Orient paper – don’t throw the baby triplets out with the bathwater
((1 USD = INR 63.75))
CMP – INR 27.1 ((USD 0.425)) –
Target Price – INR 80 ((USD 1.25))
Having learnt from both Warren
Buffet and Phil Fisher, I have developed my own unique style of stock analysis
– that involves about 40-50% of analysis on the ground (which a lot of analysts
miss out on) the rest in desk research- reading AR’s, analysing numbers etc. I
would like to call this the Holmesian way of analysing stocks - unlike
conventional analysis that relies heavily on secondary research, this creates a
double loop mechanism that feeds into the other engine and helps validate or
reject the thesis. This has often proven to be quite an advantage in micro caps
where often “what you see is not what you get in the numbers” and vice versa.
Said all of this, it is seldom
that I come across a stock that is a purists value investor’s delight which
offers a triple play of reversion to mean, de-merger/spin-off optionality and
pure and simple undervaluation. I must thank my friend, Rohit Balakrishnan who
introduce me to this stock and also shared his note with me from which I have
generously borrowed.
Company background – diamond embedded in a silver bar obfuscated by
dirt
The company is Orient Paper and
Industries – OPIL for short, (NSE: ORIENTPPR) and is a small/micro cap with a Market
cap of INR 5, 570 MM ((USD 87.1 MM)) with no analyst following (don’t I just
love these) and of course low liquidity and institutional interest.
The company, which is a part of
the CK Birla group of companies (which is quite a respected 100 year old
business family in India known for its governance and ethics, albeit a little slow
to change) is the residue of a de-merger from a parent that consisted of
Cement, Paper and Electrical appliances in March 2013. The new-born child, Orient Cement (NSE:ORIENTCEM)
has generated 6 x in a little more than two years and now trades at a Mcap of
USD 558.9 MM ! Point to note is the the Mcap of the mother entity before this
de-merger entity happened was a little less than $ 150 MM.
As is the case, given that the
cement business is monoline and has critical mass, all institutional attention
is focussed on it – the newly born, sexy child. As it always happens with
de-mergers/spin-offs, the mother business, which ironically houses a wonderful 25
% ROCE business of electrical appliances (“Orient” Brand of home and kitchen
appliances which is a market leader) has been obfuscated by the other tantrum
throwing difficult child – the paper business which is coming off a trough
(‘reversion to mean’) and is likely to see much better times in the next 1-2
years.
Triple play – tails I can’t lose much, heads I win big, really big
OPIL is a combination of two
intrinsically different businesses that have vastly different characteristics
and leads to a quadri play of:
·
Reversion
to mean: A cyclical business coming off a trough and a secular growth
business (the home appliances business) coming off a one-time expense ( a INR
500 MM (USD 7.8 3 MM)
·
Spin-off/De-merger
play: Given that there has already been one de-merger that has happened
from this business, I believe that the chances of another de-merger happening
and value getting unlocked by the consumer appliances division are extremely
high. The management has done it before and has seen the manifold value that
has been created two years back and I see no reason why they would not do so
again. The last de-merger unlocked about $ 600 MM of Mcap out of thin air and a
cat that has distilled out a sweet pudding from the same dish is likely to do
so again.
·
Embedded
value: OPIL holds about INR 2,500 MM
(USD 39.2 MM) of shares of Hyderabad Industries Limited (India’s largest maker
of fibre cement sheets and concrete blocks) and Century Textiles (an ailing
textile mill that is on the process of being sold). It holds about $ 9 MM of shares
(which is 16% of the company) at cost in GMMCO (India’s largest dealer of
caterpillar equipment http://www.gmmco.in/GMMCO/
with sales of USD 400 MM) that is worth at least $ 40 MM in book value as the
company generates about $ 25 MM of profits. On top of it, the company now owns
a now defunct paper mill in Brajrajnagar with an estimated market value of land
worth at least INR 1,000 MM ((USD 16. 6 MM)). These alone provide about 30-35%
of the value at CMP (about INR
5-7/share)
·
Plain
undervaluation: The business is trading at 1 x FY 15 book value and I
expect the business to do about 12% RoE blended in FY 17 from the core business
without taking into consideration the above mentioned optionality.
Business analysis:
OPIL has two businesses – the
electric appliances division (that’s a high RoCE jewel) and the paper division (that
barely covers its cost of capital and is a declining “dog” business)
Electric Division
Paper Division
Products offerings
Fans, CFL bulbs, luminaires, home
Writing and printing (W&P) paper,
Appliances (air coolers, toasters etc.
tissue paper
Revenues 9M FY 15 E
INR
10,530 MM (USD 165 MM)
INR 3,386 MM (USD 53 MM)
Revenue growth (estimated over the next 3
years)
20%
4%
EBITDA ( 5 year average)
7%
-3%
ROIC ( 5 year average)
25%
-6%
FY 17 E ROIC
22%
8%
-
Fans 73%, lighting 15%, home
-
W&P paper 70%, tissue paper
appliances 12%
30%
Revenue split
-
Ceiling fans account for 80% of
-
50% of tissue paper is exported
fans revenues
- CFLs account for 82% of lighting
Revenues
Fans (domestic) - 2nd largest
Tissue paper - amongst the leading
overall and largest in ceiling fans
exporter from India
Market position
with 25% market share
Fans (exports) - largest exporter
from India
Brands
Orient
1st
Choice, Orient, Diamond Touch
Capacity
Fans – 9
MM units
W&P
paper - 60k tons
CFLs -
10 MM units
Tissue
paper - 25k tons
Analysis of the two segments of business
Revenues
(INR Cr)
Segments
FY07A
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
7yr CAGR
Paper
263
274
290
239
278
334
349
430
7%
Electrical
243
285
341
481
642
756
912
1139
25%
EBIT Margins
Segments
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
7yr avg
Paper
10%
1%
-18%
-12%
-19%
-22%
-3%
-9%
Electrical
8%
10%
13%
9%
7%
6%
6%
8%
ROCE
Segments
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
7yr avg
Paper
17%
1%
-14%
-10%
-15%
-17%
-3%
-6%
Electrical
25%
30%
43%
28%
21%
19%
18%
26%
Note the reversion to mean in the
paper business – management has guided to an EBIT breakeven in FY 15 and my
sense is that this business will generate a 4-5 % EBIT next year, which should
help it generate close to 6-7 % ROCE going up to about 10% by FY 17.
Also, the electrical appliances
business’s ROCE has been dragged down by a rebranding one ime expense of INR
500 MM (USD 7.83 MM) that should start
yielding results over the next 2-3 years and hence should improve ROCE’s to the
20-25% range.
Electrical appliances business
To triangulate and validate the
academic hypothesis that the business is doing well, I spoke to a mid-level
employee in the electrical appliances, a couple of dealers and an employee at a
competitor. The distillation of their views is as follows:
The Orient brand is synonymous with fans and
association of India’s wildly successful cricketer Dhoni has helped build a lot
of brand recall. In fans, especially in Southern India, they are very strong
and have a lot of pricing power. Orient is the undisputed leader in premium
fans a fact acknowledged in the annual report of its closest competitor
Crompton Greaves.
The “fans” association has helped them in their
foray into air coolers where there has been early traction. This should help
them as the average price of an air
cooler is 5 x that of a fan and air coolers is a relatively less competitive
category
Channel checks point to a 20-25% growth in the
years ahead. Given the natural operating leverage in the business (since
manufacturing is outsourced), this should translate to a 100-200 bps in the
EBITDA
The company has put in place a new factory for
low voltage switchgear (Business News Today: Read Latest Business news, India Business News Live, Share Market & Economy News | The Economic Times)
which should provide an optionality. LV switchgear has been a high margin, high
ROCE business for everyone in India (Havells, Legrand, Schneider etc.) and the
company should be able to grab marketshare here.
Electric’s revenue mix%
Products
FY11A
FY12A
FY13A
FY14A
Fans
91%
87%
81%
73%
Lighting
9%
12%
14%
15%
Appliances
0%
2%
6%
12%
A point to note is that the
capital employed in this business went up in the last two years as the company
has invested into an extra factory and also on brand building – the company
spent more than INR 500 MM (On the electricals business) and this should come
back to mean ( ~ 25%) by FY 17 or so as
the effects of branding start playing out on sales.
On the paper business
http://www.icra.in/Files/ticker/SH-2013-Q3-1-ICRA-Paper.pdf
India represents a pretty unique
market where demand for paper continues to grow at 3 % primarily the back of
increasing literacy levels on the back of more than 400 million below the age
of 25. As the above link distils out, a lot of the overcapacity issues
involving the paper industry are bound to go away over the next 2-3 years as no
industry player is looking at adding capacity. Given that, I think the industry
will eventually get back to a state where each player earns a little above the
cost of capital – viz., say ROCE of 11-12 %. Even so, I expect cost pressures
to be a significant risk for OPIL given the increasing issues involving water,
which is becoming scarce. Overall, I expect no excitement in this business
except for a return to recovering cost of capital by FY 17, which will be a
about 8-9 years after the beginning of the reduction in supply.
Paper sales volume mix
Products
FY07A
FY08A
FY09A
FY10A
FY11A
FY12A
FY13A
FY14A
W&P paper
89%
90%
90%
85%
77%
74%
74%
69%
Tissue paper
11%
10%
10%
15%
23%
26%
26%
31%
The company has been well managed
and has been known for its governance standards over the years. Case in point, is
the de-merger of the cement business which was done through a classic mirrored shareholding thereby
protecting the interests of minority shareholders.
Valuation and returns analysis
We have valued OPIL using sum of
the parts (SOTP) methodology. We have tried to calculate EV of both the
businesses – paper and electric – separately. Long term debt has been divided
in the ratio of gross block of two divisions and working capital debt net of
cash has been divided in the ratio of revenues of two divisions. We have valued
paper business at half time its capital employed to calculate its EV and have
accordingly arrived at its equity value of INR 870 MM ((14.7 USD)) which I
believe is quite conservative given that the ROIC should near cost of capital
by FY 17 and valuing it at 0.5 capital employed gives quite a margin of safety.
The electric
business is hugely undervalued by any metric – comparables, market value of
electric division at 457Cr. Next, we have valued electric division, on a
certain set of conservative assumptions and have arrived at its intrinsic
valuation. OPIL’s electric business seems to be trading at a ~55% discount to
its intrinsic valuation of 1,017Cr.
Paper
INR MM
Capital employed (CE)
4, 080
As on Q3’15
Multiple of CE
0.5x
Conservative assumption
EV
2,040
Net Debt
1,180
Intrinsic equity value – A
870
Electric
TTM Sales
12,180
As on Q3’15
EBITDA margins %
8%
Based on peer set
EBITDA
97
EV/EBITDA multiple
12x
5yr median multiple of peer set
is 14.2
EV
11,690
Net Debt
1,530
Intrinsic equity value - B
10,170
Total Intrinsic equity value – A + B = 870 + 10,170 = INR 11,040 MM ((USD 173.4 MM))
Current Mcap = INR 5,560 MM ((USD 87.2 MM))
This indicates a 50% discount to
intrinsic value assuming no growth and at today’s numbers and points to an IRR
of 25%. This, of course does not factor in the embedded value of INR 6-7/share
of holdings in Hyderabad Industries Limited, GMMCo and Century textiles.
Optionality – Future returns
Please see below for workings on
returns analysis -
Assumptions
Growth in electric division
25%
growth in home appliances,
launch of new products and recovery in fans division – in line with past
performance and with peers
EBITDA margins
8%
EV/EBITDA multiple
12
Investment horizon (yrs)
3
Net Debt (Cr)
284
same as Sep 2014 as there
should not be any further requirements of capital
Electric
INR MM
TTM revenues (Q3’15)
12,180
Revenues - FY18 P
23,790
EBITDA- FY18
1,900
EV -FY18 (A)
22,840
Paper
EV -FY18 (B)
2,040
same as assumed to be today
OPIL
EV -FY18 (A+ B)
23,710
Equity value -FY18 – ( C )
22,050
CMP INR
27.15
CMP at (
C ) INR
107.1
IRR
57%
In summary, as the graph below shows, OPIL is a classic quadri play of
the following:
·
One high quality business hidden inside an
average business leading to a de-merger/spin-off play with a clear and present
catalyst
·
Cyclical turn around in one business and secular
growth in the other
·
Reversion to mean
·
“one-off” expenses dragging down earnings
temporarily (re-branding costs)
·
Deep value – trading close to book value
Why does this opportunity exist?
Because this business being a mix
of two diverse businesses has no tracking from analysts following paper (paper
business is sub scale) or electricals (numbers are difficult to fathom as they
are clouded by the paper business). Add to that the micro-cap nature and losses
in the business (which take some time to peel through).
Risks and concerns
Given that this is a long term
play, I am also cognizant of the following risks and have put in place
monitorables to keep track of progress and effect course corrections :
·
Paper division’s
losses do not shrink –Though this
division is no more incurring cash losses, which is a big improvement over last
2 years, it still does not pay back its cost of capital and here any upside
from monetization of land and improving efficiencies would be greatly helpful.
Also, for the de-merger to happen, it is imperative that the paper division
stand on its own legs and hence, this is the biggest risk I see to this thesis.
However, given the cyclical trough, lack of capacity addition in the industry
and a slow pick up in volumes, this should improve over the next two years.
·
Pricing pressure in
electrical appliances – There are
over 15 branded players in the home appliances market making it highly
competitive resulting in lower profitability for these players.
·
Contingent
liabilities on account of water tax liabilities – There is an old tax dispute going on between OPIL and
government of MP. Original amount of tax liabilities was less than INR 100 MM ((USD
1.6 MM)) has grown to INR 3,500 MM ((USD 55 MM)) over a period of 30
years. The company has disputed the same
in a court and the decision is pending. We draw some comfort from the fact that
original liability in this case is very small and these type of disputes tend
to be settled closer to the original claim eventually.
Orient Paper Investment Note.pdf (434.0 KB)