February 9, 2017

Analysis: Granules India Limited

www.drvijaymalik.com has a dedicated section for investment & stock specific queries of readers: “Ask Your Queries”. Over time, readers have asked queries about multiple stocks in this section. Answers to these queries have been done post preliminary analysis of the stocks under consideration. Such analysis has been found helpful by readers.

Q&A Series is an attempt to summarize & share with all the readers, the key questions and their answers, which have featured on “Ask Your Queries” section. The primary aim of this new feature is to share the knowledge with all the readers of the website.

The current section of this series, “Q&A” covers Granules India Limited, a Hyderabad-based Indian integrated pharmaceutical manufacturer, which focuses on making active pharmaceutical ingredients (API), pharmaceutical formulation intermediates (PFI) and finished dosages (FD) as primary business activities.
Equity research report analysis Granules India Limited, active pharmaceutical ingredients API, pharmaceutical formulation intermediates PFI and finished dosages FD, Actus Pharma Limited, Omnichem

Granules India Limited


Reader’s Query

Dear Vijay,

I have done the analysis as per your framework for Granules India limited. I am attaching results from framework and my views as well as certain red flags. I will appreciate if you can share your views especially on red flags found about company and also if I missed any key issue or parameter about company analysis. 

regards, 

Rohit Goyal


Granules India Limited
  • Pharma Company moving up the value chain from API to FD
  • 10-year consistent track record of 25% sales growth, 36% PAT growth, 48% ROE, 15% OPM and now increasing PAT margin as well
  • The company has generated wealth for shareholder consistent with ₹6 market cap for each ₹1 of retained earnings. 

Red Flags:
  • High promoter salary, close to 10% of PAT, max limit allowed as per law
  • 28% of promoter holding pledged can result in the share going down if forced to sell. But positive part is promoter investing in business only
  • The company got observations from few regulators which were never the case historically, but on the positive side, the company has already cleared from one European regulator showing quick response and focus from mgmt. and also indicating no major issues.
  • Debt levels are higher than desired and SSGR is lower as well. How shall one look at these 2 factors?
  • Change in rating agencies. Is that a cause for concern?

Overall, Granules India Limited looks to be a company on a growth path with a track record of sales and profitability growth. One need to keep a close watch on pledged shareholding, credit rating and PAT margins.

Final Checklist for Buying Stocks:

Criteria
Value
Remarks
1
Sales growth
CAGR >15% for last 7-10 years
23-25% for last 3,5,7,10 year period. So consistent growth
2
Profitability
NPM >8%
Margin was low 4-5% till 4 years back but due to finished dosages contribution becoming higher, margins at  7-11%
3
Tax payout
>30%
Ok. >30%
4
Interest coverage
>3
4.9. ok
5
Debt to Equity ratio
< 0.5
0.7, higher due to expansion. Need to keep check
6
Current ratio
>1.25
7
Cash flow
CFO > 0
Positive CFO
8
Cumulative PAT vs. CFO
cPAT ~ cCFO
CFO -613 cr, PAT-419
1
P/E ratio
< 10
17
2
P/E to Growth ratio (PEG ratio)
< 1
0.68
3
Earnings Yield (EY)
> 10-year G-Sec yield
5.9, less than 10 yr. g sec yield
4
P/B ratio
< 1
Not relevant for pharma
5
Price to Sales ratio (P/S ratio)
< 1.5
1.8
6
Dividend Yield (DY)
> 0%
0.5%
1
Comparison with industry peers
Sales growth > peers
Consistent growth of 25%
2
Increase in production capacity and sales volume
Production capacity & sales volume CAGR ~ Sales CAGR
Company has been able to increase sales by increasing capacity
3
Conversion of sales growth into profits
Profit CAGR ~ Sales CAGR
10Yr 25% sales growth resulting into 36% Pat growth showing better margin also excellent
4
Conversion of profits into cash
cPAT ~ cCFO
PAT <CFO
5
Creation of value for shareholders from the profits retained
Increase in Mcap in last 10 yrs. > Retained profits in last 10 yrs.
6.38 RS OF Mkt cap created for each 1 rs of earning. Excellent.
  
A) Subjective parameters
1
Background check of promoters & directors
Web search
No negative info
2
Management succession plans
Good succession plan should be in place
Salary being paid to potential successors should be in line with their experience
B) Objective Parameters
3
Salary of promoters vs. net profits
No salary increase with declining profits/losses
Profit have been increasing, but promoter taking almost 10% of PAT as salary which is max limit allowed.
4
Project execution skills
Green/brownfield project execution
No negative news found here. Have track record of expansion
5
Consistent increase in dividend payments
Dividend CAGR > 0
Dividends has been increasing with increase in profits of the company
6
Promoter shareholding
> 51%
Around 52%, but 28% pledge to fund growth and buy shares through warrants
7
Promoter buying the shares
Insider buying ++
Promoter increasing shareholding through warrants. Recent expansion done by money brought in by promoters
8
FII shareholding
~ 0%
7%
OTHER BUSINESS PARAMETERS
1
Product diversification
Pure play
Purely focused on pharma sector with trying to move up value chain
2
Govt. influence
No govt. interference in profit making
Nothing currently. One risk can be trump policies on pharma sector impacting export to the US
MoS in Purchase Price
Earnings Yield (EY)
EY > 10 Yr G-Sec Yield
EY close to 10 yr. GSEC
MoS in Business Model
Self-Sustainable Growth Rate (SSGR)
SSGR > Achieved Sales Growth Rate
8%, less than sales growth rate, can this be a potential risk due to dependent on debt/equity to chase growth?
Free Cash Flow (FCF)
FCF/CFO >> 0
52% FCF in FY 16
1
Credit Rating History
BBB- & above
CARE had suspending rating earlier. Seems co moved to India rating. Rating A+. While the rating is fine, moving to different rating agency a risk?


Author’s Response


Hi Rohit,

Thanks for sharing your analysis with the author and readers of the website. Let us analyse the past financial performance of Granules India Limited.

It is preferable that while analysing any company, the investor should take a view about the entire entity including its subsidiaries if any, so that she is aware of the complete financial and performance picture of the company. Therefore, while analysing the performance of last 10 years for Granules India Limited, we have analysed the consolidated financial performance of the company.


Granules India Limited, as mentioned by you, has been growing its sales at a good pace of 20-25% year on year for last 10 years (FY2007-16). The growth rate has been very good until FY2015, however, since then the growth rate has moderated. This is due to Granules India Limited reaching its near full capacity utilization in its core business of API manufacturing and high utilization levels of PFI as acknowledged by the management in the conference call with analysts while discussing September 2016 results:

Therefore, it has become essential that the company invest in further capacity addition to paving the way for future growth.

As a result, Granules India Limited has been investing in greenfield plant additions as well as JVs to continue on the growth path: (Source FY2016 annual report)



It remains to be seen whether the company is able to execute its planned capacity additions on time and within costs.

It is important to notice that the operating profit margins (OPM) of Granules India Limited, was following a cyclical pattern until FY2014 as visible from the OPM movement from 15% in FY2007 to 11% in FY2009, improving to 13% in FY2010 and again going down to 11% in FY2013. However, from FY2014 onwards, the OPM has been witnessing steady improvement and has steadily improved up to 19% in FY2016.

The cyclical nature of the profit margins of Granules India Limited have been explained by the credit rating agency ICRA in its rating rationale in December 2013:
“The above strengths are however partially offset by GIL‟s relatively weak profitability metrics, reflective of its presence in some of the mature and commoditized product segments restricting pricing power.”
It is essential to know that the primary products called as “Core Business” by Granules India Limited constitute some of the most used drugs in the world. These drugs have already witnessed very high penetration in healthcare services and the probability of a further sharp increase in their market size does not look highly probable.

These products: Paracetamol (reduced fever), Ibuprofen (pain killer), Metformin (lowers blood glucose for diabetics), Guaifenesin (cough syrup) and Methocarbamol (muscle relaxant), witness very mature markets with many big suppliers competing for the market. This results in poor pricing power in the hands of suppliers to pass on the raw material cost increases to buyers. This leads to fluctuation in the operating profitability margins with changes in the raw material prices.

These core products still constitute a large portion (86%) of overall sales for Granules India Limited. (Source: India Rating: Oct 2016 credit rating report for Granules India Limited)

The large portion of mature drugs ensures that the company would find it difficult to earn super margins on large constituents of its sales. India Ratings also acknowledges the same in its credit rating report of October 2016
“Scope for profitable growth of scale in the base business is limited due to commoditised nature and mature stage of the products.”

However, recently, Granules India Limited has witnessed improvement in operating profitability margins, which as per the management is a result of a reduction in raw material costs as well as the change in the product mix of sales.  Granules India Limited is planning to move up in the value chain by focusing more on the PFI business rather than the precursors and intermediaries like APIs: (Granules India Limited FY2016 annual report page: 39)

The above section of the annual report also mentions that the profitability improvement is also on account of reduction in some of the raw material prices. However, the improvement in profitability margins due to a reduction in raw material prices does not seem sustainable as the company will have to pass on this benefit to its customers, as mentioned in the India Ratings credit rationale for Granules India Limited for Oct. 2016:
“The operating EBITDA margins improved 340bp YoY to 19.5% in FY16. The improvement in margins has benefitted from the falling trend in input prices, which typically are passed on with a delay of two to three months.”
The net profit margins of Granules India Limited have followed the similar cyclical pattern like OPM and have witnessed improvement in recent years. It is advised that the investor should keep a close watch on the profitability margins of Granules India Limited.


Operating efficiency parameters of Granules India Limited reflect that the net fixed assets turnover (NFAT) has been increasing from FY2008 to FY2013 when it improved from 1.70 to 2.97. However, since FY2013, the NFAT has been declining continuously and stands at 2.23 in FY2016. This essentially indicates that the investments done by Granules India Limited since FY2014 onwards in various ventures, plants etc. are yet to bear full fruit and be utilized to optimal capacity.

An investor would notice that the net fixed assets of Granules India Limited have increased sharply from ₹263 cr. in FY2013 to ₹668 cr. in FY2016. The capacity expansion is still going on as the company has a capital work in progress (CWIP) of ₹77 cr at the end of FY2016.

An investor should keep a continuous watch on the asset utilization levels as the continuous capex many times masks the suboptimal use of existing assets by companies. The managements always find a plausible explanation of lower NFAT citing reasons of new capex not leading to full utilization. However, it many times hides the poor utilization of previously done capital expenditures.

Working capital efficiency parameters of Granules India Limited reflect that since FY2014, the working capital efficiency has been deteriorating.

The inventory turnover ratio (ITR) has declined from 7.1 in FY2014 to 5.4 in FY2016. Similarly, receivables days of Granules India Limited have deteriorated from 30 days in FY2014 to 37 days in FY2016.

An investor would notice that Granules India Limited has raised its capex significantly since FY2014. It has acquired Actus Pharma Limited in FY2014 and has also been investing in JVs (Omnichem) and acquisition overseas (Virginia, USA). These acquisitions and capex decisions seem to be weighing the operational efficiency parameters down.

An investor should keep a close watch on the operating efficiency parameters going ahead to ascertain whether the investments by Granules India Limited are working out in the favour of the company or not. It is advised that the investor should do her own analysis in arriving at conclusions in such cases and not rely on management statements as managements are known to defend their decision irrespective of the final outcome.


Moreover, while analysing the receivables position of Granules India Limited, when the investor compares the standalone and consolidated receivables position at March 31, 2016, then she notices that the subsidiaries of Granules India Limited are collecting the receivables from their end customers but are not paying/remitting to Granules India Limited on time.


A comparison of above two images shows that about ₹46 cr is stuck with subsidiaries/JVs as the consolidated trade receivables are about ₹153 cr. and standalone trade receivables are about ₹199 cr.


An investor should keep a close watch on developing receivables position to monitor the trend. An investor should focus on monitoring whether the company continues to park funds in its subsidiaries, which becomes evident from the relative rise in standalone receivables while consistent consolidated receivables.

Self-Sustainable Growth Rate (SSGR):

The investor would notice that Granules India Limited has an SSGR almost in single digits (5%-8%) over the years, which is much lower than the sales growth rate of 20%-25% being achieved by the company.


As a result, Granules India Limited has to rely on additional sources of funds, both equity as well as debt, to fund its growth requirements.

The analysis of debt levels of Granules India Limited over last 10 years (FY2007-16) indicates that the debt of Granules India Limited has increased from ₹134 cr. in FY2007 to ₹474 cr. in FY2016. Over and above the debt increase, the company has been diluting equity by way of issuing warrants to promoters at preferential terms (more on warrants issuance later in the article).

This assessment assumes significance in conclusion that Granules India Limited is growing faster than its means. It has already undertaken debt (and equity dilution) funded capital expenditures, which as discussed above are weighing down its operating efficiency parameters. It remains to be seen whether the company tries to focus more on improving the state of its existing operations to increase the utilization efficiency of capex already done or it goes for further capex.

However, as mentioned by the management of Granules India Limited in the conference call with analysts in Oct 2016, the company plans to increase its capital expenditure in coming years.


An investor should keep in mind that as highlighted by SSGR being lower than the growth rate, each incremental growth part is going to burden the company with higher funds requirements over and above what it can generate internally, and as a result will burden the company with more debt and probably equity dilution.

The assessment of SSGR gets substantiated when the investor analyses the free cash flow (FCF) position of Granules India Limited.

An investor would notice that Granules India Limited has generated ₹613 cr. from cash flow from operations (CFO) over last 10 years (FY2007-16) whereas it has spent ₹787 cr as capital expenditure over the same period resulting in a negative FCF of ₹174 cr. Moreover, the increasing debt of Granules India Limited has ensured that it has to service a significant amount of interest each year.

If an investor assumes 11% interest rate applicable to the debt of Granules India Limited over last 10 years, then she would notice that the company paid about ₹253 cr. in interest payments to its lenders.

There is hardly any doubt that Granules India Limited has to rely on debt and equity dilution to fund the excess of capex over CFO (negative FCF) and the interest payments. The negative FCF of ₹174 cr. and interest payments of ₹253 cr. required the company to arrange for about ₹420 cr. from additional sources over last 10 years (FY2007-16)

Granules India Limited has tried to meet this gap of ₹420 cr. by raising incremental debt of ₹340 cr. (₹474 cr. - ₹134 cr) and additionally relied on equity dilution to bridge the gap.
SSGR and FCF are two of the main pillars of assessing the margin of safety in the business model of any company.


The above analysis indicates that the past performance of Granules India Limited does not indicate any sustained competitive business advantage in its business model. The rising debt continued equity dilution, deteriorating operating efficiency would put pressure on the credit rating assessment by any rating agency.

It seems that the company has been doing credit rating shopping in the market by switching different rating agencies in quick succession.

Granules India Limited was initially rated by CARE (there is a publicly available rating rationale of the company prepared by CARE in June 2010). Thereafter, it switched from CARE to ICRA and as a result, CARE suspended its credit rating. Further, the company switched from ICRA to India Ratings and as a result, ICRA also suspended its rating.

Such frequent shift in rating agencies can be due to any of the two considerations: (1) to save on costs by negotiate lower pricing by shifting the rating agency and (2) negotiate a better credit rating from another rating agency in case existing rating agency is not willing to give desired credit rating to the company.

An investor should contemplate/explore further about the reasons for such frequent switching the rating agencies by Granules India Limited.

The above analysis of FCF indicates that Granules India Limited is consuming more cash than its business model is able to generate, which is resulting in continuously increasing debt levels. It seems questionable that the company has been paying dividends every year despite being in a cash flow deficit situation. Granules India Limited paid a total dividend (excluding tax DDT) of about ₹52 cr. over last 10 years (FY2007-16). Ideally, the company should have conserved resources and used the funds to repay debt, avoid equity dilution and fund the capex plans.

Payment of dividends in companies, which have negative free cash flow (FCF) indicates that the dividends are effectively funded by debt. As the decision to pay dividend depends upon the promoters/majority shareholders, most of the times, such dividend payouts are to benefit promoters even though the dividends are received by all the shareholders.


An investor would appreciate that payment of dividends out of debt proceeds effectively puts the company in an unnecessary leveraged position. It’s like benefiting the equity shareholders at the cost of the company.

While reading the annual report for FY2016, an investor comes across a few other parameters related to management, which deserve the attention of investors:

1) High Promoter’s Salaries:

An investor would notice that the promoter of the company, Mr Krishna Prasad Chigurupati (CMD) took home a remuneration of about ₹10 cr in FY2016 and his wife Ms Uma Devi Chigurupati (Executive Director), received a remuneration of about ₹8 cr in FY2016.

These salaries look very high from industry benchmark perspective despite being in statutory limits. This is after considering that the net profit after tax of Granules India Limited in FY2016 was about ₹118 cr. Salary of Krishna Prasad is about 8.5% of PAT and the salary of Uma Devi is about 6.8% of the PAT in FY2016.

We have noticed that on an average the promoter’s salaries are reasonable within the range of 2-5% of PAT, which includes fixed component as well as approximate 2% commission on the profits of the company. Considering it, the salaries drawn by promoters seem very high.

Moreover, an investor would notice that the executive director, Ms Uma Devi Chigurupati does not seem to be dedicating her full-time attention to her role in Granules India Limited. The annual report for FY2016 for the company mentions that she is also overseeing the operations of another business, which is a vineyard in Karnataka.

If the vineyard operations require much of her time, then the high salary being paid out to her from Granules India Limited might not be entirely justified.

An investor should analyse it further to arrive at a final conclusion as high remuneration to family members might be one of the ways in which the promoters might be benefiting at the expense of the company similar to the above-mentioned observation of payment of dividends out of debt proceeds.


2) Warrants:

We believe that the preferential issuance of warrants to promoters by companies is not a good sign as it allows promoters to:
  • speculate on the own company’s share price by taking a position like a call option and
  • allows the promoters to increase their stake in the company through backdoor channels, without facing the increased cost of share acquisition. Usually, the cost of purchase of shares from the market is higher as the share price increases once the market gets to know that the promoter is purchasing shares.


An investor may read our views on warrants in detail in the following article:


FY2016 annual report of Granules India Limited mentions that the company issued warrants to promoters on two occasions in FY2016:


a) 40,95,230 warrants allotted on August 28, 2015, at ₹84.91, which were exercised by the promoters in full on October 31, 2015, when the closing market price of Granules India Limited was ₹147.90 on October 30, 2015, on BSE.

This led to the promoters benefiting by ₹25.7 cr. [40,95,230 * (147.90 – 84.91)]. This is assuming that the promoters would have been able to buy 40,95,230 shares at the market price, without factoring in the usual share price increase that results on the news of promoters buying shares in the company. Additionally, the daily trading of the shares of the company involves buying and selling of about 2.5 to 3.5 lakh shares, which is low considering the number of shares being gained by the promoters.

b) 1,86,56,000 warrants allotted on September 07, 2015 at ₹95.30, out of which 72,55,000 warrants were exercised by the promoters on March 30, 2016, when the closing market price of Granules India Limited was ₹119.70 on BSE.

This led to the promoters benefiting further by ₹17.7 cr. [40,95,230 * (147.90 – 84.91)]. This is assuming that the promoters would have been able to buy 72,55,000 shares at the market price.

The conversion of about 1.12 cr. warrants by promoters in FY2016 helped them to increase their shareholding from 48.59% to 51.15%


We believe that such usage of warrants by promoters to increase the stake in the company has two aspects: 
  • The promoters are able to avoid the incremental cost of acquisition of shares if they would have bought the shares from the market as the market would have taken the share price higher. The share prices increase is even steeper when the market gets to know that the acquisition of shares by promoters would lead them to cross very significant milestones of 50% shareholding. 
  • The promoters get to buy an asset at a discount as in the above case promoters could benefit by ₹43.4 cr. when the conversion price of warrants is compared to the closing market prices of the shares.


c) As per the exchange filing done by the company on December 28, 2016, the promoters have further exercised 39,17,454 warrants on December 28, 2016, when the closing market price of Granules India Limited was ₹105 on BSE. Promoters currently have about 75,00,000 warrants that remain to be exercised at a fixed price of ₹95.30 irrespective of the prevailing market price.

We believe that warrant issuance to promoters is effectively a way to transferring the economic value from non-promoter shareholders to promoters.

Many times, the logic is given that warrants help the companies raise funds from promoters in difficult times when companies find it difficult to raise funds from other sources. However, in case of Granules India Limited, the promoters are funding their warrants purchase by raising loans by pledging their shareholding in the company, which was communicated by the promoters to analysts in the conference call in Oct. 2016

If an investor analyses the sequence of events/activities, then it indicates that promoters are using the economic value of shares of Granules India Limited to raise funds to buy more shares in the company at a discount to market price.

In case the promoters are not able to service the loans taken by them by pledging of shares, then the selling of shares by those lenders would lead to a huge decline in share price of Granules India Limited, which would hurt the wealth of all the shareholders whether promoters or non-promoters.

Moreover, such loans taken by promoters incentivise them further to get high salaries from the company as well as get dividend payouts despite negative free cash flows (dividend funded by debt), so that they are able to service these loans.

Effectively, one way or the other, it is the company and the shareholders who end up bearing the cost and repercussions of such loans irrespective of these loans being in the name of promoters. However, the benefit of these loans is primarily enjoyed by promoters as it leads to their increased shareholding in the company.

Therefore, we believe that allotment of warrants by companies to promoters and then the exercising of the warrants by promoters by paying from the funds raised by pledging shareholding in the company itself is not a good practice. Investors should be fully aware of the dynamics that result in such situations.


3) Non-Current Investments for Trade:

Granules India Limited has done investments in Jeedimetla Effluent Treatment Limited and Patancheru Envitotech Limited, which it has classified under the trading category.


Investors would expect the company to focus on investing in its own operations and monetize any of the investments, which are for trading in nature so that the funds can be used to meet the capex requirements, which are currently being met through debt and equity dilution.

An investor should assess further whether these entities are related to promoters but strictly not in the statutory definition of related parties as per Companies Act.

Granules India Limited is currently available at a P/E ratio of about 19, which does not offer any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.

You may read more about estimating the margin of safety in the target investment in the following article:


Overall, Granules India Limited seems to be a company growing at a descent pace of 20%-25%, which historically has witnessed cyclical profitability margins. However, recently, the profitability margins have been witnessing steady improvement on account of change in product mix by the company as well as lower raw material prices. It remains to be seen whether the management is able to sustain these improved profitability margins in the future.

Granules India Limited has been doing significant capex since last 2-3 years, which has led to a deterioration in its operating efficiency parameters as it has not been able to utilize these investments efficiently.

Assessment of self-sustainable growth rate (SSGR) and free cash flow (FCF) indicate that the company has been growing out of its means. As a result, it has to resort to debt funding and equity dilution to fund its capex and interest servicing requirements. Moreover, the company has plans for doing more capex in coming years. Therefore, an investor should keep a close watch on the project execution of the company as well as the debt levels on a continuous basis.

High promoter salaries, payment of dividends out of debt proceeds, allotment of warrants and funding of warrant exercise by promoter by pledging their shareholding in the company leave a lot to be desired in the governance characteristics of the company.

As a result, we believe that any investor who wishes to make an investment in Granules India Limited should keep all these things in mind and monitor the company performance on a continuous basis along with promoter’s decisions.

An investor may read more about the guidelines to follow while monitoring stocks in the following article:


These are my views about Granules India Limited. However, you should do your own analysis before taking any investment related decision about Granules India Limited.

You may use the following steps to analyse the company: "How to do Detailed Analysis of a Company"

Hope it helps!

Regards,


P.S:



DISCLAIMER


Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:


Currently, I do not own stocks of the companies mentioned above in my portfolio.