We applied Buffett’s investing framework to see if the Cochin Shipyard’s IPO is worth applying for.
Warren Buffett, in his 2007 annual letters to shareholders, talked about four key criteria he considers before investing in any business. He said, "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag"
In his mental framework, investing is that simple. We applied Buffett’s investing framework to see if the Cochin Shipyard's IPO is worth applying for.
Criteria A: Simple business
The 55-year old Cochin Shipyard derives 82 percent of its revenues from shipbuilding while the remaining comes from ship repairs. While it also builds ships for private clients, 80 percent of the orders comes from defence. Among private clients, it has delivered repeat orders to some clients in the US, Europe and Gulf countries.
Criteria B: Able and trustworthy management
The popular belief is that government-run businesses often lack management bandwidth and do not allocate resources wisely. For Cochin Shipyard, which is working with Indian navy and army, the capability of its management is important. While interacting with the management, we found that they are fully aware of their strengths and weaknesses. The company stayed away from building high-end ships (where there is significant competition from Japan and Korea), which is not its core strength and would have strained its balance sheet.
Importantly, the management knows what not to do. To put it in perspective, it deliberately kept huge cash in the books (Rs 2,060 crore including customer advance) to deal with the volatile industry cycles, where most players suffer because of want of working capital.
Cochin Shipyard prefers to keep at least 50 percent of sales in cash. Moreover, instead of showing aggression, it has always chosen to remain rational about what it can deliver, given the resources at its disposal. The company has seen several industry cycles and keeps its focus only on profitable projects with a tight control over working capital, a key to survival in this business.
Criteria C: favorable long-term economics
Cochin Shipyard enjoys long-term competitive advantages. What is hard to replicate is the know-how of the industry that it has cultivated over last five decades.
The company enjoys cost advantage given the fully-depreciated integrated ship building facility. Replacing these assets would be costly. That apart, the business enjoys huge entry barriers and has high switching costs especially, since the key customer is from defence, thereby, protecting the long-term economic interest of the business.
Moreover, it is further enhancing its (moat) capabilities with the bigger scale of operations, investing in new capabilities and optimising resources.
Shipbuilding: Dominant player
The current shipbuilding facility comprises of 2 dry docks of 255 meters having a capacity of 110000 DWT (Dead Weight Tonne). It is now building additional dry docks of 310 meters, which can built large sized vessels like Aframax or the Capesize ships. This should enable the company to build larger vessels for the India Navy like aircraft carriers.
It is already working on phase-II of its aircraft carrier INS Vikrant, a project worth Rs 20,000 crore. The new facility (to be operational in 30 months) would strengthen its execution capability. It has an order book of Rs 3,000 crore (sales Rs 2,200 crore), which will further grow as it has also placed bids for projects worth Rs 12,000 crore. That apart, it is also looking at phase III of INS Vikrant. The order book does not include the much larger phase III work. Once complete, it will pave the way for the second indigenous air craft carrier.
Repair business: Largest player in a growing market
Repair business (enjoys 40 percent market share) is fast growing with high capital turn and significantly higher margins. The size of opportunity is now pegged at around Rs 2,500 crore (current revenue Rs 544 crore) over the next 3-4 years. It has been rejecting several orders due to capacity constraints.
The company is now setting up new ship repair facility, which would enable a turnaround of 140 vessels in a year as against 80 vessels currently. Considering the high margin and RoE, this business will boost growth as well as return ratios for the company.
Inland water opportunities
It has also formed a JV with the Hooghly Dock and Port Engineers to participate in the opportunities for inland water projects like Sagar Mala. The company will have 75 percent stake in the JV.
The company is embarking on investments of close to Rs 2,800 crore on a gross block of Rs 700 crore. Interestingly, it will use Rs 980 crore from IPO proceeds and cash in the books of close to Rs 1,600 crore. Hence, the exercise will not strain the balance sheet. Moreover, the new facilities will not cost much as it will be built on surplus land, supported by existing fabrication facility. The capex, likely to be spread over three years, will also use internal cash generation (Rs 350 crore annually) thereby, limiting the impact on balance sheet.
Criteria D: A sensible price tag.
At the upper end of the IPO price band of Rs 424-432 (5 percent discount to retail) the company will have a market capitalisation of Rs 5,845 crore. Excluding cash (Rs 1,600 crore and Rs 979 crore from IPO proceeds) market capitalisation comes to Rs 3,250 crore, which is about 8 times its EBIDTA of FY17. This is quite reasonable considering the potential for growth.
During the last decade (2007-2017), its sales and profits have grown at CAGR (compounded annual growth rate) of 11.1 percent and 19 percent, respectively. Growth in the next decade is expected to be higher considering the increasing scale and size of the opportunity.
One needs to factor the high return ratios and margins (Operating margin at 27 percent) that the business has delivered. On a net worth of Rs 337 (excluding cash), the core business reported an EBIDTA of Rs 377 crore. Even after accounting for the tax, return on equity works out to 75-78 percent, which is quite high and shows the inherent strength of its core business.