The harsh portfolio!

Alembic Pharma mgmt has missed guidance consistently and stock has crashed to below 700 levels. Are you still bullish on it?

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US generic business is quite unpredictable and I do not rely on management guidances because of the inherent business characteristics. I think I mentioned this in my post on Alembic.

Alembic’s strategy is to gain from shortages, which means their growth will always be lumpy in nature. We saw this in 2016 when they gained from abilify shortage, then in 2020 when they gained from sartan shortage. This is clearly visible in US revenues per product launched, we see a jump in these years (more evident in FY16). I expect such a thing to happen again in the next 3-4 years, I just don’t know when or why.

FY15 FY16 FY17 FY18 FY19 FY20 FY21
US revenue (cr) per launch 12.15 36.11 24.84 20.91 24.30 26.00 23.51

Additionally, Alembic is positioning themself to benefit from this strategy by trying a large number of things (injectables, oncology, onco APIs, EU APIs, etc.). I have also been pleasantly surprised by their Indian business turnaround, this used to be a sore point in the past. And amidst all the pharma API problems, they have maintained gross margins in excess of 70%. This shows they are not going for volume (but for value). So overall, I feel comfortable holding (and adding to) my Alembic position.

All this said, market will only rerate Alembic when it sees execution (in form of actual profits earned). My only long term worry is market might start treating Alembic’s business as an Aurobindo which can lead to structural derating (this is also a worry I have for Laurus). I don’t think that should happen to Alembic which makes gross margins of 70%+ and ROCEs in excess of 20%, whereas Aurobindo’s gross margins are below 60% and ROCEs are in the 15-20% range. Lets see how future unfolds.

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Hi Harsh

good thread and thanks for updates.
I have 1 quick Q - what is going on with Lupin? whole Pharma bucket is doing good with some doing great.
I googled but noting much is helping with regards to Lupin.
Thanks

Lupin has disappointed on the execution front, their compliance problems have meant that they have not been able to launch enough products that can offset base price erosion. Along with this, they have had lots of writeoffs at different points in time, margins have done badly and management has not been able to read the market well. So I think there is a derating going on currently, its probably one bunch of investors are churning out as they have burnt their hands. Among large generics, Lupin and Jubilant have done really badly in the past few quarters. That being said, despite all the disappointments they were able to get back to $200mn US quarterly sales runrate. Lets see if management can turn around the ship.

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Hi Harsh,

For Amara Raja batteries, it shows in screener that promoter decreased their 24 percentage of their holding. Why did they reduce their holding, is it not a bad sing🤔

As of today, I created 2% position size in Punjab Chem. & Corp which reduces cash to 2%. I will categorize this as a turnaround candidate.

History: Company went on an aggressive debt funded acquisition spree in 2003-08 to acquire marketing capabilities in developed markets. This backfired in 2008 when there was a global slowdown and one of their factories had a large fire event, leading them to default on their debt obligations.

Things started changing around 2016-17 when management changed their business strategy, moving towards contract manufacturing for large agrichemical companies. Their largest customer UPL dug them out of the debt hole by giving large business for metamitron. Promoters saw positive business traction and settled debt obligations by infusing their own money. Since then, company has been adding new clients (Kureha, Adama, Corteva, Nippon Kayaku). I was looking at their export data, and it seems they have been supplying Metconazole technical to Valent USA (Sumitomo’s US arm). So, it seems that they are working with a large number of agchem innovators on long term contracts (5-year) and are also supplying certain patented molecules. All of this has meant that business is now stronger, and UPL’s contribution has decreased from 50% a few years back to ~30% currently. Additionally, company has beefed up top management through lateral hires and has appointed a new C-suite (CEO, CFO).

Company has also started doing investor concalls and have been quite honest about their plans. They aspire to be 1500 cr. topline company by 2025 and are confident that current capacity (along with certain brownfield expansion) allows them to reach this number. I found it interesting that their customers pay ~50% for capacity expansion through advances. Lets see how things evolve.

As I mentioned before, I have been building an agrichemical basket as this space is offering very high growth and reasonable valuations. This is actually better than the whole of pharma API theme, where there is more talk than business. Agchem (in technical export) is actually seeing very strong export growth which is because of China+1 playing out, and valuations are much more attractive. In the current fall, I am also looking at acquiring shares of other technical exporters like Meghmani, India Pesticides, Bharat Rasayan and UPL. I will keep this thread updated as and when I allocate more money. The current agchem basket has ~12% weightage and comprises of the following ompanies. I will also be happy to replace Swaraj Engine with a faster growing company.
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Core compounder (64%)

Companies Weightage
I T C Ltd. 8.00%
Housing Development Finance Corporation Ltd. 4.00%
NESCO Ltd. 4.00%
Manappuram Finance Ltd. 4.00%
Alembic Pharmaceuticals Ltd. 4.00%
Amara Raja Batteries Ltd. 4.00%
Avanti Feeds Ltd. 4.00%
Eris Lifesciences Ltd. 4.00%
Ajanta Pharmaceuticals Ltd. 4.00%
HDFC Asset Management Company Ltd 4.00%
Aditya Birla Sun Life AMC Ltd 4.00%
Aegis Logistics Ltd. 4.00%
Gufic Biosciences 4.00%
HDFC Bank Ltd. 2.00%
PI Industries Ltd. 2.00%
Control Print Limited 2.00%
Shri Jagdamba Poly 2.00%

Cyclical (16%)

Companies Weightage
Kolte-Patil Developers Ltd. 4.00%
Sharda Cropchem Ltd. 4.00%
Ashiana Housing Ltd. 2.00%
Ashok Leyland Ltd. 2.00%
SWARAJ ENGINES LTD. 2.00%
Kaveri Seed Company Ltd. 2.00%

Slow grower (4%)

Companies Weightage
Cochin Shipyard Ltd. 4.00%

Turnaround (8%)

Companies Weightage
CARE Ratings Ltd. 4.00%
Lupin Ltd. 2.00%
Punjab Chem. & Corp 2.00%

Deep value (6%)

Companies Weightage
ATUL AUTO LTD. 1.00%
Jagran Prakashan Ltd. 1.00%
D.B.Corp Ltd. 1.00%
Time Technoplast Ltd. 1.00%
RACL Geartech Ltd 1.00%
Shemaroo Entertainment Ltd. 1.00%

Its because Johnson Control was a co-promoter and had sold their car battery business to private equity (Brookfield) in April 2019. This caused them being recategorized as public shareholders. Additionlly, Brookfield sold some stake in Q1FY22. The Indian promoter family has not sold any stake.

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As of today, I have created 2% position in ICICI lombard which brings cash down to 0. The current fall is bringing a lot of companies in my buy range, there will be more churn where I will replace lower growth companies with higher growth companies available at similar valuations.

About ICICI lombard, I have always liked the business due to its short underwriting period thereby less risky than a life insurer and 20%+ ROE in the last 10 years. However, I was very uncomfortable with valuations (10x P/B during majority of its traded history) as I have read a lot about global insurance companies and none have traded at these valuations sustainably. I also had a very long discussion on the ICICI lombard thread in 2020 where my point was a valuation de-rating from 10x P/B to a more reasonable 4x P/B can take away years of returns. This has actually played out where prices have been flat (or slightly down) in the last 2-years and P/B has become a little more reasonable (~6x on FY22 numbers). However, its still a little bit high for my liking, but enough for me to dip my toes given the fantastic ROE company generates. You can look at the discussion I had in 2020 below, it helped me understand that Indian valuations were simply wrong. Are 6x P/B right? I don’t know but its more reasonable given its ROE profile. When an HDFC bank gets ROE of 18-20% and trades at 4x P/B, companies that generate cyclical ROE of 20%+ can trade at 6x P/B. Lets see how future unfolds.

Core compounder (66%)

Companies Weightage
I T C Ltd. 8.00%
Housing Development Finance Corporation Ltd. 4.00%
NESCO Ltd. 4.00%
Manappuram Finance Ltd. 4.00%
Alembic Pharmaceuticals Ltd. 4.00%
Amara Raja Batteries Ltd. 4.00%
Avanti Feeds Ltd. 4.00%
Eris Lifesciences Ltd. 4.00%
Ajanta Pharmaceuticals Ltd. 4.00%
HDFC Asset Management Company Ltd 4.00%
Aditya Birla Sun Life AMC Ltd 4.00%
Aegis Logistics Ltd. 4.00%
Gufic Biosciences 4.00%
HDFC Bank Ltd. 2.00%
PI Industries Ltd. 2.00%
Control Print Limited 2.00%
Shri Jagdamba Poly 2.00%
ICICI Lombard General Insurance Company Ltd. 2.00%

Cyclical (16%)

Companies Weightage
Kolte-Patil Developers Ltd. 4.00%
Sharda Cropchem Ltd. 4.00%
Ashiana Housing Ltd. 2.00%
Ashok Leyland Ltd. 2.00%
SWARAJ ENGINES LTD. 2.00%
Kaveri Seed Company Ltd. 2.00%

Slow grower (4%)

Companies Weightage
Cochin Shipyard Ltd. 4.00%

Turnaround (8%)

Companies Weightage
CARE Ratings Ltd. 4.00%
Lupin Ltd. 2.00%
Punjab Chem. & Corp 2.00%

Deep value (6%)

Companies Weightage
ATUL AUTO LTD. 1.00%
Jagran Prakashan Ltd. 1.00%
D.B.Corp Ltd. 1.00%
Time Technoplast Ltd. 1.00%
RACL Geartech Ltd 1.00%
Shemaroo Entertainment Ltd. 1.00%
15 Likes

Harsh - What’s the narrative here?

95% of earnings would be fairly valued at a multiple of ~18x to 20x. FMCG, ITC infotech and hotel business segments could be assigned better multiples. With this hypothesis, my math (refer table 1 remarks) shows that the current market cap is already at Par.

Earnings from FMCG segment would not grow substantially as sector grows at a sedate pace and the hulk of the sector spends ~4800 Cr in Advertising & Promotions compared to ~1100 Cr. of ITC. Even if they do, impact on the overall earnings would be mild as current contribution in earnings is only 5% (@ S.No 2).

Table -1 : ITC Segment Data (Source - Company AR)

# Segments Revenue % of Revenue EBIT % of EBIT EBIT Margin Assigned Mcap Remarks
1 Cigarettes 22557 43% 13498 83% 60% 182223 @ 18PE, Post Tax
2 Branded Packaged Food Products 12244 28% 838 5% 6% 27654 @ 44PE, Post Tax
3 Others (Education and Stationery Products, Personal Care Products, Safety Matches, Agarbattis, Apparel etc.) 2493 5%
4 Hotels Sales /Income from Hotel Services 660 1% -564 -3% -85% 26400 @ 40x of sales
5 Unmanufactured Tobacco 1314 15% 918 6% 11% 12393 @ 18PE, Post Tax
6 Other Agri Products and Commodities (Wheat, Soya, Spices, Coffee, Aqua etc.) 6688 13%
7 Paperboards and Paper 4011 9% 1099 7% 24% 14837 @ 18PE, Post Tax
8 Printed Materials 539 1%
9 Others 2329 4% 559 3% 24% 12578 @ 30PE, Post Tax
276084

Table -2 : FMCG Advertisement and Promotion Expense Data (Source - Company AR)

Name Sales (Cr.) PAT (Cr.) A&P Expense (Cr.)
Hind. Unilever 51112 8172 4754
ITC 58455 14802 1090
Nestle India 14709 1908 764
Dabur India 10708 1693 784
Britannia Inds. 13717 1864 451
Godrej Consumer 12091 1745 986
Marico 9363 1162 698
P & G Hygiene 3698 653 503
Varun Beverages 8823 694 116
Colgate-Palmoliv 5082 1036 625
Hatsun Agro 6334 248 86
Emami 3152 433 458
Gillette India 2109 310 236
Zydus Wellness 1975 249 229
Jyothy Labs 2145 199 124
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I don’t build narratives to justify investing in a given company. I have shared my speculation on growth in ITC at the end of this post.

There are some flaws in your computation.

EBIT margin of 6% will imply PAT margin of ~4.5%. A 44 P/E (what’s the logic behind such a precise number?) implies valuation of 4.5 x 44 ~ 1.9x sales. This is almost the cost to build a brand. In private markets most good brands trade b/w 4-6x EV/sales. So I think the FMCG business is much more valuable than the value you are ascribing. Also, I will not ascribe such a high valuation for their hotel division.

The EBIT margin for ITC should increase (as has been increasing in the past) and stabiliize at 14-16% kind of levels over the next few years, as branding spends come down and the newer capacities run at optimal utilization. The margins might not go to 20%+ (like HUL, Nestle) because of ITC’s large presence in atta segment which is a lower gross margin business. The main difference in ITC’s business is their integrated nature, where they do everything in-house rather than outsourcing manufacturing. This leads to lower capital efficiency but a more resilient supply chain network. This is similar to what bulk food companies like KRBL, Adani Wilmar do.

About the branded spends in relation to sales, I think we should exclude cigaratte revenues for ITC. If we do a like-to-like comparison for FMCG sales, ITC’s FMCG revenues were ~14’757 cr. in FY21 (similar to nestle) and they spent 300 cr. additional on advertising over Nestle.

About your detailed valuation work
By doing some variant of SOTP, you are arriving at a Mcap of 276’084 cr. for close to 60’000 cr. of sales (FY22E). If we take away cash of 25’000 cr., EV ~ 251’084 cr., this implies EV/sales 4.18x. ITC has broadly traded b/w 4-10x EV/sales over their history. So the current valuation is towards the lower end for their traded history. Just 4 years back, they were trading at 9x+ EV/sales. So there has been a 50%+ de-rating, this can also change in the future where they are re-rated back to a 8x EV/sales.

In my personal investing journey, I have seen this de-rating and re-rating happen quite regularly among large cap companies. When I was buying HCL Tech and Infy in 2017, valuations had de-rated to 2-2.5x EV/sales, and then re-rated back to 4x+ EV/sales in 2021. They were good businesses in 2017 and in 2021, its just that market sentiments changed over this time period. I have had similar experiences in other large cap companies (like Airtel, Bajaj auto, L&T, HDFC, HDFC bank, etc.). I find this sort of investing very easy, where you buy very well known companies when market has lost fancy for them (thus at cyclical low valuations), wait for a few years (and maybe a new bunch of investors) and sell them when they are valued appropriately. Lets see if it happens with ITC.

ITC Projections (as on 01.06.2021)
FY21 sales: 53’155 cr., After five years, revenues will grow at 10%: 85’606 cr. I want to sell it at EV/sales > 8 (implies a P/E of 32 on cyclical high net profit margins of 25%): 684’848 cr.; Assuming a 25’000 cash balance, Mcap ~ 709’848 cr. Current share count: 1230.88 cr., assuming 0.6% share count dilution in-line with history, share count: 1238.27 cr. (share price ~ 570)

Confidence in projection (High)

  • Business quality (high/medium/low): High (Generated 20%+ ROE/ROCE and FCF each year)
  • Promoter quality (high/medium/low): High (Detailed reasoning below)
  • Financial projections (high/medium/low): Medium (Should be able to grow sales at 10%+ in a normalized scenario)
  • Valuation projections (high/medium/low): High (Has traded at >8x EV/sales multiple times in history)
  • Is it a cyclical business (Yes/No): No

Management quality (High, ignoring lower cigarette growth rates)

  • Organic sales growth greater than category level growth: No (Cigarette business growth has been lower than peers, FMCG growth has been higher than industry)
  • Able to find new avenues to grow: Yes (Were able to diversify into FMCG)
  • Treats minority shareholders in a fair manner: Yes (80%+ dividend payout)
Companies Ticker Projection date Price 4 years fwd Price (FY25) Price return % Dividend yield % Total returns % FY25 EPS double over FY21 Business Promoter Financial proj. Valuation proj. Cyclical?
I T C Ltd. nse:itc 01.06.21 225.95 570.00 26.03% 4.76% 30.79% No High High Medium High No

Summary: My expected IRR is in excess of 26% and I have very high confidence in my projections, thus this comes in the 8% weightage bucket.

Hope this clarifies my thought process. Thanks for the detailed note :slight_smile:

30 Likes

Number was arrived from the current valuations assigned to HUL by Mr. Market (earnings were normalized keeping advertisement spend equal to ITC).

Indeed, it does. Thanks for a detailed and well-written response.

Edit (08-March): You laid out the numbers beautifully. And, I understand them finally!!!

In nutshell:
Over the next 5 Yrs, expectation is that the non-cigarette FMCG shall do the Tango dance [revenue should grow at ~ 13 to 15 % CAGR while EBIT margins should touch ~15 to 17%] while other segments would mimic the past performance.

2 Likes

Interesting way of looking at risk associated with Insurance companies, life vs non-life. Just curious if Life was less risky than non-life, why do we have examples of bankrupt non-life insurance companies more as compared to life…Thoughts welcome!

Below link has list of major Insurance bankruptcies in US. Out of 21 bankruptcies, only 3 are pure Life insurance firms

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That’s true, I agree. Reminds me that an ex-LIC Chairman once told me that Life is a profitable business but in Non-Life, once in a while a calamity comes and wipes out several quarters or years of profits. And this happens regularly.

It was a casual but honest opinion and not biased by his background. So I too would think that non-Life is riskier than Life. (Disc: No positions. I am sure @harsh.beria93 has researched his position well, so no comments on this specific buy but just wanted to add an expert perspective).

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I think we also need to consider how many pure life insurance companies are there vs others. As per below website: Facts + Statistics: Industry overview | III.

“In 2020 there were 5,929 insurance companies in the U.S. (including territories), according to the National Association of Insurance Commissioners. This number includes: P/C (2,476 companies), life/annuities (843), health (995), fraternal (81), title (62), risk retention groups (245) and other companies (1,227).”

Only 14% (843/5929) are life/annuities. The bankruptcy list also has 15% (3/21) pure life insurance companies.

So, the bankruptcy rate seems to be similar for life vs others.

Disc: Tracking position in ICICIGI, and considering to create a bigger position.

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Yes and hopefully they will be able to get rid of hotels division by then. Also, I think cigaratte division should grow (in terms of profitability) better than it grew in the last 3-4 years where most sales growth was driven by taxation increase (and not volume expansion). For this, we need a stable tax regime.

Thanks for showing me the base rates, its quite useful. One thing which should probably be accounted for is number of general insurance companies is generally higher than life insurance companies. Also, outside India a lot of general insurance companies can underwrite life insurance policies. But these are just some nitty gritties.

If I had to reframe my thoughts, I would say adequacy of loss reserves is easier to estimate for general insurance companies than life insurance companies (for an outsider like me). Most general insurance policies are written for 1-3 years and the underwriting capabilites will be captured in the reported combined (and loss) ratio in a period of 10-15 years. The same will not be sufficient for life insurance companies as typical policy lasts decades. The kind of acturial assumptions that are needed in life insurance (along with assumptions on future interest rate) impact the underlying value of such firms more than they would impact a general insurer. A good exercise will be to simply compare interest rate assumptions of a HDFC Life vs a Bajaj Allianz, you will see the subjectivity brought in and its impact on embedded value. All this might seem a bit blurry, it will make more sense if one reads long term reports of specific insurers (such as history of Markel).

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why have you put sharda under cyclical category?

As a follow up to this post, I made a presentation on domestic agrichemical companies last week to the VP Europe group. The presentation and summaries are available at link below.

Summary: There is an exponential growth in technical exports from India, most companies are doing very well and a lot of these companies are also available at low valuations. This sector is a better way to play China+1 as there is lower competitive intensity, less regulatory supervisory and better unit level economics.

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Hi @harsh.beria93 do you know how to track monthly AUMs of AMCs, or we can we only get that every quarter? I am invested in ABSL AMC & CAMS.

You can get each month AUM details of fund houses from www.valueresearchonline.com or www.rupeevest.com

Sometimes there are discrepancies.

Valueresearch has been in existence for many years, so I guess you can trust them.

just search AMFI Monthly AUM data on google.

Hi Harsh I have followed quite a few of your posts from the Agrochemicals Industry and I do believe that you are one of the best SMEs on this forum with regards to AgroChemicals.

I was going through the Presentation and I would only like to point out one thing which is a view on Corporate Governance. I see that 2 of the companies Meghmani ( How Shady Corporate Governance Has Given India Inc. a Bad Name » Capitalmind - Better Investing ) and heranba ( Heranba Industries | IPO Analysis | SPTulsian.com ) having histories of their own which is never a good sign for retail investors according to me. Also I was pretty interested in Punjab Chemicals but the concall did not instill in me the quality plus its linkage and somewhat hidden nature of association with UPL seemed to be an rationale for not investing.

I know Meghmani personally having seen their IT landscape and their IT investments for the future but I guess its no easy to wipe off your past . Apparently the general public seem to forget these instances but its better to be brought up again and again so that some sense prevails in the market madness.

As a safer bet went ahead with position in Bharat Rasayan as it has proven to be delivering with its successful JVs with Nissan . PI was already a part of my portfolio and I need to look into Sharda CropChem again .

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