Introduction:

If you're a regular reader of my newsletter, you've likely noticed that I conduct thorough research on companies before making investment decisions. My strategy involves long-term investments, often spanning a decade or more. If you're new here, I recommend exploring my fragility series, which delves into the intricacies of my investment methodology. 

If you found my newsletter valuable, please like/comment and do share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM (please note that there may be occasional interruptions due to personal commitments). You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.

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In this post, I'll delve into one of the numerous aspects of valuation using Cipla Limited as case study.

Cipla Limited

Cipla is engaged in the Business of Pharmaceuticals and is India’s oldest Pharmaceutical company. Cipla is presently the 3rd largest pharmaceutical player in India and leader in therapies such as respiratory and urology. It also ranks 2nd in the overall chronic business. It is the 2nd largest Indian exporter in emerging markets. 

Cipla has nearly 90 years of rich history. In 1935, Cipla was founded by Khwaja Abdul Hamied as the Chemical, Industrial & Pharmaceutical Laboratories in Mumbai. In July 1984, the name of the company was changed to 'Cipla Limited',

One of his famous statements was:

"Never again will India be starved of essential drugs."

He said this in an advertisement of Cipla in 1947, when India was facing a shortage of medicines due to the partition. He also said:

"Unlike other pharmaceutical companies around the world, we are not here to make profits but to bring relief and healthcare to the poor who may otherwise have to die for want of quality drugs."

He said this while handing over his company to his son, Yusuf Hamied, who continued his legacy since the 1970s. In 1999, under Yusuf Hameid leadership, Cipla joined the Indian Pharmaceutical Alliance as a founding member in an effort to promote the development of generic drugs in India.

On July 27th, 2023, there was news from CNBC-TV18 that Cipla’s promoters are in talks with private equity firms to sell a part of their total holding in the company. At present, The promoters own 33.47 percent stake in the company.

Cipla immediately clarified the following:

This refers to the news on CNBC TV18 regarding Cipla promoters looking to sell a part stake in the promoter shareholding to private equity investors with some detail. Pursuant to Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirement) Regulations 2015 (Listing Regulations), we hereby clarify that the Company is not aware of any event that requires disclosure under Listing Regulations. The Company will make appropriate disclosure in compliance with the Listing Regulations as and when any such requirement arises. Kindly take the above information on record.

There were subsequent news articles stating that the third/fourth generation of the promoter family is not interested in continuing the legacy and looking at exit. Further, Strategic investors like Torrent Pharma and Financial investors like Blackstone and Baring Asia are interested in acquiring a stake in the company. Cipla has not confirmed any of these news articles. 

The said news may or may not happen. In this post, as a thought experiment, I would like to address one of the many interesting aspects of valuation of a company.

Intrinsic Value of Cipla Limited

Before getting into valuation, let’s look at the financials of the company.

All the four key financial ratios indicate that the company is robust and not fragile. 

Now that we are convinced that the company is not fragile, we can move to the next step in the investment process i.e. valuation.

In FY2023, the company on consolidated basis earned revenue of ~Rs 23000 Crs and PAT of ~ Rs 3000 Crs as against revenue and PAT in FY2012 of ~Rs 7000 Crs and ~ Rs 1100 Crs. 

The Profits and revenue nearly tripled in 10 years which is a CAGR of 12%. If we extrapolate this growth for next 10 years, then the company will likely earn revenue of Rs 70000 Crs and PAT of Rs 9000 Crs. 

The company on an average traded at PE of 31 in the last 10 years. Considering this as terminal PE after 10 years, then the company's value after 10 years will work out to Rs 2,79,000 Crs. 

Now here’s where calculating intrinsic value gets interesting. The intrinsic value depends on the growth rate/return the investor is seeking. 

For example, if an investor looks at growing his/her investment at a CAGR of 15% for next 10 years, then we need to discount Rs 2,79,000 Crs by 15% to arrive at a present value of ~Rs 70000 Crs i.e share price of Rs 867 per share.

If an investor instead is looking at growing his/her investment at a CAGR of 12% for next 10 years,  then we need to discount Rs 2,79,000 Crs by 12% to arrive at a present value of ~Rs 93000 Crs i.e share price of Rs 1152 per share.

Cipla is presently trading at valuation of Rs 95,740 Crs at share price of Rs 1186 per share which is nearly 12% CAGR growth rate as calculated above.

While the average PE of Cipla in the last 10 years was 31, the PE fluctuated from as high as 55 to as low as 20. In the last 10 years,  If an investor had accumulated the shares of the company whenever PE was below 31 and held the shares without further accumulation whenever PE crossed 31, then the returns can be further maximized  over 12% as acquiring PE will be much lower than average PE of 31. This is one of the strategies an investor can utilize when accumulating shares of a company to maximize returns i.e. acquiring whenever share is trading below average PE. 

While I covered how intrinsic value can change with expected returns of minority investors like us and at PE levels at which the share is acquired. I also would like to cover another aspect of how acquisition by a majority investor can impact a company's valuation.

The Impact of Acquisition on Intrinsic Value

One of the strategic investor i.e. Torrent Pharma is looking at acquiring the company. We don't know whether this news is true or not as both Torrent and Cipla denied the news. However, what we are doing here is only a thought experiment. 

Torrent Pharma is valued at ~ Rs 63000 Crs is the 10th largest Pharma company looking at acquiring Cipla which is the 3rd largest Pharma company. Cipla’s promoters presently hold a stake of 33.46% in the company. They are expecting a sale price of Rs 1350 per share i.e. at market cap of Rs 1,10,000 Crs. Value of promoters' stake at Rs 1350 per share works out to Rs 36000 Crs.

Apart from paying ~ Rs 36000 Crs to acquire promoters stake, Torrent is also required to give an open offer of acquiring further 26% stake as per SEBI guidelines for a consideration of ~ Rs 28000 Crs. That means, Torrent Pharma or any other acquirer needs to be ready with funds of Rs 64000 Crs to acquire Cipla Limited.

The Rs 64000 Crs to be paid to acquire Cipla is more than market cap of Torrent Pharma. Torrent Pharma is required to raise funds at various levels including raising debt in Cipla itself to acquire the company. 

Raising debt in Cipla to acquire Cipla is called leveraged buyout. Raising Debt in Cipla will increase fragility in the company. To raise debt at moderate fragile levels, debt of 3 times PBT can be considered. PBT of Cipla in FY2023 is Rs 4000 Crs. That means, Torrent can look at raising debt in Cipla to the tune of Rs 12000 Crs to part fund the acquisition. In FY2023, Cipla had cash and investments of Rs 4500 Crs and Debt of Rs 800 Crs. Accordingly, net cash surplus available with the company is Rs 3700 Crs. Torrent can also look at utilizing this money for acquisition. Accordingly, Torrent can look at withdrawing cash of Rs 3700 Crs and also raise debt of Rs 12000 crs i.e. total amount that can be raised from Cipla for its acquisition is Rs 15700 Crs. 

From a minority investor’s point of view, the value of Cipla will deteriorate by ~Rs 15700 Crs due to this leveraged buyout as that much money is taken out. Further, considering the increase in fragility of the company due to leveraged buyout, we may consider to further discount the value of the company by 20% i.e. another ~Rs 18600 Crs. Accordingly, value of the company will deteriorate by Rs 34300 Crs i.e. revised value of the company for an investor looking at 12% CAGR will now work out to Rs 58700 Crs i.e. Rs 730 per share as against present trading value of Rs 1186 per share.

As calculated, the value of a company can change due to changes in capital structure or how it is acquired.

Conclusion

Discount rate i.e. rate of returns sought by investors can impact valuation of a company. Further, change in capital structure like in leveraged buyout can also impact valuations of a company. 

Stocks discussed in this newsletter are not recommendations and are for education purposes only. 

If you found this post valuable, please like/comment and do share it with your friends and colleagues who might also benefit from it by asking them to subscribe to my weekly newsletter - weekly posts every Sunday at 8 AM (please note that there may be occasional interruptions due to personal commitments). You can forward this email or click on the social media buttons below. Thank you for reading and subscribing to my newsletter! Your support is greatly appreciated.

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Introduction:

If you're a regular reader of my newsletter, you've likely noticed that I conduct thorough research on companies before making investment decisions. My strategy involves long-term investments, often spanning a decade or more. If you're new here, I recommend exploring my fragility series, which delves into the intricacies of my investment methodology. 

In this post, I'll delve into one particular aspect of investing that concerns all of us. Is the company worth the share price we are paying for? I’ll use Zomato as an example for this.

Zomato’s business model

Business model comprises of 3 divisions

Food Delivery -

Operates a technology platform that provides customers with a convenient, on-demand solution to search and discover restaurants, order food, and have it delivered reliably and quickly. Orders placed on its platform are fulfilled by a last mile delivery fleet comprising of independent delivery partners. 

Hyperpure -

Hyperpure is B2B supplies offering for restaurants in India. Company sources fresh, hygienic, quality ingredients and supplies directly from farmers, mills, producers and processors to supply to its restaurant partners, helping them make their supply chains more effective and predictable, while improving the overall quality of the food being served. 

Quick Commerce (Blinkit) -

Blinkit is a quick commerce marketplace delivering everyday products to customers within minutes. 

Arriving at Intrinsic Value

Zomato as of Aug 2023 is valued on stock market at ~ Rs 100 per share with a market capitalisation of ~Rs 84000 Crs.

While it is difficult to arrive at an exact value for a company (this is one of the reasons why stock prices fluctuate), we can try to arrive at a conservative  estimate for intrinsic value of a company below which we get sufficient conviction to invest in the same. 

For Zomato, lets try to value the company by trying to value each division separately.

Food Delivery

One starting point for valuing this division is gross order value on the platform for the entire year. Gross Order Value means the total value of food ordered by customers on Zomato from various restaurant partners. 

Total gross order value in FY2023 is ~Rs 26,300 Crs and in FY22 is ~Rs 21,300 Crs. Remember this is the value of food ordered and not the revenue for Zomato. Out of this value, the actual revenue earned by Zomato (i.e. commission from restaurants, delivery fees, etc) is Rs 4,533 Crs in FY2023 and is Rs 3,415 Crs in FY2022.

While prima-face revenue appears to grow by 33%!!, if we recall, first quarter of FY2022 was affected by the second wave of COVID. Hence, the 33% growth figure is not a true representation of growth. The actual growth in FY24 might end up much lower. 

The company did not earn any profit from the division in FY2023 and incurred a loss in FY2022. 

If we look at the presence of the company, I feel the company’s market is already saturated and doubt whether any further steam left for the growth in the near future. Already nearly 1.7 Crs families are ordering from Zomato which implies ~5 Crs population which is equivalent to tax filing population. 

Further, whether the company can take advantage of operating leverage considering that delivering each order involves a lot of variable cost as well.

We can arrive at valuation through PE if the company is earning profit. Here, the company is yet to turn profitable. You might have come across lot of news chatter on Zomato making profit in June’2023 quarter. But if you actually look at the numbers, the profit earned for all three divisions is Rs 2 Crs and it is actually negative Rs 179 Crs if we exclude interest income of Rs 181 Crs earned on Fixed Deposits held by the company (unutilised money received through IPO!!!)

However, if we assume that somehow Zomato’s food delivery business does breakeven, then if we safely assume a profit margin of 10%, then on the present turnover of Rs 4533 Crs, profit can work out to ~Rs 450 crs. I would not pay a PE of more than 20 considering that the market might actually be saturated (as population ordering is equivalent to population filing income tax returns). Going by this assumption, the food delivery division should be worth Rs 9,000 Crs which I feel is still an aggressive estimate considering the division is yet to turn profitable.  

Hyperpure

This is a relatively new division and earned a revenue of Rs 1506 Crs in FY2023 as against revenue of Rs 538 Crs in FY2022. While there is scope for growth in revenue, whether the division can turn profitable is to be seen considering wafer thin margins in trading business (hyperpure is equivalent to trading) and also considering perishable nature of items.

The adjusted EBIDTA margin for FY23 is -ve 13% vs -ve 26% in FY22. The division is yet to turn profitable. As per the company’s Annual Report FY2023,

Quote

In March 2023, our oldest city Bangalore turned profitable (before allocating central corporate overheads). 

Unquote

Oldest city Bangalore is still loss making if central corporate overheads are subtracted!!

Again, as food delivery business, even if we assume that Zomato turns this division profitable and if we assume a profit margin of 2% (inline with trading businesses) considering it is simply a trading business of groceries and goods are also perishable, then out of 3 year forward revenue of Rs 10000 Crs, the profit works out to Rs 200 Crs.

If we assume a PE of 20 for this division. Going by this assumption, the Hypercure division should be worth Rs 4,000 Crs. Since this is based on 3 year forward PE, by discounting at 15% for 3 years, same works out to ~Rs 2500 Crs which I feel is still an aggressive estimate considering division is not yet profitable.

Quick Commerce (Blinkit)

The company got this division through Blinkit acquisition. The turnover in FY2023 is Rs 806 Crs and loss incurred is Rs 503 Crs. I have my doubts that this division will ever turn profitable as people will look for alternatives like deferred delivery of 2 to 3 days (like say bigbasket) instead of quick delivery if the delivery costs increase above a certain threshold. This limits the profit earning capability of the division. Even competition like Swiggy Instamart,  Zepto, BBnow are still burning cash and none of them are profitable. Even if Zomato is successful in turning this division profitable, at this juncture, conservatively, it is better not to attribute any value to the same from investment perspective.

However, if we have to value this division, one starting point is ~Rs 4500 Crs at which Zomato acquired Blinkit in June 2022. However, market did not take the news positively.

Shareholders give thumbs down to Zomato-Blinkit deal- The New Indian Express

Considering market view is not positive on the amount paid, wont a 50% discount on the amount paid is conservative estimate? If we go by this, then value of this division works out to Rs 2250 Crs

Apart from value of the three divisions, company has Cash in books of ~ Rs 4700 Crs (unutilised IPO money).

Intrinsic Value

After decoding all the three divisions of Zomato plus unutilised cash, we arrived at an aggregate value of Rs 18,450 Crs (i.e. ~Rs 21 per share price) for the company. 

Compared to this, the market is valuing the company at ~Rs 84,000 Crs (at share price of Rs 100 per share) as of Aug’2023!!! Lowest ever valuation given by market for the company post IPO in June 2021 is ~ Rs 40,000 Crs in July 2022

Assume you are a recruiter. In an on-campus recruitment drive, will you recruit a student who has backlogs or a student who cleared all his/her exams. We have to note that all three divisions are still loss making and Zomato is yet to prove its worth. Zomato is like a student who has backlogs. Even if we give the benefit of doubt that itll turn profitable someday, then the value being arrived at is Rs 18,450 Crs (i.e. ~Rs 21 per share).

Relative valuations

Zomato’s partners deliver food on 2 wheelers. The company i.e. Hero Motorcorp  with 34% market share in 2 wheelers in India and earning yearly profit of Rs 3000 Crs and has cash in books of Rs 11000 Crs is valued at ~ Rs 58,000 Crs vs Zomato’s valuation of Rs 84000 Crs which is loss making at various levels!! While comparison of the value of a company which manufactures 2 wheelers vs value of a company which delivers food on those 2 wheelers is not appropriate. This is just to give sense of scale of Zomato’s valuations.

Info Edge which has 14% shareholding in Zomato is valued at Rs 58000 Crs. If we subtract Zomato’s value from the company, then the valuation of Info Edge minus Zomato is Rs 46000 Crs (i.e. less Rs 12000 Crs - 14% of Rs 84000 Crs).

Info Edge comprises businesses like Naukri, Jeevansathi, 99 Acres, etc. Even if we ignore all other businesses and only consider Naukri for valuation purposes,  Naukri earned a revenue of Rs 1749 Crs in FY2023 and a profit of Rs 1027 Crs. This has been profit making and growing since the past many years. Naukri is a monopoly business (Linkedin is trying hard to enter but yet to be successful) unlike Zomato which has competition like Swiggy, ONDC, etc. The revenue of Naukri grew from Rs 669 Crs in FY2018 to Rs 1749 Crs in FY2023 at a growth rate of 22% y-o-y. Naukri has been consistently earning a profit margin of 55% to 60% for the past many years. And the market is valuing Info Edge (minus Zomato)  at Rs 46000 Crs vs Zomato valuation of Rs 84000 Crs!!

Conclusion

Its hard to arrive at a valuation of loss making companies. I generally prefer staying away from such companies altogether as they are yet to prove their worth. I prefer to wait for such companies to turn profitable. Here, we tried to arrive at valuation for one such company with lots of assumptions. 

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In this post Ill try to explain the step by step approach of fundamental analysis through analysis of Sreeleathers Limited.

Background

Sri Satyabrata Dey wanted to create a durable and affordable footwear Indian brand. His dream gained consumer confidence over the years and Sreeleathers expanded to become a pioneer in Eastern India. Shrimati Shipra Dey joined the business during the formative years of the company to help out Shri Satyabrata Dey. There are 42 stores in 10 states in India. Although Sreeleathers has a limited number of stores, it’s retail performance and popularity make them a formidable footwear brand in the country.

Now we know the business model of the company, lets analyze the company from an investment point of view.

Three pillars of fundamental analysis

As I explained in my earlier posts, there are three pillars of fundamental analysis:

Pillar 1: Avoiding Investing in fragile companies

We need to try to avoid investing in fragile companies. I explained about the concept of fragility in my previous posts. A fragile company is like a flower vase. We dont know when the flower vase will break or will it even break. We only know that a flower vase is fragile and will break as soon as it falls. By investing in Robust/ Antifragile companies, we avoid this risk. A robust/Antifragile company is like a rubber ball which does not easily break upon a mere fall. I explained about how to measure fragility of a company in my post How to measure fragility in a company using financial statement analysis with Castrol Limited as Case study (budgetiger.in)

Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile

We need to avoid investing in companies when they are overvalued. Valuation of a company is like a balloon which can burst if there is too much air and on the other hand there is a lot of scope to grow if there is too little air.Valuation is an additional fragility parameter which is relevant for an investor but is irrelevant for a company. Investing in a robust company at overvaluation makes our investment fragile. I explained about overvaluation in my post Overvaluation increases fragility of our investment & Stock Market is not always right (budgetiger.in)

Pillar 3: Avoid investing in companies whose Management has fragile mindset

We can measure the fragility of a company as explained in Pillar 1 by analyzing past financial performance. We can also measure whether a company is overvalued or not as explained in Pillar 2 by conservatively estimating future performance. However, a management with a fragile mindset can hamper future performance of a company. We need to avoid investing in companies whose Management has a fragile mindset. In this post, Just as a jockey is crucial for a race horse’s success, the management is vital for a company’s performance. I explained about management analysis in my post A Step-by-Step Approach to Management Analysis for Companies (budgetiger.in)

Ill analyse Sreeleathers Limited through these three pillars

Pillar 1: Avoiding Investing in fragile companies

I have calculated the four key fragility ratios for the past 10 years for Sreeleathers Limited.

Equity as a % of Balance Sheet size

Equity as a % of Balance sheet size has been in the range of 88% to 95% which indicates that the balance sheet of the company is very robust. It also indicates that the Management is very conservative and does not like to take debt.

Breakeven sales as a % of Actual Sales

Breakeven Sales as a % of actual sales has been less than 5% in the past 6 years indicating that the company will continue to generate profits even if sales decline by 95%!!. This ratio indicates that P/L of the company is very robust.

Return on Capital Employed (ROCE)

ROCE fluctuated in the range of 7% to 17% in the past 6 years. ROCE indicates if there is any inherent strength in the business model. ROCE is like interest earned on a Fixed Deposit. Ideally ROCE should be much more than ongoing FD interest rates. However, incase of Sreeleathers, the ROCE during FY2019 and FY2020 is 17% indicating the business model is slightly robust. However, ROCE dipped to 6% during COVID year of FY2021 and increased to 10% which is also the COVID affected year. ROCE however increased to 13.5% if we consider financials upto Sep 2022 financials indicating that dip in ROCE is temporary and only due to COVID disruption, else company’s business model is robust.

Cash flow from operations / (Yearly Debt Obligations + Depreciation)

Cash flow from operations / (Yearly Debt Obligations + Depreciation) indicates the number of times the cash flows generated by a company as compared to fixed obligations of the company like Interest plus installments plus replacement capex. I have used Depreciation as a proxy for replacement capex. The Cash flows from operations has been 5 times fixed obligations since past 6 years indicating that the cash generation of the company is robust. 

As per the above analysis we can conclude that the financials of the company is not fragile and instead are very robust.

Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile

For identifying whether the company is presently overvalued or not, Ill use three ratios PE, 5 year PEG and 10 year PEG ratio.

PE (Price to Earnings)

At the time of writing this post, share price of the company is Rs 188 per share with a market cap of Rs 435 Crs. PAT of FY2022 is Rs 17 Crs indicating a PE of 25.58. If we consider the PAT of last 4 quarters, it is Rs 22.57 Crs indicating a PE of 19.3.

PE of less than 20 generally implies the company is not overvalued. PEG is a better ratio than PE as PEG also factors in growth of the company. High growth companies will command higher PE.

PEG is PE by Growth rate. PEG of near 1 or less indicates that the company is not overvalued. 

5 years PEG means PE by CAGR of PAT of past  5 years. 5 year PEG for Sreeleathers Limited is 3.84. This may be partly due to 5th year being FY22 which is a COVID affected year and hence the underperformance in PAT is temporary. PEG will definitely come down with FY23 PAT once the financials results are released as company already generated PAT of 18.88 in 9 months of FY2023 as against full year PAT of Rs 17 Crs in FY2022.  

10 years PEG for Sreeleathers Limited is 1.38. PEG of 1.38 even after considering that 10th year is FY22 which is a COVID affected year implies that company is not over valued. PEG will definitely come down if we consider FY23 PAT once released considering 9 months performance.

Company’s market cap is Rs 435 Crs as against cash in books of Rs 200 Crs indicating net market cap is Rs 235 Crs. PE and PEG will be even lower if net market cap is considered.

As per the above ratios, we can conclude that the company is not overvalued. 

Pillar 3: Avoid investing in companies whose Management has fragile mindset

We can analyze management decision making through cash flow statement analysis. Here are my observations:

• Management has not taken debt in the past 12 years which indicates that they do not have a fragile mindset.

• Management Preferred to lease properties instead of purchase of new properties indicating that they have a frugal mindset. Own properties will increase operating leverage as compared to lease properties thereby increasing fragility. Management does not have fragile mindset as per this. 

• While the company did not pay any dividends with surplus cash generated, management shared part of the profits through Buyback of shares in Nov 2020 to the tune of Rs 33 Crs. 

It is very interesting to note that PE is lowest in Nov 2020 in the past 10 years and company initiated buyback at the same time. 

This decision alone indicates that management is willing to share wealth with minority holders and also to maximize returns while sharing the same. Dividends would have had tax implications. Buyback of shares will not have tax implications for shareholders who do not tender their shares in buyback. Further, they did not buyback at some random point of time and instead brought back when the company had lowest PE in the past 10 years indicating shares were brought back at the lowest valuation in the past 10 years!! This also indicates that the Management’s thought process is long term and also have a very disciplined approach.

• It may be noted that Management tried doing buyback once before in Oct 2017. The share price fell from Rs 300/- levels in 2013 to Rs 130 to Rs 150/- levels in since 2016. Management tried initiating buyback at Rs 156/- per share in Oct 2017. However, the share price started increasing just few days prior to announcement of buyback and never dropped below Rs 156/- until COVID-19 happened. Due to this buyback was unsuccessful in 2017.

• Management accumulated surplus cash not required in business to strengthen the balance sheet. At the end of Sep 2022, there is  surplus cash of Rs 200 Crs invested in the form of Growth debt mutual funds. Management invested in growth debt funds instead of Fixed Deposits of dividend based Debt Mutual funds which is a tax efficient decision. The company need not show other income unless they sell some mutual fund units unlike incase of Fixed deposit wherein they are required to show other income on interest earned irrespective of whether they utilize the interest/FD or not.. 

• If management wants to increase share price, they can simply sell the accumulated cash reserves of Rs 200 Crs and pay dividends to shareholders. But they are not doing that despite criticism from the investor community  and instead focussed on strengthening the balance sheet. They also shared wealth to shareholders at opportune time through buyback at lowest valuation. This shows that Management is not deterred by short term price fluctuations and also has long term focus. 

• Other checkpoints to see is Management’s interest is aligned with that of minority shareholders 

  • Salary paid to Promoters/ Management as a % of shares. 

    

    Salary paid to Promoters/Management is very low at Rs 19.65 lakhs in FY22 which is 1.15% of PAT of the company and 0.15% of sales of the company indicating that this is very much within acceptable levels 

• Below is the related party transactions

  

  The quantum of related party transactions is very low at less than 1% of sales indicating that money is not no scope for diversion of funds if any to other companies.Related party transactions per se is not bad as transactions are done at arm's length basis, but lack of related party transactions means there is not scope for diversion of funds at all.

• Management has not been issued warrants till now nor has been paid any royalty. One way of diverting funds is by issuing warrants at lower than market price or promoters paying royalty themselves. That  did not happen in Sreeleathers Limited.

• Promoter group has been increasing skin in the game as they have increased their shareholding from 66.54% in June 2020 to 75% in March 2023. This indicates that their Skin in the game is increasing.

As per the above analysis,  I could not find anything which indicates that Management mindset is fragile. 

Few concerns

• Management can take the company private. For this there is an elaborate SEBI process and Promoters are required to give open offer to minority shareholders. Investor can decide to exit at that point of time.

• What will the management do with surplus cash generated in business? There are multiple options available with the management, they can acquire another company or they can pay huge dividends or they can deploy the same for growth. Management has in the past not shared wealth with shareholders except for the Buyback done in Nov 2020. There are concerns that management may not share these surplus funds with shareholders. May be management has to take more steps to build shareholders confidence. What will the management do with surplus funds is a wait and watch situation.

Conclusion

Financials of Sreeleathers is not fragile. Present Valuation is not fragile. Management does not have a fragile mindset. This makes Sreeleathers Limited a good investment at present valuation for longterm. The concerns raised can be mitigated through portfolio diversification.

Disclaimer: This is not a Buy/sell recommendation. I am not a SEBI registered advisor. I only tried to explain the concept of how to do fundamental analysis.

Thank you for reading and subscribing to my newsletter! I hope you found it valuable and informative. If you did, please share it with your friends and colleagues who might also benefit from it. It only takes a few seconds to forward this email or click on the social media buttons below. Your support means a lot to me and helps me reach more people like you.

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Disclaimer: This post is for education purposes only and cannot be construed as recommendation. Please approach your financial advisor for any investment related decisions. I am not SEBI registered RA or RIA. I own the stock discussed here.

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Business Model

Understanding the business model is important as it will help us in relating to the numbers in the financial statements of the company. Business model will also help us in making reasonable projections of the company.

Wonderla is one of the largest Amusement Park Chains in India. It presently has three operational parks located at Kochi, Bengaluru and Hyderabad and 1 resort in Bengaluru. Fourth park in Chennai is under construction.

The company originally started its operations in 2000 in Kochi as an amusement water theme park under the name Veegaland. Subsequently, the park was expanded to include land rides.

With the success of the park in Kochi, the company started a new park in Bengaluru in the year 2005. The company expanded the Bengaluru park in 2012  to include a resort with 84 luxury rooms, 30,000 sq.ft. of conference & banquet space, Cricket ground, Badminton court and Sand Volleyball court.

The company went for an IPO to raise funds to the tune of Rs 170 crs to part finance its expansion plans. Accordingly the company set up their third park in Hyderabad which commenced operations in 2016. Fourth park in Chennai is partly constructed. Company expects to complete the construction works in 18 months once the pandemic situation normalises. Company is also exploring an asset light model for its fifth park proposed in Khurda, Odisha.

The company follows a similar template for all its parks. A typical map of its park is as under:

The park is divided into primarily two sections. One section contains land rides and another section contains water rides. Each section comprises three types of rides viz. normal rides, high thrill rides and kids rides. Basically, there are rides to cater to all age groups.

Timings of the park are as under:

All the parks are located on the outskirts of the city. It typically takes 1 to 1.5 hours to reach the parks from the city. Commuting time clubbed with 7 to 8 hours of park timings ensures full day entertainment to the visitors.

The primary revenue source of the company is through entry ticket fee. Ticket fees are different for adults and children. There are two types of tickets, fast track tickets and normal tickets. Fast track ticket is generally twice as costly as a normal ticket. Waiting time for each ride is lesser with a fast track ticket. Ticket prices are also different for weekdays and for weekends and holidays as the demand is higher during weekends and holidays. With the purchase of an entry ticket, a visitor can visit all the rides any number of times during the day.

Each park has various restaurants spread across the park. The cost of food and beverages is not covered in the entry ticket and is to be paid separately.  Each park also has locker facilities to store belongings of the visitors the cost of which is over and above the entry ticket.

Downside Protection

Balance sheet analysis

Below is the visual representation of the balance sheet as on March 31, 2020.

We can observe the strength of the Balance Sheet from the following:

• The company has not availed any debt to fund its capex or working capital requirements.

• 87% of the balance sheet is funded through Equity or shareholders money. Since, there is no defined repayment terms for shareholders money, this gives a lot of margin of safety

• The company has Rs 121 crs of surplus cash in its books which is another indication of margin of safety

• Since the company is into amusement parks, it's a capex intensive business and generally working capital requirements are low. Accordingly, current assets and liabilities primarily comprise tax related entries.

• Capital employed in business primarily comprises fixed assets of Rs 831 crs which is 85% of the balance sheet size

We need to dig deeper into fixed assets as they form a major share in the balance sheet. The breakup of fixed assets of Rs 831 crs across various parks is as under:

The company incurred a total capex of Rs 570 Crs in past 10 years viz. Hyderabad park of Rs 250 crs, Chennai park of Rs 109 crs, Bengaluru resort of Rs 26 crs and upgrades of Kochi and Bengaluru parks of Rs 185 Crs. The same is funded to the extent of Rs 170 crs from IPO proceeds. Balance Rs 470 crs was entirely funded through cash accruals.

The break up of fixed assets based on nature of fixed asset is as under:

As we can observe,  land is a major contribution to fixed assets contributing a share of  61%. Company generally maintains unutilized land in all of its parks for enabling future expansion. Accordingly, unutilised land contributes to about 35% of the fixed assets.

Based on the above analysis, total capital employed in  business excluding surplus cash, chennai park and unutilised land is Rs 429 crs.

Profit and Loss analysis

Below is the broad breakup of Profit and Loss statement

Key observations of Profit and Loss statement are as under:

• Contribution margin is 90% which is high. Since the company is in the business of amusement parks, the variable expenses are typically low and the majority of the expenses are fixed in nature.

• Total fixed expenses of Rs 180 Crs include semi fixed expenses of Rs 100 Crs which consist of majorly salaries, advertising expenses, etc. These semi fixed expenses can be avoided during extreme situations like the present pandemic situation.

• Other fixed expenses of Rs 80 crs consist of Rs 40 crs of depreciation which is a non cash item

• Based on fixed expenses of Rs 180 crs and contribution margin of 90%, breakeven sales work out to Rs 200 crs which is 71% of 2019 sales indicating sufficient margin of safety. 

COVID Impact analysis

Break up of 9 months quarterly performance during FY2021 is  as under:

The quarterly cash burn during pandemic is on an average Rs 12 crs. The company has surplus cash of Rs 121 crs as on March 31, 2020 i.e. start of the pandemic. This surplus cash is sufficient to cover 10 quarters i.e. 30 months of cash burn. The company can further stretch the same by further cutting down expenses which are majority in the form of salaries.

Cash Flow analysis

We need to consider 2019 cash flows instead of 2020 cash flows as there is impact of COVID in Q4-2020 and also impact on cash flows due to one time tax related items.

Cash flow from operations in 2019 is Rs 90 crs. Based on useful life of machinery we can arrive at annual replacement capex requirement of Rs 40 crs. Hence, free cash flows generated by the company works out to Rs 50 crs. Due to high levels of operating leverage, with 10% increase in revenue, the free cash flows will increase by 50% to Rs 75 Crs.

Based on free cash flow of Rs 50 crs, Return on capital employed (ROCE) works out to 12%. With a 10% increase in revenue, ROCE can increase to 18%.

Downside protection on Sales & Profits

We can analyse the downside protection available for revenue and profits using Porter’s five forces model. Porter’s five forces model gives us an idea of sustainable competitive advantage available with the company to protect its sales from declining. 

1. Rivalry in Industry:

In Tripadvisor, Wonderla Amusement Park ranks as 3rd best attraction in Benguluru, 6th best attraction in Hyderabad and 5th best attraction in Kochi. Few key observations are as under:

• Despite being the newest attraction in Hyderabad, it finds its place in top 10 attractions in the city. All other attractions are more than 20 years old

• No similar top attraction in any of the three cities

• The other attractions in top 10 in each of the cities are primarily religious places, archeological sites, etc

We can observe that there is hardly any rivalry to Wonderla in this industry

2. Threat of new Entrants

Please find the thoughts of management of Disney with regard to setting up a park in India in this Business Standard article.

“Opening a theme park anywhere in the world is incredibly expensive and is highly complex business. Walt Disney is investing $5 billion in Shanghai in a new theme park, which excludes infrastructure,” Bird said here in an interaction with editors.

“While setting up a park, we have to keep in mind the demand pattern for the next 50 to 75 years as once you open the door to the park, it remains open on all days. Everything, including the infrastructure, has to be in place before opening the doors,” said Bird.

India is still not ready for such a high investment besides the income levels need to reach an inflection point so that the park can sustain guests for the entire year. Theme parks are single largest investments by Walt Disney anywhere in the world and the investment decisions are made after lots of studies and after a gap of over a decade in various locations. Besides, the Disney brand in India still need to grow to see appropriate traction for the park in India, a spokesperson clarified.

Disney invests atleast Rs 25,000 to 35,000 crs in each park as against Rs 350 crs by Wonderla. Due to this Wonderla can achieve breakeven easily and also can price the ticket appropriately. It will take many years before any major foreign player enters India.

If we look at new entrants from domestic players, we can take the example of Adlabs Imagica which is better explained in this Livemint article. Relevant extract of the article is as under:

Mr Manmohan Shetty, Chairman is unable to explain why Imagica did not perform according to plan. He gives the examples of Shanghai Disney Resort, which opened a couple of years ago, Dubai Parks and Resorts and Ocean Park Hong Kong. Neither is a traditional tourist hot spot, but each theme park gets millions of visitors. “Why Hong Kong is doing well and we are not, is anybody’s guess," he whispers.

Shanghai Disney gets about 11 million visitors a year, and Ocean Park around six-seven million, while Imagica is at 1.6 million.

He attempts an explanation, though he admits he does not have all the answers. India has outbound, but not enough inbound, tourists, he says. So while the Imagica founders thought tourists would come from places as varied as Delhi and Dehradun, they found that people could go to Dubai, Hong Kong or Bangkok for a similar price.

“People come to Mumbai for some or the other reason and then see Imagica; they do not come to Mumbai to see Imagica. So we were reduced to visitors from Mumbai, Pune and Gujarat—we have 20% from that state," says Shetty, whose initial estimate was three million visitors a year.

Adlabs Imagica invested nearly Rs 1300 crs in the park which is located midway between Pune and Mumbai. Management expected footfalls of 5 to 6 million per year as against which only 1.6 million visitors ended up visiting. The company is now dragged to bankruptcy.

We can observe from these two examples that this is a very difficult industry to enter. Wonderla mastered the business model wherein it is able to attract the right number of visitors and also generate operating profits for each of its parks.

3. Threat of Substitutes

To better understand substitutes for this Industry, we can refer to Forbes India article on Wonderla.

In a country that has seen middle-class incomes rise, and urban outdoor activities fall, entertainment parks are where families can go for a day of fun. “What do we do when we want to step out of the house? The nearest mall or movie theatre are our limited options,” says Snigdha Sharma, vice president of equities at brokerage firm Axis Capital. “These guys provide that differentiated play when you want to spend an entire day out with a group of friends or family.”

Indians are starved out of entertainment options. We have limited options like restaurants or the nearest mall to visit. Wonderla provides a differentiated entertainment option.

4. Bargaining Power of Buyers

We can again refer to the Forbes India article to understand the bargaining power of buyers.

“From a business perspective, multiple things work for Wonderla: Its pricing is extremely attractive, when compared to Adlabs Imagica; it’s much more affordable to an average middle-class Indian,” says Roy of Edelweiss Financial Services. The average ticket price in Wonderla’s three amusement parks is about ₹1,000 per person for all the rides. At Adlabs Imagica, the ticket prices are split with the water park tickets starting from ₹599, and the theme park tickets starting from ₹999. Food and beverage prices at Wonderla parks are also lower than other entertainment venues like cinema halls.

The one question that Arun gets asked a lot is whether Wonderla Holidays plans to become India’s version of the US’s Disneyland. It doesn’t. “What I admire about Arun is that he knows India is different, and a me-too version of a Western company model will not necessarily work here,” says Sharma. Arun’s idea of Wonderla is to provide an affordable entertainment option for the masses. “If you look at a Disneyland or Universal Studios theme park, it’s a six-day affair and the base fare is close to $300 [₹20,000-plus]. And that’s just for the rides,” Sharma point outs. Add to that the cost of food and beverage and hotel stay, she says. “That kind of price point is no way going to work in a country like India, which is price sensitive.”

Wonderla offers appropriate pricing which is not too expensive to not attract any visitors nor is it too cheap to flood its parks with visitors with over utilisation. At this appropriate pricing it is able to achieve more than break even sales and generate profits. As per earnings call transcripts of Q1-2018, we can further observe this phenomenon wherein pricing of Bengaluru park was increased by 17% which led to decline in footfalls by 3%.

There is price elasticity of demand in this industry which also acts as an advantage to Wonderla as it makes it difficult for competition to enter.

5. Bargaining Power of Suppliers

We can refer to the annual report for FY2020 of the company to understand the bargaining power of suppliers.

Based on the business model we can infer that the two key inputs/purchases for the company are Land and Rides. The company has an in-house manufacturing facility which ensures its cost of procurement of rides is lower as compared to competition. 

The company also maintains unutilised land whenever it sets up its parks. This ensures that land is procured at cheaper cost for future expansion. Further, if we assume land costs keep increasing every year, then competition will incur higher costs to set up a new park in the same city as Wonderla park.

State governments across India are supportive of this Industry as it attracts tourism to the state. Odisha Government came forward and requested Wonderla management to setup park in its state. Wonderla is exploring an asset light model to setup park on leasehold land  in Odisha.

Summary of Porter’s five forces

1. Rivalry in Industry

   • Wonderla parks feature in top 10 attractions in each city it is present in as per Tripadvisor

2. Threat of New Entrants

   • Big players unable to enter India due to lack of feasibility

   • Similar other players went Bankrupt

   • Difficult business to enter at the price point of Buyers

3. Threat of substitutes

   • Limited entertainment options like restaurants and malls

4. Bargaining Power of Buyers

   • There is price elasticity of demand. However, price point provided by Wonderla is appropriate to attract enough visitors

5. Bargaining power of suppliers

   • In-house manufacturing of rides

   • Low purchase price of land

   • Government Support

Management Quality

Wonderla was Founded by Kochouseph Chittilappilly in 2000. It started as an amusement water park under the name Veegaland in Kochi. The name was subsequently changed to Wonderla. Prior to Wonderla, Kochouseph Chittilappilly founded V-Guard Industries Limited in the year 1977. V-Guard Industries has a Market Capitalisation of ~Rs 11,000 Crs as of June 2021. Kochouseph has two sons Arun and Mithun. Mithun looks after V-Guard and Arun heads Wonderla.

How Arun Chittilapilly got into Wonderla can be better understood from the below extract of the Forbes India article.

When Cittilappilly gave Arun an opportunity to start the first Wonderla park in Bengaluru, he happily took it up. Arun candidly admits that he didn’t want to work directly under his father, the man who has become a bit of a legend by starting and building V-Guard Industries, a manufacturer of voltage stabilisers with a market capitalisation of a billion dollars. “I always wanted to do something on my own. I didn’t mind working with dad, but being under him directly would be a little...,” Arun trails off, with a smile. “We are different in our styles. I like to go with the flow whereas for dad everything has to be [done with] clockwork precision.”

We can observe that Arun, who is second generation, is passionate in proving his abilities and accordingly took over operations of Wonderla when it was still only a water park in Kochi instead of a well established V-Guard.

Here is another extract of the Forbes India article.

Arun Chittilappilly loves amusement parks. He makes it a point to go to three or four of them around the world every year. He has his favourite parks—Tokyo DisneySea in Japan, Universal’s Islands of Adventure in Orlando, US, Alton Towers in England, and Europa-Park in Germany—and his favourite rides. “He may well be the only person in India to visit the highest number of amusement parks around the world,” says his father Kochouseph Chittilappilly. And no, that’s not a complaint. For Arun is the 39-year-old managing director of Wonderla Holidays, which runs the Wonderla chain of amusement parks, India’s most profitable company in the sector.

Arun ensures that he visits parks across the world to gain first hand experience to better understand the industry and its evolving trends.

Another relevant extract of the Forbes India article

In 2005, on the outskirts of Bengaluru, Arun opened the gates of Wonderla to visitors, with rides spread across 80 acres. Because of the park’s distance from the city, “We had a house there [in the park] where we lived. We still have the house, but don’t stay there anymore,” says Arun. He started as the executive director of the parent company, Wonderla Holidays, with his father as managing director. He took over his father’s position in a couple of years.

Arun is operationally focused wherein he and his wife stayed in the Bengaluru park itself at the time of construction.

Kochouseph Chittilappilly, father of Arun is the first generation entrepreneur. He is a successful serial entrepreneur wherein he started V-Guard, Wonderla and is also venturing into real estate and NBFC. Few years ago, he redefined the word “charity” by donating his own kidney to a truck driver he do not know.

The mindset of the management is conservative which can be observed from the following actions:

• Went for IPO instead debt for Hyderabad Park

• There is uninitialised land in each Park for future expansion

• Despite having funds tie up, they delayed commencement of Chennai Park as there was delay in approval of LBT waiver by Tamil Nadu Government

Downside Protection - Summary

To summarise we can get downside protection through the following factors:

• Strong Balance sheet without any debt and surplus cash

• Flexible P/L which can withstand decline in sales and at the same time can boost bottomline due to Operating Leverage

• Strong sustainable competitive advantage

• Conservative and experienced management

• Charitable mindset of management

We can also find downside protection in present valuation wherein setting up a new park takes at least Rs 350 crs. A company with 3 operational amusement parks and 4th partially constructed park is now available at a market capitalisation of Rs 1200 Crs as on June 6th, 2021.

Upside potential

Revenue from New Parks

Management expects to set up a new park every 2 or 3 years. If we assume that within the next 10 to 15 years, there will be atleast 6 parks as against existing 3 parks, there is potential for revenue to double in 10 to 15 years.

The company already commenced work for setting up a park in Chennai wherein it spent Rs 109 crs till date and balance cost to completion is Rs 221 crs. Total budgeted cost for the Park is Rs 330 crs. There is delay in commencing Chennai park due to delay in waiver of LBT by Tamil Nadu Government. Further, ongoing pandemic also delayed the commencement of Park. Total construction time envisaged is 18 months and management proposes to start construction once the pandemic situation normalises.

Odisha Government approached the company for setting up a park in its state. Company is in the process of going for  an asset light model at a cost of Rs 107 crs on a leasehold land for its park in Odisha.

The industry market potential is 10 times the present capacity in India as there are only 150 amusement parks for a population of over 130 crs in India as against 400 parks for a population of 30 crs in USA. There is huge scope for growth in industry.

Increase in revenue from hike in ticket price

If we look at the inflation numbers in India for the past few years, it is in the range of 4% since 2015 (which is also one of the lowest periods of inflation). However, inflation reached 12% levels multiple years in the past. Based on these inflation numbers, there is scope for an increase in ticket price by 1.5 to 2 times in the next 10 years which translates to an increase in revenue by 1.5 to 2 times.

With potential increase in disposable incomes of the population and increase in middle class population in the next 10 to 15 years which translates to increase in demand for amusement parks, the company can further increase ticket prices over and above inflation numbers to maintain park utilisation at the same levels. This can lead to another multiplier factor of 2 to 3 times.

Increase in share of non ticketing revenue

Non ticketing revenue is primarily in the form of food and beverages. Presently share of non ticketing revenue is around 30% of total revenue. There is scope for increase of the same to 50% of total revenue inline with other players in entertainment industry. 

Wonderla pivoted its food and beverages business model wherein it started food delivery outlets for delivery of food to home through tie up with Swiggy and Zomato.

We can assume another multiplier of 1.20 times increase in revenue on account of increase in non ticketing revenue.

Expansion of existing park

As explained earlier only 45% of land of existing parks is developed. There is scope for development of 55% of the balance land which can generate additional revenue.

Operating leverage

With every percentage increase in revenue, there is scope for 2.5 times increase in profits due to operating leverage available in the company as majority of the expenses are fixed in nature.

Upside Potential - Summary 

If we multiply all the factors stated above, there is scope for an increase in sales and profits by 20 times in the next 10 to 15 years. If we assume a terminal PE of 20, then projected market capitalisation can work out to Rs 22,000 crs in next 10 to 15 years as against present market capitalisation of Rs 1,200 crs which can translate to a decent CAGR.

Key Monitoring Parameters

To monitor whether management is able to capitalise on the upside potential, we can monitor the following key parameters every few years:

• Increase in Footfalls

• Performance of New Parks

• Increase in Replacement Capex

• Hike in ticket price

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