Guest post by Varadharajan R. He tweets at @varadhar1
Varadha 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 : 1420|
|52 Week High / Low : 1499 / 702|
|Market Cap : 880 cr|
|9 Month FY 17 EPS : 83.5~|
Disclaimer : This is not a recommendation to buy / hold / sell any securities mentioned in the blog post. The published post is for information purposes only.
“You make maximum money when your view is contrarian and IS right”
“You make maximum money when something goes from bad to unknown to good. By the time good becomes great, much of the PE re-rating has already happened.”
I tend to focus on stocks where the majority of investors have no view or a dim view. I try and see if these stocks have the potential to scale up and deliver returns. 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).
Background of the company
Pokarna Limited was founded in the year 1991 and is one of the largest exporters of finished granite from India dealing in over 70 premium colours. Pokarna processes its granite at two state-of-the-art manufacturing facilities and has its own quarries. company also processes several colours from carefully identified independent quarries in Angola, Norway & Ukraine as well. Besides exporting finished granite, the company also manufactures and exports quartz based engineered stone under the brand name of “QUANTRA”. For the engineered stone, the company’s production facility is spread across 1.7 million sq. ft. at Visakhapatnam (Vizag). The company started with the commercial production of quartz based engineered stone in Oct’09 and spent ~200 crores on the set up of the production facility.
Genesis of the idea
Usually the first port of call is an idea that comes from an independent source. This time, it was from a US based hedge fund manager who is short a large quartz manufacturer in the USA. As a part of the thesis, he had claimed that the company was losing market share to quartz manufacturers from other countries, including from India. The gist is:
- The Engineered stone/quartz top market in the USA is about USD 2 bn and growing at 10-15%
- It’s a consolidated market with few players – the largest of which is Caeser stone at $ 550 mn
- Pokarna is at about $ 40 Mn in quartz revenues and can grow ahead of the market
- There is a place for a lower price player who can offer the same quality at Caeser stone, especially from an emerging country. Caeser stone’s facilities are in Israel and Turkey and have higher over head costs.
Source : Company presentation and verified with an industry expert
Source : National American Housing Board data
Key takeaways from the above images are that :
- Quartz market in USA is growing steadily in excess of 10-12 % and has a lot of head room for growth
- US housing market has rebounded well from the 2009 crisis on the back of a falling unemployment, stable inflation and improved bi-directional trade with the USA.
Quartz stone – is that a commodity ?
The first, instinctive reaction to the word quartz is that it probably is a low margin commodity and is susceptible to economic cycles. However, quartz slab, which is what Pokarna makes, is anything but – why so ? Because raw material costs are only 20% of the selling price and the value addition done is capital intensive, technology intensive and there are less than 200 companies in the entire world who are capable of making quartz slabs. However, less than 20 of them use Bretton Stone technology – which has various certifications that act as a diffferentiator in the US market – including Kosher, approved by Ikea/Walmart/Home depot etc. What’s also important is that quartz being an engineered stone does away with the disadvantages of natural stones – is much stronger, resists stains and spills, can be customized and has an enduring life.
Quite counter to popular belief, quartz slabs are a status symbol and are used to display finesse and an appreciation for style rendering them quite price inelastic, as shown in the table below. The graph below shows that quartz penetration in USA is still only 8 % and has head room to grow.
Pokarna’s advantages on sourcing, distribution and product mix
Sourcing : Pokarna’s Quartz plant is located in Vizag in the state of Andhra Pradesh. Andhra is blessed with one of the best quality quartz in the world which is pure milky white in color. The Quartz found in India is of much better quality than the one in Turkey or Brazil where its main competitors are located. Currently Pokarna has long term supply contracts with a supplier which exclusively supplies quartz to them. Ease of availability of good quality raw material and surety of supply will help Pokarna to scale up on the quartz business.
Distribution network : Pokarna also has used its existing network of granite dealers. In quartz, there are 3 popular thicknesses of 12mm, 20mm and 30mm with their realization varying according to their thickness. We expect Pokarna to improve its quartz realization by increasing sale from higher value 30mm category which yields higher realization ($8/sqft vs. $4/sqft for 12mm).
The following shows the financials of quartz : It’s a 30 % ROCE business with very high EBITDA margins of 35 -40% and has an incredible operating leverage of 70 %+ incremental gross margins. The management has guided for a 10-15 % growth in realizations on the back of focus on thicker slabs and some line smoothening to improve throughput – this should result in a Rs. 100 Cr. EBIT for FY ’18 on a Rs. 225 Cr. capital employed.
Sourcing: India has rich reserves of granite with over 200 color varieties from 300 colors available worldwide. Some of the colors like Jet Black, Black Galaxy are most sought after world-wide and are exclusive to India. Pokarna has a color palette of 75+ colors which it caters from its own mines as well as imports rough granite blocks and processes as per the need of the customers. It has ~15 operational mines in Andhra Pradesh, Telangana and Tamil Nadu. Raw material for more than 70% of the processed output is sourced from its own mines currently. This helps the company in having security over raw material sourcing. It can easily commit to supply large orders as per the needs of the customer without sourcing worries. It has two state-of-the-art processing units in Telangana which uses the latest technology machinery which is mainly imported. The facilities are equipped with fully automatic polishing lines. Using the best machines gives Pokarna an edge over the players in unorganized sector who use block cutters in place of gangsaws and use handheld polishing machines. Its products are upto the quality of export market which is not possible for the other unorganized sector players to match. Almost 69% of Pokarna’s granite revenues are derived from export markets. It exports granite to more than 49 countries and pre dominantly to North America, Europe and Asia They have tie-ups with few of the largest distributors in US who have been their customers for the past 20 years. It supplies to big distributors in US like Daltile, Coldspring etc. who in turn supply to fabricators for final installations. It is also entering newer geographies like Middle East by appointing distributors there. In the Domestic market, it sells its products majorly to large projects or real estate players than going for direct retail sale. It has sold its products to developers like Prestige, Sobha, Reliance group etc. for their high end projects.
Granite division financials : (all in Rs. Cr.)
Their apparel division has been a real fly in the ointment. While their apparel brand Stanza scores well on quality, distribution and brand pull are sorely lacking. Its inexplicable why the management has continued to plough into more than Rs. 40 Cr. Into this business. The business has a topline of about Rs. 7 Cr. And continues to burn money and for the 9M FY ’17 it had a loss of Rs. 5 Cr.
However, the silver lining is that the management has made a filing to BSE where they have formed an independent committee that will look to what can be done to unlock value in this entity. The most logical thing in my mind would be for this to be merged into the private company of Mr. G.C. Jain which is a distributor for Raymond at zero cost to shareholder. This would accrue value to shareholders as cash haemorrhage would stop and it would add to both EBITDA, PAT and ROCE both in the short and the long term.
Capacity to suffer
It’s a well understood fact that most moats get created after a period of suffering when the management focusses on creating a sustainable, profitable business by erecting barriers to entry. In Pokarna’s case, the entry into the quartz market in 2008 when the recession stuck made them stronger. They went into CDR because of a debt funded expansion and it was not until 2014 that they found their feet in the US market again. Once the housing sector started picking up and their distribution was able to throughput critical volumes, the operating leverage in the quartz business (70%+ GM). Usually when a business passes through a pincer and the management remains committed, when the tide turns, they bounce back – better stronger, faster and better. We’ve seen this play out in multiple companies – symphony, Hawkins, TTK prestige. In Pokarna’s case the Indications that give me confidence are :
- Shrinking balance sheet (consolidated loans have come down from Rs. 197 Cr. To Rs. 172 Cr.)
- WC discipline (Cash conversion cycle has come down from 139 days to 105 days)
- Fund infusion by promoters (promoter’s gave an interest-free loan to the company)
- Coming out of CDR recompensing bankers (that shows that management wants to carry along all stake holders) – the company has recompensed about Rs. 17 Cr. for the losses sustained by the bankers owing to company going into CDR)
- Increasing openness and transparency to shareholders : From being completely reticent till a couple of years back, Pokarna management has started giving out investor presentations and hosting conference calls. They have also been meeting institutional investors over the last one year or so. A point to note is that I am very wary of managements who come on CNBC all the time or keep meeting analysts/investors. Given that the management has done less than a couple of meetings per quarter and hardly is in the news, I treat this as a positive.
- Consolidation of promoter’s shareholding : My scuttle butt shows that the promoter Mr. Gautam Jain has been buying out his relatives/other shareholders who had financed him during his early days. This is usually a positive sign and reinforces that the executive management sees value in their shareholding
Brand scale-up : Pokarna sells under its own brand called quantra. The company has launched an app which allows for customers to experience the colours/textures of the product. While Quantra as yet is still not a brand, with new capacity coming up, company should be able to sell about 20-30% of its output under its own brand which augurs well for the future.
Pricing improvement : From my scuttle butt and back of the envelope calculations, Pokarna is at 2/3rd the price of Caeser Stone. Given that the brand pull has not kicked in as yet, this can potentially go upto 80-85 % of Caeser stone’s selling price. This will provide additional operating leverage in terms of margins. In my calculations, I have not factored that in.
Reversion to mean in granite : A mix of dumping from brazil slow down in demand and issues of integration with mines led to Pokarna’s margins coming down from 24 % to 21 % in 9M FY’17.
Shut down/divestment of appparel : The company has already said that they do not intend to sink any more into the apparel business. Given the sub-standard scale and size of this business, the only viable option seems to be for this to be spun-off into a subsidiary or possibly get merged with Pokarna fabrics, which is the distributorship of the promoters that distributes the Raymond brand.
Improving sell-side coverage : At this point, except for possibly Equirus securities, I am not aware of any other broker who covers Pokarna on a consistent basis. Given the obscure name, Hyderabad location and a chequered history, there are few who understand the story ( there in lies the opportunity for a patient investor).
Scuttle butt – views from industry experts
Pokarna’s quality is amongst the best in quartz and granites “ – fellow exporter from Jaipur
“Gautam Jain is very conservative and hence the reluctance to expand capacity by taking on debt. The FCCB and CDR debacle possibly is playing in his mind .” – Family friend of Gautam jain
Checked US port container landings and verified it with pokarna’s shipping data – it broadly matches with the sales data
- Checked with an ex-daltile employee to check on daltile’s criteria for choosing pokarna – feedback is positive
- Checked with a Jaipur based granite and quartz exporter and he confirmed pokarna has the best brand name amongst indian firms in the US market
- From MD’s words – “Daltile, a company based in the US, happens to be one of our biggest customers. It has also been my biggest distributor for the last twelve years. One of its representatives, who visited us a few days ago, said, “Mr. Jain, you need not be so perfect; even if sometimes you give us not-so-good materials, we will accept them. In the last twelve years, you have not given us a reason to complain.”
Suffice to say, I am reasonably confident that the company is not fudging sales numbers and triangulation with independent third party data broadly matches with its declared sales figures.
Assessment of the overall Pokarna business
On a consolidated basis, Pokarna trades at about 13x FY 17’E EPS of about Rs. 105-110. For a business that has incremental gross margins of 70% with ROCE’s of 30%, this is priced for zero growth. Given the buoyant demand and the fact that the company is adding capacity, this is cheap especially when compared to peers like cera, hsil which trade in excess of 20 PE.
OCF /FCFF yield
Pokarna had a post WC OCF of Rs. 105 Cr. for FY ’16 and I expect it to throw out anywhere between Rs. 120-130 Cr. OCF for FY ’17. At a Mcap of Rs. 880 Cr. plus debt of Rs. ~175 Cr. , EV/EBITDA translates to about 10-10.5x.
Inverting, Pokarna’s adjusted OCF – viz., OCF – principal – interest would be about Rs. 80-90 Cr. at a Rs. 880 Mcap this would mean an OCF yield of ~10 % leaving all growth for free.
Risks/What can go wrong ?
Quartz demand : While the USA is in the middle of a strong economic tailwind, there is a risk that something unforeseen can happen that can lead to a collapse in housing renovation demand.
Mis-allocation by promoters : Given that the promoters have just come out of CDR and they have now curtaile their adventure into the apparel business, chances of this happening are slim. However, judging by their past track record, its not an improbable event.
Environmental concerns/import duties : Given that both quartz and granite are mined, there could be potential environmental risks associated with it. Also, given USA’s protectionist stance, there could be potential duties that discourage imports. However, since quartz and granite are not native to the USA and hence jobs cannot be created, this looks unlikely.
I have illustrated how my thinking differs from conventional wisdom through a succinct graph. Very rarely do you come across a business that is growing sales, improving EBITDA margins, reducing WC and increasing dividends in an industry that’s growing in double digits. At 10-11 FY ’17 E, this is inexpensive considering the growth prospects ahead.
I have used inputs from :
- Annual reports 14,15, 16 and companys’investor presentations and conference call transcripts
- Equirus research reports on pokarna
- Inputs from a hedge fund that is short on Caeser stone, pokarna’s prime competitor in the USA
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