Kwality Ltd. - Kwality Stock

Stock Opportunities
41

as per their AR 2017, most of their Term Debt including that raised via QIP from KKR is between 12.5-19.2%. So all this is very high cost debt. partly because their credit rating was not very high in the past. Its improved recently and remains to be seen how the company is able to refinance their loans to reduce their interest cost. as per the last con call, this will be one of the things they will attempt to do.

Also, they have mentioned that apart from deploying in the business in terms of distribution channels/capex etc., the QIP will also be used to repay their debt. Which is all good. But, my question is where does that leave existing minority shareholders? Doesnā€™t that leave us with a smaller share of the pie? How shd we view these type of developments in a company?

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Thanks for the info , They should re finance it 12-19 % is too high. This must be eating a lot into profits (not good for minority shareholders as well).
Refinancing via QIP is not bad if lets say equity gets diluted by x% and Net Profit gets increased by >x% i.e, Net net EPS should increase then i am fine. I hope management should not fool enough to do a deal where EPS goes down.

Debt going off the balance sheet is always good, QIP may not be bad if they do at the right price.

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Thier blended average cost of debt from KKR is actually about ~15%, so post tax Cost of Debt is about ~10.5% considering 30% average corporate tax. This compares to a P/E of about 16x, i.e. 6.25% yield, so it should be EPS accretive (i.e. at CMP, a QIP would raise EPS) although dilution will dampen long term gains. However this isnā€™t a permanent problem as the company could start buybacks with higher earnings (hopefully from the large capex being done).

Disc. Long

44

Has anyone noticed the declining trend of quarterly profits?

Depreciation has increased by 10 times and interest expenses increased by 25% over the last 2 quarters as per Screener. Is it a concerning trend as these two costs are unlikely to go down in the coming quarters?

45

Yeah its trading cheap for a reason , As pointed out by many in the post.
The most interesting thing to think about is are these negatives temporary in nature or are they permanent ? If temp then its a value buy if permanent then at no value its a buy.
I like to look at year on year numbers and they are free cash flow negative from last 5 years

FCF
Fy17 , Fy16, Fy15 & Fy 14
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On the other hand Debt to Equity has been improving .
44 PM

May be because they are raising more and more equity and that is visible in declining ROE .
16 PM

The decline in ROA is more puzzling to me ā€¦ Are you losing out on pricing power or what ?

The FCF is the real problem in the thats why they are constantly raising equity and debt to fund growth. significant re rating will happen the day they will become FCF +ve .

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46

thats because of the Capex in their Softa plant for VAP. This new investment has only started commercial production in Feb 2017 and they expect it to be in full capacity utilisation in the next 15-18 months. As they roll out more products this ratio will again start improving.

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47

An observationā€¦ promoter pledging has increased in the September filing to 57.54% from 44.07% in June. I guess its because of the correcting in price.

48

This is what is see in 2015 AR

To translate our plans into reality, we are expanding our
capacity to produce value added products. We have
undertaken an expansion plan at our plant at Softa,
Haryana with total capex outlay of Rs 4,000 million in a
phased manner to increase, our processing capacities by
over 9 lakh litres per day. This enhancement in production
is aimed at primarily for value-added products such as
flavoured milk, variants of cheese, UHT milk, table butter,
paneer, yoghurts, and cream.

Capex 400 Cr = which is 13% of net assets as of FY17, Also Plant capacity now has increased from 3.41 mn litres 4.5 mn liters.

I donā€™t see any mention of this CAPEX in 2014 AR
so,Let assume In FY 2015 is all started then it took them two years get this done is lots of time. In two years you can make a steel factory from scratch, this is just a expansion of existing capacity of products not as complicated as steel. May be they did in phased manner Capex should be yielding something every years thatā€™s what i assumed.

If you see ROA since 2015 has gone down from 8% to 6% - which is 25% , which is a concerning for me if that rate continues & if it is really pricing power loss then all the Debt and Capex will go for a toss.

Even if you are increasing 20% of FY15 assets in 2 years made no money on it then also 25% decrease in ROA is not a good sign especially when your Net profits have gone up by 16%.

Pricing power has been down for lots of players in consumer staple space, kind of ignored by markets - Due to patanjali or whatever may be the reason - (Patanjali Ghee may be the case here ? i donā€™t know.)

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Its good that the CAPEX is done but ROA atleast should stabilized here, Real concern is they way these guys are raising money, Considering some of these risks .
I take my old comments back about why not raise more equity / debt when you can grow at 15-18% . I think they first have to get their Cash flows in order then think about QIP and stuff.

Its cheap for a very good reason and interesting to see how story plays out.

49

If you want to look for evidence of pricing pressures, why not look at NPM directly rather than try inferring based on ROA? Btw their NPM has remained more or less stable over the last 3 yrs since 2015. RoE has decreased again due to the reduction in asset turns (due to the recent Capex as mentioned).

ROA because it looks at avg Total Assets, will depend not just on Fixed Assets but also on other working capital lines like Receivables, inventory etc.

Also, in their case, when they said they would be doing this in phases, what they meant was launch various value added products in phases. The investment in their Softa plant was to put in place the additional lines for milk processing dedicated to their value added products. These lines were commissioned in Feb 2017 so couldnā€™t have started adding to their top line any earlier.

If you track their balance sheet over the years you will find that the B2B milk processing business is not a very fixed asset intensive business. Till FY14, FA formed only 7-8% of their total assets. The rest is all Current assets, mostly receivables, meaning that this was a working capital heavy business. Most of the capital is locked up in long receivable cycles. Even in 2017, of the 484 Cr inc in Total assets only 178 Cr is due to the Capex, rest is all due to inc in Inventory and advances to their distribution network (due to the new products). This is why I believe the ROA has suffered temporarily and should revert back at least to normal as the story plays out.

50

Margin will not always reflect the pricing power, if your expense cost is fixed (fixed employ salary , real estate etc)

suppose I am running a retail shop my expense can be assumed fixed. suppose i started with 3 toothpaste = inventory (part of Assets )

suppose Fy16 i sold 1 toothpaste of Rs 10 with fixed expense of Rs 8.
and next year F17 sold 2 toothpaste of Rs 5 with fixed expense of Rs 8. // pricing is gone by 50%.
Both the years this will look same :
Revenue Rs 10
Expense Rs 8
Net profit Rs 2

in P&L margins will look same.

51

NPM = Net Profit Margin = Net Profit/Sales as a %
How will NPM remain same in the above 2 scenarios? unless the expense per tube of toothpaste also drops by same factor. are you assuming no variable cost per tube of toothpaste?

Secondly, even for a moment if I assume that there exists such a product where variable cost is zero, and all costs are fixed, do you really care as long as sales remains same? while price has dropped by 50%, it has also lead to 100% expansion of the market at the same time?

52

They say moving from B2B to b2c will increase the margin.
They also said more of value added products will increase the margin.
Yet margin is constant 2.6-2.7% from last 4 years on the other hand revenue has increased 7% year-on-year but return on asset has gone down by 25% since 2014.
What this all tells you ?

53

The EBITDA is on a rising trend demonstrating the transformation of the company. The company says this will reach ~9% once they launch all the VAP over the next 1.5 yrs. So we will have to give the company time, these things cannot happen overnight.

What the NPM tells me is exactly what I mentioned earlier in reply to your earlier post

The NPM is stable and hence cannot be used to infer whether they are losing pricing power.

The fact that their NPM is stable while EBITDA is improving is due to the increased depreciation and interest costs due to their debt. Possibly this is what the mgmt meant when they said that the latest capital raising plans will be targeted towards retiring this high cost debt so that it helps improve their NPM.

My view on why their RoA has dropped is explained in my earlier post. I donā€™t believe its because of loss of pricing power. In fact as EBITDA shows, the B2C transformation will allow them to sell higher margin products, which is the whole thesis of this story.

The RoA has dropped because they have had to upfront fund the assets required for this transformation - both capex as well as in terms of giving extended credit (i.e. receivables) and advances to their channel in order to stock/sell their products. In fact the increase in receivables, inventory and advances is much larger than the capex. Once the sales start coming in with more and more launches, this should normalize.

As mentioned by the mgmt in their con call and AR, till now they have tried to use their existing distribution network while trying to expand it to organised retail as well hence this was a way of incentivising them. You can argue that a company like ITC/Nestle will probably not need to resort to this, but then its only few large FMCG players who command that sort of power over their buyers.

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54

I think thatā€™s a wonderful write up. Just one question: would ROA be a right metric? since ROA is usually for financial institutions where the raw material is money.

We need to watch out for EBITDA margins, free cash flows and mainly the capital allocation being ROCE.

55

Net margins also depend on whether the final product is a value add of the raw material eg. milk or whether is used for manufacturing altogether a new product eg. tyre from rubber.

Since milk business is largely a value add, donā€™t expect high NPMs say like IT.

56

Anyone did schuttlebutt on this ? any idea how their products are perceived in the markets compared to competitors ?

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58

anyone tracking this stock based in Delhi/NCR? Wanted to check the feedback on the ground about all their Value add products launched in the market.

Based on their Q3 and 9M FY18 results I think the story is playing out but wanted to check what is happening on the ground if someone has/could do any scuttlebutt. Unfortunately I based overseas at the moment so unable to participate.

59

How you are saying that story is playing out?
From their Investors Presentation of H1, i have one discomfort about display of charts like increase of even 5-10% is shown as if figures have doubled. Similar things I seen in Tree House AR. I am not comparing Kwality with Tree House but such presentations are misleading. Management should not depict too good picture when in reality it is far from it.

Disc: Not Invested but started tracking.

60

donā€™t just look at one quarterā€™s numbers or the company presentation. i am attaching my back of the envelope working sheet (apologise for the poor formatting etc. as I had no intention previously of sharing, was only for my own use).

the key assumption behind the projections in my opinion is the growth of the B2C/VAP products. if the growth plays out, as it has grown (except for the blip in Q1 and Q2 FY18) then there is a chance there story has legs.
Hence i wanted to check what is the reality on the ground.

I have assumed 15% dilution thru capital raising. you can test it otherwise as well, i donā€™t think long term the story changes significantly.

Kwality Analysis-3.xlsx (21.1 KB)

The risks in the story have definitely gone up due to the deterioration in the balance sheet and the declining results, so wanted to measure that against the potential rewards in store and see if the story still makes sense. To me it seems like it still does, although next quarter is also going to be similar. we have to wait for the B2C story to play out a bit more before it starts showing up in the results, hopefully from next year, with or without capital raising.

disc: I am invested in Kwality forms a significant part of my portfolio.