Saturday, 7 January 2012

Oriental Carbon and Chemicals: Keeping a close eye

As I dig deeper into the market to identify undervalued businesses that have some kind of sustainable competitive advantage for at least next 10 years, I am coming across some very very interesting opportunities available in the Indian market. It is startling to know that some of these businesses are not only enjoy no.1 or no.2 position in India but also enjoy no.1 or no.2 position in the world in their respective businesses. To name a few Vinati organics (world's largest producer of isobutylbenzene, second largest producer of ATBS), Gujarat Reclaim  & Rubber (Asia's largest reclaim rubber producer) and Oriental Carbon & Chemicals (India's only manufacturer of insoluble sulfur and world's second largest producer of insoluble sulfur). What is more amusing and intriguing is that these companies are available at very reasonable valuations (less than 10 PE) and have fairly strong balance sheets, decent growth prospects and high profit margin.

Oriental Carbon & Chemicals Limited (OCCL) is India's only manufacturer of insoluble sulfur and second largest manufacturer in the world. The company is a J.P.Goenka group company established in 1978 and first plant for insoluble sulfur was established in 1994. Insoluble sulfur is amorphous form of sulfur having polymeric form that is insoluble. Insoluble sulfur is required in vulcanisation of rubber and hence is used by all tyre manufacturers. Company has two facilities located in Haryana and Gujarat. Haryana plant, after debottlenecking, has capacity of 14,500 MT and recently commissioned plant in Gujarat has capacity of 5500 MT and is likely to go up to 11000 MT by Q4FY12.

Business Quality: Insoluble sulfur (IS) market operates in oligopoly due to technological barriers and R&D efforts required to develop certain properties for the product. Solutia Inc is the world leader (Crystex brand) in this market with close to 75% market share. OCCL was late entrant into the market but due to constant R&D and quality standards it has gained close to 10% market share. Company derives 60-70% of its revenue from exports.

OCCL is the only supplier of IS in India and hence enjoys virtual monopoly in Indian market. Company has enviable list of clients in the form of both Indian and International tyre manufacturers such as Apollo, Ceat, MRF, Bridgestone, Continental, Kumho, Goodyear. OCCL has been primary supplier to Indian tyre manufacturers and alternate supplier to international tyre companies. However, recently OCCL has introduced some value added products which has opened up doors for increase in demand from international tyre manufactures.


Financials: In last 5 years, OCCL has increased its sales by CAGR 18-20% while its profit after tax increased by CAGR 65-70%. OCCL has increased its operating profit margin from 17% to 31% and NPM from 4% to 22%. This phenomenal jump in profit margin resulted into stupendous growth in PAT in last 5 years. This increase in profit margin was result of mainly two things
  • OCCL used to sign yearly contracts with its customers that curtailed its ability to pass on increase in price in raw material for a year. This resulted into substantial erosion in company's margin as main raw material for company i.e. sulfur experienced lot of volatility in prices. OCCL burnt its finger badly in 2008-09 and it decided to sign quarterly contracts whereby company was able to pass on price rise to its customer with lag of only one quarter instead of a year.
  • Secondly, OCCL's continued focus in R&D resulted into development of some value added IS grades since 2008. This value addition was clearly reflected in the margins of the company.
OCCL has fairly strong balance sheet with D/E ratio of 0.35 and current ratio of 2.11. Company has been generating free cash flow for each of the last 5 years and operating cash flow for OCCL has moved in tandem with PAT. OCCL had net current assets of 54 crores and investment of 5 crores in March 2011.

Future Outlook: 
Even though, currently automobile sector is in downtrend, I have no doubt in my mind that demand for automobiles in Indian market is only going to go up and so will the demand for tyres. Moreover, most of the tyre companies in India are expanding their capacities. Indian tyre market is experiencing radialization and hence radial tyres are likely to get the larger pie of the tyre market. Radial tyres require higher quantum of insoluble sulfur and hence demand for insoluble sulfur is like to grow at reasonable pace (higher than growth in tyre industry). Considering the fact that OCCL has established relationship with all tyre manufacturers, OCCL is likely to garner majority share of this growing market. OCCL has focused on developing value added products that differentiates its product from smaller Chinese companies in IS market hence limiting its competition with a few large players like Crystex, Singorchem etc. OCCL is also emerging as reliable supplier for international tyre manufacturers, giving them an option to Crystex. Hence it may be possible for OCCL to increase its share in world market in next 5 years. 

Valuation: 
OCCL is available at market cap of approximately 90 crores and trading at P/E of 2.79 and P/B of 0.74. Out of this 90 Crores, OCCL has net current assets + investment of the tune of 63 crores as per September 2011 half yearly numbers. OCCL reported net profit of 37 crores in FY11. OCCL has started commercial production from phase-I of expansion program in august 2011 and likely to complete phase-2 by early next year. This expansion put together is likely to add 80% additional capacity hence resulting in substantial increase in topline. Now, if we look at the business from private enterprise value, OCCL is available at 120 odd crores  (market cap + debt -cash & cash equivalent). This is mouthwatering considering that a free cashflow generating company having virtual monopoly in Indian market and second largest in the world is available 0.5-0.6x FY 13 revenues! I, putting my self in private investor's shoes, see substantial margin of safety.

Concerns: Even though, OCCL appears like a great opportunity of entering into a formidable business at very attractive valuation, I would like to sound a caution here. Even though, OCCL management has given enough rationale for substantial increase in its NPM in last 2 years, I will keep a close eye on NPM of the company to understand the trajectory of NPM for next few quarters, before committing large chunk of my portfolio.

5 comments:

  1. Hi Dhawnil

    looks a attractive bet at current value.
    why indian tyre manufactures will prefer OCCL over Crystex, Singorchem ? does OCCL price is cheaper than international competitors ? if yes what are the reasons ?

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    1. Hi Sagar,

      I am not sure about price offered by OCCL is chepaer than Crystex or not however my assumption that indian tyre manufacturers will prefer OCCL is due to following reasons

      - OCCL has established quality standards acceptable to international tyre manufacturers and is a approved vendors with most of them hence quality of the product shall be comparable to Crystex
      - Secondly, OCCL has developed a long standing relationship with many of the domestic tyre manufacturers as it is the only supplier in India.
      - In terms of cost OCCL can definitely be more competitive as it is not required to pay 5% import duty and freight from Malaysia (Crystex's nearest plant) or China.

      So I think OCCL shall benefit from increasing demand in domestic market.

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  2. Hi Dhawnil,
    Not an environment friendly product which is one of the reasons that this stock has maintained a low PE most of the times.
    Though a monopoly business but the concern is huge AND it comes from Goenka group which doesn't have a good reputation and are not investor friendly.
    That will be a hangover for the stock and with wide variety of stocks available at discount, it a choice wide open.

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    Replies
    1. Hi Anon,

      I agree with you that Goenka group doesn't have a great reputation for being minority shareholder friendly. Moreover, their action on acquiring Schrader Duncan stake does shake up confidence of the management. I have done a follow up post on OCCL http://valueinvestinginpractice.blogspot.in/2012/03/updates-on-oriental-carbon-chemicals.html

      My sense is that lower valuation may be due to lack of confidence in management. However, insoluble sulfur is an absolute necessity for making tyres and hence is not replaceable currently. So i do not think that lower valuation can be attributed to product of the company.

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