GACL is a listed company with approximately 2500 cr. market capital as of 23 April 2020. This company was founded in 1973 in Gujarat. The company is primarily engaged in the business of multi-product chemical manufacturing , having roughly 36 products in its basket and is one of the leading manufacturer of Caustic Soda Lye in India.
INDUSTRY & PRODUCTS
The company belongs the industry of 'Chlor Alkali / Soda Ash' in the chemical sector. The industry structure is highly competitive with low profit margins and ROCE. In chemical sector - Chlor Alkali industry is a fairly cyclical play. The chlor-alkali industry is more or less a cyclical business where the combined value of chlorine and caustic soda, tends to move up and down with a cycle of about 3-5 years. As per their 2019 annual report, there are 32 active Chlor-Alkali Units in India. The production of Caustic Soda during the Financial Year 2018-19 has been 35.38 lacs MTPA as against the total installed capacity of approx. 42.76 lacs MTPA i.e. capacity utilization is approx. 82.72%.
Caustic soda lyle can be used in various areas like soaps and detergents, rayon, paper and pulp, textiles and other chemicals. The bigger consumers are the alumina industry and pulp and paper. Chlorine (Gas / Liquid) can be used in plastics (including PVC), chlorinated paraffins, pesticides and other chemicals, hydrochloric acid, water treatment etc. Given many uses of these products as they are consumed as raw materials in other products in the value chain, there are many manufacturers for Chlorine and Caustic soda lyle as well.
Competitors in the industry do not have any highly sustainable moat nor they can easily develop one. What really matters in this industry is the importance of low cost production and high distribution network.
GACL is a multi-product company, having more than 36 products in their basket, yet the major revenues are coming from Caustic Soda group and therefore, market scenario of Caustic Soda and Chlorine is of utmost importance to them. The Company’s products basket comprises of products including Caustic Soda (Lye, Flakes & Prills), Liquid Chlorine, Hydrochloric Acid, Chloromethanes, Hydrogen Peroxide, Caustic Potash (Lye & Flakes), Potassium Carbonate, Aluminium Chloride, Phosphoric Acid, Chlorinated Paraffin, Poly Aluminium Chloride (various grades), Chloro- Toluene, Sodium Chlorate etc.
The company enjoys around 15%~ market share in the domestic Chlor-Alkali industry as per their 2019 annual report. The below table summarises the major products which are contributing to the revenues of the company for the past 5 years.
Revenue Contribution per Product (%) -
Caustic Soda - Lyle accounts for roughly one-third of company revenues as of 2019. Hydrogen Peroxide is the fastest growing among the lot @ 22%~. During the period of 2018-19, GACL has produced 4.32 lacs MTPA caustic soda as against the installed capacity of 4.12 lacs MTPA and achieved capacity utilisation of 105%~.
Although GACL did not disclose its client list, they have stated that they do not recognize any material credit risk in regards to collection of payments from their customers (debtors) and have also stated that their customer base is large and fairly diversified. Below is the break-up of total debtors being contributed to their top five customers:
Below table highlights some basic facts about the company in general:
GACL reported revenues of Rs 3161 cr. for the FY 2019 achieving a growth of 29%~ from the past year. Average growth in revenues from the past 10 years is 11%~. The company reported net profit of Rs 690 cr. for the same year. This makes 'Return on Assets' to be around 15%~ and Net profit margin to be 22%~ for FY 2019. GACL has negligible debt and contingent liabilities are on a higher side being 16% of 2019 balance sheet.
Looking at their total cost break-up, the company has low (and decreasing) operating leverage and high variable costs. Below is the table with the past 10 years of data:
Variable costs account for roughly 80%~ of the total cost for GACL while fixed costs only account for roughly 20%~. 'Total expenses / Sales turnover' remain roughly constant at 80%~ through out the years except 2018 and 2019 where there was slight improvement seen mainly on account of increased caustic soda prices in 2018 and decreased expenditure in 2019. Having a 36 product portfolio, it helps GACL in such a way that part of finished product of one plant is consumed as a raw material in other plant.
Here are a few more company facts to provide details on how the company is managing its business in terms of working capital, return on capital employed, leverage etc:
The company having large set of products contributing to its revenues, does not get fully impacted by cyclicity in Chlor-Alkali industry. ROCE and ROE remain mostly constant averaging around 10%~ with the exception of 2018 and 2019 where margins were seen to be improving on account of increased caustic soda prices in 2018 and decreased expenditure in 2019. GACL has a low debt / equity ratio of 0.06 in 2019 with sufficient ICR of 56.
The balance sheet mainly consists of Operating assets (60%~) and the rest are Non-Operating assets (40%~) which do not contribute to the core business income of the company ie. income from selling various types of chemicals. GACL earns roughly 95% from Core business income and 5% from non-core activities like interest and dividend income, income from investments etc. We do not consider such 'Other Income' as very sustainable and we have a different system set in place to value such income separately from the core business.
POSSIBLE ECONOMIC MOATS
The company operates in a highly competitive industry where product differentiation is not possible. Companies in this industry do not possess any durable moat like pricing power, customer loyalty etc. GACL being one of the largest producers of caustic soda in India does enjoy economies of scale upto a certain extent. Apart from that, GACL does not seem to have any other moat that distinguishes them from their competitors.
Products like chlorine and caustic soda produced by GACL being essential products for our day to day living do not possess any major threat of substitution in the near future and hence the company is likely to be in business even after 30 years (assuming it does not do something silly along the way).
THE GOOD AND THE BAD
- GACL having more than 36 products in their portfolio, it provides diversification in revenues, enables integration of down stream plants where finished product of one plant becomes raw material for the other. It also helps tackle cyclicity faced by other caustic soda producers in the industry.
- Power and Fuel expenses are one point on which the company needs to work on. We see these expenses (as a % of Revenues) consistently increasing from 12%~ in 2010 to 24%~ in 2016 and then stabilising after 2016. On such expenses, GACL says "To augment its power requirement with eco-friendly renewable energy in 2018-19, the Company’s total Wind Energy Generation Capacity has now gone up to 171.45 MW. The Company has also commissioned 22.5 MW Solar Power Projects for captive use".
- The Company had only single source procurements for the raw materials viz., Rock Phosphate from Jordan and Potassium Chloride from Canada. Not only the company faces big risk in terms of having concentrated suppliers which can disrupt the supply of raw materials anytime, it also faces risk in terms of depreciation of Rupee which will directly increase the cost of raw materials procured from foreign countries.
- Although majority of the expense are variable, GACL has a low net profit margin (averaging around 11%~ and FCF margins around 7%~) which does not provide much cushion during downturns. The company is exposed to face minor losses in cases of severe economic collapse (like the one we are witnessing during March 2020 - Coronavirus crisis). The net profit margins are in line with the industry and nothing much can be done about it in such a competitive environment.
EXPANSION PLANS AND EXPECTED GROWTH
Although the company has set a big target to achieve Rs. 5000 cr. turnover by 2021-22, it seems unlikely especially because of the black swan event everyone is currently facing i.e. coronavirus. It will essentially have a huge impact on their expansion plans.
Below table highlights the expansion projects that are currently planned / work in progress / operational as per GACL 2019 Annual Report. The expected revenue increase has been calculated by using 2019 prices as a base. Since GACL didn't mention their current capacity for their products, we used MT chemicals produced in 2019 and 2018 for comparison:
The company management is talented and ambitious and has been able to successfully complete previous expansion plans. Below table highlights how revenues, profits and reserves have actually grown irrespective of the expansion plans taken by GACL:
For a product like caustic soda or chlorine, we do not think it would be possible to generate growth expectations through qualitative research as there are many end uses of these products. In this case, past performance would be a better and more reliable indicator of future growth rates. GACL being in an industry where supply > demand and GACL having no special advantage over its competitors, we think that it would be risky to assume a growth rate of > 12% for the coming years. Therefore, we conservatively expect expect GACL to continue its growth rate of 10-12%~ for the next 5-7 years until the growth rate comes down to 6-8%~ per annum.
Let's examine the company from the manipulation and fair value point of view:
After looking at the sum of # years of 'Cash Generated by Operations / EBITDA', it seems that GACL is indeed earning in cash what it is reporting in PNL statement. There is almost no difference between the two. Although there is some deviation in sum of 'Cash Taxes / PNL Taxes', it does not look alarming to us. We also compared growth in audit expenses to growth in revenues and we did not find any unusual growth in audit expenses which needs to be further looked into.
One of the most reliable way for us is to check the reserves of the company as we have seen in the past that companies usually try to hide losses (and profits in some cases) by directly booking PNL expenses into reserves. Therefore, one check we do is to take the change in reserves of the company over # years (10 years in this case) and we adjust it for any dividends paid (as these are directly reduced from reserves) and also add the reported profits (which is added to the reserves). If we find any material number leftover, we further try to dig up the reserves part of the company. In our case, GACL seems to be appropriately accounting for the reserves and hence does not raise any suspicion.
MARKET VALUE VS FAIR VALUE
Finally, let us look at what our valuation model tells us about the fair value of the company after incorporating all the qualitative, quantitative and risk aspects of the company.
Our valuation model suggests a fair value of around Rs. 348~ (+/- 10% range) for GACL. It was for people's optimism and the recent bull run that GACL touched an ATH of Rs. 900 in Jan 2018. We got the opportunity to buy this stock at a deep discount to fair value at Rs 212 in March 2020. Although, the stock would probably not be a multi-bagger (it has low growth rate and is expected to maintain it) in the coming years, we like GACL because it is a relatively safe stock with decent economic attributes and provides a good level of industry diversification to our portfolio. We intend to keep it for long term until better value emerges in the markets.
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