Kewal Kiran- It is not always about growth

For the last three years, I am invested in this apparel company that has hardly grown its core profits and yet share price has doubled during this period. Quite often, my friends question my investment rationale on a company that has not been offensive in its approach to expand (despite having relevant opportunities) and available at high valuations (30x trailing P/E). I say high valuations, because most investors compare P/E with growth (popularly known as PEG ratio) and for a company that is not growing its earnings this mean PEG ratio of 30 (a very high number)

I thought to review the investment case after its full-year FY17 numbers were released last week. Before I get going with financials, let me explain the business profile for the beginners. Kewal Kiran Clothing Ltd. (KKCL) designs, manufactures and markets branded jeans, formals, semi-formal and casual wear for both men and women under 4 brands- Killer, Integriti, Lawman and Easies. It is largely a branded jeans player (65% of revs.) and deriving majority of its revenues from its flagship brand Killer (51% of revs.)  The branded apparel sector growth should be driven by usual investment case (i.e. rising per capita income, growing fashion consciousness, aspiration value, etc.) and within the branded apparel sector, denim wear provides a stable long-term growth opportunity driven by the timeless appeal of denim amongst the youth. The largest section of the market is still catered by the unorganized sector and the transition to the organized (so easy to plug-in GST word here) and branded segment has lured many domestic (Flying Machine/Wrangler from Arvind Ltd, Spykar owned by PE fund.) and MNC players (Levis, Pepe).

However, it is not the biz profile that drives my attention, but accompanying financial strength that keeps me invested. Let me explain some numbers here- For FY17, company reported Rs 5 bn in revenues and with an impressive ~20% EBITDA margin (Rs 1 bn in EBITDA), minimal depreciation charge, virtually zero debt and tax rate of ~30%, it reported adj. net profit (excl. other income) of Rs 0.65 bn.    This net profit is generated on net worth of Rs 3.6 bn and capital employed of Rs 3.75 bn, translating into RoE of 18% and RoCE of 17%. But what fascinates me is how this capital (Rs 3.75 bn) is employed into biz – it has Fixed Aseets of 0.75 bn, non-current assets (excl. Investments in MFs) of only Rs 50 mn and working capital (excl. cash & ST inv.) of Rs 0.4 bn. In other words, the actual money employed into biz is only Rs 1.2 bn and rest is cash equivalents (Rs 2.5bn). Therefore, the point I am making here is KKCL’s return ratios are much higher than what appears at first sight. My calculations suggest that it has RoCE of whopping 55% (NOPAT of Rs 0.67 bn / CE of Rs 1.2 bn). Company claims for RoCE in operation are even higher at 65% for FY17. To confirm if P&L numbers are not inflated, I look at cash flow statement where I see that reconciliation between reported earnings and cash flows is excellent as EBITDA to Op. cash flow is at ~100%.

Thus, its financial strength is impeccable with sector-leading margin of 20%, net cash of ~Rs 2.5 bn, RoCE of 55%, strong cash flows and payout ratio of ~50%. Such financial strength is unheard among its peers (except Page Industries which owns Jockey brand) and is a result of KKCL’s successful brand, pan-India distribution, asset-light franchise biz. model, and most importantly it is a reflection of conscious strategy to not run with the crowd and chase market share, but indulge in steady race. Further, I find solace in the fact that promoters have ~75% of total ownership and no pledges or dilutions in the past.

The next question is at what price such financially strong biz is available- I would put that in context of theoretical RoE and P/BV relation which states that P/BV = RoE- g/ Ke–g. Assuming cost of equity as 12%, growth at 5% and RoE as calculated above at ~55%, theoretical P/BV should be 7x. Whereas stock at CMP of Rs 1700 and Mkt-cap of Rs 21bn, trades at 5.9x. In a market where most other companies are trading at frothy valuation and some making new highs everyday even disregarding basic P&L risks, I think this discount in valuation for KKCL should be pounced upon.

Key risks:

Some investors doubt how KKCL generates such margins and return ratios and have failed to understand the moat in the business that drives the strength: My argument will be that financial irregularities and P&L fancies generally do not last wrong, but KKCL has delivered consistently for last 5-6 years now with reasonably good dividend track record. Also, I have mentioned moat above- franchise based biz model, pan-India distribution network and efficient manufacturing setup.

Can denims continue to grow in the longer run: Maybe not as strong as other fashion-wear category, but certainly denims have timeless appeal among youth. 

Conclusion:

The branded retail segment has seen few success stories and quite often wealth-erosion (Koutons, Canatabil, Zodiac) companies due to over-bloated B/S and super aggressive strategies that lead to encompassing excess risks. KKCL's biz. strategy on the other hand is a classic example of slow and steady to win the race.

The dilemma of investing in Education sector

I always wanted to buy some credible company in education sector, given that the sector is benefitting from exponential inflation in fees and inconceivable willingness of parents from all socio-economy stature to provide the “best” education for their kids at “any” price (even if it means sacrificing other desires).

What I paid for my MBA course 10 years ago (Rs 0.3mn), is now annual school/tuition fees for student in class 1, and I cannot even imagine the share of our savings that will flow into our kid’s education expense over the next 15-20 years. As a hedge against this inflation (which no insurance seems to cover other than their flashy advertisements to protect child dreams), I wanted to own some company in this space that would grow its profits exponentially and give us capital appreciation that will atleast partly offset the burden.  

Till few years back, I always thought that with such super-normal growth in the sector the beneficiaries should be many in the education value chain- i.e pre-schools, private schools/colleges, tutorial classes, publishing houses, and digital content provider. However, as surprising it may sound too many, there has been hardly any listed company that has been able to reflect this benefit on their P&L. In fact, the sector has given one of the highest disappointments to investor community and sharp downfall in shares when expectations did not materialize. This includes unimaginable 99% fall from its peak in Educomp and Everonn, who were once thought to be pioneers that will change the way of learning through their digital content; Treehouse Ltd. which was easily believed as relatively asset-light, high-margin scalable pre-school biz, but has already fallen from grace; NIIT and Aptech who have tried to diversify their biz. model but have achieved little success; and finally Career Point and MT Educare in coaching classes segment who have failed to prove that they can scale-up their business to drive strong profitable growth.   

The reasons for this downfall in post-facto analysis are plenty- highly capital intensive businesses, long payback period, bloated balance sheets, poor corporate governance, competition with trust owned institutions, etc.  I can probably have endless discussion on company-specifics issues, but I will restrict those thoughts for some other day.

Conclusion

The situation has turned out to be similar to classic joke flowing around about liquor consumption- the drunkard, owner of the liquor company (Mr. Mallya) as well as banks lending to Mallya are all losing money- so the big question is where has the money gone? I think education sector has given a similar dilemma to most of us.   

The key learning to me from this sector has been that reality can be materially different that what is perceived. What appears to be money machine for a common man on the street, company’s P&L has categorically different result. The hypothetical new winners in education sector have failed drastically, while publishing house like Navneet which is believed to be in mature or declining stage of business has hold out reasonably well.

The hunt is on for some interesting biz. model in this space that can prove its mettle with financial strength. So far, only Zee Learn and Navneet Education have been able to hold strong; MT Educare had good prospects, but has given away its B/S strength recently.I will have sleepless nights till I found a good hedge.  

Century Ply: Peaking investments, to reap benefits now??

Key details: Price: 215, M-cap: 47.9 bn

While investing in consumer-driven building products sector (which includes paints, ceramics, pipes, bathroom-ware, etc.) has been a no-brainer in the recent period, I am skeptical on valuations for this group (avg: 28x FY18E earnings when steady-state growth is around mid-teens). However, the below opportunity in Century Ply (CPIL) appears interesting in the context of multiple triggers that lies ahead for this company and can be a low-volatile good long-term investment bet.

Key positives:

• Peak capex phase is almost behind us: Out of budgeted capex of 600 crs, Century has already incurred 370 crs of capex since FY16, and by end of this quarter it has plans to complete ~500 crs, which represents overwhelming 30% of FY17E revs. This capex includes commissioning of Particle board facility in FY17 (capex: 66 crs), new MDF facility which will start in next 3-4 months (capex: 330 crs by FY17E, see below as why MDF is important), and will increase laminates capacity by 50% in H1FY18 (45 crs). As these capacities ramp-up, growth will be stronger over the next few years. (Bloomberg estimate of 22% EPS CAGR in FY17-19E vs CAGR growth of 7% in FY15-17E).
• Stellar margins and return ratios: Strong retail brand (90% sales are retail driven), wide distribution network is resulting into industry-leading margins (17.5% EBITDA margin vs. Greenply at 15.6%) and stellar return ratios (RoE: 30% vs. building products company excl. paints avg. at 20%). In fact, its return ratios appears similar to paints industry (Asian paints is at ~35%).
• GST beneficiary: During its concall mgmt. noted that in plywood sector there are ~3,300 units under small scale industries (SSI), of which 2,500 enjoy 100% duty exemption and ~700 are partially exempted. However, SSIs will be stripped of all exemptions under GST which would narrow the taxation/price gap with organized players. Further, the GST rate on plywood sector is expected to come at lower rate (<20%) than the current incidence of tax (26-28%) and this should help to lower plywood prices and revive demand which has been weak recently due to demonetisation.
• Backward integration ensures long-term sustainable availability of timber, its key raw material: It has set-up veneer processing and plywood manufacturing units in resource-rich Myanmar and Laos. Also evaluating option to setup facility in Indonesia.
• Why demand is shifting towards MDF: Low-end plywood prices have increased over the past 2-3 years as face veneer prices have gone up after Myanmar restricted their exports. This gave a strong boost to MDF consumption in India as the price differential between low-end plywood and MDF declined to just 5-6%. Globally, MDF’s share in plywood is much higher (65:35), while in India MDF share is currently very low (6:94), which provides a great opportunity. MDF’s low-cost, better utility (can be easily moulded and painted; but less strength) and increasing preference for ready-made furniture provides good prospect for MDF.Note: 100% of MDF is controlled by organized players due to high capex requirement, so as MDFs penetration increases in overall plywood sales, organized players will automatically increase.
• Valuations are cheap: Based on FY17E EPS of 8.5, CPIL trades at 25x P/E which might appear little expensive to some of us, but if we assume that fruits of recent capacity addition will drive growth and operating leverage in the next two years, this P/E drops to  15x FY19E EPS of 14.3 (assuming 30% CAGR). This valuation to me looks cheap in the context of its high-return ratios and growth potential. 

Key risks/ challenges:

• Low capital requirement and less R&D intensive makes plywood industry highly fragmented. Branded players together controls over only 25% of the plywood market and this industry has always been highly cash driven. While most investors view it as a great opportunity since demand could shift from unorganized to organized sector post demonetization and GST, I would view it as a risk until tax compliance increases and more level-playing field is generated.
• Century’s mgmt. was behind its key peer Greenply in understanding the increasing consumer preference for MDF. While Greenply setup the its MDF plant 6 yrs bk, Century has only now initiated India’s largest MDF plant (~0.2mn cbm); but Greenply’s capex plans to triple its MDF capacity in the next two years (~0.54m cbm) could mean Century’s capacity would still lag its main peer. Also, increasing capacity across all players could mean risk to pricing/margins in MDFs.
• Working capital days is over 2x that of Greenply (similar receivable days, but higher inventory and lower payable days); and net debt to equity at 0.9 is higher than Greenply as well as other building-products companies.

Business profile:

• Century Plyboard is the largest seller of multi-use plywood and decorative veneers in the Indian organized plywood market (25% market share of organised and joint leadership with Greenply), and with recent addition of doors, particle board and MDF its offerings covers entire wooden interiors infrastructure products. 
  
  
• Industry dynamics: Of the total plywood/panel industry, roughly 2/3rd is made of plywood, laminates constitute 16%, and veneers/particle broad/ MDF makes up about 6-7% each. With organised sector's share at 25% in plywood, and Century/Greenply share of 25% within organised, both of them roughly hold 6.5% stake each of the plywood segment. Important to note is that in the other sub-segment of plywood, organised's share is much higher- i.e in MDF 100%is organised, in laminates  and veneers organised share is >50%, and in particle board it is ~35%.
• Its portfolio comprises brands across the luxury (‘Architect Ply’, ‘Club Prime’), premium (‘Centuryply’) and economy (‘Sainik’) categories, but lacks product offering in low-end of plywood market. It has plywood manufacturing capacity of 210,000 cbm (cubic meters per annum), and MDF capacity of 198000 cbm, spread across six manufacturing facilities. CPIL is also a significant player in laminates (7.2m sheets by Sept-17, it is already third largest in India), commercial veneers (largest player in India).
  
  
• Indian plywood industry has grown at a 6-8% CAGR in last five years, whereas the organized players, especially CPIL and Greenply, have clearly outperformed industry growth. 

Conclusion:

Market seems to be ignoring long-term benefits of CPIL's entry into MDF (which is high-growth and potentially game-changing moment for plywood/panel industry) and GST benefits of shift from unorganised to organised. Despite similar return ratios and growth prospects of Asian paints, CPIL trades at 1/3rd the valuation of Asian Paint. While I am not debating that it should trade at similar valuation, but I think CPIL could potentially double in the next 18 months as growth picks up.