In the first decade of the 21st century, the population of the world produced more economic output than the first nineteen centuries combined. How did we achieve this tremendous feat? In the last two centuries we learnt to augment muscle power with efficient energy sources like oil, natural gas, and atoms. We invented new machines which used these energy sources to get more work done in less time.
Machines and oil played a huge role in improving agricultural productivity. In 1790 around 90% of American population was engaged in farming. As of today only 2% of the population does farming. And it produces more output with less resources as 95% of American farms are mechanized. From the chart given below you can see that developing nations like India and China employs more people in agriculture as their farms are less mechanized.
Indian farmers know that mechanizing the farm increases productivity. In spite of that, from 2001 to 2010, the total power usage in farms grew at a minuscule rate of 2.32%. Why is that? Farm mechanization requires a minimum operating scale. Agricultural land for 84% of our farmers are small. And the output produced from these farms will not cover the cost of big agricultural equipments. Also majority of the farmers are poor and they don’t have access to credit. Farmers needs two things to mechanize their farms at a faster rate. They are (1) small and cost effective agricultural equipments (2) access to credit. VST Tillers solves the first problem by manufacturing cost effective agricultural equipments.
VST Tillers Tractors Limited was incorporated in the year 1967 as a joint venture with Mitsubishi Heavy Industries Limited, Japan. The company is now the largest manufacturer of power tillers in India. It also sells tractors, rice transplanters, and spares. Around 98% of its revenue comes from India and the remaining 2% comes from exports. It has two factories, one in White Field, Karnataka which manufactures tillers and the other in Hosur, Tamil Nadu which manufactures tractors.
1.1 Power Tillers
A power tiller is a low cost machine which can be used instead of a tractor. They are very effective in areas having high concentration of small farmers with fragmented land holdings. Power tillers costs Rs 1.5 lakhs which is 50% less than the price of a tractor. There are other advantages of power tillers which you can read here. The Power Tiller industry is growing at around 12% per annum. VST Tillers continues to maintain its lead and in 2014 it had a market share of 47%. Power Tillers imported from China by many smaller players have a combined market share of around 25%.
Majority of the small farmers have money only to meet their day-to-day needs. Paying Rs 1.5 lakhs for a power tiller is an ordeal task. How can he afford this much money? The answer is government subsidies. And this is the single largest factor driving tiller sales in India. The quantum of subsidy depends on the state government. In Tamil Nadu, the state I come from, tiller subsidy is limited to Rs 45,000. The farmer is expected to put a down payment of 10%. And the balance comes from bank loan which again is subsidized at a very low rate.
If there’s so much of subsidy then how come VST Tillers increased the price of tiller at a CAGR of 4%? It can’t increase the price at its whims and fancies. Every year it has to get an approval from all the states before increasing the price. Anytime during the year if raw materials goes up in price then it has to take the hit. Also dealing with the government creates a lot of processing overheads. This has delayed the release of subsidies and put pressure on its working capital management. This is evident from its cash-conversion-cycle.
On the financial front, your Company has adopted a disciplined approach towards managing liquidity though delays in realization of government subsidies have significantly pushed up the receivables and working capital. – 2012 Annual Report
A farmer should sell his produce above his operating and financing cost so that he can feed his family. If that doesn’t happen then he is in trouble. Once again government comes to his rescue by providing minimum support price for his produce. From all this we can conclude that success of VST Tillers depends heavily on government’s intervention.
In India, tractors with low horse power (HP) is under penetrated. Considering that 84% of farmers have small farms, there is a significant opportunity in this space. In order to tap this opportunity, the company manufactures 18.5 HP and 22 HP tractors and continues to maintain a significant market share in Maharashtra and Gujarat. On 25th April 2014, its new Hosur plant opened for operations which can produce 36,000 tractors per annum. For tractors there are no subsidies given by the government. In 2014 tractor industry sold 634,151 tractors of which VST sold 7,452 (1.18%) tractors. So there is a lot of room for VST to grow in less than 20 HP segment. But it’s not easy as it has to compete with other organized players.
Strong underlying demand in the less than 20 HP category has prompted the entry of organized players like M&M; a segment which is currently catered to largely by un-organized players. Accordingly, sale of less than 20 HP tractors saw strong 25.7% YoY growth in 9mFY12; albeit on a small base. With roughly 39% of the area under cultivation contributed by small and marginal farmers (less that 2 hectare land holding) the opportunity in this space are significant; more so in light of very low tractor penetration at present. Also with scarcity of farm labour and rising cost of bullock carts, the trend of ownership of small and less expensive tractors by marginal farmers is catching up. Apart from lower initial costs, these tractors deliver better fuel efficiency when compared to their higher powered cousins, making it viable for small farmers to upgrade from a bullock cart to a tractor. While currently M&M and VST tillers are the only two large players that have presence in this sub Rs 2 lakh tractor market others likes ITL and Escorts are expected to enter this segment soon. However, restricted application to soft soil conditions, competition from second hand market of higher HP tractors, and limited credit worthiness of marginal farmers are some of the factors that shall also influence the growth in the sub 20 HP tractor market. – ICRA 2012 Report
1.3 Is this a good business?
If I ask you to look at a single metric to tell if a business is good or not, which metric would you look at? Without any doubt I would look at return on capital employed. VST Tillers cranked out an average return on capital of around 40% which is fantastic. It achieved this by maintaing a high asset turn over and a decent operating margins. From the table and chart we can see that (1) agriculture is a cyclical business and it’s heavily dependent on monsoon and government intervention; look at the chart with several ups & downs (2) accounts receivable and inventory can build up quickly; look at 2012 and 2015 (3) increase in cost of raw materials can impact margins; look at 2012.
How could VST generate such high returns on capital by competing with big players like Mahindra & Mahindra which has 66x more sales? If we ask Michael Porter this question what would he tell? He would tell that VST is doing something unique. While other players were busy solving the problems of farmers with big farms, VST was solving the problems of farmers with small farms. By partnering with Mitsubishi it developed expertise in tiller manufacturing. It slowly built its dealer network (335 dealers) in Southern, Western, and North-Eastern India where farms are small.
The key to competitive success—for businesses and nonprofits alike—lies in an organization’s ability to create unique value. Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition. – Understanding Michael Porter
By doing this over time VST built a loyal customer base and dealer network to support them. This gave it a first mover advantage. It reused its dealer network to sell other products like tractors and rice transplanters. On top of this dealing with delays in government subsidies is not easy. All of this enabled VST to build a castle with piranhas and crocodiles. And this deters competition from taking away its market share.
The first test for a good management is conservatism. Anyone can generate high returns on equity by levering the balance sheet. From the chart we can see that the management generated an excellent return on equity of 26.70% without much debt. It’s hard to run a cyclical business without debt. And the management deserves some credit for that.
The second test for a good management is to see what they did with cash generated from operations. In the last ten years it generated Rs 301.53 crores from operations and used it sensibly to (1) setup a new factory in hosur to manufacture more tractors (2) repay its debt and keep the balance sheet clean (3) pay dividends (4) strengthen the balance sheet by holding treasury assets which is used for managing working capital during adverse conditions.
The third test for a good management is to look at how they compensate themselves. The top three executives in aggregate received around Rs 1.2 crores as remuneration. This represents around 1% of pre-tax operating profit which is fantastic. In FY2014 the company had a related party transactions of Rs 5.79 crores. On a sale of Rs 624 crores related party transactions constitutes less than 1%. Overall I see that the management is able, conservative, honest, and share holder friendly.
Before valuing the business let’s understand the theme on which the valuation is going to hinge on. Mechanization of Indian agriculture is very low compared to other countries. Land is a limited resource and to feed our growing population we need to improve the yield. The only way to improve the yield is to use machineries. If you read this presentation you will understand why companies like VST has a lot of room for growth.
Around 55% of our population is engaged in agriculture and they produce only 16% of GDP. This is one of the main reasons why so many farmers are poor. In order to help the farmers, government schemes like MNREGA was introduced. This scheme guarantees job for a rural citizen for 100 days in a year. This in turn created labor shortage in farming. And this placed more need for mechanization. The theme on which our valuation is going to hinge on are (1) under penetration of farm mechanization in smaller farms (2) labor shortage (3) government subsidies (4) loyal customers and strong dealer network. These are the four legs of the stool on which VST is sitting on. If anyone of them is disturbed then it will destabilize its business.
Agriculture equipment is a cyclical business and it’s heavily dependent on subsidies and monsoon. In FY2015 VST had a sales of Rs 550 crores compared to FY2014 sales of Rs 625 crores. Sales was down by 12% due to delays in the release of subsidies and poor monsoon. These issues are temporary in nature and the long term growth story is intact. As the long term sales trend is up I am going to use FY2014 sales of Rs 625 crores for valuation.
In FY2014 it had an operating profit margin of 20.46%. But that’s an aberration. The company got benefited from steady raw material costs and higher realization on products during FY2014. The normalized operating profit margin should be around 17%. Applying 17% to Rs 625 crores sales we get a pre-tax operating profit of Rs 106 crores. But I can’t blindly use that number for valuation. Why is that? Read what Buffett wrote about valuation and focus on the words marked in bold.
A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. – 1991 shareholders letter
From the above chart we can see that VST’s working capital requirement is not minor. So I am going to take a working capital charge of 10% on its pretax operating profit of Rs 106 crores. After this adjustment its pretax operating profit will be Rs 95.4 crores. Applying a 10% cost-of-capital VST zero growth valuation should be Rs 954 crores. As of this writing its total market capitalization is Rs 1,247 crores.
At this price Mr. Market is expecting VST to grow at 2.5% forever. I believe that VST can definitely grow more than 2.5% and the stock appears to be undervalued. VST has around Rs 104 crores as treasury assets and I am not using it in my valuation. The reason is because it might need these treasury assets to fund any shortfall in working capital management.
I know that the stock is undervalued. But I want to know how much return will I get if I buy the stock at the current price. In order to find this out I am going to use the technique discussed here. In the last ten years the company grew its sales and operating profits at 19% and 27%. Let us assume that for the next ten years it will grew its sales at an industry average of 15%. Using this conservative estimate the expected return comes to 13.23%.
As of this writing I don’t own any shares of VST Tillers. Click here to download the financial data I used to write this post. If you read this post along with John Deere you will learn a lot about agriculture equipment business. Disclaimer: This is not a recommendation to Buy-Sell-Hold. And I am not a SEBI registered analyst.