Valuation Shocker: Titagarh Rail as Expensive as HUL 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Before I start, here's wishing all of you a Happy and a Prosperous New Year.

Moving on to today's video, I'm sure all you've heard about the upcoming bullet train project where the work is on in full swing.

And while it may take some time for these ultra-high-speed trains to become operational, there are a few bullet trains that are moving ahead full steam in the Indian stock market.

I'm referring to stocks of wagon manufacturers like Titagarh Rail Systems, Jupiter Wagons, and even Texmaco Rail. The speed at which these stocks have moved recently, has been nothing short of bullets.

Titagarh Rail Systems is a huge 50-bagger since its lows in March 2020, Jupiter Wagons a 40-bagger and Texmaco Rail is a respectable 12-bagger.

To be honest, there are some genuine reasons behind the meteoric rise in their share prices. Foremost among them is the massive investment that's happening both on the passenger side as well as the freight side of the Indian railways.

Just to put things in perspective, passenger demand for Indian railways is expected to increase by almost 2.5x by 2051. This requires significant capacity expansion in passenger handling capacity as well as technological improvements.

Also, the impact of infrastructure spend over the last 10 years is now flowing down to freight rolling stock. For the first-time, wagon manufactures have received orders exceeding the amount they received in the last 10 years cumulatively.

Hence, the railway sector is certainly going through some massive tailwinds. This is also being reflected in the massive order book that these companies are sitting on. Titagarh Rail Systems has an order book of a whopping Rs 282 bn as of September 2023. This is 10x higher than the revenue it earned in FY23.

It's no wonder investors are making a beeline for wagon manufacturers and buying their shares hand over fist.

But have they taken their enthusiasm too far? Have they bid up the share prices of these companies so high that their valuations have run ahead of fundamentals?

Well, I'd certainly like to think so. You see a stock like Titagarh Rail Systems is now trading at almost 10x its book value.

To give you some context, FMCG giant Hindustan Unilever Ltd (HUL) trades at a price to book value multiple of 12x.

So, for a capital-intensive stock like Titagarh Rail Systems to trade close to an asset light, world class franchise like HUL, is indeed big news.

Due to its asset light nature and strong moat, HUL has always commanded a huge premium over its book value. Its 3-year and 5-year median price to book value also stands at close to 12x.

This is not the case with Titagarh Rail Systems. Titagarh Railsystems 3-year and 5-year median price to book value multiples stand at a much lower 1.5x and 1x respectively. Hence, its current price to book value of 10x is at a huge premium to its historical multiples.

Now, I know what you are thinking: Titagarh Rail Systems is a high growth stock and HUL isn't.

Yes, HUL has become so big that it will be difficult for the company to grow more than the nominal GDP of India over the long term. Titagarh Railsystems on the other hand, is currently going through a very high growth phase where sky seems to be the limit.

Hence, given Titagarh's extremely bright prospects, its current high valuations are justified.

The problem with this assumption is that Titagarh cannot grow at very high growth rates through the cash it generates internally.

You see in FY23, Titagarh Rail Systems earned an return on equity (ROE) of 14%, its best in 10 years.

Now, the problem with this ROE is that everything else remaining the same, the company can grow its profits by a maximum of 14% the next year.

You see, growth requires additional investment by way of fixed assets and working capital. Hence, the maximum the company can invest in growth is Rs 14 that it has earned on an equity base of Rs 100. And this investment can only lead to a growth of 14% in profits and not more.

Thus, even if it wants to, the profits cannot grow by more than 14% without resorting to external borrowing and improving capital efficiency.

Now, contrast this with HUL which has an average 10-year ROE of close to 40%. This is almost 3 times better than Titagarh Rail Systems. It allows the company to grow by as much as 40% if it wants to.

You see, Titagarh can also grow by 40% if it manages to improve its ROE from 14% to 40%. But this looks highly improbable given the capital-intensive nature of the business and the demands on working capital.

Therefore, if Titagarh has to grow at a higher rate, it will have to either dilute its equity to raise more money or borrow money in the form of debt. The first option will reduce its future EPS while the second option will reduce profits because of higher interest outgo.

Hence, the nature of Titagarh's business is such that it cannot grow at very high rates without raising money from outside. This can pose its own challenges going forward.

We believe this is the main reason why Titagarh Rail Systems has got a lower valuation multiple in the past and HUL much higher. Titagarh Rail Systems had both growth as well as return on equity challenges historically.

And while the growth visibility has improved dramatically, unless there are clear signs that return on equity is also inching significantly higher, the high growth may come at significant costs.

Let us assume an investor invests in Titagarh Rail Systems at the current price and hopes to at least double his money over the next 3-4 years. Let us also assume the ideal price to book value the stock deserves is 2.5x. This is twice of what it has commanded in the past.

What this means is that based on our assumptions, the company will have to grow its book value by a whopping 8x over the next 3-4 years for the stock to double.

We know that the company has a fantastic growth runway ahead of it. But still, growing book value by 8x over the next 3-4 years is not be easy at all. Hence, investors investing in the stock at the current price levels may not have the risk-reward equation in their favour.

Of course, it will be a different story altogether if the company also manages to improve its ROE significantly along with the high growth that's expected. But if that does not materialise, the valuation parity it currently enjoys with HUL can come crashing down. So, do take that into account.

Happy Investing.