Valuation in Motion: VST Industries Valuation: Smokin’ Hot

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The Vazir Sultan Tobacco Company or ‘VST Industries’ for short, is an age-old player in the Cigarette and Tobacco products market in India. The on-going lull in the economy has impacted the Sales volume of this industry as well. But with a hard-to-quite habit like smoking, the runway enjoyed by this industry is virtually limitless. But this does come with severe restrictions in terms of reinvestment, advertisement and punishing taxation by the Government of India.


The Company

The Vazir Sultan Tobacco Company Limited was incorporated on 10th November, 1930, under the Hyderabad Companies Act No. IV of 1320 Fasli and now governed under the Companies Act, 1956/2013. The name of the Company was subsequently changed to VST Industries Limited on 30th April, 1983. The Company has its Registered Office at Azamabad, Hyderabad. The Company has a manufacturing facility at Hyderabad and Toopran (Telangana) and its principal activities are manufacture & sale of cigarettes and unmanufactured tobacco.

Economic Times showcases a brief timeline of the company’s history, in case you are interested in exploring that.

The key distinctive factor about VST Industries is that while players like ITC and Godfrey Phillips focused on the high-quality segment, VST Industries went for cheap, value-for-price cigarettes targeted at the lower end of the market and first-time smokers. So far, it has worked out very well for them.


The Industry

The (Legal) Cigarettes and Tobacco products market has mainly 3 players in India: ITC, Godfrey Phillips and VST Industries. They cater to different segments of the market and command different market shares. Cigarettes form a lion’s share (~85%) of VST Industries’ product mix. So, we are going to look at this market mostly.

Market Share

The market share split is not surprising. Due to the Government of India’s stifling rules and regulations, the market for illegal cigarettes in India has been expanding. In fact, ITC’s corporate presentation often admits that the market for legitimate cigarettes in India has reduced at ~5% from 2010-11, while the market for illegitimate has grown around the same levels at the same time.

More relevant to us, the legitimate market looks like this:

Pricing

It took me about 2 hours to compile the following list and even so, it is only partial and maybe a bit incorrect too. But the general idea here is to notice that all the three players largely play in their own markets. ITC, the market leader, is able to command a premium above everyone else. Godfrey Philips sells mostly to the mid-tier segment. VST Industries, as already noted, sells to the lowest-tier and perhaps the first choice for people upgrading from non-branded to branded cigarettes.

A recent trend has been that VST Industries is trying to get into the premium segment with lengthier cigarettes. In fact, ITC and Godfrey Philips are also trying their hands at the same strategy. But largely, these three legal players have managed to stay insider their segment boundaries.

The Role of the Government

Whenever we talk about ‘sin stocks’, the role of the Government cannot be understated. Let’s be clear about one thing – cigarettes are bad for health. There’s no two thoughts about that. So, it is only natural that the Government will want to control the market with restrictions, taxes and what not. We should consider some of the important measures the GOI has taken that directly impacts the cigarette market in India:

Restriction on Advertisements: Cigarette companies cannot advertise in India. Well, largely. The COTPA, introduced in 2003, banned the advertising of cigarettes in India in most places. The only legal place for advertising cigarettes is the Point of Sales, namely Pan Shops, Liquor Shops and such.
Ban on FDI: The Government of India has outright banned FDI in Cigarettes in India. This article provides an overview and an interesting story of how Philip Morris circumvented this rule by buying a majority stake in Godfrey Phillips. This is positive for Domestic Players, since it is a massive entry barrier for new competitors, especially from successful players abroad. But it is also true that this ban has brought about the illegal cigarette and cigar imports into India.
Ban on Vaping Products: Very recently, GOI banned the sale and usage of e-Cigarettes in India. Some news articles even claim that the police can search any premises without prior permission for the possession of e-Cigarettes. Once again, e-Cigarettes continue to be sold illegally in India, but it is yet another positive impetus for Domestic Players who get to retain their customers.
Higher Taxation: If you look at the Taxes and Duties paid by any Cigarette player in India, it has only increased over the years. The current figures stand as seen below:

An even worse statistics is that although the legal cigarette market forms only 10% of Sales all over India, it contributes almost 86% of Tax Revenues collected by the Government.

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These are some of the important points to consider while valuing a company like VST Industries.


The Numbers

Note: Risk-free Rate

The 30-year Government Bond Yield in India is around 7.21%:

Note: Company Beta, Standard Deviation and Index Returns

The 5-year, 7-year and 10-year Beta and Standard Deviation calculations for VST Industries are as follows:

Just to be on the safer side, I have taken the highest figure from ‘VST Industries Beta’ and ‘NIFTY 50 CAGR’ (So, 0.65 and 11.52% respectively).

Note: Industry Beta and Industry Debt-to-Equity-Ratio

I have also calculated the Industry Beta and Industry D/E Ratio. You can download the model towards the end of this post and look at those figure if you want to. Nothing specific to mention here.


The Capital Conversions

Note: Research and Development Expenditure

VST Industries spends about 0.50% of Sales in R&D. It is important to Capitalize “expenditure” that are found in the P&L, but are actually more long term in nature.

Note: Operating Lease

VST Industries also has a small Operating Lease arrangement going on. Nothing too big to worry about, though.

What this means is that although VST Industries is ‘Debt-free’, it indirectly owes Rs. 25.51 Crores, which converts to about a ~4% D/E Ratio.


The Assumptions

Based on our discussions above, these are my assumptions for VST Industries’ runway going forward:

Note: High Growth Period

Cigarettes have a high Entry Barrier in India. Domestic players simply have too much going in their favor. The large illegal market is simply an opportunity waiting to be captured. Although it is unclear whether the Government of India will take any specific actions towards curbing illegal cigarettes in India, it is beyond doubt that the Opportunity Size is massive for legal Domestic players.

Note: Sales Growth

VST Industries has been trying their hands at premium variants. But my assumptions follow the logic that the three large legal players have so far existed in their own market segments. So, I am going to assume that VST Industries will not focus on premium products as a core strategy, but will rather continue to operate in the value-for-price segment.

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Although the on-going lull in the economy has impacted sales growth, I am assuming that it will move towards their Sustainable Growth Ratio of ~10-11% over the years, after which it will slowly decline towards half of the Risk-free Rate (Standard Assumption for Terminal Growth in most of my valuations).

Note: Operating Margins

Once again, I am not making outlandish assumptions here. I have plotted a reversion-to-mean in terms of Operating Margins. But over several years (Beyond 15 years), VST Industries will be able to increase their Margins towards the industry average of 29.56% or so. This is in line with my reasoning that the Government of India will take active measures (Eventually) to curb the Sales of illegal Cigarettes in India. So then, the absolute pricing power the legal Cigarette players have with their customers will enable a smooth transition towards higher Margins.

Note: Tax Rate

I almost never write a note for ‘Tax Rate’ assumptions, but this is a special case. You can already see the impact of the Corporate Tax Rate reduction to 25% in most companies’ Q2 Results. Cigarette companies are no different. They will also enjoy lower Taxes.

But in line with our discussions, I am going to assume that Taxes will progress towards higher grounds, but very very slowly. Over 20 years, Taxes will rise at a CAGR  of about ~1%, which is actually much lower than the historical increase of more than ~1.50% or more. This means a near-term Tax Rate of ~25% to a longer term (20+ years) movement towards 31% or so.

Note: Capital Turnover

You may notice that the Capital Turnover and Return on Capital figures look a bit too good. Specifically for the Capital Turnover, I have ignored outliers and then averaged the rest (Such as, for a few years, VST Industries has had a Liquid Cash balance far above Capital Employed in the business, which distorts the Capital Turnover calculation).

Note: Industry Beta

According to the Industry Beta-based CAPM calculation, the required rate (i.e. Discounting Rate) for VST Industries is about 11.42%.

Special Note: Discounting Rate (Public Vs Personal)

Here, I must confess something. I was recently questioned about whether I would purchase most of the stocks I value. My immediate answer was ‘no’. Apart from the fact that I would end up owning hundreds of stocks if I really did that, a part of my answer also had to do with the fact that I use different Discounting Rates and Margin of Safety for my public and personal valuations.

For instance, I am going to discount VST Industries’ Cashflows at 11.42% here. I used a mechanical model like the CAPM to arrive at this figure, because I do not want it to be biased by my personal risk-reward tendencies. But if I decided to check out the company for an investment myself, I would claim at least 15% or more. I have talked about this is some of my other posts too. But you may find sound reasoning for this behavior in an earlier post I wrote on the subject of ‘Cost of Capital’.


The Diagnostics

There are some Yellow Flags in the ‘Diagnostics Section’. But most of the anomalies are justified.

Cigarette companies have great Pricing Power over their customers. This also lets them earn stupid amounts of Return on Invested Capital (i.e. Operating Fixed Assets). The numbers say everything.

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The Cash Flows

The following is how VST Industries’ Cashflows will evolved based on our assumptions above:

It is not surprising to see a steady increase of cash from the business. It is been that way very much in the past too. VST Industries or generally the Cigarette industry in India has been a cash guzzler. In fact, you may also notice that VST Industries pays out a ton of Dividends, because they simply produce far more Cash than they have need for.

In Warren Buffett’s “Great, Good, Gruesome” Framework for Free Cash generation, VST Industries will undoubtedly fall under the ‘Great’ category.


The Value

This is how I believe VST Industries is valued:

I think VST Industries is fairly valued at ~Rs 3,220, a 27% overvaluation at the CMP of ~Rs. 4,075. Of course, it’s hard to not notice that the stock rose about ~25-30% in the last year or so, meaning it was probably slightly undervalued towards the beginning of 2019.


The Sensitivity of Value

‘The Sensitivity of Value’ tool gives us the different values for the company at different Cost of Capital and Terminal Growth assumptions:

The ‘Pessimistic Value’ of ~Rs. 2,960 is an Expected Purchase Price if you had to imagine the worst-case scenario for the company’s future.

The Monte Carlo Simulation (Risk Analysis)

Out of the several companies I have valued so far, VST Industries has had one of the most stable numbers (Read: Business). So I don’t think a Risk Analysis is necessary.

If I really have to think about a Risk for the company, it would probably be in the form of Government interventions. You will have as much clue as me in guessing what GOI may do to the Cigarette industry. So if you are really worried about such a thing, I would suggest that you claim more Margin of Safety (Say, 30-40% instead of the 20% I have claimed above).

The Model

You can download the model using the below link:

No, you don’t need to open an account with Dropbox or ‘Sign In’. Just click on ‘Direct Download‘ as highlighted above.

If you think your story for VST Industries and consequently the Value differs considerably from mine, please let me know in the comments below. I would love to talk to you about the same.

Vantage Point: Prof. Sanjay Bakshi at his Best

One of the best articles I came across while researching VST Industries is Professor Sanjay Bakshi’s “Vantage Point: 8 Points of View for Evaluating a Stock“:

Even if you are not interested in the company one bit, I suggest you drop whatever you are doing and go through the article now. Literature like this is the reason why Prof. Bakshi continues to be a source of inspiration and awe for me. Subscribe to his blog and follow him on Twitter if you haven’t already.
With this, my 2-month drought of posts in ViM comes to an end. I have been busy with work recently. But I’m positive that with this post, things should get back to normal. Oh– and you may want to send Vivek_Investor on Twitter a well-deserved ‘Thank you’.





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Dinesh Sairam
Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME
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