Tuesday, February 8, 2011

SUZLON ENERGY

Moktan Capital LLP has bought 10,000 shares of Suzlon Energy Ltd at Rs. 46.6 per share in Nov’10 and another 10,000 shares in Feb’11 at Rs. 48.6 per share. This implies a total market capitalization of c. Rs. 8,150 cr. With outstanding debt of Rs. 10,500 cr, that’s a total enterprise value of Rs. 18,650 cr.

Let’s get straight to the point - Why did I buy Suzlon?

Before I answer that question let’s look at the historical financials of this company. These financials tell a very interesting story. Let’s break them up into 2 parts:

Part A – FY 2006 to FY 2008
Part B – FY 2008 to FY 2011 YTD



From FY 2006 to FY 2008 Suzlon’s revenues went from Rs. 3,841 cr to Rs. 13,679 cr. That a 3.6x jump and an 89% CAGR. EBITDA went from Rs. 889 cr to Rs. 2,051 cr (2.3x, 52% CAGR). Interestingly profits rose only by 1.4x from Rs. 760 cr to Rs. 1,030 cr. Why? The answer is simple - Debt.

Interest payment went from Rs. 51 cr to Rs. 532 cr (10.4x, 223% CAGR) during this 3 year period. However, such was the exuberance of Mr. Market at those heady 2007-08 times that he valued the company at Rs. 38,621 cr, making Suzlon one of the biggest companies in the world and Tulsi Tanti, it’s promoter the 3rd richest Indian! On Mar-07 Mr. Market valued Suzlon at Rs. 8,604 cr which implied a reasonable 10.2x P/E. The same P/E went to 37.5x in Mar-08 when Mr. Market valued Suzlon at Rs. 38,621 cr!

Now let’s see what happened after Mar-08



In FY 2009 Suzlon actually ended up having a decent year with sales doubling to Rs. 26,082 cr. However, EBITDA did not grow as much possibly due to higher costs. Interest almost doubled to Rs. 901 cr. Even then, profits would have been healthy hadn’t it been for “Exceptional Costs” of Rs. 896 cr that reduced profits to a measly Rs. 236 cr. Closer reading of the schedules to financial statements reveals that those exceptional items pertained to costs of restoration of faulty blades. Thanks to dismal profits Mr. Market brought down the valuation from Rs. 38,621 cr to Rs. 7,604 cr!

In FY 2010, Suzlon’s revenues fell to Rs. 20,779 cr due to continued recession in the US and Europe. The EBITDA fell to Rs. 943 cr because the company was not able to reduce costs in-line with lower revenues. This coupled with higher interest led to a loss of Rs. 983 cr for shareholders. So far in FY 2011, the company has managed to book only Rs. 10,718 cr of sales. However, this is also because Hansen has ceased to be a subsidiary of the company since it now owns only 26% (Hansen revenues were about 4,000 cr last year). I have forecasted FY 2011 numbers on the basis of the last 9 months results

DEBT


No analysis of Suzlon is complete without understanding its debt. In its hey-days of growth, as often happens with companies, Suzlon decided to go overboard on acquisitions. It made 2 very expensive acquisitions – RE Power and Hansen. There was strong merit in going for these acquisitions for Suzlon – Hansen gave it the capability to manufacture gearboxes and RE Power gave it the R&D strength and European customer base it desperately lacked. However, Suzlon failed to understand the Price/Value equation for both acquisitions and ended up paying too much price for too little value. Worse – it used debt to finance the acquisition. As we have already seen through a cursory analysis of the Income Statement, the interest burden crippled the company on the back of lower sales and higher costs. The good thing was that Suzlon was able to restructure the debt in 2009-10 converting its forex debt to rupee debt and lowering repayment covenants.

From the investor’s point of view there are two good things to gain out of this:

1.The management can now focus more on improving its operations – increasing revenues, lowering costs, streamlining operations etc. Dealing with a debt problem is a full-time job that severely restricts top management from focusing on other important aspects of the business.

2.The company has learned the lessons of over-leveraging the hard-way. The promoter himself has seen his net worth fall by 80% with his company on the threshold of bankruptcy. The confidence this gives me as an investor is that the company will think twice before taking debt in the future. It has hopefully come out chastised from the experience.

Price Vs Value

Now let’s go back to the question we asked at the beginning of this analysis. Even after all these negatives why did I buy the stock? The answer lies with Ben Graham’s concept of Price and Value. I see these two attributes of stock investing as two counterweights on a weighing scale. When you weigh the company with Price on one side and Value on the other, which side is heavier? Knowing the vagaries of Mr. Market as we do, there are many instances when the scales tilt in favour of Price and other times when the scale tilts in favour of Value. If the scale tilts in favour of Value with a decent margin of safety, it’s time to start buying. This is the reason for buying Suzlon.

Now let’s put this concept in numbers.

I bought the stock when the markets tanked in November 2010 and Feb 2011. Mr Market valued Suzlon at Rs. 46.6 per share at these times implying a total market capitalization of Rs. 8,150 cr. Together with debt of another Rs. 10,500 cr, the company’s total value came to Rs. 18,650 cr. This is the weight on the Price scale.

This was the easier part – the weight on the Price scale is very easily available and calculated. Mr. Market gives you these numbers from 9:00 am to 3:30 pm every Monday through Friday. However, much of the Value is qualitative and the investor has to calculate the weight himself through proper analysis and judgment. So, what can we put on the Value scale for Suzlon?

First, the easy part. Let’s look at what we can glean from the asset side of Suzlon’s balance sheet:


Sum-of-the-parts Value:

(A)On 30-Sep-2010, the company had net current assets (current assets minus current liabilities) of Rs. 4,373 cr. We can term these as liquid assets which can be quickly recovered when things go wrong.

(B)Suzlon owns 26% of Hansen Transmissions which is currently trading at a market capitalization of c. Rs. 2,780 cr. 26% of this is about Rs. 724 cr.

(C)On 26 May 2007 Suzlon purchased RE Power at a valuation of US$ 1.6 billion ~Rs. 7,360 cr. The company currently trades at a market capitalization of Rs. 6,000 cr. Suzlon’s 90% stake here is valued at Rs. 5,400 cr.

If we sum A+B+C it gives us Rs. (4,373+724+5,400) 10,497 cr. which is 56% of the Rs. 18,650 cr value we have paid for the company and covers the entire debt outstanding. So, if the lenders wanted their money back today, Suzlon could hypothetically sell it’s stake in RE Power and Hansen, recover its current assets and become a zero debt company half it’s current size.

Now, for the tougher part. Let’s look at some of its competitive advantages.

I like to think of these as the moat that surrounds the Suzlon castle and protects it from enemies. This is one of the most critical aspects while analyzing an investment as it tells us how well our capital is protected in case of war or invasion. Companies build these up over a long period of time and these help them to weather some of the worst battles.

1. Size: Suzlon is the 3rd largest wind turbine manufacturer in the world with a 10% market share world-wide. I can think of very few Indian companies that are the 3rd largest in anything in the world. Suzlon has entered this sector early and established a strong presence across the globe. It is a well known brand in Europe, the US and Asia. Its revenues last year were Rs. 20,000 crores ($4.4 bn). Recently, Suzlon announced that it has crossed 15,000 MW of cumulative installations in 25 countries world-wide, amounting to 9% of the world’s total wind power installations. As of 31-Dec-2010, Suzlon had an order book of $7.3 billion (Rs. 33,580 cr) which is c. 2.4x FY2011 (E) revenue.

2. Cost Efficient Produc
er: Suzlon has production facilities in India, China, Germany and United States and is therefore able to deliver products quickly and cost effectively anywhere in the world. Its manufacturing facilities in India and China give it a cost advantage in terms of capital, manufacturing and labour over its European and US competitors like GE Wind (No 1) and Vestas (No 2) who have higher cost manufacturing locations in Western Europe and the US. Suzlon’s manufacturing units are located in SEZs in Coimbatore, Vadodra and Padubidri (not sure where this is but from its name it’s bound to be cheap)

3. Market Leader: In India, it has close to 50% market share thus controlling half the market. It has held this position for the last 11 years. Its installed base in India has gone from 8 MWs in 1997 to 5,500 MWs in 2010 with 1,600 customers and 40 wind farm locations in 8 states. Some of Suzlon’s biggest customers are state and public sector undertakings like Gujarat State Petronet, Rajasthan State Mines, Gujarat Alkalis, SBI and GAIL. It is also the market leader in Australia and Brazil and No 3 in the US.

4. Track Record: Having been one of the earliest companies to enter the industry it has a long and demonstrated track record of delivering superior products and value to customers. 60% of Suzlon’s order book in 2010 was from repeat customers which gives comfort on the fact that the customer is satisfied with the company’s product and service.

5. Product Range: Due to it’s size, Suzlon is able to offer a wide product range to it’s customers which differentiates it from other smaller competitors. As per the annual report, the group can manufacture wind turbines ranging from 0.35 MW to 6.00 MW. With the acquisition of RE Power, it has also developed new technology that allows it to build offshore wind farms in the sea. Offshore wind farms are seen to be the next big thing in wind energy with the first one already operational off the coast of London. On 26 Nov, RE Power signed a 295 MW contract with a Belgian offshore project development company, C-Power for the delivery of 48 turbines.

6. Superior R&D: Suzlon’s subsidiary RE Power helps it in developing new and improved products for customers. Together they have developed offshore wind turbine generators for installing wind farms in the sea. Since I am not an expert in wind energy technology I do not have a good grip on the R&D but gain some comfort from the fact that Suzlon and RE Power have a JV called SEDT which develops innovative technology in this field.

7. Brand Value: “Suzlon” is now a well know name in wind energy not just in India but across the globe. Over the last 15 years, the company has invested heavily in growing its brand. As investors in the company we inherit the value of this brand.

So, do these competitive advantages make up for the remaining 44% of value and more? This is the toughest question I had to answer before investing in Suzlon. To answer this I had to look at the classic investor dilemma – Risk vs Return.



RISK
According to me, the biggest risk of investing in Suzlon is bankruptcy risk. I have invested at a value of Rs. 18,650 cr with Rs. 10,500 cr debt. If the stock falls by 36% from here to Rs. 30, the market cap will fall to Rs. 5,200 cr with Rs. 10,500 cr of debt (2:1 ratio). Here, there would be a serious and real risk of bankruptcy. However, there are some mitigants of this risk which we could see as our Margin of Safety.



RETURN
However, if Suzlon comes out of this slump and gets back to it’s pre-crisis revenue and EBITDA numbers of Rs. 20,000 cr and Rs. 3,000 cr (15% margin) respectively, we will be richly rewarded by Mr. Market. Even at 10.0x EBITDA, Suzlon would traded at c. Rs. 30,000 cr. Enterprise Value or about Rs. 19,500 cr market cap – c. 2.4x our investment amount. The table below shows our returns at various Revenue and EBITDA levels.




When you analyse it in this manner, it looks like we have a lot more to gain than lose in Suzlon at this price. I think the risk-return equation is in favour of the investor with a decent margin of safety.

Let me also look at the margin of safety in terms of simple probabilities. After studying the competitive advantages and the Price/Value scale, let’s assume that the probability of success is 50% and so is the probability of bankruptcy. If successful, Suzlon will trade at Rs. 111 per share as per the table above. If bankrupt, we may be able to get out at Rs. 10 per share. As per the table on the left below, the expected outcome of this scenario gives us a price of Rs. 61 which gives us a margin of safety of Rs 14 or 23%.



The other way to look at this is – what is the probability that Mr. Market is ascribing to Suzlon’s failure at our purchase price of Rs. 46.6. The table on the right gives us the answer – 64%. At our purchase price, Mr. Market is implying that there is a 64% chance of bankruptcy. I think this number is a bit severe. I think the probability of bankruptcy is more like 33%.


THE OPPORTUNITY

For the company to succeed, I think we need to be sure that there is potential in the sector. These will ensure steady growth that can help Suzlon deliver better results for owners. Let’s briefly go through some of the opportunities in the wind energy sector. I got these from reading the company’s annual report.

1. Demand for Electricity
: Continued development and population growth will lead to a rise in demand for electricity. The International Energy Agency (IEA) estimates world electricity demand to go up by 2.5% every year till 2030. Although fossil fuels will be the biggest contributor to this demand, renewable energy will grow the fastest from 2.5% of total output in 2007 to 8.6% in 2030.

2. Demand for Wind Energy: Over the last 4 years, demand for wind energy has increased by 35% to 37,466 MW. Asia accounts for 39% of the installed capacity with North America and Europe contributing 29% and 28% respectively.



By 2014, the global annual capacity is expected to treble from 160 GW to 448 GW with strong additions from offshore wind farms



3. Increasing Cost Competitiveness: Wind power has the lowest cost of energy compared all other renewable energy technologies. Although fossil fuels continue to have a big cost advantage, advances in technology will continue to reduce the cost of wind energy.



4. Environmental Awareness: Generating electricity from any fossil fuel releases green house gases like carbon dioxide which contributes to global warming. Extensive use of fossil fuels severely damages the climate. I think this is the most significant growth driver for a company like Suzlon. Governments across the world have recognized this and are today actively looking at more environmentally friendly power generation alternatives like wind and solar energy. Prices of fossil fuels like coal and crude oil are also volatile and their reserves are fast depleting.

5. Government Support:
The cost of producing wind energy is still far higher than fossil fuels. Thus, governments across the world have provided fiscal schemes and incentives in order to encourage the production of wind energy. Although none of the recent summits like Copenhagen and Cancun have resulted in binding emission targets, they have led to increased awareness and focus on mitigating climate change. Let’s look at some of these schemes:

European Union – 20% of energy has to be generated through renewable sources by 2020. Fixed tariffs guaranteeing a minimum price per unit of electricity produced.
United States – Green stimulus initiatives with fixed tariffs.
China - 15% of energy has to be generated through renewable sources by 2020 and fixed tariffs.
Australia - 20% of energy has to be generated through renewable sources by 2020 and fixed tariffs.

6. Energy Security: Governments across the world are facing an energy deficit leading to a geo-political risk (US Invasion of Iraq, Afghanistan). Countries are paying special attention to their increasing energy requirements. Wind energy, being the most stable, cost effective and mature form of renewable energy is proving to be an important source for this energy requirement.

7. Offshore Market: Offshore wind farms are those that are installed and operated in water bodies. The offshore market is still in it’s infancy but is expected to become a large part of the wind energy market in the future growing from 3,000 MW to 16,000 MY by 2014. Winds are stronger and more stable offshore and availability of land is not an issue. Many countries in Europe have already installed and operated offshore wind farms. As mentioned earlier, On 26 Nov, RE Power signed a 295 MW contract with a Belgian offshore project development company, C-Power for the delivery of 48 turbines.

8. Indian Wind Energy Market:
India is the 5th largest wind power producer in the world. The cumulative installed wind energy capacity in India is expected to increase ~3x from 10.8 GW to 27.4 GW by 2014.

Conclusion




Since April 2009, Suzlon’s stock price has increased by 5% compared to an 85% gain for the Sensex. As an investor, I think my basis going into this stock is fairly low. I feel comfortable that I am not buying this company at an expensive valuation but at the same time I am aware of the risks involved. For me, the price-value makes compelling sense at this price and I feel comfortable of the risk-return equation. I think the company is in an exciting growing sector with strong competitive advantages and a more chastised management. I will continue to buy this stock at these levels.

19 comments:

  1. Hi Kunal,

    I am myself a MBA grad and appreciate the way that you have explained the Debt as biggest risk in any companies' Balance sheet from invest point of View. Would recommend investors to search for debt free company as one of important criteria from investment point of view specially in countries like India where cost of borrowing is very very high due to high inflation.

    Thanks
    Ankit
    +65 8134 7574

    ReplyDelete
  2. Hi Kunal,

    I am Gaurav Singhal, one of your juniors at IIM Ahmedabad (and BETA).

    Your post was a good analysis of Suzlon. However, your scenario for return assumes an EBITDA of 15% which i feel is too optimistic. If I look at the data for FY09, FY10 and FY11 from your table, the average EBITDA is 5.68%. Even if I remove FY11 (negative EBITDA), the average EBITDA is around 8% (FY10 and FY09). Thus, the EBITDA of 15% in FY12 sounds very optimistic (are you sure Ben Graham would have approved of it).

    Year 2009 2010 2011E Total
    Sales 26082 20779 14291 61152
    EBITDA 2816 943 -288 3471
    5.68%

    Gamesa, Vestas and Chinese manufacturers are now entering the Indian markets. This would bring competition in the market and drive gross margins down (due to price pressures). Historically, Suzlon has profited from its gross margin being at 33% compared to 28% for peers. If gross profits go down, Suzlon's high leverage would hurt it even more.

    Also, Suzlon is operating near break-even capacity of close to 1800 MW sales. Thus any drop in margins now (and also any reduced sales) would hurt it more due to operating leverage.

    About Debt: Its 2012 FCCBs are deeply out of the money. I dont see the redemption premium as a "contingent liability" (as stated in 2010 Annual report and thus not recognized in balance sheet. The conversion is around 76 for one class and 97 for another (I am not sure of exact figure).

    Thus, I see a very strong probability of restructuring which would mean further expenses and cash outlay

    Cash seems to be a big problem. Its new 2016 FCCBs are not even half of what it would spend for acquiring remaining 5% in REPower. Even the sale of 26% stake in Hansen would not give it such a large amount of cash. Thus I see a cash shortfall which could cause high short term borrowings (as in FY2010) and high short term interest cost (as in FY2010).

    I have been following this stock for the last 2 weeks and have done an SOTP valuation myself. I would love to discuss more about this stock with you over phone/email so it would be great if you could forward me your contact (PS: I have added you on IIMA chat)

    Best Regards,

    Gaurav Singhal
    (p10gauravjs@iimahd.ernet.in)

    ReplyDelete
  3. Gaurav,

    Thanks for your comments. Let me try and answer some of them.

    I took 15% because I think on a stabilized basis, Suzlon is capable of earning that much. It has certainly showed it in the past (FY07 and FY08) albeit at lower revenue numbers. We cannot take FY09 and FY10 numbers because those were aberrations and one-off years where EBITDA of all companies were affected by the economic crisis. In my analysis I have assumed a revenue of Rs. 20,000 crs and EBITDA of Rs. 3,000 crs after 4-5 years. However, i feel i have been conservative with the revenue number given the fact that Suzlon earned Rs. 26,000 cr in FY09 in revenues. Thus my EBITDA projection can also be seen as 12% of peak revenue which is reasonably conservative.

    On Ben Graham, i don't think Suzlon is a Ben Graham kind of call. Its more of a Fischer /Buffett call on the other qualitative aspects of the company and not a clinical, numerical cigar-butt analysis that Ben Graham was famous for. I have to agree with you there.

    Yes, competition is always lurking close by. But remember that Suzlon has a lot of competitive advantages (Size, cost competitiveness, track record, product range, brand etc) compared to its peers. It's costs are a lot lower than GE's or Vestas'. Also, it has an established client base in India with a >50% market share. Competition is a reality but i do not think it will lead to a blood bath in pricing.

    I agree the FCCBs are deeply out of the money and will most likely not be converted. However, I think my net debt number includes the FCCBs which means that I have factored those in my calculations. Like many other companies, Suzlon will most likely restructure the FCCBs by reducing the conversion premium or getting some extensions.

    Managing cash is Suzlon's biggest problem right now. However, i believe the company will be able to generate enough cash from operations to at least service the debt. Of course, this is not a long-term solution. Suzlon will need to generate higher cash flows from its onshore and offshore businesses to be able to pay interest and amorts. But, like I said there is a risk of bankruptcy involved here. The only question is - At what price does the value (return) adequately cover the price (risk)?

    KM

    ReplyDelete
  4. Suzlon is at 37 now...what are your views now??

    Regards,

    Ajay

    ReplyDelete
  5. My views are independent of the market price. I would buy more.

    Rgds,
    Kunal

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  6. I would too and I am....I have come to know that some funds who have redemption pressures and have invested in suzlon had to liquidate by end of this month...do you have any such info..

    regards,

    Ajay

    ReplyDelete
  7. "My views are independent of the market price. I would buy more."

    Love that answer :)

    ReplyDelete
  8. With a CMP of near 27, do you see Suzlon much closer to bankruptcy or are you still consistent with your aforementioned views?

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  9. With a CMP of near 23, do you see Suzlon much closer to bankruptcy or are you still consistent with your aforementioned views?

    ReplyDelete
  10. I would think that the risk of bankruptcy has definitely increased with the current mcap of c. Rs. 4,200 crs. However, I do not see this company going the Kingfisher way. Its operational and financial performance have actually been better in the last 3 quarters compared to the last 3-4 years. It has just closed the RE power squeeze-out which will give it access to Rs. 2,500 crs of cash on RE Power's books. I think Mr. Market is over reacting here.

    ReplyDelete
  11. I agree 100% with Kunal. There are also reports that the cash on REPower's books is between USD 1 Bn to 1.5 Bn (Rs 5000 to 7500 crore), although I don't know when/how they'll be able to use that.

    ReplyDelete
  12. yup , it is good to see UR ANALYSE ,, WHAT IS YOUR CURRENT STRATEGY WITH SUZLON, I THINK THAT THE STOCK SHOULD TOUCH 100+ ONCE FCCB ISSUE IS OVER

    CMA NIVESH

    ReplyDelete
  13. hey dude,
    looks like they 'll probably get refinancing this year atleast, also the flurry of new orders has been heartening to see
    2 important near term events for suzlon trade -
    25 may results
    11 june bond holder meet
    what are your thoughts on suzlon right now?
    p.s. hope you ll start posting now

    ReplyDelete
  14. looks like author is blackcurrant already hahaha!!

    -Ahmed

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  15. I think Kunal's envisaged 'V' is here and the down trip is over!

    ReplyDelete
  16. the sock has made a low of 16 and will touch 18/75 now technically.,most probably.
    Is it a hold at 18/75 or sell Mr Kunal..?pla respond..!

    ReplyDelete
  17. Suzlon is heading for bankruptcy and gone now !

    ReplyDelete
  18. I would like to recommend that you trade with the most recommended Forex broker.

    ReplyDelete
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