December 10, 2020 must be a day hard to forget for promoter Jaidev Shroff as well as the investors of UPL. That day, a media report citing a whistleblower complaint about the promoters knocked off 12% of the company’s market cap. On Twitter, #UPL was getting a lot of hits and Shroff would have wished that they carried updates from Uganda Premier League than that of his own company. The stock saw trading volume of 91.5 million shares of which 16.9 million were marked for delivery. Effectively, 12% of the equity was traded and 2.2% of the company changed hands at an average traded price of Rs.432. That price now effectively is a marker for existing investors in terms of whether the worst is behind for UPL.
This was the second governance issue that had cropped up in just over a month. In October, the company had informed the exchange about the abrupt resignation of KPMG Mauritius as UPL Corp’s auditor. That, too, had knocked off 10% of market cap. Earlier still, in August, just before the annual meeting, vice chairman Sandra Shroff resigned from the board as there was a hue and cry raised by governance advisory firm SES over excess remuneration paid to non-executive directors via subsidiaries. In contrast, prominent investor Vinod Sethi ceasing to be an independent director from September 2019, after being 13 years on the board, did not get talked about as much.
The excess remuneration issue died a natural death but the sudden resignation of the auditor at UPL Corp set tongues wagging. For one, UPL Corp has been the primary acquisition vehicle for the UPL promoters and hence an important subsidiary. Second, because KPMG replaced the existing auditor Crowe ATA less than a year ago and the talk then was about appointing a global firm, bringing in transparency, etc.
Even as the company in its last concall maintained that they fired the auditor because they were not finishing the work on time, Nitin Mangal, an independent research analyst feels the management’s explanation lacks credibility as KPMG Mauritius themselves have not given a proper explanation regarding their sudden resignation. “Tax havens are a big revenue driver for the Big Four. Mauritius may be a small country, but it is a prominent tax haven and it is unlikely that KPMG Mauritius does not have the required bandwidth there.” After KPMG Mauritius’ exit at UPL Corp, Crowe ATA is now back as auditor.
Before the UPL Corp auditor controversy could settle down, the whistleblower allegation about promoters siphoning off funds through shell companies popped up. Once again, the management clarified about it being an old issue for which the audit committee had given the management a clean chit after getting it vetted independently. During the clarification concall, the management said it was evaluating all options, including writing to Sebi to investigate the matter and termed the whistleblower article ‘malafide’. When Outlook Business reached out to the company to check whether the company had filed a formal complaint with Sebi and against the article, the UPL spokesperson replied, “The company is taking appropriate steps to counter the malicious reporting.”
In light of the recent development, Outlook Business also sought clarification on advances of Rs.1.09 billion and Rs.340 million to Tatva Global Environment and Urbania Realty LLP, respectively, which was disclosed in UPL’s latest related party filing (Tatva Global Environment was one of the entities mentioned by the whistleblower). According to RoC filings, Urbania is a real-estate company which has chairman Rajnikant Shroff on its board while Tatva Global Environment has Nitin Kolhatkar and Atulkumar Agarwal as directors. While Nitin Kolhatkar is vice president-finance, UPL, and has been a director since April 2014 and is also on the board of related-UPL entities, Atulkumar Agarwal was inducted as additional director in January 2020. In addition, Agarwal is also a director of RoC-Ahmedabad registered Shree Silicaam Minerals LLP, and RoC-Kanpur registered Vanshuli Properties & Constructions and VSGR Properties.
When asked about Atulkumar Agarwal’s skillsets, and the relationship between Tatva Global Environment and UPL, the company responded with, “Atul Kumar Agarwal is a Mechanical Engineer and Post Graduate Diploma in Environmental Engineering and has understanding of the environmental engineering solutions in which business Tatva is engaged. Tatva Global is a waste management company and undertakes that task for UPL. The company had undertaken similar transactions in the previous years. We expect these advances to be cleared over the next couple of months. As for advances to Urbania Realty LLP., the same is towards purchase of two apartments for senior management and the same are standing as advances as we await “Registration” of these apartments. This has also been disclosed in the recent annual report."
The company also cited, “purely commercial decision considering business feasibility”, when asked why similarly named subsidiaries, Tatva Global Renewable Energy Company and Tatva Clean Tech, were being dispensed with. The first is in the process of being struck off from the RoC and the second had already been struck off. It is not just about similar sounding subsidiaries but the sheer multitude that one finds overwhelming. And, that has only compounded since the company acquired Arysta Life Sciences in July 2018.
Many acquisitions, not much free cash flow
While the company has a history of growing through acquisitions, Arysta has been the biggest of them all. The all-cash $4.2 billion deal did make UPL an even bigger global player but saddled the consolidated entity with even more debt (See: Size at a price). UPL acquired 78% through its subsidiary, UPL Corp, by borrowing $3 billion and the rest was equally funded by investments of $600 million each by TPG Capital and ADIA. The equity investment had a lock-in of three years while the debt had a repayment tenure of five years.
Since then, the fruits of deleveraging have not come through. UPL still has net debt of Rs.238.41 billion as of September 2020 compared to Rs.263 billion in FY19 when the integration started taking place. At the time of the buyout, the management was confident that the $3 billion debt would be paid off in about three years instead of the mandated five. Shortly after, the management swapped the term loan into € equivalent of $1.5 billion at fixed rate of 1.50% per annum and $400 million into ¥ at fixed rate of 1.15% per annum citing substantial business in these currencies would provide a natural hedge.
When asked if the acquisition is going as per plan in terms of financial synergies and business growth, the UPL spokesperson replied, “We are well ahead of our target on delivering on the cost and revenue synergies committed at the time of acquisition. We delivered $153 million of cost synergies till date against a target of $200 million which was to be delivered in 2 years and delivered $299 million of revenue synergies till date against a target of $350 million in 3 years.”
With respect to steps being taken to reduce debt further, the spokesperson replied, “Net debt at end of FY19 was around $3.8 billion. As of March 2020, net debt stood at $2.9 billion, a reduction of $900 million and we remain committed to bringing down the net debt level to ensure the net debt to Ebitda of 2X levels by March 2021. With the redemption of $418 million 3.25% Senior Notes on 28th of December 2020, we expect interest cost saving of approx. $1.1 million per month.”
Even as the management claims to have reduced debt by $900 million in FY20, a recent report by Kotak Institutional Equities (KIE), indicates otherwise. It states, “In FY20, UPL generated ~$0.3 billion of free cash flow before change in working capital versus ~$1 billion of Ebitda — the overall reduction in net debt was higher at ~$0.5 billion due to an increase in receivable factoring. We compute effective net debt of ~Rs.321 billion ($4.2 billion) as on March 31, 2020 including reported net debt of Rs.220.5 billion, perpetual bonds of Rs.30.5 billion and receivable factoring of Rs.69.7 billion.” The KIE analysts also mention, “We believe UPL may find it difficult to reduce its ‘reported’ net debt to 2X EBITDA by end-FY21, without issuance of perpetual bonds or receivables factoring given unlikely material upside to our below-consensus estimates and limited scope of cash flow release from working capital, which was substantially below peer group, in terms of days as of end FY20.”
Clearly, the high debt continues to be a concern for investors and analysts alike. Mangal who was the first to highlight potential balance sheet stress at UPL says, “In the next couple of years, it will be difficult to do any deleveraging. Right now, because of improved working capital, they have been able to repay some debt. But once things get normalised, they might have to borrow more to sustain their operations."
Mangal feels the Arysta buyout was overpriced to being with. “If one looks at the financial performance of Arysta for the last three years before it was acquired by UPL, it was not up to the mark,” he points out. PE firm Permira sold Arysta Lifesciences to Platform Specialty Products for $3.51 billion in October 2014 and, in July 2018, Platform sold it to UPL for $4.2 billion. Through 2015 till 2017, Arysta’s revenue moved from $1.74 billion to $1.89 billion while reported Ebitda moved from $0.36 billion to $0.39 billion even as working capital increased from $0.38 billion to $0.72 billion.
Those dismal numbers didn’t dissuade institutional investors though. After the acquisition, UPL’s stock price hit an all-time high in May 2019. While the upheaval in October and December might have led to offloading, as of September 2020, institutional holding stood at 53.08%. Of the FPI holding of 37.15%, that of more than 1% holding adds up to just 8.89%. LIC and ICICI Prudential Life hold 7.84% and 1.35%, respectively. UPL also has relatively low mutual fund holding of 5.20%, of which 2.89% is held by HDFC AMC, SBI AMC and Aditya Birla AMC (See: Out of favour). Since UPL is a Nifty component, is the low mutual fund holding an indicator of investor distrust? Vallum Capital Advisors founder Manish Bhandari waives off that notion saying, “Mutual fund holding does not say much and cannot be a parameter for judging the management or the growth prospects of a company. UPL has many well-known FIIs, even UPL Corp has TPG Capital and ADIA as investors."
That said, about eight years ago while evaluating companies in the agrochemical space, Bhandari narrowed down on PI Industries as a better bet because of its high RoE business model. “When assessing PI Industries, we also looked at UPL. But the size of the business, its architecture and the accounting was not well understood by us. So, we gave it a pass,” he explains. PI turned out to be a multibagger for Vallum after which it invested in SRF.
Even as investors in UPL have an exit mechanism, the exit route for TPG Capital and ADIA in UPL Corp is still unclear. 2021 will be the year when the lock-in period ends.
Earlier, there were media reports about UPL's plan to buy out TPG Capital and ADIA’s holding in UPL Corp. When asked if that is still under consideration and if so, how the company plans to finance it, the UPL spokesperson replied, “At this stage there are no discussions on buying out the stakes of ADIA/TPG in UPL Corp.” If there is no drastic improvement in cash flow, that investment might just have to be rolled over unless UPL agrees to waive off its right of first refusal and agrees to a trade sale. TPG/ADIA could also explore switching its equity from UPL Corp to UPL but that could be a function of the stock price at that time. The market cap staying buoyant would certainly work in favour of the UPL management.
While listing UPL Corp was one of the options mentioned as a possible exit for TPG/ADIA, the fact remains that it might just add to an already complicated holding structure. The company spokesperson maintains the company is working on simplifying the structure. “UPL had close to 86 entities at the end of FY18. Post the Arysta acquisition, UPL group comprised of close to 233 subsidiaries. We have initiated the process of rationalising and simplifying our structure. As a result of this process, the number of subsidiaries has already reduced from 233 to 212,” states the company.
The other bone of contention is the opacity resulting from multiple subsidiaries. Mangal says, “There are a lot of unaudited subsidiaries. There is no synchronisation between the subsidiary’s financials and the consolidated financials. Some subsidiaries are not generating cash flow for a long time. If you look at UPL Corp Mauritius, there are a lot of things highlighted by the auditor there, but they have not been carried in the India balance sheet. They have to be factored in and disclosed properly to investors.”
Much of the future bounty for investors will depend on UPL getting the Arysta acquisition to pay off. After the acquisition, there are just too many moving parts – bigger geographical footprint, more subsidiaries, product litigation, forex fluctuations, and so on. Such complexity is fertile ground for obfuscation, more so when good news flow is imperative to keep the gravy train going. The joker in the pack for UPL could be its inability to reduce debt piled on for the acquisition of Arysta.
Mangal points out that deleveraging is not happening as UPL is not generating enough cash flow. “Despite that, the company is paying dividends. Now, what is the rationale for paying dividends if the company does not have enough free cash flow. You are just refinancing the dividends by borrowing more,” he says. Mangal’s point may be valid but when was the last time shareholders complained about a dividend pay-out. In fact, promoter holding company Nerka Chemicals used dividend income for ‘revocation of pledge’ of 4.1 million shares on November 3. Post the revocation, promoter holding is completely pledge free.
While not paying dividend might conserve cash for the company, the big saving was expected to come from manufacturing synergies. When UPL acquired Arysta, the thought was to combine Arysta’s asset-light approach with UPL’s manufacturing prowess. Bhandari says, “Outsourcing intermediates to India is the right thing to do. They should do as much as possible in India than source from China. The insourcing was what made the Arysta acquisition attractive and UPL seems to be progressing well on this front.”
Fork in the road
Even as management has retained its guidance of 6–8% topline growth and 10–12% Ebitda growth for FY21, Mangal says going forward, the biggest hurdle to cash flow not improving might come from China. UPL used to source a lot of raw material from there and because of the trade war that has stopped. While Latin America is an important market and Arysta’s brands are strong in Brazil because they are competitively priced, they are not expected to move the needle in terms of margin (See: Global player). “Latin America is not going to be a game-changing market for UPL. It will help them sustain revenue. For the bottomline to increase, they need to gain market share in US/Europe which are very competitive because most of the innovator companies are from those regions,” says Mangal.
In US and Europe, UPL not only faces tough competition from existing heavyweights but also has to deal with hawk-eyed regulators. One of the concerns in the Q2FY21 concall centered around fungicide Mancozeb being banned in Europe. To which the management said, “If Mancozeb remains in Europe, great, if not, we have plans to replace Mancozeb with other products. The good thing about our business is that no product makes more than a single digit percentage within our revenues.”
While weather vagaries are hard to predict, regulatory as well as technological disruptions are a big challenge for UPL going forward. To some degree, it has tried to derisk itself by getting into seeds but the payoff from Advanta has not been big enough yet. According to an Edelweiss Securities report, UPL has been aggressive with respect to assumption of useful life of products (See: Bluesky scenario). It states, “UPL’s useful life assumption of product registration and acquisition cost (net block value of Rs.86 billion –73% of other intangible assets ex-goodwill) is somewhat in the mid-range compared to international peers. While it is definitely higher than all of its domestic peers, UPL’s 15 years useful life assumption is higher than FMC and Adama, but lower than Nufarm (high end is 30 years).”
The current buzz is around governance or the lack of it but investors might just be more worried about the business model. For, it is the premise of deleveraging that investors such as TPG and ADIA might have bet on when they paid $1.2 billion for 22% of UPL Corp.
Unlike other brokerages who have maintained their ‘buy’ rating after the management clarification post the development on December 10, KIE has a ‘sell’ rating with a fair value of Rs. 375. Its analysts state, “Recurring downgrades on consensus estimates amid limited conviction on optimistic guidance-led-forecasts, low FCF generation, high effective leverage and a few other issues have kept us cautious on the stock. We also note other issues like inapt adjustments for representation of PPA-adjusted earnings post Arysta’s acquisition, reporting of forex loss related to working capital below Ebitda, sharp rise in management payout as percentage of profits and accounting of recurring one-off losses.” (See: Consistent downgrade)
The issue of recurring one-off losses has also been highlighted by analysts at Edelweiss Securities. While the firm has a ‘buy’ rating on UPL with target price of Rs.615, the earlier mentioned report states, “Exceptional items charged to P&L have been a recurring occurrence. During FY16-20, cumulatively, exceptional items have totalled 12% of cumulative PBT. In FY20, it was Rs.6.2 billion (18% of PBT, up from Rs.4.5 billion in FY19). According to the report, in the previous three years UPL has charged Rs.11.4 billion to exceptional items. More than half the expense is due to restructuring and acquisition cost of Arysta group and 37% is due to provision for litigation and litigation expenses.
Mangal says the number one thing that investors should worry about is the inflated ROCE. He explains, “It is overstated by atleast 4% through accounting innovation. There is a line item called non-controlling interest account. It is a negative balance on liability side, they have not taken write-off for entire goodwill of Advanta and plan to amortise it over five years. It is being shown as a separate account and investors are not adjusting it against networth. The real ROCE should be derived after that.”
UPL has done a lot of acquisitions, but so far, the management has not been able to generate enough free cash flow for the consolidated entity. Given the stretched balance sheet and lumpy growth, the deleveraging story looks extremely questionable.