Over my 24 years of investing, I have rarely come across cash bargains like the one in October 2008, when Eicher Motors, India’s third-largest commercial vehicle (CV) manufacturer, was available for a market cap of 700 crore, when it had net cash of over 1,100 crore on its books. Mind you, this was the time when Royal Enfield (RE) was not even considered a business worth mentioning.
How the company ended up having this pile of cash is an interesting affair. In May 2008, Volvo had entered into an agreement to pick up 8.1% stake in Eicher from the promoters at 691 a share — against the-then trading price of 320 a share — besides acquiring 45.6% stake in a new joint venture (JV) called VE Commercial Vehicles. As per the deal, Eicher was to transfer its truck, bus, components and engineering services businesses to the JV. Eicher’s surplus cash, which was invested in bonds, and the motorcycle business were not transferred to the JV. Instead, Eicher was to receive cash of 210 crore, of which 176 crore was to be paid by the JV company for the transfer of businesses and the balance 34 crore was to come from Volvo, as non-compete fee. Volvo was to transfer its Indian truck dealer and service business along with cash of over 1,000 crore to the JV in return for a 45.6% stake. The balance 54.4% was to be held by Eicher.
As a result of the deal, the net cash on the balance sheet of Eicher exceeded its market cap. In other words, an investor was not paying anything for the remaining assets on its balance sheet. It was a debt-free company and the truck business was consistently profitable and cash generating.
Within the pure CV space, the other comparable players were Tata Motors and Ashok Leyland. In the case of Tata Motors, it was not clear as to how the passenger car business would turn out. Since Leyland made heavy duty trucks, it enjoyed Ebitda margins 200 bps higher than that of Eicher, but its RoCE was in single digits. Similarly, though Eicher — which made LCVs — enjoyed 8-9% Ebitda margins, it enjoyed a very high RoCE. And that is what you have to look at while picking up stocks — the return and not margins. Leyland’s capital employed was around 2,500 crore against 200 crore for Eicher. Clearly, Eicher was the most efficient, low-cost CV player.
I managed to slowly build a position of 1.8 lakh shares between November 2008 and March 2009 at an average price of 220 a share. The Volvo deal was a big positive as it helped the company move from the light commercial vehicles (LCVs) category into the medium commercial vehicles (MCVs) category. There seemed to be a growing preference for vehicles of over 16 tonne, where the JV was expected to fill the gap.
Over FY10 and FY11, RE had also started seeing traction but no one had any clue that the once loss-making subsidiary would turn out to be the jewel in the crown for Eicher. I remember meeting the CFO of the company to understand who were the buyers waiting for six months to buy their motorcycles. The management was surprised to know this, given that the company was neither advertising the product nor did it have a sales and distribution reach. In 2011, Eicher said it would expand capacity from 60,000 units a year to 150,000 units a year by setting up a new plant.
Between FY09 and FY12, Eicher’s revenue more than doubled from 3,052 crore to 6,526 crore, primarily led by the CV business. It was around this time that the stock had also gone up nearly 10x, to around 2,300, which incidentally happened to be the level at which I ended up liquidating one-third of my holding. Now at that point no one would have imagined that RE — that sold less than a lakh vehicles a year — would eventually turn out be a seven-lakh-vehicles-a-year business. I think this phenomenon is the best example of a J-curve effect that we have seen in India. As income levels went up, customers wanted to upgrade from the mundane 100 cc bikes to above 350 cc bikes. That is when RE happened to be at the right place, at the right time.
That the 10x investment, would over the next five years go up another 14x could not have been imagined — either by investors or the management — given that RE’s entry level model was priced at 4x the price of Hero Honda’s entry level bike. It was impossible to predict this kind of growth at any stage.
Around FY12, Eicher was selling 48,000 CVs a year and its target was to sell 60,000 next year with new engines and new models. But competition was getting tougher in the heavy commercial vehicles (HCVs) category. That is the classic conundrum in India. People buy a Hero bike, but a Honda scooter. They won’t buy a Hero scooter and a Honda bike. Similarly, customers buy 12 tonne vehicles from Eicher, but stick with Leyland for higher category trucks. Not surprising that Eicher found it tough to sell its heavy duty truck model Jumbo, which eventually failed. More importantly, my sale also coincided with the CV cycle coming off. The call was validated when from March 2012, the domestic M&HCV segment saw 27 consecutive months of decline in sales before recovering in June 2014.
But as the CV business declined, the RE business flourished. RE’s new plant at Oragadam (Tamil Nadu) was commissioned in May 2013, which led to a significant step-up in supply. The business turned profitable after sales crossed 1 lakh units. But in 2012, no one could convince you that the growth would last beyond three years and the valuations were already capturing that. All of us were anyway still fixated on the CV business, which was slowly coming off.
My challenge was also that the fund size was not going up and Eicher’s position was getting larger and I was worried that it would cross 4% of the fund. I didn’t want an auto stock, a cyclical business, to be 3-4% of the fund, especially when those were not easy times. In hindsight, it was a mistake that I didn’t build on Eicher’s position.
Always bulk up your winning bets. I never increased the size of Eicher’s holding as the stock moved up, because I was overtly fixated on my acquisition price and percentage of holding in the portfolio. All those who have done well, over the last three to four years, have added to their holdings by letting incremental flows go into winners. In stocks that are on a high growth trajectory, one should focus on growth rates as a lead indicator for exit rather than valuation.
In terms of misses, the one stock that gave me a crash course in investing was the once-favoured speciality packaging company, Bilcare. As Bhandari Industries (BIL)— the earlier avatar of Bilcare — the company used to manufacture paper tubes for the synthetic yarn industry. It subsequently got into pharma blister packaging and from 2004 till 2008, it had a breathtaking run. The entry of Rakesh Jhunjhunwala and the subsequent growth in the company saw the stock move exponentially from 100 in 2004 to its peak of 1,800 in January 2008. Bilcare was then the acknowledged leader in the domestic blister barrier market with 62% share, serving marquee domestic and multinational clients.
But in an ambitious drive to scale up its global operations, Bilcare acquired the packaging films business of Swiss chemicals company, Ineos, for 607 crore in August 2010. This was the biggest acquisition coming on the heels of its previous buyouts across the US and Europe. In 2005, it acquired the US-based ProClinical and a year later, bought out the UK-based DHP. From 84 crore in FY05, the company’s debt had already ballooned to 599 crore in FY10. The Ineos buyout saw its consolidated debt spike further to 1,190 crore in FY11. While the acquisition helped Bilcare double its sales from 1,066 crore to 2,326 crore in FY11, its profit grew only 22% to 149 crore, given the lower operating margin of the acquired business and the ensuing rise in interest cost. Total expenses in FY11 more than doubled to over 1,940 crore. The buyout also resulted in Bilcare owning up 51% stake in Caprihans India, a marginally profitable flexible PVC entity. Around the same time, the company had started spending borrowed funds on non-core capex with an aim to create an alternate revenue stream. It came up with a technology to prevent counterfeits in sectors such as pharmaceuticals, security services and agrochemicals. It had also set up a research centre in Singapore.
By September 2010, the stock had already lost two-third of its value from its peak as global demand had shrunk post the credit crisis, and the huge fixed operating costs came to haunt the company. In what would turn out to be a big mistake, I ended up buying 255,431 shares (1.13%) in the company at 550 levels around September 2010. I took that position, after interactions with the management gave me a sense that the issue of leverage was transitionary and that things would eventually get sorted out. Given the company’s debt to market cap was 3:1, my bet was that in the event of deleveraging, the market cap gains would be significant.
But the business went from bad to worse, when the profitable domestic operations also came under pressure following imports from China. Expenses kept mounting, going up from 1,941 crore in FY11 to 3,170 crore in FY12. I kept meeting the management even as I had further ramped up my holding to 317,883 shares (1.35%) by December 2012 (Q3FY13). By then the stock had already halved from my acquisition price to 224 levels.
In hindsight, it was erroneous on my part to have trusted the management to turn around the business. It was just too big a bet that the promoters had taken. While the bet had already gone against me, a tax raid on the promoters was the final nail in the coffin. I was completely disillusioned and ended up taking a hit by selling off the entire holding in the March 2014 quarter, at an average of 45 a share, after a massive 91% erosion. The company’s leverage at the end of FY14 stood at 2,146 crore and it had slipped into a loss of 124 crore. The damage to my portfolio was minimal as I had bought the stock in the bigger UTI Equity Fund whose corpus was over 3,800 crore, nevertheless it was a big jolt.
Never buy leveraged companies, which make acquisitions outside their core competency. Also, new technology adoption can take much longer than you think. Bilcare went bust because the promoters did not understand the complexity of running businesses across 12 countries, in Europe and in the US, and they lacked the capability to turn things around. More importantly, just because a stock has come off two-thirds from its peak does not mean that’s the bottom! Before betting on a turnaround stock, one should wait for the first sign of a credible improvement. In leveraged cases, the first sign should be that the debt at the end of the year should be meaningfully lower than at the start of the year. We also got carried away by seeing a 100 bps jump in margin as we felt that Bilcare would be able to service its debt. That’s being foolhardy because a couple of quarters of margin gains can be completely wiped out by higher working capital requirement.