“Castrol India Won’t Stop Investing in India”

Posted on by fundooprofessor

DNA reports “Castrol India says it won’t stop investing despite slowdown”

Huh? When did it start? Not for the last 16 years, no!

Castrol India's Investment in India

You can’t really stop what you haven’t started for last 16 years, can you?

🙂

Nevertheless, over those 16 years, Castrol India paid its shareholders dividends aggregating INR 28 billion and to top it all, as of the end of 2012, the company had Rs 6 billion in cash on its balance sheet.

Castrol is a cow that doesn’t need much grass but boy has it been milked!

END

Published by fundooprofessor

I am Distinguished Adjunct Professor at Flame University, Pune. Previosuly, I was Adjunct Professor at MDI, Gurgaon, where I taught MBA students two popular courses titled “Behavioral Finance & Business Valuation"(BFBV) and Forensic Accounting and Corporate Governance (FACG) for many years. I am also Managing Partner at ValueQuest Capital LLP— an investment advisory boutique which helps its clients invest their capital in good quality businesses.

26 thoughts on ““Castrol India Won’t Stop Investing in India””

  1. Castrol’s volumes have actually declined in the last 10 years from what I understand. Drain intervals have increased with improvement in technology and also they have vacated some segments. Their revenue growth has been largely pricing led. Hence the ability to not invest in fixed assets but still increase revenues. I don’t know how long will this sustain. But See’s Candy comes to mind where volumes grew at a 2% CAGR from 1972 to 2007.

    1. In 2000, Castrol India sold 213,846 KLs/MT of lubricants. In 2011, it sold 208,694 KLs/MT. So yes you are right that none of the earnings growth has come from volume expansion.

      The MD does give a hint about how ominous things could be for this industry in the long term:

      QUOTE

      For example, for Tata Motors trucks, they used to change the oil every 9,000 kms a year and they upgraded and went to 18,000 and today we are talking about 40,000 kms. So, the amount of oil getting used is coming down. In the CV space, the new vehicle sales is not fast enough to overcome the technology growth.

      UNQUOTE

      Imagine you could find a high-quality business capable of solid earnings growth because of (1) volume growth in the industry; (2) a faster volume growth in the business than the industry due to market share gains; and (3) pricing power.

      Further imagine that you could own these businesses at less than half the 23 times pre-tax operating cash flow one is being asked to pay for Castrol India today.

      Then, assuming management quality is the same, is there even a contest between investing in such a business vs. investing in Castrol at its current market price?

      1. Thanks for the article Prof.

        Like NR said, I see similarities between Sees – 2% growth rate in 35 years, threw a lot of cash out (which a fantastic capital allocator in Buffett made even better use of). Except for the infrequent depreciation led asset replacement, they did nothing much on capex.

        Now, I see a few things in Castrol:
        1. If business slows down & volume dips (looks like a possibility), working capital requirements will come down (even after inflation I would guess) releasing bit more capital.
        2. Business is already throwing out cash and co is sitting on a pile of cash already. Operating margins are high. Asset turn has been steadily going up. Going forward, the company will have even higher ‘more-cash than you need’ problem. (payout has been at ~80%).
        3. Now, management could return the entire cash generated to shareholders or find new uses for it (not happening I guess). The company, though volumes aren’t growing, with its strong pricing power could still raise prices before inflation and keep generating cash at a good clip. Thats about it.

        My question to you:
        This is not a bad situation to be in at all, but how many times earnings should this company be valued at? Should it not reflect the inflation + pricing power aided growth rate instead of the >25 multiple it enjoys? (Also, factor in real risk of volume drop) (Pls correct me if I am wrong with any pointer above).

        Now, the 2nd part: You seem to indicate there is another company thats more attractive. I would like to hazard a wild guess :). Amara Raja?
        – Industry volume growth – yes
        – market share growth – yes
        – pricing – 15% OPM
        – netblock has increased only 3.6 times in 10 years against a 17x jump in sales (I havent checked if beginning period data is an anamoly though). Here too asset turns are slowly but surely going up while margins have held up or improved. The fast growth has meant the accruals were used up – but I guess you could see an Castrol like situtation in this company too once growth has saturated, but for now, growth is there.

        If my answer was wrong, could you pls give more clues :).

        Btw, without diverting topic away I just want to point out that Amara Raja is a potential corporate governance red flag (agree?).

        Cheers,
        Prem Sagar

        1. While there are similarities between Castrol India and See’s (the milking of both being a key one), there are two (related) reasons why drawing parallels between the two would be wrong, in my view.

          One, Castrol India is a shrinking company but See’s Candy was not. A 2% growth rate a year in business volume is still growth. So when Buffett bought into See’s he bought into a company which not only has pricing power, but also potential for volume growth.

          Two, while lubricants may go obsolete over time, that’s not likely to happen with candy.

          When investing in a company whose business volume is shrinking and where one is not sure that the shrinkage is temporary, one should be very careful of the consequences of the shrinkage over time. The volume shrinkage may be camouflaged by frequent price hikes (as is happening with Castrol) which may ensure rise in earnings over time. But the investor must go deeper and identify the reasons for the rise in earnings and ask tough questions about the sustainability of those reasons.

          Other things remaining the same, it’s far better to be invested in a company whose earnings are growing for multiple reasons than for just one reason. I like the metaphor of having a few friends instead of just one because if you lose one, you have the others. What will happen to Castrol if it’s pricing power engine sputters and stops?

          One must also keep in mind how the market will value a company a few years from now. A few years from now, the value of any financial asset will be a function of earnings beyond those few years. By then, if the shrinkage in business volume is unable to be camouflaged by price hikes, markets will quickly re-rate that stock downwards. THAT is the key risk in Castrol India because at 23 times pre-tax operating cash flow, the market is expecting continuous earnings growth in its business.

          I cite here four companies which are enjoying volume growth (driven by both increase in the size of their industry as well as market share gains for the companies) AND pricing power: Relaxo Footwear, Cera Sanitaryware, Kewal Kiran Clothing, and Thomas Cook. I am sure there are many many more out there…

          1. Absolutely. See’s came to mind only looking at where the puck has been, not looking at where it is going.

            Here are some numbers: there are roughly 5 to 6 million heavy trucks and buses on India’s roads today. Now, even assuming a replacement cycle of 40k kms and 5mn trucks multiplied by 300 kms a day for 200 days a year, that’s a replacement demand for 7.5mn trucks worth of oil. Now, compare this to the 260,000 new heavy trucks and buses we sell every year. Also, the 40k I have assumed is optimistic because the drain intervals can be lower in the older trucks. We might be yet to hit that number for the national fleet. Demand growth from new trucks is grossly insufficient and there is a real risk of a substantial shrinkage in volumes which is hard to quantify today. And its a risk I’d avoid considering the valuations.

            1. True. In addition, the huge success of the all-electric vehicles like Tesla, has demonstrated that automobile technology which requires very very few movable parts (and hence lubrication) is already here, and it’s getting better very very quickly. The point is not whether Tesla will prosper or not. The point is that a very disruptive, hugely more efficient, and cheap technology which can render many auto-related businesses (that, by the way, includes lead-based batteries) obsolete, is here and investors in those businesses should really worry about that…

          2. Dear Sir

            Just wanted to understand one thing…Why do you think that Thomas Cook has a strong pricing power??..I can understand that the market is expanding but what factors make you think that the Travel business has a strong pricing power??..Regards, Anish

            1. Anish,

              Thomas Cook is India’s dominant cash forex company having more than 50% market share. In the retail forex business it enjoys pricing power. Check out the company’s forex rates on its website and compare them with those charged by Wiezmann and Centrum. You will find that Thomas Cook’s rates are higher. On airports, where Thomas Cook has significant presence, the rates are even higher (even after adjusting for the revenue share with the airport operator).

              In the package holiday business, Thomas Cook is one of the largest players in India but like other players in the organised segment (such as Cox & Kings), the company competes with hundreds of small travel agencies which also offer package tours. As a class, the organised players (of which Thomas Cook is one) enjoy pricing power over smaller players. Also, given that Thomas Cook is a large buyer of international travel components (room nights, air, bus and train tickets etc), it leverages its large size to get quantity discounts which are not available to smaller players. While this latter factor about scale economics does not translate into pricing power, it does deliver higher margins for Thomas Cook.

              Just for fun, and some learning, check out the profitability (or the lack of it) of India’s largest online travel company— Makemytrip. It’s listed on Nasdaq and its financial numbers are publicly available. You’ll find that it is haemorrhaging cash. In contrast, Thomas Cook’s travel business has been cash generative for decades…

              1. Dear Sir

                Thanks for your guidance. I am on the same page with respect to the bargaining power with the suppliers. But, my observation is that from 2008 to 2012, the pre-tax cashflows have not shown a steady growth. Average pre-tax cashflow of 100 crores. I believe that the volumes would have increased in this period. But still the cash flows are not growing as much non-linearly which could indicate a pricing power. So if the bargaining power has increased then the pricing power would have decreased. I think forex would have a higher pricing power than the retail and business travel as indicated by you. So, I think it is virtually impossible for the cashflows to compound just on the basis of travel and forex. To me, the company’s biggest competitive advantage in comparison to peers is that it’s business has 50-50 presence in forex and travel (Business model) unlike other travel operators (Eg Makemytrip). One is working capital positive and other is working capital negative. So the next question to me is, what will take the 100 cr cashflow to 200 cr and 200 cr to 400 cr over the long term. So that brings us to it’s new acquisition IKYA. Sir, is it possible for you to give me a company that is close to the Ikya business model?? Any idea about the competitive advantage in terms of pricing power in the Ikya business. Why among all the opportunities available to TCIL, would it go and buy an HR firm? I can understand the synergies between the corporate clients of Ikya and TCIL travel business. But would like to understand Ikya more.

                1. Anish, I will be doing a case on this company in my class soon and will post it on my site and/or blog. So, this will have to wait for now.

                  You can compare IKYA with PeopleStrong, Addeco, ManPower and TeamLease. Also, you may want to read the following books.

                  1. Overbooked: The Exploding Business of Travel and Tourism
                  2. The Temp Economy: From Kelly Girls to Permatemps in Postwar America
                  3. Triumph of the City
                  4. Work in the New Economy: Flexible Labor Markets in Silicon Valley

                  In the HR space, another business model to study would be that of Info-Edge (naukri.com).

      2. “Further imagine that you could own these businesses at less than half the 23 times pre-tax operating cash flow one is being asked to pay for Castrol India today.” I guess you were comparing Symphony with Castrol. Symphony was trading at half of Castrol pre-tax OCF multiple during Aug 2013. Could not believe return on capital and ROE of Symphony [excluding non-core items]

  2. Interesting observation! However, just looking at net block might not reflect the complete picture due to depreciation etc.

    Only in the last 10 years, the company has invested over Rs. 260 crores towards purchase of fixed assets (I am not able to trace data older than that but am assuming the figure would be over Rs. 300 crores over 16 years). Looking at these numbers, it might be reasonable to state that the company has invested in India (theoretically it could have chosen not to do so).

    On high dividends and cash balance, that is the strength of the business model due to which it is able to generate healthy FCF consistently.

    Do let me know your thoughts.

  3. Dear Sanjay Sir,
    u had written exceptionally good educational article for peoplr from non-finance background likes “moat in 3 parts”, “vantage points”.

    I request to write more such educational articles to educate people like us from non-finance background.

    Regards
    Sameer

  4. many from our village who were/are working in Castrol Mumbai have become rich through comapny shares … seems like castrol have good employee policy

  5. What matters is Return on Assets and RoE/CROIC as long as the company increases it even in the face of declining revenue growth, I would be comfortable. Revenue growth in isolation means nothing, I would rather take a 2 % revenue growth flowing straight to the bottomline rather than a 10% revenue growth without a commensurate growth in profitabiliity

    1. An increase in ROA/ROE/ROIC in a shrinking business could easily make it less valuable over time. Similarly, a reduction in ROA/ROE/ROIC in an expanding business could make it hundreds of times more valuable over time.

      What matters is not how high the return ratios are, but (1) how high is the spread between those ratios and passive rates of return; and (2) how much capital can be poured into those positive spread businesses.

      What would you rather own? A low-cost steel mill which has a sustainable technology-driven, patented advantage which allows it to earn 20% ROIC when interest rates are 10%, and in which it can invest hundreds of millions of dollars, or a road side vendor who enjoys a three-digit ROIC but no scalability?

  6. Newpapers (and even CEOs) use the term ‘investing’ very loosely. It need not always be capex. They probably meant ‘investment’ in things like distribution, product dev, even marketing.

    1. As mentioned in one of the comments, volume growth in vehicle sales has not been able to offset technological advantages. So, it hasn’t happened yet. I don’t know if it will happen in the future or not. What I do know is that there are growing INDUSTRIES and within those industries there are companies growing FASTER than the industries and other things remaining unchanged, its better to look for value in those situations than Castrol-type of situations…

    1. Yes, three

      1. It’s a good idea to return money which cannot be productively deployed in the business, but
      2. This has is nothing to do with the intrinsic valuation of Castrol India’s shares; and
      3. The transaction may attract provisions of Section 2(22) of Income Tax Act (deemed dividend).

      1. Yes they have to pay DDT on it, as I believe Colgate Palmolive did sometime back. Its just like a dividend. Still scratching my head on why they are doing this!

        1. Maybe because Colgate did it 🙂

          Seriously, though it could have something to do with how much of a normal dividend the company is allowed to pay given its profits (under Companies Act). Castrol already has a high dividend payout ratio.

          Also note what they are NOT proposing to do: a buyback…

  10. Dear Professor,

    Despite investors in the US burnt their hands less than 5 years back, I simply wonder at the irrationality of the Tesla valuations? The positive research reports being written are simply mind boggling with all the lease related accounting issues.

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