Perspectives

INVESTMENT THESIS ON GARWARE TECHNICAL FIBRES LTD

A Technical Textile is a textile product manufactured for non-aesthetic purposes, where function is the primary criteria. Garware Technical Fibres (GTF) manufactures Technical Textiles catering to needs of the fishing, aquaculture, sports, agriculture, defence, shipping and the infra sectors.

GTF has been in the Technical Textiles business for over 4 decades.  Led by Vayu Garware, it is now the largest netcompany globally with 2.5x scale advantage over its closest domestic peer.  Over the last few years it has evolved its business model to designing more customized products for clients from just selling commodity products.  ~ 70% of GTF sales in 2019 came from value-add customised products, up from 35% in 2015.  

Customization is creating more end value for customers. Some examples:

• Its Fishing nets have improved yields and reduce costs for fishing trawlers – Some of its nets are as strong as steel but nearly 7 times lighter, which lowers drag helping save fuel costs by up to 40%.
• Its aquaculture cage nets reduces in site cleaning cost by 50% and ensure better cleaner fish through lower disease rate. Its predator cages protect salmon farms from seals resulting in record decrease of its licenced culling.

This has also resulted in significant market share. It is the domestic market leader in Fishing Nets (65% market share) and Shipping ropes, and has almost monopoly status in aquaculture in Scotland & Canada.  

What makes GTF a core part of our portfolio is:

• The focus on customization and new product development.  ~ 30% of GTF revenue is from products which are <2 years old.   We don’t come across many Indian companies who are global and investing to build competitive advantage through product differentiation.   Value addition through customization builds customer intimacy, which is a key differentiator in a B2B business.  
• The financially attractive business model.  As more value is created for the customer, there is a clear differentiator vs other competing products.  Customers are more willing to allow some pricing premium and there is higher ability to pass on RM price increases.   Further, a labour-intensive product manufactured in India provides a cost advantage.  This is reflected in its financial numbers as EBITDA has expanded from 10% in FY 2015 to ~18% in FY 2019 with a ROIC post tax of ~30% in FY 2019 – quite exceptional for a Manufacturing B2B business
• The growth opportunity ahead of it.  GTF is still a USD 140M company while the total Technical Textiles market is worth USD 165 B.  There are multiple drivers of growth – ability to expand into new segments, new markets and upsell higher margin products.   GTF has ~3000 products which serve needs in 7 Sectors today.

The company’s growth over the last 5 years has been tepid at 8% CAGR. This is because even though the higher margin export sales (58% of mix in 2019) has grown at 12% CAGR, domestic sales growth (more commodity portfolio) has been sluggish at 4% CAGR primarily due to delay in offtake of defence products, weak agriculture growth due to time consuming process to educate farmers and increasing competition in commodity fishing and shipping products.

Our hypothesis is that Exports should continue to grow well (as GTF continues to expand into new products and geographies). Domestic sales growth should also revive as defence spending (Surveillance balloons, sleeping bags, inflatable tents etc.) and fisheries picks up (GoI has allocated 25,000crs over next 5 years on projects to attempt l doubling of Fishermen’s income). Moreover, other segments like Agriculture have significant possibilities – Agriculture nets improve crop yields by up-to 30%.

Management is stepping up Cap ex (will spend ~120-150crs over next 3 years to augment capacity versus ~75crs over last 3 years) and new product launches (Launched 28 unique products in 2018 versus 19 over 2011-16). All the above provides confidence that growth rates should pick up.

The track record of Small Caps that have been able to grow into Large Caps is poor because of inability to scale.  GTF has the market opportunity, business model, segment leadership and Balance Sheet quality to make this transition (~235 Cr net cash as of 31 March 2019).   Given the potential and longevity of growth (we believe the bottom line can grow at 15% CAGR over long periods with fairly high consistency), dominant franchisee with strong customer value proposition, high ROIC, and a strong Balance sheet, we find GTF reasonably priced at 18-20x FY 19 Earnings adjusted for new tax rates. We have hence taken an initial position and will look to add over time.

Our risks to the thesis are non-materialization of growth.  Further, the GTF management communicates with minority investors only once a year at the AGM.  While there is nothing wrong with this approach (we like managements who don’t spend excessive time on Investor PR), it does create a time lag in interpretation of financial results.  

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INVESTMENT THESIS ON MAX fINANCIALS (PLAY ON MAX LIFE INSURANCE)

Life Insurance is a decadal and more growth opportunity.  India’s Insurance penetration is very low and as awareness increases, more people will buy Life Insurance (penetration) and people will enhance their cover as Incomes increase (consume more).   In an industry that offers long term growth prospects, there can be many winners as there is space for many players. 

Max is a well-run franchise reflected in high persistency (renewal) ratios and amongst the most productive Agency channels (own sales force) in the country.    Max Life is distributed by Axis Bank with ~57% of its business originated by Axis Bank.  However, its partnership with Axis Bank expires in Sep 2021 and uncertainty of whether the partnership will be renewed hangs heavily over the stock price.  Bank led distribution is a key success factor in an Insurance company’s growth.

INVESTMENT THESIS ON JSW ENERGY

Our call on JSW Energy is a non-consensus call. What do we see that others do not?

• JSW Energy has ~ 80% of its capacity tied up under PPA.   With limited manufacturing capacity coming on stream, the Power demand/supply gap will shrink over the next few years benefitting players like JSW Energy who have spare capacity to sell in the Merchant market.
• Moreover, with a Debt/Equity <0.9, ~2000 Cr Free Cash Flow Generation (post interest expenses) and well placed to invest for future growth (among the favourably placed to win troubled Power Assets at the NCLT). 
• JSW Energy has a great management team, has displayed significant discipline in the past, and the cash generation means that the Market Cap/Enterprise Value ratio only keeps increasing over time, even if additional power generation capacity is not being added.  And at current market price it is trading below replacement cost and at 5X Free Cash Flow. 

INVESTMENT THESIS ON SEQUENT SCIENTIFIC

Many Indian companies have created large Human Pharma businesses out of India.  However, other than Hester Bio Sciences ¹ (focus on Animal and Poultry vaccines), there are no Pharma companies with a global footprint out of India focusing on Animal Health.  Sequent’s strategy is to create an Integrated (formulations + API) Animal Health care company out of India.

In buying Sequent, we are also aligning interests with an entrepreneur (Arun Kumar) with a strong track record of value creation in Pharmaceuticals and Life Sciences.²

Animal Health is an attractive business segment.  Compared to Human Health (USD 1000 Bn), Animal Health is a much smaller market (USD 42 Bn), with favourable implications for competitive intensity.  However, leading Animal Health care companies have margins ^{3 4}which are significantly higher than leading Human Health care companies.   Animal drugs/products in the Developed markets are primarily sold as Branded products, which need to be prescribed by Vets, akin to how drugs are sold in India. Most Human Pharma products are primarily sold as Generics.  Animal Healthcare requires limited innovation or new product development as the goal is not to prolong life but more to enhance productivity/safety of Animals.  Hence, R&D expenses are much lower vs. Human Generics.  At the same, regulatory scrutiny is intense. 

It takes time to build an Animal Health business organically and reach meaningful scale.   Existing brands and relationships are moat’s to be overcome by a new entrant Hence, M&A for a new entrant as a way to achieve scale cannot be wished away.  Product registrations are required by country, front end relationships need to be created with vets in each market. While an M&A led strategy is inherently risky, there are examples of Management teams that have made it work and created significant value by being disciplined on acquisition prices paid and through a process of rapid integration. 

Over the past five years, Sequent has been transformed into a focused Animal Healthcare franchise.  

• Sequent was a portfolio of unrelated businesses prior to 2014 with Animal Health ~38% of revenue.     All non-Animal Health businesses have either been divested (Specialty Chemicals, Women Health), demerged into other companies (Human API) or shut down (Penems).   
• API Facilities were upgraded for compliance with developed world regulatory standards.  
• Formulations: Over 9 acquisitions (of which 3 were material) have been completed.  Acquisitions were of sub scale businesses where promoters lacked Capital for growth, but had access to registrations, distribution and/or manufacturing facilities.   Sequent has invested growth capital in the Businesses and ensured that erstwhile promoters retain some minority stake for continued engagement.  Sequent now is present in over 100 markets across the world and has Manufacturing sites not only India, but also Brazil, Germany, Spain and Turkey which provide local market proximity and a de-risked manufacturing footprint.    

Sequent’s API facilities in Visakhapatnam are a hugely advantaged Asset in today’s environment.

• Sequent already supplies APIs to the top 10 Animal Health care companies globally, is the only USDFA approved uniquely Animal API facility in India and has the highest number of Animal API filings in the US amongst all API players globally. 
• The up-gradation of Infrastructure and compliance standards in Sequent’s API facilities has coincided with tail winds of increased FDA scrutiny on API players,⁵ China’s crack down on pollution and US China trade and geopolitical tensions.   Many API players in China have to invest in zero liquid discharge facilities which reduce their historical cost advantage over India.   Geopolitical issues are making US companies look to diversify their sourcing from China. ⁶ 
• When supply stability is threatened, supply availability becomes paramount and pricing is secondary.   This has created a significant opportunity for Sequent to gain market share in APIs with developed world companies while earning its fair share of the margin in the entire value chain

After 5 years of grind, we believe Sequent earnings/cash flows are now poised to break out over next few years.   The API business should deliver very strong cash flows in the short term with Formulations picking up pace in about 2 years

• We expect the API business to register robust top line growth and even stronger bottom-line as lower margin developing world business is replaced with higher margin business from the developed markets.  In addition, the API business has significant Operating Leverage.  Growth with some pricing power without proportionate increase in Fixed Expenses should translate into a big boost in EBITDA growth. 
• The Formulations business is growing at ~10% (constant currency) with some infusion of Working Capital into acquired companies.  R&D investments being made (35 products under development), more control on Manufacturing facilities located within the same geography should help step up growth rate over the next few years. 

Progress on the transformation is visible in FY 19 results

• API business grew 38% in FY 19 over FY 18.   The top 5 customers from Developed markets have grown their API sourcing from Sequent 2.4X in FY 19 over FY 18
• Formulations growth has been steady
• Operating cash flows were 115 Cr in FY 19 compared to 56Cr in FY 18 and –10 Cr in FY 17
• Debt reduced significantly from 5x Debt/EBITDA in FY 16 to 1.5x Debt/EBITDA in FY 19.  If monetizable investments ⁷ are included as Cash equivalents, Sequent is practically debt free with Debt/EBITDA < 0.2x

The company now has a credible global distribution network for formulations which will be enhanced with entry in the US markets by FY 21.  The strong cash flows in the API business over next 3 years will help expedite investments in R&D and product filings across multiple geographies leading to strong growth in formulations FY22 onwards. This would make it a very valuable platform for a potential acquirer.

We believe the current stock price is not reflecting the transformation delivered by the management in the last few years, the fact that a lot of the M&A risk is behind us or the prospects for incremental cash flow growth and ROCE.     Sequent had a massive stock price run up between 2014- 2016 (see chart below ⁸) perhaps driven by the value creation reputation of Arun Kumar.  Despite a confused business portfolio and no profits, the promoters’ track record catapulted the stock to a peak Market Cap of 6000 Cr.  When the numbers did not live up to the narrative, the stock declined over time.   Pessimism often becomes deeply rooted.   Even though the numbers are now supporting the growth narrative, there is insufficient interest with very limited Institutional holding or broker coverage.   This provides an opportunity to ride both earnings growth and valuation re-rating.

Even as the narrative for Sequent is strong, future cash flows will be a function of how well the management team executes in building the Formulations franchise, and also how the sourcing environment for APIs for regulated markets evolves in China (which will influence market share and margins in APIs for Sequent).   The competitive moat is not very wide at present, but is being built.   We have hence taken our first “foot in the door” position and will build it further over time as we see evidence of execution. 

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1. Hester has just started to build a footprint in Africa ↩︎
2. https://the-ken.com/story/strides-sequent-solara-an-indian-entrepreneurs-ingenious-pharma-spiderweb/ ↩︎
3. Zoetis, the industry leader is at ~34% EBITDA margins ↩︎
4. Despite being #3 player in Turkey, Sequent’s Turkish operations earned ~35% EBITDA Margin in FY 18.  ↩︎
5. The API industry was in the dog house for many years as low regulatory oversight led to a proliferation of suppliers and a collapse in margins.  Over the last few years, the US FDA has increased scrutiny on API and intermediate suppliers.  It becomes unviable for API players to supply both regulated and unregulated markets from the same plant as compliance costs don’t justify unregulated market margins.  Many players have chosen just to focus on unregulated markets. ↩︎
6. API business models that are more reliant on selling in spot markets or developing markets, rather than regulated markets will be vulnerable when China supplies return.  ↩︎
7. Sequent’s equity stake in Strides and Solara post demerger of the Human API business is valued at ~180 Cr ↩︎
8. Net Debt used for EV calculation considers monetizable Assets as Cash Equivalents ↩︎