Under a cloud but happy

Value investor Mohnish Pabrai has taken a studied bet on calcined petroleum coke player Rain Industries

There are not many investors who are betting on commodity companies today. Which is why the bet that value investor Mohnish Pabrai has placed on Rain Industries has everybody interested. Pabrai has so far picked up 10 million shares of the company at about ₹40. 

As is well known, Pabrai only invests in stocks that he thinks have deep value and the potential to give multi-fold return. So, what is it exactly that this California-based investor sees in this Hyderabad-headquartered company? In an e-mail response to Outlook Business, Pabrai said he appreciated the interest but didn’t wish to comment on the purchase.

Rain Industries’ core business is cyclical in nature as its main customers are aluminium manufacturers. The company provides them with calcined petroleum coke (CPC) and coal tar pitch (CTP) products, which go into the carbon anodes used in the aluminium extraction process. One tonne of aluminium requires 0.4 tonne of CPC and 0.1 tonne of CTP.

Together, both these carbon products account for 71% of Rain Industries’ revenue. And with exports accounting for 85% of its revenue, cross-currency movements play a major role in determining the company’s earnings.

For the quarter ending March 2015, the company reported a 3% year-on-year fall in the sales of carbon products. The company attributed the fall to a 19% decline in average blended realisation and a depreciating Euro.

And therein lies the rub — the company’s existence is wholly dependent on its global fortunes. Rain Industries’ European assets account for 56% of the total revenue generated from its subsidiaries; while US assets account for 21%, the rest comes from its Egyptian, Chinese, Russian, Canadian and Indian assets.

Rain Industries’ customers are spread across the continents and include the Canadian-based Rio Tinto Alcan and Aluminerie Alouette, US-based Alcoa and Century Aluminium, Norway’s Norsk Hydro and Emirates Aluminium and Dubai Aluminium in west Asia. Back home, its customers include National Aluminium, Vedanta Aluminium and Hindalco. 

Days of glory

While there was a time when the Street was excited about the stock, these days, the advice tends to be of the ‘buy at your own risk’ variety. An analyst with a leading domestic brokerage says that Rain Industries has several moving parts, complicating matters for the company. To add to this, with the removal of export duties in China, smelters there can now ramp up production and bring down aluminium prices, which would have a negative impact on the demand for CPC. Starting out with a 0.3 million-tonne capacity in the port city of Visakhapatnam, the group’s calcining arm has travelled places over the years. But all this expansion has come at a price and Rain Industries’ current valuation bears testimony to this.

In 2007, Rain Calcining became the second-largest calciner in the world with the acquisition of the Texas-based CII for a consideration of $618 million; the company’s debt-to-equity ratio shot up to 12X for the year ending December 2007.

However, Rain managed to bring its debt-equity ratio down to 1.7X by CY11 and a few brokerage houses initiated coverage on the stock the same year, excited by the deleveraging story.

Analysts expected the company’s debt-equity ratio to fall further to 0.5X by CY13 but their excitement was short-lived. Before the end of CY12, Rain Industries was back in expansion mode — it entered the CTP and chemicals business by acquiring the Belgium-based Rütgers Group for €700 million. The stock lost nearly 10% in the sessions following the Rütgers announcement.

The company funded the acquisition partly through its own money and the rest from long-term bonds worth €533 million. For the year ending December 2012, the company’s debt to equity was 2.7X, which it has managed to bring down to 2.5X in CY14. 

2014 was also a tough year for the company, as growth concerns in the US and Europe dented aluminium demand. Unsurprisingly, Rain Industries saw its net profit dive 77% to ₹88 crore for the year ending December 2014. However, the management expects the company to bounce back.

“Although the volatile scenario has continued, it had a comparatively lower impact in Q1FY15 due to marginal recoveries in certain areas. This certainly signifies a positive outlook for the future. The recent increase in aluminium prices to above $1,900 per tonne is an encouraging development,” said Jagan Mohan Reddy, managing director, Rain Industries, during a recent earnings call.   Since that concall in early May, the spot price of aluminum has fallen to $1,725 per tonne and that damage has been reflected in the stock price of Rain Industries.

Spotting opportunities

But as Rain fumbles its way through this volatile phase, what exactly has excited an astute investor like Pabrai? According to a well-known value investor, who did not wish to be identified, his contemporaries tend to look for a few key parameters when evaluating companies — the competitive positioning of the company, high entry barriers and earnings sustainability.

“Rain Industries has a competitive edge, as its CPC facilities are located close to crude refineries in the US, from where it is relatively easier to procure its key raw material green petroleum coke (GPC) says, Rohit Agarwal, research analyst, SPA Securities. GPC is a residual by-product of oil refining and its limited availability and difficulties in procurement are major entry barriers in the CPC industry.

For now, the firm’s fortunes are dependent upon the world’s appetite for aluminium. With aluminium demand expected to grow at a 5% CAGR between 2015 and 2018, the company’s earnings visibility looks good at this point.

The US-based Alcoa — one of the largest manufacturer of aluminium and one of Rain Industries’ customers — reversed its fortunes with a net profit of $195 million in its recent quarter. “Demand for aluminium has never been greater,” Klaus Kleinfeld, chairman and CEO, Alcoa, said during the company’s annual shareholder meeting.

The signs of recovery seen in Europe also come as good news. The European Commission recently said that tailwinds such as cheaper oil and ECB’s quantitative easing programme should help the Eurozone’s GDP improve by 1.5% in 2015; its earlier forecast was 1.3%. “The Western world seems poised for market recovery, with demand outstripping production,” Gerard Sweeney, president and CEO, Rain CII Carbon LLC, USA, said during the recent earnings call.

Analysts say Rain CII’s plants are operating at around 80% utilisation levels, which could go up to 85-90% if aluminium demand improves. Another positive for it is US refineries’ switch back to crude from shale; this will increase GPC availability.

The unidentified value investor also feels that a re-rating could be on the cards. Rain Industries is a high-delta stock — a 1% change in the company’s margins would add another ₹10 to its earnings per share. “The current price seems to have priced in all the negatives, which makes the stock an attractive risk-reward bet. There is limited risk but the rewards are high,” says the value investor.

Bauxite crush

Pabrai might have also found the company’s current valuation too tempting to resist. The stock is trailing at a 12-month price-to-earnings multiple of 3.9X and price-to-book of 0.5X. For perspective, Goa Carbon has a price-to-book of 0.9X even though its CPC-producing capacity is not even half of that of Rain Industries. However, debt of more than ₹7,000 crore on a net worth of ₹2,945 crore is still a concern and the weight of the company’s debt has kept the stock price subdued. 

But analysts take comfort in the company’s interest coverage ratio, which is at a healthy 2.5X. For the year ending December 2014, the company had cash of ₹899 crore on its books, while its finance costs were at ₹607 crore. “The company should be able to deleverage its books soon. Also, the company’s capex cycle is more or less past, so additional debt is unlikely. Going ahead, this would improve the company’s ratios,” says Agarwal. 

Though Rain Industries has come a long way since its days in the cement sector, where the company was declared sick, the million-dollar question still remains — will the commodity cycle turn in its favour. It definitely has Pabrai’s vote. So, if you want to ride along with Pabrai, you may want to track this counter closely.