I was still on a high, fresh out of hosting the IDFC annual investor conference — The Stock Called India — when Outlook Business popped this question — which is the one stock you would place your bet on in 2015?
Of course, one need not be a pundit to understand that India is on the cusp of the next growth phase. Most of the ingredients are in place: bottoming out of economic growth, a sharp fall in prices of crude, gold and other commodities, slowing inflation, a powerful government and a very optimistic population and India Inc. It is with this backdrop that several investors from across the globe at the conference scanned the marketscape for answers to the same questions: with the market having seen the worst in the past few years, which are the gems that will find fresh radiance under the new dispensation? Which are the Indian companies that will redeem the lost pride of the India story?
Faced with this unenviable task and with so many contenders to the throne, my mind went back to a company we had visited in early 2013. I am talking about UPL (then United Phosphorus), a company that had the genetic code of an Indian company with global ambitions embedded in its DNA. Starting off as a niche specialty chemicals firm catering to domestic markets, UPL became the third-largest manufacturer of generic crop-protection chemicals in 15 years thanks to the around $700 million spent on 14 global acquisitions across multiple climatic zones. Key elements that made UPL a game-changer among Indian peers (largely contract manufacturers for Western majors) were low-cost plants in India supporting an increase in global operations and forward integration, product registrations, marketing and distribution that targeted the global markets directly.
But FY09-12 saw significant volatility across the value chain, as product pricing has a strong correlation with agri commodity prices and raw material pricing is dictated by crude oil prices. That, coupled with increasing incidences of weather fluctuations across regions, puts significant pressure on business models of most global agrochemical players. As a result, shares of global agrochemical players such as Nufarm and Makhteshim plunged.
UPL was not immune to this, given that it had created a global platform with expansive distribution and retail capabilities through the inorganic route. It was not for nothing that UPL was called a serial acquirer. The reasons, though, were not wholly of its own making, notwithstanding its obsession with revenue growth. FY09-12 was a turbulent period for the global agrochemical industry. But investors punished UPL as its revenue-focused growth model did not pay off during those four years and, in fact, had resulted in deterioration in operating metrics with declining gross margins, higher SG&A costs and lower profitability growth. During the four-year period, despite a decent 16% CAGR in revenue (from around ₹49 billion in FY09 to around ₹77 billion in FY12), profits saw a dismal 6% CAGR (from ₹5 billion to nearly ₹6 billion) and, as a result, return on equity fell 600 basis points from 21% to 15% over the same period.
Through the smokescreen of the global challenges facing the sector and UPL’s own strategic skew towards inorganic growth, we spotted a company seeking to leverage these challenging times to broaden and strengthen customer relationships through aggressive revenue scale-up. When we sought to visit the company in January 2013, we had sensed the stirrings of a change in their DNA, a shift in management focus towards consolidation of operations and improvement in profitability.
Focus on profits
As the revenue growth-centric thrust clearly did not create value for shareholders despite around 3X growth in business over FY07-12, the focus has shifted to enhancing profitability through rationalisation of low-profit products, optimsation of the supply chain, a more judicious allocation of capital and alignment of profitability deliverables with key result areas across the organisation.
UPL is aiming for around 200 basis points margin increase to 21% over the next two to three years, led by pruning low-margin products and backward integration for key products such as Mancozeb, reducing overheads (realignment and optimisation of supply chain) and improving profitability of its Brazilian operations. It had acquired DVA Agro in 2011 to address the $10 billion agrochemical market.
Inorganic streak curtailed
Inorganic growth has been integral to UPL’s growth strategy. In the early 1990s, its acquisitions were with a view to acquire higher margins, as India’s growth at that time was flat and there was an onslaught of cheap Chinese products. Later, the strategy was to adopt an aggressive growth model by de-risking the business from the vagaries of climate and weather, creating a balanced and expanded product portfolio and establishing a wider distribution outreach.
However, despite creating a solid base of around ₹108 billion in consolidated revenue (FY14), strong free cash flows (₹4.6 billion in FY14 after accounting for capex and interest costs) and a diversified and entrenched presence across key markets (each of the four major geographies contribute around 25% to revenue), investors did not take kindly to its north-bound leverage levels. It is perhaps in response to this that, over the years, UPL has been acquiring partial or full entity stakes instead of buying out selective brands that it pursued in earlier years. Also, the frequency of transactions reduced significantly with enhanced focus on organic growth.
What emerged from our interaction is that shortening the working capital cycle is now a key focus area for UPL, given significant implications for debt reduction and return ratio expansion. With easing working capital requirements, its free cash generation should improve significantly in the coming years. Also, limited capex would help free up cash for debt reduction.
The focus on profitability improvement notwithstanding, UPL will continue evaluating strategic buyout assets that fit its investment criterion. So, while UPL is likely to reduce its short-term working capital loans through internal accruals, my sense is that it intends to hold on to its long-term debt portfolio, which would provide it with greater leverage to grab any potential acquisition opportunities. Its current net D/E is 0.4X. However, I believe that organic growth will gain prominence in future — as has been the trend in recent years.
With its global scale and diversified geographical presence, UPL has been a strong play on the global agricultural cycle. The global imperative of increasing food production implies secular growth for agrochemicals. With a track record of consistently growing faster than the market and an extremely competitive manufacturing and distribution model, UPL is one of the best models to play the global agriculture opportunity. The fact that the company is six times the size of the second-largest Indian agrochemical player, Rallis, reflects the high entry barriers and challenges inherent in building a successful global agrochemical business.
The stock has done exceedingly well in CY14, given the company’s shift in focus from revenue growth to profits, emphasis on organic growth, higher return ratios and distribution of free cash to shareholders, which underpin its new growth strategy.
Further, UPL successfully executed a couple of buybacks over the past two years and given the free cash generation, I believe the company may continue to explore options to reward shareholders in subsequent years too. This will help improve return ratios as well as EPS growth. At 11X the estimated FY16 earnings and at 6.4X the EV/Ebitda (FY16 estimates), that is at a sharp discount to peers and 15% EPS CAGR likely over FY14-FY17, I believe the stock has all the ingredients to repeat its CY14 performance, which saw the stock dishing out over 60% return.
Disclaimer: The author of this report, his relatives, IDFC Sec and its associates do not hold this stock. The author may have recommended this stock to clients of IDFC Sec, for whom he works as co-CEO. UPL was not a client of IDFC Sec in the past 12 months. The author, IDFC Sec, their associates and relatives do not have any conflict of interest, have not engaged in market-making for UPL and have not been compensated in any manner by the subject company. The author has not been associated in any capacity with UPL. IDFC Sec has applied to Sebi for registration as a research analyst.