Image credits: tirehub.com
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.
Source: expertmarketresearch.com, IMARC group, OCCL Annual Report
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.
PS: This is not a recommendation.