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In have started a Business Valuation Education Video Series in which, I will explain Valuation concepts by valuing an Indian Healthcare Provider – Kovai Medical Center Hospital – as an example. I will value companies in other sectors (e.g., insurance, banks, asset management companies, industrial, fmcg, retail etc.) after finishing healthcare.
This video series is meant for students / working professionals intending to build a career in / pivot to Finance particularly Valuation or Equity Research.
Estimating Discount Rate – Risk Free Rate, Equity Risk Premium, Beta and Cost of Equity
Implied Intrinsic Enterprise Value
Sensitivity Analysis
Free Cash Flow to Firm (FCFF)
Estimating Discount Rate – Cost of Debt and WACC
Implied Instrinsic Market Value of Equity
Sensitivity Analysis
FCFE vs FCFF
Relative Pricing
If you are really serious about learning Valuation or Equity Research, please pick this company – Kovai Medical Center Hospital – and value this company along with me – this is the best way to learn! I’d be happy to share all the spreadsheets (without the projections). Start from the first video of this playlist.
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As I have understood, there are two packaging types – rigid and flexible. In rigid packaging, there are broadly two methods to make packaging – Thermoforming and Injection Molding. In thermoforming, plastic rigid sheets are subjected to heat for molding into a desired shape. IM on the other hand, converts plastic pellets into molten material, which is then injected into a mold. Thermoformed packaging is thinner than injection molded and as such both methods have different applications.
Rajshree Polypack (RPPL) is a microcap company that was started as a partnership firm in 2003 and then incorporated as a pvt ltd in 2011. The company makes plastic rigid sheets and thermoformed packaging for food and beverage industry. Plastic rigid sheets are both sold directly to end-customers and are used in captive production of packaging goods. The company has been steadily increasing capacity of both extrusion (for making rigid sheets) and thermoforming.
In FY23, they got into making IM packaging through a toll manufacturing agreement (i.e., Rajshree supplies the raw materials and pays a fee to access the contractorโs manufacturing capabilities). As of now, the mfg capacity is 1,000 MT.
They have entered into a JV – Olive Pack – to make coated paper cups, glasses etc. The capacity will be 12,000 MT. This will get operational in FY25.
Moat
RPPL has a good list of marque F&B customers that have a stringent quality, timely delivery and turn-around-time criteria for packaging. It is not easy to become an approved supplier to such customers. In a very competitive and fragmented industry, this is perhaps RPPL’s biggest and only moat.
What is stopping me from developing 100% conviction just yet?
RPPL is trading at a market cap of INR 230 Cr (as of 20/12/24). 10 years ago in FY14, Mold-Tek Packaging – which makes Injection Molded packaging for paint, lube and F&B companies – had very similar sales (250 cr) and margin (12-13% EBITDA) as RPPL has today. But, Mold-Tek sweated their assets better and made Rs 3 for every Rs. of assets, whereas RPPL, which has a asset turnover of 2 currently. However, Mold-Tek had a higher D/E of 1.3-1.4 vs RPPL 0.7 currently.
During FY14, Mold-Tek saw its market cap become 5-6x from 50 cr to 250-300 Cr, which is at a shouting distance from what RPPL is trading at today. Mold-Tek then went onto post great results year after year. Although, initially they used a lot of debt to drive growth, but very quickly they pared it down to comfortable levels and used internal accruals to increases sales 3x (from FY14; 4x from FY13) to 730 Cr, expanded cumulative EBITDA margin to 17.5% with a weighted avg asset turnover of 2.3. The company now has a market cap of ~3,000 Cr i.e., 10x after its peak valuation of 300 cr in FY14.
The question is can RPPL replicate Mold-Tek’s growth? I do understand that comparison with Mold-Tek may be unfair since it draws 70% of its sales from paint, lube and oil customers; I am attempting to dig out what worked for Mold-Tek and how is RPPL placed currently.
So, now coming to why I don’t have full conviction just as yet?
RPPL supplies to F&B industry only. Thermoformed packaging is thinner vs IM and hence is used in holding lighter content i.e., packaged food. IM packages, on the other hand, find application in a wide variety of industries – paints, lubricants, oils besides F&B. (Back in FY14, Mold-Tek drew 90%+ sales from paint and lube industry and how the split between paints, lubes: food, fmcg is 70:30. Being able to supply do multiple industries seem to have worked well for Mold-Tek). Moreover, thermoformed packaging cannot cater to heavier food content such as ice creams, shrikhand, spreads, dosa batter etc. Not saying thermoforming is inferior. It certainly is not. It finds its end use in different applications, which has limited RPPL to one industry. Make no mistake, F&B industry has great growth potential, but I would have been more confident about RPPL’s prospects if they didn’t stay confined to just F&B.
No in-house Injection Molding yet. RPPL recently forayed into IM through a toll mfg agreement for food delivery containers. Since RPPL does not own the IM mfg tech, they likely wouldn’t be able to tech innovate (as Mold-Tek has been able to) and sign up existing and new marque customers for IM containers. Mold-Tek designs, maintains and manufactures their own molds (they also use robots for in-mold printing and decorating), which has given them an edge over competitors and has also helped them get exclusivity contracts with certain lube customers. Large customers are very picky when it comes to packaging since it is the face of their brand and hence they may not source from a company that does not own the mfg process. This may change in the future if and when RPPL begins investing in its own IM capability (and this may also help them foray into other industries).
Capital allocation decisions! Value proposition in developing paper packaging? Will it lead to a moated business model? I am not so convinced. Although, this will likely give them good sales uptick serving HoReCa, but then how does it help in building a sustainable competitive advantage? Paper packaging is a non-differentiated / commodity item (but then one might argue that plastic rigid sheets are as well). What stops HoReCa customers from switching to (and keeping) other vendors? I believe the differentiation may not entirely be in the product per se (but because they have a good clientele, they may be to upsell them this new product category). Moreover, this new mfg capability demands an investment of 100 Cr, of which RPPL is putting half. To put it in context, this 50 cr is 1/3rd of RPPL’s gross fixed assets. Allocating an amount equivalent to 1/3rd of your gross fixed assets in a capability with low competitive advantages may not have been the best thing to do in my opinion. I hope I am proved wrong!
Possibility of margin expansion? Over the last 5 years RPPL has witnessed its margin deteriorate (although, they have been able to more-or-less pass on RM price increases with a lag). This has been due to low operating leverage, high depreciation and interest cost. As op leverage plays out, they should see their margin expand. Mold-Tek expanded their cumulative EBITDA margin by 5% over the last 10 years because of widening gross margins, operating leverage and low levels of debt. Moreover, in-house IM mfg and automation has aided Mold-Tek keep in its margin expansion. Now, RPPL has in-house thermoforming, but since they don’t own the IM mfg, this may constrain RPPL’s ability to expand its margins to the extent Mold-Tek has been able to.
Promoter giving aggressive guidance?. There have been instances (although I am leaning towards not reading much into them for now) where the promoter has not entirely walked the talk e.g., promoter was confident on margin expansion in FY23, but that didn’t happen. They were also expecting the olive pack mfg plant to commence from Oct, Nov 2023, but that didn’t happen. Re: barrier packaging sale, promoter gave a guidance of 30 cr+ in FY24, however only 10 cr in H1 has happened. I like conservative promoters better.
Tube lamination business commenced, but was put on halt. The management seemed very ecstatic about this business at one point, but now they are saying it has been paused and will be looked into at a later point.
Statutory audit fees increased from 8 L in FY21 to 16 L in FY22 to 22 L in FY23. Sales and scale of operations also did increase from 16K MT to 26K MT in this period. Scale can be equated to more work for auditors. So this is fine for now. However, if the disproportionate increase in audit fees continues then it will be a red flag.
Strategic foreign investor gradually reducing their holding. Wifag Polytype Holding AG has been decreasing shareholding; 19.8% FY22 to 17.2% FY23 to 16.4% now. Moreover, Mr. Alain Edmond Berset (DIN: 07181896) resigned from the post as the nominee director of the Company (on behalf of Wifag Polytype Holding AG) w.e.f March 10, 2023.
Aging receivables. 8% of the receivables were aged in FY23 i.e., beyond 1 year. This number was 4% in FY21 and 2% in FY22. RPPL has credit terms of 60 days. Since RPPL adds a good number of customers every year. I am assuming not all of these are very known brands. Many of these may be small mom-n-pop F&B businesses. If these small businesses don’t do well, they may shut shop and just not honor their payments to RPPL.
Regulatory overhang. RPPL has stated that its products are of a much higher thickness than the ones which the government has sought to ban. Even if the regulations become aggressive, the end-companies wouldn’t stop selling their products. They will resort to alternatives such as bio-degradable packaging or thicker plastic. RPPL has also repeatedly stated that it has the capability to manufacture bio-degradable / sustainable products and they have the required certifications.
Despite having raised the above, one can’t overlook the fact that RPPL has a great set of F&B clients that can be sold more products in the future (but that will take some doing). Even with supplying the existing set of products to these existing clients, RPPL should continue growing. However, I’d like them cover a broader part of the value chain; they are doing it currently, but perhaps not in the way it has been done (by Mold-Tek).
Closing Thoughts and Valuation
It is interesting to note that as per my DCF (after projecting the three financial statements), for RPPL to almost justify its current valuation of Rs. 230 Cr, the company needs to demonstrate very similar growth, margin expansion and capital efficiency as Mold-Tek did over the last 10 years.
I am tempted to say that the market is pricing in the same high growth as Mold-Tek for RPPL, but that may not be entirely true. Right now, Indian micro and small cap scape seems to be in euphoria. People are playing the momentum game (I don’t know how to time the markets; I have a very long term investing horizon) so the market pricing currently does not seem rational. When the frenzy fades away and normalcy returns, and RPPL is available at sane valuations, then I may take a small stake subject to how some of the above points unfold in the future.
P.S: This is not a recommendation.
For any questions or comments, feel free to email me at gautamrastogi.investandrise@gmail.com or PM me on linkedin.
When you come across a growth story with powerful powerful (yes used the word twice!) tailwinds, you may be inclined to overpay for growth. But then you hit on too many red flags relating to quality of reported financials — then you pause, you think shall I leave it and go find another company or am I overthinking? This is great industry to be in! Perhaps the red flag is really amber or could even be green if I give this company a chance!
Putting this gyan aside, I’d try to be objective in my short notes about this company. Again, these notes are more like my personal journal that I am making public.
Company Business
Tinna Rubber is witnessing strong circular economy tailwinds. The company sources End-of-Life (EOL) tyres and recycles them to make Crumb Rubber, Crumb Rubber Modifier, Reclaim Rubber and Steel (by-product). They are the largest EOL tyre recyclers in India.
Timeline:
1998: Company claims to have pioneered CRMB (Crumb Rubber Modifier for Bitumen) or rubberized asphalt, which are used to in road construction.
2010: Claims to become largest producer of CRMB. Commissioned bitumen emulsion plant
2014: Commissioned reclaim rubber plant. Reclaim rubber is sold to companies making tyres, conveyer belts and mats.
2017: Started exporting
2020: Set up organized collection and safe disposal of waste tyres in tie-up with Bridgestone
2021: Expanded capacity of micronized rubber (ultra fine crumb rubber) and reclaim rubber. Set up subsidiary in Netherlands.
2023: Set up ops in Oman by buying a rubber crumbing plant.
Infrastructure Segment:
Crumb Rubber and Crumb Rubber Modifier are sold to road builders. Crumb Rubber Modified Bitumen (vs virgin bitumen) is said to increase the life of roads and also reduces GHG emissions. There is a lot of government push to use CRMB for building roads.
Crumb Rubber Modifier is also sold to refineries like IOC. Petrochemical refineries, when they refine crude oil, a byproduct for them is bitumen / asphalt. IOC produces bitumen and blend it with the crumb rubber modifier for selling to road contracting community directly. Other refineries produce their own CRMB. They source the raw material – Crumb Rubber – from companies like Tinna.
Industrial Segment:
Crumb Rubber (specifically fine crumb rubber) and Reclaim Rubber is sold to Tyre and conveyor belt makers.
With Extended Producer Responsibility going into effect, the onus is on tyre makers to be more responsible for recycling their produce and use a portion of recycled rubber (from EOL tyres) instead of all new rubber. This is not only acting a strong tailwind for recycled rubber consumption, but also finally catalyzing the process of setting up an infrastructure for the disposal and collection of EOL tyres in India.
Tinna rubber has struggled with sourcing EOL tyres in the domestic market (despite there being abundance of EOL tyres in India). They currently import 60% of their EOL tyre requirement. This should reduce overtime.
Tyre companies have a long 2-3 year approval process for recycled raw materials (actually, tyre makers have a multi-year approval cycle for everything and not just recycled raw materials). Tinna is doing business with all leading tyre manufacturers in India and has now been approved to supply to two international players as well.
Consumer Segment:
This is the smallest segment for Tinna and is witnessing the highest growth rate both owing to low base and industry tailwinds.
Points of Caution
While there are strong tailwinds for the business segments they operate in – there is government push on circular economy i.e., using recycled material for roads (infra) and EPR regulation for tyre makers, which is going to drive decadal demand for this company, but there are quite a few points of caution I noticed when I delved into their financials. I have listed the key ones below:
Contingent liabilities (these are liabilities for which a company does not need make provisions; they lead to earning erosion if they materialize in the future):
corporate guarantee to credit facility taken by related parties – subsidiary Tinna Trade and associate company TP Buildtech – worth 86 Cr in FY23, 48 Cr in FY22
disputed tax litigations of Rs 11.5 Cr
Curious accounting: a tax dispute of 5.6 Cr from FY14 was not debited from P&L in FY21 when the matter resolved, but was debited only from equity. A CA could comment if accounting allows such a treatment, but logically speaking if this were allowed then companies would look more profitable than they really are.
Non-core investments of Rs 24 Cr: Good thing is that company recognizes these as non-core and is looking to liquidate them — this red flag changes to green when this happens!
Investments into associate company: Tinna Rubber has invested 7.4 Cr (of which 2 Cr were done in FY23) in an associate company TP Infratech. The promoters say that this associate company is into construction materials and hence has synergies with their core business. Not a whole lot about the business operations of this associate company is known.
Receivables from associate company: The holding company i.e., Tinna Rubber has receivables worth 2 Cr in FY23 (6% of overall) and 5 Cr in FY22 (15% of overall) from the associate company.
Loans to and from related parties: Many such transactions. A key one worth mentioning — promoter Bhupinder Sekhri gave a loan of 1.2 Cr and 1.6 Cr in FY23 and FY22 resp. He recovered these amounts from the company in the same year after charging interest. This is fine. Investors can live with it. However, he took a loan of 2 Cr from the company in FY22. There is a receivable of 1.2 Cr in FY23 i.e., he is yet to pay this amount to the company. Moreover, this seems to be an interest free loan (At the same time, his compensation from increased from 1.2 Cr in FY22 to 2.4 Cr in FY23). Case of promoter treating company as their personal bank offering their desired interest rate?
Related party transactions contd: Many purchase from sale to related parties transactions. Moreover, overall receivables from related parties far exceed payables to related parties — negatively impacting the working capital.
Discrepancy in numbers:
I wasn’t able to reconcile the reported sale volume numbers across the quarterly investor presentations in FY22 and FY23. An analyst did ask about this to the management during a concall. I wasn’t able to understand management’s explanation. Nor do I think the analyst did (unless the analyst emailed the management later and got justification for the anomaly).
Moreover, the capacity expansion communicated via investor presentation from FY24-Q2 does not exactly match with the plan communicated via concall. Anyways, this is not necessarily a red flag. This is me knit picking!
Volatility in sales and profits up until FY20: Management’s explanation “That was the phase when our multiple customer base between the road sector and non-road sector had not stabilized is achieved now. Therefore, going forward I feel we have better visibility, better ability to adjust to any down cycle in a particular sector. So, we feel more confident now of our revenue projections and our profitability”
Valuation
The company has a market cap of ~INR 1,000 Cr at 39x TTM earnings as of 1/12/2023.
Management expects sales to reach 900 Cr in FY27 (from 300 Cr in FY23) on the back of tyre crushing capacity increasing from 80,000 MT in FY23 to 250,000 MT in FY27.
Taking management’s guidance as inputs to my DCF model – after projecting the 3 financial statements – I find the fair market cap to be ~600 Cr i.e., 23x TTM earnings. At a market cap of 1,000 Cr, I find Tinna Rubber excessively overpriced. Future growth seems to have been priced in given the strong industry tailwinds.
There is subjectivity in valuations. Below are my key assumptions:
Sales Growth: Tinna Rubber grows 3x to 900 Cr in Sales by FY27 (as per management’s commentary). With strong recycling tailwinds, the company adds a whooping 2,000 Cr to Sales by FY38 i.e., Sales grow almost 10x from current over 15 years.
Capacity Expansion: Tyre crushing capacity grows 3x to 250,000 MT by FY27 (as per management’s commentary). Capacity further expands to 600,000 MT by FY38 i.e., Capacity expands almost 8x from current over 15 years.
Debt: Company raises debt of ~30 Cr in FY24 (as per management’s commentary). As per my model, the company will need to raise additional debt of ~50 Cr by FY30 i.e., 80 Cr debt to fund expansion. Internal accruals won’t suffice until then. However, post FY31, the company will generate sufficient cash flows and will be able pare down debt.
Margin: With operating leverage and reduced interest costs, PAT margin increases almost to 10% in FY38 from 7.5% currently
Cost of Equity: 14% as my bare minimum return expectation
Summary
The above assumptions need to be true to justify a price of INR 600 Cr (i.e., 23x earnings) today. I believe my base case assumptions paint quite an optimistic story.
Let’s say that the company walks the talk (and my optimistic assumptions start being true), market exuberance gradually fades away (i.e., sanity returns) and the stock trades at its fair multiple of 23x 3-4 years out.
โIn the short run, the market is a voting machine but in the long run it is a weighing machine.โ โ Ben Graham.
As per FY27 projection, the company will do Sales and PAT of INR 900 Cr and ~80 Cr respectively. Assuming the company trades at 23x 3-4 years out, then the then market cap could increase to ~INR 1,800 Cr (from 1,000 Cr as of 1/12), which is 1.8x growth. While this is not a bad return at all. But, I wonder why should I put my capital in a this risky stock for slightly better returns vs the relatively low risk index.
Although, I like the strong strong tailwinds, but because there is good scope of improvement in earnings quality and corporate governance, and also because of ridiculously high valuations I’d give this company a pass.
I am yet to look into GRP and Elgi Rubber, which are trading at even higher P/E multiples.
PS: This is not a buy/sell recommendation.
I’d be fine enclosing my 3 financial statement linked valuation model of Tinna Rubber for anyone looking to learn valuation and equity research. Interesting things one would learn in this modeling exercise (besides the usual):
when (and how much) debt is needed to fund growth? i.e., when does the model indicate that internal accruals are not enough to fund growth?
how to project terminal cash flows when the company in question has generated uneven free cash flows owing to regular capital expansions?
Feel free to email me at gautamrastogi.investandrise@gmail.com or PM me on linkedin.
I came across CNC machines through a post in LinkedIn. Up until that time, I had never heard of CNC. CNC stands for Computer Numerical Control. CNC machines are software driven machine tools used in manufacturing plants for metal cutting. My wife, who has an automotive engineering background, explained to me the application of these tools in automobile plants (these tools find application in almost every industry and not just automobiles). She explained to me – I am over simplifying – that at one end these tools are as simple as just having one axis for making one cut or a hole at one time, and at the other end these tools are as complex as having multiple axis for making multiple cuts or holes at one time. Simple tools are also used for making multiple cuts, but they need manual intervention since after each cut, the metal needs to be fed to the CNC machine again (at a different angle perhaps) to make another cut / hole.
Market Size
As per Indian Machine Tool Manufacturers Association (IMTMA) Annual Report 2023, this is a INR 24,000 Cr market in India. More than 50% of the machine tools – by value – are imported. 75% of the market in India is of metal cutting. 25% of the market is in metal pressing, grinding, sheet metal technology like laser cutting and press pack etc. A bulk of this 25% market and some of the metal cutting market is imported.
In India, if manufacturing share in GDP is to increase to 21-22% (as per Morgan Stanley) from current 17% over a decade, then the machine tools market could cross INR 70,000 Cr from 24,000 Cr in 2023. Assuming Make in India impetus drives import substitution down to 40%, the market for Indian players could cross 40,000 Cr (over the next decade) from 12,000 Cr today – this is 3.5x growth in 10 years.
Company Profile
Established in 2003, Macpower CNC Machines Limited is engaged in the manufacture of Computerized Numerically Controlled (CNC) machines. It has a CNC Machine manufacturing unit in an area of around 8 acres at Metoda G.I.D.C., Rajkot, Gujarat (India). The company listed (IPO) in 2018. Proceeds of the issue were used to help the company backward integrate into the manufacture of Machining components and enhance production capacity. They supply their products to automobile, defense, general engineering and other industries.
Competition
6 prominent players in India – Lakshmi Machine Works (listed), Bharat Fritz Werner, Ace Designers, Lokesh Machines (listed), Jyoti CNC and Macpower CNC. These are present in the 75% metal cutting market.
Market Share
Macpower (~INR 200 Cr sales in FY23) has a market share of 1.6% by value. Lakshmi Machine Works (~INR 1,000 Cr sales in machine tools in FY23) and Ace Designer have the largest share. Until recently, Macpower drew its market share primarily from simple or low-end machines (with an average selling price of INR 20L per machine), they are now striving to establish a stronger foothold in high-end or high value machines (Larger players have an average selling price per machine of ~INR 30L). To achieve this, they have increased their service and sales force across the country.
Things I like about Macpower
Conservative Management: Promoters follow a model of gradual growth and remaining debt free, with a focus on the margin. Macpower has an operating cost (or in-direct cost) of 20% vs peers 25%. Among the peers, Lakshmi Motor Works is also debt free, but has higher operating costs of 25%.
Receivable Management: Macpower has a sharp focus on receivables. Their average receivable is 20 days. All peers have higher receivables. The company takes advances against the orders they receive and dispatches the goods only after they receive full payments – specifically for non-government i.e., private orders.
Focus on selling high value products: Macpower has set up service and sales force across the length and breath of the country – inline with large players – to help increase their sale of high value products.
Industry Tailwind: There is a lot of focus on manufacturing in India and offering companies an alternative to China. Manufacturing companies need machines and machine tools are central to machines. Right now, the number of CNC machines that India makes in a year is equivalent to the number that China consumes in a month.
What needs improvement?
Backward Integration: COGS (or direct cost) at Macpower is higher at 70% vs peers at ~65%. Macpower is focusing on backward integration to drive their COGS down. As per promoters, in this industry, one can’t make more than 60-65% of raw materials or backward components in-house. Macpower makes 35% in-house and imports the remaining.
Because there is scope for backward integration, an investor would notice that the company typically keeps a lot of raw material and semi-finished goods inventory. They have ~190 days or ~6 months of overall inventory outstanding. Large player Lakshmi Motor Works on the other hand has faster inventory turns.
Macpower is deploying CapEx to make backward components like Turrets and others to reduce imports and consequently reduce COGS. Moreover, foundry is a large part of COGS, which Macpower currently does not do. Many of their peers have their own foundry, as a result of which their COGS is lower. Macpower promoters have indicated that setting up their own foundry and casting will help drive their costs lower (however, they have not indicated when).
Points of Caution
Related Party Transactions: Although, promoters in the past have waived their right to receive dividends signaling a minority shareholder friendly management, but they do make purchases from related parties. Purchases from related parties were worth 24L in FY23, 49L in FY22, 16L in FY21, 6L in FY20. It would be good to see these purchase going down overtime. Moreover, there was a delay in filing related party transactions in FY23 resulting in a fine.
Miscellaneous Expenses: They reported high miscellaneous expenses of 3.2 Cr in FY23 and 2.4 Cr in FY22. Shareholders will benefit if the company itemizes or explains these expenses. These expenses are under 1.5% of sales, but substantial relative to PAT
Investing (rather I should say long-term investing; and certainly not trading) in small cap companies is all about betting on their promoters. Once you have established that the promoters are not treating the company as their ATM, then placing your bet mostly hinges on the promoter’s vision and their ability to execute that vision. Of course, you want to buy stake at the right price and you want the company to be in a growing market!.
Valuation
Since the time I started looking into this company, the market cap increased from under INR 500 Cr to ~INR 600 Cr. , which is 40x earnings. As per my DCF valuation – after projecting the 3 financial statements – I find the fair market value of this company to be around INR 450 Cr, which is 30x earnings. Lakhsmi Machine Works is trading at ~34x earnings.
Valuations are subjective. I have taken the following assumptions to project out cash flows and value Macpower:
Growth: Driven by gradual capacity expansions and 75-90% capacity utilization (inline with history), Macpower doubles it market share to 3.3% over the next 10 years resulting in sales increasing 7x to INR 1,400 Cr.
Capacity Expansion: From 1,500 machines to 2,000 machines by FY25 (per management commentary) and 6,000 machines (assumption) by FY33. I have factored in the cost of land requirement (45,000 sq foot of land requirement per 500 machines – as per management) to expand beyond 2,000 machines.
Margin: Gross margin increases to 31% from 29.8% today due to backward integration. I will give them a higher gross margin if and when they get their own foundry. Economies of scale benefit resulting in indirect expenses reducing from 19.6% to 16% over 10 years.
Cost of Equity: Discount rate of 14% as my bare min return expectation.
Summary
The above assumptions needs to be true to justify a price of INR 450 Cr (i.e., 30x earnings) today. As per my FY28 projection, the company will do Sales and PAT of INR 550 Cr and ~70 Cr respectively. Assuming the company trades at 30x 5 years out, then the then market cap could increase to ~INR 2100 Cr (from 600 Cr as of 24/11), which is 3.5x growth in 5 years i.e., 28% CAGR.
I am keen to participate in the machine tool growth story, however I am being resistant to FOMO and will not take a position in Macpower until the company is available at a significant discount.
OCCL makes Insoluble Sulphur, which is used as a vulcanizer in the manufacturing of tires. There are 4 companies – Eastman / Flexsys (US), Shikoku (Japan), Chinese Sunsine and OCCL – that make a major chunk of the IS in the world. High capital intensity and long IS approval cycles by tire manufacturers has posed high barriers to entry making this industry an oligopoly.
Market: As of FY23, the global market size of IS is under 3,00,000 MT (or 300 million kgs). A bulk of the demand is driven by replacement (~70%) and the rest through new tires. The table below shows the global demand distribution.
India (non mentioned explicitly in the above table) has a market size of 20,000 MT i.e., ~7% of global. Only 50% of Chinese demand is quality IS. Since OCCL is into making various grades of quality IS, hence, the addressable market as of FY23 is closer to 2,50,000 MT.
The table below lists the global tire production and avg IS requirement per tire. You would see that the avg IS requirement per tire is 120 grams. Take these numbers with a pinch of salt, since I wasn’t able to reconcile tire production numbers from other sources, but they are in a distant ballpark.
Indian market is expected grow in double digits over the next 10 years driven by increasing radialization of tires and shift towards EV. EVs require lighter tires, which in turn demand more IS. Global market is expected to grow at 3% CAGR over the decade.
Market Share: Eastman has 60-70% global market share and is a price setter and other companies are price takers. OCCL has 55-60% market share in India, and a market share of under 10% globally. Tire makers like to work with more than one supplier and hence OCCL is either a preferred or secondary supplier to leading players like MRF, Brigdestone, CEAT, JK Tire etc. OCCL has sub 5% market share in the US. Over the past few earning calls, OCCL management has said that they are targeting to get to 10-12% market share in the US and it is a key focus area for them. They couldnโt penetrate the Chinese market and are not focusing on that market anymore.
Business: Over the last 3 years, the industry has witnessed high raw material (sulfur) costs. Although, like other players OCCL is able to pass the increase in raw material costs to its customers with a lag, resulting in OCCL able to largely sustain the absolute gross profit per kg of sold IS, but this does not help sustain gross and operating margins. Due to high sulphur prices, the IS ASP / kg for OCCL increased from Rs 125 in FY22 to Rs 150-160 in FY23 per my estimates, but the gross and operating margin remained depressed at 60% and 15% respectively. On a good year, their gross and operating margins are 70% and 25%.
OCCL has a total IS capacity of 39,500 MT. Every 3-4 years, they do an IS capacity expansion of 11,000 MT in two phases if they have reached 85-90% of capacity utilization and if they see a healthy demand environment (They also manufacture Sulfuric Acid and use the steam produced in the process to make IS. Sulfuric Acid makes under 10% of their sales). Making IS is capital intensive and while ramping up capacity, it takes a while to reach optimal utilization.
Moat: the oligopolistic nature of the industry, high entry barriers, and tire radialization and EV tailwinds, coupled with regular expansions and low cost manufacturing (vis-ร -vis US and Japanese makers) are moats for OCCL.
Few things to note before considering an investment:
High Freight Expenses: Other expenses were 102 cr and 135 cr in FY21 and FY22 respectively. Freight was 25% and 31% of other expenses in these years. Due to supply chain congestion around the world and since all the markets have presence of IS suppliers on their shores, OCCL incurred high expenses shipping to export markets. This dilutes OCCL’s moat of being a low cost player.
High expansion spending? May be not!: Phase 1 of a brown field expansion costs OCCL Rs. 200-220 per kg, whereas China Sunshine incurs 50% less than OCCL to build phase 1 IS capacity. Reasons could be a.) OCCL is spending more than they should Or b.) As per my estimates, OCCL sold IS at Rs 125 per kg in FY21 and FY22, but China Sunshine sold IS at Rs 90 in the same time periods. This suggests that China Sunshine perhaps makes an inferior quality and hence it costs them less to set capacity for IS.
Threat from Chinese competitors: While there is always a lingering threat from China, but as per ICRA credit report from Augโ22, Chinese companies lack the required Environmental, Health and Safety standards and because of their inconsistent quality, global tire manufactures are wary of sourcing from them.
Sale of Eastmanโs tire additive business to PE: This transaction happened in 2021. It remains to be seen what the new management does. If they expand aggressively then it will adversely impact IS prices.
De merger into two listed entities: Oflate, OCCL has done a lot of AIF investments, which has not gone well with the shareholders. They are now splitting into two companies – one will be the chemical business and the other will be focused on such investments. Existing shareholders will get shares of both the companies.
OCCL Promoters – Compensation: The promoters Arvind Goenka and his son Akshat Goenka have demonstrated good execution, resulting in increasing capacity from 3,400 MT in 1994 to 39,500 MT today and achieving a dominant market position. Overall compensation of the two promoters combined has been historically at 6.5% of PAT. Since, the PAT declined (from 83 cr in FY21 to 46 cr in FY22) by 44% in FY22, the commission portion โ tied to profits โ declined as well (from 2.2 cr to 1.7 cr i.e., 23% decline), but the salary component increased (from 3.1 cr to 3.3 cr) to offset the decline in commissions. As a result, due to sharp PAT decline, the sticky overall compensation jumped to 10.9% of PAT in FY22 (still within the statutory limit). For now, I think this is fine and am not making anything of it, but it needs to be tracked.
Unexplained Payments of service charges, rent to related parties and miscellaneous expenses: There are unexplained services charges of 1.26 cr in FY22 (and 1.07 cr in FY21) to Duncan International (India) and New India Investment Corp, which are promoter entities. There is an additional annual service charge of 1.08 cr, which is embedded in the highlighted line item below. I am not sure what these charges are for. There is a rent payment of 0.83 cr in FY22 to a Cosmopolitan Investments Ltd, another promoter entity. While rent can be understandable, but these service charges make up 1.7% and 2.1% of other expenses (and 0.6% of sales) in FY22 and FY21. There are unexplained miscellaneous expenses of 8.16 cr in FY22 and 6.68 cr in FY21. These make up 6.0% and 6.5% of other expenses (and 1.8% and 2.0% of Sales) in FY22 and FY21, respectively. They could itemize this and provide some detail. Service charges and Miscellaneous expense combined form 8-9% of the Other Expenses and 2.5% of Sales. This is the main gripe I have – unexplained expenses! This is up to investors as to how they want to read this.
Valuation: OCCL is trading 16x earnings and 1.3x book at a market cap of ~780 Cr as of this writing (1/7/2023). My DCF valuation (after projecting the three financial statements) finds OCC to be fairly valued.
Valuations are subjective. I have taken many assumptions to project out cash flows for OCCL. Some of the key ones are as follows:
Discount rate of 14% as my bare min return expectation
Operating Margin of 20% which is their historical average.
Implied 10 year CAGR growth of 6.5% after assuming a market share decline from 55-60% to 50% in India, a global market share of under 10% and only a slight increase in realization per kg of IS over 10 years. Any radialization and EV tailwind is my (unquantified) margin of safety.
2×11,000 MT capacity expansions in two phases resulting in an overall capacity of 61,500 MT over 10 years. This is consistent with history.
While I need to get clarity on the unexplained expense line items (particularly the service charges to promoter entities), I am leaning towards taking an educated bet given their business moats. But Iโd sit on the fence for a while and will likely pull the trigger when it is available at a discount.
In my quest to find honest, well run and moated undervalued securities, I chanced upon the Cotton Textiles sector. I quickly realized that most of the companies (more specifically companies that spin cotton yarn and make fabrics) in this sector are trading at high single digit / low double digit PE due to commodity nature of the business.
The companies differentiating themselves in this sector see their valuation multiples expand. Companies that have commanded a premium overtime are those that have vertically integrated e.g., KPR Mills (not analyzed as of this writing), which makes apparel (including branded apparel starting 2019) from most of their own yarn and fabric.
In this sector, I looked at Ambika Cotton (disc: I have taken a small position in Ambika) and Vardhman Textiles. This writing is on Vardhman. Usually, I love getting to the point of valuing companies after I have analyzed their business and evaluated their management, but in this case I couldn’t move over to valuation. Reasons are presented below.
Business
Textile Value Chain: Spinning -> Fabric making -> Apparel making -> Apparel branding
VTL is into the spinning commodity cotton yarn (63% of FY22 sales) and fabric making (31% of FY22 sales; more or less at this level since the last 5 years) business.
In FY22, most of the spinners across the world did well and in FY23, the spinners saw their sales and margin drop due to falling demand and very high cotton prices.
Spinners like VTL are very sensitive to raw material prices and are easily replaceable (although, with increase in cotton prices the yarn prices also increase worldwide, but when Indian cotton prices are higher (than world cotton), then it puts Indian spinners in a disadvantage since Indian spinners alone will not be in a position to increase the yarn prices commensurately in the world market — this results into the business shifting outside India to countries like Vietnam). The sensitivity to raw material reduces as you move up the value chain. Spinners diversify either by producing specialty yarn, which is less sensitive to raw material (e.g., Ambika Cotton) and/or moving up the value chain (e.g., KPR Mills)
Note – American, Brazilian and Australian cotton sells typically at a $0.15 premium to NY futures and Indian cotton has a lower premium of $0.5. Although, length, touch, feel of Indian cotton is comparable (or even better) than others, but Indian cotton is contaminated because it is manually pit. Owing to this contamination, Indian cotton typically sells at a discount. However,in FY23 (and now in FY24), the Indian cotton prices are trading at par with American and that of other countries.In turn, Vietnamese yarn sells at a premium since they use American cotton. Since Indian cotton prices are high in FY23 (and now in FY24), Indian spinners are not making margins.
a. Continued focus on the commodity game
VTL has ~12 lakh spindles, which is 2% of India’s spindle Capacity (6 cr spindles). Each spindle produces ~200 kg of yarn annually. VTL plans to add 10% (i.e., 2.5 lakh spindles) of the industry’s incremental capacity addition (25 lakh spindles) over the next 3 years. While this appears as playing a commodity game, which is true, the good thing is that they use 25% of their own yarn for fabric making.
Per FY23-Q2 con call, VTL does not seem to have any plans to expand on cotton fabric (and garmenting), where in they use their own produced cotton yarn (and fabric). This is despite expressing cotton spindle expansion plans. Hence, it seems they will continue to play the commodity game without doubling down on the cotton fabrics. They do intend to expand into the synthetic fabric side, but synthetic fabric raw material is petroleum based, which means they will have to depend upon other (synthetic) yarn producers for synthetic/blended fabrics. They make only 1% of sales from garmenting, which is an area they have not expanded yet.
b. Not so much focus on captive energy i.e., operational efficiencies from existing business
VTL’s energy expense as % of sales is 8-9%, which is 2x that of Ambika Cotton, a company that produces all the power it consumes. VTL plans to add 10% (of 2.5 lakh spindles) of the industry’s incremental capacity addition (25 lakh spindles) over the next 3 years, and has not communicated on running more efficiently via captive energy consumption.
Management
a. High Incentives
Promoter commission higher than the set limit: CMD, Mr S P Oswal received 42.44 cr in commissions in 2022. This is 2.74% of the Net Profit. However, per resolution dated 27th September, 2018, he can receive a commission “equal to 2% of net profit calculated as per Section 198 of the Companies Act, 2013 subject to total remuneration being within the limits as prescribed in Part-II of Schedule-V to the Companies Act, 2013“.
Sticky performance incentives despite falling PAT: Per the annual report, for the JMDs Mrs. Suchita Jain (daughter of promoter Mr. SP Oswal) and Mr. Neeraj Jain (not related to the promoters), their “Performance Linked Incentives are decided by the Nomination & Remuneration Committee based on the profits calculated at the end of Financial Year. When PAT increased from 592 cr to 741 cr in 2019, their combined incentive increased from 1.28 cr to 1.62 cr. When PAT fell to 591 cr in 2020, their combined incentive fell very marginally to 1.59 cr and stayed at that level when PAT declined further to 427 cr in 2021.
Associate company promoter commission exceeds the set limit: Mr. Sachit Jain, who was with VTL until 2018, is the JMD of Vardhman Special Steels (VSSL), which is an associate company of VTL. He is also VTL promoter Mrs. Suchita Jain’s husband. Mr. Sachit Jain’s commission is based on the VSSL’s Return on Average Net Worth: “1.5% of the Net Profit of the Company if RoANW for that year is up to 15%. 3% of the Net Profit of the Company if RoANW for that year exceeds 15%”. However, I see that Mr. Sachit Jain was paid 6.4% of Net Profit as commission i.e., Rs. 5.56 cr. in excess commission over 2021 and 2022. Moreover, when incentives amplify on crossing a threshold, it motivates clever accounting.
b. Related Party Transactions
Subsidiary Vardhman Acrylics paid a dividend of 200 cr on a net profit of 15 cr, resulting in reducing its book equity from 318 cr to 132 cr. VTL owns 70% of this subsidiary and hence, received 140 cr of this dividend. In fact, over the last 10 years Vardhman Acrylics has paid a dividend of 305 cr on a FCF of 228 cr. The 140 cr constituted 73% of the 193 cr dividends of the holding company VTL in 2022. In prior years, this subsidiary has constituted 20-25% of VTL’s dividends, but in 2022, VTL made up for its low payout by drawing 140 cr from VA at the expense of VA’s book equity. Hence, shareholders of Vardhman Acrylics compensated those of its holding company VTL.
c. Unexplained Miscellaneous Expenses
There is no explanation given regarding the “other miscellaneous expenses”. These are not small numbers. For context, these are 40% and 20% of the 2021 and 2022 capex respectively.
Summary
I am out for now because VTL is a commodity business with low moat / competitive advantages. I will consider though when they move up the value chain from spinning commodity cotton yarn to not just fabric making but garmenting. This will make them less sensitive to cotton prices. Moreover, unexplained miscellaneous expenses, high promoter incentives, related party transactions does not tick my investment checklist either.
Hope this was informative. Please feel free to write to me if you have any questions
Disc: I have a small position in Ambika Cotton. I have no position in Vardhman Textiles and KPR Mills as of this writing.
Well, to each their own, but here are some metrics that one may want to consider looking
๐๐๐๐ ๐๐จ๐ฆ๐ฉ๐จ๐ฎ๐ง๐๐ข๐ง๐ : Long term stock price compounding for banks follow Bookย Value / Share compounding, which in turn depends on ๐๐๐ = ROA * Leverage ๐๐-๐๐ง๐ฏ๐๐ฌ๐ญ๐ฆ๐๐ง๐ญ๐ฌ (incl equity raises)
a. ๐๐๐ญ๐ฎ๐ซ๐ง ๐จ๐ง ๐๐ฌ๐ฌ๐๐ญ๐ฌ:(Net Interest Inc + Fees + Treasury Inc – Op Expense – Provision – Tx) / Assets NII is the interest earned on loans given – interest paid on deposits; Fee income is loan processing, credit card fees etc An ROA of 2% means that the lender makes Rs 2 on a loan of Rs 100 4 largest private banks have ROAs ranging 1.3-2.4%, while all PSBs are < 1%
b. ๐๐๐ฏ๐๐ซ๐๐ ๐: Assets / Equity PSB SBI has an equity of Rs 6 on assets of Rs 100, making it 17x leveraged, while HDFC and Kotak have equity of Rs 12.5 and Rs 20 on assets of Rs 100 BS of quality private are levered 5-9x equity, while large PSBs 13-17x
Lower the leverage the better. Why? When you have levered balance sheets, a small change in asset quality wipes out a big portion of your equity, leading to credit agency downgrade and stock falling. ROE supported by high ROA and low leverage reduces earning volatility Private banks 10 yr avg ROE has ranged 10-18% while PSBs have ranged -1-7%. With an improved cycle, SBI has reported a TTM ROE of 12%, but this has come on the back of 17x leverage
There have been several past instances where PSBs (and others) have reported high GNPAs. Even in F22, PSB GNPA is over 2x of private banks
With this understanding, I will summarize ๐ฐ๐ก๐ฒ ๐ซ๐๐ญ๐๐ข๐ฅ ๐ข๐ง๐ฏ๐๐ฌ๐ญ๐จ๐ซ๐ฌ ๐ง๐๐๐ ๐ง๐จ๐ญ ๐๐ ๐ฌ๐ฐ๐๐ฒ๐๐ ๐๐ฒ ๐ ๐๐๐ฌ ๐ข๐ง๐ฏ๐๐ฌ๐ญ๐ข๐ง๐ ๐ข๐ง ๐ฅ๐จ๐ฐ ๐/๐ ๐๐๐๐ฌ:
๐. ๐๐๐ ๐๐จ๐ฏ๐ญ ๐จ๐ฐ๐ง๐๐ซ๐ฌ๐ก๐ข๐ฉ: Interest of the majority shareholder are put first (nothing wrong), but interests of minority shareholders like me may not be the same as those of the govt ๐. ๐๐๐ซ๐ค๐๐ญ ๐ฌ๐ก๐๐ซ๐: Private lenders have gained share from 20 to 40% at the expense of PSB ๐. ๐๐ซ๐จ๐ฐ๐ญ๐ก: PSB loan growth 7%; Private growth 18% over F12-22. Current lending market size is 170 Lakh Cr. This market has more more than quadrupled every 10 yrs starting 1950 and the trend is expected to continue moving forward given the low credit penetration. Quality private lenders are expected to continue taking share away ๐. ๐๐ข๐ ๐ก ๐๐๐ฏ๐๐ซ๐๐ ๐: optically high ROEs for select PSBs (like SBI) supported by high leverage and not high ROAs. When asset quality issues surface again, high levered lenders would be the most impacted. On the other hand, quality lenders will be relatively unscathed ๐. ๐๐๐๐ ๐๐จ๐ฆ๐ฉ๐จ๐ฎ๐ง๐๐ข๐ง๐ : Over the last decade quality private lenders have compounded BV 10-20% on the back of ROA led med-high ROEs, while PSB -3-7%. Since stock prices follow BV, PSBs have delivered no/low returns over the last decade
I read a few Berkshire and Marcellus newsletters to deepen my understanding of non-life insurance. Below are the key factors that one should analyze. I have applied them to two listed private non-life Indian insurers: ICICI Lombard and Star Health
๐ญ. ๐๐น๐ผ๐ฎ๐ = investment assets accumulated over time Insurers receive premiums upfront and pay claims later. This leaves them holding money, which Buffet call “float”. Meanwhile, insurers get to invest this float (in turn called โinvestment assetsโ on the BS) to generate interest income IL: 40,000 Cr float; 21,000 Cr gross premium i.e. float accumulated is 2x premium SH: 12,000 Cr float, 12,000 Cr gross premium i.e. float 1x premium Moreover, over the last 5 years SH has partly relied on external capital to grow float
๐ฎ. ๐๐ผ๐๐ ๐ผ๐ณ ๐ณ๐น๐ผ๐ฎ๐ = underwriting loss/float If premiums exceed expenses and eventual claim payments, insurers register an underwriting profit i.e. they get paid to acquire float. Underwriting loss on the other hand is the cost of float. Quoting Buffet โan insurance business has value if its cost of float overtime is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for moneyโ Pre-COVID 5 year avg IL: 2%, SH -2% i.e. SH was paid 2% to acquire float. Since SH is almost exclusively into retail health, which has higher premiums leading to lower claims ratio (but higher expense than IL) resulting in overall higher UW profitability pre-COVID
๐ฏ. ๐ฅ๐ฒ๐๐๐ฟ๐ป ๐ผ๐ป ๐ณ๐น๐ผ๐ฎ๐ = investment yield – cost of float The underlying profit/loss adds to the investment income produced from the float Pre-COVID 5 year avg IL: 8.5%-2%=6.5%, SH: 7%-(-2%)=9% Negative cost of float has yielded better return on float for SH
๐ฐ. ๐๐ป๐๐ฒ๐๐๐บ๐ฒ๐ป๐ ๐๐ฒ๐๐ฒ๐ฟ๐ฎ๐ด๐ฒ = investment assets/book equity The investment assets or float generated per unit of equity is called leverage. Pre-COVID avg IL: 3.5x, SH: 2.2x. IL has been able to drive a higher leverage. Why?
๐ฑ. ๐ฅ๐ฒ๐๐๐ฟ๐ป ๐ผ๐ป ๐๐พ๐๐ถ๐๐ = posttax return on float * leverage Insurers with high ROE (>> COE) over extended periods of time generate a lot of shareholder value Pre-COVID avg IL: 17%(=6.5%*3.5* 1-tax%), SH: 15% Remember, expenses are upfront, claim payments come over a period. Since, IL has higher claims ratio, but lower expense ratio, it has done better in retaining float for longer resulting in higher leverage and in turn slightly better ROE
IL and SH are currently trading over 6, 7x BV resp. For valuing a non-life insurance firm, one needs to project the long-term outlook of all these factors. I have valued both of them. Valuation summary in another post.
Section 1:Understanding Health Insurance Business in India
The number of lives covered has increased from 22% of the population in FY15 to 40% (~55 Cr) in FY22. Government sponsored schemes (including RSBY Rashtriya Swasthya Bima Yojana) accounted for 68% of the total lives covered as of FY22; Group Business (i.e., employer provided coverage) 22% and Retail 10% (5.5 Cr lives).
Retail has over 40% MS by value i.e., 5.5 retail lives contribute over INR 30,000 Cr to the overall INR 73,000 Cr health insurance premium.
Health Insurance is provided by standalone health insurance (SAHI; Care, Niva Bupa, Star Health, etc.), multiline (ICICI Lombard, Bajaj Allianz, etc.) and public sector insurance companies (New India Assurance, National, etc.)
SAHI companies are retail focused; more than 50% of retail customer premium goes to them. SAHI companies derive 80% of their premium from Retail.
Retail Health insurance is an agent assisted product. Retail customers rely on agents, web aggregators and advisors like Ditto Insurance to guide them towards purchasing the right policy.
๐๐จ๐ฐ ๐ฉ๐๐ง๐๐ญ๐ซ๐๐ญ๐ข๐จ๐ง: As of FY22, only ~17% (from 10% in FY17) of India’s population outside of govt plans is penetrated with health insurance. There is certainly scope for more penetration.
๐๐ข๐ ๐ก ๐จ๐ฎ๐ญ-๐จ๐-๐ฉ๐จ๐๐ค๐๐ญ ๐๐ฑ๐ฉ๐๐ง๐ฌ๐๐ฌ: Over 60% of spends are out-of-pocket in India – highest in the developing countries.
๐๐ ๐๐ง๐ญ ๐๐ฌ๐ฌ๐ข๐ฌ๐ญ๐๐ ๐ฉ๐ซ๐จ๐๐ฎ๐๐ญ: Health insurance can be a complex product for customers to understand. As mentioned previously, agents guide customers to purchase policies suited to their needs. IRDAI norms allow individual agents to sell policies of three insurers โ one life insurance company, one non life insurer and one standalone health insurer. 75% of the total premium of retail business came from individual agents in FY20. There is high co-relation between growth in number of agents and individual health insurance premium. Insurers with a growing and productive network of agents stand to benefit.
๐๐ซ๐จ๐๐ข๐ญ๐๐๐ข๐ฅ๐ข๐ญ๐ฒ: Higher retail premiums (than public and group, which has corporate customers with high bargaining power) lead to higher profitability (pre-COVID Claims ratio: SAHI 59%; Multiline 67%; Public sector 92%). Lower the claims ratio the better.
All these are key reasons behind the enormous potential in this segment.
Section 2: Star Health is a health insurance leader in the retail business segment
Being a StandAlone Health Insurance (SAHI) company (others being Care, Niva Bupa, Aditya Birla HI etc), its singular focus on health insurance has led to new and innovative products (aided by IRDAIโs use and file regulation) aligned to specific health conditions.
SH clocked gross premiums of ~INR 11,500 Cr in FY22 (from 3,000 Cr in FY17). It has the ๐น๐ฎ๐ฟ๐ด๐ฒ๐๐ ๐บ๐ฎ๐ฟ๐ธ๐ฒ๐ ๐๐ต๐ฎ๐ฟ๐ฒ ๐ผ๐ณ ๐ฏ๐ฏ% ๐ถ๐ป ๐ฟ๐ฒ๐๐ฎ๐ถ๐น (3x higher than HDFCERGO and NIA; 4x higher than Care and Niva Bupa) and draws 90% of its premiums come from this segment (higher than any other company) The market share gains have come due to an enormous network of 13k+ hospitals, 5.5 lakh agents (3x higher than the closest SAHI) with the highest premium / agent of INR 180,000 in the industry.
But this growth has not come without some not-so-pleasant developments –
Claims: For customers getting their accepted and settled on-time is paramount. SH has one of the highest claim repudiation rate of ~14% i.e., 14% of claims over the last 4 years were rejected. Aditya Birla and Niva Bupa are in a close ballpark. In FY21, CARE Health closed ~100% of claims in one month followed closely by ICICI Lombard that settled 99.7% of claims made during this period within a month Among the SAHI players, SH had the last spot with 94.4% claims settlement in one month. Public companies have lagged in claims payments
Regulation: IRDAI has proposed to cap the tenure and age of MDs/CEOs of insurance firms at 15 and 70 years resp. SH CEO is past this cap.
Management Compensation: If you are a value investor, you would like overall comp to not exceed 2-5% of PAT and expect comp to increase with PAT. But credit needs to be given where it is due. The management has built a good business from the ground up and they have very adequately compensated and rewarded themselves with ESOPs, which is typical for a growth company.
SH is the only listed SAHI. It has a market cap of INR 43,000 Cr i.e., 9.5x book value and 3.7x FY22 premium. For some context, multiline insurer ICICI Lombard trades at 6.5x book value and 3.4x FY22 premium.
No matter how attractive a business is, one wants to get in at a reasonable price! So would you invest? What price will you be willing to pay?
“Bhav Bhagwan hai”
Rakesh Jhunjhunwala
Section 3: Bhav Bhagwan hai!
No matter how attractive a business is, one wants to get in at a reasonable price.
Like other insurers, SH has two profitability streams – underwriting profit and income from investments.
Underwriting profit/(loss) is defined as gross premium less 1. re-insurance, 2. risk reserve, 3. net incurred claims (claim ratio) and 4. net commissions and other operating expenses (expense ratio)
SH has been able to increase investment assets more than 5x from 2,000 Cr in FY18 to 11,000 Cr in FY22, which is 2.4x book equity. This is a key metric they track; higher this metric, higher is their interest income Going back five years pre-COVID, with a 7-8% yield, interest income from investments have been 2-6x UW profit pre-COVID” Only in FY19, Cash Flow from Operations was enough to fund their investments. Other years, they have relied on raising equity, debt and existing cash to fund investments – necessary to generate an interest income (and in turn supplement the UW income/loss)
Moving forward, assuming less reliance on external capital and existing cash (~INR 550 Cr), there is more reliance on CFO i.e., profitable growth to fund investments. In the absence of that there is a danger to maintain solvency (since losses causes a double whammy – they erode equity value and increase regulatory required solvency margin) and generate interest income. After two unprofitable years, FY23-Q1 seems to be on the way to recovery with a combined ratio (claims + expense ratio) of 98% from 118% in FY22
As of FY22, only 17% (~5.5 Cr retail and ~12 Cr group lives) of Indian population outside of govt plans is penetrated with health insurance policies SH has covered ~1.6 Cr of the 5.5 Cr retail lives. With increasing awareness, rising incomes, retail segment may very well more than double in a decade to 13-14 Cr as per industry estimates.
My key assumptions in valuing SH:
Growth: With growing hospital and agent network, SH covers 1/3rd retail lives (from ~30% today) in a decade. This translates to a premium CAGR of 15%
Profitability: Combined ratio improves to 96% in FY24 and owing to operating leverage continues to gradually improve to 94% over the decade
Hygiene: Profitable growth eliminates reliance on external cap and leads to a. maintenance of regulatory solvency margin and b. increase in investment assets (to 2x of networth; consistent with history), which in turn well supplements UW profit
With these assumptions, I valued SH at INR 27,000 Cr i.e., 5.7x book equity. As of 9/9, SH was trading at 9.5x book. As stated previously, for context, ICICIL is priced at 6.5x book (There is no listed SAHI player yet for a peer-to-peer comparison)
Clearly, at 9.5x book, the market is assuming a much higher growth – perhaps for both retail segment and SH market share – and/or profitability. This is my conclusion based upon my analysis and assumptions (stated above). If you are more optimistic than I am, then you may find SH to be reasonably (or even under) valued.
Does it mean, I will give SH a pass? For the moment, Yes!
Even if I get in at this the current price, in the long term I’d be okay, but I’d like to buy growth at a reasonable price (and I am not going to speculate on a target price). Remember, every normal year it is going to add earnings and may command a higher valuation.
What do you think?
PS: Not a Recommendation
EDIT: As of 14/03/2023, SH is trading at 6.9x book and ICICIL at 5.6x book. My fair valuations of SH and ICICL are largely the same at 5.5-5.7x and 5x book respectively. I will keep on waiting on the fence and take positions (if and) when they fall within my margin of safety
** I will be creating an equity research report for ABSL AMC. For now, I am sharing the summary of my analysis and valuation (long-term return expectations) of ABSL AMC **
** Analysis and Valuation dated 29/7/2022 **
2 months ago, I had put out an equity research report on HDFC AMC, in which I had valued the firm at 28x earnings. In this post, I will present my valuation summary of another AMC, Aditya Birla Sun Life
ABSL is the 5th largest AMC in India by overall AUM. HDFC is 2nd. SBI leads, followed by ICICI ABSL and HDFC AMC are the only two listed companies in the top 5
As of F23-Q1, ABSL has an overall and active equity AUM of ~โน3000B and ~โน1200B (i.e. 40% equity mix) with a market share of 8% and 6.5% resp, while HDFC has an overall and active equity AUM of ~โน4000B and โน2000B (i.e. 50% equity mix) with a market share of 11%
ABSL reported a PAT of 46% and EBTDA of 65%, well behind that of HDFC (PAT 57%, EBTDA 78%).
Why is ABSL less profitable than HDFC AMC? 1. Active equity is the most profitable asset class (do remember that pressure on equity yields continues owing to low priced NFOs and material gross flows), but HDFC’s higher mix of equity is a key but not the only reason for its higher profitability 2. Both ABSL and HDFC incurred ~200 Cr in other expenses โ BD, new fund offering, marketing and tech expense. This is 14% of ABSL and 8% of HDFCโs revenue 3. HDFC incurred 13% employee expense, ABSL 18% This industry has economies of scale. HDFC seems to be getting the scale benefit. It certainly is maintaining a tight ship.
ABSL IPOed last year in Oct. From a high of โน20,000 Cr, it has fallen to โน12,000 Cr. HDFC has not done well either. Market seems to have priced in the low present and future yields and the continual debt outflows with these listed players trading near their lows
Now, I will use some rounded numbers to derive the return expectation of ABSL โ 1. Ind active equity AUM is expected to grow to โน 40,000 B from โน 18,000 B today 2. ABSL AMC derives ~70% revenue from active equity. They reported a quar. avg. active equity AUM of ~โน1200 B. If they can slow the active equity market share decline to 5.5% by FY27 (from 6.5% today), they will reach an active equity AUM of โน 2,300 B (i.e., ABSL active equity continues to grow slower than ind) 3. ABSL derived an active equity yield of ~72 bp in FY22. With ongoing equity yield pressure, this may drop to mid-60s 4. ABSL revenue in FY27 = โน 2,300 B * 0.65% / 70% = ~โน 2,100Cr @ same 46% PAT in FY27 = 46% * ~2,100 = ~980 Cr 5. Using 1-4, mybase caseDCF valuation of the company is ~โน13,500 Cr i.e., 20x FY22 earnings
** valuation with underlying excel models and assumptions will be present in the equity research report **
Considering ABSL trades at this PE 5 years out: MCap by FY27 = 20 * 980 Cr = โน 19,600 Cr (from 12,200 Cr as of 29/7/2022); Adding 2.5% div yield (based on hist. payout), the ann. return over the next 5 years is est. at 13% (after accounting other income and using actuals) i.e., if ABSL AMC continues to grow below the industry amid a declining overall and equity yield environment coupled with higher interest rates, you could still expect 13% return over 5 years
Disclaimer: Invested. Please do your own analysis before investing.
There is an additional annual service charge of 1.08 cr, which is embedded in the highlighted line item below. 
I am not sure what these charges are for. There is a rent payment of 0.83 cr in FY22 to a Cosmopolitan Investments Ltd, another promoter entity. While rent can be understandable, but these service charges make up 1.7% and 2.1% of other expenses (and 0.6% of sales) in FY22 and FY21. 
There are unexplained miscellaneous expenses of 8.16 cr in FY22 and 6.68 cr in FY21. These make up 6.0% and 6.5% of other expenses (and 1.8% and 2.0% of Sales) in FY22 and FY21, respectively. They could itemize this and provide some detail. Service charges and Miscellaneous expense combined form 8-9% of the Other Expenses and 2.5% of Sales. This is the main gripe I have – unexplained expenses! This is up to investors as to how they want to read this. 
