Kothari Petrochem Ltd~ A hidden moated small-cap company?

Stock Opportunities Untested - but worth a good look
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Company Overview
The company is the largest producer of PIB compounds in the country & among the largest players across the globe.

About the industry
Polyisobutylene (PIB) is a Polymer made from Isobutylene. PIB is an inert polymer in nature but will react with other chemicals under certain conditions to give various derivatives to target specific end usages.

  • Dependence on an automobile: The fortunes of the industry are directly tied to the growth in AutoMobiles, as it is mainly used in/as a lubricant & two-stroke (2T) engine oil

  • Expected growth in the coming decade: owing to the applications in new industries like Adhesives, cosmetics, plastic masterbatch & rubber, and tire & sealants, the demand is expected to grow in the coming period.

  • The primary Raw material is some Crude derivative.

Polyisobutylene (PIB) is a Polymer made from a Hydrocarbon stream termed C4 in the industry. This is available in Refinery, Naphtha crackers, and MTBE crackers.

The availability of raw materials is a major concern for the industry, with some companies even shutting down their plants owing to the inability to get materials.

Competitive intensity: The industry is characterized by low competition owing to several players leaving due to the inability to get raw materials. There are negligible domestic producers in this space & the main competition is from imports (which have suffered post covid owing to higher freight costs.

About the company
The company is a part of the esteemed HC Kothari group of companies that have a presence across three industries ~ Sugar, petrochemicals & safe deposit lockers.

The company was earlier headed by the late Mr. Bhadrashyam Kohli who passed away in 2015, post which the promoter’s son ~Mr. Arjun. Kothari took over as MD at the age of only 24 years.
During FY15, the company was reeling with a poor demand scenario, difficulty in gaining a supply of raw materials as well as being highly dependent on the lubricant producers for demand, however, he has completely transformed the business in the past few years slowly & consistently.

Positives

  1. Strong market positioning- The company is the largest domestic producer of PIB catering to around 80% of the domestic market demand in the last 3 years (91% in FY23). This is owing to the Strong ENTRY BARRIERS wherein due to the scarcity of raw materials, several other players had to close their shops/ couldn’t produce the chemical. While the company owing to its strong relationships & investments in developing the pipeline with Chennai Petroleum (which also allows it to source material at lower costs due to proximity) & Reliance Industries, has helped in ensuring a consistent supply of materials making it a preferred & reputed supplier.
  2. Marque clientele: The company has a strong clientele comprising lubricant manufacturers and 2T lube-oil producers like Lubrizol India Limited, Hindustan Petroleum Corporation Limited (HPCL), Bharat Petroleum Corporation Limited (BPCL), and Indian Oil Corporation Limited (IOCL), etc, in the domestic market, and Infineum Singapore PTE Limited in the overseas market.
  3. Strong operational efficiency: The company owing to its constant focus on automation has been able to reduce its employee count as well as function the plants for more than 300 days consistently (350 days during the covid period!).

Its constant investments in its captive power plant, solar, waste heat recovery systems, & effluent water treatment have helped in controlling the power costs despite the high prices & volatility in the past few years.

Further, the company has not only run its plant consistently at utilization levels >90% but has also ensured zero fire/accidents since the start of its operation, which is a commendable feat for a chemical company.

  1. Renewed growth prospects: The company after a slump in revenues till FY21 (partly contributed by the closure of LPG sales) has started showing strong growth owing to higher realizations as well as greater volumes due to 1) higher contributions from exports which rose by 140% in FY23 (25% of total revenues now), 2)increased domestic market share owing to non-feasible imports (with freights costs being high & supply chain issues post-covid), 3) Increased contribution from Non-lubricant industry like Adhesives,plastic-masterbatch among others which has diversified its revenue profile as well as giving a good growth opportunity.

This is visible from the doubling of capacity from 24,000 ~ 48,000 MTPA in the last 3 years, which is a big thing considering its capacity was constant at 24,000 MTPA between FY15-20.

  1. Strategic location Advantage: The company owing to its proximity to the port in the South-east as well as its supplier Chennai Petroleum, can save on freight costs as well as deliver products efficiently (in exports).
  2. Improvement in margins & ROE profile: The company owing to sourcing of higher quality IB content feedstock, has been able to reduce its costs (& increase quality) substantially owing to negligible waste generation (unreacted feedstock) & no-remnant LPG produced (by-product which had low margins). While at the same time, due to its improved competitive position, its ability to enter into formula-linked pricing mechanisms & higher commodity prices, the realizations have improved and remain stable leading to high margins & extraordinary ROE (30% in FY23) while maintaining a lean balance sheet (D/E~0.1).

  1. R&D aggression: The company has started heavily investing in its R&D from the erstwhile 50 lakhs Per annum to 2 Crs in FY23. The results are also visible in the form of the development of new chemicals like HR-PIB & High molecule weight polymers. The company also received a patent recently for a particular chemical which shows its R&D prowess.

Negatives

  1. Volatility in the commodity to hit realizations: The company’s sales have been boosted by higher realizations for its chemical which is highly correlated to LPG & Naphtha prices (which have risen sharply in the last 3 years). Thus any downward movement in the same can affect the sales numbers.

  1. The potentially low terminal value of the existing business segment- The company currently derives a major chunk of its revenues from Lubricants & two-stroke engine oils, which are expected to degrow after 5-10 years owing to the arrival of EVs. Thus dependence on this segment remains a huge risk that might not be visible in the current numbers & its ability to diversify in other segments will ultimately determine its fortunes.
  2. High client concentration risk: The company’s top 5 customers have historically contributed around 50-70% of total sales. Although, due to the addition of new clients (especially in exports), the company’s dependence is reducing which is visible from a decrease in the contribution of the top client (from 25% to 15% YoY), it remains a major risk.
  3. Availability to procure raw material: The company’s ability to source raw material can be a major risk in the future (which is currently a source of its moat!) as the company procures these from only 2 producers & it remains to be seen how it will procure in future given the projected increase in volumes.
  4. Increased working capital cycle: Owing to the company’s higher share of exports as well as supply chain issues, the working capital cycle has increased in the past 2 years which led to CFO/Net profit falling to around 60% in the last 2 years. Therefore, this needs to be tracked in the coming period.

  1. Potential competition from imports: The company’s domestic market share increased rapidly owing to supply chain issues created by covid which led to lower imports in India. However, the company does face competition from well-established international manufacturers, such as Daelim Corporation in Korea and an MNC in Singapore. It, therefore, remains critical to see how the company will utilize its higher capacity & if the domestic share is sustainable or not.
  2. Recent compensation hike for the Chairperson: Recently, The company passed a resolution to pay 1% of net profits as a commission to the chairperson~ Mrs.Nina Kothari. Earlier, she was eligible for only sitting fees (which indicates a lack of involvement in the daily operations as she held this post after the death of her husband) & got around 30-40 Lakhs of dividend income owing to her 10% direct stake. So, this sudden change in the remuneration policy looks like a red flag.

Management overview

  • The management team is headed by Mr. Arjun Kotharti (MD & CEO)
  • The company is an HC. Kothari Group company.
  • The promoters have a healthy 71% stake ensuring skin in the game.
  • The corporate governance standards have been decent with no major related party transactions except some 4 Crs paid to a group company as a professional service fee (the nature of this fee is still unclear to us).
  • The management team is well experienced
  • Management pay has also been reasonable given the size of the company

Capital Allocation

  • The company has regularly given a dividend payout of around 15-20% in the past few years.
  • Capex: The company has doubled its capacity in the last 3 years from 24,000 MTPA to 48,000 MTPA. While this is commendable, the company has also shown great restraint to do any major capex between FY15-20 where the capacity utilisations as well as the demand was low instead of focusing solely on showing higher volumes at lower realizations (which would have led to value destruction).
  • The company has never indulged in any M&A activity.
    The company has also regularly invested in R&D (2 Crs in FY23) which led to new product developments that de-risk its business profile (owing to high contribution from conventional PIB in the past)
    In conclusion, the company’s strong & conservative Capital allocation policies have ensured an average ROE~20% in the past decade.
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Financials:

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~ 5 yr sales & PAT growth: 20% & 32%
~ Working capital days: Around 30 days
~ ROCE (FY23): 29%

Disclaimer: I have a tracking position.

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Extraordinary results by kothari petrochem when other chemical cos (dependent on crude derivatives as raw materials) have reported poor nos.
OutcomeofBoardMeeting09082023_09082023123955.pdf (2.2 MB)

~Revenues up 2X (yoy)
~ Profits up 5X ( yoy)

Commissioning an INR 6Crs pilot plant in manali for HR-PIB production which will diversify its revenue profile & help in margin improvement.

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Thanks a lot Dhruv. Any ideas on what has been happening with Kothari over the past few days? Is there some underlying fundamental shift in the company or just market correction?

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Hey, I think the current correction is primarily due to market correction (possible profit booking considering the sharp move from INR 65 to 130 within 3 months. The current rate of POLYISOBYTYLENE has been pretty stable (as per screener data) & business is moving in the right direction by adding capacities & derisking business model through diversifying end user industries. But that being said, can’t really comment on the price movements.

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Hi, thanks a lot Dhruv. Any idea how the results are gonna come this quarter? Chart looks strong… has given a good cup breakout couple of weeks ago. Still in the process of reading about the company. Excellent fundamentals but markets dont seem to like petrochemical companies… generally have low PE, so do you think there is a scope for PE rerating along with earnings growth?

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Hey harsh, although its difficult to predict the trend of quarterly results especially for chemical companies due to uncertainty about their inventory position & pricing of raw materials (in this case base oil) & End product (i.e. PIB~ HS Code 390220). However the prices of PIB have definitely moderated in the past 3 months which might lead to an okayish quarter.

In terms of PE I completely agree with you that markets dont give good multiples to petrochemical cos, however, if you will look at its past valuation multiples it has generally traded at around 12 times ( which is the rate at which i took my position).

Now, I believe that given increase in diversification of end user base, nicheness in product with high market share thanks to the scarcity of raw materials (which it sources from Reliance & CPCB) & renewed aggression by the young promoter wherein they are developing new products & doing rapid expansions(surprisingly recording very high utilisation rates), I am fairly confident that the coming years will be much better in terms of the quality of the business as well as growth prospects & thats why it deserves a better multiple.

So to conclude, as long as business trajectory will be upwards ( unlike other petrochem cos who recorded poor results in Q1 & are actually seeing increased capacity across the industry), I believe multiples for this business might be higher in future.

It is important to note that its scale is much smaller than other petrochem players & thats why we need to see how scalable this business is… However so far, it looks decent.

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thanks a lot. Absolutely agree… will track this company closely!

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Will the increased usage of highly reactive PIB affect the sales of Conventional PIB, which is a major chunk of revenue for Kothari? What are your views on it? @Dhruv_Bajaj sir .

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SUPER STRONG RESULTS BY KOTHARI PETROCHEM with EPS doubling & revenues growing by +20%
Company has reported strong Cashflows for H1 & its H1 Eps ~ FY23 EPS (which itself was at a higher base)

The company has been transitioning from traditional lower weight PIB to HR PIB, high molecular weight PIB and different grade variants from
main grade PIB products.

Further, its revenue base is diversifying with contribution from several other industries like Lubricants & masterbatches industry which itself reported strong nos this qtr (check Gulf Oil’s & Plastibends performance).

Overall, Outlook remains positive.

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Thanks for the update @Dhruv_Bajaj

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Please note that company’s operations have been disrupted to some extent owing to the Chennai floods~

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Hi Dhruv,

Can you share what source materials (if any) you’ve used apart from the annual reports please? I wanted to do a deep dive myself since I have a decent position.

Also, if the moat is currently just (lets say 80:20) the cos relations with their suppliers, and efforts towards becoming the least cost producer, I wonder what stops a chinese co from just coming in and stealing market share. Because my assumption is that the RM supply crunch is localised to India, i.e., in India there is very little RM supply and most of that is cornered by Kothari. If it is indeed localised then wouldn’t global competition be possible for their export business in the long run, especially if they continue to expand margins?

Cheers and thank you,
Divyang

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Hey, regarding the competition bit, i completely agree that RM issue is primarily in India & foreign players might come back, however, there are 2 important things-

There are few large companies in this space like BASF, TPC group & DAELIM, coupled with some in China, but Kothari petrochem stacks up as one of the largest players globally which highlights the small/niche market size at the moment (2Bn dollar market globally)

Secondly, Kothari has had a dominant domestic market share of more than 60% for almost a decade now. This increased to 80-90% post covid owing to supply chain disruption, but there has been limited dumping issue when it comes to the business.

Based on my research, High molecules PIB contributes 65% of the total PIB market…& funnily enough the company has onlu recently ventured into this space which indicates greater potential to increase revenue in the existing molecules.

On the pricing front, the company’s positioning is improving wherein it is getting into formula linked pricing arrangement to protect its margins,however utility costs like power fluctuations was an issue in the past. Hence,.it has also started including utility costs clause in its contracts thus shielding the company from volatility to a certain extent.

While the spread has definitely improved post covid which has helped in boosting its margins, my thesis on kothari is simple-

A) Iconoclastic promoter who has turned around the business post his father’s death.His capital allocation has been beyond excellent wherein the ramp up of the new capex has been very swift & on a calculated basis.

They have earlier exited their loss making LPG business as well, which positively ticks my historical capital allocation performance check.
B) Strong growth prospects in terms of new molecules like HR PIB, high molecule weight molecules among others

C) Increased application of its products from just 2T engine oil & lubricants to masterbatches,adhesives ,rubber among others has improved the “TERMINAL VALUE” of the business significantly since lubricants is a dying business in the long run, hence, newer applications which have increased post covid will help in reducing dependence on one dying industry & at the same time contribute to higher growth due to small base.

D) Strong balance sheet wherein there is 0 debt in the business despite doubling its capacity in the past 3 years(unlike its peers who took massive leverage at the peak of the cycle).

And, Industry consolidation is just a bonus that Aids to its ROCE profile.

It is one of the very few listed companies that have maintained ROCE > 15% for the past 10 years despite difficulties.

Sources that I have referred are- AR (PAST 10-15 YEARS), all the credit rating reports, website, google search (for understanding PIB industry)

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This helps a lot Dhruv, thank you so much. Happy New Year!

Looking forward to one of your IRL talks, I know you were a part of the IAS but wasn’t able to attend :slight_smile:

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That was really a great analysis Dhruv.

  1. I had few questions did you find anything about R&D spend in AR are they working on any new products?
    They have mentioned in their AR even tho EV is future there are many other transport which will require engine oil because they are just not viable in electric format.
  2. Also how does the company look at valuation front right now? I see the PE multiple is little above 5 yr average but how does the company look on other valuation front? Is it still a good buy at current CMP?
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Hey, R&D expenses has been minimal so far, however i am expecting high expenses in FY24 as newer products will most likely come online as per credit ratings.

My thesis is simple - My initial valuation multiple was similar to past 5-10 yrs however my belief was that fundamental growth is outpacing the share price growth & business is structurally in a much better positioning both from a competitive as well as growth lense.

I will keep tracking the business & add after getting more conviction on a quarterly basis.

I believe this can become a good steady compounder story , however, I have been wrong several times especially in chemicals sector…so bit more cautious this time.

Regarding EV, the company’s products are finding application in other industries like rubber, adhesive, plastic master batch which ks reducing the risks.

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Any update?? What is happening in the company?