Pondy Oxides Management Q&A: Sep 2010

Management Q&A

1.  WE ARE IMPRESSED BY THE TURNAROUND POSTED IN FY2010. GOING BY 1QFY11 RESULTS, THE ROBUST RESULTS SEEM TO BE CONTINUING. CONGRATULATIONS!

FY09 was a difficult year for commodity metals. Compared to FY08 there is only a 15% jump in consolidated Sales, but consolidated EPS has gone up ~8x. Apart from the firming up & stability in lead & zinc prices in FY10, what are the contributing factors to this turnaround? Have you effected any changes in your business model from the learnings in FY09?

The kind of steep RM volatility seen in FY09 was never seen before. prices just kept plummeting and plummeting. After some 14 years in this business, in FY09 we were caught unprepared – with huge inventory pile up, high open positions in the spot markets.  We did our homework and shifted to a LME (London Metals Exchange) based pricing model, got key supplier buy-ins -linked purchase to sales, included monthly LME based price revisions in contracts. And capped open positions to only 15-20% for spot markets. This was retained so they could still take advantage of price swings when availble but cap the risk exposure.

It was a tremendous learning for us. We believe we have emerged a stronger company with better procurement and pricing models and removed some of the vulnerabilities from our business model. From a purely manufacturing company we are transforming to a more commodity markets savvy company as we continuously track and monitor global supply/demand and pricing, based on the models we work on/keep tweaking. We have done well in FY10, we should do better in FY11. Perhaps we will need to again sit and revisit FY11 to identify and reduce other vulnerabilities in our business.

2.  POCL BUSINESS IS MAINLY LEAD SMELTING AND ZINC REFINING. LOHIA METALS IS ENGAGED IN REFINING LEAD METAL FROM SCRAP LEAD. LEAD SMELTING & LEAD REFINING ARE ESSENTIALLY DIFFERENT PROCESSES.

Please give us an overview of the industry, your business positioning and that of subsidiaries. What are your main customer/product segments and how do you see the stability/growth in the near & medium term.

Lohia Metals Private Limited is engaged in the refining process of lead metal from the impure lead (commonly known as scrap lead) while POCL operates a lead smelter plant for the extraction of lead metal from scrap batteries and ore. The processes for refining and smelting are entirely different from each other. While the starting point for the former is lead bullion, for the latter it is lead ore or battery scrap. The clearances required from the Pollution Control Board for refining and extraction of lead are also separate from each other.

We operate in 3 segments. Metals, Metal Oxide and Plastic Additives. Metals segment is now more export focused (70-80%) with higher margins. Metal Export sales started from Oct 2009 onwards so FY10 saw about 6 month of export sales benefit; FY11 will be the first year getting the benefit of export sales for the full year. Metal Oxides segment (Litharge, Zinc Oxide, Lead Oxide) sees about 2/3rd sales in domestic market, while the balance 1/3rd caters to captive consumption. Plastic additives section caters primarily to the needs of domestic PVC pipe manufacturers and some exports. Plastic additives segment is ultra competitive fragmented market with low margins.

We enjoy a good position in Metals & Metal Oxides with a 8-10 percent market share. We are probably the largest organised player after the giant Hindustan Zinc which dominates this space. The only other listed player that we know of is Nile Ltd.

POCL brand has been slowly built up in export markets over the last few years. Our quality, deliveries, service & packaging meets international standards and Leading customers have put us on their approved list. We now are in a happy situation where we don’t have to worry about Marketing our product, but need to augment our manufacturing capacity substantially to meet demand. We do not see any slackening in demand from Battery manufacturers catering to Auto OEMs & Replacement market (which is bigger), Railways, Defense, and the Power substitutes like Inverters,etc. The demand will keep going up for many years to come.

3.  SOME OF YOUR CLIENTS ARE AMARA RAJA, EXIDE, SUPREME INDUSTRIES, JK TYRES, MRF

Please tell us more on your top clients and the nature of relationship with these clients. How much of your business is long-standing repeat business? Do you enjoy sole-supplier/critical supplier status with any clients? Any client contributes more than 10% of Sales?

Amara Raja is one of the top Indian clients. We have several top battery manufacturers in Export Markets. South-East Asian countries are our top export markets followed by the Middle-East. We also export to Japanese customers like Yuasa. Tata-Yuasa which set up battery manufacturing operations in India about 2 years back, is also a customer. About 80-90% of our business is repeat business. We have not lost a single client so far. Our relationships are deepening with time.

4.  EXPORT SALES HAVE DONE VERY WELL IN FY10. AT 51 CR THAT’S ~20-25% OF CONSOLIDATED SALES. THERE WAS ALSO A NEWS ITEM ANNOUNCING 100% EOU IN SEP 2009.

Please elaborate on the export sales/marketing model? Better margins, debtor levels management?? Is there a concerted focus on Export sales? How much will export sales likely contribute from here on?

We have developed the Export market from scratch in the last few years. Researching the customer base, personally contacting them, demonstrating our quality, labeling & packing practices, getting onto approved lists – the hard way.

Today POCL brand is very well accepted. Infact for most of our customers the trust in the brand is so strong that our metals do not anymore go in through incoming material inspection, but are taken in straight at the shop-floor.  We are seeing larger orders, and incremental Sales efforts are much less now.

Yes, Exports is the primary growth driver. Export sales contribution should double in FY11.

5.  COMPETITION AND MARKET SHARE

What is the nature of competition? Who are your biggest competitors – domestic & exports? What kind of market share do you enjoy in your respective segments? What kind of competitive advantage do you enjoy? Scale economies, better technology, integrated operations, entrenched customer relationships??

The customers that we supply to are huge. They have their own processes for supplier approval. It takes upwards of 6m-1 year for a metal manufacturer to get through this process and onto the approved list. We have not lost a single customer and 80-90% business is repeat business.

Lead refining or smelting is a space that has got restricted license-based entry, due to environmental pollution norms. It is not easy for new players to get started. Besides raw material import licensing is also a severely restricted process.

Our Lead smelting plant is one of the most modern facilities in India, with advanced smelting and spectro-analyser technologies deployed. We also enjoy tremendous cost advantages with in-house design and fabrication skills for many components. Our process knowledge and technology is among the best – We are able to customise alloy-lead as per any customer requirement. We are able to extract the last bit of lead present in any scrap, battery plates or ore. The SLAG (residual output) is completely lead-free.

Hindustan Zinc the giant PSU dominates our space. It makes only Lead metal and not Lead alloys. We manufacture both Lead and Lead-alloys as per customer requirements. We probably have a market share close to 8-10% of the overall market for lead metals and lead-alloys.

6.  500 CR TARGET BY FY12 –NEWS ITEM IN BUSINESS STANDARD SEP 2009

The Batteries division was closed in FY09. Baschem Pharma doesn’t contribute meaningfully to the topline/bottomline. What’s the Mangement’s vision and current direction? Where do you see this company in the medium term? Is the existing business scalable enough or are you eyeing further diversification into Aluminum and value added products as mentioned in the news item?

We have a internal target of reaching 500 Cr by FY13 (2012-13). Currently we are able to produce ~2000 tonnes per month. We have plans of setting up another modern smelting plant with a ~4000 tonnes per month capacity. We have applied/bid for land. We hope to have the land alloted in FY11. Setting up the plant would take another 9 months.

See the demand is huge. We could have made sales of 5000 tonnes per month, if we had the capacity installed today. So in the next 3 years the Lead metals segment itself can take us there, if things go well. There are some plans on Alumunium metal, but are too preliminary to discuss at this stage. Raising funds for capacity expansion is not a problem, as we are practically debt-free. Long term debt stands at ~1.4 Cr.

7.   INSTALLED CAPACITIES : METALS -17400 MT; METALLIC OXIDES – 14280 MT; PLASTIC ADDITIVES-6000 MT

Capacity Utilisations are respectively 51.14%, 32.53%, 88.43% for above. Metalllic Oxides saw lower utilization than FY09. Plastic Additives now contribute ~30% to revenues while Metals contribute 44% with Metallic Oxides contributing 26%. Kindly elaborate on the product mix strategies – current and planned

Metals segment capacity will see ~90% capacity utilisation in FY11, as we told you FY10 only saw 6 months of export sales which started from Oct 2009.

Lead Oxide that we produce is used only for captive consumption. Most battery manufacturers have their own Lead oxide plants. Zinc Oxide we are supplying to Tyre and Ceramic industries. We have increased manufacturing Litharge which will contribute to better capacity utilisation this year. This segment capacity will remain under-utilised for some time. You see getting licensing and increasing capacities is a cumbersome process in our industry!

Plastic Additives sector is operating at 90% utilisation, which will remain at these levels.

8.  TOTAL DEBT AT FY10 STANDS AT 60.27 CR AT ~2X DEBT-EQUITY. 54 CR OR 90% IS UTILIZED FOR WORKING CAPITAL. BURGEONING WORKING CAPITAL REQUIREMENTS ARE THE BIGGEST DRAG AND PRIMARILY RESPONSIBLE FOR THE SERIES OF NEGATIVE CASH FLOWS

Working Capital requirement seems to be running far ahead of Sales. From a low of ~18% in 2006, Working Capital/Sales is now touching 30% due to Inventory days almost doubling and Debtor days too seeing a huge rise . Operating Cash flows have been negative primarily due to this. What’s Management’s view on this situation? Any improvements likely in FY11 or the medium term?

Yes there is a surge in working capital -inventory days doubled from 21 to 42 days sales and debtor days went from 29 to 50 in FY10. This was essentially because of a shift in our product mix towards metal exports. On absolute basis these are not bad numbers for a manufacturing firm.

We are trying to bring down our financing cost. This will come down by 15-20% easily as we have better terms now on FCPC (Foreign currency packing credits) $ credit norms -Libor. Its likely that inventory & debtors will remain at these levels.

Long term Debt is only 1.4 Cr. Short term loans of ~53 Cr comprise the bulk of total loans of some 60 Cr for FY10.

9.  PROMOTER EQUITY STANDS AT A LOW 37% SINCE JUNE 2009. THIS IS HIGHER THAN THE ~32% PROMOTER EQUITY IN JUNE 2008. WE ALSO FIND THAT AS OF MAR 2006 THE PROMOTER HOLDING WAS ABOUT 42.13%, SUBSEQUENTLY THE COMPANY CAME OUT WITH A RIGHTS ISSUE BUT THE PROMOTERS HOLDING REDUCED DRASTICALLY TO 28.53% BY MARCH 2007.

Could you elaborate on the circumstances prevailing in 2006-07. What’s Management’s current view on enhancing promoter equity??

Together with our associates the promoter equity in POCL stands at about 43%. We are looking to augment this by another 10% as soon as we can. To sustain operations in FY09, lot of our personal funds had got tied up.

We don’t think the figure of 29% promoter equity in FY07 is correct. Promoter equity has always been above 30-32%.

10.  Lohia Metals is a 51% subsidiary. Its performance has significantly contributed to the turnaround in FY10.

POCL metals segment (smelting) and Lohia Metals (refining) –are they addressing different customer segments/applications? Otherwise isn’t there a potential conflict? Do they bring different advantages to the table? What is the more cost-competitive technology? Why hasn’t the Management converted Lohia Metals to a 100% subsidiary? How is the balance 49% structured??

Lohia Metals also exports Lead metal and did a turnover of 95 Cr in FY10. It operates a lead refining plant, whereas POCL operates a lead smelting plant. Lead smelting is more backward integrated as it can use anything that contains Lead metal in the smelter as a feed e.g. lead scrap, battery plates, and ore. Smelting has a slight edge on margins, but only that much.

Yes, Ashish Bansal who looks after POCL export marketing and is responsible for building the POCL brand in export markets, also looks after Lohia Metals!

So, why isn’t there a conflict of interest? How do we handle it? This might have been a valid question in the context of a declining market. But in a market where demand far outstrips supply, this is irrelevant. To give you a context, we can roughly manufacture 2000 tonnes per month; if we could manufacture 5000 tonnes per month we could have easily made the sales. We don’t see the demand slackening for the next 10 years! battery manaufacturers are thriving on auto OEM and replacement market (bigger than OEM), telecom, inverter, railways, defence markets.

11.  POCL HAS BEEN KNOWN TO BE A DECENT DIVIDEND PAYING RECORD. IT HAS BEEN MAINTAINING DIVIDEND PER SHARE AT THE SAME LEVEL FOR PAST FEW YEARS.

While Dividend per share (DPS) is maintained at ~ Rs.1.2 per share for last few years, dividend payout is not keeping pace with earnings. Payout has dropped drastically from over 40% in FY05 to below 10% in FY10, despite the good results. When will payouts improve? Is there a dividend policy that Investors in Pondy Oxides can expect in future?

We paid dividends even in our loss making year FY09, as we did not want our dividend payment record to be impaired. Yes, we did much better in FY10 but restored dividend to earlier year levels and didn’t increase it to compensate for FY09. FY11 should see higher dividend payouts.

12.  PONDY HAS MANUFACTURING SPREAD OVER SEVERAL LOCATIONS WITH RELATIVELY SMALL CAPACITIES.

Is there any locational advantage derived –in serving customers or procuring material? 75% of raw material is imported.

Well, historically our Pondicherry units had tax benefits that have ceased some 3 years back. It still has CST at 1% but that also might cease once GST gets rolled out.

There certainly is a advantage in having manufacturing spread across a few locations, and more so in our industry. Initially units are located at the outskirts of a town/city but with the passage of time as population spreads, environment pollution norms would require shifting to more distant locations, as we are in a what is called ‘Red category” industry.

13.  PONDY OXIDES SEEMS TO BE A NET FOREIGN EXCHANGE BUYER. EXPORTS CONSTITUTE 50% OF SALES BUT 75% OF RAW MATERIAL IS IMPORTED. CASH FLOW STATEMENT SHOWS A POSITIVE CONTRIBUTION FROM FOREIGN EXCHANGE FLUCTUATIONS CONSISTENTLY FOR THE LAST FEW YEARS!

What’s the foreign exchange fluctuation impact? What kind of hedging policy is involved? With growing contribution from Export Sales will a natural hedge get in-built in the business model??

Yes we expect export sales growth to build a natural hedge for the raw material import forex risks. We can’t say we have a very evolved forex hedging policy, we watch movements closely, we are proactive in tracking and taking corrective actions fast, that’s all I guess.

14.  1QFY11 RESULTS SHOW EXCELLENT TOPLINE GROWTH AND DECENT BOTTOMLINE GROWTH COMPARED TO 1QFY10. HOWEVER, OPERATING MARGIN IS BACK TO ~5% LEVELS (~8%) WHILE NET MARGINS ARE AT ~2% LEVELS (~3.5%).

This is on the back of lower finance charges – almost halving at 1.02 Cr vs 1.96 Cr in Q4FY10. What is the current debt level and what is it likely to be during the next few quarters? RM/Sales is back at 80%. What are the indications going forward? Where do you expect margins to stabilize at in FY11?

As mentioned our debt is almost entirely on account of short-term loans to cover working capital requirements. These are expected to remain at similar levels. We will bring down financing cost substantially. last qr finance cost was down to 1Cr levels (from 1.96 Cr in 4QFY10), which is where it should get pegged at similar level of sales.
We hope to maintain the profitability levels achieved in FY10.

Disclosure(s)

Donald Francis: No Holdings in the Company; ;
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