Is Low P/E “Value”?

- The beautiful story of Rasandik Engineering

Sunday, December 21, 2008

How many of you think a stock trading at a P/E of 1x forward earnings is ‘cheap’? I can see a lot of hands
going up. Since the story is so enthralling I’ll dive straight into it.

The business
Rasandik is an auto components company that supplies sheet metal components and dyes/moulds to auto
OEMs. Maruti is its largest buyer (accounts ~75% of its sales). Other customers include Tata Motors, TVS
Motors and Bajaj Auto.

The business is commodity-like, a volume game with low-margins. Rasandik moved over to a newer
technology that was supposed to increase (relatively) the margins of the company. I say supposed to
because the desired outcome seems a mirage for the company, till date at least. The company’s problems
began since late last year with the broader economic deterioration.

The problem(s): Operational

The company pumped in lot of money to setup a plant close to its customer Daewoo Motors some time back
but the plant piggybacked Daewoo into bankruptcy. The woes continued with the company setting up
another plant to cater to Tata Motors. The plant was ready for operation by August 2007 but Tata Motors
suffered some delays at its end leading to Rasandik’s plant idling till April 2008. Then another setback hit
the company. The company pumped in US$10 mm into a plant at Singur to cater to Tata’s Nano. But the
latter’s ruckus with the Bengal government led to the venue being shifted to Gujarat. Result: Rasandik got
hit again. Around $3-$4 mm of the total investment is sunk cost. The company has been trying to recover
this amount from Tata Motors.

The problem(s): Financial

The worsening conditions started showing up on the company’s numbers. Volumes have been growing
reasonably well but unit prices have been on a downtrend, reflecting the commodity and intensely
competitive nature of the business. Combined effect of this led to sales growth of about 14% last fiscal (to
$40 mm). EBITDA came in at $4 mm and Net income came in at $1.5 mm (net margin = 3.5%).

Moving onto capital structure, the company has $36 mm of total debt outstanding against $6 mm of book
equity. I emphasize book because the current market value of the equity is $2.5 mm. The punitive
debt/equity ratio of 6x, gives the company a very high ROE (22%) but a paltry ROC (4%). For years, strong
macro conditions and demand camouflaged the over-stretched balance sheet. But a turnaround for the
worse in the very factors that drove Rasandik’s growth led to the magnifying of negative effects of a
stretched balance sheet.

The company has a $3 mm senior debt repayment and $11 mm FCCB coming up for redemption in 2009.
Net income turned negative in 1H2009 and in all probabilities will end the full year in the red. Let’s turn to
the Cash Flow to assess if Rasandik can handle the debt redemptions. Assuming Net income and
depreciation to offset each other, operating cash flow will still end up in the red in F09 after adjusting for
working capital. To make matters worse, you could shave off some more as discretionary capital
expenditure. Add the $1 mm in cash in the company’s books as of last fiscal year end and there isn’t much
cash left with the company. Not a good sign. The company will be hard pressed to pay back senior debt, let
alone the FCCB. A default seems likely.
Book value of the company’s fixed assets is $33 mm and net working capital was $2 mm. Assuming in a best
case that the company is able to get 100 cents on the dollar for its fixed assets and full recovery of working
capital, it still won’t suffice to pay off all the debt. What’s left for the equity?

What are the options available to the company? It can hope that Maruti will bail it out by throwing a lifeline.
But if Maruti’s switching costs are low, and it seems they are low, it’s unlikely that this option will be
workable in reality. The other option is to request the FCCB holders to extend their loan. The terms of the
new structure will be even more crushing, as holders will demand a higher rate of interest on their
extended loan. Rasandik’s receivables cycle has lengthened with the auto OEMs getting hit and if this
situation continues, the company could see the bad operating performance continuing for longer than it
would like. The other hope is that credit conditions improve by April 2009 and the company is able to
obtain refinancing. With a lot of much larger companies struggling for credit, what are the chances of a
small company obtaining requisite financing? Lastly it could go in for financial restructuring, with some of
the lenders translating into equity holders. As a lender, I am not terribly excited at the prospect of holding
equity in a company that’s besotted with problems in a commodity-like wafer-thin margins business.

So is the common equity “Value”?

I don’t think so. This example is a classic on how apparently low multiples do not always translate into
“value”. Lots of times, companies trade at abysmally low multiples for good reason. Indeed in this case, the
equity doesn’t seem to have any value given a set of bad conditions. One could set forth a compelling
argument for the company’s common stock to be overpriced at current levels, and the argument would
make a lot of sense! The other key learning is that no amount of financial engineering will be able to save
an investment if the underlying business is ‘bad’ (i.e. it does not enjoy a sustainable competitive
advantage).

Warren Buffett: take a bow!

- Hemant Sreeraman

Blog: www.haphazardlinkages.blogspot.com