Welspun India has been marred in a controversy over supply of fake Egyptian cotton to its US customers like Target and Walmart. Given this controversy, investors are running away from the company using adages such as ‘there is never just one cockroach in the closet’. Investors using such adages as crutches without considering the monetary impact of these events are acting like Mark Twain’s cat – the one that never sat on a stove again! We are firm believers in price being the dictating factor in whether a company is a good candidate for an investment or not. For even a bad business can be a great investment at a given price.
This is not to say that Welspun is a good investment just because it has falling in price but, to say that we are not going to jump to conclusions without analysing it first.
In order to value Welspun, we divide our valuation into two stages:
- First, we are going to go back a month before the scandal broke out and value it as if nothing had happened. We are going to consider that the market price prevailing at the time was correct and back out the operating income that the market was expecting it to deliver based on the expectations incorporated in that price.
- Next, we are going to consider the consequences of the scandal on Welspun’s revenues and operating margins.
Pre-scandal valuation of Welspun
Our pre-scandal story for Welspun is that it is a leading player in the home textile products with its competitive edge being strong relationships with leading US retailers. Given the nature of its product and the diverse base of its customers, we felt that the business risk was low reflecting in the 10.79% cost of capital we used for the company.
We assumed a high growth period of 5 years with a growth rate of 11.85% (based on a reinvestment rate of 81.79% and return on capital of 14.48%). Thereafter, we assumed that the company would reach a steady state with a growth rate of 4.81% (equal to the risk free rate for the Indian economy). We also assumed that the company’s cost of capital would drop to about 9.84% during steady state and it would end up making a return on capital of 11% forever. Reproduced below is a summary of inputs used and our DCF:
Based on these assumptions, we obtained a value of about Rs. 13,200 cr. for the operating assets of the company. Adding the cash (Rs. 124 cr.) and reducing the market value of the debt (Rs. 2,594 cr.) and minority interest (Rs. 503 cr.), gives us a value of Rs. 10,200 cr. for the equity in the company or Rs. 101.68 per share. Since this value is extremely close to the share price prevailing before the scandal (the share was trading at Rs. 102.85 on 19 August 2016), we can take the trailing-twelve-month EBIT of Rs. 1,223 cr. as largely what the market was pricing in its current price. This EBIT will form the basis of our valuation post the scandal breakout.
Post scandal valuation of Welspun
One thing is for sure, Welspun has lost trust of its most important customers and there will be consequences for the Company. We divide these in the following three categories:
- One time penalties: These are the financial costs that Welspun might have to incur for falsely labelling its products. These would include potential lawsuits by Target and others over misrepresentation, customer refunds and any other contractual penalties that the parties might have agreed to. We believe that these one-time penalties should not exceed the value of the total product that was faulty. The company has represented that the total Egyptian cotton business was 6% of total sales of the company, which comes to about 370 cr. Accordingly, we estimate these costs at around Rs. 500 cr. in a conservative basis. We consider that 50% of these costs will be tax deductible for the company.
- Legal and administrative costs: These are the costs of hiring outside consultants to mitigate the damage caused by this scandal. We attach a cost of Rs. 50 cr. in increased legal and other fees. We consider that all of these costs will be tax deductible for the company.
- Revenue effect and loss of operating profits: Given that Target has already cancelled all of its business with Welspun and Walmart has cancelled the bed sheets business, we can expect other customers to follow suit. However, we do not believe that other customers will sever all ties with Welspun and are more likely to follow the Walmart route. Accordingly, we assume the following cost of lost opportunities for the Company.
- A 20% cut in revenues from all other customers for the next 2 years before the business gets back on its feet and the scandal blows over (Egyptian cotton sales accounted for about 20% of the total business that Welspun did with Walmart). These assumptions give us a total revenue drop of about 28%. from current levels.
- Loss in operating margin: One of the consequences of the scandal will be the increased concessions that Welspun might have to offer to save business with existing customers. Also, given Welspun’s history, we believe the company will be hard pressed to maintain such operating margins going forward. It’s premium Egyptian cotton business, which was a high margin product, is ruined for all practical purposes. Accordingly, operating margins can be expected to drop going forward and we assume these to be 14% instead of the current 19.70% forever.
- A 20% cut in revenues from all other customers for the next 2 years before the business gets back on its feet and the scandal blows over (Egyptian cotton sales accounted for about 20% of the total business that Welspun did with Walmart). These assumptions give us a total revenue drop of about 28%. from current levels.
The loss in margin gives us an updated EBIT of Rs. 866 cr. (14% of Rs. 6,185 cr.) as our starting point. Due to the fall in market capitalisation of the company and consequent increase of debt ratio, there is an increase in the cost of equity of the company. This in turn leads to a slightly higher cost of capital of 10.93%. Other assumptions regarding reinvestment rates, growth rates, etc. do not change.
Given these updated assumptions, the value of the operating assets now drops to about Rs. 8,500 cr. Adding the value of the cash and reducing the value of the debt and minority interests gives us a value before scandal costs of about Rs. 5,600 cr.
We value the other costs of the scandal – one time penalties, legal costs and loss in revenues – separately and come up with a present value of lost opportunities at about Rs. 800 cr.
When deducted from Rs. 5,600 cr. derived above, it gives us a value of Rs. 4,800 cr. or Rs. 48 per share for the equity in the company.
Based on our base case valuation, we arrive at a value of Rs. 48 per share when the current price is Rs. 55.75 per share, thereby indicating an overvaluation of about 14%.
Investing is a game of odds, and there is no one correct value for a company. Reproduced below is a scenario analysis which comes up with the value of the company at different assumptions regarding operating margins and drop in revenues.
As you can see, the valuation is most sensitive to operating margins since every 1% change causes a change of about Rs. 7.50 in value on a per share basis. The cell highlighted in green reflects our base case scenario. It is mainly at the 16% operating margin that the shares appear to be undervalued and these cases have been highlighted in blue.
Purpose of this exercise
Many investors are bound to question the use of valuation in such uncertain circumstances where assumptions have to be made about the most important of inputs. We believe that valuing at times like these has the potential for the greatest payoff. Valuing the company, forces us to think in terms of investing basics rather than running away from an investment. It enables us to understand which key drivers are likely to cause a shift in value of the company. In the case of Welspun for instance, it is the loss in operating margin that has the potential to erode much of the value in the company (more than Rs. 4,000 cr. in our valuation). This gives us a direction as to where our energies should be focused going forward – assessing the impact of the scandal on the operating margins of the company.
There is no denying that we may turn out to be woefully wrong about many of the assumptions used in the valuation. But at least, we’ll know where we went wrong!
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