It’s mid-afternoon — 2.30 p.m. to be precise — in Pimpri-Chinchwad, the industrial belt of Pune, but the weather is surprisingly pleasant with a cool nip in the air, thanks to the monsoon. As we make our way to the gates of Finolex Industries’ head office, what immediately grab our attention are the huge stacks of pipelines laid across the vast plot — 70 acres in all — and several trucks manoeuvring through the maze of these pipes. Standing smack in the middle of the massive mounds of plastic is a four-storeyed building that is home to the country’s largest PVC pipe major that currently lords over the ₹6,000 crore organised market with 28% share.
The big picture
PVC pipes account for a lion's share of the domestic pipe market
Wired to follow a predictable line of questioning as an analyst, the first few questions I ask Finolex MD SS Dhanorkar are: “Why does your company continue to use prime industrial land for an activity that has very low economic value? And what is the reason for the huge inventory pile-up?” Sitting in his spartan cabin, the 57-year-old Dhanorkar, who has been at the helm at Finolex for the past 31 years, replies rather candidly, “We do want to monetise the land, which is currently worth ₹700 crore, but there are hardly any buyers. And the inventory you see outside will vanish once the monsoon ends and the festive season kicks in.” The reason is that Finolex generates about 70% of its revenue supplying PVC pipes for irrigation, apart from for construction activities, both of which largely kick off post monsoon. “We need to stock up on pipes so that we can comfortably meet the growing demand in future,” adds Dhanorkar.
With pipe manufacturing capacity of 230,000 tonne under its fold, the ₹2,500-crore Finolex Industries has clocked annual sales and profit growth of 10% and 24% over the past five years, as its capacity doubled over the same period. The robust profit growth is a clear indication that the company enjoys good pricing power despite a modest sales growth. So, it’s not surprising that the stock market took a fancy for the stock, which has dished out a 150% return over the past one year. Going forward, while the Street will be excited about the management’s plan to monetise its landholding, what actually makes the company, which has a market cap of over ₹3,500 crore, an interesting prospect is the business it derives its strength from. But to assess what the future holds, it is important to understand how the past unfolded at Finolex.
In 1945, Prahlad P Chhabria and his brother, Kishan P Chhabria, came down from Karachi to settle in Pune. They started a small electrical cables shop before venturing into the manufacture of PVC insulated cables in the following decade (now undertaken by a separate company, Finolex Cables). Finolex, which is a portmanteau of ‘fine’ and ‘flexible’, moved into pipe manufacturing a few decades later as the Chhabrias realised the potential of the pipes business and found pipe manufacturing a natural extension thanks to the similar process and technology used.
The brothers started with a 5,000-tonne pipe manufacturing capacity in the early 1980s, making them pioneers in India. “The biggest problem in this era was that as the pipe business grew, importing resin was an uphill task because of the difficulty of getting an import licence and restrictions on foreign transactions, thus limiting our growth and profitability. We realised these difficulties and to deal with the situation, put up a huge investment for manufacturing our own resin,” recalls Dhanorkar.
The unit, with a capacity of 130,000 tonne, was operational by 1993. This was huge, given that Finolex Industries’ own consumption of resin at the time was not more than 15,000 tonne. By default, then, Finolex ended up becoming a resin player, at a time when Reliance Industries too had huge resin capacity, making India surplus in the product. But, gradually, because of the demand from PVC pipe manufacturers, this surplus capacity started getting absorbed, and by 2002-2003, India again became resin-deficient. That’s when Finolex decided to double its capacity, to 260,000 tonne — this was twice as much as the group needed for captive consumption. And initially, in the absence of internal consumption, a large part of the resin was sold in the open market.
The backward integration turned into a weakness. Finolex had invested in the capacity expansion using borrowed funds and its attention, understandably, remained on building the resin business. But troubles were mounting. Over the years, the user industry (buyer of raw material) made more money by selling pipes directly to consumers, compared with players such as Finolex, which was supplying low-margin resin to these pipe manufacturers.
Besides, with increasing competition, Finolex could not exercise pricing power and PVC resin, which is a petroleum derivative, was feeling the impact of international price fluctuations and currency management. More importantly, because its customers for resin were largely confined to industrial clients, Finolex had little control on the price, which put pressure on operating margins.
Even otherwise, operating margins in the resin business were hardly 6-8% and prone to volatility because of the swing in global petroleum prices. For instance, when the global crude oil prices peaked at $140 a barrel during the financial meltdown, in that financial year — 2008 — the company made an operating margin of 10.7%, against 13.4% in FY06. It didn’t help that the company was managing huge forex risks and had high working capital needs. “About three years back, because of forex exposure dealing in currency derivatives, we had about ₹400 crore liability, which now stands at about ₹30-40 crore,” says Dhanorkar.
That apart, because of imported raw material inventories, it used to run huge working capital requirements, which were largely funded through bank credit. A direct fallout of this volatility and fragile financial profile was that earnings predictability was very low, which, coupled with investor fears about the capital-intensive and commoditised nature of the business, had a bearing on its share prices, as investors refrained from paying higher valuations. “We were viewed as a commodity company operating on wafer-thin margins, further compounded by earnings volatility,” points out Dhanorkar.
The inflection point
In FY12, the founders handed over the reins of the business to Prahlad’s son, Prakash, and a strategic shift in the company’s operations came about, one that entailed renewing focus on the pipes business. In other words, the resin capacity was used to feed and grow the PVC pipes business. Today, while the PVC resin capacity is static at 270,000 tonne (2006 level), the PVC pipe capacity has nearly doubled — from 114,000 tonne to 230,000 tonne. As a result, 90% of the resin capacity is used in captive consumption. Further, the company has managed to move up the value chain by venturing into producing higher-margin PVC fittings. Where resin fetches margins of 6-8%, PVC pipes earn margins of 10-12% and PVC fittings rake in as much as 18-22% margins, thanks to the last two being consumer-facing businesses.
Finolex has moved up the value chain with PVC pipes
The biggest challenge for the new man at the top now was to add more consumers by expanding the company’s network, and the management was up to the task. Finolex Industries’ backward integration and strong brand equity worked to its advantage, allowing the company to gradually expand its pipe business, both in terms of its products and geographic diversification. Says Vinay Khattar, head of research at Edelweiss Wealth, “In PVC pipes, there is huge competition from both organised and unorganised players, but Finolex enjoys huge brand equity in the minds of consumers. In fact, its products are largely sold to dealers on a cash-and-carry basis, which is a reflection of its strong branding. The fact that its pipes command a premium price also reflects its position over its competitors.” Currently, Finolex is the leader in organised PVC pipes, followed by large players such as Jain Irrigation and Supreme Industries, which have market shares of 15% and 8%, respectively.
Switching back to PVC pipes has helped reduce volatility in margins and earnings, says Dhanorkar. “Moreover, we are now able to leverage our network and customers’ trust in our quality, thus exercising some pricing power.” Currently, it has a network of 600 dealers, over 1,500 sub-dealers and 15,000 retail points covering south, west and north India. Today, 40% of Finolex’s revenue comes from west India, 30% from the south, 20% from the north and the remaining from east India. It is now looking to the north and east to consolidate more market share. “We are testing some of the markets and regions — such as UP, Bihar, Odisha and West Bengal — that are ignored or where we do not have large presence,” points out Prakash.
Post this shift in focus, Finolex’s business, too, has become more predictable and structurally sound because of the sustained demand for plastic pipes, which continues to grow at 10-12% a year. Interestingly, higher growth is also a result of plastic pipes emerging as a substitute for cement and galvanised steel pipes, which are relatively costly. Plastic pipes are now available in different shapes, diameters and thickness and made from different materials to suit varied requirements. Accordingly, demand has shifted, to some extent, from cement and steel pipes to plastic.
Today, though the company is not entirely insulated from volatility in the resin business, it is able to pass on cost increases and protect its margins. The increasing contribution of high-margin businesses such as pipes and fittings has also helped Finolex improve its operating margins and return ratios. From 47% of revenue in FY12, PVC pipes’ share has now gone up to 64% (see: Changing mix), while the share of fittings, that is clubbed within the PVC pipes segment, is up from 5% to 8%. Consequently, operating margin is now 19%, compared with 11.96% in FY12.
Return on shareholders’ funds, too, has increased from 9.63% in FY12 to 22.5% in FY14. Now, Finolex doesn’t plan to add further resin capacity — the business doesn’t use capital as efficiently and brings lower returns. Accordingly, says Dhanorkar, even if Finolex requires more resin for its PVC pipes manufacturing, it will buy the raw material from the open market.
Bolstering the books
Bringing the focus back to pipes has meant Finolex Industries has had to invest heavily in new manufacturing capacity as well as increasing its distribution reach. This investment was partly financed by debt and, as a result, the company accumulated debt of ₹840 crore in FY13. But that concern is easing as the business has started to throw more money and cash flows have improved, which is being used to strengthen the balance sheet. “Our focus is on becoming a billion-dollar company in five years from now,” says Prakash. Currently, Finolex Industries generates cash flow of around ₹200 crore a year, which is expected to grow to ₹300 crore by FY16 thanks to better margins. This money is now being used to retire debt. About ₹200 crore was retired in FY14, bringing down the total debt to around ₹600 crore and improving the debt-to-equity and return ratios.
Debt-to-equity has come down from 1.2 in FY13 to 0.9 in FY14. Retiring debt has also helped the company save on interest costs, thus increasing profit and return on shareholder funds. More importantly, future cash flows, too, will be used to retire debt. “The pipe business is remunerative, with an RoC of around 40%. As its contribution to revenue increases, we will become debt-free over the next three years, and this should reflect in the return ratios,” says Dhanorkar.
Despite a sharp run-up in its price, Finolex trades at a discount to its peers
That sounds feasible, since a large part of business capital expenditure, such as investing in capacities, is already in place. Indeed, even after investing the ₹50 crore-₹60 crore that may be required for brownfield expansion of the existing PVC pipe manufacturing capacity, the company should be left with ₹200 crore-₹250 crore of free cash annually. That’s a good sign for investors, as they can now look forward to higher dividends in the coming years.
In FY14, Finolex distributed ₹80 crore as dividend (₹6.5 per share) against Rs 43.3 crore (₹5.5 per share) the previous year. Interestingly, the promoters are the largest shareholders, with a 52.46% stake in the company.
Ripe for re-rating
As business dynamics change and Finolex’s financial performance improves, it is quite possible that its stock, too, will soon be re-rated. Markets tend to give higher premium to companies that generate strong free cash flows, earn better returns for shareholders, have less debt and make strong operating margins. Finolex is improving its position on these four counts, which, over a period of time, should reflect in the valuations that the market is willing to offer. “We are extending our product basket and geographical reach. We are also investing in our brand and visibility,” says Prakash.
At current market capitalisation of ₹3,307 crore (share price of ₹288), the company is valued at 16 times one-year forward earnings. However, the Street believes that these valuations do not capture Finolex’s changing financial profile, which is to some extent comparable with its competitors such as Supreme Industries and Astral Poly that are in the value-added products segment and generate similar margins and returns for the shareholders. “Finolex is fast transitioning to a PVC pipes company from being a predominantly PVC resin manufacturer. The transition (B2B to B2C) will lead to the company capturing incremental margins and narrow valuation gap,” says Kashyap Pujara, executive director of Axis Capital, in a note on the company.
For now, Finolex is trading at an attractive multiple, compared with Supreme Industries and Astral Poly, which are trading at 27 times and 50 times. (see: Going cheap) Though its competitors make higher returns and are financially sounder — which is also a reason for this divergence — if Finolex stays on its course, it could deserve a higher price, too. “The company appears to be in a sweet spot, aided by multiple drivers, such as increased revenues from PVC pipes and fittings businesses, margin expansion and contracting forex losses through appropriate hedging policy. All these factors would lead to strong earnings growth (20% annual growth over FY14-16) and trigger a re-rating in the stock,” says Edelweiss’ Khattar.
Considering that the industry has structural growth drivers (in fact, if government projects such as linking of rivers see the light of the day, this industry could grow even faster), and Finolex being the leader, its investors should do well over a period of time. Importantly, improving return ratios with a renewed focus on high-margin businesses and conscious attempt to bring down debt to zero and higher free cash flows could help Finolex create higher value for investors. This is one company that has assured growth in the pipeline.