ACE - The One That Got Away
Disclaimer: I am not invested in Action Construction. I am not an investment advisor. I love thinking about investing and businesses, and this blog is just an expression of that love.
When asked for some of their biggest mistakes, most senior long-term investors reluctantly recall the ones that they missed, the ones that got away. Early in my career, whenever I heard such an example, I used to think - ‘Pish! Tosh! That ain’t making any sense. How can that be an error? It is obvious that the bigger error has to be an investment you made but where you lost money and time.’
This state of mind continued till the market hit me with an ACE in the hole. The lesson of the impact of a missed opportunity was pounded into my head with what seemed like a (figurative) sledgehammer in the form of Action Construction Equipment.
I did my research on Action first in FY19. It is a relatively simple business with straightforward drivers (detailed note below).
In the midst of Covid, the business was available at a price of Rs 31.5 - I vividly remember seeing this price on the exchange website. I remember thinking - I am going to be a disciplined investor; I am going to discipline the hell out of this one. I would buy it at a price of Rs. 30 (the absolute number sounded very nice to me), a price the stock never saw since then. In my attempt at discipline to save Rs 1.5, (as of today) my opportunity loss is Rs. 830 (the price today is Rs. 863).
Before I go into the details of my experience and the lessons from this episode, it would be help to share my note on Action Construction. This note is old - I wrote it some time in FY19. I have not updated the note as I think the point can be conveyed with this old note.
Action Construction Equipment (Ace)
Ace was started by a professional, Vijay Agarwal in 1996 and is today one of the largest construction equipment manufacturers in the country. From a standing start in 1996, the company has a market share of 64% in mobile hydraulic cranes and mobile tower cranes, 95% market share in fixed tower cranes, ~30% in crawler cranes upto 70 tons and 20% in forklifts.
The company has four business segments - cranes, material handling (forklifts, pallet trucks, etc), construction equipment (backhoe loader, etc) and agricultural equipment (tractors, etc).
The company's equipment range makes it sort of a pick-axe to the infra industry. Its products can be used in any major infra, construction, warehousing, real estate (many storey buildings) and logistic industry.
Cranes is the mainstay today contributing to more than 60% of revenues. Hydraulic mobile cranes is where the company started off manufacturing, which then followed by tower cranes, forklifts, tractors, etc. In most new segments it entered, it used to sell traded goods in the beginning before deciding to manufacture it on its own.
The company intends to push the construction equipment (CE) and the agri equipment segment in time to come to gain market share there as well. Apparently, one thing that held them back was NBFC financing which has been resolved. In case of CE like backhoe, the demand dried up and the biggies began competing on price and so Ace withdrew from the market.
Business Strategy
Ace's strategy is to produce quality products at reasonable price and support it with good spares and service availability. They back it with strong marketing push and heavy R&D focus.
Ace's two R&D facilities were the first among the CE players in the country to get accredited by Dept of Science, India. They have spent >1% of sales on average (last 8 years) and have more than 70 people working in the R&D department.
The company management consistently mention their focus on market share and being an economically priced player. Construction equipment forms a major portion of the cost of infrastructure or construction. Thus being a large player with scale while keeping prices low may be a good strategy for long-term. The EBITDA margins are around 10%-13% while PAT margins in the best case scenario could be around 8%. This coupled with the strong brand, customer relationships (who would not want to risk errors when they are lifting heavy stuff), R&D DNA and dealer network acts as a good barrier to entry.
Going forward, the intent is to increase portion of defense and export segment to reduce cyclicality in the business. As per the company, it has won the order in conjunction with Ashok Leyland, and these are long-term orders where the numbers can be 100s or 1000s.
Receivable cycle: Sales to large customers like government, L&T, etc are done through credit of 30-60 days which stretches to 90 days. Sales to everyone else is on funding from NBFC. Cash from NBFC is obtained in 15 days. Tractors are sold on cash - no credit.
On pricing, Ace is not always a price leader. In some cases, they increase prices first but in other cases they want to protect market share.
The company has recently embarked on a Theory of Constraints project with Vector Consulting to implement a GFA (Guaranteed For Availability) project which would ensure any customer order would be delivered to the customer in 3 days flat or the company would take a hit. This would just strengthen the barrier.
Promoters:
Execution: I think the management's execution capability is quite good. To become the largest mobile crane player in ten years is difficult. Then to become the third largest forklift player within 4 years and then replicating it again in tower cranes - these are enough evidence.
Long-term thinking: The company has a 82 acre land parcel of which only 30acre is used so far. When in 2014, an analyst asked him why he did not sell non-core real estate holdings, he (mistakenly) assumed it was this parcel and his response was "that would be foolish. There is no non-core land parcel and all land is in government approved industrial land. And we require it for growth."
Also, during the depth of the downturn from 2012-2017, the company continued to spend on R&D and launching newer products into the market and the annual report had mentions of "preparing for when the rebound occurs." This is quite commendable.
Conservative-Aggressive: Mgmt focus has been to reduce debt and become debt-free recently. This can be a major strength for a capital goods exposed business. In the past it helped them continue spending on R&D while the PnL statement was taking a beating.
Aggression is indicated in the intent to become the largest construction company in India, and the way they have grown. They have divided the business into four segments with each of them having considerable long-term growth potential.
Focus: When asked about entry into other segments, Vijay Agarwal's answer was, "No, no, no, we will not enter any new unrelated segments. We have seen what happens when one enters new segment.Escorts entered telecom, hospital, etc but had to give it all up. We will focus only on manufacturing construction equipment."
Minority shareholder friendliness: The salary taken home is quite high. The four family members together take home more than 5cr every year. The salary is increased during good times and Central Govt. approval is taken during bad times to maintain it and then increased again. This would have been fine.
There have been two dilutions in the past where private companies were merged with Ace. First involved a dilution of 6%-8%.
But the major integrity issue is the acquisition of the privately held ACE Rental in 2016. Promoters issued 1.8cr shares (total share count then was 9.9 cr) and 3 cr pref shares at 8% dividend for a business which had sales of 16cr and PAT of 2.5cr.
If the value of the ACE Rental was 50cr, then the value of promoter's stake in the company went from 272cr (68% of assumed intrinsic value of the Ace of 400cr) to 329cr (73% of new value of 450cr). So they paid themselves 57cr for this business AND also pref shares with 8% dividend 30cr. Cumulative payment of 87cr.
This was done in 2016, when Ace Rental was not doing well. Even in FYE18 and 2Q19 concall, Saurabh Agarwal mentions that rental business, which is primarily tower crane rental, faced issues with repayments because the RE sector was not doing well. Even now, the sales is around 20cr and profits maybe 20-25%.
The company had also issued warrants to promoters in the 2011 around period which they did not convert as the price was lower.
Industry features and potential
The industry, needless to say, is violently cyclical. This is evident in the company's history.
But the potential in my opinion, can be huge. The company sells around 6000 cranes per year (63% market share), 1000 forklifts (20% market) share. This seems quite small for a country of India's size. International companies like Manitowoc, Kion, etc are multiples in size of Ace in terms of revenues and profits. Thus the runway for growth for Ace is quite long.
A business should be seen as a moving picture and not a snapshot in time. Just to get a flavour of how the growth for Ace can be in the long term, it would help to get a decade wise snapshot. Ace sold 110 cranes in 1996, it sold 1902 units of equipment in 2006. Now in 2018, it sold > 5000cranes, >900 forklifts, >3500 tractors and >200 backhoe loaders (a 40,000 equipment market which is the largest market in construction equipment).
The number of customers moved from around 5 in 1996, to 3300 in 2006, to more than 10,000 today. No single sector (wind, power, etc) contributes to more than 10% of revenues and no customer contributes to more than 10%.
Financials and business model:
The financials indicate a few things –
It indicates the cyclical nature of business (2002-2008; 2012-2016).
It indicates the kind of growth in an upcycle which is just explosive – 40x growth in sales and 700x increase in profits from 2002-08. From the bottom in 2014-15, the sales doubled quite quickly while the profits are up 13x. The interesting part is the capacity utilization of the business is still less than 55%-60%.
It indicates the fixed asset light (increased crane capacity by 50% with sales potential of >400cr) and working capital light nature of the business – which allows them to maintain such low EBITDA margins but still generate respectable returns on capital. The low margins also probably act as a good barrier to entry.
Particularly interesting is the ability to generate cash even in the depths of the down-cycle. This ensured despite the deep pain, the company never was in danger of adding debt and stretching the balance sheet.
Valuation:
P/S is probably the best metric to look at for the business given the range in other two metrics. The above table is an excellent indicator of the value that is sometimes made available by the stock market. At ~130cr market cap, the company was being valued at the land value only! It did not include the brands, R&D strength, customer relationship, dealer network, etc.
As can be evident from the above, the thesis was simple - in the midst of covid, I was getting the largest pick-and-carry crane company by far in the second most populous country in the world with a long history for profitable operations at a valuation of ~$40 million (~2x the total land value).
So, why did I not invest?
Black and White or Shades of Grey: Right or wrong, I gave too much importance to the fact that the promoters had issued shares to themselves at terms which were very favourable to them. Don’t get me wrong - in general, share issuance and the manner in which it is done is definitely an extremely important variable in deciding the quality and the intent of the management. On that front, the management did not score well. But the key question is should this be measured in black and white or shade or grey?
Perhaps the better approach should have been the one recommended by Ben Franklin centuries ago- that of prudential algebra. While the share issuance was a negative, the question I should have pondered over is - whether there are positives which outweighed the negative? The tremendous business strength coupled with the damn cheap valuation should have been given importance as well.
Munger said it best in his Almanack - “the forces coming out of the mental models are conflicting to some extent. And you get huge, miserable trade-offs. You need to be able to synthesise the forces. If you cannot think in terms of tradeoffs and recognise tradeoffs in what you are dealing with, you are a horse’s patoot'“
Politely put, I think I was a horse’s patoot here.
Covid led psychological freeze: Another factor that led me to the arbitrary ‘disciplined’ figure of buying at Rs. 30 was Covid. Covid, as most of us can remember, was period of pure mayhem. There was huge loss of life and the world pretty much stood still with bated breath for a few months.
Life was extremely painful in the markets as well. As I wrote in the Tata Steel post - ‘By 2020, I had been investing full time for around 4 years, and my portfolio was deep in the red. By March 2020, I was successful in reducing my family’s total wealth by 60% (that takes some skill too :-)). This at the time my wife and I were expecting our first kid. Needless to say, my emotions were all over the place. It was hard to think straight or rational’
Simply put, I was under stress, and it was super hard to think rationally under so much stress. My mind was craving certainty, and a violently cyclical business gave me pause. In the midst of such sharp drawdowns in the market, I gave tremendous weightage to the past action of the majority owners.
Hindsight bias?
I understand that there is potentially a case of hindsight bias. When I rejected the opportunity in 2020, I had no way of knowing that the business will do so well and the stock would hit such a high price. One can argue that it is with the benefit of hindsight that I am calling my decision a mistake. And the quality of the decision should not be judged based on hindsight.
The quality of a decision is dependent on the facts and circumstances that are available at the time the decision is made. In this context, I still believe, my decision not to buy was perhaps a mistake.
Once again, Action ran a relatively simple business, was the largest player by far in the space, had a very strong balance sheet and was available at a no-brainer price. It would be the last one to perish in its space. It was running at ~50% capacity utilisation. And if there was an upturn in the industry, it would be the first to benefit. In this context, the risk of share issuance could be capped at the portfolio level.
Another reason why I believe this was an error is because there are other examples where I stocks went up 5-10x after I sold the stock. In these cases, the opportunity loss does not bother me so much, as my process would not allow me to stay with them.
One other lesson
To my mind, there is one other lesson that this episode taught me.
It is to not try to get the stock at the bottom. In a bear market, stock prices tend to drop sharply. Our evolutionary tendencies lead us to extrapolate the recent events, and I believed the stock would fall further. I wanted to get a much cheaper price than what was already a really cheap price.
The funny thing is, the opposite happens in a bull market. There is a tendency to chase the price due to FOMO (the fear of missing out). The discipline slacks off materially during bull markets as the self tries to avoid the pain of missing out on what seems like sure-shot gains. There is a sense of belief that the stock is waiting for me to buy before it runs away. This has historically proved to be quite a harmful habit.
The lesson I learnt was this - like the archer / shooter accounts for the wind speed and direction before taking his shot, an investor should account / calibrate for emotions and circumstances before making an investment. It is easy to say that one has to be rational when taking investment decisions, quite a different thing to practice it in the real world.
In this context, one should account for the euphoria and the sense of optimism in a bull market - and thereby have a deliberate stronger sense of discipline in filtering ideas and the price to purchase a stock. In a bear market perhaps one should ‘relax’ one’s discipline and account for the sense of panic that tends to engulf the our psyche.
The sin is in not in committing a mistake but in repeating the mistake. My goal in writing down this experience is to ensure that I reduce the number of times I repeat this mistake.
Hi Rohith, I enjoyed reading this and thank you for sharing an example of your thought process through the crash during the pandemic. To play devil's advocate, given the integrity issues, would it not be better to pass on the company entirely? Other opportunities that did not come conjoined with such promoter integrity issues may be more actionable in tumultuous times - how do you think about this?