Phillips Carbon Black Ltd - In a Sweet Spot!

There will be some people who will surely run away after seeing that Phillips Carbon Black Ltd (PCBL) is a RPG group company, hence the warning! :-) Also, please read my disclosure at the end of this post.

PCBL is India's largest manufacturer of Carbon Black. It is also the largest exporter of carbon black in India, deriving around 20% of its revenues from exports. The company has three manufacturing units with an installed capacity of 2.7 lakh MT, as shown in Fig. 1.

Carbon black is basically a black powder, used as a reinforcing agent in rubber. The tyre sector accounts for more than 60% of the carbon black consumption in India. The principal raw material for carbon black is carbon black feedstock (CBFS), which is a crude derivative. Hence, its price is always pegged to the price of crude. (Fig. 2)

Consider the following points about the carbon black industry in India:

• Only 2 players, PCBL and Hi-tech, a unit of Aditya Birla Nuvo, control over 80% of the country's carbon black market. It is a virtual duopoly. (Total size of the market is approx 6.2 lakh MT) 
• However, the duopoly does not result into any pricing power for the pair. The risk of cheap imports (a.k.a. dumping) always ensures that the carbon black prices are benchmarked with international prices. Carbon black is a commodity business, with operating margins between 13-15%.
• Currently, the industry is protected by an anti-dumping duty which is in force.
• Tyre manufacturers are on a massive expansion spree in India, which will inevitably result into improving demand for carbon black, which is expected to grow at a CAGR of around 8% over the next three years.

Sounds cool? So what is PCBL doing to take advantage of this situation?

• Of course, PCBL is expanding capacity from the present 2.7 lakh MT to 4.1 lakh MT (0.9 lakh MT Greenfield at Mundra and 0.5 lakh MT Brownfield at Kochi). These capacities are expected to be operational towards the end of this calender year. Considering the customer-industry growth, this expansion seems to be well-placed.
• PCBL has also made its maiden international foray by forming a 80:20 JV with Vinachem, a Vietnam based company for manufacturing 1 lakh MT of carbon black in Vietnam.
• During the manufacture of carbon black, a combustible waste gas is released, which has to be flamed up. PCBL has established co-gen power plants, where this waste gas is used as fuel to generate power. The company is targeting expansion in this segment too, from the present 44.5 MW to about 70 MW. This move augurs well for the company, since there is virtually no feedstock cost (no coal/gas required). The per unit cost of generation is below 40 paise/unit, while the power can be sold on merchant basis at above Rs.4/unit. This segment wont add much to the top-line, but will add tremendously to the bottom-line.
• For re-using this waste gas, instead of flaming it up, PCBL is also eligible for carbon-credits. (Not clear exactly how much)
• Additionally, PCBL also has investments in listed group companies, with market value of investments of about Rs.100 cr. (Since i do not believe in the 'holding company valuations' theme, this is totally meaningless for me.)

PCBL is currently valued by the market as given. One can check the detailed financials of the company here. The trailing valuations surely look cheap. With the expansion expected to be operational by the end of this calender year, the carbon black business can do close to Rs.190 cr operating profit for FY11. (Assuming 2.8 lakh MT sale @ Rs.50000/MT and operating margin @ 13%). All the figures have been taken on a bit lower side, to be conservative.

The power business, on the other hand, is an even better story. By the end of next year, PCBL will have operational power capacity of 70 MW against 44.5 MW currently. Out of this, about 30 MW would be used by PCBL and the remaining 40 MW would be sold to SEBs. When the company starts generating power at full capacity, the operating profit from the same could easily be more than Rs.100 cr.

Surely sounds like a steal? Well there is some stuff I am afraid of:

• This RPG group company may do something RPG-ish and screw up returns for shareholders of PCBL.
• Volatility in crude prices as well as forex could distort future numbers.
• Like PCBL, Hi-tech also has aggressive expansion plans. If tyre demand were to taper off or is not as high as expected in future, both these players will sit on their expanded capacities, looking at each other! This is typically what happens in a lot of commodities and is exactly why investing in commodity companies should not be one's first choice.

To sum-up, PCBL is currently in a sweet spot, with decent visibility of revenues as well as profits over the next two years. The EPS growth could also be accompanied by a PE re-rating, once the 'power story' of PCBL gets marketed well! ;-) On the basis of current as well as forward valuations, the 'bright future' does not seem to be priced-in at the present market-cap..

Cheers and happy investing!!

P.S. : Investing in commodity companies is risky. Investing in a RPG group commodity company is, therefore, risky-raised-to-two. So, considering the illustrious history of the RPG group, I have yet not had the guts to invest in this company. I do not have any position in PCBL.

An interesting (and profitable) experiment..

As I had mentioned in my introductory post, as a hobby, I teach in 3 B-Schools in Pune as a visiting faculty. Besides the regular syllabus, I discuss lots about psychology, investor behaviour etc in class. Sometimes, I also conduct certain experiments where my poor students become the guinea-pigs! (evil smile)

I recently conducted an experiment in Behavioural Finance which i had adapted from one of the many books i read on the subject. The results were pretty interesting!

I started by telling the students that I am going to sell them a Rs.50 note. The concept of 'buying money' itself was a bit hard to digest for some, but what the hell. I also told them that this note was signed by a very famous personality and they could get at least Rs.1000 if they sold that autograph. (This was a mere distraction; the note was signed by just me, but I refused to tell them whose sign it was!!) Almost everyone started fixating on whose signature it might be.

Then I asked them how much would they pay for it. Most of the students quoted an amount up to Rs.50. Some dare-devils also quoted beyond 50. I asked them if they would be ready to buy this Rs.50 note for Rs.5. Everyone said yes. So I said lets have an auction. The auction had the following rules;

1. The bids would start at Rs.5 and in multiples of Rs.5 thereafter.
2. A person can talk only to place the bid during the auction and for no other reason. (So that no-one influences others)
3. The highest bidder wins the auction and gets the Rs.50 note.
4. The second highest bidder (runner-up) has to pay me an amount equivalent to his bid. (This was the critical condition which no-one really understood. They were all busy thinking about the signature!)

Well, the auction started at Rs.5 and rapidly went up to Rs.45. Almost everyone was interested in bidding. I now told them that the signature was mine and the Rs.50 note was worth Rs.50 only! Then the fun started. (Evil smile again)

• One chap bid Rs.50 for the note. (After all, it was Rs.50 for a Rs.50 note..no-profit-no-loss right?)
• Then i told the Rs.45 bidder that if he loses, he needs to pay me Rs.45 as per the rules. So, in order to avoid the loss, he needed to win. Naturally he bid Rs.55.
• Then I came back to the Rs.50 bidder and told him the same thing. He too placed a higher bid at Rs.60 in order to avoid loss. 
• None of them could afford to be a runner-up, otherwise they would have to pay me the amount of their bid. The bidding frenzy continued unabated.
• In a matter of minutes, the bidding had reached Rs.210!!! It was then that I had to decide to stop the auction. 
• Well, the chap who had bid Rs.210 won the Rs.50 note. And the runner-up who had bid Rs.205 had to give me Rs.205. In effect, I sold a Rs.50 note for Rs.(210+205) = Rs.415! Sweeeet!

We all have observed similar things happening to us during investing in the stock market. So what are the lessons we can learn from this exercise;

• One should become a teacher and swindle unsuspecting students. Its quite profitable. (Ok ok, thats not a lesson to be learnt. In fact, I gave them all chocolates out of the money I collected from them!!)
• We all fixate and concentrate on un-important stuff and become blind to the obvious. Just like everyone fixated on the signature on the note so much that they failed to carefully consider the trick condition of the auction! While investing, we must give due importance to all parameters and conditions and not get excited or influenced by some single attractive parameter. We wouldn't want to miss out on something important, would we? 
• We are extremely loss-averse: Our brains are wired in such a fashion that we will do anything to avoid losses. Its a natural human tendency. In the experiment, everyone started with the objective of earning profits, but ended up trying to avoid losses!! The loss aversion of humans plays out well. We have to learn that there is no need to pay more than Rs.50, for something which is worth Rs.50. This was a losers' auction and those who participated were destined to lose. Similarly, in stocks, if one has made a mistake, then one should get out immediately upon recognising it, irrespective of the loss.

Emotions and thought patterns are truly wonderful (or harmful) and it is fascinating to study them. We just had an introduction to some concepts of behavioural finance and i intend to post separately on each topic.

Hope you all enjoyed this one. (Including any students of mine who are reading this!)

Cheers and happy investing!!

ACGL - Murphy's Law Holds True!

"Anything that can go wrong, will go wrong". So says Murphy's Law. And in case you want a real life example of the same, look no further than Automobile Corporation of Goa Ltd. (ACGL).
ACGL, whose promoters are Tata Motors and the Govt of Goa, is one of India's largest bus-body manufacturers. It also produces sheet metal components. But things just haven't gone ACGL's way. I honestly feel bad for the company's management.

• In 2007, the company raised money through a rights issue to double capacity. And then the global economic crisis hit. Talk about perfect timing! Bus exports fell and ACGL, with its expanded capacity and lesser demand, suffered a lot.
• The company had decided to move its sheet metal business to Pune, to make Goa a dedicated bus-body manufacturing operation, since the scale had increased. Of course, then the global economic crisis hit and this plan had to be shelved. The company has now bought a plot at Dharwad for this purpose.
• Well, things improved gradually and the company seemed to be limping back to normal. But then, Murphy's Law!! The labour union declared a strike and also prevented any workers from entering the premises. The seriousness of the strike can be judged from this article.

Well, feeling bad for the management and all is fine, but the critical question is, does the company have any value? Now since the company is going through a really bad phase, lets try and find out the bare minimum valuation that can be given to the company;

ACGL is being valued by the market as given. It is important to remember that the cash on books is because of the company's rights issue and is not fully internally generated.

Anyway, the company has two divisions, Sheet Metal Components and Bus Body Building. 

The Sheet Metal Component Division is smaller in size and is profitable. This division's performance was hit in 2009 because of closure, for shifting to another location.

So what kind of valuation should one give to this division? Since we are trying to calculate the minimum value of the business, let us value it at 4x FY08 PBIT of Rs.7 crores. This division may be valued at Rs.28 crores.

Moving on, to the bigger and more important Bus Body Division;

• This division has not performed efficiently. In 2009, the PBIT per bus body was down to a record level of Rs.35307/-. This was essentially because the company got more orders for smaller buses, in which margins are lesser. 
• The current capacity of the division is 4800 bus bodies. The only thing lacking is orders!!! As and when the operations become normalised, the company should be able to sell at least 4500 bus bodies a year, generating PBIT of at least Rs.18 crores at Rs.40000 PBIT/bus body. Both these numbers have been deliberately taken on the lower side. (In fact, all requirements for hiking this capacity to 10000 bus bodies are complete).

Ok, let's day-dream here a bit. Let's suppose that the scenario improves drastically and the company manages to get large orders on the domestic as well as foreign front. It is able to operate at full capacity of 10000 buses! What would happen then? Even if we consider PBIT/bus body of Rs.40000/-, the potential for PBIT of at least Rs.40 crores exists!

Those numbers felt nice huh? Good, now back to reality! :-) 

One can surely give this business a value of 8x PBIT, resulting into a 'normalised' valuation of Rs.144 crores. (Rs.18 crores x 8 times)

So let us see what can the fair value of the business be;

I have assumed that cash Rs.25 crores has been eroded during FY10.  Hence, in the adjoining valuation, cash has been taken as only Rs.40 cr. The valuation works out to Rs.212 cr against present market cap of Rs.147 cr!! Sweeeeeeet!!!

Well, before you place the 'buy' order with your broker, please read The Good, The Bad and The Ugly of the company!!

The Good

• ACGL has strong promoters in the form of Tata Motors. TaMo has been supporting the company throughout its times of distress. TaMo has also increased its stake in ACGL over the last 2 years.
• The conservative valuation of ACGL works out to much more than the market cap.
• The business potential is huge. With rapid urbanisation and transportation requirements, large demand for buses is expected.

The Bad

• Due of one reason or the other, historically, ACGL has failed to deliver and live up to its potential.
• Our valuation is at 'normalised' operations. When will the operations normalise? Well, thats anybody's guess. Absolutely no visibility is there.

The Ugly

• ACGL's promoters (Tata Motors) have a JV in India with one of the world's largest bus body manufacturers, Marcopolo. Details can be read here. In my view, this is a huge conflict of interest. The promoter has a JV, which competes directly with its subsidiary! So how does TaMo divide its business between its JV and its subsidiary? Not really clear. Big risk here..

Well, to conclude, one can say that ACGL definitely has value. The key question is, when will the company get back on track so that this value gets unraveled? Or will Murphy's Law continue to wreck havoc with ACGL? Time will tell...

Cheers!