Oriental Carbon Management Q&A: July 2012

Management Q&A

  1. ORIENTAL CARBON & CHEMICALS HAS TAKEN SOME RAPID STRIDES OVER THE LAST 5 YEARS. SALES HAVE GROWN AT A 25% CAGR WHILE NET PROFITS HAVE GROWN AT AN AMAZING 73% CAGR. ALSO THE COMPANY HAS BEEN OPERATING AT A DIFFERENT LEVEL SINCE FY 2010. OPERATING MARGINS HAVE JUMPED FROM 14-16% LEVELS TO 30% PLUS LEVELS IN LAST 2 YEARS.

Kindly share the journey. The business started picking some momentum around 2005-6. What were the catalysts?

You see in 2006 we had doubled our capacity to ~6000 MT from earlier 3000 MT. There was the EOU unit benefit and economies of scale kicking in.

The company entered a different trajectory from 2010, as margins moved dramatically upwards. What changed in the market dynamics? What have you done differently in the last few years?

Well actually the different trajectory started from 2009 itself. 2008-9 was a bad year because of huge increases in RM Sulpher prices. But it wasn’t a bad year for Oriental Carbon!

You see Insoluble Sulpher market is dominated by Flexisys. They set the pricing terms. They had different pricing policies for different regions – US, Euro, and Others. The Euro-Dollar volatility also used to lead to anamolies, which Flexisys could not correct dynamically. This was going on for last 7-8 years. The huge increase in RM in 2008 resulted in big anamolies, and Flexisys had to do something to smooth out these. This they did finally by resorting to a quarterly Dollar pricing policy on a global basis – with an adjustment range for RM (Sulpher) fluctuations.

Oriental Carbon also followed suit, and started entering into similar quarterly pricing agreements with customers instead of annual agreements. This allowed flexibility to pass on the raw material price increase.

So economies of scale with capacities doubling & continuous de-bottlenecking, benefits from the EOU status, and these changes in the pricing policy resulted in significant improvement in the profitability.

  1. INSOLUBLE SULPHER IS TODAY THE MAIN PRODUCT SEGMENT AND TYRE MAJORS ARE THE MAIN CUSTOMERS. FLEXISYS (USA) IS REPUTED TO BE THE DOMINANT SUPPLIER WORLDWIDE. APART FROM ORIENTAL CARBON, OTHER PLAYERS KNOWN SHIKOKU (JAPAN) & SINORGCHEM (CHINA).

Kindly tell us more on the market Opportunity. What is the total size of the market- Domestic & Exports? What is Flexisys market share and what is yours? What are the growth drivers – both in India & in Export markets.

This is a niche market and there are no industry-published figures. We can only provide some estimates.

As per our data, the total market is ~225,000 MT per annum. Solutia controls 70-80% of this market. Oriental Carbon caters to about 8-10%. Shikoku, Japan goes neck & neck with Oriental Carbon. We believe they have a capacity of 17-18000 MTPA.

Insoluble Sulpher is mostly used by the Tyre Industry. Increased Radialisation is the main demand driver.  A shift in preference for value added grades is being seen as these offer ease of handling and more production flexibility to the Customer.

How big are the Chinese & Japanese competitors. Do you enjoy any competitive advantages over the other Asian players?

Chinese capacity is reportedly 35,000 MTPA. Sinorgchem, a new entrant, is also reportedly putting up a new plant of 15,000 MTPA capacity. The first phase of 5000 MTPA is supposed to come up in 2012-13.

The Chinese capacity is at present completely consumed in-country. Shikoku is serving Japan and Korea mostly. In Europe, for example Oriental Carbon is the only competitor to Solutia.

How do you match up in quality to say market leader Solutia?

OCCL Insoluble Sulpher grades substantially match that of the larger players like Solutia.

  1. ENTRY BARRIERS. COMPETITIVE ADVANTAGES.

Kindly tell us more about the nature of this market? Why is one company Flexysis having such a dominant market share? Why has it not attracted more investment and more players? What are the entry barriers?

As explained before, the total market size is small. The technology is closely guarded. No tyre major is interested in shifting vendors or entertaining new vendors unless you can supply in sizeable quantity – atleast 2500-5000 MT. The approval process is also very lengthy and costly.

The risk/reward situation does not warrant much fresh investment.

Oriental Carbon has been in Insoluble Sulpher business since 1994! But Business Performance has become noticeable only since last 2 years, Why?

There is also the history of the company that you have to consider. Carbon Black was the main business. This business gradually became a commodity business. We recognised Insoluble Sulpher as the business of the future, but were struggling to put up required capacity till 2000. We decided to divest the Carbon Black business altogether only after the new capacity was up.

Solutia has reportedly announced plans of 50000 MTPA expansion in Thailand. How does this development impact OCCL? When will this new capacity likely to come on-stream?

We don’t see anything changing materially. It is in market leaders interest to maintain price levels. If the pricing reduces by 1$ we are affected to the tune of $20,000, but they may then be staring at a $200,000 impact.

Having said that, we also need to be careful of not altering the current balance. We can grow at a calibrated pace.

How is Oriental Carbon placed today? Will it be able to sustain its competitive advantages? Why?

We are reasonably well placed. Any new plant needs fresh approvals which is lengthy & time-consuming. For a new line (in existing plant) a competitor needed 1 full year for approvals.

This is also a very capital intensive business. Asset Turnover is generally in the range of 1:1. Rupee depreciation etc may take it to 1:2 at most. For us to get a payback in 3-4 years time, the business needs ~25-30% margins, at the minimum.

We hope to be able to maintain that due to the reasons mentioned before – Limited Market size, closely guarded technology, lengthy approval process, etc. discouraging fresh investments.

  1. CUSTOMERS. REVENUE CONTRIBUTION FROM TOP CUSTOMERS.

You have been mentioning OCCL getting preferred alternate supplier status. Can you elaborate on that.

As mentioned before, in certain geographies like EU we are the only other supplier capable of servicing the tyre majors. So we have relationships going back a number of years.

Do you have long term contracts with any of the majors? What is the normal contract duration?

Yes. we have very long term arrangements with some of our customers. No formal contracts, but s mentioned before strong relationships and understandings that extend to both commercial and technological aspects.

Kindly share recent customer successes and or deeper penetration into existing accounts. Have more marquee names been added to the list?

Continental AG, Goodyear, Bridgestone, Pirelli are some of our big customers. In the domestic market we have MRF, Apollo, JK tyres and some more.

How much does your top 3 customers contribute to Sales? Does any one customer contribute more than 10% of Sales?

TBD

What kind of approval process do you have to go through with your major customers? Do you have to take plant-specific approvals? Is the new Mundra Facility approved for all your customers?

Approval process varies from customer to customer. Any plant in a new location has to ofcourse go through fresh approvals. The Mundra plant is approved. The new line at Mundra plant will have to go through the process, but will take less time.

Are there any majors that you are persuing currently that may lead to increased sales?

We have been pursuing Michelin for some time now. Its under process.

  1. CAPEX. INSTALLED CAPACITY HAS GONE UPTO 22500 MTPA. YOU HAVE BEEN MENTIONING CAPACITY BEING PRE-SOLD. YOU HAD ALSO BEEN MENTIONING LAND AVAILABILITY FOR THE NEXT 11000 MTPA EXPANSION.

Looks like, demand was far outstripping supply. Please tell us a little more on the demand situation you saw in FY11 and FY12. How is the demand outlook looking now with double the capacity?

Demand situation warranted that we expand quickly. Yes capacities were pre-sold as per arrangements with our customers. We are working at something like 75% capacity utilisation at the moment. The Phase 1 expansion of 5500 MT is working at full capacity and the phase 2 5500 MT expansion is at 25-30% utilisation levels.

What is the total Capex cost for the 11000 MTPA incurred in Mundra Phase I & II expansions? And how much will be needed for the next 11000 MTPA expansion?

The total capex for 11000 MTPa was ~120 Cr. The next 11000 expansion is in the same premises (already acquired) will cost less due to spreading of fixed costs.

The latest AR mentions slowing growth possibility in Euro Zone. Have any major customers cut back on plans? What are the plans for the next expansion?

The last 11000 MTPA expansion was pre-sold. We have agreements in place. But customers have their own process of demand-slack allocations. So plans may be deferred by 3-6 months. Most of these customers have geographically diverse plants. Demand slack in one region may be compensated by pick up in another.

Can some slack be taken up by the domestic market?

Yes. but only of the order of 200-300 MT

  1. EXPORTS. EXPORTS TODAY CONSTITUTE ~60+% OF TOTAL SALES UP FROM 40% LEVELS IN FY 2001. EXPORT GEOGRAPHIES & CONTRIBUTIONS.

Kindly provide the Geographical spread – how much from Europe, US and other markets. How much of export sales is booked in Euros and how much in US$? Any other currencies

Most of our sales come from Europe and RoW (Rest of the World) Market. We do not have any significant presence in the US. In terms of currency breakup, roughly 60% Euro and 40% in US$ sales.

Do you have higher margins from Export sales?

Slightly higher margins in Export Sales.

What kind of hedging policy is followed by the company? US $ Hedges seemed to be order of 50 lakhs only and same for Euros. Loan positions are left unhedged. Do we see changes coming in due to increased volatility, or will this policy remain largely unchanged?

We hedge our Sales for protecting margins. Typically 3-6 months rolling basis. US $ Loans are left unhedged as that provides some natural hedge.

If you have been hedging on a regular basis, why have we not seen better performance in FY12?

That’s also because of the 3-6 month lag effect. You will see some impact in coming quarters.

What is the sense that you have got from your Export customers? What is your order book size at the moment? Have you noticed any slowdown in order book already?

We have covered this before. There is some delay in allocations by 3-6 months. We will defer the next expansion phase accordingly.

If Export demand sees a decline, what are the plans to counter this risk? Can domestic market absorb additional sales? Can you penetrate deeper into customer accounts from the US, if say Euro Zone slows down?

As mentioned before most customers have geographically diversified plants. There are plants in Indonesia, Korea, South Africa where demand pick-up can compensate. Middle East is also another important and promising market.

  1. RAW MATERIALS. SULPHER AND NAPATHANIC OIL ARE THE MAJOR RAW MATERIALS. RM/SALES USUALLY IS IN THE 30-35% RANGE. BUT HAD SHOT UPTO 45% IN FY09. LAST 2 YEARS HAVE BEEN BENIGN WITH RM AT 26-28% OF SALES. 1QFY12 HAS SEEN RM SHOOT UP SIGNIFICANTLY TO 35% OF SALES

Kindly explain the overall raw material linkages and demand supply situation. If crude prices soften, will that see prices of Napathanic Oil & Sulpher both easing off?

RM procurement is on SPOT basis. There is no real direct correlation with crude prices. What happened in 2008 for example to Sulpher prices -was pure speculative in nature.

As you are aware prior to 2009 we had annual contracts, but subsequently we work on a quarterly pricing structure with customers, with RM price revisions being of a pass-on nature.

Kindly explain the nature of RM procurement. Do you have agreements with leading suppliers, how does it work? In most years we see a mix of local purchase and imports. Some years we have seen no imports? Imported RM in FY12 is ~19% compared to ~14% in FY11. Kindly comment.

We procure from both domestic and international suppliers. Realtionships are strategic in nature.

Would you say there is a direct linkage of raw material prices to operating margins?

Yes, there is a direct correlation to margins.

  1. POWER & FUEL COSTS. POWER IS THE SECOND BIGGEST COST COMPONENT FOR THE COMPANY.

Power costs have gone up to ~13% of Sales from ~10% levels a year or two back. Kindly explain.

That is because in Dharuhera plant we had some advantage from steam co-generation from the Sulphuric Acid plant, which isn’t there in the Mundra plant.

However this will stabilise as Mundra facility works at peak capacities. We draw quality power at Mundra with lower costs.

  1. WORKING CAPITAL. FY11 HAS SEEN WORKING CAPITAL/SALES CLIMBING UP TO ~40%. MOSTLY BECAUSE OF DEBTOR DAYS GOING UP BY A SIGNIFICANT 20% IN FY11 (OVER THE 40% INCREASE IN FY10 OVER FY09). IN FY12 WORKING CAP/SALES IS BACK TO ABOUT 34% OF SALES.

Kindly explain the sales cycle – What kind of debtor days do you have for International & domestic sales? What kind of Inventories do you normally need to hold on the RM front, especially Sulpher?

Debtor days and Inventories are actually at normal levels. The year end picture looks skewed as most of the investment in assets were towards the the 2nd half of the year. This year we should see reversal to normal levels, as capacity utilisation goes up.

Why have we seen big jumps in FY10 & FY11, followed by some cooling off in FY12? What according to you is a sustainable level for the next 2-3 years? And Why? Please comment.

Basically the same reason as above. You will see better figures for FY2013.

  1. MARGINS & PROFITABILITY. FY10 AND FY11 HAS SEEN OPERATING MARGINS AT 30% PLUS FOR THE FIRST TIME. REALISATIONS HAS MOVED UP FROM ~RS 70/KG IN FY07/08 TO ~RS 95/KG IN FY09 AND RS 100/KG FOR FY11 & FY12. IN FY12 REALISATIONS HAVE CLIMBED TO RS. 116/KG.

Is it correct to say that because of Sulpher prices going through the roof ion 2008-09, operating margins in FY09 were subdued. Otherwise OCCL had started getting higher realisations from FY09, and margins were actually on an upswing since then, not FY10.

Yes, we have covered this before.

Is it correct to say that FY12 higher realisations are entirely due to the Rupee depreciation effect?

That’s not entirely correct. We have forward covers and there is the 3-6 months lag effect.

Export Realisation came in at Rs 113/kg, while overall realisation is at ~Rs 116/kg. It also looks like you had better realisations in the domestic market in FY12 than in exports? Is that correct? Does the domestic market work on Import-Parity basis?

Domestic realisations are slightly lower actually. Perhaps the figures you used included that of Sulphuric Acid as well.

International prices of Insoluble Sulpher are quoted at $2200-2600 per Tonne? OCCL seems to be billing at ~5-10% discount to the lower range. Are there any chances of improving $-realisations? Why?

No. we have been billing at this $2200 -2600 range only. You might have taken an average Rupee-US Dollar conversion rate for the entire year – that would be misleading.

The Rupee has depreciated by ~22% against US$ and some 10% against the Euro in FY12, but OCCL has not really been able to ride the benefits all the way. What are the main reasons for this? Were there any losses on Forex account due to hedging?

We have covered this before. The actual impact will be seen in FY13 because of the lag effect.

What kind of realization levels are possible in FY13 & FY14? If rupee remains at current levels, do we see margins reverting to 30%+ levels? At what levels do you see Operating margins sustaining for the next 2-3 years?

Yes, we should see a reversal to higher operating margins. If rupee remains higher, margins should be better ~ 30% range.

  1. VALUE-ADDED PRODUCTS. INSOLUBLE SULPHER HIGH STABLE AND HIGH DISPERSION GRADES. SUPPLIES OF HIGH STABLE GRADE STARTED IN FY 2009 ON A REGULAR BASIS. HIGH DISPERSION GRADES HAVE BEEN APPROVED BY SOME TYRE MAJORS.

Please tell us a little more on higher grade Insoluble Sulpher market and the demand for it. What are the advantages? Are margins superior and by how much? Is the demand shift trend more in export markets?

Well Oriental carbon clearly is a follower. Whatever quality grades are required by the customer, we try to match that quality. We interact and collaborate on technology aspects with the customer. Our customers help us in moving up the value chain as we are the 2nd alternate supplier for them. Offering higher grade products is a continuous process, and usually comes with better margins.

What is the contribution of High Stable, High Dispersion grades in better price realizations for the last 1-2 years? What is the revenue mix currently in Insoluble Sulpher segment from High Stable grades?

TBD

2011 & 12 Annual reports mention Company is currently working on development of pre-dispersed Insoluble Sulphur. Is this another value-added grade? Any other new products/grades in the R&D pipeline.

TBD

What kind of R&D Set-up do you need to maintain? Is this sufficient for the current needs, or will it need sustained higher investment?

TBD

  1. CHEMICALS PRODUCT SEGMENTS – SULPHURIC ACID & OLEUM

Kindly tell us a little more on these product segment markets, demand/supply and raw material linkages. Is it true that the domestic market moves with the whims of the main supplier – Hindustan Zinc?

Sulphuric Acid market in India is dominated by Hindustan Zinc. This is a by product for Hind Zinc. The demand for Sulphuric Acid is dependent on industrial activity and therefore cyclical in nature. Since they produce a certain quantity anyways (unlinked to demand cycles) they have to dispose it off anyways! Sometimes demand situation is so bad, that people are paid to take away Sulphuric Acid in Tankers.

In such situations, the industry margins become negative. The last 2-3 years margins have been positive and stable. Though it reduced quite a bit in FY12

Chemicals segment contributes just 10-12% in Revenues but in bad years have the potential to drag down margins drastically? Why would you continue with such volatile segments? How much is the cost saving from Steam, generated from the Sulphuric Acid plant, in percentage terms?

We have been continuing with the Sulphuric Acid segment, as it generates steam which is used by the Plant at Dharuhera. The savings from steam generation is significant and makes that segment viable.

FY11 & 12 were benign for the Chemicals segment – with 14% plus EBIT margins? But FY12 EBIT levels were down to 5%. What is the outlook for FY13?

This year should be better

Any plans of divesting this segment altogether?

No

  1. MEDIUM TERM OUTLOOK

Given the 22500 MTPA capacity, what is the capacity utilisation and Volume targets in the medium Term?

75% capacity utilisation. We should continue to grow at current levels. The volume growth may be limited to 10-15% if the demand slack continues.

How is the overall market growing in the medium to long term?

India is a high potential market and should more than double by 2020. Global market also is growing steadily. Medium term outlook is good and we expect good margins.

What rates do you see the domestic market growing? Will it be able to absorb higher levels of supply in the medium term?

Domestic market is growing at about 15% on an annual basis. It can take about 7500-800 MTPA. Chinese market currently is at 35000 MTPA, so there is huge scope for growth in India.

  1. TAX IMPACT FOR FY13 ONWARDS

Please indicate the applicable tax rate for FY13? Will Mundra SEZ facility get any MAT credit? Does that mean in FY13 11000 MTPA production/sales will get MAT credit at 18% rates while the rest will be taxed at full rate?

Effective tax rate will be lower at 20-22%. This is because of the Mundra facility which as an SEZ gets MAT credit at 18% which can be off-set against the overall tax liability. As the share of production in Mundra facility goes up, effective tax rate will come down.

Where do you see Net Margins stabilizing at for the next 2-3 years?

Operating margins should expand but we are not banking on the same and going conservative in our plans. Net margins should also expand due to  better operating margins and Lower tax. However there is the impact of higher debt servicing costs. Net margins may be slightly lower in FY13.

  1. SCHRADER DUNCAN ACQUISITION.ORIENTAL CARBON HOLDS 12.58% IN SCHRADER DUNCAN, A LISTED ENTITY.

Kindly explain the rationale-Why was the stake in Schrader bought in Oriental Carbon?. It looks like an unrelated business with poor return ratios and was earlier making losses? What is the situation now? Since OCCL has divested businesses in the past, what are the plans for the Schrader now?

This was a JV company where we had 25% ownership. The foreign parent company was getting sold and hence in the course of re-structuring they wanted to sell the Indian arm as well. Pneumatic area has good potential. The price was good and the issue with the company were more of structural nature (like high salary due to expats). We knew we can correct them. By selling the property worth 40 Cr, we could bring down the debt and the company should turn profitable.

What is the current status?

It has already started turning around. We have some plans for expanding the business.

  1. DIVIDEND POLICY

Please indicate the dividend policy followed by the company. While dividend amounts have increased over the years, it has not kept pace with the increase in earnings. Payouts have fallen from ~47% in FY03 to 11% in FY11. And has increased somewhat in FY12.

If you see the last 5 years, we have generally been increasing dividends. In FY12 again we have increased dividends. 

If you consider the Dividend Tax component, Payouts have increased to over 19% in FY12. We intend to maintain payout ratios at 20% or so.

  1. PLEDGING OF SHARES. 254514 SHARES PLEDGED

Although this is under 5% of promoter shareholding in the company, this has been continuing for a number of years. Please explain the circumstances for the same and why is this not being paid off & revoked.

The pledging was for some corporate loan taken from bank. Shares were given as an additional security.

  1. MAJOR OPPORTUNITIES & CHALLENGES

Where does Oriental Carbon see itself in the next 5 years? Can we see Oriental Carbon reach 500 Cr Sales, by when? What are the major challenges before the company and where are the big opportunities?

Yes 500 Cr is possible and should happen after the expansion of the next 11000 MT capacity. The next big opportunity would come from penetrating the US Market.


Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 6 months;
Donald Francis: No Holdings in the Company; ;
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