around 12%.
The total book value for STFC comes to Rs 442.85 [Core: Rs 405.54; CE: Rs 22.00; Automall: Rs 15.31]. At the current price of Rs 773, the price-to-book ratio comes to 1.75. For FY2015 the core business EPS comes to around Rs 55. Also let us ignore both the subsidiaries to get a feel for the valuation. At the price of Rs 773 the company is giving an after tax earnings yield of 7.12%. Overall the valuation looks reasonable for a quality business like Shriram Transport. I believe at this price there is a decent margin of safety.
Mr. Market overreacted to the current situation in CE business. I thought about the current situation for sometime. And Confucius statement came to my mind and I became a shareholder of STFC. Disclaimer: This is not a recommendation to Buy-Sell-Hold. And I am not a SEBI registered analyst. Being a shareholder my writing could be tainted with confirmation bias and liking tendencies.