JHS Svendgaard Laboratories : Can It Become A B2C Play ?

Current price : 68.5

52 Week High / Low : 77/29

Market Cap : 295 cr

Disclaimer: This is not a recommendation to buy / hold / sell any securities mentioned in the blog post. The published post is for information purpose only. The intention to share write ups on this blog is to create a repository of ideas so that investors can have a look at various frameworks & approaches. Please read the detailed disclaimer at the bottom of the post. 


JHS Svendgaard, it’s a small cap stock with a bit of an odd name (Peter Lynch would have loved!) which is primarily a surrogate play on the development and growth of Indian oral care market.

What makes this particularly tricky is that the business had a near death experience in its limited life span and is coming out slowly from that phase. There is an added optionality of an emerging own brand story, which if executed well, can turn this into a real FMCG play in the longer term.

The company is involved primarily into contract manufacturing for many top brands in the oral care space. It also manufactures its own brands both in toothpaste and toothbrushes which are marketed separately and sent for exports. The scope on the liquid filling contract manufacturing space can be expanded to other FMCG opportunities like shampoos and hair oil – and thereby the size of the opportunity is no way limited.

In the flow of the discussion, we will highlight instances from the past, which doesn’t augur well for the minority shareholders. Given that company was going through a very difficult phase, one can be hopeful that these won’t be repeated in the future. However, one needs to be cautious and needs to monitor the future proceedings accordingly.

Sector Opportunity

The Indian oral care market (9,000 Cr size) is dominated by toothpaste (75% share, 6,750 Cr size), toothbrush (17% share, 1,500 Cr size) and other products. The toothpaste sector is dominated by key incumbents – Colgate (55.6% market share), HUL (19.2%), Dabur (15.5%) and others.

With over 300 million Indians not having access to oral care products, Colgate has been instrumental in spreading the awareness and converting this population by actively reaching out to 125 million school children across the country. The second movers will largely benefit from the huge groundwork undertaken by Colgate to develop the category and expanding the market.

While Colgate is the erstwhile market leader and category creator (even today in many places people ask for Colgate and not a toothpaste!) the growth in recent years has come majorly from the “natural” basket – with players like Patanjali coming out of nowhere and grabbing close to 2% market share (excluding sales through own outlets) with its ayurvedic brand “Dant Kanti”. Patanjali reportedly closed FY17 with 940 Cr of Dant Kanti sales (including all products), indicating much larger market share at present.

The India toothpaste market has reached decent penetration (Overall 81% – Urban 93%, Rural 76% as per 2015 data). Penetration is expected to inch by 1% per year for urban and 2% per year for rural over the next decade. (projected CY23 Urban – 97%, CY23 Rural – 88%). The penetration growth is assumed to 2.5% per year for the next decade.

While the market has matured in terms of penetration, it lags in terms of per capita consumption as well as average selling price. The per capita consumption lags not only to developed markets, but also to that of China. Even if India, matches up to the per capita consumption levels of China, it can lead to additional volume growth of 3% per annum for the next decade.

In addition, only 20% of the population is estimated to brush twice daily. This leaves a great scope for premium toothpaste manufactures (which is currently only 20% of the overall market). Given rising disposable incomes and consumption, price growth is assumed to be 7%. Including the volume growth, this leads to a 13% growth in value terms for the premium toothpaste market.

Also, GST implementation will boost consumption in this space, as the indirect taxation will move from 25% at present to 18%, and all manufacturers would pass on this benefit to consumers under the anti-profiteering provisions of the GST thereby adding to the consumption. However, this might act as a short-term negative as indirect taxation moves from 5% to 12% for the ayurvedic products and might affect the likes of Patanjali.

The toothbrush market is estimated to be around 700 million units, with 70% volume coming from organized players. The toothbrush replacement cycle is very low in India where users change a toothbrush every 8 months compared to 4 months for China and around 2 months in western markets. Thus, the toothbrush market is also expected to exhibit strong double digit growth from increased penetration and higher replacement cycle.

In effect the 9000 Cr oral care market with strong double digit growth can be worth over 15,000 Crores over the next 5 years. With added focus on the company’s own brand – Aquawhite – the company can leverage this opportunity much better compared to others.


                                                     

JHS Svendgaard : Background

JHS Svendgaard ( JHS, henceforth) started as a manufacturer of toothbrush only, back in 1997. Incorporated as small-scale industry, which were incentivised on toothbrush manufacturing, this was a proprietary business which later ventured into toothpastes and other oral products.

There were 3 smaller proprietorship’s – Sunehari Svendgaard Laboratories which belonged to Mrs. Sushma Nanda (mother of Mr. Nikhil Nanda), and two others being Sunehari Oral Care & Jai Hanuman Exports which belonged to Mr. Nikhil Nanda. While JHE was focused on exports the two other domestic units catered to entire oral care portfolio including the following.

Jai Hanuman Exports (100% EOU) Sunehari Oral Care Sunehari Svendgaard Laboratories
Location Noida SEZ, UP Mathura, New Delhi Mathura, New Delhi
Product manufactured Toothbrushes Toothpaste, Mouth rinse, Whitening Gel, Effervescent Tablets Toothbrushes, Tongue cleaners & packing trays

                                   

The three entities were merged into the one integrated company with Mr. Nikhil Nanda as the promoter from April 2005, leading to the emergence of JHS Svendgaard –  in its present form. The company got listed through an IPO in 2006.

In arriving at valuations and issuing shares to the three entities, the company didn’t obtain any valuation report from an independent valuer. In effect the average cost of equity for promoter Mr. Nikhil Nanda came at Rs 17/- with book value of Rs 23.45/- and same was offered in the IPO at Rs 58/-. Mr. Nanda however did subscribe to 5 Lakh additional shares of the total 67 Lakh shares issued during the IPO.


Business Overview

The company is primarily engaged in the manufacturing of oral care products with the most important being toothpaste and toothbrushes. JHS imported modern equipment including – anchor free technology enabled toothbrush machine from Boucherie, Belgium and state of the art toothpaste manufacturing machinery from Woowon, Korea and Norden, Sweden. (Follow the links to know about these global suppliers of oral care manufacturing equipment.)

The following are the key products (left) and the raw materials(right) required for the business:

Tooth Brushes: Polypropylene (plastic Granules/dana), Nylon, bristles, Master batch (for the desired colour combination), Anchor wire etc.
Toothpastes: SLS (Sodium Laurel Sulphate), Glycerine, Sorbitol Sodium Saccharine, water etc.
Whitening Gels: Aqua, Carbomer, C2H5OH (Ethyl Alcohol), H2O2 (Hydrogen Peroxide), etc
Whitening mouth rinse: Sorbitol, Glycerine, Purified water, Sodium Fluoride, Saccharine Sodium etc
Effervescent tablets: Soda Ash, sodium Bi-carbonate, Citric Acid, Sodium Sulphate, Peppermint Oil etc.

Source: Company DRHP

Before delving into how growth looks in the future, let’s step back into the past. JHS’ ride over the past decade has been a roller coaster. It has seen high growth, followed by a near death bankruptcy – defaulting on bank debt, resorting to outside funds – and slowly turning around with newer tie ups and own brand launch.

The entire journey can be narrated in 4 phases


Phase 1 : 2006-2009, Green field capex hit by 2008-09 recession.

The company moved in for the IPO in late 2006. Marred by severe capacity constraint, the IPO proceeds were largely targeted towards setting up of a large green field project in Kala Amba, HP incentivized by tax sops and other advantages.

In FY- 2007 : Sales were largely flat because of capacity restrictions, as company was readying for commercialization of new capacity. Commercial production started in April 2nd, 2007. JHS witnessed 42% growth for SSL division while SOC also reported growth from exports and supply to Subiksha retail stores and other FMCG players in India. The 100% export oriented JHE was not doing well due to an appreciating rupee against us dollar.

Division Sales (FY07) Sales (FY06) Growth
SUNEHARI SVENDGAARD LABORATORIES DIVISION (SSL) 17.64 25.11 42.3%
SUNEHARI ORAL CARE DIVISION (SOC): 3.48 3.18 9.26%
JAI HANUMAN EXPORTS DIVISION (JHE): 5.33 9.21 -42.1%

In FY – 2008 : Company reported marginally higher sales. The rise in operating margins were seen from trading activities, while new capex (6x rise in fixed assets) led to higher depreciation (up 3x) and interest outgo, denting the bottom line. The company went for cheap equity dilution by issue of 4 Lakh share and 16 lakh share warrants to promoters and non-promoter groups at the cost of 46/- (remember the IPO was at Rs 58/-).

The highlight of the year remains the setting up of the trading unit in UAE free trade zone by the name of Jones H Smith FZE. The following emphasized points deserve notice.


Legal status and business activity:

1.  Jones H Smith FZE., Ras AI Khaimah Free Zone-United Arab Emirates (“the Establishment”) was incorporated on December 10, 2007 and operates as a Free Zone Establishment under the trade licence issued by the Ras AI Khaimah Free Zone Authority of Government of Ras AI Khaimah.

2. The main activities of the Establishment as per trade license is Trading in Perfumes, Cosmetics, beauty, personal care requisites, soap & hair care products.

3. The registered office of the Establishment is located at RAK Free Trade Zone, P.O. Box 10559, Ras AI Khaimah, United Arab Emirates.

4. The management and control is vested with Mr. Ajay Kumar Gupta.

5.  These financial statements incorporate the operating result of trade licence No.3250.

6.  On October 29, 2007 the Establishment got the remittance from India for incorporation expenses


The company was trying to do too many things and diluted equity at warrant prices much below the IPO prices. Most of the incremental sales were from this trading activity.

In FY- 2009 : The company was hit by the sever recessionary environment as both production and trading activity took a deep plunge. This is also the time where Subiksha goes bankrupt which accounted for some sales in previous years.

The company disposes of Unit 1 – Sunehari Svendgaard laboratories division (SSL) and this becomes the corporate office(!). There is no explanation towards this. Most likely old machinery was shifted to Kala Amba facility and the location was maintained as corporate office.

what was marked in AR 2008 as Unit -I

was changed to the corporate office in AR 2009. A simple intimation would have helped.

The company went for further equity dilution by issue of 11 lakh share warrants to promoters and non-promoter groups at the cost of 30/- (IPO was at Rs 58/-). 10 lac warrants or bulk of it went to Mr. Nikhil Nanda with only 25% of upfront payments.

Company incorporated another subsidiary in probably more unrelated diversifications. And distributed unsecured loans to these.


JHS Svendgaard Dental Care Limited was incorporated as subsidiary company in the month of April 2008. Presently your  

 Company holds 59.99% of total paid up share capital of the subsidiary. The subsidiary Company has proposed plans of

 opening a chain of dental clinics in all the major cities across India. During the year, the subsidiary has successfully launched two clinic in Delhi.


In all the capacity expansion, without a sound client linkage for uptake, backfired badly. The 2008-09 recessionary environment added to the pain. Being a small company, trying to do too many things, led by debt is a sure recipe for disaster.


Phase 2 : 2009-2011, The breakthrough P&G Deal

FY- 2010 : Brought in a welcome break for JHS when P&G decided to give a second shot to their foray in the Indian toothpaste market by launching “Crest” toothpaste. JHS got the contract for manufacturing this for P&G.

The deal with P&G for outsourcing of production for Crest toothpaste, Oral-B toothbrushes, Tide detergent powder among others was a significant landmark deal for JHS. Not only it ensured strong revenue visibility and offtake for JHS’ facilities, it also established the company as an outsourcing vendor of choice, compliant with all quality standards and meeting stringent supply guidelines of a global FMCG major (P&G).

The watershed year FY2010 saw revenues rise by 144% and 500% rise in PAT from 2009 lows. However, of greater significance was the close process integration in P&G’s supply chain to establish the global procurement standards – something JHS would leverage in years to come.
Although company identified the risk of client attrition as detrimental, still it didn’t realize the true risk of capacities tied up to a single client. Perhaps it was bit carried away by the success and scale of the P&G deal. The 68 Crore capacity expansion was taken up backed by this deal. Debt obligations for secured and working capital loans would allow ICICI Bank to take up management control in case of distress, with additional guaranty in the form of shares held by Mr. Nikhil Nanda.

The company was still pursuing ahead with the T32 Dental clinic plans. With 3 operational clinics and 32 more planned in years to come.

FY – 2011 : showed the peak growth year for the company. Challenged by industry headwinds, the company did well in negotiating contracts with new clients. It acquired 4 clients in this tough environment which narrates the management zeal. JHS ended FY11 with 86% sales growth and 54% rise in EBITDA.

It started the journey with key clients like Dabur, Himalaya, Patanjali from this year. JHS started manufacturing of Oral-B toothbrushes for P&G along with new deals in toothbrush from Amway, Dr. Fresh (an US-based FMCG brand).

Tano Mauritius came on board and was offered 25 Lac shares at 97.75/-  for a 14.8% stake. Mr. Nikhil Nanda too subscribed to 5 Lac additional shares at the same price later in 2012. The proceeds were used for setting up a modern facility with (21,600 MT/pa toothbrush capacity) at Kala Amba premises.  The key aspect of this plant was the complete automation across the manufacturing, filling and packaging processes for the toothbrushes – a first in India.

The phasing out of the SEZ clause meant, only the operating units prior to 31.03.2010 would continue to enjoy tax breaks going forward. Hence the Kala Amba facility was enabled with excise and sales tax benefits till 2020.


Phase 3 : 2011-2014, The near-death experience

FY- 2012 :  saw a disastrous year having its full effect on the company. The company was till now operating as a contract manufacture without the benefit of cost+margin basis to its procurers. JHS mostly focused on quality and timely delivery.

High inflation on input prices could not be passed on to clients and led to huge dent in operating margin (from 19% in FY11 to 12% in FY12), almost wiping out all net profits. Also, company tried to grow too fast without proper due diligence from customers resulting in sticky receivables from some customers. When the funds dried up, working capital constraints, led to difficulties in fulfilling other client orders leading to further reduction in order volumes.

The only saving grace was exports which jumped to 30 Cr from 2 Cr thereby managing some sales, however margins were poorly hit.

JHS changed its broad strategy at this juncture from a product delivery model to move to a conversion model. The new model would ensure clients support JHS on the input cost side, de-risking the company from input price fluctuations and efficient working capital management. This model also ensured clear margin visibility.

FY – 2013 : It was the darkest year in the history of JHS. Company was hit by the double whammy of sticky receivables and the largest client – P&G cancelling its order intake as opposed to earlier levels. All capacities tied to P&G suddenly were idle, leading to JHS defaulting on bank debt to ICICI Bank.

The auditor’s note by Haribhakti & Co, for FY2013, marked few critical observations:

  • Attention is invited to note number 4.2 and 17 of financial statements in respect of management’s decision to write off unrealisable trade receivables amounting 482,892,640 by utilising securities premium account.
  • Attention is invited to note number 48 of financial statements with regard to non renewal of contract by a major customer. The Management does not expect significant impact of this on operations of the Company
  • …. there has been defaults in repayment of dues to the banks during the year

The consequences were faced by the minority shareholders

  • The company wrote off 48.28 Cr from the reserves and surplus pursuant to a EGM and subsequent court approval. The bad debts, as mentioned in FY2012, from chasing growth from unworthy customers led to this permanent loss of capital.
  • The non-renewal of contract by P&G brought unprecedented distress since almost 80% of the sales were tied up with the single client. JHS filed a case against P&G alleging the undue termination caused them market cap loss of 100 Cr. In the complaint, Mr. Nikhil Nanda alleged that projections were made for a 10 year period, with the expected renewal in 2013, and contract was expected to run through till at least till 2016. However, third party audits found the JHS allegations to be baseless and CCI (in its Nov 2013 verdict) dismissed all charges against P&G.
  • ICICI Bank marked the account as NPA and followed up with further actions on recovery of principal and interest due from JHS.

FY2013 also saw the amalgamation of two entities created outside of JHS for supplying to P&G in the same line of business, with the main company, leading to significant equity dilution for the minority shareholders. The two entities – JHS Svendgaard Hygiene Products Limited (Transferor Entity No-1) and Waves Hygiene Products (Transferor Entity No-2) were amalgamated into JHS Svendgaard Laboratories Limited (Transferee).

Additional 65 Lakh shares were issued, which helped improve promoter shareholding and further diluted the ownership of minority shareholders.

FY – 2014 saw the lowest point in the company’s erstwhile history. Company undertook a major reorganization to survive this phase and resorted to funding from outside investors, while it continued to default on bank loans outstanding.

The auditor’s note by Haribhakti & Co, for FY2014, highlighted more critical observations:

  • Company should have impaired 35.43 Cr of fixed assets (solely tied to facilitate contracts for key lost client – P&G ) but these were still carried on books, showing inflated fixed assets.
  • The conditions of interest free loan granted to subsidiaries Number One Real Estate Private Limited and JHS Svendgaard Dental care Limited where doubtful and had no fixed repayment timelines outlined.
  • Company continued to default on repayment of dues to financial institutions and banks.
  • Company misused funds applied for short term basis on long term investments amounting to 50.76 Cr

The loans from ICICI Bank were long overdue and company was tiding over a tough phase to avoid being referred to the Debt recovery tribunal. The turnover plummeted further to 35.3 Cr from 56.1 Cr as the ill effects of high fixed costs triggered the negative operating leverage.

The only positive outcome was the inception of company’s own brand – AQUAWHITE during this year. JHS planned to launch the full range of oral care products under its own brand to create a parallel revenue stream. Company was seeing traction in toothbrush where volume jumped 37.4% from 230 million to 316 million.


Phase 4 : 2014-2017, The turnaround for JHS Svendgaard

FY- 2015 : It brought in the much-needed relief for the company due to facilitation of one time settlement with the banks on the debt defaults. The banks agreed to a large haircut amounting to 30.82 Cr. The said benefit was directly carried over to balance sheet, bypassing the P&L which showed a loss of 22.13 Cr for the fiscal ending FY15.

The one-time settlement had two major impacts – a) It removed the debt overhang and company being referred to Debt recovery tribunals and b) it removed the impairment on fixed assets and personal pledge of shares from Mr. Nikhil Nanda. JHS was now debt free with only long term vehicle loans outstanding.

The company raised capital in the form of warrants priced at Rs 11/- per share, which would add 3.49 Cr shares when fully converted, to the base of 2.41 Cr. This led to 5.9 Cr shares outstanding at the end of the conversion – a massive dilution. The warrants were issued at 11/- when market price was at 25/- clearly exploiting the SEBI (ICDR) Regulations 2009. The promoter holding would go up to 43% when warrants are fully converted. However, given the precarious situation with bank debt, this was the only avenue for raising capital at this point.

JHS changed their auditors this year. The new auditors, M/s S N Dhawan & Co., also raised the same note against the carry over of older assets which should have been impaired related to the loss of major client – P&G.

One particularly disturbing aspect was the treatment of 48.28 Cr of account receivables. Management had earlier sought court approval to write this off (refer above in FY2013) while in FY15 it canceled the application – recovery of doubtful receivables after 2 years doesn’t fit well. The whole treatment of this receivables to the tune of  company’s annual turnover raises many questions.

Another big issue was the chain of litigations. While the company lost its case against P&G – it continued to fight cases amounting to damages worth 629.99 Cr. P&G also filed cases against the company with counter claims amounting to 206.14 Cr. An amount easily sufficient to wipe off the mere existence of JHS.

The Aquawhite brands launched in FY14 was in focus and registered a 200% growth in FY15 and the Annual report carried full page ads for distributorship of the same.

In media interviews, Mr Nikhil Nanda, highlighted there were suitable ‘white spaces’ in the oral care segments, which they wanted to address with a suitable product portfolio.

This was a promising development, which could provide an alternate revenue stream for the company apart from the contract manufacturing – one with higher margins.

  Fiscal FY15 (Cr) FY14 (Cr) Growth %
Total Sales 55.32 35.28 57%
Own Brand 6.30 2.07 204%
% Contribution 11.4% 5.9%  

FY – 2016 : It saw the company moving ahead with the plans. JHS outlined some broader guidelines in its growth plans, learning from the past mistakes of relying solely on one client.

  • It decided to broaden the client base, with no more than 20% of revenues coming from a single client.
  • Resorting to long term contracts, with strong revenue visibility. It signed two 5-year contracts with key clients. Ensuring that expanded capacities are utilized and not depend on immediate contract renewals.
  • Focus on own brand – Aquawhite – which grew to 9.71 Cr (up 54% YoY) to 10% of expanded revenue base. Management focused on taking this up to 50% of sales by FY2020.

There were strong new deals from the likes of Dabur and Patanjali, for the manufacture of toothpastes and toothbrushes, helping in overall capacity utilization. Company also added 10-12 new SKUs to the Aquawhite toothbrush portfolio.

While company was working at 60-70% capacity, the old plant was not fungible and meant only for specific client requirements. They took some key steps on the capacity side.

  • Decision to retrofit the old plant with current standard equipment making the it cater to multiple order stream.
  • Setting up a new plant, with modern equipment, at the cost of 40 Cr which would be funded by internal accruals and warrant proceeds. Management expected this to come on stream by early FY2018.
  • JHS divested the older detergent plant (linked to P&G’s Tide contract) which had become a non-performing asset, and asked to be written off by auditors in the past. This was divested for 16.25 Cr.

Mr. Nikhil Vora, on behalf of Sixth Sense ventures fund, invested a sum of 3.3 Cr ($0.5 million) picking up 11% stake in JHS, through market purchase. He had earlier invested on personal capacity in the capital raising round through warrants. JHS had 3.49 Cr warrants outstanding for conversion, out of which it converted 1.35 Cr warrants to shares, in this year. There were 2.14 Cr warrants still outstanding for the company.

There were some concerning issues as well. These were as follows:

  • Company continue to issue interest free loan to the promoter Mr Nikhil Nanda (outstanding 1.73 Cr loans in FY2016) while it continued to borrow from outside private sources at 15% interest (outstanding 1.1 Cr unsecured loans in FY2016)
  • The company could not publish results in a timely manner and paid penalty to the tune of 17.90 Lac in the fiscal 2016 and 46.51 Lac in 2015.
  • There were lot of transactions with related parties specially with one private entity ‘Apogee Manufacturing Private Ltd’ with which JHS had significant dealings in the past also.
  • Company wrote off loans and advances for the subsidiary Jones H Smith, FZE which was disposed of in FY 2016.

FY – 2017 : This year saw increased traction from all business fronts. Company signed new contracts with Patanjali for manufacturing of toothpaste and increased traction from other clients. After the turnaround, this was the first year where company registered positive profits for all quarters and the full year

Q1FY17

Q2FY17 Q3FY17 Q4FY17

FY17

Sales

23.9 30.91 22.72 27.93 105.47

PAT (Reg)

0.3 1.34 1.7 1.81

5.18

NPM % 1% 4% 7% 6%

5%

JHS ended FY17 with sales of 105 Cr. The YoY numbers are not comparable, since FY16 numbers had sales from the detergent manufacturing division which was divested on slump sale basis. The Aquawhite sales registered 54% growth YoY (14.94 Cr vs 9.71 Cr) and now commanded 14% of revenues. Once the new capacities come on stream, higher growth is expected on the overall contract manufacturing sales as well as from own brand sales.

Perhaps the biggest relief for the management and shareholders came in April 2017, when JHS had an out of court settlement with P&G, thereby removing the over 206.15 Cr contingent liability hanging over the company’s head. Company received a favorable settlement amount of 27.50 Cr from the client which has not been recognized in the results of Mar 2017.

A large chunk of outstanding warrants was converted on July 2017 (1.63 Cr) thereby leading to 5.72 Cr shares outstanding. Additional 0.47 Cr shares are still pending to be converted. Total outstanding shares would be 6.19 Cr after all warrants are converted.

In Jan 2017, JHS did an advertisement deal with HT Media. HT Media were issued 0.18 Cr shares at an issue price of 43/- resulting in a sum of 8 Cr for the company. JHS would keep this money as security, and promised to place advertisements worth at least 10 Cr in HT Media over the next 5 years. The 8 Cr amount would be returned to HT Media at the end of the contract, while they have the shares as collateral in the interim period (already worth 13 Cr at CMP). Link

As seen from the past 10 years’ journey, JHS has emerged from this turnaround as a focused, debt free company, with new capacities coming on stream tied to long term sales contracts and traction from new brand sales.


Investment Thesis For JHS Svendgaard

  1. Successful Turnaround : JHS has emerged stronger from the woes of near bankruptcy and has experienced all perils related to debt laden expansions. The management has resolved to a debt free status, with future expansion planned through internal accruals and equity.
  2. New Capex : As outlined by management, they are facing a double problem – on one side they are still underutilized on total capacity and on the other hand this capacity is not fungible hence they cannot take up multiple SKUs from clients. The retrofitting on new equipment on existing plants and new capacity coming on stream should solve both problem

Moreover, management is exploring inorganic capacity expansion in West and South India. With strong client relationships, JHS can ramp up fast, post-acquisition of new facilities through inorganic route

  1. Client Relationships Is A key Entry Barrier : Given that Oral care market is pretty saturated with key incumbents, strong relationships with clients is a key entry barrier. Having walked the whole path with P&G in the past, JHS boasts of the requisite process standards and manufacturing quality certifications which would lead to meeting stringent product quality in a timely delivery schedule. For a new player, getting into the trusted list of suppliers for the key FMCG brands would be costly and time consuming. Hence ramping up with clients is much easier for JHS, compared to a new supplier.
  2. GST and Shift from SSI/Unorganized Segment : GST would lead to an immediate pain for a few quarters due to inventory de-stocking however the reduced tax of 18% from earlier ~25% for toothpastes augurs well for the growth of this segment. Already we are seeing a 9% price cut from Colgate and others are bound to follow soon. Link

The excise duty and other exemptions available to SSI would now be not available any more. Hence private label manufacturers would prefer shifting to large organized players like JHS.

  1. Growth in own brand (Aquawhite) : Management has closely guarded the profitability of the own brand sales, citing lack of adequate accounting measures in its system to report segment profitability. We expect very high margins for this segment. If management can indeed ramp up the own brand sales to 50% of overall revenues, it would add significantly to the top line and profitability.
  2. Other FMCG Products : Over the next 2 years, management expects traction related to opportunity in liquid filling contract manufacturing. Given that clients like Dabur are already on board, this can be a huge opportunity in the future.
  3. Exports : Given that JHS has successfully exported in the past to private label clients in the US and other markets, it can lead to additional opportunities in sales.

The investment thesis is based on the optimism outlined above, that management will be able to deliver on the promise and opportunity and achieve high sales growth both in contract manufacturing and own brand.

However, the key issue had been large and frequent equity dilution. If JHS goes on diluting equity again in immediate future, instead of buybacks, the wealth creation scope would be limited.

Year end 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Shares (Cr) 0.57 1.25 1.29 1.4 1.44 1.45 1.75 2.41 2.41 2.41 3.76 5.72 6.19

There are two growth streams for JHS – contract manufacturing led growth and own brand sales. FY18 would have disruption for GST in short term and capacities coming on board, full effect in new sales would be seen from 2019

The own brand margins would remain higher than contract sales, but would be capped as JHS plans to spend on advertisements in the future. Hence a higher than 21% EBITDA is not estimated.

Valuation wise, it is tricky to value a business which has just turned around.  JHS is in between Converters (85% sales) and FMCG (15% sales). Going forward, management expects the FMCG sales to become 40% + of the overall sales, along with strong revenue growth.

It would be interesting to monitor the progress and see if JHS indeed emerges as a strong FMCG player in years to come.


Key Risks

  • Revenue dependency on key customers: Company has few large clients who are accountable for bulk of the revenues. In case of any adversities with client businesses JHS would end up with fixed costs and incur huge losses
  • Backward integration for clients: If the current buyers decide to go for own manufacturing capacities this can be detrimental for current and future prospects of the company.
  • Compliance and Standard checks: Clients conduct regular audits to check standards and compliance. If JHS fails to meet these audits it can lose significant business from clients.
  • Dependence on few products: Company is largely limited to few products for the revenue streams. Any adverse development would lead to large sales gaps, difficult to fulfill by other products.
  • Dependence on few suppliers: Company is dependent on few suppliers for raw material procurements. Any large disruption in the supply chain will lead to cancelled orders.
  • Underutilization of capacity: Delay in timely ramp up of projected order volumes can lead to high fixed costs for the company impacting the profitability.
  • Threat of low cost imports: If the large buyers decide on importing from other low cost destinations company would be in a difficult position.
  • Exchange Rate Fluctuations: Exchange rate fluctuations might render the company’s exports noncompetitive and impact the revenues.
  • Key man Risk: Company has been largely driven by Mr. Nikhil Nanda. There is no dedicated 2nd line of command capable of leading the business in its growth phase.
  • Conflict of Interest: If JHS progresses in its own brand journey, it might come into conflict with its large clients in the same line of business, resulting in lost sales.

Disclaimers :

The information herein is used as per the available sources of bseindia.com, company’s annual reports & other public database sources. Alpha Invesco is not responsible for any discrepancy in the above mentioned data. Investors should seek advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents.

Author of the report has investment positions in the stock at the time of publishing this post. 

Future estimates mentioned herein are personal opinions & views of the author. For queries / grievances  – support@alphainvesco.com or call our support desk at 020-65108952.

SEBI registration No : INA000003106

Readers are responsible for all outcomes arising of buying / selling of particular scrip / scrips mentioned here in. This report indicates opinion of the author & is not a recommendation to buy or sell securities. Alpha Invesco & its representatives do not have any vested interest in above mentioned securities at the time of this publication, and none of its directors, associates have any positions / financial interest in the securities mentioned above. 

Alpha Invesco, or it’s associates are not paid or compensated at any point of time, or in last 12 months by any way from the companies mentioned in the report.

Alpha Invesco & it’s representatives do not have more than 1% of the company’s total shareholding. Company ownership of the stock : No, Served as a director / employee of the mentioned companies in the report : No. Any material conflict of interest at the time of publishing the report : No.

The views expressed in this post accurately reflect the authors personal views about any and all of the subject securities or issuers; and no part of the compensations, if any was, is or will be, directly or indirectly, related to the specific recommendation or views expressed in the report.

Reliance Capital : Will You Pick Up A Good Sofa From A House On Fire ?

Guest post by Varadharajan R. He tweets at @varadhar1 

Varadharajan_RVaradha is a self taught investor who views investing as an intersection of economic incentives, psychological motivations and on the ground triangulation. He focuses on hypothesis that confluences several broad ranging factors and picks stocks that have an asymmetric risk-reward trade-off. He has done several sessions on forensics, triangulation, scuttle butt and writes occasionally. He is an engineering graduate from IIT Madras, and has studied finance at IIM Ahmedabad.  

 

Current price : 651
52 Week High / Low : 693/365
Market Cap : 16450 cr
FY 2017 EPS : 42.9

Disclaimer: This is not a recommendation to buy / hold / sell any securities mentioned in the blog post. The published post is for information purpose only. The intention to share write ups on this blog is to create a repository of ideas so that investors can have a look at various frameworks & approaches. Please read the detailed disclaimer at the bottom of the post. 


Thought Process…

Continuing with the theme of out of favor stocks, i try to look at beaten down stocks that have multiple cushions – yawning gap in perception vs reality, change in promoter behavior, reversion to mean on multiples, reversion to mean on earnings & low institutional ownership & sell side coverage. If you buy these at low enough prices, eventually you make good money and if your thesis is wrong, you end up not losing much – say 10-20%. To do this, I apply a principle of triangulation – where I validate three independent data points and see if I can build a very robust, tight thesis. Usually I look for consistency in management actions, financials and independent industry/third party feedback (from someone who is not in the industry).

Given the obvious shift in savings to financial instruments  and financial instruments like mutual funds, insurance – general/health benefiting from this shift as also the massive growth in affordable housing, I looked at Reliance Capital – only of course to be taken aback at the long and dubious history of all ADAG companies. However, I saw several slivers of hope.

‘Anmol Effect’: Anil Ambani Says Son Is Lucky Charm For Reliance Capital 

Anil Ambani’s son Anmol joined Reliance Capital (and only Reliance Capital out of all his entire set of companies) as an additional director in September 2016.

Bajaj’s finance Devang Mody joined Reliance commercial finance recently. He was instrumental in building Bajaj Finance to its premier position over the last decade.


Company Background

Reliance capital was floated in 1990s as a financial services outfit for reliance group which was under the aegis of Dhirubhai Ambani. This got split and was allocated to Anil Ambani in 2005 and ironically since then is the only business which has grown well fundamentally. You can read here about the entire business.

https://en.wikipedia.org/wiki/Reliance_Capital 

I prefer to focus on interpretation of facts as most of these facts are covered in analyst reports/company presentations.

Business lines

 

Company Presentation

Download (PDF, 5.14MB)

BSE announcement

Download (PDF, 4.36MB)

a.   Mutual fund business – Crown jewel business

This is the crown jewel of the business. It is a cash cow and generates stable, predictable free cash flows given the incredible operating leverage of the AUM business.

http://www.thehindubusinessline.com/companies/nippon-completes-14-stake-buy-in-reliance-mf/article8365155.ece

This business was valued at Rs. 8542 Cr. a couple of years back  – with the tailwinds of post demonetization and improvement in market share of reliance mutual fund, this business is worth upwards of Rs. 10,000- Rs. 12,000 Cr.  Nippon now holds 49% in this business which generates free cash of upwards of  Rs. 500-600 cr.

Given that the next round would involve either IPO or  Nippon crawling up beyond 51 % which would give complete control, this should happen at a significant premium to the last round which valued it at Rs. 8542 Cr.  Also, given that Nippon holds 49% and has a board representation and has very good profitability numbers. We also gather from scuttle butt that since it is a stand alone fund house, it has been focusing on getting direct B2C business through the internet – which should improve its profitability numbers in the long run. Also, persistence of SIP’s which lower the cost base in the long run will help all AMC’s improve upon profitability numbers

Valuation should be in the region of Rs. 12-15,000 Cr. for the business in case of an IPO or even higher in case of  a stake sale.  The AMC has RoE’s of 25 % and is expected to touch 30% based on my calculations by FY ’19 – making it truly a durable franchise business. So, the attributable value for reliance capital with 51 % stake would be in the region of Rs. 6-7,500 Cr.


b. Reliance General Insurance – A small, High Growth Business With Tailwinds

Reliance General Insurance (RGI) is a leading private sector insurer with a 5 year CAGR of 24%, and has become a highly profitable company. RGI has formed key alliances with over 20 firms including IndusInd Bank, Bank of India, Andhra Bank, Catholic Syrian Bank, City Union Bank, Paytm and Freecharge. RGI processes over 10 lakh claims annually and has the lowest ‘complaint ratio’ amongst peers. Anil ambani has indicated that he is open to selling stakes – he has already got offers from several global majors to sell stake in his general insurance company.

Reliance owns 100% of this business and at 20x FY ’18, this could be valued at about Rs. 3,000 – Rs. 4,000 Cr. Reliance health insurance (RHI) is a new initiative that focusses on an under penetrated segment. RHI has significant experience in managing the business and has the second highest reach amongst stand-alone health players. A “Digital First’ approach, value unlocking opportunities through strategic partnerships and focus on profitable growth in one of the fastest growing insurance companies.  This is not a great business unlike the MF business and I would conservatively estimate its worth about Rs. 4,000- 5,000 Cr.


c. Reliance Nippon Life Insurance – Consolidating for superior profits

Reliance Nippon Life Insurance (RNLI) has a wide nationwide footprint with 770 offices and approx. 1 crore individual policies issued and 30 lakh in force. Nippon Life Insurance is a very strong and committed partner. It holds a 49% stake in the company. Nippon Life has invested over Rs. 5000 crore, valuing the business at approx. Rs.10,000 crore.  RNLI’s focus has been on profitable and healthy growth. Over the last one year, it has weeded out unprofitable and poor quality business, resulting in right sizing the expense base and corresponding reduction in premium growth. RNLI has an Embedded Value of Rs. 3,074 crore as on Sept 2016, and AUM of Rs.16,247 crore as on Dec 2016. Market leader like HDFC max is valued at about 4.3x EV while ICICI prudential trades at 3.4x. This should trade at 3.0-3.5x given the reliance pedigree and its independent distribution network. Given Reliance capital’s 51 % stake, it should be worth Rs. 5,100 Cr. or so.


d. Reliance Broking:

Reliance’s broking business is quite small and has a PBT of Rs. 40 Cr. on a topline of Rs. 300 Cr. However, what’s interesting is the wealth management business that has more than Rs. 4,100 Cr. AUM. This has a value of about Rs. 15x FY ’18 E of about Rs. 50 Cr. – roughly around Rs. 750 Cr.  Reliance has a strong digital platform and is seeing increasing traction in IPO funding.


e. Reliance Commercial Finance:

Mr. Devang Mody who was instrumental in building up Bajaj  finance, here has been appointment of Mr Mody as CEO, who was the erstwhile President of the consumer finance business of Bajaj Finance and leverage on his expertise in tapping  SME lending segment. The current AUM is 16, 000 Cr  . The Equity Invested in this  business is Rs. 3,280 Cr.. The business has grown 10% over last year and its expected to do a profit of 200 crores in FY2017 with an ROE 12.2% which would improve with operating leverage kickin in. This can get valued at 1.2-1.5 x PB that translates to a a valuation of Rs. 3,500 – Rs. 4,500 Cr.


f. Reliance Home Finance 

Reliance home finance has a good differentiated offering with affordable housing and self employed/salaried book forming 53 % of its AUM. It would be demerged from its parent and listed shortly – all the approvals needed for it are already in place. At a 15 x PBT, this should trade at about Rs. 2,500- Rs. 3,000 Cr.


Valuations :

1st Cushion / Trigger

Reversion to mean – All ADAG group stocks have been hammered ever since end of may ’17 when Rcom’s bonds got downgraded on fears of default. While Relcap belongs to the same group, there is nothing material here to get worried about. Relcap has an exposure of Rs. 293 Cr. in equity and about Rs. 100 Cr. in loans (as of March ’16) and even if one were to take a conservative write-off of Rs. 1000 Cr on the networth, it will not materially impact valuations.

2nd Cushion / Trigger

Impending de-merger and listing of home finance : All the approvals are already in place for demerger and listing of reliance home finance. Given its PBT, it should trade at a Rs. 4000 – 5000 Cr. Mcap. Given that 50% of the stake will be held by Reliance capital, this will add Rs. 2500-Rs. 3000 Cr. value to Relcap’s books.

3rd Cushion / Trigger

Potential stake sale/IPO of MF : The MF is a crown jewel where reliance holds 51 % with Nippon holding 49%. Given that the last round of stake sale happened at about Rs. 10,000 Cr. and that was 2 years before demonetization and the tailwinds if any have become much stronger, this should be done at Rs. 15,000.

4th Cushion / Trigger

Deleveraging of BS by divestment of non-core investments: One has to remember that these were non core investments for Reliance capital and have not contributed to the ROE in anyway over the years. It has some good investments in companies like ICDEX, paytm, yatra all of which combined can return in excess of Rs. 1000- Rs. 1500 Cr. The company has committed to clean up all these before March ’18 as it wants to become a Core Investment Company – a pure holding company with stakes in other companies and has already begun the process with RBI/SEBI.

5th Cushion / Trigger

De-merger/QIP on Reliance Commercial Finance: Given that commercial finance is bound to grow and will need fresh funds, a sensible option would be list it or get in private equity money at more than 1 PB. This is likely to happen post March ’18 and will be another trigger to create value in the long run.

6th Cushion / Trigger

Stake sale in General insurance : Given that FDI interest in general insurance is substantial and reliance has a good, niche proposition in general insurance/health insurance, a stake sale here again would add Rs. 1,000 – Rs. 1,500 Cr. to the kitty with an optionality to sell at a higher valuation at a later date once FDI rules allow for 51 % +.  Reliance has also announced a plan to do an IPO to sell down some stake in this.

Said all of the above, given the fact anil ambani treats this as his crown jewel and is creating value, we may see lesser sand bagging and improved governance standards.  Also, listing these separately might help attract better quality talent – like it has happened with edelweiss/IIFL where even top guys of foreign banks have joined them.


Valuation

Valuations are undemanding at about 1.2 FY 17 BV. One must remember that the mutual fund business requires very little incremental capital and generates terrific free cash flows. The insurance businesses too, if run well can generate good amounts of float for the owner. Doing a sum of parts valuation,

Thinking Through The Risks 

One has to remember that in the short run the market is a voting machine – what does that mean ? with all these developments on, there is little or no movement in the stock. That is because ambani has had a long track record of shoddy execution and broken promises to shareholders. The majority do not believe this time it will be different – However, looking at the pointers above, I believe it is different this time.  Hopefully, the market will accord this business its due in the near future.

My Interpretation Of Anil Ambani

My interpretation of Anil Ambani is that he is a good salesman – someone who can craft good deals and get a great value for the sell side – aka an investment banker. Needless to say, based on his track record, his execution is very patchy.  However, one must remember that he has set some lofty benchmarks in selling his business to foreigners:

  • He has sold stakes in each of his businesses – mutual fund, life insurance to Nippon at good valuations.
  • He is a great deal maker and has been able to sell a dream in each of his deals including IPO’s
  • He realizes that this is his crown jewel (hence the induction of Devang Mody from Bajaj Finance and also his son Anmol to the board) and has takena series of progressive steps to unlock value – demerger of HFC, IPO of MF, stake sale in general insurance business and potential QIP of the commercial finance.

He is a bit like Mohammad Aamir  – the Pakistani bowler who was banned in 2010 for match fixing and lost a promising part of his career. Yet he came back stronger than ever in champions trophy and won the match for Pakistan against India.


What Can Go Wrong ?

Mis-allocation by promoters: Given that the promoters are just coming out of a de-levering cycle, I do not expect reliance capital to again invest into non core businesses.

Stake sale/pledge: Any stake pledge by ambani to raise money to fund other businesses will create a over hang on the stock.

Regulatory approvals : Given that anil ambani’s other businesses are levered and have a lot of debt repayment issues, there could be potentially costly litigation or delay in getting approvals from SEBI/RBI/lenders. 

Acknowledgements:

I have used inputs from :

  • Annual reports 14,15, 16 and companys’ investor presentations and conference call transcripts
  • ICICI securities research reports on Reliance capital
  • Inputs from people in the financial community

Disclaimers :

The information herein is used as per the available sources of bseindia.com, company’s annual reports & other public database sources. Alpha Invesco is not responsible for any discrepancy in the above mentioned data. Investors should seek advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents.

Author of the report has investment positions in the stock at the time of publishing this post. 

Future estimates mentioned herein are personal opinions & views of the author. For queries / grievances  – support@alphainvesco.com or call our support desk at 020-65108952.

SEBI registration No : INA000003106

Readers are responsible for all outcomes arising of buying / selling of particular scrip / scrips mentioned here in. This report indicates opinion of the author & is not a recommendation to buy or sell securities. Alpha Invesco & its representatives do not have any vested interest in above mentioned securities at the time of this publication, and none of its directors, associates have any positions / financial interest in the securities mentioned above. 

Alpha Invesco, or it’s associates are not paid or compensated at any point of time, or in last 12 months by any way from the companies mentioned in the report.

Alpha Invesco & it’s representatives do not have more than 1% of the company’s total shareholding. Company ownership of the stock : No, Served as a director / employee of the mentioned companies in the report : No. Any material conflict of interest at the time of publishing the report : No.

The views expressed in this post accurately reflect the authors personal views about any and all of the subject securities or issuers; and no part of the compensations, if any was, is or will be, directly or indirectly, related to the specific recommendation or views expressed in the report.