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).
Read MoreWe 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 4th 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
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.
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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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.
Read MoreWe 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
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.
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.
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 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.
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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Read MoreHDFC 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.
Read MoreA 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:
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 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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Read MoreLife 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.
Read MoreOur call on JSW Energy is a non-consensus call. What do we see that others do not?
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 4which 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’s API facilities in Visakhapatnam are a hugely advantaged Asset in today’s environment.
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
Progress on the transformation is visible in FY 19 results
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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Over the last few years China has witnessed wide spread governmental crackdown on its chemical industries due to pollution & environmental concerns, which has resulted in arbitrary shutdown of entire chemical belts (including non-polluting manufacturers). Further, fear of trade wars with the US has led to MNCs looking to de-risk their supply chains.
Indian Chemical players with a track record and culture of environmental compliance, and who have invested to build a technology edge should benefit structurally as India is home to strong chemistry and process development skills, low cost manufacturing & good track record of respect for customers IP.
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