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.