This article provides in-depth fundamental analysis of Finolex Industries Ltd, a leading Indian manufacturer of PVC pipes & fittings and PVC resin.
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.
Finolex Industries Ltd Research Report by Reader
Introduction:
Finolex Industries Ltd (FIL) was incorporated in 1981 as a PVC pipe manufacturer. It backward integrated in 1994 and now also manufactures PVC resins at its plant in Ratnagiri. Furthermore, the in-house group consumption of PVC is a distinct advantage enjoyed by FIL.
FIL is the second-largest player in the PVC resin market, and the largest manufacturer of PVC pipes in India. The company has three manufacturing facilities, one each in Pune and Ratnagiri (both in Maharashtra), and Masar, near Vadodara in Gujarat.
Metric Analysis of Finolex Industries Ltd:
Finolex Industries is growing its sales at CAGR of 8.5% in last 10 year, although growth has slowed down to CAGR 6.8% in last 3 years. As per management, a slowdown in realization in value terms is low in recent years because the price of PVC has come down in that period. The volume growth between FY15 and FY17 is 2% CAGR and volume growth between FY11 and FY17 is 7% CAGR.
Looking at the SSGR (self-sustainable growth rate) of the company, we will notice that it is negative, but the company is growing its sales. Due to this, the company’s debt has increased from Rs 691 cr. in FY08 to Rs 1042 cr. in FY12. After FY12, the company has reduced its debt to Rs 94.2 cr. in FY17. In that period, SSGR has also increased to 6.42% in FY17.
Looking at the low SSGR and comparatively higher sales growth rate gives us the impression that the debt should increase. However, when we adjust the SSGR for cash flow to net profit ratio we find that SSGR is actually higher than sales growth rate in the last two-year period. A major part of the debt is reduced in that period. From FY12 to FY15 company has reduced its debt and funded its growth from cash and investment present in its balance sheet. Cash and investment reduced from Rs 522 cr. in FY12 to Rs 191 cr in FY15.
Finolex Industries Ltd’s OPM (operating profit margin) is dependent on PVC/EDC spread as company purchases EDC as raw material and sells PVC as a product. EDC and PVC are by-products of crude oil but their price is not directly related to crude oil. However, a sudden move in crude oil price (higher or lower direction) can have a huge effect on PVC/EDC prices and thus in company’s margin.
The effect of sudden crude oil movement can be seen from OPM in FY 09 and FY 15 of the company. The company incurred losses in the third quarter of FY 09 and in the third quarter of FY15. Apart from these shortly lived glitches, the company’s OPM is continuously improving year on year. Going forward management believes this margin will improve further as the share of pipes and fitting in total sales will increase.
Over the years, Finolex Industries Ltd has a tax payout ratio of about 32%, which is in line with the corporate tax of India.
Cumulative cash flow from operation in 10 years (cCFO) is Rs 2244.8 cr. and cumulative net profit in 10 years (cNP) is Rs 1272 cr. This shows that the company is getting all the profit that it is showing in P/L statement as cash flow and profits are not stuck as working capital.
Calculating the free cash flow of the company by subtracting capex and total interest from cCFO gives us free cash flow of 1583 cr. The free cash flow the company has used to pay dividend of Rs 341.2 cr. in last 10 years and reduce its debt from Rs 691 cr. in FY 08 to Rs 94 cr. in FY 17.
In the working capital management of Finolex Industries Ltd, receivable days have reduced from 15.35 days in 2008 to 4.28 days in 2017. The inventory days are constant between 100 days and 90 days over the years.
The low value of the company’s receivable days is due to cash and carry model followed by the company. Recently the company has started 30 days credit to dealers for CPVC products, but since the share of CPVC products in total sales is very less, it will not have much effect in receivable days of the company.
Inventory days of the company are continuously high because of stocking up of inventory during monsoon season. The company sources raw material from a jetty near Ratnagiri plant, which remains closed for 3-4 months during monsoon season. To fulfill the demand during that period company has to stock up its inventory before every monsoon season.
Finolex Industries Ltd has created Pawas Port Ltd. to convert this jetty into all season port in November 2007 but until date, management has failed to generate any result in this direction. The stocking of inventory with raw material makes the company vulnerable to raw material fluctuations. This vulnerability can be seen in the results of FY09 and FY 15.
Net fixed asset turnover ratio (NFAT) of Finolex Industries Ltd has improved from 2.66 FY 08 to 3.51 in FY 17. NFAT implies the amount of sales the company generates per rupee spent on fixed asset. Therefore, a higher value of NFAT implies better efficiency in the company. In the future also, we can expect further improvement in NFAT as the sales of pipes and fitting increases.
Return of capital employed (ROCE) of the company has increased from 7% in FY 11 to 20% in FY 17. ROCE is important because it is one of the input parameters in any company valuation. Company with higher ROCE generally trades at higher P/E ratio. Going forward ROCE is expected to improve for the company as the percentage of pipes and fittings in total sales increases. As ROCE improves for the company, re-rating to higher P/E ratio is less likely because of the continuing risk of inventory loss.
Debt to equity ratio stands at 0.04 and interest coverage ratio in excess of 29. This makes company safe in term of credit risk.
Fund Flow Analysis of Finolex Industries Ltd:
Fund flow analysis provides a better picture of which part of the company’s balance sheet the cash generated by the company over the years are going. This provides a picture of whether the company is growing its balance sheet because of increased shareholder equity or because of liabilities. We can see that the liability side of the company’s balance sheet is increasing because of shareholder equity over the years.
Looking at the liability side of the balance sheet, we find that the liability side has mainly increased because of increase in shareholder’s equity and non-current liability. The shareholder’s equity has increased from the net profit generated in this year. The non-current liabilities have increased because of increase in differed tax and others. Others section has increased because of increase in government grant (~61.34 cr.).
The asset side of the balance sheet has increased because of increase in non-current investment and working capital (inventories and receivable).
As per management commentary, after demonetization dealers’ demand has reduced that has resulted in higher finished goods in inventory. Management expects that the demand will pick up in FY18. The receivables have increased because the company has started giving 30 days credit for CPVC pipes to push the new product in the market. The non-current investment of the company is divided into three categories:
- Fair Value through other comprehensive income (FVOCI),
- Fair value through profit and loss (FVTPL), and
- Investment carried at cost.
The FVOCI include investment in Finolex Cables (~1146 cr.) and Finolex Infrastructure Ltd. (~8.6cr.). The increment in non-current investment in FY17 was mostly because of increment in market value of Finolex Cables (~522cr.). The FVTPL include investment in Gulf Oil Corporation (~ 35 lakh), Gold crest corporation ltd (~4.3 lakh), Sarawat Co-operative bank ltd (~.1 lakh) and Peninsula realty fund (~2.8cr). The investments carried at cost include Finolex Plasson Industries (~7.5cr) and Pawas Port Ltd (~5 lakh).
Sales Distribution Analysis of Finolex Industries Ltd:
Finolex Industries Ltd operates broadly in three main segments, PVC, Pipes and fittings, and Power. The company produces PVC resins for captive consumption and excess amounts are sold to the third parties in the open market. The power plant is also for captive consumption only.
In pipes and fittings segment, Finolex Industries Ltd is the market leader in PVC pipes with 20% market share in organized sector sales. In PVC pipes, the market between organized and unorganized sector is 40%-60%.
The company has recently entered into CPVC pipes and fittings segment. CPVC pipes have application in industrial use due to better heat properties. The company’s sales of Pipes and fittings can be segmented into two broad segments as Agri (70%) and non-agri (30%). The management has guided that they have the internal target to make this distribution 50-50 by FY20.
Geographically the company only caters to the domestic market and total exports account for less than 10% of total sales in the current financial year. The company has in 900+ dealers and more than 18000+ sub-dealers all over the country.
In volume terms, Finolex Industries Ltd is increasing its pipes and fittings segment sales at CAGR of 7% since FY11 from 138,322 MT in FY11 to 209,419 MT in FY17. PVC resin production remained almost at the same level over the years, but the percentage of captive consumption has increased with the increase in PVC pipes and fittings sale.
Peer Comparison of Finolex Industries Ltd:
Comparing Finolex Industries Ltd with its peers, we find that the company has sales higher to only Astral Poly, but looking into the sales of others we find that Supreme industries and Jain Irrigation is involved in other plastic businesses making PVC pipes and fittings only part of their sales.
In terms of operating profit margins, Finolex Industries Ltd has recently surpassed all its peers after reporting the higher share of PVC pipes and fittings in total sales. We can also see that FIL has the most fluctuating OPM among the peers due to the inventory risk the company carries during monsoon season. That makes Finolex Industries Ltd more susceptible to raw material price movement.
In terms of return on total capital, Finolex Industries Ltd is second only to Supreme Industries and most fluctuating among the peers. The reason is same as fluctuating margins i.e. inventory loss risk that the company carries.
Further advised reading: How to do Business & Industry Analysis of a Company
Shareholding Pattern of Finolex Industries Ltd:
In the shareholding pattern, higher promoter holding signifies higher confidence of promoters in the company and is considered positive. Higher institution holding and lower retail holding is considered positive for the company as institution money is considered a smart money and stable money.
In case of Finolex Industries Ltd promoter holding is above the desirable level of 50%, which gives us confidence in the company. The institution holding is in general increasing even though quarter on quarter it is fluctuating, that gives positive views towards the company in terms of shareholding pattern.
Credit Report Analysis of Finolex Industries Ltd:
The credit rating for Finolex Industries’ debt instrument is done by CRISIL. CRISIL has given the company “CRISIL AA” rating for the long-term instrument, which is only two points below the highest rating ‘CRISIL AAA’ given by the company. For the short-term instruments, CRISIL has given “CRISIL A1+”, which is the highest rating given by the agency.
As per the agency (CRISIL), the key strengths of Finolex Industries Ltd include established brand in PVC resin and PVC pipes market. The company holds 20% market share in organized PVC market. The company has the highest operating efficiency because it is the only vertically integrated large player in the domestic market. We can see the comparison of OPM in the peer comparison section. The company also have strong financial risk profile with no long-term and short-term debt (the company has paid off the remaining debt in FY18) and no debt funded capes plans.
In the weakness section, CRISIL has mentioned that the company is susceptible to raw material price fluctuation. Profitability of the PVC resin business is volatile due to movements in the international prices of PVC and its raw materials: EDC, ethylene, and VCM. Furthermore, the company imports most of its required raw material for manufacturing PVC resin, exposing it to inventory-related risks.
Management Analysis of Finolex Industries Ltd:
Key management personnel of Finolex Industries Ltd includes Mr. P.P.Chhabria (Executive chairman), son of Mr. Pralhad P. Chhabria (former chairman of finolex industries) and Mr. Anil V. Whabi (Director Finance and CFO).
Mr. Chhabria has been the Executive Chairman of Finolex Industries Ltd since August 11, 2012, and has been its Whole Time Director since December 1, 2006. Mr. Chhabria holds B.Sc in International Business from the University of Evansville USA and Completed Advanced Management Programme at Wharton Business School. (Source: Bloomberg)
Mr. Whabi has been Whole-Time Director of Finolex Industries Ltd since August 26, 2016. Mr. Whabi holds Bachelor of Science from Jai Narain Vyas University.
Looking at the management remunerations as a percentage of net profit, remuneration has reduced recently to 5% of net profit. Before FY17, the remuneration as a percentage was high but still below the allowable limit of 10%. In FY15, the remuneration was especially higher due to a sharp decline in net profit after the company has report loss in Q3 FY15.
Related party transactions conducted by the company over the year are with only associate and subsidiary companies already mentioned in the annual report. No individual or privately owned company not mentioned in other parts of the annual report is involved in related party transactions. This practice provides confidence in management’s fair dealing.
The Company’s board consists of 10 members. Out of 10 members, six are independent, 3 are executive directors and 1 is a nonexecutive director. This is in accordance with the SEBI guidelines.
Points of Caution for Finolex Industries Ltd:
- Finolex Industries Ltd is trying to convert its jetty in Ratnagiri to an all-weather port but has failed to have any progress in that direction. Since the jetty in Ratnagiri remains closed during monsoon season, the company has to fill their inventory for monsoon season, which puts the company into inventory loss due to fluctuation in raw material prices.
- Though it is not clear but it seems the market share of the company is reducing as the company has mentioned 25% market share in FY11 annual report but in FY17 annual report the company has mentioned only 20% market share.
- There is no solid succession plan for management as Mr. Chhabria’s both the daughters are not fully involved with the operations of finolex industries.
Regards,
Manu Agarwal
Dr Vijay Malik’s Response
Hi Manu,
Thanks for sharing the analysis of Finolex Industries Ltd with us! We appreciate the hard work done by you by analysing the past annual reports, credit rating reports, analysing different peers of the company etc. and then sharing the analysis with us. Your analysis would be a good guide for anyone analysing Finolex Industries Ltd.
Let us first try to analyse the financial performance of Finolex Industries Ltd over last 10 years. The company has been publishing standalone financials until FY2015 and from FY2016 onwards, the company has started publishing consolidated financials as well.
We believe that while analysing any company, an investor should always look at the company as a whole. Therefore, she should focus on financials, which represent the business picture of the entire group including operations and assets. As a result, while analysing the past financial performance of the company, we have analysed standalone financials for FY2008-15 and consolidated financials from FY2016 and FY2017.
Financial Analysis of Finolex Industries:
Finolex Industries Ltd has been growing its sales at a moderate pace of 8-10% over last 10 years (FY2008-17). An investor would notice that even though the company has witnessed its profit margins improve over the years as it grew its sales, however, the profit margins have been very volatile.
The operating profit margins (OPM) of the company has improved from 1% in FY2009 to 19% in FY2017. However, during this period, the OPM has changed from 18% in FY2010 to 10% in FY2012 to 13% in FY2014, again declined to 8% in FY2015 and is at a level of 19% in FY2017.
The trend of wildly changing OPM remains true even if we analyse the performance of the company on quarterly intervals. For example, a look at the below chart indicating the OPM for the last 10 quarters (Sept 2015 to Dec 2017) would indicate that the OPM of the company has been very volatile witnessing sharp fluctuations.
An investor would notice that on a quarterly basis, the OPM of the company almost doubled from 11% in Sept 2015 quarter to 22% in Dec 2016 quarter. However, the OPM declined by 50% within next three quarters to 10% in Sept 2017.
Such fluctuating profitability margin pattern indicates that the company lacks pricing power over its customers and as a result, finds it difficult to pass on the increasing raw material costs to its end customers.
This fact is reiterated when an investor analyses the trend of the raw material cost as a percentage of sales over the years:
An investor would notice that the raw material costs as a proportion of sales have been changing from 53% to 73% over the years. This indicates that the company is not able to increase the final product prices to its customers as and when the raw material costs increase and in turn has to take a hit on its profit margins.
An investor would notice from the above discussion on the OPM of the company, that the company witnessed a marked improvement in its profitability (OPM) from FY2009 to FY2017 when its OPM increased from 1% in FY2009 to 19% in FY2017. Ideally, such an improvement in the OPM will indicate that the company is able to charge its customers comparatively higher and as a result, the OPM is increasing.
However, in the above chart, an investor would notice that the raw material costs as a percentage of sales in the year FY2009 and FY2017 are almost the same at 65-66% level whereas, in these years, the company witnessed a marked improvement in the OPM from 1% in FY2009 to 19% in FY2017. Therefore, it becomes evident to the investor that the improvement of OPM from FY2009 to FY2017 is not because of increased pricing power of the company over its customers.
Further advised reading: How to do Financial Analysis of Companies
To understand the key factors, which have led to the improvement of the OPM of the company over FY2009 to FY2017, an investor needs to study each of the components of the operating expenses and their changes over FY2009-17:
After doing the comparative analysis of the operating expenses, an investor would observe that the improvement of 18% in the OPM of Finolex Industries Ltd is primarily because of the improvement in two factors: power & fuel costs and other expenses.
An investor would notice that the power costs as a percentage of sales have declined from 10% in FY2009 to 2% in FY2017 leading to a contribution of 8% in the improvement of the OPM over these years. This is a significant performance in the cost controls by the company. This became possible due to the power plant created by the company.
While reading the previous annual reports of Finolex Industries Ltd, the investor would observe that the company had put up a captive power plant, which it completed in FY2010. The chairperson of the company intimated the same to the shareholders at page 3, FY2010 annual report:
The power plant has been commissioned and is expected to be fully operational during 2010-11.
As a result of the own power plant of the company, very soon its power costs starting declining and the power & fuel costs declined to 4% of sales by FY2013. The company reported the same to its shareholders in its annual report for FY2013, page 7:
In order to ensure continuous high quality power, your Company decided to set up a 43 MW power plant at Ratnagiri. The plant is designed to also take care of the future power requirements of your Company. With the coal prices coming down from its peak two years ago, the power plant is generating substantial savings for your Company as compared to the cost of purchase of power from the grid.
Further advised reading: Understanding the Annual Report of a Company
Therefore, an investor would notice that the commissioning of own power plant has been one of the major factors, which has led to marked improvement in the operating profit margin (OPM) of 8% for Finolex Industries Ltd over the years.
To appreciate the savings in the absolute terms, an investor would notice that before the commencement of the power plant, in FY2009, power & fuel costs used to be 10% of the sales.
Going by the same proportion, in FY2017 when the sales increased to about ₹3,000 cr, then the power & fuel costs could have been about ₹300 cr. However, the actual power & fuel costs incurred by the company in FY2017 is only ₹71 cr indicating a substantial savings of about ₹230 cr in FY2017.
By analysing the comparative data of operating expenses for FY2009 and FY2017, an investor would notice that another parameter that has led to significant improvement in the OPM of the company is “Other Expenses”. From FY2009 to FY2017, the other expenses have declined from 14% of sales to almost negligible levels in FY2017.
The significant decline in the other expenses as a percentage of sales of Finolex Industries Ltd requires further analysis by investors.
While analysing FY2010 annual report for the company, page 49, an investor notices that the company has disclosed “Premium, Loss on Exchange fluctuation/derivatives” of about ₹187 cr. in FY2009 and ₹93 cr. in FY2010.
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Apart from mentioning these expenses under other expenses in the detailed notes to financial statements, Finolex Industries Ltd has not provided further details about these losses in the annual reports during that period. However, another group company under the same management, Finolex Cables Ltd, also suffered significant losses on derivatives transactions during the same period and it had provided details of these losses under “Other Expenses” in its annual report for FY2009.
Advised reading: Analysis: Finolex Cables Ltd
The management of Finolex Cables Ltd had communicated to the shareholders in The Directors’ Report section of the FY2009 annual report, page 2 that these losses have resulted from derivatives due to adverse movement of currency and interest rates.
The unprecedented volatility in currency and interest rates resulted in a charge of Rs. 1,094.391 million on account of exchange variation and foreign exchange derivatives that your Company had entered into with the intent of risk mitigation.
These losses in derivatives have been one of the key reasons leading to operating losses reported by Finolex Cables Ltd in FY2009. Moreover, upon analysis of annual reports from FY2008 onwards, the investor would realize that Finolex Cables Ltd had recognized losses exceeding ₹250 cr. because of the derivative contracts from FY2008.
If an investor takes into account that the same management was running the two group companies (Finolex Cables Ltd and Finolex Industries Ltd) and therefore, it might have entered into similar derivatives transactions for both the companies. Because of the adverse movements of the currency & interest rates, both the companies might have suffered such significant losses. (For exact details of these losses, we advise that an investor should contact the company directly).
While analysing the FY2017 annual report, page 170, for Finolex Industries Ltd, an investor would notice that the company is yet to settle the derivatives losses and it is carrying an amount of $20.8 million (₹135 cr at March 31, 2017) as contingent liabilities, which are under dispute with the counterparties.
Further advised reading: Understanding the Annual Report of a Company
The reduction and later on non-provision of these derivatives losses have been few of the key parameters, which have led to the significant improvement in the profit margin of the company over FY2009-17.
Therefore, the improvement in the profit margins of Finolex Industries Ltd seems to be primarily on account of the reduction of operating expenses like power & fuel costs and deferment of disputed derivatives losses instead of strengthening of the negotiating position of the company over its customers.
An investor would appreciate that both the key business segments of the company face very high competition. The key competitor of the company in the PVC resin industry is Reliance Industries Ltd. An investor would appreciate that considering the size of Reliance Industries, it is highly difficult for Finolex Industries Ltd to get a pricing that it wants from the customers. In all probability, it would be a price taker in the market instead of price maker.
The other segment of the company, PVC pipes, has hundreds of manufacturers including both organized and unorganized segments. In light of many suppliers competing with each other, it becomes difficult for the company to increase the prices on its will. The management of the company has communicated to the stakeholders during its conference all in November 2017 that the industry has about 500-1000 manufacturers (Conference call transcript, page 14):
Chintan Seth: Estimate about how much you have gained compared to industry growth so if the industry has grow next and you grown 23% plus so?
Prakash Chhabria: Hardly two or three companies who report out of whatever 500 or 1000 pipe manufacturer so what we focused on is our own growth because for me to give you a number is okay I mean I can say we are 10% of full market or 20% of unorganized from 20 moved to 25 whatever, but it is still going to be all numbers in the air, there is no real number
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The fact that the company is not able to grow volumes by keeping its pricing terms is evident when the investor reads the conference call transcript of November 2017 further. The company witnessed its operating profit margins decline to 10% in Sept 2017 quarter and while discussing the results, the management of the company explained that they had to give a lot of discounts in order to grow volumes. The management further stated that if the company had tried to maintain its profitability (16% OPM in June 2017 quarter), then it would have had almost zero or negative volume growth. (Conference call Nov 2017 transcript, page 3):
Maulik Patel: Second question is on the pipe margin and we have seen in your competitors numbers also the margin has come down because there was a significant restocking in the month of July, August, which is also seen in your volume number, but we have to give such a high discount that the margin has come down to such a low number?
Prakash Chhabria: It is not necessarily high discount, I would say it is a volume game, so for volume sometimes you have to do go into the market to try and capture whatever is there. Now what we had expected on July 1, 2017 that first whole July month will go and by the time we will recover be August, September that did not happen. Actually middle of July only the volume starts picking up and when we saw the volume in the market we had to take corrective action and either we could have had less volume or even negative volume and may be higher profitability, but we said it would be better to try out a better volume game because as you know we were working aggressively on our capacity, so with a higher capacity we want to test what is to see and very happy, see to be able to physically ship out 23% higher volume terms in pipes and fittings also is a big exercise, so it is helping us to look forward to have a better and healthier future
Conference call Nov 2017 transcript, page 8:
Vasant Patil: So we are not losing in front of the realization, if you look at the average realizations even that has actually taken a hit, so that is largely due to, we are passing the discount largely to gain the market share, is that correct Sir?
Prakash Chhabria: For PVC pipes and fittings yes, absolutely correct.
The key essence of the above discussion is that improvement of the profit margins of the company over past few years is on account of containment of the operating expenses and not on account of increased pricing power of the company. Therefore, investors need to track the OPM of the company going ahead to monitor whether the company is able to maintain its OPM at reasonable levels.
An investor would notice that the net profit margin (NPM) of the company has witnessed similar fluctuations like the operating profit margin.
The tax payout ratio of Finolex Industries Ltd has been in the range of 30-34% over the years, which is in the range of the standard corporate tax rate applicable in India.
Further advised reading: How to do Financial Analysis of Companies
Operating Efficiency Analysis of Finolex Industries:
While analysing the net fixed asset turnover (NFAT) of the company over the year, an investor would notice that the NFAT has improved from 2.10 in FY2010 to 3.51 in FY2017. An improvement in the NFAT indicates that the company is able to operate more efficiently and is able to generate a higher amount of sales from its assets.
Looking at the inventory turnover ratio (ITR), an investor would notice that during the growth path, Finolex Industries Ltd has been able to keep its inventory levels incheck over the years. The ITR has been consistently within the range of 5-6 over the years. The company faces the challenges of seasonality in which the jetty used to import the raw material for the company stays closed during monsoons. The company has to stock the raw material for coming months within May itself before the commencement of the monsoon. (Conference call Nov 2017 transcript, page 6):
Chintan Sheth: Thanks Sir for taking my question. Sir on the spread side apart from the planned shutdown at PVC and jetty, if that event would not have been occurred then we would have enjoyed the spread that is what you are implying right?
Prakash Chhabria: No, what happens is our jetty shutdown during mid May because of monsoon and this happens every year from the beginning, so if the EDC price goes down that means if the spread becomes better we will not enjoy it fully in the month of July and August because my inventory would be filled up in the month of May itself, so that works against us when the price go down, but it works in our favour when the price go up.
The company has to stock inventory for five months before monsoons. As a result, many times the company is stuck with inventory purchased at high prices whereas the raw material prices go down later on. The credit rating agency, India Ratings, has highlighted this risk in its report for the company published in April 2017 (page 2):
The company is also exposed to raw material price volatility as it has to stock inventory for five months during monsoons.
Further advised reading: 7 Important Reasons Why Every Stock Investor Should Read Credit Rating Reports
In the past, the company has to recognize losses due to carrying inventory at higher prices whereas the prices witnessed a decline later on. In FY2015, when the OPM of the company witnessed a sharp decline to 8% from 13% in FY2014, the key reason was losses due to holding inventory (both raw material and finished goods) at higher cost prices, whereas the PVC resin prices witnessed steep decline later on. Investors would remember that this was the period of sharp decline in crude oil prices, which witnessed crude oil prices declining from about $110/barrel to $35/barrel later on.
FY2015 annual report, management discussion & analysis, page 8:
The business scenario both in terms of product demand and pressure on margins was affected largely due to a sharp drop in PVC prices during October-December 2014 and due to unseasonal rain and hailstorms in many parts of the country during the year under review.
The steep decline in the price of crude oil, which in turn caused more than a 20% fall in the price of PVC resin, resulted in an abnormal erosion in your Company’s margin during third quarter of FY 2015. The loss of inventory carry of raw material and finished products during this unprecedented and unforeseeable situation caused a heavy loss to your Company during the third quarter.
An investor would appreciate that despite the challenges faced by the company in terms of advance stocking of the raw material and resultant risk of inventory losses, the company has kept its inventory utilization in control by keeping its inventory turnover under check.
Looking at the receivables days of the company, an investor would notice that the company has witnessed a significant improvement in the receivables days over the years. The receivables days have declined from 15 days in FY2012 to 4 days in FY2017.
Further advised reading: How to Analyse Operating Performance of Companies
While reading past annual report and the conference call transcripts of the company, an investor would observe that the company sells the PVC pipes directly to dealers and does not have distributors in between the supply chain. The company sells the goods to the dealers on cash & carry basis and as a result, it is able to have low receivables days.
Moreover, the company has done a strategic shift towards increasing the share of PVC pipes in the revenue by expanding capacity. As a result, the company is able to use more of the PVC resin production within the company. The company sells PVC pipes to dealers on a cash & carry basis. This strategic shift has also led to the improvement in the receivables days over the years.
However, currently, the company is planning to increase its focus on selling CPVC (Chlorinated Poly-Vinyl Chloride) pipes in collaboration with Lubrizol. The company is giving a higher credit period to customers to increase sales in this segment.
Therefore, an investor should keep a track of the trend of receivables days of the company going ahead.
Further Advised Reading: Receivable Days: A Complete Guide
Stable inventory and improving receivables position indicate efficient working capital management. As a result, working capital has not put the unnecessary financial burden on the company and it has been able to convert its profits after tax into cash flow from operations.
The company reported a cumulative net profit after tax (cPAT) of ₹1,284 cr. over last 10 years (FY2008-17) and a cumulative cash flow from operations (cCFO) of ₹2,245 cr over the same period indicating good working capital management.
Further advised reading: Understanding Cash Flow from Operations (CFO)
Margin of Safety in the Business of Finolex Industries:
i) Self-Sustainable Growth Rate (SSGR):
Further advised reading: 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 is attempting to grow its sales at a rate higher than its SSGR and additionally, it is not able to convert its profits into cash flow from operations, 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.
An investor would notice that Finolex Industries Ltd has witnessed an SSGR ranging from 0-4% over the years. The SSGR has increased recently because of a sharp increase in the profit margins in recent years. However, as discussed in the section on the OPM above, the recent increase in OPM might not be sustainable as the profit margin of the company is highly susceptible to raw material price changes, which have witnessed the OPM to decline to 10% in Sept 2017 quarter from 22% in Dec 2016 quarter.
The sales growth achieved by the company over the years is 7-10%, which is higher than its SSGR. Therefore, investors would expect that the company would have to raise debt from additional sources to fund its growth.
However, in the SSGR article shared above, we have highlighted a situation (Case C), where companies that have SSGR less than the current growth rate but still manage to reduce debt over the years. In such cases, efficient working capital management ensures that the company has a significant amount of CFO, which is not stuck in working capital needs of the growing company. As a result, the cash is available from the internal sources for the capital expenditure needed for growth.
An investor is able to observe this aspect of the company’s business when she analyses the cumulative cash flow position including free cash flow for the company over last 10 years (FY2008-17).
ii) Free Cash Flow Analysis:
Over FY2008-17, the company increased its sales from ₹1,435 cr. in FY2008 to ₹2,988 cr. in FY2017 by doing a capital expenditure (capex) of about ₹661 cr. Over the same period, the company generated a cash flow from operation of ₹2,245 cr. The company could meet its entire capex requirements from its CFO and had a free cash flow (FCF) of ₹1,584 cr.
The company used its FCF of ₹1,461 cr. pay the interest on the debt, pay dividends and it could reduce its debt substantially by about ₹600 cr from a total debt of ₹692 cr in FY2008 to ₹94 cr in FY2017.
Free cash flow (FCF) and SSGR are 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
It seems that the markets have rewarded the company for efficiently managing its cash flow and working capital position and as a result, the markets have rewarded the company and its shareholders by giving a valuation of ₹9.19 for every ₹1 of retained earnings. Over last 10 years, the company has retained earnings of about ₹794 cr. and has witnessed an increase in market capitalization of about ₹7,290 cr.
Additional aspects and annual report analysis of Finolex Industries:
On analysing Finolex Industries Ltd, an investor comes across certain other aspects of the company, which are essential for making any final opinion about the company:
1) Management Succession:
Two brothers founded Finolex group: Mr. P.P. Chhabria and Mr. K.P. Chhabria. In FY2013, as part of the succession planning, the founder promoters handed over the charge of two of the key companies of the group: Finolex Cables Ltd and Finolex Industries Ltd to the next generation.
- D.K. Chhabria who is the son of Mr. K.P Chhabria took over as Executive Chairman of Finolex Cables Ltd.
- P.P. Chhabria who is the son of Mr. P.P Chhabria took over as Executive Chairman of Finolex Industries Ltd.
This step of management succession seems to have taken place smoothly for the company.
Mr. P.P. Chhabria is currently about 55 years of age currently (FY2017 annual report, page 51). As per the annual report of the company for FY2017, Ms. Ritu Chhabria, who is the wife of Mr. P.P. Chhabria, is currently a part of the board of directors. However, she is currently a non-executive director.
It might be the case that in case of an emergency, the management of the company can be taken care by the current generation of the family. However, we believe that investors should get clarification from the company about the plans of the third generation of the promoters to get associated with the company or an increased role of professionals in the leadership positions of the company.
We believe that the details of succession planning in terms of any member of the promoter family or increased role of professionals in the company are essential details for long-term investors in the company.
Further advised reading: Steps to Assess Management Quality before Buying Stocks (Part 3)
2) Project execution skills:
While analysing Finolex Industries Ltd, an investor would notice that the company has been able to consistently increase its manufacturing capacity over the years in both the key segments of PVC pipes and PVC resins. Moreover, the company has been able to achieve the growth in capacity while keeping its debt levels in check.
Such performance of the company by increasing capacity while keeping the fundamental financial position under control, by keeping its working capital levels under check indicate good project execution skills of the promoters.
As a result, the company has been able to reduce debt over the years. The company has been using primarily its own funds for working capital management and most of the short-term working capital loans given by the banks to the company are unutilized.
The credit rating agency, India Ratings, has highlighted this aspect in its report for the company in April 2017 (page 1):
Strong Liquidity: FIL’s liquidity continues to remain strong with positive cash flow from operations and free cash flows during the three years ended FY16…… Liquidity is also supported by near zero use of fund-based limits for the twelve months ended January 2017.
Therefore, it does not come as a surprise to the investors when they notice that both the credit rating agencies, which cover the company, CRISIL and India Ratings, have upgraded its credit rating agency in the past. CRISIL has upgraded the credit rating of the company twice in recent years:
- From A+ to AA- in Oct 2014
- From AA- to AA in March 2017
Further advised reading: 7 Important Reasons Why Every Stock Investor Should Read Credit Rating Reports
3) Deteriorating performance of Investee Company Finolex Plasson Industries Ltd:
Finolex Industries Ltd (FIL) has done investment in one of the associate company, Finolex Plasson Industries Ltd (FPIL), which is a key player in the micro/drip irrigation segment. As per the annual report of FIL for FY2017, page 264, FPIL is profitable; however, the profits of the company are consistently going down.
We believe that investors should seek clarification from the company about the future business prospects of FPIL, the reasons for the significant decline in profits as well as the strategy of the company to increase or reduce investments in FPIL going ahead.
4) Declining value of investments in Finolex Infrastructure Ltd:
While analysing the FY2017 annual report of the company (page 223), an investor would notice that it has made investments in a company, Finolex Infrastructure Ltd, which is one of the group companies of Finolex group.
The status of Finolex Infrastructure Ltd as a group company gets established when an investor looks at its list of directors (Source: Tofler)
The investor would notice that the company is increasing investment in Finolex Infrastructure Ltd, which is evident by the increase in the total number of shares held. However, the value of the investment is going down, which indicates that the business of Finolex Infrastructure Ltd is not performing well.
We believe that investors should seek clarification from the company about the future business prospects of Finolex Infrastructure Ltd, the reasons for the decline in the value of the investment as well as the strategy of the company to increase or reduce investments in Finolex Infrastructure Ltd going ahead.
Further advised reading: How to Identify if Management is Misallocating Capital
5) Pledging of promoters’ shares:
As per the shareholding disclosure filed by the company on BSE for Dec 31, 2017, promoters have pledged 14,621 shares of the company with lenders.
As discussed above, the financial/liquidity position of the company seems sound. Therefore, it might be that any of the promoters have pledged the shares to lenders to take debt in his/her personal capacity for personal needs. Nevertheless, we believe that investors should seek further details and the clarification about the pledging of the shares created by promoters.
Further advised reading: How to know if Promoters are Losing Commitment to the Company
6) A sudden increase in equity and cash & investments in last 2 years:
An investor would note that in last two years, FY2016 and FY2017, the cash and investments held by Finolex Industries Ltd have increased significantly. The cash and investments have increased from ₹192 cr at March 31, 2015 to ₹1,280 cr at March 31, 2017. On similar lines, the total shareholders’ equity (equity capital + reserves & surplus) has increased from ₹787 cr at March 31, 2015 to ₹2,315 cr at March 31, 2017.
Investors would note that recently the company has started following the new accounting standards (Ind-AS), which mandates that the investments of the company should be recorded in the balance sheet at fair value/market value. As a result, Finolex Industries Ltd now records its investment in Finolex Cables Ltd, which is a listed entity, in the balance sheet at the market value on the last date of the financial year instead of the purchase cost of shares.
Investors would note that Finolex Industries Ltd holds 22,187,075 shares of Finolex Cables Ltd since last many years. In FY2015 annual report, when this investment was recognized based on acquisition cost, then the value of these shares in the balance sheet at March 31, 2017 was ₹102.6 cr.
However, in the FY2017 annual report, the balance sheet value of this investment at March 31, 2017, has increased significantly to ₹1,146 cr due to the change in the manner of recording from cost value to market value. FY2017 annual report, page 222:
Further advised reading: Understanding the Annual Report of a Company
Investors would note this increase in the recorded value of the stake in Finolex Cables Ltd by more than ₹1,000 cr, which has increased the value of cash & investments on the asset side of the balance sheet, has increased the total equity on the liability side of the balance sheet under reserves & surplus.
The total equity value of the company has increased and now reflects the market value instead of historical cost values earlier. As a result, all the ratios used in the analysis of the company, which use equity as a component like debt to equity (D/E) or return on equity (ROE) would look depressed.
We have discussed this aspect of change in accounting norms as a part of the current analysis to highlight to the investor that she would need to keep in mind the changing equity value because of changing fair/market value of investments while doing her analysis and comparing different ratios on a historical basis.
Margin of Safety in the market price of Finolex Industries:
Currently (March 01, 2018), Finolex Industries Ltd is available at a price to earnings (P/E) ratio of about 27 based on trailing 12 months standalone earnings, which does not offer any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.
However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes 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, 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.
- 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
- How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
- Hidden Risk of Investing in High P/E Stocks
Analysis Summary
Overall, Finolex Industries Ltd seems to be a company, which had been growing at a moderate pace of 7-10%. The growth journey of the company has witnessed highly fluctuating profit margins. It seems that the company is not able to pass on the increase in raw material costs to its customers and as a result, its profit margins get impacted whenever the raw material prices increase.
The company faces a double whammy of facing losses when raw material prices fall sharply. This is because when the raw material & consequently the finished goods price decline sharply as happened in Dec 2014 quarter when crude oil prices fell sharply, the company was stuck with the large amount of inventory, which it had purchased at high prices previously. As a result, the company had to face significant losses on its inventory. The unique business situation of the company where it has to store five months’ worth of raw material in advance when the jetty used by it to import the raw material closes during monsoons, exposes it to such raw material price fluctuation risk.
However, despite these challenges on the front of raw material and product pricing, the company has been able to improve its profit margins over the years. The analysis reveals that this improvement in the profit margin is a result of the reduction in other operating expenses especially the reduction in the power & fuel costs and other expenses. The power & fuel costs of the company have declined in the past due to the commencement of its own power plant and the other expenses have declined due to part settlement and part deferment of losses on derivatives contracts faced by the company during FY2009 & FY2010. Derivatives losses of about $20.6 million (₹135 cr at March 31, 2017) are still under dispute and are a contingent liability and investors need to monitor the same.
Despite fluctuating profit margins, the management has been able to grow the company by showing good project execution and consistently creating new capacities while keeping the working capital and the debt levels under check. As a result, the company has been able to grow from its own generated funds and has been able to repay most of its debt over the years.
The company seems to have invested in some of the companies like Finolex Plasson Industries Private Ltd and Finolex Infrastructure Ltd, where the value of the investment seems to be going down in recent times. We believe that investors should seek clarification from the management whether the business of these companies has deteriorated and whether it would be prudent to invest more money in these companies.
Finolex Industries Ltd along with Finolex Cables Ltd witnessed a smooth transition of management from the founding generation to the next generation in FY2013. The current executive chairperson of the company is about 55 years of age. It remains to be seen whether the current promoter management plans to groom any member of the promoter family as next line of leadership or plan to hand over the reins to professionals.
Going ahead, investors should monitor the company for operating profit margin, debt levels and investments in different group companies. Investors should get clarify from the management about the management succession planning.
Further advised reading: How to Monitor Stocks in your Portfolio
These are our views about Finolex Industries Ltd. However, investors should do their own analysis before taking any investment related decision 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”
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.
