(This is the note I’d written for someone when I started buying this in Aug 2014)
Though this is operating in the commoditized steel tubes segment, I was drawn to this story (started buying in Aug 2014) for the following reasons -
- Share of organized players in the ERW tubes segment is under 50%, other than APL none of the other large players have expanded since 2010-11 due to this either being a peripheral segment for them or them being saddled with debt. Volume growth at 20% looks probable over the next 3-4 years even without an immediate uptick in the business cycle
- Looks like a good proxy for the India infra urbanization story without excessive reliance on any single segment
- Since the product differentiation is low the key to success in this segment could emerge from relative scale advantages. PAT margin, interest cost & freight out expenditure are all in the 2.5-3% range which place APL at a significant advantage due to a hygienic debt levels, improving operating cash flow & working capital and distributed production
- Appears to be the only player with the ability to quickly launch customized products for niche applications due to the ability to get closer to end customers, which in turn is due to their evolving direct marketing model
- The stock was being priced as a cyclical commodity play, my evaluation told me that the quality of the business is better what it appears to be at first glance with emerging advantages that have the potential to cement APL’s dominance in the segment
Real world events that could trigger a virtuous cycle from where we are -
- Volume growth in the 18-20% range backed up by capacity addition in the same range. Capex to be funded (approx 100 Cr each announced for 2016 and 2017) mostly from internal accruals since OCF is very likely to be 100 Cr+ every year here on, long term debt to see a reduction
- WC which has been trending down over the past 5 years continues to improve due to better receivables management, evolving distribution model (share from direct marketing to increase) & interest rates coming down. Interest as % of sales coming down from the current 2.4% to add to bottom line and improve ROE
- Effect of new product launches (door frames, color coded pipes & exports) to enhance product portfolio and improve realizations
- BTL marketing efforts to enhance repeat business and channel stickiness
- Demand environment getting better over the medium term due to Govt infra spending from FY17 onward
Latest interview by the CEO confirms that (1), (3) and (4) are well underway and that (2) and (5) are expected to play out over the medium term. However for a business of this nature I would demand a higher margin of safety, at CMP the 1 year forward P/E is 11.5 for the consolidated business and I believe the risk reward is in favor of investors
Negatives I can highlight (current scenario) -
- Some fuzzy accounting till Q3 FY2016 - they had a local auditor and were amortizing BTL expenses instead of charging to P&L. Set right after they changed auditor to Deloitte, 17 Cr was charged off in Q3
- No control over pricing, commodity nature of the business may not ever change. Fall in HRC prices will mean inventory writedowns, reduced EBITDA margins with return ratios going for a toss
- Competitors now starting to expand, Surya Roshni is doing a capex which may introduce the element of competition which was missing for the past 3-4 years
- No big margin of safety at CMP, market cap of 2300 Cr with FY17 PAT expected to be 150-160 Cr
- Market acceptance of color coded pipes hasn’t been great so far, management has been transparent about this though