Archive for the ‘Industry analysis’ Category.


I shared the following note with subscribers on how the current trends in solar/wind power and battery technology are likely to cause disruption in the energy markets. The impact of this disruption is already being felt in the capital goods sector, which is an early proxy of the long term trends in an industry. Any management planning to invest with a 20 year horizon will carefully analyze the long trends before committing capital for this duration.

I have kept out the name of the company we hold, for obvious reasons, but the conclusions are valid for any company in the energy sector value chain. In addition, I think these technologies are likely to have a huge impact in the transportation, oil & gas, coal, power storage and other industries too

I highlighted the following risk in 2016 for our holding.

Solar energy – I wrote extensively about it in the previous year’s update and the solar energy market continues to develop as expected. It is critical to track this sector as solar is a substitute for other forms of energy (such as coal or Oil) and hence its adoption will have some impact on the demand for the products of the company.

The company continues to focus on process co-gen, waste to energy (including biomass based power generation) and the IPP sector. As I wrote in the previous update, the first two sectors continue to do well as they serve as a complementary power generation system. The IPP segment however is under threat as solar can easily displace this at a lower cost and the company’s performance seems to bear this out.

I have been tracking the renewable and battery/ storage space for the last few years. Let me share some data points before discussing the implications

The graph below shows the price trends for the next 5 years. Please keep in mind that the drops in the recent years have been much higher than predicted and there is no reason why the current rate of 15% annual price drop will not continue

This is a comparative cost across countries

As you can see, India has the lowest costs due to lower soft costs (aka labor costs).

The recent solar auctions in India and several parts of the world are now hitting the 1.3-1.5 Re/KWH levels already and this is expected to drop further. In comparison, the cheapest fossil fuel generated power – Coal, is priced at around 3 Rs/KWH and rising due to transport and other costs

At this point, a lot of naysayers, point out the lack of storage and intermittency of solar and wind power. Let’s look at another data point – Cost of lithium ion storage. This has now hit 200 dollars/ Kwh and continues to drop by around 15% per annum. At the current rate, the cost ofs batteries will drop below 100$/ KWH in 3 years. Why is 100$/KWH important?

This is the point at which solar + Large scale storage start becoming cost competitive with base load or Coal based power. Again, keep in mind that these trends will not stop in 2020, but will keep continuing beyond that due to economies of scale and new research (in other forms of batteries such flow batteries, Lithium air etc)

Is this all hypothetical?
We may assume that all this is theory and the energy markets are yet to be disrupted. That is not true and we already have a few early signs of disruption

a. Gas based Peaker plants (which take care of sudden spike in demand for electricity) are not being built as it is cheaper to use battery storage to take care of such spikes

b. Companies like GE and Siemens have seen a large drop in demand for gas turbines and announced re-structuring of their power business.

c. What natural gas did to coal, will be repeated again

In 2012-14, we had a new technology called fracking reach scale in the US. This technology had been in development for almost a decade and hit an inflection point in 2014. The resulting glut in natural gas led to a sharp drop in the price as can be seen in the chart below.

The result of this drop was that, natural gas suddenly became cheaper (and cleaner) than coal and caused a switch in fuel for power generation. This can be seen in the picture below. This in turn led to a drop in the demand and price of coal, leading to large scale bankruptcies in the coal sector in the US

Keep in mind that fracking only works if you already have deposits of gas/ oil in place, but were uneconomical earlier. There is no such limitation for solar or wind energy.

Please ignore the S curve
Lets go back to the first principles in economics – People respond to incentives. Companies, individuals and governments are not going to switch to solar or wind energy because they have suddenly realized that these are green technologies, but the because these technologies are now becoming cheaper than the alternatives (fossil fuel).

We still have a lot of naysayers including some of the think tanks, who keep suggesting that these disruptions are atleast 15-20 years away. If you look at the numbers, for some reason their predictions assume that the price drop in these technologies will change from the current 15%+ to around 3-5% due to which the uptake of these technologies will proceed in a linear fashion.

You can believe these predictions if you are ready to ignore the S-curve model of adoption, which states that these kind of non-linear technologies follow an exponential adoption rate till they hit saturation.

Look at the example of cell phones, internet, Computers and so on which show the adoption rates are only speeding up, not slowing down !

we cannot predict precisely when the inflection will occur. However, it is not difficult to see the disruption ahead. At the current valuations, the market is not discounting the threat of disruption for companies in the capital goods sector, oil & Gas, automotive, power and coal sector.

We can wait till the threat becomes obvious and then exit our positions. I am however not inclined to wait till the last minute before jumping off the track, even though I can dimly see the train coming towards us.


I recently posted the following comment on twitter

Indian IT still earns 30%+ Roe vs. 15-20% for other IT majors. Cannot see any competitive advantage to justify such excess profits 4 long term

This initiated a discussion with prabhakar on twitter. Now, a 140 character space is sufficient to provoke a discussion, but very painful to explore any meaningful topic. So I decided to write a post and share some thoughts (and hopefully carry the discussion with prabhakar and others in the comments section)

I have written about the competitive advantage (moat) of Indian IT companies in detail here. I drew the following conclusion then,

The broad conclusion one can draw from the above analysis is that IT companies do enjoy a certain degree of competitive advantage. The source of this advantage is no longer the global delivery model (everyone does it) or the employees (all the companies source from the same pool). The key sources of competitive advantage can be summarized as follows

  • Switching cost due to customer relationships
  • Economies of scale
  • Small barriers due to specialized skills in specific verticals such as insurance, transportation etc
  • Management. This is a key source of competitive advantage in this industry and explains the wide variation of performance between various companies operating in the same sector with the same inputs and under similar conditions.

Let’s look at where we stand on these factors

  1. Switching costs – I personally think switching costs are coming down now. The nature of work is getting commoditized and as a result, companies are less reluctant to switch vendors. Sure, it is a pain to do so, but if the cost benefits are large then a lot of companies are ready to bite the bullet. In addition, the threat to switch to a different vendor is sufficient to drive down prices.
  2. Economies of scale – This is now turning from an advantage to a disadvantage for the larger firms as they continue to grow. A firm with 150000 employees (top IT vendors) will develop diseconomies of scale as it grows further
  3. Specialized skills – this was a weak advantage to begin with and in most cases these skills reside with individuals (who can leave easily) and are not really institutionalized (via a product offering)
  4. Management – It is important to have a good management, but a great management cannot change the competitive dynamics of a company completely.

Weak and strong moats

Let me introduce a new concept here – Weak and strong moats. A strong moat is one which cannot be breached easily by competition. Think about the moats enjoyed by titan industries (brand, distribution), Asian paints or Crisil – these are wide and strong moats which cannot be easily breached by competition.

A weak moat or weakening moat in contrast is a moat which is shrinking and can be breached much more easily by competition.

My hypothesis is this – Indian IT has a weak moat which is shrinking by the day.

Some numbers

Let’s look at the ROIC numbers for some IT companies (Indian and global)

IBM – 15-20 % (based on invested capital including debt)

Infosys – 50% (based on invested capital, excluding cash)

NIIT tech – 25%+ (based on invested capital, excluding cash)

The above numbers are not precise, but sufficient to paint a picture. The mid cap and foreign IT majors have an attractive ROIC (in excess of 15%) and are good businesses. The large cap Indian IT companies have phenomenal return on capital numbers, in comparison to their Indian and global counterparts.

What explains this big difference?

Eliminating some factors

I would like to argue against some points which are put forward to justify the presence of a competitive advantage for the IT majors

Talent – Everyone has access to the same talent (in India and abroad). You can easily pay 10-20% more and hire employees from competition, if you need to do that. So all this talk about differentiated talent and training ….is just talk and does not create any competitive advantage

Intellectual property – Some Indian companies focused on niche areas, do have IP and are able to charge more for it. At the same time, IP is not a sustainable competitive advantage and a company has to constantly invest, to build on it. In addition, if IP was such as source of sustainable advantage, then companies like IBM (which has more IP than a lot other vendors) would be earning a much higher return on their service business (they earn around 10% NPM)

Differentiated model, client engagement etc etc – This is all fluff and good for annual reports and client presentation.

The future

I will take a guess now (which is as good as yours). I think the return on capital  (margins and asset turns) will slowly drift downwards for the top IT companies as the commoditization increases without the presence of a sustainable competitive advantage.

This has already started and you can see it happening with several of the large cap IT companies. If I am even half correct, it is important to be careful in looking at valuations based on the past performance alone.


At first blush, mining stocks are a value investor’s dream. A company with a mandated monopoly, earning around 50%+ net margins and almost 400%+ return on capital should be an ideal opportunity. On top of that if this business sells for 7-8 times cash flow, it is like hitting the jackpot!

Is the stock market nuts to ignore such companies?

Let’s look at the numbers

Let’s look at some of the Government owned mining companies. I will look at two examples in this post – NMDC limited and GMDC (Gujarat mineral development corporation).

NMDC is the largest iron ore producer in India, with an annual production of around 26MMT per annum. The company earned around 12680 Crs in 2011, mainly through the production and sale of iron ore. The company made a net profit of around 50% and earned a return on capital of around 400 % (after excluding the excess cash).

The net profit has grown from around 2300 Crs to almost 6500 crs in the last five years, mainly due to the rise in iron ore prices (as volumes have grown only by around 10% during the same period). The company has around 17000 Crs of excess cash and can easily meet capex requirement from the interest income alone.

The company is also selling at around 6-7 times free cash flow (excluding the cash)

GMDC is one of the largest lignite producer based in Gujarat. The company earned around 375 Crs on a topline of around 1400 crs in 2011. The company made around 25% net margins and around 25% return on capital (excluding excess cash). The company has grown the topline and profits at around 18% p.a in the last 10 years.

As you can see, the numbers look good and are likely to be maintained as iron and Lignite/coal continues to be in high demand (With imports being far more expensive)

Why is the market discounting these companies?

There is more to these companies than meets the eye. The numbers look good for a specific reason – These are government mandated quasi monopolies, which have preferential access to these mineral resources. A private company cannot get license to a mine (other than for captive purposes).

In addition, even if a company were to get a license, it would take a lot of effort and money for the company to get all the clearances to operate the mine. These factors add up to a meaningful competitive advantage.

The flip side of this advantage is that these companies are run by the government as it sees fit and not necessarily for the benefit of the shareholder (or maybe the general public too – which is a different issue completely)

The impact of government control

There are several obvious and non obvious impacts of government ownership . For starters, these companies are not in the business of maximizing shareholder value. These companies exist to serve a specific objective, as decided by the government.

For example, NMDC’s objective seems to be to expand the mining operations to meet domestic and international demand. It has managed to make a lot of money in the process, but the excess capital has not been returned to shareholders. You may argue that this is true in case of a lot of companies. However in all such cases, where the management (private or public) uses the capital inefficiently, the stock market takes a dim view and does not give the company a high valuation

In case of NMDC, the company has now decided to invest in a 3 MTPA steel plant at the cost of around 15000 Crs. You can call this as forward integration, but I see this as a high return business investing in low to average return business – not exactly a value enhancing decision.

In case of GMDC, the company is now expanding into power generation. Power generation in India, is a very tough business with poor free cash flow. In case of the GMDC, look at page 56 of the annual report –  The mining segment made almost 570 Crs on 60 Crs of asset (1000% !),  whereas the power segment made around 57 crs on 1300 (less than 5%).

I hope you can see the pattern here – We have a very profitable business in mining (due to the government policies) and the big profits from this business are being invested into some very mediocre businesses (again due to the government)

Isolated cases ?

The above example may be seem to be a case of related diversification. The problem with such related diversification is that the bureaucrat making these decisions, is doing it with some non financial objective in mind (nation building !!) and does not care about the return on capital

In addition to all these lofty goals, there are smaller cases of waste of capital too. NMDC recently acquired sponge iron limited for around 80 Crs. This is a  30000 TPA producer  of sponge iron with a sale of around 65 Crs and loss of around 10-15 Crs per annum. In comparison , Tata sponge iron has a capacity of 300000 TPA , made a profit of around 100 Crs and sells for around 300 Crs (net of excess cash).

GMDC has several such cases of cross holdings in other PSUs, guest houses and what not!

The above cases are small, but indicative of the way these companies are being run.

Should one avoid these companies?

I am not indicating that these companies are to be avoided at all costs just because they are controlled by the government. On the contrary, there are several PSUs which are run much better , where economics and not politics is the driving factor.

In the case of mining companies one should not get infatuated by the huge cash profits being made by the company, but also look how these cash flows will be utilized. One can expect  to receive decent dividends over time in case of some of these companies, but the intrinsic value of these companies is unlikely to grow rapidly (more likely at around 10% per annum).

The bladder theory is very much at work in these companies – When  management  and more so the government has too much cash, there is a high tendency to piss it away.

What do you guys think? please share your thoughts in the comments

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.