PI Industries - another look

I have been invested in PI Industries for many years now. The aspects which appealed to me first, continue to appeal to me even now. The company has, over the years, managed to strengthen its moat and scale greater heights. The way the company has scaled its CSM & CRAMS business along with strengthening domestic distribution has been exemplary. 

Recently, during the Valuepickr conference in Goa, I was thinking about if PI's business moat and whether it was widening or shrinking. So, I decided to see how they were placed and see if I can poke some holes in their story.



BEAR CASE

• Move from contract research to manufacturing will mean additional capex, reduced asset turns and lesser ROE
• Risks - i) GM seeds, ii) herbicide resistance in plants, iii) client concentration, iv) gene-edited seeds
• Contract research market is slowing due to:
• New molecules are more difficult to get
• 1st year sales have reduced drastically
• High cost of new development of new molecules
• Bio-tech is replacing agrochemical usage
• Bayer, PI's largest client, is forecasting poor agrochemical growth due to high inventory, farmer stress in Brazil and Europe, reduction in corn acreage in US
• Excel Crop has applied for manufacturing registration of (Bispyribac Sodium) Nominee Gold
• 33% of the products in PI’s portfolio is in-licensed and faces a risk of import restrictions
• Tax rates to go up substantially from 10% to 22-23%
• With Bayer's acquisition of Monsanto (if it gets completed), there may be some changes in the relationship with PI

BULL CASE

• $6bn is going off-patent in next 6 years
• Moving to Pharma CRAMS, a much larger market. Inducted a team from AstraZeneca over last 2 years. They have also inducted a Pharma veteran - Mr Balaganesh, ex-MD and Head of Research of AstraZeneca's anti bacterial research facility - on their board as Additional Independent Director. Several other senior level recruitments to drive Pharma CSM.
• Domestic market to grow substantially. 
• Imports made more stringent, hence more products to be made in India versus imported
• Recent tie-up with Kumiai Chemicals for producing Nominee Gold in India and also partner on other new molecules
• JV with Mitsui for providing registration services - pre-launch feasibility analysis, market research and feasibility analysis. Mitsui is a global major in performance materials, petro & basic chemicals and functional polymeric chemicals
• JV with BASF to produce 
• Pendimethalin - Global sales US$325m - directly competing with Rallis in India
• Saflufenacil - Global Sales US$180m
• Dimethenamid - Global sales US$145m
• Order book of $1 bn (June 2017) for 8-9 molecules
• Improving margins due to better product mix and operating leverage
• Jambusar facility capacity utilization is 65-60%, leaving a lot of room for operating leverage to kick in
• Global AgChem spending has been on a downswing and a recovery is supposed to pickup from 2018

From Bayer's presentation - Jun 2016

CONCLUSION:

PI seems to be consciously changing themselves with JVs & partnerships to launch newer service offerings and product launches in India. Having done very well during the time AgroChem producers have struggled globally, they are poised for better times in FY19. The near term (1 year) may still remain a struggle due to the industry headwinds and revenue growth may not be very strong. The business seems to be on a very strong wicket specially given that agriculture as a sector is likely to be very strong with increased global population and need for more efficient & abundant farm production.

Highlights from Book - Common Stocks and Common Sense - Edgar Wachenheim

Common Stocks and Common Sense by Edgar Wachenheim is a case-study based book on investing. In structure it is similar to Beating the Street by Peter Lynch. Edgar used to run Greenhaven Associates with an excellent long term track record. In the book, he goes through some of his picks, the rationale of why he bought them, his process of stock selection and the emotions that goes with investing. It is a good book dealing with real-life examples of a good value investor. 

Below are the key points I noted from the book.



The strategy is to try to purchase deeply undervalued securities of strong and growing companies that hopefully will appreciate sharply as the result of positive developments that already have not been largely discounted into the prices of the securities.

I do my best to make decisions that make sense given everything I know, and I do not worry about the outcomes.

When an investor is barraged with particularly bad or good news, he can reread the memos, notes, and models he wrote before the occurrence of the news. He then can ask himself three questions: What really has changed? How have the changes affected the value of the investments under consideration? Am I sure that my appraisal of the changes is rational and is not being overly influenced by the immediacy and the severity of the news?

When we purchase a stock, we are interested in what the company will be worth two or three years

I knew that my projections of IBM’s earnings and values were nothing more than best guesses based on incomplete information. However, having the projections to work with was better than not having any projections at all, and my experience is that a surprisingly large percentage of our earnings and valuation projections eventually are achieved, although often we are far off on the timing.

I greatly admire Warren Buffett. He is one of the great investors of all time. But I strongly disagree that the shares of most wonderful businesses can be held forever because most wonderful businesses become less wonderful over time—and many eventually run into difficulties.

My job would be a lot easier and much more relaxing if I could fill a portfolio with outstanding companies that I never would sell. But our ambitions lead us to seek shares that are temporarily deeply undervalued and then sell the shares when they become fully valued. This is an approach to investing that is less relaxing and that requires considerable effort and time, but that has worked for us.

I almost always start my analysis of a company by studying its balance sheet. It is said that a shareholder makes money off the income statement, but survives off the balance sheet, and I agree.

When studying a balance sheet, I look for signs of financial and accounting strengths. Debt-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and “hidden” assets and liabilities all are among common considerations, with their relative importance depending on the situation. If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise.

If a company’s balance sheet passes muster, I then try to get a handle on management. The competence, motivation, and character of management often are critical to the success or failure of a company. To form an opinion on management, I normally pay careful attention to the management’s general reputation, read what the management has said in the past, assess whether the management’s stated strategies and goals make sense, and analyze whether the management has been successful carrying out its strategies and meeting its goals.

However, I am humble about my abilities to accurately assess managements. Experience shows that investors can be unduly impressed by executives who are charismatic or who purposely say what investors want to hear—who play to their audience. Also, investors frequently will undeservedly credit management for a company’s favorable results and vice versa. Favorable or unfavorable results often are fortuitous or unfortuitous.

After trying to get a handle on a company’s balance sheet and management, we usually start studying the company’s business fundamentals. We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital.

Our models normally include earnings projections for the next two or three years. Our valuation is based on a multiple of projected earnings and cash flows.

In the stock market, it is best to be flexible and not be tied to conventions or rules.

My own policy is that no single stock should equal more than 12 percent of the total value of a portfolio and that no single industry should equal more than 25 percent of the total value. When measuring the percentages, I use the cost of the stock rather than its market price. That way, I am not forced to reduce the size of a position that appreciates faster than the portfolio as a whole.

Current fundamentals are based on known information. Future fundamentals are based on unknowns. Predicting the future from unknowns requires the efforts of thinking, assigning probabilities, and sticking ones neck out—all efforts that human beings too often prefer to avoid.

In the investment business, relatively unpredictable outlier developments sometimes can quickly derail otherwise attractive investments. It comes with the territory. So while we work hard to reduce the risks of large permanent loss, we cannot completely eliminate large risks. However, we can draw a line on how much risk we are willing to accept—a line that provides sufficient apparent protection and yet prevents us from being so risk averse that we turn down too many attractive opportunities. One should not invest with the precept that the next 100-year storm is around the corner.

I revise models frequently because my initial models rarely are close to being accurate. Usually, they are no better than directional. But they usually do lead me in the right direction, and, importantly, the process of constructing a model forces me to consider and weigh the central fundamentals of a company that will determine the company’s future value.

I strongly believe in Warren Buffett’s dictum that he never has an opinion on the stock market because, if he did, it would not be any good, and it might interfere with opinions that are good. I have monitored the short-term market predictions of many intelligent and knowledgeable investors and have found that they were correct about half the time. Thus, one would do just as well by flipping a coin.

In the end, the psychological rewards of being right can be as important as—or more important than the monetary rewards. And they are interrelated. When you feel good, you are more likely to do well.

But I believe that investors sometimes need to be open to new ideas that challenge previous convictions. In the investment business, as in life, one becomes disadvantaged if one develops tunnel vision.

Often, when I am in a quandary about whether to sell one of our holdings, I sell half or some other fraction that makes sense under the circumstances.

Occasionally, a black swan adverse event does derail one or more of our investments. When this happens, we must be ready to unemotionally rethink the economics of continuing to hold the investments—and, if necessary, sell.

When we are wrong or when fundamentals turn against us, we readily admit we are wrong and we reverse our course. We do not seek new theories that will justify our original decision. We do not let errors fester and consume our attention. We sell and move on.

Our central strategy is to purchase deeply undervalued securities of strong and growing companies that likely will appreciate sharply as the result of positive developments.

To successfully assess probabilities and make good investment decisions, an investor should hold considerable amounts of information about the companies and industries he is investing in. Having superior information (both quantity and quality) can give an investor a competitive edge. To obtain information, we spend a large percentage of our time researching the fundamentals of companies.

Pay more attention to what managements do than to what they say. Remember, managements, like most other people, tend to act in their self-interest.


Favor managements who are highly incentivized to achieve higher prices for their shares.

Learning from Security Analysis - Part 1

I have started re-reading Security Analysis, 6th edition, (also will add on things from the 5th ed). I have been putting it on the backburner for sometime, but since the last time I read this was about 14 years back, decided that I have changed too much not to re-read this once more. Hoping to learn a lot more the second time around.

From the preface to the 6th edition by Seth Klarman

Value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. For one thing, not all elements affecting value are captured in a company’s financial statements—inventories can grow obsolete and receivables uncollectable; liabilities are sometimes unrecorded and property values over - or understated. Second, valuation is an art, not a science. Because the value of a business depends on numerous variables, it can typically be assessed only within a range. Third, the outcomes of all investments depend to some extent on the future, which cannot be predicted with certainty; for this reason, even some carefully analyzed investments fail to achieve profitable outcomes.

It is not enough just to number crunch. A business participates in a complex adaptive system, which is continuously in a flux. We need to be able to understand businesses and their operating environments; political, economic and social environments are also important to be understood.

While bargains still occasionally hide in plain sight, securities today are most likely to become mispriced when they are either accidentally overlooked or deliberately avoided. 

Before buying, it is important to ask the question, why is this cheap?

When bargains are scarce, value investors must be patient; compromising standards is a slippery slope to disaster. New opportunities will emerge, even if we don’t know when or where. In the absence of compelling opportunity, holding at least a portion of one’s portfolio in cash equivalents (for example, U.S. Treasury bills) awaiting future deployment will sometimes be the most sensible option. -- This is a difficult thing to do emotionally, especially in a rising market.

Like Klarman says, this is a very very difficult thing to practice. In a rising market, most value investors get out too early, which in itself is not a bad thing, but tests ones patience and fortitude immensely, to see ones friends keep making money when one is out of the market, sitting on cash.

Even in an expensive market, value investors must keep analyzing securities and assessing businesses, gaining knowledge and experience that will be useful in the future. 

Keep sharpening your saw or as Peter Lynch has said, keep turning over as many rocks as possible. I think it is important to study business in a pattern to get the most benefit. I like to look at a particular industry and multiple stocks within it.

Selling is more difficult because it involves securities that are closer to fully priced. As with buying, investors need a discipline for selling. **First, sell targets, once set, should be regularly adjusted to reflect all currently available information.** Second, individual investors must consider tax consequences. Third, whether or not an investor is fully invested may influence the urgency of raising cash from a stockholding as it approaches full valuation. The availability of better bargains might also make one a more eager seller. Finally, value investors should completely exit a security by the time it reaches full value; owning overvalued securities is the realm of speculators. 

For stocks which are compounding machines, we need to keep updating the intrinsic value, so that we do not get out of them too early. On the other hand, a sense of what a stock is worth is a must at all times for all stocks in one's portfolio.

Aarti Industries - Good Chemistry

Business Overview
• Aarti Industries (AIL) has 3 divisions –
    o Specialty chemicals - Polymer & additives, Agrochemicals & intermediates, Dyes, Pigments, Paints & Printing Inks, Pharma Intermediates, Fuel Additives, Rubber chemicals, Resins, Fertilizer & Nutrients
    o Pharmaceuticals – APIs, Intermediates for Innovators & Generic Companies
    o Home & Personal Care - Non-ionic Surfactants, Concentrates for shampoo, hand wash & dishwash
• One of the leading supplier to global manufacturers of Dyes, Pigments, Agrochemicals, Pharmaceuticals & rubber chemicals.
• Manufacturing units (16):
    o Specialty chemicals - 10
    o APIs - 4
    o home & personal care chemicals – 2

Specialty Chemicals
• Largest nitro-chlorobenzene producer of India with a capacity of 60,000 TPA
• Amongst the largest producers of Benzene based basic and intermediate chemicals in India
• Lowest cost producer of Benzene in the world
• Exports account for 51% of specialty chemicals division with 90% of exports USD denominated
• Offers 100+ products to MNCs globally; has "strategic supplier" status with many
• Globally ranks at 1st – 4th position for 75% of its portfolio
• Works on a cost+ model. Increase in cost of benzene will increase working capital requirement funded by short term debt. Decrease may lead to inventory losses and revenue reduction
• Benzene accounts for ~60% of the company’s revenues, while aniline and sulphuric acid compounds contribute ~12% to revenues.
• With start of the Dahej facility of 30,000 TPA capacity in Q1FY18, AIL will also enter toluene chemistry.
• Exports contribute ~50% to revenue with incremental capex planned to enhance standing in the export market.
• Co supplies products to more than 500 domestic customers and over 150 international customers from 50 countries with a major presence in USA, Europe, China, Japan and India. The customer list comprises marquee brands like BASF, Bayer, Clariant, Dow, DuPont, Flint Ink, Hunstman, Makhteshim Agan, Micro Inks, Solvay, Sudarshan, Sun Chemicals, Syngenta, Teijin, Ticona, Toray, UPL Limited

Pharma
• Pharma business has broken even in FY12 and can aid in growth
• Company has two USFDA facilities one for API and another for Intermediates.
• Comprises of about 15% of total revenues
• 48 commercial APIs with 33 EDMF, 28 USDMF and 16 CEP. 12 new APIs under development

Home & Personal Care Chemicals
• Low margin business
• Expected to grow on the back of larger consumption of hygiene and personal care products. Increasing consumption is driving the demand for range of cosmetic chemicals, health care products and hygiene products using performance chemicals, polymers and oleo chemicals.
• Comprises of about 5% of total revenues

Industry Overview
• Indian specialty chemicals industry is around $25 bn (FY13-14 FICCI report)
• India contributes about 3% of global specialty chemicals industry, which leaves a very large opportunity size.
• Global chemical companies are de-risking the supply chain for their raw-material by diversifying from China to India
• The most impactful regulation from an Indian perspective has been the European Union’s REACH (Registration, Evaluation, Authorization and Restriction of Chemicals), which went into effect in June 2007. This legislation addresses the production and use of chemicals and their potential impact on human health and environment. The substantial impact of REACH will come into play following the implementation of Phase 3 from June 2018 that will regulate any chemical supplied to EU at quantities of 1 tonne per annum or more. Aarti has been REACH-complaint since 2011.

Competitive Landscape
• Chlorination (ranked among the top three globally)
• Nitration (ranked among top four globally)
• Ammonolysis (ranked among the top two globally) Hydrogenation (ranked among the
top two globally), and
• Halex Chemistry (only player in India).

Risks & Concerns

• Co operates in an environmentally sensitive sector and is open to regulatory risk. Government can put in place stringent environmental guidelines which may make their products uncompetitive internationally.
• Fire and accident hazards during operations causing major disruptions cannot be ruled out.
• Issues with US FDA / cGMP on pharma APIs
• Co has exposure to foreign currency fluctuations
• Debt is high
• Though co works on a cost plus basis model in its speciality chemical segment, any significant increase in benzene prices will increase the working capital requirement for the business funded by short term debt, leading to increase in interest outgo and decline in profitability.

Management
• Management compensation aggregates to 10.25cr and is especially high amongst the Gogri family members.
• Management has maintained a dividend payout of over 25% for the last 10 years
• Management is paying out full tax

Financials
• Net debt / Equity is 1.9 at the consolidated level, which is on the higher side. Interest coverage ratio is 4.89 which is healthy.
• Co has maintained strong operating cash flow / net profit ratio, which means they have been able to generate cash successfully over a long period of time.

Piotroski's F-score Analysis

Co fairs well in the Piotroski’s F-score with a score of 6 (out of 9). The 3 points where it did not get a score were very near misses.

Dupont Analysis

• Majority of the ROE is being derived from the financial leverage. The co is slowly improving its margin profile and can maintain its ROE at the current level, even if they reduce debt. At the same level of leverage, ROE can be improved by better margins.
• With a large part of the capex already done, specially for the toluene plant, asset turnover is likely to improve, thus improving ROE further.
• The co is consistently improving its ROE over the last 5 years

Key Assumptions & Key Monitorables
• Growth led by capacity addition will continue
• Debt-Equity levels will not rise further
• Margins will be on an upward trend based on better product mix
• No issues with US FDA or any other regulatory compliance
• Toluene and ethylation plants get onstream with good capacity utilization

Valuation

Stock Update: Century Ply

Q3 FY17 investor presentation and concall summary -

• Hoshiarpur plant for MDF is to start in Mar 2017
• Sainik sold 11,819 CBM (cubic meter) vs 12,037 cbm last year. This is despite impact of demonetization
• Ply sales have been strong in January 2017 as well
• There are around 3,300 plywood units in the country and out of 3,300 units, 2,500 are totally exempted, the turnover is less than Rs1.5 crore, 700 units are under the partial exemption their turnover is Rs1.5-5 crore and only 100 units are there which are in the full duty paying
• MDF: Co 600 CBM/ day capacity MDF plant is expected to come on stream by April, 2017. It entails an investment of 380 cr with 207 cr spent till Q3FY17. 
• The company would also use the MDF produce to make value added products like doors, pre-laminated boards. While it would also produce high density fibreboard (HDF) for manufacturing wooden flooring
• Market share: The company looked to maintain market share in difficult times post demonetisation. Hence, it gave dealers some discounts which led to a margin contraction. However, going forward, the management has indicated that they would reduce these discounts over the time
• Demonetisation impact: The management believes that demonetisation impact is over as the company witnessed ~5% growth in January, 2017. Though the unorganised sector is still witnessing problems, the company believes that it has a great opportunity to capture market share from unorganised players post demonetisation
• Pre-lam particle board plant: Currently, the company has a capacity of producing 1000 boards/day at its pre-lam unit and it would augment its capacity to 3000 boards/day by commissioning one more unit in next 3-4 months
• Commercial veneer: The realisations of commercial veneer increased sharply during the quarter as company sold premium veneer. It expects to maintain such realizations, going forward
• Pricing changes: The company has not taken any price hikes post demonetisation. It would benefit from softening raw material prices and so would look to maintain prices, going forward before the final rate of GST is known. Further, the unorganised players have already take price hikes of ~5% post demonetisation and could also take further price hikes. This would lead to contraction in price differential between organised and un-organised products which would help the company gain market share from unorganised players
• Winding up furniture business: The company has decided to completely wind up its furniture business which it started in 2012. Over the years, the division has accumulated losses of ~25 crore
• Laminates capacity expansion: The company is planning to rampup its laminates capacity by 50% to 7.2 mn sheets
• GST rate: The management expects a GST rate of either 18% against the current incidence of ~27-29%. Post GST implementation, a level playing field would be established and organised players are set to benefit

Near term triggers
• GST implementation is likely to migrate unorganised to organised sector
• Pre-lam is expected to give good growth
• MDF, new facility, is expected to give good growth - FY18 revenue is expected to be around 400cr; At full utilization it can generate 600 cr

Learnings from Buffett's 2017 Annual Letter

This year Buffett dealt with a few important points. I found his lengthy discourse on the superiority of index funds intriguing - but not really applicable for the Indian markets as here, maybe unlike in the US, there is significant outperformance by good funds over the index.

On being in the market

The years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost  certainly do well.

Having a portfolio of good businesses, without being leveraged and not needing to pull out of the market when there is a downturn, can produce good results over a long period of time.

On share repurchases

It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.

Here, I think, the Indian tax laws on dividend distribution has skewed the investor giveback so that companies are looking at share repurchases as an alternate mode of returning cash to shareholders. But, in general, the principle outlined by Buffett holds true.

On insurance operations

A sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can’t be obtained. Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.

This is important bit of wisdom to be kept in mind, since we are seeing listed companies in this space now in India. Insurance is a long gestation business which has the potential to create significant wealth for shareholders.

My takeaways from Howard Marks' presentation

My notes from Howard Marks' presentation on 2-Mar-17:

• Definition of "great" companies is dubious. Very difficult to identify great companies over a very long period
 
• Investing is not a matter of buying good things, but buying things well (buying assets which are out of favour)
 
• Forecasting is not possible as the future is not knowable. Try to know the knowable. Focus on specific sectors, industries, companies
 
• The main decision to make at any point in time - whether to play defensive or offensive. You cannot play both at the same time.

• Low purchase price is more important than anything else (including quality of company)
 
• Have to think differently (variant perception) and better - need to have some knowledge different from everyone else
 
• Most investors behave pro-cyclically
 
• You need to have a philosophy and process that you can stick to even in most trying of times
 
• Most corrosive of emotions is to sit up and watch others make money
 
• Plan to survive the "worst day" in the market without having to sell. The challenge is we don't know what the "worst day" will look like, but can get an idea from the past.

• Hubris, ego, over-confidence are enemies of an investor
 
• Your approach needs to be consistent with your personality
 
• Turn cycles to your advantage
 
• Look at E/P and compare with interest rates to get a sense of overall market valuations

Overall, it was a great presentation with some very good Q&A. Thanks to Prof Bakshi for inviting me and hosting such a fabulous and memorable event.