Bajaj Holding

Bajaj, like Tata, is an old and trusted name in India. The Bajajs have been around for decades. But in their newest avatar post the demerger of their flagship Bajaj Auto in 2007, they own and manage two exciting (value investor wise) businesses - Bajaj Auto Limited and Bajaj Finserv.

Bajaj Auto Limited is a two and three wheeler manufacturer - it is India's second largest two wheeler manufacturer and the world's largest 3-wheeler manufacturer. Bajaj Auto the business has done excellently well in the last 3 years - with very high and increasing returns on capital invested (it has averaged an RoE of 52% over the last 4 years). The consolidated revenue has grown from Rs 9,254 cr in FY08 to Rs 17,955 cr in FY11, PAT has grown from Rs 748 cr to Rs 3,454 cr in the same period and the market cap has consequently sky rocketed from ~Rs 8,300 cr in FY08 to ~Rs 42,000 in FY11. Under Rajiv Bajaj, the MD, the company has very successfully implemeted a strategy of focusing on higher end products and created a strong brand. The stock is moderately expensive at 12 times ttm PE, the company has negligible debt, negative working capital and negative cash conversion cycle and an exceptional Return on Investment.

Bajaj Finserv is a financial services company and manages - Bajaj Allianz Life Insurance Corporation (BALIC), Bajaj Allianz General Insurance Corporation (BAGIC), Bajaj Finance (NBFC that is into two wheeler and consumer durable loans etc) and Bajaj Financial Solutions (wealth management and advisory business in startup phase). The main profit driver so far for Bajaj Finserv has been BALIC, followed by BAGIC and Bajaj Finance. The good thing about Bajaj Finserv management (Sanjiv Bajaj, Rajiv Bajaj's brother, is the MD) is that they are prudent and conservative - for instance, they do not chase business at the cost of profitability. So in some years, depending on interest rates and other macro economic variables and regulatory requirements, they may lose market share since they do not pursue new business as aggressively as LIC or ICICI does. But this policy of prudence while writing new business premium will also ensure that they do not have too many bad years from a profitability perspective. This fact is reflected in their combined ratios (best in the industry) and their annual results - BALIC and BAGIC are the most profitable private sector insurance companies in their respective domains. Bajaj Finserv is currently quoting at between 5 and 6 times ttm PE.

While I think both Bajaj Auto and Bajaj Finserv are great businesses, from an investment perspective I find Bajaj Auto to be slightly expensive. Bajaj Finserv is currently quoting at a reasonable valuation.

But there is a great investment opportunity in the form of a holding company, Bajaj Holdings and Investment Ltd (BHIL). BHIL holds 31% stake in Bajaj Auto and 38% stake in Bajaj Finserv. The company's market cap is a little over 3 times the FY11 consolidated net profit (the underlying companies themselves are currently trading at much higher multiples of their respective consolidated earnings - Bajaj Auto at 15 times and Bajaj Finserv at 6 times). BHIL currently is quoting a market cap of a little over Rs 8,300 cr. Consider below, the share of profits of the associate companies (that BHIL has a significant stake in) that should accrue to BHIL owing to its shareholding.

(All amounts in Rs cr)

In FY10, BHIL's share of its associates profits totalled Rs 773 cr and its investment activities (interest, dividends, capital gains on sales of investments) earned it an additional Rs 771 cr, totaling Rs 1,544 cr. In FY11, its share of associate companies' profits was Rs 1,662 cr (helped by an almost doubling of profits from both Bajaj Auto and Bajaj Finserv), while the investing activities earned another Rs 1,000 cr for a total Rs 2,662 cr. Of course you need to subtract the expenses of the holding company BHIL from these cash flows, but those are minimal. And what multiple do you currently have to pay to get access to the upsides from these cashflows generated by good solid businesses with efficient and honest management and having great long term potential? - slightly over Rs 8,000 cr - a little over 3 times.

Both the large associate companies (Bajaj Auto and Bajaj Finserv) are great businesses in terms of the industry they are in as well as in having good management, and should continue to increase their profitability. Below is the position of BHIL's investments as of 31 March 2011, at cost and at current market value.

(All amounts in Rs cr)

You can see that the balance sheet carries the investments at cost (which is an 80% discount to current market value). Even considering this highly truncated value (80% discount to market values), the value of investments of BHIL is close to half its current market cap.

One final issue on the holding company discount. Mr Market tends to always value holding companies at a discount from the value of their underlying (investee) companies, due to the additional management layer in between. But I do not see a reason for a discount (or at least such a huge discount of 80%) in this case. One, the promoters have a track record and a reputation of integrity and fairness. Two, and more importantly, they have demonstarted this by paying out all the dividends BHIL has earned from its investee companies out to the final shareholders of BHIL and then some more. So effectively, there is no leakage of dividends at the holding company level.

Dividend received by BHIL from investments

FY09 - Rs 145 cr

FY10 - Rs 141 cr

FY11 - Rs 225 cr

Dividends paid out by BHIL to its shareholders

FY09 - Rs 101 cr

FY10 - Rs 318 cr

FY11 - Rs 390 cr

So the company is not hoarding dividends received from underlying companies, but is distributing them out to shareholders and adding to the pie from their investment returns.

The underlying companies - Bajaj Auto and Bajaj Finserv - themselves have all the ingredients of being blockbuster stocks - they are in high growth sectors, have excellent return on equity, and have good cash flows. Through BHIL, one gets access to the upsides of the cash flows of these two excellent companies - at slightly over 3 times multiple of annual earnings. In all, definitely a huge bargain.

The Piramal Arbitrage

There is a unique opportunity to make a profit out of an arbitrage situation with regard to two Ajay Piramal controlled companies.

Background - In 2007-08, Ajay Piramal spun off the New Chemical Entity, the entity doing research on new chemical and biological molecules that could evolve into blockbuster drugs in the future, out of what was then the pharma company Nicholas Piramal, and into Piramal Life Sciences Limited (PLSL). Nicholas Piramal was subsequently renamed Piramal Healthcare Limted (PHL). In mid 2010, Ajay Piramal pulled off a coup of sorts by selling the domestic formulations business and the Diagnostics business of PHL (which together accounted for almost 60% of PHL's then revenues) for fairly high valuations, and netted PHL about Rs 17,740 cr from this slump sale. Out of this amount, about Rs 10,200 cr was paid up front in 2010, and the balance of about Rs 7,540 cr is to be paid over the next 4 years. This future payment, which is not contingent on any conditions being fulfilled, has a net present value of approximately Rs 6,500 cr (keep this number in mind), discounting at a rate of 10% per annum.

The opportunity - The NCE unit, which is currently part of PLSL is now to be demerged back into PHL, for PHL stock. The proposed price is to issue 1 PHL share for every 4 PLSL shares currently held by the existing PLSL shareholders, for giving up the future potential of the NCE business to PHL. As of Friday, 22nd July's closing prices, PHL stock closed at Rs 400 a share, while PLSL closed at Rs 94.85 a share, both on the BSE. The demerger proposal is to be put to vote in a shareholder meet on 9th August 2011. Upon shareholder approval, the share exchange will be done on a Record Date to be decided by the boards of PHL and PLSL. So here is the arbitrage opportunity - going long on 4 PLSL shares, and short 1 PHL share (or multiples thereof) - if things work out as planned, there is a guaranteed profit of a little more than 5% (less transaction costs) to be made in less than a month. Of course, in life, nothing is guaranteed or risk free. The risks here are that the deal does not receive shareholder approval on 9th August for some reason, or the Bombay High Court disallows it or delays it for some reason - I estimate the probability of either event happening to be small.

But here is how I would play this trade - While a conservative investor would be well advised to go along with the above arbitrage opportunity and net a (almost) risk free 5% with cash deployed for less than a month (which annualizes to 60%), without caring about the underlying details of the businesses, a more intrepid investor might want to look under the hood and take a slightly different approach. Stock market price quotes are opportunities to buy small portions of great business at sometimes really favourbale valuations, that would never be possible if you were negotiating with the owners for an outright purchase of the whole business. Of course, this is assuming that the managers of the business are honest and treat all shareholders (including minority shareholders) alike. With this assumption, I do not see any difference between buying only a small portion of a business as compared to buying out a whole business. In Ajay Piramal's case, based on past track record, I would venture to state that this is a reasonable assumption to make. Based on closing prices of July 22nd 2011, the market is valuing PHL at just shy of Rs 6,700 cr. So if one were to buy PHL for Rs 6,700 cr today, one will, over the next 4 years, be eligible to receive an aggregate sum of Rs 7,540 cr (with an NPV of Rs 6,500 cr) as balance payouts from the slump sale done in 2010. So the payouts alone should recoup the intial investment. But in the balance, after recouping the investment, you are still left with the operating businesses of PHL, which had a revenue of Rs 559 cr and a profit after tax of Rs 71 cr in Q4FY11 (March 2011). Note that these businesses have immense potential to grow revenues and profitability in the future and you are getting these businesses for virtually no price. On top of this, PHL also had an investment income of Rs 130 cr in Q4FY11, which is just sweet gravy on the top.

So to sum up, at the current quoted price (Rs 400 on the BSE), PHL is an absolute bargain. PLSL represents an opporuntity to buy into PHL at a further 5% discount. Keep an eye out for these two stocks - a further divergence in their valuations (lower PLSL prices and higher PHL prices) will magnify the bargain in this opportunity, at least until the demerger happens.