The Company
The Industry
The Commercial Vehicles industry in India isn’t as glorified as its more famous counterpart in Passenger Vehicles. Here is how the growth looks like for the CV segment in the past few years:
There is a general uptrend in the growth here (An overall CAGR of about 3.66% in the past few years). Considering the explosive population in India, the automotive sector and subsequently, the auto parts sector is bound to receive an ever-increasing demand.
However, considering how Harita Seating is a supplier of parts to the auto industry stalwarts like Tata, Ashok Leyland, John Deere, M&M, JCB and so on, the company’s pricing power leaves a lot to be desired (As is evident from their financial statements). Further hurting their business trajectory would be the fact that most auto manufacturers have their own captives for producing seating solutions. It won’t be a stretch to imagine that Harita’s existing clients would like to create their captive too, some time in the future. In fact, in-house production of seats is one of the major business threats facing Harita Seating Systems.
The positive here is that there aren’t many companies in this space, at least at the scale of Harita. Bharat Seats is the closest competitor, but they largely service passenger vehicles.
The Numbers
I have filled out Harita’s financial information as follows:
Once again, as I have warned in my recent posts, this information is not accurate to the dot. The model has been filled on a ‘latest available Consolidated financial information’ basis. While this has been largely from taken from the company’s financial reports, a part of it is also raw data from Screener. I have never been shy in expressing how India’s financial reporting format is inadequate for an individual investor to make a completely informed decision. Some companies only report standalone financial numbers for the quarters, whereas complete Balance Sheet information is only available during the Q4 results every year. This messes up the accuracy of valuing any stock in India (For example, when I want to value a company as on Q2, like I’m attempting to do with Harita Seating Systems). But anyway, back to the post.
Harita Seating Systems holds a 51% subsidiary named Harita Ferher. Since we’re working with Consolidated numbers, we need to remove 49% of Harita Ferher’s value from Harita Seating Systems’ own valuation. Based on the company’s 2017-18 Annual Report, I have valued this subsidiary at 4.8 times its Net Worth (4.8 times is the average P/B of both Harita Seating Systems itself and its close competitor, Bharat Seats — there aren’t many competitors in this space). You can see this value, Rs. 338.80 Crores in the ‘Minority Interests’ tab at the end.
Also noteworthy is the fact that I’m going to use Company Beta to determine the Cost of Equity for Harita. I usually prefer Industry Beta (i.e. Bottom up Beta), but as mentioned already, the lack of competition in this space prevents me from going for that here. If you’d like to get a hands-on about how to calculate a company’s Beta (And subsequently, the ‘Indexed Returns’), feel free to access the following file:
The Capital Conversions
Nothing out of the ordinary here.
Harita spends about 10% of post-tax profits on R&D regularly, which is impressive, considering the acute lack of R&D in India companies (On a comparative basis with companies in more developed nations). It has a small amount of lease, but no ESOPs.
The Assumptions
We’ve arrived at the juiciest part of this exercise.
Without further ado, let me try to justify the assumptions I’ve put down here:
1. High Growth Period: It is not a rosy path down the line for Harita. It’s not too far-fetched to assume that many of Harita’s existing clients will want to develop their in-house manufacturing facilities for their seats some time in the future (It will ideally happen if and when Harita’s pricing exceeds the cost of in-house production). This severely dampens the Competitive Advantage Period for Harita. I’ve used a 15-year High Growth period.
2. Sales Growth: Harita’s Return on Equity is in the range of 25% for the past few years and its Dividend Payout in the range of 15% or so. In essence, Harita can have a sustainable growth at around 21% or so. However, I’m holding myself back with the long term average growth rate for the initial years (10.75%), a slightly higher, but within-the-sustainable-growth rate for the next few years (15%) and then slowing down towards half the long term Risk-free rate in India (9.58%, 4.15%)
4. Tax Rate: This one’s simple. The long-term average tax rate of Harita (31.93%) slowly converges towards the Corporate Tax Rate in India (30.97%, 30%) for the High Growth Period and then the Marginal Tax Rate in the world (25%) for the Terminal Period.
5. Capital Turnover: The long-term average Capital Turnover for Harita is 5.70 or so. I have made the minor assumption that the experience and knowledge of the TVS group will allow it to make better Capital Allocation decisions down the line, thereby slightly increasing the Capital Turnover (At 5% for every 5 years i.e. 5.70, 5.99 and 6.28)
6. Reinvestment Rate: You can see all the above assumptions having a combined impact on the reinvestment metric. So much so that, the Reinvestment Rate almost stays the same throughout the valuation period (Actually there is even a slight decrease). This goes along with our story of Harita seeing a nominal growth, but nothing to write home about.
7. Return on Capital: It is economic truth that an industry with higher amounts of Return on Capital will attract competitors. However, Harita in its 30-year operating history, has managed to be a niche player in this space. So, the general stability in the Return on Capital simply reflects this truth.
8. Depreciation: The long-term average Depreciation-to-Sales rate remains fairly stable. As an aside, even if we did have some basis to change this specific input throughout the valuation period, it wouldn’t affect the final value so much.
The Diagnostics
No red flags here. Let’s proceed.
The Cash Flows
Based on our inputs, this is how Harita Seating System’s Cash Flows would evolve over the valuation period:
This leads us to..
The Value
Here we are, at the end of the road.
The company’s stock took a 40% dive from its recent high of Rs. 1088 (At which point, my calculations would have found the stock overvalued). Unfortunately, the reason behind this is largely unknown, although the dive did happen right smack in the middle of the mid-cap crisis and SEBI’s ASM fiasco (Harita was never part of the ASM, however). What’s more puzzling is the fact that the volumes during its steep decline were actually negligible (Meaning only a few HNIs or FIIs decided to sell the stock). If I didn’t know any better, I’d say that the steep drop was unwarranted. But it’s exactly this kind of unwarranted fear that paves the way for the undervaluation of a stock.
The Sensitivity of Value
Even the Sensitivity of Value tool shows Harita Seating Systems in great light, with the company clocking an impressive Win-loss Ratio of 4 (A Win-loss Ratio great than 1 is good to begin with. A 4 is quite impressive):
As I have mentioned several times over, the Sensitivity of Value tool is a poor way to account for randomness in the model. I prefer a better way.
The Monte Carlo Simulation
As is my usual practice, I will simulate all of Sales Growth, Operating Margins, Capital Turnover, Tax Rate, Depreciation and Cost of Capital in the range of +/- 15% (A nominal spread). This is how the initial output looks like:
Using this, I can build a Probability Distribution (A Normal one, to be more specific). This will allow me to view Harita Seating System’s value as a range of probabilities, rather than a single value:
If you have a general idea of how a Normal Curve works, this is what you should interpret from the above diagram:
For instance, if I had to value the company for myself personally, I would probably use a 15% Cost of Capital and a 30% Margin of Safety (Without changing anything else). This would put my Expected Purchase Price at somewhere around Rs. 504 and would indicate that I’d require a Probability of Undervaluation above a good 90% and more.
That’s why I always make it point to establish the fact that investing is very, very personal (At least, it should be). Don’t listen to anyone without doing your own research. Be very, very cautious. And make no mistake, investing is a game of probabilities. It’s not like playing Chess, where every move can be calculated to perfection. It is also not like playing Poker, where every move is based on intuition rather than fact. It’s somewhere between the two. As an astute investor, it’s important to always have this in the back of your mind.
The Model
Do you think I’ve overlooked something in my valuation that would drastically alter the value of Harita Seating Systems? Kindly download the model and change the assumptions as you see fit (Downloads can be made from ‘File -> Download As’):
After all, opinions form markets. I’d be glad to discuss with you about any difference of opinions in the comments section.
If you are a keen observer, you might have noticed that there’s something still left unsaid. Well, it’s the title, of course. ‘Buying things well’ is a phrase from a Howard Marks Memo (Of the Oaktree Capital Management fame). He says:
“Superior results (In investing) don’t come from buying high quality assets, but from buying assets – regardless of quality – for less than they’re worth. It’s essential to understand the difference between buying good things and buying things well.”
This philosophy is at the heart of “Value investing”, as it is famously described. I figured the title was apt. The assumptions I have used in the valuation aren’t extraordinary. Not even close. But regardless of the mediocrity of the assumptions, the stock seems undervalued to a high level of probability. If Howard Marks is right, then Harita Seating Systems sounds like quite the bargain. What do you think?
