Analysis: Rain Industries Ltd

The current section of the “Analysis” series covers Rain Industries Ltd, the world’s second-largest manufacturer of calcined pet coke (CPC) and coal tar pitch (CTP) used primarily in aluminium production.

The “Analysis” series is an attempt to share with all the readers, our inputs on the company analysis submitted by readers on the “Ask Your Queries” section of our website.

In order to benefit the maximum from this article, an investor should focus on the process of analysis instead of looking for good or bad aspects of the company. She should learn the interpretation of different types of data and transactions and pay attention to the parts of annual reports etc. used to get the information. This will help her in improving her stock analysis skills.

Rain Industries Ltd Research Report by Reader

Dear Dr Vijay,

Thanks for your reply. Please provide inputs on my analysis of Rain Industries Ltd, which is attached below.

Regards,

Kamal Kanugo

Rain Industries Ltd:

It seems that the company is generating very high cash flows from operations (CFO) when compared to its profit after tax (PAT); almost 2 times. However, the free cash flow (FCF) is still only 11% of the CFO.

The company has done some heavy capital expenditures (capex). It recently shut down one of its units in Europe. Its revenue has increased by 11% CAGR in the last 3 years. Additional capex is being done in 2019, which will increase 2020 earnings and onwards.

Rain Industries Ltd has not made any losses in the last 10 years. However, its net profit margin (NPM) is not consistent. NPM ranges from 12% to 1%. When a company gives consistent earnings year on year, it compounds its stock value/price. Hence, this is missing in the case of Rain Industries Ltd.

In addition, the operating profit margin (OPM) has been inconsistent, reducing from 25%, and hovering to 12% in 2019. It seems that Rain Industries Ltd does not have a pricing advantage on its products and hence, OPM has been reducing. Hence, the moat of Rain Industries Ltd is not very strong.

However, Rain Industries Ltd is one of the global players in their products having tough competition from Chinese companies. With the current situation in China, in the future, many international customers will possibly tweak their supply chain strategy and become less dependent on China. Therefore, it seems that Rain Industries Ltd can have increased demand for its products; thereby, it can improve its OPM going forward and improve its revenue growth.

The receivables days of Rain Industries Ltd have improved from 48 to 43 days. The working capital cycle has reduced from 108 to 99 days in the last 10 years.

• FCFE 3357 cr + DIV 392 cr + Cash/Investments 864 Cr = 4613 CR
• Total Debt = 4748 Cr

So overall the figures look ok and the application of funds by Rain Industries Ltd looks in line.

The debt-to-equity ratio has reduced from 2.5 times to 1.7 times in the last 10 years. In the last 3 years, it has reduced from 2.3 times to 1.7 times.

CFO – CFI – CFF is positive for last 10 years (602 Cr). The company has 851 Cr cash and equivalents on the balance sheet.

The total debt of Rain Industries Ltd in the last 5 years has more or less remained constant, which means that operations are running efficiently and that the capital allocation efficiency of Rain Industries Ltd is good.

The interest on the debt is 6%, which is on the lower side. Assuming the cost of capital is 10%, hence, sizable debt on the balance sheet makes sense.

I need to look into the terms of the debt. As debt is mostly from outside India; therefore, currency fluctuations with Rupee depreciation can increase the interest outgo of the company.

When we compare the latest numbers of the year ending Dec 2019 and compare inventory and trade receivables of 2018, then we notice that Rain Industries Ltd is operating efficiently and its working capital is optimized.

However, it can be seen that Rain Industries Ltd has created a market value of only 0.4 times retained earnings (RE). It seems the company is not yet valued by the market and therefore, the available at price to earnings ratio (PE ratio) of eight. Price to book value (P/B) ratio is 0.7 and the P/E*P/B is 5.5

Hence, I think that Rain Industries Ltd does not have a very strong moat. However, the company is generating a healthy CFO and investing regularly in its business.

I think that Rain Industries Ltd has good fundamentals and the market will eventually price the company correctly. I think this is a value buy at this price and there is a good margin of safety.

I would appreciate your feedback on my thoughts and if I am going in the right direction.

Many thanks.

Kamal Kanugo

Dr Vijay Malik’s Response

Hi Kamal,

Thanks for sharing the analysis of Rain Industries Ltd with us!

While analyzing Rain Industries Ltd, an investor would notice that almost all the business activities of the company are present in its subsidiaries. Rain Industries Ltd in its standalone financials does not have any operating activity. On a standalone basis, the company only has investments and loans in the subsidiaries and receives dividends and interest from them.

All the operating businesses of Rain Industries Ltd like calcined pet coke (CPC), coat tar pitch (CTP) and cement etc. are present in its subsidiaries. At the end of 2019, the company had 26 subsidiaries and one associate company (2019 annual report, pages 96-98).

We believe that while analysing any company, an investor should always look at the company as a whole and focus on financials, which represent the business picture of the entire group. Consolidated financials of any company, whenever they are present, provide such a picture.

Further advised reading: Standalone vs Consolidated Financials: A Complete Guide

Therefore, in the analysis of Rain Industries Ltd, we have used consolidated financials assessment.

In addition, an investor should note that Rain Industries Ltd follows the calendar year (January – December) for its financial reporting instead of the normal convention of the financial year (April – March).

With this background, let us analyse the financial and business performance of the company over the last 10 years

Financial and Business Analysis of Rain Industries Ltd:

While analyzing the financials of Rain Industries Ltd, an investor would note that in the past, the company has been able to grow its sales at a rate of 10%-15% year on year. Sales of the company increased from ₹3,752 cr. in 2010 to ₹12,365 cr in 2019. However, the sales have declined slightly to ₹12,062 cr in the 12 months ending March 2020 (i.e. April 2019 – Mar. 2020).

In the last 10 years (2010-2019), the sales growth of the company has not been consistent and it faced periods of decline in its sales.

The company witnessed a decline in its sales in 2012 when the sales of the company declined from ₹5,627 cr in 2011 to ₹5,352 cr in 2012. In 2013, the sales of the company increased to ₹11,728 cr, primarily, due to the acquisition of Ruetgers Group of Belgium on January 4, 2013.

However, the company again witnessed a decline in its sales in 2015 and 2016. The sales of the company declined from ₹11,921 cr in 2014 to ₹9,258 cr in 2016. Thereafter, the sales of the company increased over the next two years to ₹14,049 cr in 2018. However, the sales of Rain Industries Ltd declined again to ₹12,361 cr in 2019 and further to ₹12,062 cr in the 12 months ending March 2020 (i.e. April 2019 – Mar. 2020).

Similarly, when an investor analyses the profitability of the company over the last 10 years (2010-2019), then she notices fluctuating cyclical patterns in the profit margins as well.

The operating profit margin (OPM) of the company was 19% in 2010, which increased to 24% in 2011. Thereafter, the OPM consistently declined to 10% in 2014. Thereafter, the OPM increased to 20% in 2017. The OPM then declined to 12% in 2019. Rain Industries Ltd reported an OPM of 13% in the 12 months ending March 2020 (i.e. April 2019 – Mar. 2020).

Therefore, an investor would notice that the sales, as well as the operating profit margin of Rain Industries Ltd, have witnessed large fluctuations from 2010-2019. Such kind of fluctuating business performance indicates to an investor that the business performance of Rain Industries Ltd is exposed to cyclical factors.

When an investor notices such kind of cyclical performance in both sales as well as profitability, then she acknowledges the need for a deeper understanding of the business of Rain Industries Ltd to understand the factors influencing the business performance of the company. This is because, once an investor has understood the key factors for Rain Industries Ltd, then she would be able to have a view of the expected future performance of the company.

To understand the underlying factors influencing the business of Rain Industries Ltd, an investor would first have to understand its key products and the industries on which they are dependent. This is important because once an investor is able to understand the industries on which the company depends to sell its products and the industries on which it depends to buy its raw material, then she can easily anticipate the impact of different macroeconomic developments on the business performance of Rain Industries Ltd.

An understanding of the consumer industries of Rain Industries Ltd will help the investor to assess when its products will have high demand at high prices and when its products are expected to face low demand at low prices. Similarly, understanding the industries that supply raw materials to Rain Industries Ltd will help an investor understand when it will face challenges in the availability of raw materials and in turn will have to pay more for them; thereby affecting the profit margins.

Rain Industries Ltd has the following key business segments and products:

A) Carbon segment:

In 2019, the Carbon segment constituted 66% of the total revenue and 73% of the operating profits of the company. The carbon segment has the following key products:

A.1) Calcined Pet Coke (CPC):

CPC is used in the production of aluminium in the form of anodes. Aluminium production consumes about 70-80% of the total CPC produced around the world.

Credit rating report of Rain Industries Ltd by India Ratings in December 2015, page 1:

About 70%-80% of CPC and CTP are consumed by aluminium smelters as anode and binders, respectively.

CPC is produced from Green Pet Coke (GPC). GPC is a byproduct of crude oil refineries.

Therefore, an investor would appreciate that the business performance of CPC is highly linked to the aluminium and crude oil refining industries. If the aluminium industry is not doing well, then the demand and prices of CPC will decline. Similarly, if the crude oil refining industry is not doing well, then the availability of the raw material, GPC, will be low and its cost will be high.

A.2) Coal Tar Pitch (CTP):

As per the above disclosure from the credit rating report by India Ratings, about 70-80% of CTP production around the world is consumed by aluminium producers. Apart from aluminium production, CTP is used to manufacture graphite electrodes, which are used in steel manufacturing by the electric arc furnace route.

CTP is produced from coal tar, which is a byproduct of metallurgical coke production. Metallurgical coke is used in the production of pig iron, which is then converted into steel. This is the blast furnace route of steel production.

Therefore, an investor would notice that the business performance of CTP is linked to the aluminium and steel industries. If the aluminium industry is not doing well, then the demand and prices of CTP will decline. Similarly, if the steel industry is not doing well, then the availability of the raw material, coal tar, will be low and its cost will be high.

Apart from CPC and CTP, in the carbon segment, Rain Industries produces some other products. These are produced by coal tar distillation and therefore, they are also highly dependent on steel production for their raw material.

Therefore, an investor would notice that the business performance of the carbon segment of Rain Industries Ltd (66% of total revenue and 73% of operating profits) is highly dependent on aluminium, crude oil refining, and steel manufacturing.

B) Advanced materials segment:

This segment constituted 26% of revenue and 18% of operating profit for Rain Industries Ltd in 2019. The key products in the advanced material segment are naphthalene derivatives, petrochemical intermediates, resins, and engineered products.

These products are made from Naphthalene oil and crude oil derivatives. Naphthalene oil is derived from coal tar, which is linked to steel manufacturing. Therefore, for raw materials of the advanced material segment, Rain Industries Ltd is dependent on steel manufacturing and crude oil refining industries.

The construction industry is one of the key consumers of Naphthalene.

2014 annual report, page 58:

A popular use of Naphthalene is production of dispersants which are used in construction industry as superplasticizers and in production of concrete and gypsum. Therefore demand for Naphthalene is correlated to the construction industry.

Resin sales are dependent on the automotive industry among others.

2019 annual report, page 37:

Continued lower resins performance due to weakness in European automotive and adhesives industries

Therefore, an investor would notice that the business performance of the advanced material segment of Rain Industries Ltd (26% of total revenue and 18% of operating profits) is highly dependent on steel manufacturing, crude oil refining for its raw materials and on construction, and automobile industry for its sales.

Advised reading: How to do Business Analysis of Steel Companies

C) Cement segment:

This segment constituted 8% of revenue and 9% of operating profit for Rain Industries Ltd in 2019. The cement segment is primarily dependent on the housing and infrastructure sectors for its demand.

After learning about the products and their influencing industries, when an investor takes a comprehensive overview of Rain Industries Ltd, then she finds that the business performance of the company is primarily dependent on the following industries:

• Aluminium: It is the largest consumer industry for the products made by Rain Industries Ltd (CPC and CTP). This is the most important industry determining the business performance of Rain Industries Ltd.
• Steel: Steel manufacturing by blast furnace route provides coal tar, a raw material for CTP and advanced materials. Steel manufacturing by electrical arc furnace route consumes CTP in the form of graphite electrodes.
• Crude oil refining: it provides green pet coke (GPC), which is the primary raw material to produce CPC.
• Housing and Infrastructure: Key consumers for cement and advanced materials (naphthalene).
• Automobile: Key consumers for advanced material (resins).

With this basic understanding of the business of Rain Industries Ltd, it would become easy for an investor to understand the business performance of the company over the years.

In 2012, the decline in sales revenue, as well as profit margins, was linked to the oversupply of aluminium in the world market at the end of 2011. As a result, the aluminium prices fell and a few aluminium producers decided to shut down their plants.

2011 annual report, page 25:

The year 2012 started off choppy with dip of Aluminum prices to around US$ 2,000 and the stocks in LME reported at historical high level of over 5 Million tons and there have been announcements of productions curtailments by the smelters in response to dampening demand and high operating cost vis-à-vis falling metal prices.

In 2013, the sales revenue of Rain Industries Ltd more than doubled; however, at the same time, the operating profit margin (OPM) almost halved from 21% to 11%. The increase in sales was due to the acquisition of the Rutgers group by the company. However, the decline in OPM was a result of the weak state of the aluminium industry.

The credit rating agency, India Ratings, highlighted this aspect in the credit rating report of Rain Industries Ltd in September 2014, page 1:

RAIN’s consolidated revenue increased in 2013 to INR115bn (2012: INR53.4bn) primarily because of the revenue from the newly acquired subsidiary (RUETGERS). However, the volume of calcined pet coke (CPC) fell 5% yoy in 2013 and realisations dipped 13% on continued weakness in aluminium markets. However, the price of the key raw material – green pet coke (GPC) has fallen moderately (less than 5%), resulting in a decline in EBITDA per tonne.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

In 2014, even though the sales of the company witnessed some increase; however, the company reported the lowest profit margins in the last 10 years (2010-2019).

2014 annual report, page 56:

Year 2014 turned out to be a challenging year due to various macro-economic factors including prolonged weakness in primary Aluminum metal prices, falling commodity prices in general and Crude Oil price in particular, subdued end markets, falling interest rates in Europe and adverse currency movements…

Although there is an increase in revenues by Rs. 1.9 billion, there is a substantial fall in net profit by Rs. 3.0 billion due to weaker operating margins.

After 2014, up to 2016, the sales of Rain Industries Ltd declined significantly by more than 20% from ₹11,921 cr in 2014 to ₹9,258 cr in 2016. The company said that a decline in its product prices is the key reason for lower sales. However, the company could improve its profit margins because of its cost optimization initiatives.

2016 annual report, page

The revenue in CY2016 was lower compared to CY 2015 mainly due to lower price realizations. Although the revenue in CY 2016 was lower, the operating margins in CY 2016 were comparatively higher due to the contributions from new expansion projects (i.e. Russian Tar Distillation Plant, Chalmette FGD Plant, Indian CPC Blending Facility, etc.) and various cost optimizing initiatives.

After 2016, first, the sales, as well as profit margins of the company, increased in 2017 as the business entered into the upward phase of its business cycle where the demand for the products of the company as well as its sales increased.

2017 annual report, page 101:

The revenue in CY 2017 was higher by 20.6% compared to CY 2016 mainly due to an increase in volumes and improved price realizations.

The company highlighted the positive momentum the industry experienced by it in 2017 in its annual report for 2018 as well. Rain Industries Ltd highlighted that the upcycle in the aluminium business has led to an increase in aluminium prices. As a result, many closed aluminium plants have also started production now. Therefore, the demand for the products of Rain Industries Ltd as well as their prices has increased.

2018 annual report, page 10:

We began 2018 by continuing to ride a wave of momentum that began in mid-2017, as global aluminium production and demand for our calcination and distillation products steadily increased, leading to corresponding improvements in selling prices and margins. The global economy also continued to strengthen, especially in the US, where import tariffs and rising prices for aluminium and steel motivated US manufacturers to restart mothballed facilities and increase capacity utilisations.

However, in 2018, the upward phase of the business cycle was over and the company faced many challenges. As a result, it witnessed its profit margins decline sharply from 20% in 2018 to 14% in 2019.

2018 annual report, page 10:

2018 was a turbulent year for your Company, characterized by shifting market dynamics, a continued deceleration of the Chinese economy and government actions that had a decidedly tangible impact on our businesses……..the spread between our raw material costs and prices for our finished products began to shrink, reversing a trend that was a principle factor in our strong earnings and EBITDA in 2017.

2018 annual report, page 123:

The revenue in CY2018 was higher by 22.7% compared to CY2017 mainly due to improved price realisations, including the depreciation of the Indian Rupee against the US Dollar and Euro. The operating margins in CY2018 were comparatively lower due to higher operating cost resulting from an increase in raw material prices.

The down cycle in the aluminium industry continued in 2019 when Rain Industries Ltd experienced a decline in sales as well as profit margins. The prices of the company’s products declined whereas the costs of the raw materials went up.

2019 annual report, page 151:

The revenue in CY2019 was lower by 12.0% compared to CY2018 mainly due to lower price realisations and reduction in volumes. The operating margins in CY2019 were also lower due to higher operating cost resulting from an increase in raw material prices in the first half of the year.

Therefore, an investor notices that the business performance of Rain Industries Ltd is highly cyclical with phases of high demand for its products followed by phases of reduced demand. In the upward phases of the business cycle, the company reports high-profit margins and in the downward phases, it reports declining profit margins.

Even in the March 2020 quarter, the company highlighted that the prices of its products have declined by about 19%.

May 2020 conference call transcript, page 7:

During Q1 of 2020 the average blended realization decreased by 19.1% due to changes in industry-related dynamics…

The dependence of the performance of key business segments of Rain Industries Ltd on the commodity prices has been highlighted by the credit rating agency, India Ratings, in its report for one of the subsidiaries of the company, Rain CII Carbon (Vizag) Ltd (RCCVL) in July 2019, page 2:

Commodity Price Fluctuations: RCCVL’s profitability remains exposed to fluctuations in commodity prices, which depends on demand-supply dynamics.

When an investor correlates the above-discussed different business phases of Rain Industries Ltd with the business phases of the aluminium industry, which is the largest consumer of its products, then she realizes that the fate of the two is highly linked to each other.

The following chart shows the historical price of aluminium on the London Mercantile Exchange (LME) in USD per tonne for the last 10 years (2010-2020).

From the above chart, an investor can notice the following phases of the aluminium industry in the last 10 years and then correlate them with the business performance of Rain Industries Ltd:

• 2010-2011: Aluminium prices increased | profit margins of Rain Industries Ltd increased
• 2012-2015: Aluminium prices decreased | profit margins of Rain Industries Ltd decreased
• 2016-2018: Aluminium prices increased | profit margins of Rain Industries Ltd increased
• 2019-2020: Aluminium prices decreased | profit margins of Rain Industries Ltd decreased

Looking at the above correlation, an investor can easily ascertain that going ahead whenever the aluminium industry will have a phase of high demand (higher prices), then Rain Industries Ltd will also witness good sales with high-profit margins. On the other hand, during the phases of low demand for aluminium (lower prices), then Rain Industries Ltd will also witness poor performance with low-profit margins.

Read: How to do Business & Industry Analysis of a Company

Rain Industries Ltd highlighted this association between the aluminium industry cycles and its own performance in its 2019 annual report, page 79:

…there may be cyclical periods of weak demand that could result in decreased primary aluminium production. RAIN Group’s sales have historically declined during such cyclical periods of weak global demand for aluminium.

Moreover, from our discussion on the industries affecting the business of Rain Industries Ltd, aluminium, steel, crude oil, housing, construction, infrastructure, automobile etc., an investor would notice that all these industries are cyclical. As a result, the cyclical nature of these industries whether by way of raw material providers or customers of Rain Industries Ltd is bound to affect the business performance of the company. As a result, we notice that the business performance of Rain Industries Ltd has resulted in a cyclical pattern with phases of high demand with high-profit margins alternating with phases of low demand and low-profit margins.

From our previous analysis of companies operating in cyclical industries like graphite electrode manufacturers, an investor would remember that in the cyclical industries the business conditions could be brutal where many manufacturers go out of business in down-phases whereas, during up-phases, manufacturers add a lot of capacity additions lead to oversupply, setting the stage for another down-phase.

For further understanding, an investor may read our analysis of HEG Ltd operating in the graphite electrode manufacturing industry, which is a cyclical industry, in the following article: Analysis: HEG Ltd

An investor would remember that during down-phases of cyclical industries, many manufacturers shut down their plants. In the case of Rain Industries Ltd, we noticed that at times, during the down phases of the industry, the company had to reduce the production of CPC. On other occasions, it had to shut down a few of its manufacturing facilities when the business hit a downturn during 2011-2015.

In 2009, the company restricted the production of CPC from its plants due to low demand.

2009 annual report, page 8:

However, in the year 2009 due to global economic downturn that coupled with unprecedented decline in the Aluminum metal prices resulted in substantial reduction of global aluminum production. The demand for CPC was also reduced in the similar percentage. In these circumstances management took a holistic response by initiating various actions including curtailment of CPC production, overhead rationalization and working capital improvement.

In 2014, Rain Industries Ltd shut down one of its manufacturing facilities in the USA.

2014 annual report, page 9:

Effective January 1, 2014, Rain Group closed the Calcining facility in Moundsville – West Virginia, USA. This site has been slated for closure brought on by the impact of new and more stringent regulations by the Environmental Protection Agency, USA. These regulatory challenges would require a level of investment exceeding US$ 50 million on a plant that has been operating at less than 50% capacity since 2008, which is not economically feasible.

In 2015, the company closed its manufacturing facility in China.

2014 annual report, page 8:

Effective January 1, 2015, Rain Group closed the 20,000 Tons capacity Vertical Shaft Calcining Petroleum Coke (“CPC”) plant in China due to new Environmental regulations applicable from January 2015 which would require additional investment.

Similarly, in the next downturn, which started in 2018, the company closed further manufacturing facilities.

2018 annual report, page 12:

As a result, we are shutting down production lines in Germany that rely on outdated technology or whose products are no longer competitive or fail to meet the needs of a changing market.

2019 annual report, page 82:

Due to falling demand for certain advanced materials, we announced the shutdown of our Uithoorn production facility in the Netherlands by March 2020.

The cyclical industries are characterised by shutdown of facilities during down-phases and the creation of overcapacity in up-phases. In the light of sharp upturn in the aluminium industry in 2017, many large aluminium producers who had closed their plants in the previous downturn restarted these plants. This resulted in oversupply in the market and as a result, aluminium prices declined in 2019.

2019 annual report, page 34:

However, in 2019, the aluminium market was weak as London Metal Exchange prices fell following a surging supply. The glut occurred as a second large North American aluminium smelter restarted idled capacity, and a leading Brazilian producer resumed full-scale production……

An investor would appreciate that these decisions by manufacturers keep the perpetual cycles of commodities and their dependent industries going.

Even in the case of CPC and CTP, the key products of Rain Industries Ltd that are dependent on the aluminium industry, the world has an overcapacity indicating the supply is higher than the demand.

Advised reading: How to do Business Analysis of Nonferrous Metal Companies

2019 annual report, page 75 shows that the world has a surplus of calcined pet coke (CPC) capacity and it is expected to remain surplus in the years to come.

Similarly, the world currently has a surplus of coal tar pitch (CTP) capacity, which is expected to remain in surplus for many years. 2019 annual report, page 77:

The surplus in the manufacturing capacity is not limited to the carbon segment (CPC and CTP) of Rain Industries Ltd. Other business segments also face a similar situation.

In the case of advanced material, the company intimated to its shareholders that naphthalene currently has an overcapacity. As per the management, the overcapacity in the naphthalene business will continue to affect it.

2019 annual report, page 85:

Oversupply will continue to impact naphthalene business.

Even for other products in the advanced materials business segment like resins, modifiers and petrochemicals, the company faces intense competition from China.

2019 annual report, page 82:

Key threats to RAIN Group’s Advanced Materials business are volatility in commodity prices and Chinese competition. The price of benzene, C9 and C10 fractions largely depend on the price of crude and fuel oil. Tariffs implemented by the United States have caused Chinese products to compete in the European market.

On similar lines, the third business line of Rain Industries Ltd, the cement business, also faces huge overcapacity. In India, the cement industry on average has a low capacity utilization of about 70% whereas the capacity utilization in South India, which is the relevant market for Rain Industries Ltd, is about 60%.

2019 annual report, page 84:

The Indian cement industry’s average utilisation has increased to approximately 70% in CY 2019, led by improvement in demand and lower capacity additions during CY 2019. Pan-India utilisation is expected to reach 75% in CY 2020 while the utilisation levels in the southern region are expected to remain stable at 60% in CY 2020.

An investor would appreciate that when any product has a surplus capacity over its demand, then in a fair market the manufacturers do not have a high negotiating power over their customers. As a result, the manufacturers face fluctuating sales and profit margins.

To understand more about the cement industry, an investor may read the analysis of the following article where we discuss the business analysis of cement companies in detail: How to do Business Analysis of Cement Companies

In such businesses, during the downturn, the manufacturers that have a high level of debt have a high probability of bankruptcy and in turn, being taken over by other players. In the case of calcined pet coke (CPC), the ownership of large CPC manufacturing assets has seen significant changes over the years.

In 2007, the largest CPC manufacturer in the world Great Lakes Carbon (GLC) was sold. Rain Industries Ltd (formerly Rain Commodities Ltd) tried to buy it; however, the Oxbow group of USA got GLC by paying a higher price. (Source: Oxbow Carbon bids $820M for Great Lakes Carbon fund, topping Rain offer)

Privately owned Oxbow said early Wednesday it plans to bid $13 a unit for Great Lakes, a Toronto Stock-Exchange-traded company that supplies global aluminum customers such as Alcan Inc. (TSX:AL), BHP Billiton Ltd. and DuPont.

In early February, Rain Commodities Ltd. bid $437 million, or $11.60 a unit, to acquire the remaining 80 per cent of the Great Lakes Carbon fund it doesn’t already own in the largest takeover bid yet for a Canadian-based company by an investor from India.

Soon thereafter, the second-largest CPC manufacturer was available for sale and Rain Industries Ltd bought it. (Source: Rain to acquire CII Carbon for $595m)

Barely three months after opting out of the race for Canadian company Great Lakes Carbon, the Hyderabad-based Rain Group has sprung a surprise by announcing the agreement to buy US-based CII Carbon LLC for $595 million.

The acquisition, this time through Rain Calcining, fulfils the same objective the group had sought to achieve through the bid for Grate Lakes through Rain Commodities: to become the world’s No 1 maker of calcined petroleum coke (CPC)

From the above developments in the calcined pet coke (CPC) industry, an investor would notice that in quick succession both the world’s first and the second largest manufacturers were sold by their existing owners.

Such kind of events indirectly present to an investor a glimpse of the challenges of running a business in commodities and their dependent businesses. Commodity cycles are almost inevitable and they might be tough to handle for manufacturers who have a weak financial position in terms of high debt, which may become unsustainable during down-cycles. Then even the world’s largest manufacturers may not be able to save their businesses. Therefore, in the commodities and their dependent businesses, an investor should always be cautious about the debt levels of the manufacturers and the companies in which she decides to invest.

In the case of Rain Industries, all the customers, as well as raw material supplier industries, are cyclical. These cyclical industries in turn, affect the business of Rain Industries Ltd and make it suffer wide fluctuations in its sales and profit margins.

Therefore, going ahead, an investor should be cautious and monitor the profitability margins of the company closely.

Read: How to do Business & Industry Analysis of a Company

While analysing the tax payout ratio of Rain Industries Ltd, an investor would appreciate that the key operating businesses of the company are spread across many countries like the USA, Belgium, Germany, India etc. As a result, the tax payout ratio of the company is impacted by the laws of all these countries.

Nevertheless, an investor would notice that for most of the last 10 years (2010-2019), the tax payout ratio of the company has been in line with the standard corporate tax rate of 30% in India and other countries of the world. However, in some years, the tax payout ratio has been lower like in 2013, 2014, 2017 and 2019.

In 2013 and 2014, the tax payout ratio is lower due to deferred taxes, which primarily seem due to the impact of the acquisition of Rutgers Group of Belgium by the company.

2014 annual report, page 149:

Further advised reading: How to calculate Deferred Tax

In 2017, while reading the annual report, an investor gets to know that during the year, the tax rates declined in the USA and Belgium. In addition, the company had done internal corporate reorganizations, which optimized the debt across the USA and Europe leading to an increase in deductions of interest in the profit & loss statement (P&L).

2017 annual report, page 108:

As a result, the interest costs are allocated fairly between North-American and European operations and completely addressed the new US tax regulation of restricting interest deduction being capped at 30% of operating profits. With the reduction of corporate tax rates in Belgium and USA, coupled with the internal reorganization implemented by RAIN Group over last two years in Belgium and Germany, the effective tax rate would reduce by 2% to 3%.

2017 annual report, page 259:

In the United States of America, The Tax Cuts and Jobs Act of 2017 was approved and enacted into law on December 22, 2017. The law includes significant changes to the U.S. corporate income tax system, including a reduction in the Federal corporate tax rate from 35% to 21%.

In 2019, the company received the benefits of corporate tax deductions announced by India.

The corporate announcement at BSE, May 28, 2020, page 8:

Out of the two major Indian subsidiaries in the Group, One entity elected to exercise the option permitted u/s 115B AA of the Income-tax act, 1961 in the quarter and year ended December 31, 2019. Accordingly, the Group computed provision.for income tax for the year ended December 31, 2019 with respect to the Indian subsidiary using the new tax rate and re-measured its Deferred Tax Liabilities basis the rate prescribed in the said section.

Read: How to do Financial Analysis of Companies

Operating Efficiency Analysis of Rain Industries Ltd:

a) Net fixed asset turnover (NFAT) of Rain Industries Ltd:

When an investor analyses the net fixed asset turnover (NFAT) of Rain Industries Ltd in the past years (2010-19), then she notices that the NFAT of the company has consistently been in the range of 1.2 to 1.5. In 2019, the company had an NFAT of 1.32.

An NFAT of 1.32 indicates that if a company invests ₹1 in its fixed assets, then it is able to generate sales of ₹1.32 from this investment. While analysing companies, an investor would notice that an NFAT of 1.32 is in the lower range for manufacturing companies, which usually have NFAT from 1-4. A low NFAT indicates a capital-intensive business.

In addition, when an investor notices that the net profit margin (NPM) of the company has been in the range of 3-4% (3% in 2019), then she acknowledges that the company is making low returns on its assets. Such businesses, which require a lot of investment in assets to generate sales and in addition, earn low profits on their sales, are particularly vulnerable to excessive debt burdens.

This low asset turnover combined with low profitability has serious implications as a huge amount of incremental investment is needed to show future growth. For example, let us assume that in the first year, such a company targets to achieve ₹1,000 cr. of additional sales.

• As per the NFAT of 1.32 then it would need to invest INR 750 cr. in fixed assets (1,000/1.32, because the fixed asset turnover ratio is 1.32).
• This ₹1,000 cr. of additional sales would provide additional net profits of ₹30 cr. (assuming 3% NPM of Rain Industries Ltd in 2019).
• If the company retains its entire profits and invests in its operations, then this incremental investment of ₹30 cr. of entire profits would generate only ₹40 cr. of incremental sales in the second year (as the fixed asset turnover ratio is 1.32, 30*1.32=39.6).
• If the company wishes to grow sales by another ₹1,000 cr. in the second year as well, then it would have to generate ₹960 of sales (=1,000 – 40) by investing an additional ₹720 cr. (=960/1.32 or can be calculated as ₹750 cr of total requirement – ₹30 cr. of net profits reinvested). This ₹720 cr. needs to come from either fresh equity infusion or debt.
• Please note that these calculations would give the same inference even if an investor assumes that the new capital investment in the first year will take about 3 years to reach full utilization and that the company will plan a new capital expenditure only after about 3 years of the last capacity addition.

Thus, we may see that a low fixed asset turnover of 1.32 combined with a low net profit margin of 3% results in a situation where the company would have to keep on relying on additional sources of funds to maintain its growth. As a result, it does not come as a surprise to the investor that over the last 10 years, the debt of Rain Industries Ltd has increased by ₹4,667 cr from ₹3,178 cr in 2010 to ₹7,845 cr in 2019.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

We observe this aspect of the growth of Rain Industries Ltd when we analyse its self-sustainable growth rate (SSGR) later in the article.

Moreover, looking at the continuous significant capital requirements of the business, an investor appreciates that eventually the existing investors get tired of running such businesses and after a while, they sell out. We saw this in the terms of acquisitions done/attempted by Rain Industries Ltd where the companies who were the largest manufacturers of CPC and CTP were sold by their existing investors to other shareholders.

In the CPC business, both the world’s largest (Great Lakes Carbon) and the second-largest (CII Carbon) manufacturers were sold within a span of a few months. In the CTP business, in 2013, the shareholders of the second-largest CTP manufacturer (Rutgers) sold off the business to Rain Industries Ltd in 2013 whereas the world’s largest CTP manufacturer (Koppers) had to shut down many of its plants in 2016-2017 (Source: For Rain Industries, it pours when there’s deficit of pet coke, coal tar)

CTP too, is in short supply as the largest producer Koppers has shut down some of its plants.

Looking at the above developments, an investor would appreciate that growth in such capital-intensive, cyclical businesses, which do not produce a decent return on their assets is very tricky. As the internal return generation ability of the business is low, therefore, the growth is mostly debt-funded.

Carrying a large amount of debt in a business, which is cyclical and frequently faces periods of subdued business performance, is risky. This is because, many times, the high debt may make the survival of the low-margin capital-intensive business very difficult in a down-cycle when the earnings decline and the large debt repayments fall due.

Many times, such businesses rely on continuous debt refinancing and may face bankruptcy risk if they are not able to get refinancing when the large repayments of the existing debt are due. From the above discussion, an investor would appreciate that in tough times (down cycles), in these low-margin, capital-intensive, cyclical businesses, it does not matter even if you are one of the world’s largest manufacturers. When the lenders come to collect their due, you have to sell assets irrespective of being one of the largest manufacturers. An investor should always keep this aspect of low-margin, capital-intensive, cyclical businesses whenever they appraise them.

In cyclical businesses, there will always be phases of an uptrend when the industry would face tailwinds and the sales as well as profit margins would increase. It is common for investors to lose sight of the true nature of the business during these rosy times. However, the commodity cycles of uptrend and downtrend have been in existence for centuries and almost always, in such businesses, periods of good business performance are followed by periods of subdued business performance.

In the recent past, investors witnessed such a scenario in another cyclical, capital-intensive industry, Graphite Electrodes, which supplies electrodes to steel manufacturers for use in the electric arc furnace. An overview of the performance of one of the graphite electrode manufacturers, HEG Ltd, over the recent past will provide good insights to the investor about the role industry phases play in such cyclical industries.

If an investor analyses the quarterly business performance of HEG Ltd from March 2017 quarter to the latest available results of the December 2019 quarter, then she can appreciate the way in which the uptrend of the industry influenced the performance of the company. (The data in the below table is in ₹ crores/10 million).

In the above data, an investor will notice that during March 2017, and June 2017 quarters, HEG Ltd used to report quarterly sales of ₹200-250 cr and hardly any net profit. In March 2017 quarter, it reported a profit of only ₹1 cr and in the June 2017 quarter, it reported a net loss of (₹7 cr).

From September 2017 quarter, the uptrend in the industry started and the sales, as well as the profit of the company, started increasing rapidly. The industry cycle reached its peak in September 2018 quarter when HEG Ltd reported sales of ₹1,794 cr in the September 2018 quarter as compared to ₹200-250 cr in the March-June 2017 quarters. Similarly, HEG Ltd reported a net profit after tax (PAT) of ₹889 cr in the September 2018 quarter as compared to ₹1 cr profit or (₹7 cr) loss in the March-June 2017 quarters.

HEG Ltd witnessed its net profit margin (NPM) rise to 50% at the peak of the industry cycle in September 2018 quarter as compared to losses in June 2017 quarter.

However, thereafter, the industry cycle turned and the down-cycle started. As a result, the business performance of HEG Ltd started declining. In the latest available results for December 2019 quarter, HEG Ltd has reported sales of ₹394 cr, down from the high of about ₹1,800 cr quarterly sales at the peak of the cycle. The sales in December 2019 quarter are more in line with what the sales of HEG Ltd used to be before the up-cycle in the graphite electrode industry started in September 2017. Similarly, in December 2019, HEG Ltd reported net profits of ₹6 cr with an NPM of 2%, down from the quarterly net profit of ₹889 cr with an NPM of 50% at the peak of the industry cycle in September 2018.

If an investor analyses the history of cyclical industries over a long period, then she will notice that in these industries, periods of good business performance always lead to periods of subdued performance and vice-versa. This has been the case for centuries and it may remain the same in the future as well. Therefore, an investor should always keep this fact of changing business performance during industry cycles in mind while assessing these cyclical industries. The investor should not be overly influenced by the good business performance of the company over the up-cycle phase of the industry. If she loses sight of the cyclical business phases of these industries, then she may lose money while investing in these industries.

In the case of HEG Ltd, when the industry up-cycle started in September 2017 and reached its peak in September 2018, the stock market took the share price of HEG Ltd from the levels of ₹150/- in early 2017 to an all-time high of ₹4,950/- in October 2018 at the peak of up-cycle. However, once the down-cycle of the graphite electrode industry started and the business performance of the company started declining, its share price has also come down to about ₹450/- in March 2020. HEG Ltd’s share price closed at ₹913.15 on June 12, 2020.

An investor may read our complete analysis of HEG Ltd in the following article: Analysis: HEG Ltd

Therefore, while investing in cyclical commodities and their dependent industries, an investor should always keep in mind that periods of good business performance lead to periods of subdued business performance. The investor should not be carried away when she notices the increasing sales and profit margins of the companies in the up-cycle phase of the industry.

While analysing Rain Industries Ltd, from the above discussion, an investor would notice that in 2017, the company faced the up-cycle phase of the industry when its sales, as well as profit margins, increased at a sharp pace. The aluminium demand, as well as prices, were increasing. Many inefficient aluminium plants, which were earlier closed due to unviability at low prices, were again started by the aluminium manufacturers. As a result, the demand for CPC and CTP increased. The company also acknowledged this momentum of the industry upcycle of 2017 to its shareholders in its annual report.

2018 annual report, page 10:

We began 2018 by continuing to ride a wave of momentum that began in mid-2017, as global aluminium production and demand for our calcination and distillation products steadily increased, leading to corresponding improvements in selling prices and margins. The global economy also continued to strengthen, especially in the US, where import tariffs and rising prices for aluminium and steel motivated US manufacturers to restart mothballed facilities and increase capacity utilisations.

However, starting in 2018, the industry cycle turned and the industry entered a down cycle. The sales and the profit margins of the company started declining.

2019 annual report, page 10:

….many of the challenges that impacted our businesses in late 2018 persisted, in particular: continued softness in the Chinese economy; reduced automotive sales in China, Europe, the UK and Japan, which impacted demand for raw materials that we produce for aluminium, automobile tyres and adhesives; and disruption to our calcination business due to India’s restrictions on petroleum coke imports, resulting in high-cost inventories in a declining market that reduced profit margins.

The down cycle of the aluminium industry that started in 2018 is continuing in 2020.

If the investor notices the share price movement of Rain Industries Ltd over these industry phases of upcycle in 2017 and then the resultant downcycle, then she notices that the share price movement is similar to HEG Ltd discussed above.

From the above chart, an investor would notice that before the start of the industry upcycle of 2017, the share price of Rain Industries Ltd used to be in the range of ₹30/-. In the industry upcycle the stock market to the share price to the high of ₹475/-. However, once the down-cycle of the aluminium industry started and the business performance of Rain Industries Ltd started declining, its share price has also come down to about ₹47/- in March 2020. Rain Industries Ltd’s share price closed at ₹73.85 on June 12, 2020.

Therefore, once again, we would stress that while investing in cyclical commodities and their dependent industries, an investor should always keep in mind that periods of good business performance lead to periods of subdued business performance. If an investor is carried away by the increasing sales and profit margins of the companies in the up-cycle phase of the industry, then she may face negative surprises when the industry enters the down-cycle and she may even lose her hard-earned money put in the investment.

Advised reading: What I learnt from brief analysis of 2,800 Companies

b) Inventory turnover ratio of Rain Industries Ltd:

While analysing the inventory turnover ratio (ITR) of the company, an investor notices that the ITR of Rain Industries Ltd had been nearly stable in the range of 6.0 to 7.0 over the last 10 years (2010-2019). This reflects efficient inventory management by the company.

Nevertheless, an investor would appreciate that the raw material of the company are by-products of cyclical commodity businesses where prices keep on fluctuating widely over time. As a result, the company has frequently faced inventory write-downs where it purchased raw materials at a high price; however, later on, the prices declined sharply to an extent that the company had to recognise a loss.

In March 2020 quarter, Rain Industries Ltd recognised a loss of ₹90 cr due to a write-down of inventory.

May 2020 press release, page 3:

…..there is no material impact on its financial results as at March 31, 2020, and carrying value of its assets except certain inventory-related write-downs amounting to ₹ 900 million.

When an investor reads the publicly available annual reports of Rain Industries Ltd from 2009, then she realises that the company has faced inventory write-downs for a very long time. In 2008, Rain Industries had to write down inventories worth ₹68 cr.

2009 annual report, page 85:

During the previous year, the Group recorded write-down of inventory by Rs.686,236 which was disclosed as an Exceptional Item.

An investor may note that in the 2009 annual report, the financial data is reported in (₹ ‘000). Therefore, the above figure of ₹686,236 represents ₹68.6 cr.

In 2014, Rain Industries Ltd faced an inventory write-down of ₹23 cr.

2014 annual report, page 160:

On account of a sharp decline in the prices of certain commodity inputs the Group’s inventories were significantly impacted in the last quarter. This decline of Rs. 236,921 was unusual and has been reported as an exceptional item by the Group.

In 2016, Rain Industries Ltd had to record a loss of ₹54 cr due to losses on inventories.

2016 annual report, page 9:

Profit After Tax for CY 2016 is adjusted for (a) ₹ 262 Million towards provision made for closure cost of impregnated wood product manufacturing facility in Hanau, Germany (b) incremental pension liability from actuarial losses of ₹ 1,109 Million (c) provision for inventories ₹ 547 Million…..

In 2017, the company faced an inventory write-down of ₹40 cr, which further increased to ₹51 cr in 2018.

2018 annual report, page 238:

The above inventories are net of provision for net realisable values of ₹ 516.99 and ₹ 401.10 as at December 31, 2018 and December 31, 2017 respectively.

The hit on the profits of Rain Industries Ltd continued in 2019 when the company recorded a loss of ₹51 cr due to loss of value of inventories.

2019 annual report, page 263:

The above inventories are net of provision for net realisable values of ₹ 513.14 and ₹ 516.99 as at December 31, 2019 and December 31, 2018 respectively.

From the above discussion, an investor notes that the write-down of inventory due to commodity price declines are a frequent item for Rain Industries Ltd. In such a situation, she doubts the reasons why the company used to disclose it under “Exceptional Items” in the financial statements.

Advised reading: Inventory Turnover Ratio: A Complete Guide

c) Analysis of receivables days of Rain Industries Ltd:

While analysing the receivables days of the company, an investor notices that the receivables days of Rain Industries Ltd have remained stable in the range of 40-45 days over the last 10 years (2010-2019). This reflects efficient receivables management by the company.

The position is despite a few challenges faced by the company in collecting receivables during the down-phases of the business cycle.

As discussed above, in 2015 one of its customers filed for chapter 11 bankruptcy and as a result, Rain Industries Ltd had to provide for a loss on its dues/receivables from that customer.

2015 annual report, page 168:

Provision for doubtful debts of Rs 134.32 included in the exceptional items consist of provision for the amount receivable from one of the customer for Group’s US and Canadian subsidiaries for the sale of goods. On February 8, 2016 the customer filed for Chapter 11 bankruptcy protection in the USA.

Then again, in the next down-phase, in 2018, the company had to make a large provision of ₹78 cr for receivables that it believes would be difficult to collect.

2018 annual report, page 258:

Further Advised Reading: Receivable Days: A Complete Guide

Nevertheless, looking at the inventory turnover ratio as well as at receivables days of Rain Industries Ltd, an investor would notice that the company has been able to keep its working capital position under control and not let it deteriorate over the last 10 years (2010-2019). As a result, it has not witnessed a lot of money being stuck in the working capital.

An investor observes the same while comparing the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of the company for 2010-19.

Over 2010-19, Rain Industries Ltd Limited reported a total cumulative net profit after tax (cPAT) of ₹4,187 cr. During the same period, it reported cumulative cash flow from operations (cCFO) of ₹12,083 cr. An investor notices that the company has a very high cCFO when compared to the cPAT over the last 10 years (2010-2019).

It is advised that investors should read the article on CFO calculation, which would help them understand the situations in which companies tend to have the CFO lower than their PAT. In addition, the investors would also understand the situations when the companies would have their CFO higher than the PAT.

Further advised reading: Understanding Cash Flow from Operations (CFO)

Learning from the article on CFO will indicate to an investor that the cCFO of Rain Industries Ltd is significantly higher than the cPAT due to the following factors:

• Interest expense of ₹4,775 cr (a non-operating expense) over 2010-2019, which is deducted while calculating PAT but is added back while calculating CFO.
• Depreciation expense of ₹3,574 cr (a non-cash expense) over 2010-2019, which is deducted while calculating PAT but is added back while calculating CFO.

Therefore, an investor would appreciate that during 2010-2019, Rain Industries Ltd kept its working capital requirements under check. As a result, it has been able to convert its profits into cash flow from operations.

The Margin of Safety in the Business of Rain Industries Ltd:

a) Self-Sustainable Growth Rate (SSGR):

Read: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.

Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.

While analysing the SSGR of Rain Industries Ltd, an investor would notice that the company has consistently had a low SSGR (negative to 0%) over the years. One of the key reasons for a low SSGR for the company has been its low asset turnover and low profitability.

As discussed above, Rain Industries Ltd has consistently had a low NFAT in the range of 1.25-1.50. In addition, the net profit margin (NPM) of the company has been consistently low at 3%-7% over the last 10 years.

While studying the formula for the calculation of SSGR, an investor would understand that the SSGR directly depends on the net fixed asset turnover (NFAT) and the net profit margin (NPM) of a company.

SSGR = NFAT * NPM * (1-DPR) – Dep

Where,

• SSGR = Self Sustainable Growth Rate in %
• Dep = Depreciation rate as a % of net fixed assets
• NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
• NPM = Net profit margin as % of sales
• DPR = Dividend paid as % of net profit after tax

(For systematic algebraic calculation of SSGR formula: Click Here)

Therefore, an investor would notice that Rain Industries Ltd has continuously had a low SSGR (negative to 0%) over the last 10 years (2010-2019). However, an investor would appreciate that the company has been growing at a rate of 10%-15% over the years.

The historical low SSGR indicates that the company does not seem to have the inherent ability to grow at the rate of 10%-15% from its business profits. As a result, investors appreciate that Rain Industries Ltd would have to raise money from additional sources like debt or equity to meet its investment requirements.

While analysing the past financial performance of Rain Industries Ltd, an investor notices that the company relied on additional debt to meet the requirement of funds to grow at 10-15% over the last 10 years. The total debt of the company increased from ₹3,178 cr in 2010 to ₹7,845 cr in 2019 indicating a net increase of ₹4,667 cr (= 7,845 – 3,178) over the last 10 years.

An investor reaches a similar observation when she analyses the free cash flow (FCF) position of the company over the last 10 years (2010-2019).

b) Free Cash Flow (FCF) Analysis of Rain Industries Ltd:

While looking at the cash flow performance of Rain Industries Ltd, an investor notices that during 2010-19, the company had a cumulative cash flow from operations of ₹12,083 cr. During this period it did a capital expenditure (capex) of ₹11,018 cr. As a result, an investor would note that over 2010-2019, Rain Industries Ltd had a free cash flow (FCF) of ₹1,065 cr. ( = 12,083 – 11,018).

In addition to the capital expenditure, the company had to meet the interest expense of about ₹4,775 cr on the debt that it had for 2010-2019. Please note that the amount of interest capitalized by Rain Industries Ltd is already reflected in the amount of capital expenditure.

As a result, the company had a total cash shortfall of ₹3,710 cr (= 1,065 – 4,775). The company met this shortfall by raising additional debt of ₹4,667 cr over the last 10 years.

In light of the cash shortfall faced by Rain Industries Ltd after meeting the capital expenditure and interest payments, an investor would appreciate that the dividend payments, as well as the buy-backs done by the company in the past, are effectively funded by the debt that it had raised.

An investor would note that money is a fungible item. Therefore, a company may easily show that it is paying dividends from its profits and raises large amounts of debt to meet capital expenditure (capex) and interest payments. However, the investor should appreciate that if any company has a cash shortfall from capex and interest payments and it has to raise debt to meet these expenses, then any payment done by the company to the shareholders in the form of dividends or buybacks has effectively come from the debt.

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

Free cash flow (FCF) is one of the main pillars of assessing the margin of safety in the business model of any company.

Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

Looking at the above discussion on the cyclically fluctuating business performance, low asset turnover, low-profit margins, high capital requirements to fund growth, low SSGR, and cash deficit requiring additional debt, an investor may appreciate that the business of Rain Industries Ltd is a tough challenge. In the past, even the largest manufacturers in the world like Great Lakes Carbon (GLC), CII Carbon, Rutgers, Koppers etc. could not escape the tough challenges posed by this industry. As a result, Great Lakes Carbon, CII Carbon and Rutgers had to be sold by their existing shareholders whereas Koppers had to shut down many of its manufacturing facilities.

In light of these challenges, it becomes obvious to the investor that the business of Rain Industries Ltd relies primarily on additional debt to meet its growth and continuous debt refinancing to sustain the large debt. If interest rates increase or at the time of debt repayment, due to any reason, the debt markets freeze, then it would be very difficult for any company carrying large debt to service the debt.

While reading the 2013 annual report of Rain Industries Ltd, an investor comes to know that subscribers of its “Junior Subordinated Notes” (JSN) had declared a loan default and asked the company for early loan repayment along with an additional 5% rate of interest.

2013 annual report, page 116:

On February 4, 2013, holders of Junior Subordinated Notes requested an accelerated loan repayment and additional default interest of 5% per annum from the assumed date of default. Based on legal advice received, management strongly believes no default has occurred and accordingly have not recognized any liability in the books.

However, none of the subsequent annual reports has any further details about the said default or the dispute with the subscribers of “Junior Subordinated Note” (JSN). Therefore, an investor is not able to assess the complete development of events in the above case whether the company had actually defaulted and later on settled with the JSN subscribers or the JSN subscribers were wrong in their interpretation of the terms of the notes.

Nevertheless, an investor would appreciate that if a company has a large amount of debt where it is relying on refinancing for loan repayment, then it carries the risk of bankruptcy if, at the time of repayment of the existing loan, the credit markets freeze due to any reasons.

The fact that Rain Industries has been relying on refinancing for repayment of its existing debt has been highlighted by the credit rating agency, India Ratings, in its credit rating report for the company in February 2017, page 1:

Rain’s debt servicing requirement in 2018 is INR27.6 billion. The company will have to resort to refinancing these repayment obligations as the internal cash generation is insufficient.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

Reliance on refinancing as a strategy to repay existing debt is very risky. Many times, such situations have led to bankruptcy for highly leveraged manufacturers.

Rain Industries Ltd experienced the impact of bankruptcies in its business when in 2015, one of its customers filed for chapter 11 bankruptcy and as a result, Rain Industries Ltd had to provide for a loss on its dues/receivables from that customer.

2015 annual report, page 168:

Provision for doubtful debts of Rs 134.32 included in the exceptional items consist of provision for the amount receivable from one of the customer for Group’s US and Canadian subsidiaries for the sale of goods. On February 8, 2016 the customer filed for Chapter 11 bankruptcy protection in the USA.

An investor would appreciate that carrying large debt in a cyclical, capital-intensive, low-return generating business is risky.

In light of the above challenges, it does not come as a surprise to the investor when she notices that the stock market has not given a high valuation to Rain Industries Ltd when compared to the amount of earnings retained by it from its profit by not distributing them to the shareholders.

Over the last 10 years, the company retained profits of about ₹3,800 cr; however, the market capitalization of the company has increased by only about ₹1,180 cr. This amount to the generation of about ₹0.31 in market value for every ₹1 of shareholders retained by the company in the last 10 years.

As a result, over the last 10 years, shareholders have witnessed wealth erosion of about ₹2,620 cr (= 3,800 – 1,180) when the company decided to keep the money with itself.

Additional aspects of Rain Industries Ltd

On analysing Rain Industries Ltd and reading its publicly available past annual reports and reading other public documents an investor comes across certain other aspects of the company, which are important for any investor to know while making an investment decision.

1) Management Succession of Rain Industries Ltd:

Rain group with Rain Industries Ltd as the holding company is run by Mr. N. Radhakrishna Reddy (age 78 years) and his two sons, Mr. Jagan Mohan Reddy Nellore (age 53 years) and Mr. N. Sujith Kumar Reddy (age 48 years). The presence of a father along with two sons in active managerial positions in the group provides for visibility of the succession planning in the group.

In the conference calls conducted by the company to discuss its results with the investors, usually, Mr. Jagan Mohan Reddy Nellore, Vice Chairman, is the active participant along with other professional managers. Therefore, he might be the most active out of the family members who are a part of the management of the group.

Nevertheless, an investor should do her own analysis to understand the terms between the two brothers Mr. Jagan Mohan Reddy Nellore (age 53 years) and Mr. N. Sujith Kumar Reddy (age 48 years). This is because it may lead to ownership issues in the future. An investor may be aware of many instances where the business group went through prolonged periods of discord between family members when the senior-most member of the family was not there e.g. Reliance group.

In addition, the investor may seek details from the company about any member of the next generation i.e. children of Mr. Jagan Mohan Reddy Nellore and Mr. N. Sujith Kumar Reddy or any other family members who might have joined the company in management positions.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

2) Complex corporate structure of Rain Industries Ltd:

While analysing the company, an investor notices that Rain Industries Ltd in itself does not have any operating business. The company only has loans & advances and investments in its subsidiaries and it earns interest and dividends from these investments. All the operating businesses whether they are located in India or abroad, are present in other subsidiaries.

As per the 2019 annual report, the company had 27 subsidiaries and associates on December 31, 2019. However, in the past, the number of subsidiaries was even higher. In 2016, the company had 41 subsidiaries and associates including 4 subsidiaries in India and 37 in overseas locations.

An investor would appreciate that the analysis, as well as the audit of these many subsidiaries, is a cumbersome task. One main auditor audits the standalone and consolidated financial statements of Rain Industries Ltd. In addition, many of the subsidiaries in different countries would have different auditors. The main auditor of Rain Industries Ltd has to rely on the reports of these other auditors for preparing the consolidated financials. It becomes difficult for the investor to assess the quality of the auditors assessing the financial statements of the subsidiaries.

Moreover, it is still ok if at least all the financial statements of all the subsidiaries are audited before the consolidated financials of Rain Industries Ltd are published. However, there have been instances when at the time of publishing the consolidated financial statements, the financial statements of many of the subsidiaries had not been audited by any qualified auditor. On these occasions, the management submitted unaudited financial statements of these subsidiaries to the main auditor who incorporated these unaudited financials while preparing the consolidated financials.

At times, the size of the subsidiaries whose unaudited financial statements were included in the consolidated financials was very significant. E.g. in 2019, the consolidated financial statements of Rain Industries Ltd included unaudited financials of companies that had ₹1,038 cr of revenue, ₹287 cr of net profits.

2019 annual report, page 232:

The consolidated financial statements include the unaudited financial statements of subsidiaries and associate, whose financial statements reflect Group’s share of total assets of ₹10,462 million as at 31 December 2019, Group’s share of total revenue of ₹10,385 million and Group’s share of total net profit after tax of ₹2,879 million for the period from 01 January 2019 to 31 December 2019 respectively, as considered in the consolidated financial statements.

Further advised reading: Understanding the Annual Report of a Company

In the past, in 2017, the consolidated financial statements of Rain Industries Ltd included unaudited financials of companies that had ₹3,671 cr of net assets out of the total net fixed assets of ₹8,690 cr. owned by the company.

2017 annual report, page 203:

We did not audit the financial statements of certain subsidiaries, whose financial statements reflect total assets of ₹ 37,154 million and net assets of ₹ 36,713 million as at December 31, 2017 and total revenues of ₹ Nil and net cash outflows of ₹ 244 million for the year ended on that date, as considered in the consolidated Ind AS financial statements. The above financial information is before giving effect to any intra group eliminations and consolidation adjustments. These financial statements are unaudited….

Therefore, an investor would appreciate that when the consolidated financial statements of a company include a significant size of unaudited financials, it leads to uncertainty in the minds of investors about the numbers that she is analysing. There is always a probability that when these unaudited financial statements are subsequently audited by any qualified auditor, then the auditor may have many observations on them and may challenge the assumptions of the management in the preparation of financial statements. Such events may even lead to changes in the financial statements later on.

An investor may seek clarifications from the company directly whether the said unaudited financial statements of the subsidiaries included in the consolidated financial statements of Rain Industries Ltd, were subsequently audited by any qualified auditor. If yes, then did the financial statements change to any extent after the said audit was completed?

If the management says that the unaudited financial statements of none of the subsidiaries changed after the subsequent audit, in any of the years in the past, then it may raise another doubt. If the unaudited financial statements submitted by the management never change after the audit, then it raises the possibility of the presence of “rubber-stamp” auditors who simply sign on the financial statements submitted by the company without doing their own due diligence. In these cases, the investor may make her own judgment.

Apart from the challenges of completing the audit of all the subsidiaries in time for consolidated financial statements as well as the quality of the audit, the presence of a large number of subsidiaries presents other challenges. At times, such companies keep on reorganizing their corporate structure, which presents additional challenges for the auditors as well as investors.

Rain Industries Ltd undertook a major corporate reorganization in 2017 when it merged many of its subsidiaries.

2017 annual report, page 108:

RAIN Group has implemented internal reorganization during the past two years to achieve optimal allocation of debt from US to European operations and simplify the corporate structure in Belgium and Germany by merging companies (resulting in reduction of 9 legal entities).

In such reorganizations, assets of one company are transferred to another entity and usually, it involves many assumptions on the part of the management. All these instances of mergers and reorganisations present challenges to investors and auditors in their analysis.

Rain Industries Ltd has sold and purchased holdings of its different companies among its subsidiaries in other years as well, which again complicates the assessment of the financial position of the group for any investor and as well as an auditor.

2015 annual report, page 36:

Rain Industries Limited (the Company) holds 60,000 (100%) equity shares in Rain Coke Limited. Due to internal re-organization, 60,000 equity shares held in Rain Coke Limited were sold to Rain Cements Limited ( Wholly Owned Subsidiary).

Rain Cements Limited (A wholly owned Subsidiary Company) holds 10,00,000 equity shares in Rain CII Carbon (Vizag) Limited (A Step down wholly owned subsidiary Company). Due to internal re-organization 10,00,000 equity shares held by Rain Cements Limited in Rain CII Carbon (Vizag) Limited were purchased by the Company.

Similarly, in 2010, when the company transferred its cement business to its subsidiary, Rain Cements Ltd, then it recognised a loss of about ₹200 cr.

2010 annual report, page 65:

The assets and liabilities of the Cement business have been transferred at their net book values as on April 1, 2010. Rs. 1,995,200, being the loss on transfer of Cement Business (the excess of the net assets value over the consideration receivable) has been charged to the Profit and Loss Account and disclosed as Exceptional Item.

Investors may note that in the 2010 annual report, the company reported its financial data in (₹ ‘000). Therefore, “Rs. 1,995,200” in the above section represents ₹199.52 cr.

This loss is present only in the standalone financial statements of the company and has been cancelled out while preparing the consolidated financial statements. However, still, in an investor’s mind, it raises doubt whether the assets of the cement business are actually worth the amount that they are stated in the balance sheet or whether the assets are impaired and the company is delaying the recognition of the same.

Investors may appreciate that when they have to work upon multiple layers of subsidiaries and their investments like layers of an onion, to understand the financial position of any company, then it always creates a possibility for error that their final analysis may not be accurate.

When companies deal with multiple subsidiaries, then invariably the annual reports are not able to provide sufficient details for each one of them. The management only describes the affairs of key large subsidiaries and segments in the annual report and many small subsidiaries are ignored.

For example, one of the subsidiaries of Rain Industries Ltd, RGS Egypt Limited, finds a mention in the 2010 annual report for the first time when an investor gets to know that the company has made investments in RGS Egypt Limited by acquiring a 51% stake.

In the 2010 annual report, on page 90, in a note in the short font below the fixed assets schedule, the investor gets to know that Rain Industries Ltd has received fixed assets of ₹9 cr on the acquisition of RGS Egypt Limited. In addition, on page 95, the investor notices that the company received a finished goods stock of about ₹15 cr on this acquisition. Therefore, an investor may assume that the total assets acquired by Rain Industries Ltd when it took over 51% of RGS Egypt Limited are about ₹25 cr.

The 2010 annual report did not have any comment from the management about why the subsidiary was acquired. What are the business plans for RGS Egypt Limited? Who are the other partners that owned the remaining 49% and whether it is a third party or a related party?

Thereafter, in the 2017 annual report, as a small footnote under the list of subsidiaries included in consolidated financials on page 56, the investor gets to know that Rain Industries Ltd has sold off RGS Egypt Limited.

Just like at the time of the acquisition of RGS Egypt Limited in 2010 when there was no explanation, in 2017, at the time of disposal of RGS Egypt Limited, there was no explanation by the management in the annual report about the reasons for its disposal.

In another such instance, in the 2009 annual report, an investor notices the shareholding of the company in its subsidiary Rain Global Services LLC. (RGS) declined from 100% to 61% in 2009.

2009 annual report, page 82:

The annual report of 2009 does not contain any explanation from the management about either the reasons for this decline in the shareholding in RGS or who is the counterparty who has acquired a 39% stake in RGS.

Investors face such situations frequently in cases where companies have a complex corporate structure involving many subsidiaries, associates and joint ventures. Many times, in such cases, the management is not able to provide details about all the decisions taken by them in the annual report and instead, restricts their discussions to the key large subsidiaries and business segments. However, the absence of discussion on many corporate decisions like the acquisition and disposal of subsidiaries leaves the investors to make their own assumptions about the management actions.

Investors may appreciate that in complex corporate structures, many times, underlying weaknesses may take a long time to be exposed as investors, investment analysts, and auditors find it difficult to assess complex corporate structures.

Further advised reading:  7 Signs to tell whether a Company is cooking its Books: “Financial Shenanigans”

3) Management’s claim about low availability of raw material “Anode grade GPC” as a key barrier to entry:

While reading the annual reports of Rain Industries Ltd, an investor notices that for many years, the company has claimed that it is difficult to get the key raw material, anode-grade green pet coke (GPC), which is used to make calcined pet coke (CPC) as well as the supply of coal tar used to make coal tar pitch (CTP).

The company highlighted it in its 2012 annual report, page 6:

Long-term contracted raw material supply-a key barrier to entry: In both CPC and CTP industries, secure access to raw materials is a key competitive advantage. Given the expectation for a continued tightening in the worldwide supply of traditional Anode Grade GPC and Coal Tar, we believe it would be difficult for a new entrant to get secure supply of these critical raw materials.

The company continued to highlight it over the years. In 2019, Rain Industries Ltd highlighted that the key threat to the CPC industry is the availability of good quality GPC.

2019 annual report, page 76:

The main threat for the CPC industry is the availability of suitable-quality GPC.

However, when an investor notices the demand and supply of anode-grade GPC in the world in the 2019 annual report, then she notices that until now, the world has a surplus of anode-grade GPC.

2019 annual report, page 75:

An investor may note that the recent shortage of GPC faced by the company for its Indian plants is due to the restrictions imposed by India on the import of GPC. This shortage is not due to the scarcity of GPC in the world.

Moreover, the company also disclosed in its 2016 annual report that the price differential between the “sweet crude” leading to the production of anode grade GPC and the “sour crude”, which normally leads to fuel grade GPC, is declining. As a result, in future, more refineries may opt to consume “sweet crude”, which would increase the availability of anode-grade GPC.

2016 annual report, page 23:

As the spread between Sweet-Crude to Sour-Crude has narrowed, it is expected that few Oil refineries would shift to Sweet-Crude resulting in improved availability of Anode Grade GPC.

Please note that an investor should always take the future projection data of demand for any product with a pinch of salt as many of the times, these data turn out to be very different from the actual demand when the time comes. The cyclical nature of the commodities businesses is a key example. No one can accurately predict these cycles and the demand at a particular point in time in future including the promoters/professional who is working in these industries full-time.

An investor may remember the acquisition of Corus by Tata Steel in April 2007 (Source: Tata Steel completes £6.2bn acquisition of Corus Group plc). However, it later turned out that Tata Steel acquired it at a very expensive valuation and at the peak of the steel industry cycle. Subsequently, the steel industry entered a downturn and Tata Steel could never recover from this expensive acquisition. It is still facing problems with many of the assets/plants acquired by it in different European countries.

Later on, the former MD of Tata Steel, Mr. J.J. Irani acknowledged that acquiring Corus was a mistake. (Source: Corus acquisition was an aspirational mistake: J J Irani)

From the above example of Tata Steel and Corus, an investor may appreciate that even the companies, professionals, or promoters who are a part of any commodity industry for their entire life make mistakes in assessing the demand for commodities at any point in time.

Therefore, when Rain Industries Ltd highlights that the availability of anode grade GPC is a key entry barrier for new players in the CPC business as in future, the demand for GPC would be higher than its supply, then investors should take it with a pinch of salt.

Moreover, from our above discussion on industry cycles of graphite electrodes, an investor would recollect that the supposed scarcity of raw material and non-entry of new players in the industry for many decades is not able to save the existing players from subdued business performance in the down cycle of the industry.

In our analysis of HEG Ltd, we noticed similar claims by the management of the company in relation to the graphite electrodes industry.

At the peak of the graphite electrodes industry up-cycle, in the FY2018 annual report, the management of HEG Ltd highlighted the very high barriers to entry in the graphite electrodes industry. It mentioned about factors like the availability of its key raw material “needle coke”, a type of pet coke like anode grade GPC, along with other barriers like technology, capital-intensiveness, long time to start a new plant etc.

FY2018 annual report of HEG Ltd, page 20:

However, from our discussion above on the sharp decline in the business performance of HEG Ltd during the down phase of the industry cycle, an investor would appreciate that the supposed high barriers to entry are not able to protect existing manufacturers from subdued business performance in down-cycles. From the above discussion, an investor would remember that even the shareholders of the world’s largest producers of CPC and CTP producers had to sell their companies despite having key competitive advantages like high barriers to entry.

Therefore, it is advised that in the case of commodities and their dependent businesses, an investor should always question the claims of the management whether it is HEG Ltd, Tata Steel or Rain Industries Ltd. Cyclical commodity businesses have the potential to proving wrong even the seasoned professionals/promoters who have spent their entire life dealing with these commodities.

Advised reading: Why we cannot always Trust What Management Claims

4) Curious case of compulsory convertible debentures (CCDs):

While reading the 2016 annual report of Rain Industries Ltd, on page 170, an investor notices that in the long-term borrowings section in the consolidated financials, the company has disclosed the presence of unsecured debentures for ₹15.06 cr.

Upon further reading of the footnotes, the investor gets to know that these are compulsorily convertible cumulative debentures (CCCDs) raised by the group.

2016 annual report, page 171:

This represents 15,062,600 compulsorily convertible cumulative debentures of INR 10 each, carrying an interest rate of 12.5%p.a. They are convertible into equity shares in the ratio of 1:1 at the end of 20 years from the date of issuance. The interest on these debentures shall accrue from the expiry of 18 months from the commercial operations date.

An investor notices that these CCCDs are present only in the consolidated financials and are absent in the standalone financials; therefore, it indicates that these are raised by any subsidiary of Rain Industries Ltd. Moreover, their presence in the consolidated financials without being cancelled in the intra-group transactions on consolidation indicates that the subsidiary of the company has raised these CCCDs from outside parties.

In addition, there is no mention of these CCCDs in the related party transactions table on page 180 in the annual report, indicating that these are not subscribed by the promoters but by any outside third party.

However, there is no mention in the annual report about which subsidiary has raised these CCCDs.

Moreover, an investor is not able to find out any board resolution or any intimation to the shareholders of Rain Industries ltd in the previous annual reports of the company about raising these CCCDs. It might be because of the reason that the CCCDs are raised by a subsidiary and the board of Rain Industries Ltd would have given approval as the majority shareholder in the subsidiary, which might not have needed approval from the public shareholders of Rain Industries Ltd.

Nevertheless, an investor suddenly comes across this equity dilution in the form of 1.5 cr CCCDs in the 2016 annual report.

In addition, the quick manner in which these CCCDs, which had a tenor of 20 years, had appeared in the 2016 annual report, in the same quick manner, they disappeared in the 2017 annual report.

While analysing the 2017 annual report in detail, an investor finds a sum of ₹15.06 cr, which is reduced from borrowings and seems to be adjusted into “other equity” in the “Reconciliation of Balance Sheet as on December 31, 2016” section.

Further advised reading: Understanding the Annual Report of a Company

After that, there is no mention of these compulsorily convertible cumulative debentures (CCCDs) anywhere in the subsequent annual reports.

An investor noticed that these CCCDs, which are a liability/loan in the balance sheet are different from the other compulsory convertible debentures (CCDs) of ₹15.67 cr, which is an asset/investment done by the Rain group in its subsidiary Rain Coke Ltd.

2017 annual report, page 238:

The investment by Rain Industries Ltd in the CCDs of Rain Coke Ltd makes its appearance in the 2016 annual report, are present in the 2017 annual report as well but they disappear in the 2018 annual report as Rain Industries Ltd sold Rain Coke Ltd in 2018 to GreenKo group.

2018 annual report, page 264:

Rain Coke Limited is a 51% owned company which is involved in generation of Solar power. As the Group does not control Board and other partners have significant participating rights, the Group’s interest in Rain Coke Limited has been accounted for under the equity method of accounting under Ind AS 111- “Joint arrangements”. The investment in Rain Coke Limited has been sold to GreenKo Group on December 15, 2018.

Therefore, while reading the annual reports of Rain Industries Ltd, an investor should not get confused between the liability of compulsorily convertible cumulative debentures (CCCDs) raised by the group in one of its subsidiaries with the investment/asset of compulsory convertible debentures (CCDs) done by Rain Industries Ltd in Rain Coke Ltd in 2016.

If we focus on the compulsorily convertible cumulative debentures (CCCDs) of ₹15.06 cr raised by the group in 2016, which give the right to the subscriber to convert them into 1.5 cr shares, then the investor does not get sufficient information from the annual report about many key aspects. The investor does not get to know the purpose of these CCCDs, which subsidiary had raised them, who invested in them, and why none of the subsequent annual reports had any disclosure on them if they had a tenor of 20 years before conversion.

An investor may contact the company directly to seek clarifications and further information on these compulsorily convertible cumulative debentures (CCCDs).

Further advised reading: How should investors contact Companies/Management for clarifications or additional information?

5) Related party transactions of Rain Industries Ltd:

While reading the annual reports of the company, an investor comes across some transactions between the company and the entities controlled by the promoters/related party entities, which are of significant size. These transactions provide some insights to investors.

a) Rain Enterprises Private Ltd (REPL):

While reading the 2018 annual report, an investor notices some large transactions with one of the promoter-owned entities, Rain Enterprises Private Ltd (REPL).

2018 annual report, page 284

An investor notices that in 2018, Rain Industries Ltd provided an advance of ₹230 cr to REPL, which was refunded by REPL within the year. Similarly, in 2017, Rain Industries Ltd provided an advance of ₹443 cr to REPL out of which it refunded ₹396 cr within the year. The balance of ₹47 cr in 2017 is shown as the purchase of services from REPL in the annual report.

2018 annual report, page 284

An investor should note that many times such transactions of advances to related parties, which are refunded by them within the year act as short-term interest-free loans to the related parties in order to meet cash needs during the year.

In addition, while reading the related party transaction in the 2018 annual report and comparing it with the related party transactions of the 2017 annual report, an investor notices a strange thing. The advance of ₹443 cr given by Rain Industries Ltd to REPL and the refund of ₹396 cr by REPL to Rain Industries Ltd in 2017, which is present in the 2018 annual report, is not present in the 2017 annual report. In addition, the purchase of services of ₹47 cr from REPL in 2017, which is present in the 2018 annual report shared above, is not present in the related party transactions table in the 2017 annual report.

The only transaction between Rain Industries Ltd and REPL in the 2017 annual report, page 299 is about “Reimbursement of ocean freight, and other expenses” of ₹5.2 cr.

Moreover, REPL is the entity through which the promoters own a 7.53% stake in Rain Industries Ltd from 2014 until March 2020. Therefore, it is not a case where the status of the company changed from a non-related party to a related party between 2017 and 2018.

An investor may contact the company directly for any clarifications in this regard.

b) Arunachala Logistics Private Limited (ALPL):

While reading the annual reports of Rain Industries Ltd, an investor notices that the company has transactions of significant size with another promoter entity Arunachala Logistics Private Limited (ALPL).

ALPL at its website claims itself to be “one of the biggest fleet operators in south India owning a huge number of Heavy trucks operating all over South India” at its website (https://www.arunachala.biz/)

Rain Industries Ltd did transactions of ₹365 cr (2019), ₹349 cr (2018), ₹317 cr (2017), and ₹305 cr (2016) with ALPL.

An investor would appreciate that such large value transactions between the company and the promoters’ entities carry the potential of shifting economic benefits from the minority shareholders to the promoters if they are not at a fair market price. If the company pays a comparatively higher price to the promoter entity for its services than what it could get at independent third-party vendors, then it may be equivalent to shifting economic benefit from minority shareholders to the promoters.

In addition, similar to the case of Rain Enterprises Private Ltd (REPL) shared above where the transactions with REPL of 2017 are present in the 2018 annual report; however, they were absent in the 2017 annual report. In the case of ALPL, an investor notices that the transactions between Arunachala Logistics Private Limited (ALPL) and Rain Industries Ltd in 2016 are present in the 2017 annual report, but they are absent in the 2016 annual report. In fact, the 2016 annual report does not even mention ALPL as a related party.

2017 annual report, page 299:

The 2016 annual report does not mention the name of Arunachala Logistics Private Limited (ALPL) as a related party.

2016 annual report, page 187:

An investor may think that in 2016, Rain Enterprises Ltd might have business dealings with ALPL but it might not be a related party in 2016. This can be because the promoters might have acquired the company only in 2017. As a result, ALPL might have become a related party in 2017 only. Nevertheless, while preparing the 2017 annual report, the company might have disclosed its dealings with ALPL in 2016 even though it was not a related party in 2016.

This can be one of the possibilities. However, when an investor tries to find more data about Arunachala Logistics Private Limited (ALPL), then she notices that the directors of the company are two persons with the Reddy surname and they are directors of ALPL since 2000 and 2002 respectively. (Source: Zaubacorp Corporate Database)

An investor would appreciate that if someone purchases/takes over a company, then the usual first step is to change the directors in control to bring in herself or her own people as directors. Since the current directors of ALPL are in the position since 2000 and 2002; therefore, it is unlikely that ALPL underwent an ownership change in 2017.

Investors may do their own due diligence in this regard or contact the company for clarifications.

This is important because if in the subsequent annual reports, an investor finds related party transactions related to previous years, which are not disclosed in previous annual reports, then she would always be sceptical about relying on the data presented by the company in its annual reports. Say, while reading the 2019 annual report, the investor would always feel that the data in 2019 may not be the complete data and the 2020 annual report to be published next year may disclose transactions belonging to the year 2019, with some related parties that are not disclosed in 2019 annual report currently.

c) Rain Entertainments Private Limited (REPL)

While analysing the past annual reports, an investor notices that Rain Industries Ltd had transactions with a promoter-owned entity, Rain Entertainments Private Limited (REPL).

An investor notices that in 2012, Rain Industries Ltd had given an advance of ₹10 cr to purchase raw materials to REPL and then in 2013, it gave an additional advance of ₹19.9 cr to REPL for purchasing raw materials.

2013 annual report, pages 121-122:

The amount receivable by Rain Industries Ltd from Rain Entertainments Private Limited (REPL) increased to ₹123 cr in 2014.

2014 annual report, page 158:

When an investor tries to find out more information about the business activity of Rain Entertainments Private Limited (REPL), then she is not able to find a lot of information about the company on the internet except an expired job posting by the company on job portal “Naukri” for the position of “Cinema Project Operator”.

If Rain Entertainments Private Limited (REPL) is a company that runs cinema screens, then an investor is left confused about the nature of the raw material that Rain Industries Ltd is buying from REPL.

An investor may do her own further due diligence and contact the company directly for any more clarifications.

Further advised reading: How Promoters benefit themselves using Related Party Transactions

6) Frequent disruptions in plants of advanced materials/chemical division of Rain Industries Ltd:

While reading the past annual reports and other company disclosures, an investor notices that the manufacturing plants of the advanced materials (previously called chemicals) division face disruptions frequently.

In the 2017 annual report, Rain Industries Ltd intimated to its shareholders that the performance of the chemicals division suffered due to “unplanned shutdowns”.

2017 annual report, page 109:

During CY 2017, our Chemicals business segment generated ₹ 17.9 billion in net revenue, an increase of 5.3% as compared to ₹ 17.0 billion during CY 2016.….Despite increase in revenue, the Adjusted Operating Margin decreased from 14.7% to 7.5% due to increases in operating expenses and raw material prices coupled with unplanned shutdowns.

The plants of this division, now reorganized as “Advanced Material” faced “unplanned shutdowns” in 2018 as well.

2018 annual report, page 124:

During CY2018, our Advanced Materials business segment generated ₹ 34.8 billion in net revenue, an increase of 8.8% as compared to ₹ 32.0 billion during CY2017.……The adjusted operating margin decreased from 16.8% in CY2017 to 10.9% in CY2018 due to an increase in operating expenses and raw material prices, coupled with unplanned shutdowns.

The advanced material division again faced “unplanned shutdowns” in 2019.

2019 annual report, page 152:

During CY2019, our Advanced Materials business segment generated ₹ 31.3 billion in net revenue, a decrease of 10.0% as compared to ₹ 34.8 billion during CY2018.……..The operating margin decreased from 11.5% in CY2018 to 9.9% in CY2019 due to an increase in operating expenses and raw material prices, coupled with unplanned shutdowns.

Even in Q1-2020, the Naphthalene derivatives plant (a part of the advanced materials business division) faced disruptions.

May 2020 conference call transcript, page 4:

Naphthalene derivates also saw lower sales during this quarter and were impacted by disruptions in our system due to electrical outages that resulted in several days of loss production at phthalic anhydride plant.

Looking at the frequent disruptions year after year at the advanced material plant, which results in production loss and hampers the business output, an investor starts to question the quality of the assets bought by Rain Industries Ltd when it purchased Rutgers Group in 2013. This is because the company entered into the chemicals business (later reorganised into the advanced materials division) after it had purchased Rutgers in 2013.

2013 annual report, page 19:

The Group has entered into the Chemical Business through the acquisition of RÜTGERS effective from January 4, 2013.

We believe that going ahead; an investor should keep a close watch on the disruptions or “unplanned shutdowns” faced by Rain Industries Ltd.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

7) Curious case of Rain Industries Ltd increasing cement capacity when the utilization levels are very low:

An investor would notice that in a fair market, any manufacturer put in additional investment to increase the capacity of its plants when it achieves high utilization levels in the plant. If the utilization levels of the plant are low, then it indicates a situation of oversupply and in such a case, putting more money in the plant may not be a good decision.

Even in the case of Rain Industries Ltd, an investor notices that during the business down cycles, the company closed its unviable facilities that had low capacity utilization. An investor would remember from the above discussion that the company refused to put additional investments in one of its USA facilities and China facility when new environmental regulations demanded that it should put more money in these plants to make them relevant for the new laws.

The company decided that its capacity utilization was low and the huge amount of investment did not make economic sense.

2014 annual report, page 9:

Effective January 1, 2014, Rain Group closed the Calcining facility in Moundsville – West Virginia, USA. This site has been slated for closure brought on by the impact of new and more stringent regulations by the Environmental Protection Agency, USA. These regulatory challenges would require a level of investment exceeding US$ 50 million on a plant that has been operating at less than 50% capacity since 2008, which is not economically feasible.

However, when an investor analyses the cement business of Rain Industries Ltd, then she notices that the company has started expanding the capacity of the cement business even when the capacity utilization of the cement business is only about 60%.

In the 2019 annual report on page 153, Rain Industries Ltd intimated to its shareholders that the cement business of the company has had a low utilization over the years. In 2019, the capacity utilization was 62% whereas it was 56% in 2018.

The Cement business segment operated at an improved average capacity utilization of approximately 62% during CY2019 compared to approximately 56% in CY2018.

In light of such low capacity utilization, it comes as a surprise to the investor when she notices that the company has announced an expansion of cement manufacturing capacity at its Kurnool plant.

2019 annual report, page 29:

We have initiated an upgrade of the line 1 cement mill at the Kurnool plant, which will facilitate an increase in production from 50 tonnes per hour to 155 tonnes per hour.

This expansion plan comes as a surprise to the investor because, in a fair market scenario, a company will make investments in any plant only when it is running at near full capacity. In the case of plants where the capacity utilization is low like 55%-60%, then the manufacturers attempt to first fully utilize the existing manufacturing capacity before they put more money in the plant towards expansion.

However, when an investor reads more about the cement industry and its continuous history of capacity expansions while its capacity utilization has been low for the entire last decade, then she realises that somehow, fair market principles do not work for the cement industry.

Upon further reading about the cement industry, the investor gets to know that the cement industry has acted like a cartel that deliberately kept the capacity utilization low to create an artificial scarcity of cement in order to increase prices and earn higher profits.

The failure of normal market forces of supply and demand and their impact on the price of cement was noticed many years back by the Builder Association of India (BAI), which primarily consisted of the consumers of the cement industry. BAI noticed that despite significant underutilized capacity, the cement manufacturers are not producing cement in sufficient quantities. As a result, there was an artificial shortage situation for cement in the market, which led to an increase in the price of cement.

Therefore, the BAI complained against the cement industry to the Competition Commission of India (CCI) about the cement manufacturers acting as a cartel by producing a lower amount of cement and keeping the prices higher. CCI asked the Director General (DG) to conduct an investigation. After the investigation, CCI found that indeed, the cement manufacturers were coordinating with each other to restrict supply and keep the prices higher.

As a result, CCI held the cement companies guilty of acting in collaboration with each other to distort the market and in turn hurting the consumers, the market, and the economy. CCI put a steep penalty of about ₹6,700 cr on various cement manufacturers as well as their industry body, Cement Manufacturers’ Association (CMA). CMA was held guilty of providing the platform where the cement players met and coordinated their production and pricing strategies in order to keep the prices higher.

Competition Commission of India’s order on the Cement Manufacturers:

The CCI order on August 31, 2016, downloadable from the CCI website (click here) is very interesting reading. We have incorporated the key aspects from the order below, as the order is a very important resource to understand the cement industry and its dynamics.

Key aspects of the complaint by the Builders’ Association of India (BAI):

• Page 10: Cement manufacturing units had deliberately reduced their production and produced much less than their installed capacity to create an artificial scarcity and raise the prices of cement in order to earn abnormal profits.

Key findings of the investigation conducted by the Director General (DG)

• Page 22: The nature of product being almost homogeneous in nature facilitates oligopolistic pricing. Further, the cement industry has witnessed a lot of consolidation and concentration of market in the last decade. However, in terms of market power, none of the companies has the strength to operate independently. The DG has submitted that the price of cement charged by all the companies is not at competitive levels and the cement manufacturers have been operating at a profit margin of more than 25%.
• Page 22: there has been a continuous divergence between the cement price index and the index price of various inputs like coal, electricity and crude petroleum and the gap has widened since 2000-01. The price of cement is rising faster than input prices.
• Page 23: It has been noted by the DG that the price of cement has been on rise since 2004-05 from about Rs.150/- per bag to close to Rs.300/- in March 2011, whereas during the same period, the cost of sales has only increased about 30%. As such, the price of cement has been independent of the cost of sales. The price of cement is changed frequently by all the companies. Sometimes, the price changes are made twice a week.
• Page 27: The Opposite Parties were not able to substantiate reasons for low capacity utilisation even during the period when the demand was high.
• Page 27: According to the DG, reduction in capacity utilisation is not in line with the overall growth of Indian Economy. Further, as far as consumption is concerned, whatever is produced by the cement manufacturers is consumed in the market. Therefore, the argument of cement manufacturers that the capacity utilisation has been lower in recent years because of low demand is not tenable.
• Page 29: Hence, the DG has concluded that the reduction in capacity utilisation during 2009-10 and 2010-11 was deliberate in order to limit the supply of cement in a concerted manner to charge a higher price.
• The DG, during the investigation found instances where the prices of cement were increased after the cement manufacturers met in their industry body (CMA) meetings. Page 106:

Key parts of the order by CCI:

• Page 144: The Commission notes that evidently the growth rate in production lagged substantially in 2010-11 as against the growth rate of capacity additions. Installed capacity witnessed an increase in growth rate by 16.06%, but the production grew marginally by 2.85% only. In comparison, in the year 2009-10, the growth rate in capacity addition was 19.80% and growth rate in production was 12.87%.
• Page 151: From the data tabulated above, it is evident that during November 2010, all the cement companies including the Opposite Parties had reduced production, although in 2009, in some cases, there was drop in production and in many cases there was increase also.
• Page 161: The Commission further observes that the third and fourth quarter of 2010-11 witnessed a GDP growth rate of 8.3% and 7.8% at factor cost respectively and the construction industry witnessed a growth of 9.7% and 8.2% in Q3 and Q4 of 2010-11 respectively. However, the cement industry registered a negative growth rate of 5.43% and 3.41% in cement production in November and December of 2010-11, respectively.
• Page 161: Thus, the Commission observes that the cement companies reduced production and dispatches of cement in a period when the demand from the construction sector was positive during November and December, 2010 and thereafter raised prices in the months of January and February, 2011,
• Page 161: Thus, it is evident that the cement companies have been limiting and controlling supply in periods just before the peak demand season to create artificial scarcity in the market in order to sell cement at higher prices in the peak season.

As a result, the CCI observed that:

• Page 175: The Commission notes that the impugned action of the Opposite Parties was not only detrimental to the interests of the consumers but the Opposite Parties also earned huge profit margins by acting in concert and co-ordination upon prices, production and supplies. Such conduct deprives not only the consumers but the economy also from exploiting the optimal capacity utilisation and thereby reducing prices. Further, the act of the Opposite Parties is also detrimental to the whole economy since cement is a critical input in construction and infrastructure industry vital for economic development of the country.

From the above order of CCI on the cartelization of the cement industry, an investor notices that:

• The cement manufacturers reduced production even when there was a demand. After all, whatever they were producing was getting completely sold in the market.
• Cement manufacturers reduced cement production even at times when the India GDP as well as the construction industry was growing at a fast pace.

The cement companies appealed against the CCI order in National Company Law Appellate Tribunal (NCLAT). However, the NCLAT dismissed their appeal in July 2018. (Source: Cement firms lose cartel case: The Telegraph).

Currently, the cement companies have appealed against the CCI order in the Supreme Court of India (Source: SC stays CCI penalty of ₹6300 crore on cement firms: Livemint)

Investors would notice that the CCI order explains the unique situation observed in the cement industry where there was continuously a low capacity utilization. However, still, the cement manufacturers were adding new capacities. This goes against the normal market behaviour where any company first attempts to utilize its existing manufacturing capacities fully before it puts up a new manufacturing plant.

Therefore, while assessing the future of the cement business of Rain Industries Ltd, an investor should keep in mind the above action taken by regulators on the cement players. In case, the Supreme Court of India upholds the CCI order and the cement industry starts following the fair market principles, then it is expected that the capacity utilization of the cement industry will go up and it may lead to a decline in the price. This, in turn, can bring down the profitability of the cement manufacturers.

To understand more about the dynamics of the cement industry in India, an investor may read the following article: Analysis: Heidelberg Cement India Ltd

8) Environmental impacts of business of Rain Industries Ltd:

While reading the annual reports of the company, an investor comes across multiple instances where Rain Industries Ltd has highlighted that it focuses a lot on the preservation and protection of the environment while running its manufacturing operations. The company has repeatedly highlighted that it has taken initiatives that have led to its plants becoming the most environment-friendly plants of its kind in the world.

2019 annual report, page 11:

In addition to making the shaft calciner the most environment-friendly plant of its kind in the world, the liquid-ammonia scrubbing system will convert the gases into ammonium sulphate, which will be supplied to Indian farmers as fertiliser.

An investor may note that the company may be absolutely right in its claims that its plants are the most environmentally friendly in the world and it is making a lot of effort and investments to preserve and protect the environment from its manufacturing operation. However, still, the process of converting GPC into CPC and converting coal tar into coal tar pitch (CTP) is a pollution causing activity.

Over time, the company has faced many lawsuits in the localities of its plants that the company’s operations have damaged the environment.

In the 2016 annual report, page 182, Rain Industry Ltd disclosed that in the USA a case has been filed against the company alleging that its manufacturing operations have caused “bodily injury and property damage”.

One of the Group company in United States, along with other co-defendants, is involved in mass tort lawsuits whereby plaintiffs, in different cases, allege bodily injury and property damage caused by alleged exposure to by-products from the calcining process at the Moundsville facility.

In the 2018 annual report, on page 289, the company disclosed that a case has been filed against the company in Minnesota alleging that its manufacturing operations have contaminated the storm-water-drainage ponds of the locality.

During December 2018, several Group Companies, along with four other third party defendants, was named in a lawsuit filed in federal court in Minnesota.The Plaintiffs, comprised of 9 municipalities in the Minneapolis and St. Paul metropolitan area, and sought a court order directing the defendants to remove sediment contaminated with Polycyclic Aromatic Hydrocarbons (PAHs) from their municipal storm water drainage ponds which they claimed was caused by runoff from the defendants’ products.

Again, in the 2018 annual report, page 289, the company disclosed that in Canada, the manufacturing operations of the company led to “product discharge and release of vapour emissions” that might have damaged the environment. Currently, an investigation by the Environment Ministry of Canada against the company is underway and it may face fines and penalties in future.

One of the Group Companies in Canada may face certain fines or penalties under Section 14 of the Environmental Protection Act arising from an investigation by the Ministry of the Environment, Conservation and Parks into incidents involving product discharge and release of vapor emissions at one of our facilities during 2017.

In the 2019 annual report, page 308, Rain Industries Ltd intimated the shareholders that during the year in Canada, the company had two instances of product spills and the Ontario Ministry of Environment Conservation and Parks (MECP) is investigating these product spills along with an allegation of improper disposal of hazardous wastes from its distillation plant.

The MECP has initiated separate investigations related to two separate product spills and the alleged improper disposal of hazardous waste that occurred in connection with activities undertaken at the Group’s distillation facility in Ontario, Canada on or about July 29, 2019 and December 17, 2019, respectively.

Further advised reading: Understanding the Annual Report of a Company

An investor would appreciate that the concerns related to the impact of manufacturing plants on the environment demand special attention. This is because there have been numerous instances where the manufacturing plants that damaged the environment has been ordered to shut down by the authorities.

An investor would remember the case of Graphite India Ltd, which manufactured graphite electrodes from needle pet coke at its facility in Whitefield, Bengaluru. The facility was ordered to shut down by the authorities in April 2019 as it caused environmental pollution. (Source: Graphite plant shut, Whitefield breathes easy: Economic Times)

In another such incident, the largest copper manufacturing plant in India by Vedanta’s Sterlite Copper in Tuticorin, Tamil Nadu was shut down in May 2018. It was claimed that the plant polluted the environment and as a result, the local population started protesting against the operations of the plant. The protest escalated to such an extent that the police had to open fire and as a result, 13 protestors lost their lives. (Source: Tuticorin protest: Tamil Nadu government orders permanent closure of Sterlite plant: Economic Times)

Therefore, while assessing the companies whose manufacturing processes cause pollution of the environment, an investor should be extra cautious. This is because, all of a sudden, the investor may wake up to the news that the plant’s operations are shut down as the local people realised that the plant is affecting their health.

In addition, environment-conscious governments keep on making the environmental regulations tighter that demand additional investments by the companies to make their manufacturing processes environment-friendly. Many times, these additional investments make the operations of the plant economically unviable and the company may have to shut down the operations of its plants.

In the past, Rain Industries Ltd has faced such situations where it had to close one of its plants in the USA and another plant in China as it could not meet the new stricter environmental regulations.

In 2014, Rain Industries Ltd shut down one of its manufacturing facilities in the USA.

2014 annual report, page 9:

Effective January 1, 2014, Rain Group closed the Calcining facility in Moundsville – West Virginia, USA. This site has been slated for closure brought on by the impact of new and more stringent regulations by the Environmental Protection Agency, USA. These regulatory challenges would require a level of investment exceeding US$ 50 million on a plant that has been operating at less than 50% capacity since 2008, which is not economically feasible.

In 2015, the company closed its manufacturing facility in China.

2014 annual report, page 8:

Effective January 1, 2015, Rain Group closed the 20,000 Tons capacity Vertical Shaft Calcining Petroleum Coke (“CPC”) plant in China due to new Environmental regulations applicable from January 2015 which would require additional investment.

Moreover, the current restrictions imposed by India on the import of green pet coke (GPC) and calcined pet coke (CPC) in the country are due to harmful impacts of pet coke processing on the environment.

Therefore, investors need to be cautious in their due diligence of the companies that have manufacturing processes affecting the environment. This becomes especially important when the manufacturing operations of the company are based in countries where the penalties for any harm caused to the people or the environment may reach very high levels.

While reading the 2017 annual report of Rain Industries Ltd, an investor notices that one of the employees of a contractor of the company suffered a leg injury while working. Thereafter, the employee claimed damages of about ₹12.8 cr. The amount of damages claimed is very high when compared to the compensation paid in India by companies and govt. to people who sustain bodily injuries at work or in accidents.

2017 annual report, page 308:

In February 2016, an employee of a Contractor responsible for securing barges at a facility of a Group Company in the United States allegedly suffered a leg injury while attempting to secure a barge. The employee is claiming damages of approximately USD 2 million (INR 127.86).

Therefore, an investor should be aware of the extent to which a company’s operations can be impacted if its operations affect the local people and the environment.

9) Acquisition of Tarlog GmbH by Rain Industries Ltd; a case of throwing good money after bad money?

In the 2017 annual report, an investor notices that Rain Industries Ltd increased its stake in Tarlog GmbH from earlier 50% to now 100%.

2017 annual report, page 300:

Tarlog GmbH is a 50% owned which is involved in logistic services located in Germany. On July 1, 2017, the Group acquired the balance 50% resulting to 100% subsidiary for a consideration of INR 7.62

(Please note that the monetary amounts mentioned in the disclosure above are in ₹ millions.)

However, while reading the previous annual reports, an investor notices that even before the increase in stake from 50% to 100% in 2017, Rain Industries Ltd in the previous years, had already written down its entire 50% investment in Tarlog GmbH, due to its poor existing performance as well as its expected poor performance in the future as well.

2016 annual report, page 176:

Therefore, acquiring a 100% stake in a business where one has already written down its existing 50% investment looks like throwing good money after bad money. When Rain Industries Ltd already knew that the business of Tarlog GmbH is very poor, then its decision to put more money to buy out the other partner holding the balance 50% stake seems more like a bailout to the other counterparty.

In addition, an investor notices from the above section from the 2016 annual report that the amount of “Aggregate provision for diminution in value of investments” is mentioned as ₹3.45 million, which is the amount of investment of Rain Industries Ltd for its existing 50% stake in Tarlog GmbH. However, when the investor reads the amount paid by Rain Industries Ltd to acquire the balance 50% stake, then she notices that the company paid ₹7.62 million to the other counterparty. It looks like Rain Industries Ltd paid more than its own investment’s worth to the other counterparty to buy it out.

Nevertheless, in the next year, 2018, the entire investment; the ₹3.45 million relating to the existing 50% stake of Rain Industries Ltd in Tarlog GmbH as well as the additional ₹7.62 million put in by the company to acquire the balance 50% in 2017 is written down to zero.

2018 annual report, page 236:

Looking at the above data, it appears to an investor that the acquisition of the balance 50% stake by Rain Industries Ltd in Tarlog GmbH looks like throwing good money after bad money when it had already written down its existing 50% stake due to poor existing business performance as well as poor expected business performance in future.

Advised reading: How to identify if Management is Misallocating Capital

10) Strange incident where a contractor of Rain Industries Ltd had to file a lawsuit to recover its dues:

While reading the 2015 annual report, an investor comes to know about an incident where one of the contractors of Rain Industries Ltd who had worked on the waste heat recovery power plant of the company in the USA had to file a case against the company to recover its dues. It seems that the court upheld the claim of the contractor and ordered the company to pay the contractor. Thereafter, the company entered into a settlement with the contractor and paid the dues of about ₹42 cr.

2015 annual report, page 168:

Exceptional items include loss on Litigation settlement by US subsidiary of R. 428.80. The subsidiary was a defendant in a law suit regarding capital works carried out by one of the EPC contractor for construction of a waste heat recovery power generation unit (“Unit”) in Calcasieu Parish, Louisiana. During the year, the said subsidiary received an adverse order for claim of damages and penalties to be paid by the Subsidiary to the contractor. On February 4, 2016, the parties entered into a confidential settlement agreement to fully and finally resolve this dispute.

When an investor comes across such cases where the suppliers have to raise court cases against any company to recover their legitimate dues, then it does not reflect well on the reputation of the company as well as its corporate culture. An investor may note that the dues seem legitimate, as Rain Industries Ltd did not file any appeal in any higher court of law against the said “adverse order”, which it might have done if it had felt that the demand is non-genuine. In addition, an investor would note that the amount under dispute of about ₹42 cr is not a small amount to let go if the company feels that the decision of the lower court of law is not correct.

11) Loans & advances, inter-corporate deposits to “others” by Rain Industries Ltd:

While reading the annual reports of the company, an investor comes to know about instances where Rain Industries Ltd has given significant amounts of money to “others”, which is not classified under advance to suppliers, capital advance etc.

In 2014, the amount of such advances was about ₹75 cr and in 2015, it was about ₹44 cr.

2015 annual report, page 153:

In the past as well, Rain Industries Ltd had provided advances of ₹60 cr to “others” in 2010 and 2011.

2011 annual report, page 92:

Looking at these loans & advances of significant size, which do not seem like advances to suppliers, customers and govt. authorities etc., an investor wishes to know the details of the counterparties who are benefiting from the economic value of these loans, which ideally belongs to the shareholders of Rain Industries Ltd.

Going ahead, an investor should keep a close watch on such loans and advances in the financial statements of the companies and for any clarification contact the company directly for more details. This is because there have been instances in the corporate world where such loans and advances to “others” have turned out to be loans to friends & family and those entities that are not classified as related parties as per the definition of the law.

The Margin of Safety in the market price of Rain Industries Ltd:

Currently (June 14, 2020), Rain Industries Ltd is available at a price to earnings (PE) ratio of about 5.79 based on the last four quarters’ consolidated earnings from April 2019 to March 2020.

However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, taking into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.

In the absence of any strength in the business model of the company, even a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.

• Further advised reading: 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
• Read: How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
• Further advised reading: Hidden Risk of Investing in High P/E Stocks

Analysis Summary

Overall, Rain Industries Ltd seems a company that has been growing its business at about 10-15% year on year for the last 10 years (2010-2019). However, the business performance of the company over this period has been cyclical, alternating between good periods and poor performance periods. The company witnessed an upcycle during 2010-2011, which was followed by a long period of subdued performance until 2015. Thereafter, the company witnessed another uptrend, which reached its peak in 2017. Thereafter, the performance of the company has again come down until now in 2020.

At the customers’ end, the business performance of the company is closely linked with the phases of the aluminium industry whereas, at the raw material end, the business performance of the company is dependent on steel manufacturing and crude oil refining industries. The other industries that affect the demand for products of Rain Industries Ltd are housing, construction, infrastructure, and automobiles etc. All these industries behave cyclical in their performance due to their dependence on general economic activities. As a result, the business performance of Rain Industries Ltd has also followed the cyclical patterns of good performance and poor performance periods.

The company faces oversupply in most of its product segments along with intense competition from countries like China in other segments. As a result, the impact of down cycles of the industry in the form of lower demand and low profitability margins have a significant impact on the company. At times, it had to cut down the production and even permanently close down its poorly performing plants.

The business of Rain Industries Ltd is capital-intensive with low-profit margins. As a result, to generate any growth, the company has to rely on debt/external sources of funds because its internal return generation ability is low.

Over the years, the company has achieved significant growth in its business size by acquiring the world’s second-largest CPC manufacturer (CII Carbon) in 2007 and the world’s second-largest CTP manufacturer (Rutgers) in 2013. Both these acquisitions were debt-funded. As a result, Rain Industries Ltd has witnessed its total debt increase significantly. However, the company is relying on refinancing as a strategy to meet its debt repayments, which looks like a risky strategy because any event leading to a freeze in credit markets when its repayment of existing debt is due, can push the company to the brink of survival. In addition, if the interest rates increase, then the interest expense would consume its already low-profit margin.

The business landscape of Rain Industries Ltd is tough where the shareholders of even the world’s largest manufacturers of CPC and CTP had to sell their companies or close their manufacturing facilities (e.g. Koppers). At times, many of the customers of Rain Industries Ltd go bankrupt, close down their plants, or reduce production in operating plants in order to survive the down phases of commodity business cycles.

The corporate structure of Rain Industries Ltd is very complex and as a result, frequently, the auditors are not able to complete the audit of its subsidiaries by the time its consolidated financial statements are published. As a result, frequently, the consolidated financial statements include unaudited financial statements of many subsidiaries. This might be one of the reasons that at times an investor notices that some of the transactions with the related parties in a year (e.g. 2017), which are presented in the subsequent annual reports (say 2018 annual report) as a part of the previous years (2017’s) records are not found in the annual report of the previous year (2017).

In addition, it seems that due to the complex corporate structure of numerous subsidiaries, the management is not able to provide details of many of its corporate decisions. As a result, frequently, an investor notices that the company has purchased stakes in some subsidiaries, sold a stake in others, reduced shareholding in other subsidiaries etc. about which the annual report does not provide any meaningful explanation. As a result, the investor is left to make her own interpretations of such corporate decisions.

At one such occasion, the company raised compulsorily convertible cumulative debentures (CCCDs) of 20 years duration in one of its subsidiaries, which were subsumed into “other equity” on the transition to the new Indian Accounting Standards (IndAS). However, the investor is not able to extract any meaningful information from the annual reports like which subsidiary had raised these compulsorily convertible cumulative debentures (CCCDs) or who was the counterparty that had subscribed to them and what is their status now.

While reading the annual reports, an investor notices many transactions with the promoter owned entities (related parties), where an investor needs to do additional due diligence like payment of advances to a company, Rain Entertainments Pvt. Ltd, which supposedly runs cinema screens. Other related party transactions like large advances and their refunds with Rain Enterprises Pvt. Ltd seems like money given to the related party to meet its short-term funds’ requirements.

The plants acquired by Rain Industries Ltd while taking over the Rutgers Group, which led the company to enter into the chemicals/advanced materials business, seem to face disruptions year after year. It questions the quality of the assets purchased by the company from Rutgers. In addition, over the years, the company has faced many lawsuits and investigations regarding the damage to the environment done by its plants in terms of product spills, improper disposal of hazardous waste, damage to stormwater drainage, bodily injury and property damage etc. in the USA and Canada. An investor should keep a close watch on developments related to these environmental matters because there have been numerous instances of local authorities closing down those manufacturing plants that damage the environment.

While assessing the capital allocation decisions of the management, an investor comes across an instance where the company purchased an additional stake in a company where it had already written off its own existing investment due to poor business performance and poor future prospects of its business. Such instances look like throwing good money after bad money or an attempt to bail out the other counterparties by buying them out in a poorly performing business.

An investor also comes across an instance where a contractor that had worked on one of the projects of the company had to resort to a lawsuit in order to recover its due, which the company paid after a court order. In other instances, an investor notices that the company had paid large loans and advances to “others” who do not qualify as suppliers or customers or govt. authorities. Due to these instances, it becomes essential that an investor keep a close watch on the fund flow in the company to assess where the money is coming from and where it is going.

Going ahead, an investor should keep a close watch on the sales & profit margins of the company to assess the phase of the industry cycle it is in. In addition, the investor should focus on the debt levels of the company, its interest costs and ascertain whether the company is able to refinance its debt at the time of need. Moreover, the investor should monitor the related party transactions as well as loans & advances to “others”. In addition, the investor should keep a track of the developments on the lawsuits and investigations related to the alleged environmental issues damages done by the plants of the company.

Further advised reading: How to Monitor Stocks in your Portfolio

These are our views on Rain Industries Ltd. However, investors should do their own analysis before making any investment-related decisions about the company.

You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks”

I hope it helps!

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.