Manish Bhandari

Looking for companies which gain the most from operating leverage is core to our investment philosophy. In 2014, China was exiting low-cost manufacturing as costs were rising there. So, we were looking at companies that could gain the most  from the change in China’s priorities and operating leverage kicking in due to better utilisation of assets.

Home textiles was one space where India had a natural advantage over China as it had easy access to cotton, a vital raw material, whereas the Chinese did not enjoy any natural advantage. They had to import cotton and then process it. So, many of the Chinese players were moving out of the home textiles space. We were certain that the Indian home textiles players would stand to gain the most given their market share. 

One of the companies that looked attractive given its asset-light model was Indo Count Industries. Focused on spinning yarn since its inception in 1988, the management decided to forward integrate into the home textiles segment in 2005. Indo Count had the capacity to manufacture 36 million metre of bedsheets and was exporting to countries like the US, the UK and Australia. It manufactured 50% of the yarn and greige fabric requirement and oursourced the rest. Greige is an unfinished fabric that hasn’t been bleached or dyed and needs to be processed to make the final product, in this case bedsheets. India had excess capacity in yarn manufacturing. You could buy good-quality yarn at reasonable prices. So, they outsourced their yarn requirements. However, Indo Count did 100% of the processing and cutting work in-house, focusing on the designing and finishing of the fabric. The company justifiably focused on front-end processes as it fetched higher margins.

We liked the involvement of the second generation in the operations of the company. It showed dedication and skin in the game. The second generation was involved in marketing and that was the toughest area to crack in the home textiles business. It is typically not easy to convince US retailers like Walmart to select you as a supplier and not buy from competitors in Bangladesh or other countries. Also, you need to have your ears and feet close to the ground as you need to design collections that would be put on shelves six months hence. In a business like home textiles, the main selling point of a product is the way a company can differentiate it compared to its peers without compromising on its quality while offering competitive price. 

We could see that Indo Count’s lean model would be a positive trigger for return on capital employed (ROCE) going ahead. Its capacity was under-utilised, operating at around 60%. There was enough room for return ratios to move up. In FY14, the company’s ROCE stood at 31%. Players like Welspun were operating at 80%-85% utilisation levels. Welspun had already made in-roads in the US market with 25% market share in the bedsheets segment. We knew that Indo-Count would gain market share in the US following the exit of the Chinese players. The company already had a marquee set of clients including Walmart, Target, JCPenney, and Bed, Bath and Beyond.

With the industry’s prospects looking bright, we were betting on the operating leverage to play out. So we bought Indo Count on June 9, 2014 at Rs.88 per share. The company had reported net sales of Rs.1,467 crore and profit of Rs.110 crore in FY14. The stock was trading 4.6x FY15 estimated earnings. The company had just exited the corporate debt restructuring (CDR) cell. It was admitted to CDR cell in August 2008, post the financial crisis. The global slowdown that followed the crisis saw demand fall off a cliff, resulting in cost overrun in its home textile plant and impacting its profitability significantly. What made matters worse was that the company also had hefty forex losses of Rs.150 crore which masked the earnings. But all that was in the past and the company’s improving prospects wasn’t reflected in its valuation. 

We felt that at a steady state the stock should be worth Rs.300-350. We liked the margin of safety that this stock was offering. We were expecting Indo Count to grow its revenue by at least 20% annually over the next 3-4 years. The timing of our entry turned out well as we didn’t see any drawdowns. In the first year, the stock price kept moving up as the company’s numbers started to improve with capacity expanding from 36 million metre to 45 million metre. At the end of December 2014, it closed at Rs.345, 4x our purchase price. Quarter-ending June 2015, a year after our investment, net sales were up 48% YoY and net profit had improved 109% YoY.  

We were happy to own a company where earnings looked depressed because of the one-time incident of forex losses, but had the possibility of earnings re-rating and a huge business potential.

In the second year of our investment, more good news came Indo Count’s way. China decided to liquidate its cotton reserves which pushed cotton prices lower. The prices of cotton, a key raw material for Indo Count, declined by 15% as China liquidated its inventory. Indo Count had long-term contracts with its customers, so they benefited from the fall in cotton prices.

By quarter-ending March 2016, the company’s operating margin was up 173 basis points as against 22% posted in June 2015 quarter. Net sales were up 11% on a YoY basis and profit was up 142% YoY. Its return ratios improved substantially. In FY16, ROCE stood at 48% as against 41% in FY15. In FY16, Welspun India’s ROCE stood at 27% and Himatsingka Seide’s ROCE was at 14%. 

The valuation had jumped from one-year forward P/E multiple of 2x in 2014 when we made our investment to around 12.8x in December 2015. We felt the market was assigning the business too much value when the future was fraught with uncertainty. We knew that this model only works when the cotton prices are stable or on the lower side. If there is a huge fluctuation in cotton prices, this model will not work. Commodities by nature are volatile and after every 3-4 years there is always a downturn. You don’t need supernatural powers to see it coming. However, the market didn’t see it as the case and was extrapolating this to be a compounding story. 

We were also worried about the increasing competitive intensity due to increase in overall capacity. Since our investment in 2014, additional capacity to manufacture almost 80 million metres had come on stream. At the same time, there were signs of pressure on the demand side. In the US, 8,000-odd stores had closed down. US retail chains were locked in an intense competition and there were reports of some retail chains filing for bankruptcy. We thought it was time to exit. 

We started unwinding our position in December 2015, exiting at a weighted average price of Rs.850-900 after two years of holding our position, clocking returns of 9x-10x. We sold the last tranche of shares on January 13, 2016 at an average price of Rs.1,090 per share. Our thesis that making money may be difficult in this industry going ahead, as almost all players have expanded their capacities did work out. As one can see from subsequent performance of the company, its ROCE has contracted over the last three years from 39% to 20% (FY15-17) which was a definite indication of the changing landscape. 

In 2014, we also started to look for companies that were linked to revival of the capex cycle. We felt that the capex cycle was going to revive as economic growth was starting to look up. The capex cycle was depressed for 3-4 years and typically it tends to revive after so many years of lull activity. Meanwhile, the new government was making all the right noise about investments in infrastructure. 

We started to look at pump manufacturers since pumps, being critical in setting up any industrial project, were expected to benefit from the revival in capex cycle. Pumps are critical to any capex cycle. For instance, if you put up a refinery, you need to install a lot of pumps. For sugar industry, you need pumps. If you are drilling oil somewhere, you need to install pumps. Moreover, the pumps business also enjoys brand stickiness as you would typically buy pumps of a reputed brand to make sure your operations don’t run into any breakdowns. 

WPIL or Worthington Pumps was a specialised pump company, which also had the capacity to manufacture pumps for nuclear plants. There were talks about government changing the composition of power from thermal to nuclear. A nuclear project typically requires Rs.1,000 crore worth of pumps. We were betting on the demand going up sharply and huge demand sitting in the balance-sheet. In the case of a capital goods company, the bottom-line tends to grow a lot faster than topline as there are a lot of fixed expenses. Capital goods companies tend to have high operating leverage. The company was expected to gain from the change in product mix — from thermal pumps to nuclear pumps — and improving utilisation levels. Again (like in case of Indo Count), we felt that WPIL would see a huge operating leverage going ahead.

WPIL was doing something different from other Indian pump players. It was an Indian pumps company that was trying to gain global scale. It acquired companies across the UK, Thailand, Australia, South Africa, Dubai and Zambia. The company invested Rs.170 crore across geographies to gain access to newer markets from 2010 to 2014. These acquisitions not only gave the company access to cutting-edge technology, but also diverse markets. It could even challenge MNCs as it was an India-based player with better cost structure. 

The management had sought to de-risk its business by entering new geographies and as an investor, we were happy to have our risks hedged. The company was not just betting on one capex cycle, but multiple capex cycles across geographies. We felt that this strategy should work out well. If the domestic capex cycle didn’t pick up, there was always the chance of a global nuclear or oil and gas capex cycle coming in as a trigger.    

Through our background checks, we had got positive feedback on the management. It was a Kolkata-based company and the management was strong in terms of professional background. These were people who had run the business long enough and seemed to know what they were doing; there wasn’t much reason to be worried.

Revenue had grown around 11% on average over the previous five years (FY09-14) and profit had grown at 15% during the same period. Meanwhile, the stock was trading at 13x one-year forward earnings (FY15 estimates). The ROE of the company was consistently above 21%, well above those of peers. The ROE of KSB Pumps was 11%. A reasonably sound balance sheet and a slew of subsidiaries in investment phase provided a good platform for WPIL to grow faster than its peers as the capex cycle picked up pace. We were convinced that we were buying an efficiently-run company. It was a relatively small company with consolidated topline of Rs.368 crore as of FY14 but we felt it had the potential to become a Rs.1,000 crore-1,500 crore company if its bets paid off. We expected the revenue to grow at 15% and profit to grow at 30% over the next 3-4 years. So we bought WPIL in December 2014 at a market cap of around Rs.580 crore. We bought a position that amounted to 4% of our assets under advisory. 

However things started to unravel soon after our investment. The company started to face uncertainty on several counts. Mathers Foundry, a subsidiary that contributed 35% of FY14 sales, which made pumps for oil and gas industry, was facing a slowdown as oil prices collapsed in 2014-2015. Nothing had moved on the ground on nuclear power plants. The domestic capex cycle was far from seeing a revival. The commentaries of all the capital goods companies sounded bleak. The index of industrial production (IIP) was falling month after month. At the end of FY15, profit had declined 39% YoY to Rs.18 crore. In FY16, profit was down to a trickle at Rs.1 crore. While the company’s investment in capacity, resulted in depreciation costs going up by 4x, operating profit declined by 40% due to weakening demand.

The company’s strategy of de-risking its business by entering various geographies had backfired. These were high-cost geographies. Turning around subsidiaries, gaining market share and changing the cost-structure would be a long gestation cycle. There were just too many moving parts. 

In a matter of six months after we entered the stock at Rs.590, it started trading below our purchase price. However, we never averaged the stock. We look to average a stock when it falls 33% or more. Only if the fundamental remains unchanged, we average. Within a year’s time from our purchase, WPIL had corrected 33%. The fundamentals had changed. We exited our position at Rs.350-360 in June 2016, 40% lower than our purchase price. As it was an illiquid position, we sold it in two or three tranches. It is a logical question to ask, why we didn’t exit earlier. We wanted to give our investment a reasonable time-frame. But, after one and a half years, we were sure that things were beyond repair. We reconciled that capex cycle will not take off, nuclear power projects were too far off in the horizon and oil was not going to make a comeback. We realised that we had made a mistake in understanding the demand side and the economic environment. To further complicate matters, the competitive intensity in export markets had gone up thanks to Chinese pump manufacturers. So we decided it was time to exit the stock.

Investing lesson

The first key lesson is that when you invest you should look at the underlying business carefully. What worked for us in the case of Indo Count, went against us in the case of WPIL. We did not understand the demand side factors well enough. We assumed a turn in the capex cycle but it did not materialise because of various factors. Oil capex was poor because of collapse in prices, nuclear did not take off because of government inaction, and the rest of the industry didn’t spend because growth continued to be poor and companies were debt-laden. One key lesson is never buy a business when the underlying has got huge inflation built in. Even though WPIL was a pump company, its demand was dictated to an extent by oil prices and the softening of oil prices impacted its business. In today’s context, for instance, it’ll be difficult to grow housing finance or mortgage book over the last 10 years as they have benefitted due to inflation in real estate prices, which will see deflation going forward. I have become far more careful in analysing underlying matrices while making an investment.