Select Company Perspectives

INVESTMENT THESIS ON STAR HEALTH LIFE INSURANCE

Star Health is a Health Insurance company primarily ¹ focused on the retail segment. This is a business we would like to own for long periods of time.

• It offers a product which has a tangible value proposition – Health insurance is something we think everyone should own.
• Dominant leadership position in a large and growing market with a long runway for growth.
• Attractive business fundamentals supported by high repeat purchase, agent stickiness and ability to correct pricing errors through product repricing.

INVESTMENT THESIS ON MAYUR UNIQUOTERS

The lack of Earnings growth for Mayur in the last few years coupled with no immediate triggers has resulted in a reasonable valuation today.
We continue to own Mayur despite a few years of no operating earnings growth because its poor financial performance can be principally explained by the environment. The business is evolving well on operating metrics and its valuations are attractive. We also have a variance perception on key person risk.  While Mr Poddar is the visionary and face of the firm, the business growth and resilience are not as dependent on the promoter as the market believes.

INVESTMENT THESIS ON SOLARA ACTIVE PHARMA

Solara has a strong Pharma API ¹ and an emerging CRAMS ²business.  It has recently announced a merger with Aurore, a privately owned company in the API/CRAMS space.  Pharma API is a USD 180B industry globally of which India has ~ USD 4B share.  The developed world has been outsourcing manufacturing and India now has the additional tail wind of the developed world wanting to de risk from China (USD 35B).

INVESTMENT THESIS ON AXIS BANK

We believe Axis is amongst the 4 private Banks in India that has the right to win long term. It offers opportunity for long term compounding but where entry valuations are significantly in favour in a richly valued market.

Partners are aware that we already own ICICI Bank, HDFC Bank and Kotak Bank as our core Banking positions. 

Why add a 4^th Bank? Banking is not a winner takes all business.  The RBI ban on issuing of additional credit cards (now lifted) and repeated technology outages at HDFC Bank is a reminder that one never knows where risk lurks.  If there is opportunity for multiple players to do well, one should spread the risk. 

We believe Axis is amongst the 4 private Banks in India that has the right to win long term. It offers opportunity for long term compounding but where entry valuations are significantly in favour in a richly valued market.  

The principal value of any Bank lies in its deposit franchise.   A bank’s Cost of Funds (COF) determines its right to win long term because it can choose the risk it wants to underwrite.  If COF is not in the top decile, you are doomed to a vicious cycle of pursuing higher risk segments which eliminates resilience during a crisis.  And it takes time to build a superior COF position.  Low valuations accompanied by high COF is a high probability value trap.  As one can see from the chart below, Axis’s deposit franchise is amongst the best in the business, even as it has ceded some ground to its peers in the last few years.

Source: Spark Capital

Financial institutions are like icebergs as the true risks in their Balance sheets are not well disclosed.  Hence, a conservative mindset in credit and credibility on reported NPAs is key.  Under new leadership, Axis Bank is undergoing a transformation to a fundamental culture of conservativeness with a more prudent provisioning policy, more granular loan book being built and prioritizing credit discipline over growth. ¹ 

Why is the stock trading at close to 1 std deviation below mean valuations in a raging bull market?

Source: Bloomberg

• Axis was seen as a superior franchise to ICICI Bank till a few years ago with much lower cost of funds but ICICI Bank has now pulled ahead with more granular lower cost deposits and higher NIMs.
• Axis leadership does not seem as well settled as its peers. The top deck comprises people mostly hired from outside the bank with very low tenure at Axis vs peers.  The average tenure within the group of the top leaders at Kotak, HDFC Bank and ICICI Bank is well over 20 years. 
• This has led Axis to miss growth opportunities such as the one created when HDFC Bank was stopped from growing in Credit cards by regulators.  And hence Axis has reported far lower growth than other Banks in H1 of this year. 
• Moreover, there is also a credibility deficit that needs to be bridged.  The CEO mentioned an 18% ROE target by 2022 (a CEO’s aspiration is Dalal street guidance) at the start of his tenure and the bank is far from that number at present. 

Despite the above, we believe Axis Bank at present provides a compelling opportunity as this pessimism is being reflected in valuations (one std dev below mean) while growth is looking up. Hence, Axis offers a rare combination of both growth and valuation re rating. 

• While ICICI Bank is a superior franchise at present, (it is also our 2^nd largest position), we believe that 5 years from now Axis Bank can be a 15-17% ROE business while growing Book value per share at 15%+.  The bank’s transformation journey is perhaps two years behind ICICI Bank, and it is well positioned to gain market share in the Banking system from weaker players. 
• We don’t worry about short term growth rates in credit, and these can be especially misleading in Banks when cautiousness may be prudent in an unpredictable environment. And a leadership team which is reorganizing itself after a period of credit losses will understandably be more cautious in underwriting risk.  That is not a structural issue in our opinion and growth rates will inch up over time. 
• The management team is not in denial as can be seen from a recent interview of Amitabh here where he concisely lays out the work to be done for Axis to catch up with its peers.

In our optimistic scenario, we assume Axis valuations re rate over time to one standard deviation higher than mean.  In this scenario, the returns could be closer to what one has seen in ICICI Bank over last 3 years. When sentiment changes, multiple expansion happens swiftly (see chart below).  However, markets tend to wait for certainty.  Therein lies the opportunity as you can get superior outcomes by ignoring the herd if you are willing to bear short term pain and not play momentum.     It was only 3 years ago that ICICI Bank was derided for having a fundamentally flawed culture and now ICICI Bank seems to be the consensus pick for the Banking stock of the next decade. 

Source: Bloomberg

In our pessimistic scenario, Axis Bank’s transformation remains incomplete, and its deposit franchise weakens.  Or it is unable to gain market share on Assets.   This could happen if the Axis senior leadership team is not stable.  In this case while returns in Axis Bank will be poor, the beneficiaries of its challenges will be the other three private Banks (ICICI, HDFC, Kotak).  Hence, as a portfolio play, we will do fine as we are also participating in the others quite meaningfully and they would then generate significantly better returns than our base case estimates. 

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1. As on 30 Sep 2021, total restructured loans for the bank stood at just 0.7% of loans, whereas the BB and below exposures are further ~1% of loans. Restructured loans as % of respective loans across segments are 0.7% for corporate, 0.8% for retail and negligible for SME. Provision coverage on overall restructured book is 24% with 100% cover on all unsecured retail. ↩︎

INVESTMENT THESIS ON ITC

While our core approach to investing is to buy “disciplined compounding stories at a fair price”, it is equally true that “at the right price, all assets are AAA” (except where one suspects governance issues). We will buy companies in “Special Situations” when they trade at a meaningful discount to fair value. ITC meets our Special Situations criteria.

ITC has multiple business lines.

INVESTMENT THESIS ON INDIAMART

We hold a position in India Mart whose price fell sharply since then by ~35% in the last two weeks.

In this note we explain
a) Our Investment thesis on the company
b) Our hypothesis on what could explain the decline
c) How we have acted post the steep decline

Investment thesis

India Mart is a B2B product and service listing platform that allows buyers to discover vendors for specific products & services.   Suppliers are allowed free listing but pay a price to get more visibility and leads. 

We find India Mart an attractive long term investment opportunity as

1. It has a long runway for Earnings growth in its core business through volume, pricing and operating leverage.
2. Significant competitive edge which reflects in high market share and expanding margins
3. Attractive economic model which generates Infinite ROIC.
4. Option value of adjacencies.
5. Conservative and disciplined management that we trust and which stands out vis-à-vis the more cowboy approach we see in new age tech companies

Long run-way of growth

India Mart customers are primarily SME.  It has about 70 Lac “supplier fronts” on its platform of which 1.56 Lac are paying customers (balance are free-listings)

We believe the number of paying suppliers can continue to grow over time. 

• There are 58 Lac SMEs in India who have registered for “Udyam” (needed to bid for Govt tenders and get subsidized loans)
• 120 Lac GST registrations in India. 
• 18 Lac customers of the Software Tally.
• 1688.com, a similar business model in China, has 9 Lac paying customers (~6x of India Mart).

Average revenue per user

The average revenue per customer is ~48,000 today.  We believe India Mart has significant pricing power which it can exercise once user growth slows to create win-win outcomes.   For example 1688.com which enjoys ARPU of ~1.45 lacs has grown its top-line at 30% CAGR over 2015-20, primarily through price increases.

• As India Mart can track how much a customer is benefitting from enquiries/lead generation, it can segment and continue to migrate customers to higher pricing tiers where it offers suppliers more visibility.
• It can continue to provide more value-added services and charge a higher price for the same.  For example, India Mart is adding features like product videos. 
• India Mart plans on introducing differential pricing based on value of products, which can be ARPU accretive given high value nature of products transacted on platform (On Average ~$600)

Significant competitive edge

The business model enjoys network effects as a virtuous cycle gets created.  More buyer participation attracts more seller participation which in turn gets more buyers on the platform.  Today 100% of buyer traffic is generated organically without advertisements. ~36% of suppliers on the platform are also buyers and 55% of buyers are repeat buyers.

The number of products, buyers, suppliers and transactions on India Mart’s platform has continued to increase resulting in increase in Cash Generated from Operations.

Not surprisingly, India Mart is the dominant market leader.

Attractive economic model

The business has about 80% contribution margin (Revenue less Customer Service costs) and hence has significant operating leverage and better productivity as over time Revenues will increase faster than Fixed costs.  Moreover, Contribution margins should also expand over time as more technology is leveraged for automation.   Hence we expect EBITDA margins to keep expanding over time by 1%+ per year even as Revenue can grow 20%+.

As suppliers pay in advance, India Mart operates on a negative working capital cycle and requires no fixed assets.   Hence, incremental return on capital are very high with FCFF exceeding PAT as no significant re-investments in Fixed Assets required and all Technology expenses routed through the P&L Account. 

Option value of adjacencies

We like to think of India Mart’s business definition as that of a “company enabling SMEs to compete in the digital age through enablement of commerce”.  Hence, while its core offering is the product/service catalogue service, it can offer other products/services to SMEs over time.  Hence, the average revenue per user can continue to grow non-linearly. 

It has also recently acquired an accounting software company and continues to invest in start-ups in related service offerings that SMEs need.  Its sales force can over time cross sell these products to suppliers registered on its website.   This “Option value” can create growth over and above the 25% EBITDA growth we believe is achievable in the core business. While it is still early in the integration of acquisitions/investments to the core platform, progress on of the early investments, Vyapar, has been quite remarkable.  Since Sept 2019 till date, paid users and monthly revenue run rate has increased from ~15k to 100k and 20 lacs to 1Cr+ respectively.

Conservative and disciplined management

The business has been built over 20 years with experimentation and discipline rather than the “fast burn” model one sees in new age Digital business models.  All through the pandemic, the management has not talked up its prospects but talked about challenging business conditions.  They have been very cautious in investments in adjacencies taking small stakes in companies, barring the recently announced 500 Cr acquisition. 

Why has the stock price collapsed recently?

India Mart used to trade at about 2200/share pre the pandemic (about 2 years ago).  It ran up to a peak of 9800/share in the last 2 years.  It was trading at about 6800/share in mid-January and fell ~35% over the last 2 weeks. 

The following reasons could have led to the price decline.

• The market did not like results.  India Mart reported 8% Revenue growth and 10% EBITDA decline for Q3 results.   This perhaps has not been taken well by the markets, especially for a Digital company that should thrive during Covid.  India Mart’s progress should primarily be evaluated based on Cash Collections from customers and not on quarterly P&L which gets impacted by revenue recognition and how management steps up Sales and Marketing efforts.  Hence, while EBITDA declined 10% YoY, Collections from customers grew 24% in the quarter and 41% for 9M comparison which we think is good execution in a tough environment for SMEs.  What matters is Cash Flow and not accounting profits.

The pace of volume growth guided by management was too low relative to expectations.  The management guided for about 6000 new customers per quarter, which implies ~15% volume growth. This was perhaps not exciting enough for the markets that have expected much faster Digital adoption by SMEs.  This growth is reasonable in our view given the SME sector would be hurting due to lockdowns and the company has enormous pricing power once SMEs can experience what the company has to offer. Longevity of growth and pricing power is being underappreciated.

• India Mart announced a large acquisition which the market perceives as being reckless.  India Mart has agreed to pay 500 Cr to acquire an accounting software company (BUSY) with Revenue of 40 Cr and PAT of 11 Cr.  This deal does look expensive if judged standalone but we must respect judgement of entrepreneurs who have shown conservatism in the past and keep in mind current market context of prevailing digital valuations.  We believe India Mart has significant ability to boost growth of this business due to cross sell potential to the 7Mn suppliers registered on its website, the less than 20% overlap in customer base and through its ~2600 field sales employee force.  A strategic acquisition deserves a premium, and there is significant VC interest in Software/Digital assets at present.  With a ~2,500 Cr cash balance and cash accretion of 300-350 Cr a year, this is something one can live with, especially when strategic synergies exist and no leverage is being taken.

Correlated sell off in Internet names.  Almost all recently listed Digital business models in in India are loss making.  These companies have sold-off recently (chart below shows 1 month price movement) and one wonders whether India Mart has also been collateral damage of a sectoral sell off despite being solidly profitable and cash generating

Solidarity stance

A sharp price decline always triggers an immediate re-examination of facts to ensure there is no new information that requires us to revisit our thesis.  Based on what we know at present, the Investment case for India Mart has not changed. 

We take rolling 5-year views.  The ability to not worry about optimising short term outcomes helps us to take advantage of price dislocations.  A sharp sell-off does not change our conviction as there are people out there operating with different time horizons, objectives and compulsions.

We typically hesitate from paying up over 50x PE ratios for any company as when you pay such high multiples, there is always the risk of “unknown unknowns” which you cannot eliminate. However, we believe a 50x Free Cash Flow multiple for India Mart is justified if it can grow bottom-line at over 25% for a decade (user growth, ARPU growth, operating leverage) and has a significant and expanding competitive edge with option value for growth in adjacencies.  With Infinite Return on Invested Capital in the core business, it generates significant cash flow requiring no re-investment.   

We had first bought India Mart two years ago and had trimmed some of our position on the way up when we felt valuations were euphoric.  We had started buying India Mart on the way down for new accounts. 

We have hence used this opportunity to add to our positions in accounts where we have cash. 

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INVESTMENT THESIS ON HDFC BANK

HDFC Bank is perhaps India’s most secular compounding story with over two decades of superior growth backed by prudent risk taking

Enclosed is a brief note to explain our thought process underlying this investment.

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.