Rain Industries - An oversold de-leveraging play


(Prasanna Sankaranarayanan) #1

Today Merrill Lynch unloaded 1.5 Cr worth of Rain Industries, the reasons for the same are unclear.

The depressed valuation of this leveraged, underfollowed, niche market, stable margin, and oligopolistic natured business provides an opportunity for a serial capital compounder.

Currently Rain trades 2.7x 2013E earnings with a market capitalization of â*12.0 bln (US$195 mln). While a margin squeeze in the companyâs calcining business explains most of the earnings compression, a number of factors have contributed to Rainâs depressed valuation, namely: i) despite an acquisition valued at ~4.0x Rainâs market value investors have not seen any earnings accretion to date; ii) investors are worried of the companyâs leverage ratios; iii) the aluminum industry is out of favour with aluminum prices falling 25% since Jan -2011;

**Quality of Business.**Rain operates as a market leader in both pet coke calcining and coal tar distilling, which are best described as oligopolistic. Barriers to entry for these businesses include: regional markets created by notable transportation cost, longstanding customer and supplier relationships, strategically located facilities, and trademarks and patents.

**Management Plans and Interest.**Rain is operated by a well-aligned management team with a track record of prudent capital allocation. Jagan Mohan Reddy is the CEO of the company co-founded by his father, and overall the Reddy family owns ~40% of Rain Industries providing significant alignment of interest. Management is well aware of its depressed valuation and plans to return capital to shareholders while de-leveraging the corporate structure. From 2007 to 2012 Rain reduced its net-debt from US$728 mln to US$413 while returning 12% of income to shareholders.

Valuation

Overall, Rain is worth in the ball park of â177/sh;Even using the âTight Marginâ scenario across all business segments, Rain should still be worth roughly â72/sh, or 80% more than its current price, providing little downside.

Disclosure: Taken a small position in Rain


(Naveen Daiya) #2

ICICI value fund-1 about 10 crore of investment is done in rain industries.

Disc: invested


(onefoothurdle) #3

Even i am invested a bit into it and having a ride :). Anyone else into it


(sjain_13) #4

What is the latest view on Rain Industries. With the recent qtr performance being good and Mohnish Pabrai invested, it makes sense to discuss


(capwise) #5

Rain Industries appears to be quite cheap at current levels.

Admittedly, it does not generate a very high ROE. In 2014, it generated an adjusted ROE of 8.69%. But, this low ROE is primarily because it is in a cyclical industry. At the peak of the cycle, its ROEs were much much higher.

But, even this low ROE of 8.69% looks quite attractive when we look at how cheap its equity is currently available at. Currently, it is available at a P/B of just 0.45.

Also, it continues to generate a lot of cash, which is being used to repay debt.
In the last quarter, it earned cash of Rs. 224 crores (PAT + Depreciation), i.e. around $35 million.
In the last FY 2014, it earned cash of Rs. 603 crores (PAT + Depreciation), i.e around $95 million.
In the last 6 months, it has repaid debt of $67 million.
Compare this cash generation to its market capitalisation of just Rs. 1500 crores, i.e. around $240 million.

I believe the biggest overhang for Rain Industries is that it still has a debt of $1.016 Billion on its balance sheet. A business of this size can easily manage debt of $500 million - $600 million. I believe it will take a few years for the company to reduce its debt to this lower level. But as it continues to repay debt, the value of equity will keep rising. The promoters have a track record of de-leveraging in the past.

I believe that another overhang for this stock is the perception that it is a commodity stock. Although, it is indirectly exposed to aluminium and oil prices, there is no direct correlation. Lower aluminium prices do not impact Rain directly. Rather, if aluminium prices stay low for the coming decade, many other industries (like car manufacturers) will find increasing use for aluminium. And this increase in production for aluminium will require more CPC manufactured by Rain Industries. As such, to some extent, low aluminium prices & low energy prices, are not bad for Rain industries.

If you look at the last two quarters, there was a carnage in the commodity sector. Yet, Rain has delivered a fairly steady performance in the last two quarters. I believe that if it continues to generate cashflows of $100mn - $150mn each year, it will be able to de-lever its balance sheet in 2 - 3 years, and deliver very handsome returns, possibly become a multibagger.

Rain has very good quality management and follows very good corporate governance. They have always treated equity shares as very sacred. They have always returned excess cash to share holders using buybacks and dividends.

Rain is the largest (??) or the second largest (??) producer of CPC in the world. I believe that such a business with revenues of $2 billion can easily trade at a market cap of around $1.5 bn to $2.0 bn.
If Rain is able to de-lever its balance sheet, it will enjoy substantial savings in interest expenses. Very conservatively, it will still be able to earn a PAT of around $150 million (even considering the current low margins). At a PE of 12 - 15x, it can easily trade at a market cap of $1.8 bn to $2.3 bn.

Rain could well become something like a Shree Cements which suffered from a lot of debt in 2002-2003, but went on to de-lever its balance sheet and expand capacities with internal cash generation.

Disclaimer: I continue to hold Rain Industries in my portfolio for the long term.


(sjain_13) #6

Excellent capwise. Thanks.


(Chintan) #7

but have anyone seen goodwill on books!! as of Jun’15 its at Rs 5420cr vs NW Rs 2931cr | MCap Rs 1530cr | Net Debt Rs 6500cr…i think such high goodwill at sm point in time will get ammortized frm P&L…currently company is charging only Rs 80-85cr as depreciation/qtrly against Net FA of Rs 3267cr and add goodwill to that it will be Rs 8687cr…i think they have not yet started ammoritizing their goodwill thats why Profit looks reasonable as compared to MCap

Discl - Not invested


(manish) #8

Amortising goodwill will reduce the reported profit but it is not going to effect the cash flow.

Question
Also in my opinion amortising goodwill will be better as the PBT will be lower ,so the company should pay less tax. Please correct me if i am wrong.
Also it will improve RoE.


(capwise) #9

Goodwill is certainly huge. Reported profits can become lower, ROE may also come down if they start amortising big amounts. But, I agree it does not have any bearing on the cashflows. If anything, cashflows will improve marginally if they use high amortising to lower reported profits.

I believe the plan of the promoters is to list the carbon company in the US markets in a few years. They have always highlighted this in their discussions. A lot of this goodwill will move to this proposed listed entity when they decide to list it. So they may not be in a hurry to amortise it.

For me, one of the biggest risks with Rain Industries was their debt of around $1 bn. What if they are not able to service this debt in this down cycle ? However, one big comfort factor is that all their $1.0 bn debt is in their carbon and tar pitch business. There is no debt in their cement business which has a capacity of 3.1 million tonnes. Cements is a debt free business.

As per the valuations of recent transactions in cement industry, they can easily sell their cements business at $100 / tonne or more, generating about $300 million if required. Today, this is the replacement cost of any cement plant in India. Most recent deals in India have happened at much higher EV (for example: Century Cements selling to Ultra Tech at $130/tonne; Jaypee selling to UltraTech at $135/tonne).

For Rain industries, its cement business hardly makes much money. For both CY2013 & CY2014, cements business share in the total operating profits was just 4%. So it will not have a big impact on its PBT, but it can surely help reduce debt by $300 - $350 very easily if required. This gives me comfort that they will be able to manage debt well.

Disclaimer: I hold Rain in my portfolio for the long term.


(rohan shah) #10
  • Management has indicated that it has no intentions to dispose of the cement unit
  • Management has been talking of listing the US subsidiary for around 7 years but has refrained from doing so citing unfavourable market conditions
  • There are limited growth prospects in volumes/price of the CPC and CTP that they sell. Therefore, they have resorted to acquisitions in the past, which were aggressively funded with debt at a time when liquidity was easy. Any further acquisitive intent would need to be monitored closely.
  • 16-18% Euro depreciation adversely impacted financials last year and any further EUR/INR depreciation could further impact.
  • Debt is expected to be paid down at maturity in 2018 and 2021. While management has prepaid a small proportion of this recently, which is encouraging, they do not seem to have any intentions of aggressively paying down debt.
  • Falling aluminium prices will not directly impact the company’s product prices, but will reflect in smelter shutdowns which will reduce demand. Also, the company does not supply significantly to Chinese smelters and any shift in capacity to this region will reflect in lost volumes.
  • While the stock may appear cheap, unless any tangible progress takes place on the debt front and promoters refrain from any empire building acquisitions, it may languish as it has done in the past. Any progress could have exponential effects on profitability and price.

Disclosure: hold tracking position


(Shan) #11

Past instances show that such calculations can be misleading. If Rain lands in a position where it is required to sell of a business unit then the buyer will most definitely not pay market price. Further cement itself is highly cyclical so there might be no buyer interested if there is excess capacity in the market.

Disc: no position, this stock doesn’t fit my investing criteria anyways, but I’m tracking it because Pabrai has a position.


(capwise) #12

Shan,

In recent cement deals, Jaypee was laden with debt and was forced to reduce debt. They still were able to sell their units for $135/tonne. Admitted, Century was not in a desperate situation as Jaypee. But, I believe factoring in a $100/tonne is a fairly conservative estimate, when most big players like Ultratech / Ambuja / Shree cements are trading at more than $200/tonne valuations. Today, just the replacement cost of a cement plant is $130 - $140 / tonne. So, I believe $100/tonne is fairly conservative.

Rohan,
They may not have intentions of selling their cement unit, but it certainly provides comfort that they have assets that can be sold to service debt if things go out of hand (margin-of-safety).

Aluminium is a tricky commodity. Most vehicle manufacturers are very keen to transition to aluminium bodies to reduce weight and emission (to meet regulations). But the biggest issue was the cost of aluminium. A lot of power is used in aluminium smelting, about 40 - 50% of the cost of production is power. With both bauxite & power prices down, the cost of producing aluminium will be a lot lower in the years ahead. I believe this will attract a lot of new applications including car manufacturers. So lower prices may not necessarily mean smelter shut downs.

Anyways, for Rain Industries to be a good investment, all it has to do is maintain status quo. During the last cycle, they reduced their debt by $400mn and digested their earlier acquisition of CII. If it can maintain its cashflows at current levels, they will be able to reduce debt and accrue EV of equity holders.

This is certainly a long term investment (3 - 5 years), but returns will be many folds.

Disclosure: I hold Rain in my portfolio for the long term.


(rohan shah) #14

@capwise
As per my back of the envelope working, if you assume operating cashflow to be static based on latest quarter and annualize, it will generate approx 500 cr of OCF every year. If this is entire sum is applied towards debt reduction + interest payment, it will take 15 years to wipe out debt. A 10% prepayment in debt will save 50 cr in interest/per annum or <INR 2 per share. Please correct me if this is off the mark.


(capwise) #15

Rohan,

Last quarter, the cash generation was Rs. 226 crs (PAT+ Dep) (after interest). This will be Rs.900 crs per annum. Even if they apply Rs.500 crs p.a. from this towards debt repayment, This can wipe debt of 6500 crs in 13 years, if we do not assume any interest savings. If we assume interest savings from prepaid debt, this can wipe debt in 10 - 11 years and the entire EV of $1.25 billion will accrue to equity holders (400% in 10 years).

The above calculation does not consider any increase in EV or PE multiples. Both of these are at depressed levels. Both multiples can atleast double from current depressed levels or even more. (i.e. 800% in 10 years).

I believe the important thing is that the market will not wait for the debt to become zero. At some point, if the market becomes comfortable with a particular level of debt given the size of business or the consistency of the cash generation, they will push the value of equity higher, much higher from current levels.


(manish) #16

Hi Capwise,
I don’t think its a good idea to add depreciation for cash flow. Company would need to spend money for maintenance and upgradation of plants etc. What about Margin of safety. The error should be on safe side.

As per presentation the company has to make a bullet payment of USD 395 million in 2018 - abt 2500 cr, where is the money going to come from and about 4000 cr in 2021. I understand the company would be re-financing same.
Also present cash flow is more because the company is paying only interest on its USD 1b loan and principal payments will be in 2018 and 2021.
if i remember correctly as per concall , the CPC indian plants are working at almost full capacity and US at 80-85% capacity. so looks like the growth would mostly come from increase in realisations.
If the Aluminium prices remain subdued , it would lead to lower Aluminium production ( why would mines operate at high capacity if the realisations are going to be lower) and should in turn affect demand for Rain products.

Also oil prices are down - this should give access to cheaper raw materials but should put pressure on the realisations for their chemical business.

However, the mgmt claims that crude and Aluminium prices don’t have much effect on their business ?? and they are governed by different supply demand dynamics.

We don’t know how China story will play out. Chain has removed export duties for Aluminium.

For expansion there is a plant in russia - 0.3 million t capacity and a power plant for cement unit and a Solar plant ?


(Umang) #17

The company has again delivered a good set of nos … I don’t understand why it is so undervalued ?? Is anyone aware of any corporate governance issue with the company ?? Or is it just because of the company’s high debt ??


(Arun Kumar) #18

The Company has not delivered any returns to the shareholders in the last 7 yrs. The low undervaluation is a myth and if you look at EV/EBITDA, it will compare well with other commodity companies. The Management is not share holder friendly- have not been generous in dividends and buy backs. The market has lost all credibility in the Management and the Company.


#19

Its astonishing that Rain industry got investor like PABRAI…


(Arun Kumar) #21

Good read. I have few points to make- a) You should look at the company from EV/EBITDA and my sense is it is not cheap. b) It trades at a lower multiple than its acquisitions- its last acquisition was some 7-8 times EV/EBITDA and hence the value destruction for the Rain shareholders. c) The Management is not shareholder friendly. In the last eights years, it has done two acquisitions with no change in equity valuation, no big dividend and very small buy back. Why is the Management not concerned about the low equity return to the shareholders? I agree that it does not matter if the company has not given returns in the past, but it does reflect the Management thinking and their low concern for the shareholders. I am sure all the existing institutional shareholders are also very disappointed.


(Aravind Sankeerth) #22

Rain is going to make a sudden move when the actual global businesses start to break even and the debt bonds are repaid.