ZF Steering Gear India Ltd [BSE code ZFSTEER, market cap 200crs, EV 240cr] is an auto ancillary company which manufactures power steering for M&H CV [80% of revenues] and manual steering mainly for tractors [20% of revenues]. It operates in a duopoly market with market share of 50-60% and enjoys STRONG ENTRY BARRIERS. Unlike passenger car segment, where technology obsolescence is high and steering technology is evolving rapidly, in M&H CV segment technology obsolescence is LOW, which results in low capex [FCF yield after tax but before capex on Solar project is 6% for last 12 years and 9% for last five years] Obviously this has to do with the end consumer in case of M&H CV which is much more price conscious. To my knowledge, there are ONLY TWO major players across the globe ZF Lenksysteme [ZF holds 26% in ZF steering India] and TRW Automotive, which has JV with Rane group to manufacture power steering in India.
In an industry where vendors are known to squeeze their ancillary suppliers, ZF has maintained one of the highest margins among auto ancillary companies. [See Table 2]
A company which over the last 15 years has reported average ROE of 25% [ROE less than 20% only in three years] is currently trading below BV [0.9x BV] and is providing dividend yield of around 4%. Moreover, net of debt [major part of debt relates to its solar project] company has INR 70 crs [net of debt and 10crs spike in trade payable compared to last year] of surplus cash and investments, which represents almost 35% of its current market cap.
Concern on management: I am little skeptical on management for few reasons [Income tax raid, unrelated diversification, high remuneration & hoarding of surplus cash]. For FY13, despite increase in surplus cash management has cut dividend from INR 10/sh in FY12 to INR 8 per share in FY13. Plan to attend their AGM [expected in 30 July] and would like to see how friendly management is in answering shareholder queries.
Check out here for the mind map, containing brief summary
Would request readers to share their opinion, especially on management…
For any investment to be successful it has to qualify on three elements 1) Business 2) People and 3) Price. It’s rare that you will find any stock which qualifies on all the three counts and there the dilemma starts as to what extent you should compromise on each factor. Z F steering is one such stock. It scores VERY HIGH on business [being in a cyclical industry does not matter to me, as long as I am buying at cheap valuation and business is with strong entry barriers] and price, but as highlighted in management quality section below little concerned on management integrity.
Reasons to buy:
- Operates in a duopoly market: As per my calculation it has increased its market share by 8-10% over last three years. Even when the M&H CV sales were flat in FY12, ZF sales increased by 15%. Even for FY13, when overall M&H CV sales had declined by more than 20%, ZF sales had declined by only 11% suggesting further increase in market share.
- One of the HIGHEST EBITDA margin among Auto ancillary players: EBITDA margins for the last ten years are between 18-20% except for 2009 when it declined to 16% and Net profit margin is between 8- 10%, which is almost double that of average auto components companies. Even in a year where M&H CV sales had declined by more than 20%, it had maintained its EBITDA margin at 20%. Never reported a loss in the last fifteen years.
- Strong cash flow: During 2008-12, company has generated FCF [after tax, but before capex on Solar project and excluding proceeds from sale of land of 48crs] of 100 crs. This is mainly aided by strong working capital management [nil incremental investment in working capital during 2008-12, though sales increased by almost 60% over the period], incremental capex [net of depreciation and excluding windmills] of only 16 crs.
- High ROE with low debt: For the last ten years, ROE averaged more than 20% while employing little debt [ Less than 0.5x]. Debt is mostly in the form of sales tax deferral. Company took long term loan for the first time in a decade in FY12 for installation of solar power plant.
Reasons not to buy:
- Management quality: I am little sceptical on management for few reasons [Income tax raid, unrelated diversification & high remuneration – see management section for full details].
- JV with minority share in same business: ZF has set up a JV [commenced production in Apr-12] in which company has only 26% share and its JV partner has majority of the share. The new plant under JV has the capacity of 70,000 commercial vehicles steering systems. This poses two concern1) There is a possibility that new technology is purposefully withheld from ZF steering and is transferred only to new JV. New JV has capacity for 400K power steering for passenger vehicles [ZF presence in passenger vehicles is negligible]. Company claims that the JV will be manufacturing technologically advanced steering demand for which is still quite less in India.
- Threat from China: Currently because of steep depreciation in INR and increase in wages in China, there does not appear to be much threat from China. But during 2008 & 2009 company highlighted that owing to cheap imports from China, pricing and market share is under pressure.
- Current cyclical downturn in M&H CV: For close to one year, sales are declining at high double digit. It’s impossible to predict when the current downturn will end and growth will pick up. In the past M&H CV sales did not recover for upto three years and current downturn is less than two years.
- Income tax raid: In Oct 2011, Income tax search operations were carried out under section 132 of the IT act. Company has paid INR 12 crores as tax to settle the charges. It was showing this amount under advances, but charged to P&L account in Q4FY13. [Company cash tax rate for last 10 years averaged around 30%.]
- Remuneration on higher side: Management remuneration was around 7.5% on average for last 12 years [of PBT, before managerial remuneration]. Over the last five years fixed component in the total remuneration has almost doubled whereas commission has declined.
- Unrelated diversification: Installed 5MW Solar power project at a cost of 70 crs. This is around half of the accumulated cash and almost 35% of current market cap. Once commissioned will not have much recurring project. I think this is clearly unrelated diversification. But returns appear to be attractive. Because of various taxation benefit and high fixed tariff during initial years, payback period is merely 5-6 years [Project period is 25 years]. You can read more on solar project from here
- Low dividend payout ratio: Dividend payout ratio stands at merely 20% [avg of last 10 years] of operating cash flow [after tax]. This conservative policy has resulted in accumulation of cash and cash & investment [net of debt ] of around 80crs. Majority of this surplus fund is being invested in equity mutual funds and in listed equity shares. During current year, despite increase in surplus cash, company has cut dividend from 10 per share in FY12 to 8 per share in FY13.
- FIIs and MFs have never owned any meaningful stake in the company. It might be because management never interacts with analyst; very few brokers have covered the company. There is also a possibility that there is something strongly negative about the management or industry which I am not able to understand.
- Increased stake over the years: Indian promoters had increased their stake in the company over the years. They increased it from 41.8% in 2001 47.5% by Dec-12. During Mar 2013, they have again started increasing their stake, though it’s very nominal.
- No material related party transactions. Not noticed any attempt by promoters to issue preferential shares to themselves or try to merge their private loss making entity in the listed company or any other thing which put minority shareholder at disadvantage.
The Management does not meet or interact with analysts other than at the AGM and hence updates on performance will be sketchy. Its neither positive nor negative, but alteast assures that management is not promotional.
Past cycle of commercial vehicles
I have analysed the past cycles based on data on trucks, which constitute approximately 80% of total M& H CV, as I do not have long term data for total M& H CV.
- 1991-93: Sales declined continuously for three years. Peak to trough decline was close to 35% [Y/Y basis]
- 1998-99: Sales declined for two years. Peak to trough decline was close to 50%. ZF volumes declined by 37%
- 2001: Sales declined by 30%. ZF volumes still increased by 25%. I guess it was because CVs just started to adopt power steering. Between FY02-05, ZF market share increased from 30-45%.
- 2008-09: Sales decline for two years, peak to trough 40% decline. ZF volumes declined by 36%.
Current downcycle: After remaining flat in FY08 and declining by 32 in FY09, sales increased by high double digit (~30%) in FY10 & 11 and remained flat in FY12. Current downcycle begin from Mar 12 with 1% decline and after average decline of 10% during May to Oct 12, decline has accelerated to around 50% between Nov-12 and Feb-13. Rate of decline has come down to 7% in April, but in all possibility decline may accelerate once again. Truck sales are estimated to decline by 25-30% in FY 13. In absolute number, FY13 sales number are already 10% below FY07 numbers.
At the end let me address the two main arguments against companies like ZF steering 1) Cyclical company: ZF steering fortunes are linked to M&H CV and the M&H CV sales declined by close to 25% in FY13 and were flat in FY12. Many investors might want to wait till they see sign of turnaround, but I think when the signs of turnaround become visible it might not be cheap enough. I believe in what Howard Mark says “Knowing where you are in a cycle and what that implies for the future is very different from predicting the timing, extent and shape of the next cyclical move”. So I know we are in the down cycle and it cannot continue like this forever. 2) Not a high growth company: Here I would repeat what Mason Hawkins of Long leaf Partner often says “. If we buy a company for half its value, if the value grows 12% per year through business operations, and if the share price rises to reflect corporate worth in the fifth year, we will compound capital at 29% per year.” ZF steering can easily compound its capital in the worst case scenario at 12% per annum.
In my view MANAGEMENT is the MAJOR RISK for this investment idea and who so ever decide to invest in this stock, need to continue to monitor management actions closely. Presence of foreign JV partner give some comfort. But at the current price there is very low probability of loss and the stock can easily double over next 3-5 years.
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