Of price takers and capped RoEs - Cochin Shipyard and the PSU dilemma

Disclaimer: This is a purely educational piece and not intended as investment advice. Please consult a registered investment advisor or conduct your own diligence for your investment decisions.

On the face of it Cochin Shipyard looks like a mouth-watering prospect. The firm has a market cap of 5,000cr, is debt free, and 2,300cr of cash and cash equivalents on the book. At 920cr EBITDA, that's a sub 3x EV/EBITDA.

This got Manu (one of our earliest ZappChai writers) curious, so he decided to dig deeper into the firm, its business, and the curious case of the firm's valuation.

Business & Industry overview

Cochin Shipyard Ltd. is the largest public sector shipyard in India having the capacity

of accommodating 110K DWT (deadweight tonnes) for ship building and 125K DWT for ship

repair. It is the only shipyard in India catering to both commercial and defense sectors.

Globally the shipbuilding industry has shifted from Western world to Asian region due to cheap labour and government subsidies. China, South Korea and Japan now account for 91% of global ship deliveries.

Closer home, the Indian shipbuilding industry is primarily driven by defense orders and coastal trade. Given the lack of an industry for ancillaries almost 70% of the raw materials are imported. The Make in India initiative is likely to be the primary driver for growth in the space, helping both the building and ancillary space.

Orderbook visibility, growth, and margins

The firm currently has a very healthy orderbook of 15,000+cr that gives revenue visibility atleast for the next three years. With the Indian Navy as a client - this is a trustworthy secured revenue stream for the company. With a proven track-record of delivery of ambitious projects like the Vikramaditya - the firm will most likely be the preferred contender in future tenders.

This has translated to a healthy 15% CAGR in revenues from 2012, with a comfortable 4x+ orderbook to revenue for the company.

The firm manages to keep a sharp control over costs - with bulk sourcing directly from suppliers with whom they have dealt for more than 60 years now. They manage to keep labour costs in check - a key variable in the ship-building industry - by maintaining a healthy mix of contractual labour.

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Tying up the loose ends

Which brings us to the all important question - why does the firm trade at such dirt cheap valuations. A look at the firm's RoEs will help us understand this better.

For a firm that has clocked a 15%+ growth, maintained a tight control over costs, and worked hard at improving efficiencies - its return on equity has been capped at around 16%. When a traditional firm becomes more efficient and gains scale - it reflects in its returns, either via higher margins or via higher asset turns, both of which improve your return on equity.

However, for PSUs like Cochin - these benefits of scale and efficiency are passed on to the government - who is both the largest shareholder (72%+) and largest customer (90%+ via the Indian Navy). The returns are thus capped at a number slightly above the cost of capital which allows the firm to make a modest normal profit, but denies it the true benefit of all the improvements the management is undertaking.

And that is just another in a long list of dilemmas that make a lot of Indian PSU value traps. Brilliant businesses, but shareholders denied the benefit of that brilliance.

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About the Author - The post is written by Manu Jindal. Manu is an IIM Calcutta graduate and an ardent follower of the stock markets. He currently works as a product manager at Airtel.