Gandhi Special Tubes Management Q&A: May, 2011

Management Q&A

1. GANDHI SPECIAL TUBES HAS CARVED OUT A SPECIAL NICHE FOR ITSELF IN THE SMALL DIAMETER WELDED AND COLD DRAWN SEAMLESS TUBES. WHAT IS ESPECIALLY NOTICEABLE IS THE STEADY OPERATING MARGIN EXPANSIONS TO OVER 40-50% LEVELS THAT IS BEING MAINTAINED. THIS IS AN EXTRAORDINARY ACHIEVEMENT COUPLED WITH THE CLEAN DEBT FREE BALANCE SHEET.

Congratulations! Kindly share with us the factors that have contributed to this performance. Appreciate if you can share the kind of market share the company enjoys in the 3 market/product segments, and their respective margin contributions. On both fronts – Is it sustainable, and why?

The Seamless Tubes segment catering to Automobile OEMs is our most profitable segment. The Welded Nuts segment catering to refrigeration industry is fragmented, very competitive and the margins are very poor.
We will continue to enjoy leadership position in seamless tubes because of our technology, focus on quality and customer relationships built over the years.

2.     SEAMLESS TUBES, COLD FORMED NUTS SEGMENTS – ARE PROBABLY 100% IMPORT SUBSTITUTE PRODUCTS.

Looks like there is a deliberate focus of the company towards complex technology, high precision products and making a complete sweep of import substitution – probably with a high degree of automation involved – enabling the kind of margins above. Kindly share the business & product philosophy followed.

Yes, import substituition was a key focus as also segments which would enable us to garner a good market share with high profitability.

3.     GIVEN THE DOMINANT MARKET SHARE AND THE RELATIONSHIPS IT ENJOYS WITH MAJOR OEMS, ONE WOULD EXPECT THE COMPANY TO LEVERAGE AND PENETRATE THESE RELATIONSHIPS DEEPER. WITH MOST GLOBAL OEMS NOW HAVING A BASE IN INDIA, THE COMPANY SHOULD BY NOW HAVE A MUCH WIDER CUSTOMER BASE.

Kindly explain the company’s thinking and efforts on this front for a bagging share of the global market in its niche segments. When will we see a revival in export focus from the company?

We enjoy excellent relationships with major OEMs. However we have not been able to leverage this relationships for the export market. You see our products typically weigh a lot and freight costs are such that we are not competitive in other markets.
Focus on exports is not really there, but we keep talking to our customers, to see if they can source from here for global requirements.

4.     NEW PRODUCT INTRODUCTIONS

The 3 product segments have been contributing to revenues for the last several years together. Seamless Tubes share of revenue contribution has seen the most growth. No new products have been introduced. Are there new product launches in the anvil, or this situation is likely to continue?

Seamless Tubes and Cold Formed Nuts are the main Product segments.

 

5.     TOP CUSTOMERS –CURRENT BUSINESS & POTENTIAL MAPPING/PENETRATION

Kindly share some details on your top customers. How much business does your top 3 customers contribute. Is there any customer contributing more than 10% of Sales? Kindly give us a sense of the potential from such marquee customers if say you could service them a) across most platforms (e.g. commercial, SUV, passenger) b) bag a sizeable chunk of global business

Top 3 customers would contribute about 30% of Sales. Imperial Auto would account for more than 10% of Sales.

6.     BENTELER –RELATIONSHIP

Kindly share the kind of relationship enjoyed with Benteler who provided the initial technology impetus, process knowhow and raw material sourcing. Where is this relationship today? Is it a source of competitive advantage for the company? Why has the relationship not progressed to say a full-fledged JV that can leverage mutual strengths – global relationships/sourcing and Gandhi Special’s strengths on productivity, cost efficiency, automation, etc.

Benteler relationship is very strong. we continue to source most of our raw material from them. The Indian market is probably not big enough for them to make a big commitment yet.

7.     SALES GROWTH NOT KEEPING PACE WITH CORE BUSINESS CAPEX ADDITIONS.

In 5 yrs from FY06 to FY10, Net Sales has increased by ~21 Cr. However in the same period capex spend on core business (taking out windmill capex of 11.52 Cr in FY06 and 6.29 Cr in FY08) is ~31 Cr.

Also Asset Turnover in the last 2 years has fallen much below 1. Kindly explain the circumstances leading to this and the Management’s plan to improve on this situation.

We had made big investments into Capex in FY07 & FY08 but have not been able to capitalise on that because of the slowdown that occurred. We are consolidating on that base and have kept profitability intact. Hopefully in the coming 2 years we will do much better.

8.     LONG TERM SALES CAGR IS ~13%

Although investors are pretty happy with the earnings quality, the performance on the growth front is worrisome. What are the main reasons for this sluggish performance from a dominant market leader? Please comment on the following scenario plays that are being theorized by analysts in the market.

a) Overall market size is small for the niches you operate in. Having cornered a very dominant market share (some reports mention over 85% share), there is little scope for big ticket growth

b) Unless you find a way to crack open export markets through leveraging relationships with global OEMS, this situation is likely to persist

Yes overall market size is small for our product niches. There are several marquee OEMs who have set up factories in the South. In the next 2 years they are likely to reach full capacity by when we are hopeful of seeing sizeable growth coming through.

9.     FREE CASH FLOWS. SUSTAINABILITY. INORGANIC GROWTH CONSIDERATIONS?

Free Cash flows as a percentage of Sales has climbed to over 25% in FY10. What is the outlook on the next 2-3 years. Is this likely to be maintained? How is the company geared to cope, if there is sudden spurt in demand. Are there enough latent capacities/de-bottlenecking possible to cater to say double the long term growth rate (~13%)in the next 2-3 years. As per the current outlook and plans, when will the company have to incur major capex again.

Is there any thinking in the company on acquiring specialty niche companies in related domains, and growing through the inorganic route.

There are no plans for inorganic growth at the moment.

10.     RECENT FINANCIAL PERFORMANCE – OPERATING MARGINS ARE CONTRACTING. NOT MUCH CORRELATION WITH RAW MATERIAL COST SITUATION.

Going by 9m FY11 performance, GSTL has recorded an 18% increase in Sales coupled with a modest 2% rise in Earnings. This is on the back of higher raw material and other expenditure costs. Operating margins are likely to fall in the 45-46% range from the 50% levels in FY10.

Kindly explain the reasons for margin contractions over the last year, and what is a normalized level that we can come to expect.

FY10 was a very good year where we recorded high sales growth and benefited from some softening in raw material prices. We should be able to sustain at current year levels.

11.   HIGH MANAGEMENT COMPENSATION – FOR A COMPANY OF ITS SIZE (<100 CRS) GSTL SENIOR MANAGEMENT IS TAKING IN OVER 15% OF THE NET PROFITS OF THE COMPANY. (3.77 CR, 25CR IN FY10, 2.49 CR, 15 CR IN FY09).

No doubt, the Management has driven the high performance and great margins for the company, but this level of compensation seems high especially on peer comparison with companies of similar sizes that have registered much better growths. Please comment.

Management compensation is certainly within the permissible limits as per company law. We have maintained very high profitability and have been rewarding shareholders with good dividends. How many companies of our size have an accelerating dividend record as ours?

12. RAW MATERIAL VOLATILITY – WHILE RAW MATERIALS CONSTITUTE ~30% OF SALES, IT MUST BE NOTED THAT OVER 50% OF THE RAW MATERIAL IS IMPORTED (FY10) AND EXPOSES THE COMPANY TO FOREX VOLATILITY RISKS ON TOP OF RAW MATERIAL RISKS. EXPORTS ARE MINIMAL.

How is the company managing on this front?  Does the company resort to hedging? What are the terms from Benteler for raw material sourcing? What kind of credit terms does Benteler offer Gandhi Special Tubes? Is that also a source of competitive advantage?

There are no special terms received from Bentler.

13. BROAD PLANS AND VISION FOR THE COMPANY

Kindly share the major opportunities before the company, and the challenges ahead. How it is gearing up to meet these challenges? When will we see Gandhi Special Tubes crossing Rs. 500 Cr in sales?

We will continue to reward shareholders and maintain our excellent dividend record. Sizeable Growth in the business is expected in about 2 years when OEMS who have set up production in India recently scale up in a big way.


Disclosure(s)

Manish Kulkarni: No Holdings in the Company; ;
Donald Francis: No Holdings in the Company; ;
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Gandhi Special Tubes

Background

Gandhi Special Tubes was set up in technical collaboration with BENTELER of Germany for manufacturing small diameter welded and cold drawn seamless steel tubes. The plant situated at Halol, Gujarat, started commercial production in April 1988.

Gandhi Special Tubes Ltd. have also started manufacturing of Cold Formed Tube Nuts for Fuel Injection Tube Assemblies as well as Hydraulic Tube Assemblies. This is a pioneering effort in India as hitherto tube nuts were being manufactured by machining.

Gandhi Special Tubes (GSTL) product focus is in import substitution. With the focus on Quality (ISO/TS 16949 : 2002 as well as ISO 9001: 2000) they have been successful in winning over most OEMs hitherto importing, and enjoy a large market share in their niche product segments.


Main Products/Segments

Welded Steel Tubes [32.60%] – (3.1-12.7 mm OD) – These tubes find applications mainly in refrigeration and automobile industry.

Seamless Steel Tubes [55.33%] – (3-75 mm OD)- These tubes find applications in high pressure fuel injection tubings and hydraulic tubings -mostly in diesel engines.

Cold Formed Nuts/Scrap [9.84%] – These nuts find applications as Coupling Nuts for fuel injection tubes and Coupling Nuts for hydraulic fittings.

Wind Power [2.23%] – 5 plants based in Gujarat & Maharashtra totaling 5.35 MW


Main Markets/Customers

Seamless Steel Tubes – Customers include automobile OEMS like Telco, Tisco, Ashok Leyland, M&M, Simpson, Kirloskar Oil Engines, Mannesman Rexroth, HMT, L&T, etc. and ancillaries like Imperial Auto.

Welded Steel Tubes – Refrigeration Industry customers include Godrej, Voltas, Electroloux, Carrier, etc. Major automobile/engine manufacturers like Telco, Ashok Leyland, M&M, Simpson, Kirloskar Oil Engines , Maruti Udyog, etc or their ancillaries.

Cold Formed Nuts – Automobile OEMS for seamless steel tubes as above

Wind Power – Captive consumption (Gujarat plants) & supply to State grid (Maharashtra plants)


Bullish Viewpoints

  • Good track record – GSTL has a good track record over the last 10 years. Operating profits (~7 Cr in FY2000) and Net Profits (~3.5 Cr in FY2000) have clocked a CAGR of over 20% to reach over 41 Cr and 25 Cr respectively.
  • High profitability with consistently expanding Margins – Net margins have moved up from over 13% in FY2000 to over 30% in FY10. Operating Margins have moved up from ~27% in FY2000 to over 50% in FY10. This trend has accelerated in the last 5 years, as the company has perhaps consolidated its position as the leading supplier of seamless & welded tubes and cold formed nuts to the automobile OEMS, refrigeration and general engineering industries. Return on Capital employed has been high, in the 30-35% range.
  • Good Free Cash Flows, Completely Debt free – GSTL has the unique record of remaining largely debt free and funding all its capital expenditure requirements out of internal accruals, without resorting to long term debt or equity dilution. Having completed major expansions in FY07 and FY08, capex in last 2 years has been minimal. Free Cash flows as a percentage of Sales has climbed to over 25% in FY10. This would seem sustainable for the next 2-3 years as Sales growth has not kept pace.
  • Great Dividend track record – Dividend Payout has consistently been increasing from ~18% of earnings in FY06 to 29% in FY10. 5 yr DPS CAGR is 25% while it has accelerated in the last 3 years to clock a DPS CAGR of over 41%
  • High Dividend yield – at CMP of Rs 115, the stock provides a dividend yield of over 4% which provides good comfort. However it should be noted there was a special silver jubilee dividend declared in FY10, so sustainable yield is more like 2%

Bearish Viewpoints

  • Sales growth track record has been faltering – If you ignore a stupendous FY10 performance (on the back of a poor FY09), GSTL Sales growth record has been far from impressive. GSTL has only tripled its Sales in last 10 yrs from 25 Cr in FY2000 to over 75 Cr in FY2010 recording a 10 yr Sales CAGR is ~13%; 5yr Sales CAGR is poorer at 8.6%. While the company has been served well by margin expansions over the last few years, Sales growth lagging substantially behind earnings growth is not a very welcome sign.
  • Gross Block additions higher than Sales growth – Gross Block has moved from Rs 55 Cr in FY06 to Rs 87 Cr in FY10 and Sales from Rs 64 Cr to Rs 84 Cr in the same period. Sales to Capex ratio in last 5 years is < 1.Asset Turnover has been below 1 for last 2 years, improving from 0.66 in FY09 to 0.74 in FY10
  • Recent Financial performance – Going by 9m FY11 performance, GSTL has recorded an 18% increase in Sales coupled with a modest 2% rise in Earnings. This is on the back of higher raw material and other expenditure costs. Full year FY11 picture is unlikely to be much different.
  • Higher Working capital requirements – Debtor days has climbed to 71 days (41days) and Inventory days have risen to 171 days (131 days) – significantly up from levels prevalent 2 years back.
  • High Management Compensation – For a company of its size (<100 Crs) GSTL Senior Management is taking in over 15% of the Net Profits of the company. (3.77 Cr, 25Cr in FY10, 2.49 Cr, 15 Cr in FY09). No doubt, the Management has driven the high performance and great margins for the company, but this level of compensation seems high especially on peer comparison with companies of similar sizes that have registered much better growths.
  • Raw material volatility – While raw materials constitute ~30% of Sales, it must be noted that over 50% of the raw material is imported (FY10) and exposes the company to forex volatility risks on top of raw material risks. Exports are minimal.

Barriers to entry

  • Technology Intensive – Small dia seamless and welded tube manufacturing is a technology intensive process refined through decades of experience, going down to the quality of raw material – specialty steels, used. In FY10, over 52% of raw material was imported by GSTL.
  • Product Line extensions – Manufacturing Cold Formed Nuts with superior reliability and tensile strength as opposed to machined nuts (a first in India) used in fuel injection and hydraulic tubings also helps GSTL in its quest for niche domination

Interesting Viewpoints

  • Zero debt and no equity dilution – GSTL has increased its Net Worth almost 5 times over the last 10 years. Reserves & Surplus have gone up over 6 times. Gross Block has gone up from some 30 Cr in FY2000 to ~87 Cr in FY2010. It has funded all capital expenditures out of internal accruals (over 50 Crs). Not once has it resorted to long term debt or equity dilution.
  • Consistent Margins expansion – GSTL boasts of an envious record in margin expansions especially over the last few years. Operating margins have shot upto over 50%. Is this an oligopoly kind of situation developing?

Disclosure(s)

Donald Francis: No Holdings in the Company;