SHILPA MEDICARE 2015 AGM MANAGEMENT Q&A

Management Q&A

SHILPA MEDICARE 2015 AGM 

Shilpa is an API provider of oncology molecules and other niche molecules. Much of the API provider’s revenues depends on the fortunes of the formulator whom he supplies. For eg: formulator may have FDA issues, plant upgradation, may decide to get out of some formulations etc which in turn affect the demand of Shilpa’s APIs. To overcome this, Shilpa has decided to get into formulations of some of the molecules which may give it better control over the molecules to target.

Shilpa does not work with innovator/originator currently. Predictability is little less in generic business. Hence, Shilpa refrains from giving numbers.

This year there was more talk of First to Files (FTF) for formulations. Shilpa will be filing its first FTF this year (own name, however, it has filed FTFs for its partners). Shilpa management feels it has the strength in molecules to file FTFs in its own name.

Shilpa has taken significant capex and investments last few years and the revenues will come from 2017-18. Shilpa has around 400 R&D engineers (300 at Vizag and 100 at Raichur) and has filed around 175 patents of which 75 have been filed last year. However, it can be that one molecule itself can have up to 5 – 10 patents.

RAICHEM MEDICARE LIMITED (JV with ICE and PCA, Italy)

PCA is a subsidiary of ICE Italy (was acquired by ICE). ICE manufactures cholic acid while PCA manufactures deoxycholic acid and its derivatives like ursodiol etc. Cholic acid is used for manufacturing deoxycholic acid. PCA also manufactures the API and is not into formulations. ICE and PCA over a period of 50 – 60 years have worked on only this molecules and have an edge over any other company (ICE controls 70% of the world’s cholic acid demand while PCA controls 45% of the world’s demand for deoxycholic acid) which primarily is in R&D and sourcing as it is naturally produced (ox bile, chick bile etc). ICE and PCA can increase prices of this molecule as and when required. Shilpa just provides the CRAMS for manufacturing of ursodeoxycholic acid where raw material, process, technology etc are provided by ICE only.

The current market for this API is 1500-2000 tonne which is around Rs.2500 crore in value terms. Currently, Shilpa has 8-10% of the API market share while the JV will have 2 – 2.50 times the existing capacity of Shilpa for manufacturing the product. There is a lot of shortage of this molecule worldwide. Shilpa has orders up to two years from ICE. However, due to supply constraints it is not able to fulfill the demand. ICE does not want to expand in Europe due to high costs and other issues. Scaling up will be easy for the company here and through JV their interest and longevity will be higher. ICE has 50% stake in the JV. It will be ICE’s only facility outside Italy. The reason for ICE to stick with Shilpa is trust. The benefit for Shilpa in the JV is it is de risk its major revenue source and freeing up capacity at its API plant for other business divisions. Shilpa also has contract for selling this API in few markets like India. Once this JV plant is functional, this will be a separate profit center for Shilpa (kind of self pilot mode).

The plant is a world class one and took almost two years for construction. The plant is in final stages of construction and will be ready in one – two month’s time. The company has already started working on exhibit batches and by June, 2016 the company will have 9 – 10 months of stability data after which it will file for DMF in Japan. This will start yielding revenues in FY17 but majority of it will come in FY18 after all the shifting has been done from the standalone API facility. It might happen that due to shortage of this molecule, Shilpa on standalone basis might continue to supply for few years too.

ANTIRETROVIRAL (ARV)

Earlier, the vacated facility for manufacturing of ursodeoxycholic acid was proposed to be used for manufacturing of ARVs. However, due to less clarity on the issue of when the manufacturing of ursodeoxycholic acid will stop in standalone operations, the plan has been put on hold. If Shilpa starts constructing a new block for ARV and all the transfer happens to Raichem JV soon, it will lead to idle capacities. The company will take a decision on this in short term (three to six months). Apart from the four molecules (QUAD), the company has also worked on few other molecules at R&D stage. Company has plans to go into formulation also in the long term for ARVs.

JAPANESE CRAMS

Shilpa Medicare has ventured into CRAMS with a Japanese pharmaceutical company to produce tranexamic acid. The company is dedicating an entire block for this arrangement, the construction for which is expected to be completed by December 2015. The total cost incurred on the capex was Rs.31 crore. The manufacturing of the exhibit batches will start from January, 2016 onwards. The capacity for this block will be 100 tonnes and can result in revenue of Rs.50 crore. However, it will have higher margins compared to the current arrangement with ICE as Shilpa will procure raw material directly and will have its own manufacturing process. Shilpa has also got license to sell it in few markets (not regulated markets like US or EU). Like ICE, the partner has expertise in the manufacturing of this molecule and has extensive experience in it.

Shilpa’s management views this a stepping stone with relationship with Japanese Generic players. Shilpa is the only company whose API is registered in the Japanese markets. Establishing relationship generally takes a long time and they initially start with only small volumes and scaling up happens over a longer period. A few large oncology companies have also visited Shilpa’s facility. A lot of patience is required for working with Japanese partners and there is no room for short cuts. This can be a sustainable model after 5-10 years and a separate revenue stream.

Unlike US, the Indian pharmaceutical companies except for Lupin haven’t been able to make a mark in the Japanese markets. Reva Pharma, a sister concern, is an official advisor for Indian Government for Japanese pharmaceutical companies. It has been instrumental in asking PMDA, the pharmaceutical regulatory authority of Japan to set up an office in India. Japanese market has very low generic presence which is expected to increase significantly going forward benefitting Indian pharmaceutical companies.

REGULATORY APPROVALS

API Facility: The USFDA inspected the plant in March, 2015 and there have been few observations. However, none of them are related to data integrity, which has been a major concern for the pharmaceutical companies. The company has replied to these observations. The company has been regularly writing mails and following up with the authorities and expects an outcome by October/November.

Formulation Facility: Shilpa’s Jadcherla formulation facility was inspected by USFDA recently. The management was expecting the inspection after January, 2016 but an ANDA getting into bio-equivalence/ later stage of approval triggered the inspection. The inspection happened over 10 days and there were few 483 observations. However, there are no data integrity issues. Shilpa has responded to these observations and is expecting FDA approvals for this plant by around mid 2016 after which it is expecting to get ANDA approvals one by one. Shilpa Medicare has shared these observations with its customers and they are confident of getting the FDA approval soon. Many of the issues related to regulation are because of lower level employees taking short cuts. Shilpa has taken many steps to address this including hiring an ex-FDA inspector (who charges USD 280,000 annually) consultant to visit the plant and give inputs and training.

Shilpa has got approval from Brazilian, Mexican and EU authorities (that Slovenian approval was for whole of EU). Argentinean regulatory approval has also been triggered and they might come for inspection.

As per the management, USFDA is trying to categorize pharmaceutical companies into various grades and the grades will decide the frequency of USFDA audit going forward.

APIs

The company has 20 DMF filings in the US markets. The same molecules have been filed in the EU market as well. The company has a hybrid approach for development of new molecules – sometimes R&D employees find a molecule lucrative, sometimes customers approaches and few of the times the management finds a molecule to work on. Shilpa is even working on few molecules which have expiry in 2025 – 2027 or are currently undergoing clinical trials. The key here is non-infringing patent and being able to tie up with formulator. The company has worked on 35 molecules out of which 17 have been commercialized till date. In APIs, Shilpa has a lot of strength in few of the molecules where it can impact the prices of it. However, the company does not have a philosophy of gaining market share by reducing the prices. Competitive intensity of a particular molecule decides the step taken to manufacture it. If it’s a competitive molecule, R&D people start from the scratch and work from N – 5 and N – 4 stage to reduce cost while in not so competitive molecule the company goes back to just N – 2 stage as well. China is expected to be the biggest oncology market in the medium term. In US, out of every 10 new molecules being approved by USFDA, seven are in oncology. Few molecules which were discussed:

  • Capacetabine: Shilpa has expertise in this molecule and has begun expanding the capacity four fold. Post the expansion, Shilpa will have around 25% of the world’s capacity. Although, the prices have come down, Shilpa will still be able make decent profits and benefit from increase in volumes.
  • Gemcetabinie: Intas had completed expansion at its plant last year. So they took less quantities from Shilpa in FY15. As many finished players have entered the European market, production has fallen by a third. Capecetabine is expected to make up for this.
  • Bortezomib: Shilpa is expected supplying to many formulators as it has a patent for the molecules under which it works (stability) even in some specific temperatures.
  • Imatinib Mesylate: This will be the next big molecule for the company after Capecitabine. Company has an edge in this molecule.
  • Ambroxol: Shilpa also wants to diversify into non-oncology molecules. They have expanded capacities in this molecule four fold. The capex for the expansion was around Rs.30 crore. Although, the molecule has lot of competition and is not difficult to manufacture, they have lot of experience in it, more filings and better quality. The market for this molecule is expanding. Other companies are decreasing the price while they are increasing it.

On being asked about the molecules which they are currently working on (taken from Karvy report and company’s website) have a market size of more than USD 5 billion, the management said that they are also working on bigger molecules than the ones mentioned. Post approval from USFDA, Shilpa might take further increase in capacities for the US market. The company works at various levels to ensure that its process and molecules are non-infringing. Shilpa had won a case against Bristol Myers Squibb (BMS won against Dr. Reddy’s, Natco and Hetero) in India for a molecule despite the company assuring BMS that they don’t have plans to launch it in the domestic market. Pfizer had also launched a case against Shilpa for a molecule in India. However, after Shilpa told them that they won’t be launching that molecule in the Indian markets, they withdrew it.

FORMULATIONS

USA

Shilpa has filed 13 ANDAs as on date. Out of these 13, 5 have been filed in Shilpa’s name while 8 have been filed by the partner. The marketing arrangement for this filing is:

  • Own filing: Shilpa will incur the R&D costs and tie up with the partners at various stages of development of the molecule. If Shilpa ties up with partner at the beginning of development of molecule, they will have lower profit share while if they tie up after the filing of ANDA, it will have higher profit share. Out of the 5 filings in its own name, it has mix of all. Shilpa has a marketing arrangement with the partners where they sell our products in the US market. Shilpa will be filing our first FTF this year in our name. Typical cost of filing an ANDA is Rs.5 – 6 crore plus litigation costs. Going forward, Shilpa will try to file new molecules in our name. Shilpa had filed its first ANDA in its own name in Dec 2013.
  • Filing in partner’s name: Here the strategy is to work on CRAMS basis (cost plus profit). R&D expenses, litigation cost etc are incurred by the partners. The main purpose of this model is to hedge its API supplies also. For off patented molecules, Shilpa ties up with 3 – 4 formulators while for FTFs, they exclusively tie up with just one formulator (the company has filed for few FTFs through its partners). The partners chosen are good in marketing and have capability of garnering good market share.

The company currently has one line for manufacturing tablets and one for injectable at it formulations plant. The company has fully tied up for its existing lines for manufacturing of tablets and injectables. The company is constructing one more line for tablets and one for injectable at its formulations plant, the cost for which is expected to be Rs.30 – 40 crore. The construction for the new lines is expected to be completed by December – January. In oncology, there has been gradual shift towards tablets from injectables (unlike other segments). The company is also planning to build third dry powder injectable line at its existing facility. It will be first such dry power line for oncology products in India. The total capex for the line is expected to be Rs.200 crore. The company might go for another expansion in three to four years which along with the dry powder line will cost around Rs.450 crore. For third or future lines, the company might tie up for innovators also. The company might go for equity dilution for the capex in near to medium term.

For formulation facility, the company has tied up with new customers. In FY16, the company has plans to file five ANDAs (one in its own name and four in the partner’s). The company is not looking to file for biosimilars currently due to high cost involved (USD 15 million per molecule) as well as lack of clarity from the regulatory authorities. However, there seems to be some clarity emerging from the regulators and the company might plan to go for its manufacturing in the long term.

EU AND OTHER ROW MARKETS

Company has filed or planning to file five dossiers for the five ANDAs it has filed in the US in its own name in European market too. The approval from the EU regulators usually takes less time of around one year as compared to more than two three years for the US markets. The company’s partners are filing for formulation drugs in Mexican and Brazilian markets.

Going ahead formulations will be major revenue generator for Shilpa. The Jadcherla plant is being setup with advanced machinery which will have lesser chances of recalls. Shilpa had made investments of around Rs.250 crore in this facility. Shilpa Medicare has got a strong IPM department which will help decide which molecules to pursue.

FUNDING GROWTH/EQUITY DILUTION PHILOSOPHY

Shilpa does not like to take too much debt. If a company has too much debt, the focus is on repaying debt instead of thinking of new ideas. Besides, having cash in the bank helps Shilpa to fund its new R&D proposals. Hence, all the capex will be funded with mixture of debt, equity and internal accruals. Equity dilutions might be done at good valuations (most probably for future capex) which can lead to less dilution. The company has a philosophy of funding big capex with a mix of internal accruals, debt and raising more equity.

TALENT RETENTION/IP RISKS

As per the management, Shilpa does not have problem of retaining top talent. Shilpa’s R&D head has been with the company for more than 20 years. There is a bit of attrition of lower levels like chemists. However, top level R&D scientists continue to stick with Shilpa. Most employees get between 15-30% hikes every year. They are given a free hand in R&D projects with management supporting innovative proposals. One of the reasons is that Shilpa management likes to keep cash in bank instead of borrowing too much. It can fund these small R&D proposals easily and not wait for funding. Shilpa is thinking of ESOP incentives for retaining top talent. Salary is in line with the best in the industry. Sometimes people leave at 3x salary. However, this has no impact on Shilpa. They file a patent at initial stages for the idea on feasibility analysis. This prevents the new company from filing patents for these ideas once the chemists leave.

JOINT VENTURES/SUBSIDIARIES/INVESTMENT PHILOSOPHY

Shilpa is keen to fund smaller companies (startups) with good people and good technology. This requires management with VC kind of mindset. This keeps the company abreast with new technologies and new ideas like nano technology etc and new drug delivery systems (NDDS). NDDS will help Shilpa in future projects through launch of its own formulation through them.

MAIA Pharma: Shilpa funded initial round and recently there was another round of dilution in which Shilpa did not participate at around four times the valuation at which Shilpa had invested earlier. They are filing a 505(b) (2) and Shilpa will be providing API too.

INM Technologies: It is working on nano technology. The company is based out of Bangalore. The company also bought an R&D center at Bangalore for this technology.

Shilpa has funded Rs.8-10 crore last year in these ventures and is looking to fund the same amount in next 2-3 years. The company has philosophy of funding new ideas with good technology and not spend too much money on a single idea.

Loba continues to be in red and seems to be a mistake committed by the management. There are lot of regulations in the market and management is trying to make it self sustainable.

OTHER POINTS

  1. All revenues are in USD and thus not exposed to Euro depreciation
  2. Admired Alembic and Torrent apart from Natco
  3. No targeted R&D/sales ratio. Everything is based on requirements
  4. Most of current Oncology molecules are Injectables. But after 5-6 years most expiring molecules are Orals.
  5. The company won an award for Patent work recently and shared the stage with big pharmaceutical companies like Divi’s and Aurobindo.

Disclosure(s)

Ankit Gupta: More than 5% of Portfolio in the Company; Holding for more than 1 year; No transactions in last 30 days
Ananth Shenoy: More than 5% of Portfolio in the Company; Holding for more than 1 year; No transactions in last 30 days
Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 2 years; No transactions in last 30 days
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Kitex Garments Management Q&A: Aug, 2014

Management Q&A

Kitex Garments Management Q&A : Aug, 2014

1. INDUSTRY/INDUSTRY STRUCTURE

We just finished a tour of the Garmenting and the Knitting-Bleaching-Fabric-Processing factories. Its nothing like we have seen before. You have set up a high-quality infrastructure on par with the best in the world with state-of-the-art advanced machinery. Who were the early influencers? How did you benchmark Kitex to be where it is shaping up to be today – a preferred choice of the largest global retailers? [Kitex Production- Infrastructure Video]

Well I guess the credit for it goes to my dad and the early training he put me through. He was a strict disciplinarian and he ensured I learnt to respect every aspect of the work ongoing in our factory. As a 13 year old, I was started out from cleaning the lavatories, to the shop-floor, to becoming a machinist, technician, bleaching and processing to garmenting operator.

I grew up with the ethos and the confidence of trying to do something different from the run-of-the-mill. We were not afraid to take risks. We were always prepared to order and try out the latest advances in machinery that wasn’t being used in the country. Somehow from the initial days we focused on infant wear. Certainly I have traveled and seen many factories worldwide. But we haven’t copied blindly. We have adopted creative solutions that we found could add to quality, efficiency or productivity.

We make it a point to publish results immediately after the year-end – even that is a creative first!

The working & living conditions for the workers that we witnessed was the most striking – certainly a few notches above comparable factories in India/Asia. What would you attribute that to?

My early training ensured the need to provide good working and living conditions for our workers was internalised early on. As we grew, we therefore had no hesitation in investing in people, infrastructure and processes that complied with all social and environmental norms right from the start.

Kitex has established itself as a large manufacturer of infant wear globally and made rapid progress in the last few years. Kindly share with us more on the global market size, growth areas for next few years, and Kitex’s own unique positioning and current market share.

Kitex specializes in infant wear (0-24 months) market.  Trust and Quality play a big role in consumer buying choice. Quality Standards on fabric and dye stuffs, colours and printing methods are much stricter to ensure products are infant-friendly and harmless. Chemical dyes cannot be used in the fabric (child saliva often comes in contact with fabric), for example. Parents lay great emphasis on Trusted Brands like Carter, Babies-R-Us, Gerber, The Children’s Place, Mothercare and a few others – brands that have endured over several decades.

Infant wear has continued to enjoy a relatively protected niche. Unlike most textiles/garment segments, infant wear market is not commoditised. It is also the only textiles/garments segment to have proven to be relatively recession-proof.

These large brands sell in huge volumes in US, Europe and rest of the world. Globally there are 12 companies of some scale that manufacture volumes large enough to meet the needs of these large brands. Winlu (China) is the No. 1 player with 7.5L pieces per day today. Gyn (Singapore) with 6.5L pieces per day is the second largest. They have manufacturing facilities spread across various countries. At 5.5 L pieces per day, Kitex has now emerged as the 3rd largest manufacturer.

 

(US $20 Bn market, Canada, Japan & China – $25 Bn, as per Carter AR). Kindly give us a sense of how big is the runway. 

US is a huge market yes, but volumes in US market are stagnant.

But Asia is growing very fast. India, China and Middle East growing very fast. Korea there are lots of stores. China there are lots of stores opening. Most International brands are today present in India – the aspirations of the new generation are different. In the next 2-3 years I see every brand will be here in India – and not just the big cities.

Infant market is growing rapidly in India. Earlier a family had 5-6 children. Now its 1 or 2 children at most. [reels of many employee names with single child, speaking to AGM Finance]. Parents are ready to spend more. There are so many shops today targeting infants & toddlers. Even a small place like Cochin has 7-8 toy shops. There are small cars prices at 25000, 30000, 40000 and people are buying. I went back to one shop f3 days later for a Jeep for my son – the piece was gone – it was for Rs 32000! Nothing comes cheap in these shops. Small cute chappals for the kids cost Rs 700-800. Parents are willing to splurge.

Some brands like Carter may be selling upwards of $500 Million in India 3-5 years down the line and there will be fast ramp-ups. Look at US Population – 300 Million; India’s 4x that and couple that with twice the birth-rate; that’s 8x the US market potential in India only. 

Infant wear for 0-2 years has an added advantage. 2-month and 3-month old toddlers grow very fast till 2 years, adding 40 gm or so every day or about 1.2 kg every month.

But the price-structure may be very different?

Actually it is worth noticing that the US market sells products at half the price of the Indian market. A Tommy Hilfiger shirt sells for Rs 3500 in India. In the US it comes for $35-40. Buying at a sale you can get it for $25, so at a discount you can get it for Rs 1500. I am a fan of Tommy Hilfiger, I buy all my shirts in the US!

In US the Sale structure is very interesting. The Initial Sales are placed at a Value that gives them 80% margin. They make all the profits there. Then they start selling at 60% margin, and next at 40% margin and then finally at 20% margin to liquidate stocks and be ready for the next spring/fall season.

When the market really opens up in India in next 3-5 years, it will be good for players like us. We will be able to save something like 20% straight on the duties and logistics costs. Gerber sells a body suit for $2 in the US market or Rs 120. It sells 1 million pieces a month at Walmart at $1.78. A comparable kids garment in India sells for Rs 350-400.

But what about product quality? Jockey International and Jockey India products are very different and at different price-points.

Yes you are right if you take the example of Jockey International products and those that are offered in India. There is a reason for that – Jockey products are offered by a company in India under a License from Jockey. As a Licensee you have the freedom to design and manufacture as per Indian market conditions. However Franchisee operations are different – where the same global quality & standards & products are offered.

Mothercare hasn’t taken the licensing route and has established many stores in India under company owned and Franchisee operations. We expect similar initiatives from the others when they establish their presence in India.

Is it right to say that the Industry structure is favourable for large manufacturers like KItex – Large Retailers have to come to Large Manufacturers?

Look there are only 3 or 4 major players from India. All others are at $1Mn (or sub) kind of volumes. Gerber has only 3-4 vendors. Carter has 2 approved vendors and is trying for 1 more.

Who are these large vendors?

Best Corporation, Jay Jay Mills and First-step are some of the larger established vendors.

But we have heard Mothercare sources from 15 and more vendors for infant w
ear?

Mothercare came to India much earlier and has established more vendor sources.

As companies scale up direct sourcing, are large scale global sourcing firms like Hong Kong based Li & Fung getting limited. Carter scaled up direct sourcing from 5% to 30% in 2013 and has aims of taking it up to 50% in next 2-3 years? Earlier the same sourcing agent was handling 70% of inventory purchases. How widespread is this trend? What does it mean for a manufacturer like KItex – in working capital management & margins?

Not true. Direct Sourcing is being pursued aggressively by players but with little results to show. Just where are the manufacturers with scale? And sourcing from a large number of vendors directly, is proving complex.

Three years back a leading player’s annual direct sourcing target was $80 Mn but they could get only $22 Mn. Last year they planned for $500 Mn direct sourcing in 3 years but are making slow progress. The same player wanted Kitex to supply $150 Mn in 3 years. We are not ready to supply more than $50 Mn to a single player. It is much safer to spread the same volume between 3-4 leading players. 

Once you have a trusted supplier relationship going with a global retailer, kindly give us an idea of the level of penetration possible? $150 Mn is just 5% of Carter’s annual sales today.

We have very good relationship with all our Customers. Over the years of association, in many cases it becomes like personal family relationship. Some of them call me at any time of the night, on business. Some of them I have to call every weekend, wherever I am.

We enjoy preferred supplier status today. We can keep growing the relationship with all of them steadily. As mentioned before, though we have offers to scale up very significantly on one or the other relationship, we prefer to go about it in a balanced way – not expose ourselves to undue risks/pressures.

Does any scale-relationship with any one retailer, restrict or impose any limitation on sourcing by other Brands or direct competitors?

Not at all. US way of business is different – they are very fair. Just like they want us to be fair in all our practices as well like not forcing our Labour force and meet all social compliance norms – hygiene, work timings, fair wages, working conditions, etc. 

They don’t/won’t interfere in our business at all, there is complete freedom. Gerber or say The Children’s Place don’t ask us about the level of business that we do with others. 

2. GLOBAL CUSTOMERS

Can you explain the difference between European brands like Mothercare and US brands like Carter?

Mothercare is UK based and sells at a premium. Their styling is simpler – more white-based. More family oriented. ” I love you Mummy” or “My Daddy” – with prints or embroidery.

US is more design oriented with lots of colours and various styling. Gerber and Carter sell in huge volumes in the US market. As mentioned before US market is the cheapest in the world. Quality and standards  are enforced. Customers don’t like a product they can return it. They have some health problems – they can make a claim.

It is interesting to note that KItex made its entry with Gerber Childrenswear (mass-market player) 14 years back and only in last few years getting into sourcing agreements with Carter premium segment player). Kindly comment.

As mentioned before we do not have a preference for any of the bigger players. We would like to be in a steady relationship with all of them and continue to grow the business. There is enough scope with all the leading players.

But some of them like Carter are more profitable and growing, whereas someone like Gerber has changed hands 4-5 times, and Babies R Us is a subsidiary of the loss-making Toys R US? So isn’t it fair to assume there would be a preference for the growing more profitable customer?

Actually, Gerber is the most profitable customer for us. They source in huge volumes and some of their designs run unchanged for 6 months or a year sometimes. The efficiencies and productivity we derive from there is much higher. 

Apart from Carter and probably Babies R Us, most of the global retailers are finding it tough to compete and have been having financial difficulties and/or downsizing home operations to concentrate on International operations like Mothercare? Kindly comment and educate us on on the risks from this front?

in Europe, population is coming down, birth rate is coming down. Most families have maximum 1 child. Its like a cycle you know. The US has also gone through that stage of 1 child. Now everyone there wants 2-3 children. They are coming back. My feeling is Europe will also come back a few years down the line.

But Middle East is selling very well. In 2 years India and China will be selling very well. Take Mothercare, earlier they used to sell 80% in UK and 20% Internationally. This is now getting reversed.

But in this process of major market shifts, profitability is at risk? As per Mothercare AR their top priority is to replace profitability, and per casual enquiries by us their sourcing people have very stringent profitability targets?

Yes, they are aggressive on pricing. They compromise maybe a bit on design and styling. It is certainly not affecting the manufacturers like us.

Most Brands are however concentrating more on E-Commerce? Their e-commerce sales are doubling every year? What does that trend mean for manufacturers like you?

Yes E-commerce is shaping up very strongly. In US, in next five years e-commerce may occupy more than 80% market share. No one has time to travel. Standards are very tight and customers are assured that they will not be cheated. Customers have right to return the purchase if they are not satisfied in any way.

But E-Commerce has also meant margins are thinner? Brands like The Children’s Place have increased sourcing from places like Bangladesh drastically, to meet profitability? Kindly comment.

In Bangladesh wages are 2000-3000 per month compared to 8000-10000 in India. Kitex wages are among the highest in textile sector in India. Bangladesh superiority comes where products involve lots of manual labour and less machinery. But in infant wear, machine productivity and process is equally important and Kitex can compete with Bangladesh lower labour cost with its higher efficiency and productivity.

Kindly give us a sense of the Revenue mix from your top customers. What level of penetration have you been able to achieve over the years?

First 2 years they watch our performance and execution – quality and on-time delivery, etc. Just like we watch them and the relationship. Beyond that stage, all our buyers are in the $13-15 Mn range or $28-30 Mn range. 

To give you an example, a new relationship is at $14-15 Mn for us currently – this can double – they are also watching. They are currently sourcing 60% from India and 40% from China. They are looking to increase this to 80-85% from India, 15% to China in next season. They don’t mind paying 2% higher here – value is much more. 

In the past you have tried to risk-diversify across smaller retailers in US & Europe. Apparently that did not work out and you have reverted back to focusing on the large customers. Kindly educate us on the reasons for the same?

Yes, we did experiment with that. In our own calculations we had reason to believe that would be more profitable. But it didn’t turn out like that. Volumes were smaller, designs changed faster, our utilisation, efficiency and hence productivity was much lower. Order flow was sometimes volatile, scaling up was proving difficult. We had to move away from that model.

Kindly educate us on the Jockey Relationship and its potential for next few years?

We forayed outside of infant-wear market on specific request from an existing Customer. Gerber had taken the children’s inner-wear license from Jockey and wanted to manufacture it out of China. They got it developed there but Jockey rejected on quality front. Subsequently they jointly came to us for a new concept OUTLAST® technology for inner wear, which regulates skin temperature and helps you feel cooler in everyday situations. We are the only manufacturer for that product.  We make 2x the Sales for the same production time as infant wear as value-addition is much higher because of special chemicals and raw materials. Sales have been flat for last 3 years, as this is a niche segment. The project was taken up to showcase our ability to make such a product with complex technical requirements. It is more of an aberration. Even Arvind Ltd. had tried but failed to deliver on this product.

So it will not be incorrect to say you will continue to focus on infant wear 0-2 years segment only? You do not even need to get into the Toddlers segment 2-4 years. You see enough opportunities for you to harness and scale up in infant wear itself for the next few years?

That is right.

3. TECHNOLOGY/QUALITY/DIFFERENTIATORS

Kitex today has established a world-class state-of the-art manufacturing plant with the latest advanced technologies. It has shown the vision and the self-confidence to do things differently than most others in the sector. Reportedly it has been a lead-user of latest advances in technology/automation. Kindly take us through this evolution. How were the early days? How long did it really take to start getting noticed?

From 1995-2000 we struggled. Buyers took us for a ride and exploited us. Gradually we understood the game and started investing in the Safety-Security- Social and Environmental compliance norms. We took big risks and invested in the latest advanced machinery. To maintain quality we standardised on our yarn suppliers – both in North and South India – and nurtured them. Today we have 4-5 major suppliers. We have agreements with them for guaranteed off-takes. Today we are known for the best quality at competitive prices.

What have been the critical milestones in differentiating Kitex as a serious player – able to rise upto and match/exceed the stringent demands of global customers?

1. In-house use of critical Technology and sophisticated state-of-the-art machinery for complete control over Fabric Quality (70m Open width Continuous Bleaching, Auto Dye Dispensing System, Continuous Cold Pad Batch Dyeing, Continuous Washing, Screen Engraving, Rotary Printing, etc) [Kitex Production- Infrastructure Video]

2. The right raw materials – Kitex specified high-quality yarn – based on Okeo Tex Class I – normally not available in the market  3. Superior process chemistry used for bleaching and fabric processing 4. Use of Organic Dyes 5. Lastly our Labour strength – which we can proudly say is much better, more efficient than elsewhere – they are better trained, disciplined and punctual. Our labour utilisation/efficiency levels are close to 50-60% whereas most would struggle at 40-45% in the industry. We pay them the highest.

So, how did you set out to do things differently?

Well it depends on individual capacity I guess. It is in the Execution. It is in the Creative Ideas. You have to design new things – you have to think!

Kindly explain to us the manufacturing process value-chain and how Kitex has been able to add value and where – Yarn—->Fabric—->Dying/Bleaching—–>Knitting—–>Cutting—->Sewing.

Yarn: Kitex specified superior quality yarn based on Okeo Tex Class I vs normal yarn used by other vendors

Knitting: Advanced machinery from Italy. 

Bleaching/Processing: Technically superior Open Width Continuous Bleaching process vs Soft Flow process used by others; completely controlled by advanced Robotics machine – installed recently, again a first-in-the country. Only one person required to operate the 70m long bleaching line

Dyeing/Finish: Only organic dyes are used; Recently we have used Avocado based dyes with excellent results; started recommending these to Buyers

Cutting: Advanced fully automated machines increasing efficiency and low wastage

Sewing: Advanced high-speed more efficient Japanese machines with lower power consumption

You continue to mention Quality as your biggest differentiator. Yet, isn’t it true that the Buyers specify the product they want? They specify the base fabric, the colours and the dyes, even the printing method, etc. They inspect and test as per specifications before dispatches are allowed. So where is the quality differentiator, really?

While dye stuffs, processing and finishing play their part, the difference comes mainly from the Yarn specifications. The feel of the fabric changes drastically depending on the yarn used. As mentioned before we only use Kitex specified superior grade yarn based on Okeo Tex Class I yarn. We have contracted suppliers with guaranteed off-takes of 100T/200T a month from them – on strict yarn specifications provided by us.

You will see that we are the only vendor in the country that specifies upfront the yarn that goes into our fabric. Interestingly the buyers do not specify what type of yarn is to be used. When they specify base fabric – they will mention either Interlock fabric, Single Jersey or Rib Fabric and along with that 150 gsm or 180 gsm which is a only a measure of the density. They do not insist on a specific yarn quality. The usual standard is 18% Combing on 100 Kg whereas 15% combing or 10% combing, even 1% combing are possible for different levels of value addition.

The fabric feel ultimately depends on the quality of the yarn used. What kind of cotton is used in the yarn – longer 8 mm staple or shorter 6mm or less staple. The longer staple gives more strength. In normal Okeo Tex Class I atleast 20% long staple cotton is to be used. There is a variety in Gujarat which is the most suited. We specify all that in our yarn specifications to our suppliers. Because of that we can ensure CPSI of 2700 (a measure of yarn strength/breakage) versus 2000 for normal yearn. Defects are nil or of the order of 1/3rd to 1/4th that from normal yarn. There are some 10-15 different parameters where Kitex specified yarn is significantly better quality than normal yarn – this is what we try to showcase and explain to our buyers.

Well usually there is a reason for such omissions by both vendors & buyers. It must be taking up your costs. So how do you compete, then?

Certainly, it is a competitive world, and we have to be competitive. What we offer by way of higher input cost raw materials and investments in superior technology machines and processes, we make up in volumes and constantly improving on efficiency and productivity levels. Today we are at 60% utilisation levels and we will take it up to 70% with more recent investments in advanced machinery and robotics. Beyond that it’s not possible in Knitting industry.

Let’s examine the impact of Sourcing by large buyers? Don’t they have stiff sourcing & profitability targets where they are continually focused on shaving of that 2-3% and exploring manufacturing from low-cost regions that can give them some incremental advantage?

“Sourcing” – as we have known/experienced has changed over the years, especially for the Infant Wear segment. Earlier the accent of sourcing teams was only on pricing. Teams would travel to Asia, visit lots of vendors, decide what to buy at what quantities at a pric
e. Earlier the Buyers (Sourcing folks) were mostly blind to issues other than pricing. Now they are getting a better holistic understanding of the larger issues involved – price-competitiveness is important, but so is on-time delivery and quality as they have realised from sourcing in other regions in Asia (especially for infant wear).

The 0-24 months segment is the most brand-quality-conscious. Colours, quality and design play a big role; there is a lot of Trust in the Product. The Customer’s Product Department decides the Product design, the Planning department distributes according to Sales Plan drawn out. And then the Buyers, Planners, and Sourcing Team gets into action.

Earlier only the Sourcing Team used to come and visit us. Today at major Buyers whole teams drawn from Product Design, Planning, Logistics, Sourcing get involved. Recently when I visited a large Buyer in the US, a 22 person cross-functional team sat down to understand from us and appreciate the myriad of issues involved.

We share with them the impact of using normal yarn vs Kitex specified Okeo Tex Class I yarn. We also share the outlook on Yarn costs, Trims & Accessory costs, Labour costs, and the $-Rupee equation. We provide them advance information if costs seem to be going up – that there may be a 1% cost escalation next year.

Yet, the reality is its a very competitive difficult market. Apart from Carter and maybe Babies R Us, no one is really profitable. They will be trying to find that extra 3-5% savings if they are to scale up a relationship?

Yes, we try to make them understand the impact of compromising on input costs on the quality. They do ask us if we can make cheaper by 3-5%.  We say No, we can’t as we will not compromise on quality. 

Instead we ask give us a full product line, you will see a 4-5% higher Sales. Retailers and wholesalers have found out that the customer can also easily discern better quality by just the feel of the fabric. The same brand/design (Kitex-sourced) sells out much faster. For example, earlier we had the last row in Babies-R-Us stores, now Kitex-sourced products are placed in first 10 rows. Every season Kitex-sourced garments sold out faster – which led to the upfront placement.

Buyers have started to appreciate that. You see everyone has to survive. No manufacturer can can continuously cut-down on costs. In 2008 in the face of recession, large buyers started squeezing. Every season they would ask for a 2%, 2% reduction. Now no Buyer does that. Why? They know after some time, it is bound to break. They all understand the cost structures today. They tried sourcing from China cheaper. They couldn’t supply. They didn’t get the goods on time, leading to loss of Sales because they had already booked space at places like Walmart and others.

Besides there are lots of sales “tricks” that Retailers resort to. The same product that sells for $2 in Walmart can be sold at $6 somewhere else with some more work (frills & accessories) and better packaging. They know how to sell it. Its like Fashion – not high fashion though. There are buyers who don’t buy at Walmart. There’s a 25% audience segment that does not look at prices. For them most important is the Brand – design & quality.

How critical a role have Technology Consultants/Employees like Christian Strahm (Santex and Strahm Texile Machinery) played in improving quality and matching up to global quality standards required? Have they also played a role in improving assembly line efficiencies and/or de-bottle-necking. Kindly give us a sense of the significance of these contributions.

Well he is a consultant for maintenance and upkeep of processing machinery. He was the owner of Santex Textile machinery company but unfortunately had to sell out. He was employed with us also for some time. Now he has started Strahm Textiles and back to his consultant role with us and visits us regularly. 

Kindly educate us on the Jockey Outlast manufacturing line? Are there major process differences? Where? Are the issues the same in scaling up these lines, or are there differences?

Not really. As mentioned before we can make twice the Sales from the same lines as value-addition is higher – raw materials and chemicals used.

4. ORGANISATIONAL READINESS/STRATEGIC

While Kitex has positioned itself strongly today as one of the preferred choices for Global retailers, how ready is it organisationally to harness and execute on the opportunities before it? Kindly share with us the organisation structure and key operating responsibilities and the key people behind them? Their experience base and their journey within Kitex.

We are organised entirely along the lines of our Buyers. Business Managers are assigned to a specific Buyer depending on the volume of the business. For Jockey, we have 1 Business Manager with 500 people reporting to him. For Carter we have 2 Business Managers managing 1000 people under them. 

Each Business manager has several functional heads reporting into him. The Production Head, the Sourcing Head, Inventory Head, the Merchandising Head and the Operations Head for Jockey report into the Jockey Business Manager. So each Buyer has dedicated functional heads and dedicated Teams (across Production, Sourcing, Merchandising, Garmenting operations) for delivering on our commitments to that Buyer.

Its not about manufacturing/selling garments/products to the Buyer. It is about selling a factory to a Buyer. We like to sell by Blocks. You buy a Full Block’s capacity and you get a full dedicated group of workers to deliver that for you – the group includes your own sourcing, merchandising, production and operation teams including tailors and sweepers!

That’s why you might have seen that we are organised by Blocks. Each Production Block has its twin but separate  Block (in adjacent Tower joined by pathways) for accommodation and dining and other space for the Workers in the Opposite Block.

Wow! That’s a pretty interesting and original way of organising your business around Buyers. But what about the 2nd and 3rd level of Leadership in the organisation?

The 2nd rung of leadership is built around 8 Core Managers – managing operations at the company level – each handling a specific function – Finance, Administration, Production, Sourcing, Inventory Management, Merchandising – and have their own Centralised Sourcing Team, or Centralised Inventory Management Team, for example.

3rd Level of Leadership are the individual Business Managers. And 4th level are the Buyer specific functional heads.

So for each functional head, there is a direct reporting at the Business Manager level and also a lateral reporting at the Core Manager level? 

That’s correct.

Also how are the responsibilities divided, what does the Centralised Sourcing Team do and what does a Buyer Sourcing Head decide on?

The Centralised Sourcing Team is responsible for policy setting, vendor identification, selection and nurturing, etc. and managing the individual Sourcing Heads at the company level while the Sourcing Head at the Buyer level can decide which of the 4-5 company specified sources he/she wants to work with. The rest is all about execution and adherence to laid-out standard procedures.

Let’s move on to some group issues. Kindly share the genesis or the requirement for a separate entity like KCL (100% owned by you) in addition to the listed entity KGL?

This was a situation that was forced on us around 2006. We had plenty of orders to fulfill in KGL but also a stretched out balanced sheet. Bankers were unwilling to lend us the 30 Cr we needed for fulfilling orders on hand. I had no option but to create a separate entity like KCL. I took very high risks. Had to pledge everything I had, all my personal holdings and savings. Even then, no single bank w
as willing to fund us. we finally managed to rope in 3 different banks to fund us 10 Cr each.

This is how it happened. For me there is no difference between the two – it’s like my left arm and right arm!

We understand group capacity is at 5.5 L pieces/day today. While KGL (440 Cr) has higher Sales than KCL (250 Cr) it also sells Fabric. Kindly share the garmenting capacities at KGL and KCL specifically. (ICRA Reports on KCL and KGL cite this at 90 Mn and 65 Mn pieces annually).

TBD

You have talked about doubling the group capacities from 5.5 L pieces/day to 1.1 Mn pieces/day in next 2-3 years. How will this be achieved and what kind of investments will we be needing.

We completed ~70 Cr investments in the Robotics assisted Fabric Processing plant last financial year towards enhancing capacities. The fabric capacity now at 48 MT is sufficient to see us through the targeted garmenting capacity of 1.1 Mn pieces/day in 2-3 years.

Now some more investments will be required towards cutting and sewing machinery. We have already ordered Advanced fully-automated Cutting machinery that will be here soon. Also we have ordered more advanced Sewing machines that are more efficient and will consume less power. Totally some 30-40 Cr additionally for the group. For KGL it will be about 15 Cr.

So, how do you see KCL and KGL growing individually in the next 2-3 years?

Both will double the capacities. Both should keep growing at 20-25% annually.

What about the Employee Base? ~4000 are direct employees at KGL. What is the total KGL+KCL direct employee strength? How many are contracted?

Total employee strength is ~8000. There are no contract labourers.

While capacities are being enhanced what about the Labour situation? will that also need to be doubled ~16000 employees in 2-3 years? And, if you continue to double volume capacities every 2-3 years – realistically, where do we see Labour counts growing to in the next 3-6-9 years?

Actually we will need only incremental 10% more additional Labour to reach 1.1Mn/pieces per day.

That’s something difficult to grasp and will take some doing. Kindly share how will this be achieved?

Firstly productivity improvements through use of advanced technology, backed up by productivity improvements through increasing efficiencies. Thirdly automation is being brought in new areas. For example we are installing a shaving machine that will bring in 4:1 savings in manpower. That itself will free up 300 people. We are bringing in lot of automation in Kitchen that will free up another 100 people. Automatic Roti-Maker (just need to put the Maida) producing 60 Chapaties every minute. Automatic Idly-Maker producing 2000 idlies per hour. 30 kg onions will get peeled in 1 hour. 2000 plates will be cleaned every hour. All imported fully automatic machines being introduced. Imported German machines for Vaccuum Cleaning that will bring in 75% labour saving.

It’s not one single thing that will do the trick, but a whole host of new initiatives in every area that we can identify where we can improve productivity and/or increase efficiency. Together we are confident these will deliver double the capacity at low incremental labour addition.

Okay. But even managing a 8,000-10,000 kind of Labour Force with high attrition is a tough job. How are you handling things today? How do you manage attrition/training/motivation and sourcing Labour?

Earlier we were using local people. But since last 2-3 years that supply wasn’t enough and we had to source labour from other states like Jharkhand, Orissa and other locations. Fortunately we have found a very competent partner who is able to provide us on a regular basis.

However, the Training part is the most challenging. When you went around the factory, you must have observed how disciplined the workforce is – they continue to do their job efficiently, silently. Most people wont even look up while you are passing by except if you are directly at their table.

But getting them to be like this is a big big challenge. When they come they are uneducated, unhygienic, raw folks. There is also the phase of adjustment to Climate and adjustment to Culture, living and eating and even basic hygiene training. Its tough, but today we have the processes to manage this transformation. Don’t see a problem for next 5 years at the least.

So how big a acclimatization-training team do you have today?

At any point of time there are 100 people being trained at Kitex. 15 days off-line, followed by 15 days on the line on the job training. With this 1 month training they are at about 35% productivity. Another 45 days before they get to the usual 60-70% full productivity.

There must be constant outflux too. Normal attrition. plus since its mostly women once they reach marriageable age, etc. When they go on annual leave after a year, many may not come back? How big a challenge is it really as the Labour force scales up?

Yes it is our biggest challenge, but something that is manageable. We are probably doing a better job of it than most places in India. We have an excellent outsourced partner in Don Bosco. DB Tech or Don Bosco Tech mobilises these youngsters and sends for training in sewing to Kitex. Don Bosco has been managing the mobilisation extremely well for us.

The Kitex team takes over and is able to make them productive within 1 months and fully productive within 3 months as mentioned before. Actually when someone goes on leave for a month, they usually return with 5-6 of their own -sisters, cousins, neighbours, relatives – their transformation is there for all to see! [Kitex Training-Corporate Video]

Kindly educate us on the US Wholesale Operations set-up? What are the aims and what is the investment size?

There are 3 ways of entering the US market

A. X or Y Brand manufactured by Kitex (manufactured by Kitex is imprinted on the garment)

B. Kitex made private label for someone like Walmart (where Kitex branding is non-existent)

C. License some established brand – that is not present in infant wear – take advantage of the mother brand while providing best quality manufacturing by Kitex (again Kitex manufacturing brand is enhanced). In US market Quality comes first (probably even before Brand) hence huge Branding exercise may not be required. Since customers can return products even after few days of use, quality is critical, and we can leverage Kitex quality while piggy-riding on the mother brand.

Is it right to conclude that these are probably longer -term initiatives and that initially the most significant impact will be on timely deliveries and logistics cost savings? What impact is this likely to see on the margins front? and by when?

We have hired some office space in US. We will import Kitex garments in bulk ourselves, pay the landed duty price (LDP) and offer our products directly to retailers. This activity should get started in next 2 months and will help shave off 0.5% of current logistic costs.

In time we may be able to replace distributors in between and supply directly to Retail ourselves. Distributors today are marking up as much as 30-50% off us while selling to retail.

There looks to be a conflict of interest here. Why wouldn’t this strain your relationships with existing customers (like Carter) who also procure in volumes for themselves (their retail presence) as well as supply to Walmart and other big retailers.

No, we do not think so. US is a very competitive but business-like place. If you can get additional business from Retailers, good for you.

Why can’t
a US manufacturer do a good job with more of the automated machines and efficiency drivers like you have spoken of before?

$12/hour is the minimum cost of Labour. For 8 hours this would cost $96, say $100 or Rs 6000 per day. Rs 6000/- per month is the Labour cost in India. Even if someone were to manufacture in US efficiently, who is going to consume products that will need to priced that much higher?

5. PRODUCT MIX

Kindly explain the major product mix components. Baby/Layette, Sleepwear, Play clothes and so on.

Body Suits : 40%; Sleep Suits : 20%; 20% Playware; Caps/Booties:2% ; Others: Blankets, Mittens, Pvt Label

Which are the low-value items and the high-value ones? Are there major avenues for value-addition by moving up the quality-chain?

Caps/booties are low-ticket items while Body Suits are higher-ticket items 

What are the major sources of growth and profitability?

Body Suits with high volumes and higher realisation at $1.25/piece

Any plans of producing more than infant wear? What about Toddlers 2-4 or say 2-7 years and service the full range of a major retailer like Carter?

Only of there is a (unintelligible hand-notes :-().This 2-7 years segment is much more commoditised market.

 

6. OPERATIONAL OUTLOOK

6.1 CUSTOMER CONTRACTS

In the past there have been instances where customer‟s product failure (2012-13) or delayed orders from clients (2010/11) has led to order volatility impacting the group‟s revenue growth.

As explained before we experimented with relatively smaller buyers, but that didn’t work out and we have resorted back to the large buyer relationships where visibility is strong and scale and volumes are maintainable.

You had problems with TESCO?

TESCO and another buyer. That was in 2010-2011 time frames

We haven’t incurred even 1 hour production loss in the last 3 years. Our business model now is more stable.

Today how are we safeguarded against problems of similar nature? Do contracts have stringent clauses for guaranteed off-takes/penalties for non-adherence to schedules?

Large buyers have contracted wall space with Walmart – much in advance of the season. Wall spaces like 3 feet, or 6 feet, 9 feet or 12 feet, Wal-Mart is in the business of selling walls to brands. Supposing you are booking space for Mar 1st to July 31st. In addition to the Rent for space, you have to provide a minimum sale guarantee. You have to fill the space in time. If you sell less than minimum guaranteed – you need to pay penalties.

This is not India – where if you have contracted something for Mar 1st, and you can call up and request can I shift to Mar 7th, my suppliers are unable to supply! 7 days of unutilised wall space at any retail outlet in US will carry huge penalties.

How are Order books/Capacities negotiated? How often are these negotiated – 6-monthly or annual process? Are prices fixed or is there some pass through for cost escalation, say with a lag effect?

Usually Orders are negotiated for the Season or 2 Seasons. Spring/Summer and Winter/Fall. No, once a order is negotiated the Price is fixed. Normally while negotiating for the upcoming season, the RM is available at fixed pre-negotiated points for us, and cost is known. Once the order is negotiated, currency hit/gain onus is on us completely as is fluctuations in yarn/other RM. 

However in case of any abnormal gains/losses (more than 10%) there can be some passing of benefits from either side in coming season(s). Cotton prices can go up one year and come down the next. There has to be give and take. Both sides have to survive. Only then both can win.

What is the relationship between annual order scale-up and the inevitable margin pressures? How often do you face this?

As explained before, those days are over. The cost structures are known to both sides. Everyone has to survive. Room for some minimal negotiation have to kept – the Buyers/Sourcers have to be seen doing their job. We have mechanisms in-built to handle that. 

What are the debtor days norms with major customers? Have there been any instances of debtors going bad with any of the major customers? In last 10 years Debtor days have usually been at ~58-60 days, FY 2014 has seen it at 45 days? Is this a result of any re-negotiations?

Standard Debtor terms are 60 days. For delays we charge additional 0.5% to 1% for 60-90 days. In some cases/new deals we open LCs 

Inventory days record has been more uneven. ~60 days in earlier years to 100-110 days post 2010 (RM used to include Processing charges till 2010, why excluded now?) is down to 17 days in FY14 (11 cr vs 45-50 Cr in immediately preceding years. Kindly comment. Is this a one-off aberration this year, or?

Standard inventory days are 45-65 days. You have seen higher levels when we had visibility of yarn prices shooting up. We are improving our Inventory Management processes and trying to bring Inventory levels lower. Lower levels should be sustainable.

 

6.2 SUPPLIER CONTRACTS

What are your major Raw Materials – Yarn, Fabric? Who are your major suppliers? How many suppliers do you deal with? What is the duration of such relationships?

As explained before, Yarn is the mainstay of fabric quality. We manufacture garments only with superior quality Kitex specified yarn based on Okeo Tex Class I specifications. Yarn is the main RM (50-60% of total RM). Major suppliers are GTM and PBM. Kitex specified superior quality yarn is not available in the general market.

What kind of contracts do you sign with major suppliers? Are they spot-basis, yearly negotiated or long-term contracts with cost-escalation pass-throughs? What is the nature of cost- escalation pass throughs – only currency related?

We have been nurturing 4-5 suppliers (both in North India and South India) for over 5 Years. We offer guaranteed payment for guaranteed volumes. For some of them we have been sourcing 100T/200T per month. 

Who are your major technology suppliers? Do you enjoy any supplier credits with them?

We enjoy very advantageous pricing deals – we get all machinery at Cost Price. They are willing to give up their profits as Kitex buying some machinery from them is something of an endorsement for them.

Why exactly are you in that happy situation today?

We are known for our willingness & ability to take risks on using advanced machinery using latest technology. Our technology suppliers take credit in showcasing Kitex factory as a buyer for their latest advanced machinery. They bring customers from all over Asia and even European countries like Turkey to our factory. Every month there is someone or other visiting.

Creditor days have been constantly improving over last 5 years, dropping to 20 days in FY14 (Sundry Creditors have stood at ~24-26 Cr over last 5 years despite the impressive Sales pick up). Kindly explain – why have you been obliging suppliers with such benign credit terms?

Our interest charges work out to be 7.5% whereas our Supplier have to work at 12-14%. We are availing less credit from RM suppliers and negotiating better prices for us.

6.3 CAPACITY

The augmented Fabric Processing Capacity at 48 MT is sufficient for catering to what Garment capacity? 11 L/pieces per day? When will we need the next big augmentation of Fabric Processing capacity – at what Garmenting capacity?

The Knitting and Fabric processing capacity curr
ently should see us through the next 2-3 years i.e. suffice till targeted Garmenting capacity of 1.1 Mn/pieces per day.

Kindly educate on how 90 Mn Annual capacity (KGL) and 65 Mn Annual capacity (KGL) translate to the 5.5 L/pieces per day. How many working days/month or year

Working days are 26 per month, Sundays being weekly off. Add some festival holidays. 

72 Lakhs capex was completed in FY14. This was mainly for the Fabric Processing part. Is it correct to say all Capex in FY15 and FY16 will now mainly be for augmenting Cutting and Sewing machines? How much for Cutting machines? How much for Sewing machines?

Yes further capital expenditure will be on Automatic Cutting machines (already ordered) and more advanced Sewing machines as explained earlier (already ordered)

What has been the spend so far in FY15 and what will be the spend till Mar 31st?

About 15-20 Cr

Will we see some augmented capacity in place by 1HFY15? And what will be the likely enhancement by FY15 end?

Gradual ramp-up throughout the year.

What happens to the older machines? For sewing machines that get replaced say, are you able to get a good price or they are more like scrap?

Our accounting depreciation rate taken is ~8%. But Heavy machinery have a practical life of 20 years. Even Sewing machines – we are not using any Chinese machines. We have been using robust Japanese machines, where initial investment is very high, but these have a practical life again of 19-20 years.

We are able to get a decent price. a) A new sewing machine say today costs $800, roughly the same it used to cost when we originally purchased on $basis. b) while purchasing our $-Re equation would have been at Rs 35!

How often do you need to replace machinery?

In our experience, we have seen it is better to replace every 5 years. One, it straightaway leads to a 10% increase in efficiency. That allows us to get more productivity out of the labour-force – something that we are quite focused on.

Net-net, what would you say is your Return time frame for investment in machinery?

Processing machines returns – Maximum 3 years; Sewing machines – 2 years

6.4 SALES

FY14 Q1 Sales came in flat at ~100 Cr. Was this more due to the ongoing technology/ automation initiatives pursued by the company that required extensive trial runs as also the stabilisation of the enhanced Fabric processing capacity?

Mainly attributable to seasonality in Sales

Kindly explain the seasonality experienced in Sales during the quarters? Why?

For US and Europe, Spring/Summer and Winter/Fall seasons- that’s how the Buyers procure. Fall/Winter sees heavy buying while Spring/Summer is slower. Spring you get only about 1 month of Sale, while in Summer you get 2 months of Sales (holiday season). So barring some exceptions, you will see that Q1 is always slow, Q2 is better, Q3 is heavy, and Q4 super heavy sales. 

Kindly share the contribution from government subsidies, duty drawbacks and other export incentives? 

TUF   – 5% subsidy on interest rates; 10% subvention on Capital Expenditure

Packing Credit – 3%  

What is your average cost of Capital (Debt Funds)?

Term Loans – 12.5% currently. But we are expecting will come down by atleast 0.4% to 12.1% or so as our credit ratings have been revised 2 notches up by ICRA from A- to A+. We may be the rarest of the rare Textile company to be rated A+ – most Textile companies are at A- levels or lower (about 750 Textile companies are rated today). And better still our Bankers – State Bank of India have upgraded us to SB2 from SB4 (SB1 is the highest rating).  

7. RISKS/CHALLENGES

Would it be correct to say that the Marketing challenge is over? It is now mainly an Execution challenge in stepping to service demands from global customers?

You can say that. 

What are the major challenges before the organisation?

Today Labour training/controlling is the only real constant challenge. We are in a comfortable situation on most other fronts.

What is the take on lack of geographical diversion – both on customer front and manufacturing front?

While US is still the largest market, all major customers have a growing international presence. As explained before, Middle East and Asia are growing very fast. In the next 2-3 years we will see more business from every buyer from these regions.

Manufacturing wise, we have no foreseeable plans to locate another plant elsewhere. 

Why is the Political Risk not real or negligible in your eyes? Everyone says Kerala is a very difficult place to do business in. 

That is mostly perception (misplaced). Those days of business-unfriendly political and labour environment are long gone. Today Media is very strong, development oriented public opinion is strong, people are much more educated.

Every year we contribute 700 Cr of valuable foreign exchange to the state. We are already the largest employer in Kerala. This would not have counted for much in bigger states, but Kerala is a very small state. The political establishment – all mainstream parties – value our contribution to the state. 

Yet you yourself have faced protest and delays in clearing expansion plans in the past. While coming to your factory we saw hoardings of Panchayat and SDPI – citing some details against Kitex?

We have not done anything wrong. We have never violated any laws of the land. We pride ourselves in adhering and bettering every environmental or social compliance norms/laws. There are no issues with mainstream political establishment. This was a small outfit called SDPI who are always trying to create trouble, in order to extract something. But we have handled that in our own way.

Why are you confident this cannot/will not repeat again – there will not be any production stoppages or some charges slapped unfairly on other grounds of say – women workforce exploitation – the bogey that SDPI raised?

For that you will need to understand the genesis of the problem, our determination in weeding out the problem, and our process behind the same.

This all started in 2012 in June by a local outfit called SDPI – (Wikipedia Link) – they controlled the local Panchayat at that time. Our environmental license was up for renewal and they started making hugely exorbitant demands. Naturally we refused.

They first raised the environment pollution bogey and ran a mis-information campaign against us. They enlisted  local villagers support (we had minimal local contact then). Their attacks got more and more personal and made me to be seen as a villain and a criminal, vilified me in every manner possible.

One way is to acquiesce and pay what they want. Keep on paying bribe/sleaze money and work without any problems. But I have been seeing these things – seen my dad suffer from the time when I was in 1st standard. 

But now we had the resources to mount a serious challenge at the very roots of the problem. For a normal fee of x, if someone puts up an extortion demand of 10x, we can spend 100x to quash the problem once and for all. 

The problem was our lack of contact and strong support base within the local village community then. I started local contact myself. I went direct to the people and explained how my father brought me up, inculcated the discipline in me, so we could create something like Kitex in your village. I explain
ed my vision for the village, how every child can be taught the value of discipline, and aspire to achieving the best in life. Fortunately people listened to me, staying on in rain for hours, and urging me to speak on every time I wanted to stop. They wanted to hear me. Meeting went on for 3 hours non-stop, people came out in large numbers to hear. Opposition also conducted meetings – attendance started to become thin -if they had 50 people gathered, our meetings would have 5000! [lots of footage shown to us].

Soon, we conducted a signature campaign. In one day we collected 16000 signatures!!

We started conducting cultural programs on Onam festival for the region – with 25000 people in attendance. We went to schools in the region and sponsored their football teams. Today we support 40 football teams of schoolchildren – soon we will have our world-cup [laughs]. We have conducted all types of awareness programs, invested in projects for drinking water supply, and the like.

We want to make this village a model village – example of the best, anywhere in India. This is the third year of engagement. we have the complete support of people in this village and nearby villages.

Today if I stand for elections, I will win easily. Opposition will lose their deposit.

Some might question if this is not bordering on over-confidence? And, you are so passionately involved now, it will be fair to question whether your priorities might change – after all you are the key man for Kitex?

[Smiles] This work/passion is properly scheduled. Sundays and after 5 Pm. Also on holidays. Kitex is always remain the first priority – that is business.

All this must have been very frustrating for you, also depleting lot of your energy?

With every opposition, I have only grown. What is Life without challenges? 

8. FOREX/HEDGING

There is no stated Forex/Hedging policy outlined. We are watching the situation very closely and have taken adequate measures. We hope to show some decent gains

9. DIVIDEND POLICY

What is your stated dividend policy?

Again no stated dividend policy. But we will show steady, stable growth in dividends. We must ensure there are no dips.

As companies get comfortable on the debt front and there are stable cash flows, mature companies have a fixed/target Dividend Payout in line with the Earnings growth. What is your thinking on that front?

We are not yet a mature company. We have taken very aggressive bets to reach here.

Our first target was to become debt free. You can say we have reached zero debt level only now, if you account for the Cash. Whatever Surplus we generate, we need to ensure enough to save us on a rainy day. What if there is a crisis next year, what do you do? 

There are external pressures (from shareholders), but I think we are right in resisting those pressures till we reach a situation where we can be called a mature company.

10. Kitex Garments Ltd and Kitex Childrenwear Ltd

Minority shareholders like us are however concerned with the listed entity KGL. In the current scheme of things, concerns on Management discretion and Corporate Governance will always remain. Why not merge the two?

Yes Merger should happen at the appropriate time. 

One needs to appreciate that we are in this situation, because of historical reasons, as explained in detail earlier. You must also appreciate that there is lot of value creation still to be done at KCL level. I have staked everything I had on this entity (taken on very aggressive bets) and merging the two at their current stage will be really short-changing myself and my children. When KCL business and Clientele grows to a certain level, merger is surely on the cards.

What kind of value creation are you looking at?

First, the business in KCL has to grow to a certain level. It has to independently demonstrate the track record of sustained growth on the back of sustained customer relationships. Once that level is reached, it will be easier to envisage for anyone whether KCL can go the next level or not. That will be the right time to merge the entities.

You already have significant holding in the listed entity KGL. Purely from a financial gains standpoint (notwithstanding the value creation) – Investing community likes to point out Merger of the 2 entities looks unlikely because with Promoter shareholding is capped at 75%, you lose more.

Yes, we appreciate that.

So, you are saying you don’t mind that minority shareholders getting benefited more?

Yes. It should be a win-win situation. Shareholders in the company should also benefit

But Actually minority shareholders (of KGL) are walking away with a good chunk of the value creation in KCL for free, while you stand to lose that chunk of value creation, in the merged situation. There would be other gainful options for you, surely?

There will be value unlocking in both the companies after the merger, the combined entity valuation will benefit everyone, so even if I give away some to minority shareholders I too stand to gain.

An objective assessment of this situation would point to the above inequity and suggest that KCL acquiring KGL is the more likely outcome – after the Value Creation.

Not going to happen!

Taking that argument line, one can say I can do anything with KCL – I am the only owner. But KGL is a listed entity – there are other significant shareholders, one cannot just walkover them. Any decision taken can only be arrived at after due process. Only proposals that can carry everyone and convinces everyone, can be taken for KGL.

————————————————-  End of Q&A———————————————————–

Disclosure(s):

Management Q&A:

1. Ayush Mittal : Tracking & buying > 1 year, added more recently; Holdings > 5% of Portfolio

2. Tirumal Rao: Tracking & buying > 1 year, added more recently; Holdings > 5% of the portfolio

3. Pratyush Mittal:Tracking & buying > 1 year, added more recently; Holdings > 5% of Portfolio

4. Anil Kumar: Recent entry; Holdings > 5% of Portfolio

5. Vinod MS: Recent entry; Holdings > 5% of Portfolio

6. Donald Francis: Recent entry; Holdings > 5% of Portfolio

Special Contributors:

1. Kiran D: Recent entry; Holdings > 5% of Portfolio

2. Omprakash Davuluri: Recent entry; Holdings > 5% of Portfolio

————————————————-  End of Disclosure(s)———————————————-


Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 1 year;
Tirumal Rao: More than 5% of Portfolio in the Company; Holding for more than 1 year;
Pratyush Mittal: More than 5% of Portfolio in the Company; Holding for more than 1 year;
Anil Kumar: More than 5% of Portfolio in the Company; Recent Entry;

MUTHOOT CAPITAL SERVICES

Background

Muthoot Capital Services Ltd. promoted by Muthoot Pappachan Group is a deposit taking Non Banking Finance Company (NBFC) registered with the Reserve Bank of India and listed on the Bombay Stock Exchange. 

Established in 1994, Muthoot Capital Services Ltd offers vehicle loans – primarily 2 wheeler and 3 wheeler loans.


Main Products/Segments

Muthoot Capital AUM (Cr)
9mFY14
GNPA
Q3FY14
Sales (Cr)
9mFY14
 Contrib
%
2 Wheeler 504.54 1.01% 386.46 96%
3 Wheeler 105.41 4.86%    6.57 4%
Blended 609.95 1.68% 403.03
Muthoot Capital FY09 FY10 FY11 FY12 FY13 9mFY14 FY09-FY13
CAGR
AUM (INR Lacs) 7167 9669 17184 29578 45569  60995  58.79%
Disbursements (INR Lacs) 1044 4285 13835 28845 43117  40316  153.53%
Avg Lending Rate 24.25% 28.81% 28.74% 28.39% 28.79% 27.09%
Avg Borrowing Rate 10.72% 11.01% 11.08% 11.92% 12.83% 12.39%
NIM 13.53% 17.80% 17.66% 16.47% 15.96% 14.69%
Avg Loan Size (INR) 33405 33315 39391 43351 45139 42502 7.82%
Gross NPA 0.94% 0.81% 0.63% 0.26% 1.00% 1.84%
Net NPA 0.73% 0.63% 0.52% 0.20% 0.87% 1.61%
RoA 9.32% 8.43% 6.85% 6.24% 5.50% 3.89%
RoE 38.29% 38.29% 38.27% 26.71% 22.92% 19.51%
Cost to Income Ratio 0.44 0.38 0.39 0.42 0.45 0.46
Capital Adequacy Ratio 21.12% 20.86% 16.48% 28.56% 21.71% 19.61%
Total Customers 4343 15393 46589 99647 118568 212682 128.58%
Avg Monthly Disbursement 260 1072 2927 5545 7960 10540 135.23%
Salary Costs/Op Income 5.05% 11.15% 13.84% 18.22% 20.39% 21.90%
Sales (INR Lacs) 1712 2239 3770 6701 10664 11235 57.98%
PAT (INR Lacs) 542 717 967 1551 2176 1626 41.55%
Total Employees 55 207 505 1034 1626 2146 133.18%
Avg Employee Count 131 356 770 1330 1886
Sales/Avg Employee (INR Lac) 17.09 10.59 8.70 8.02 5.96
PAT/Avg Employee (INR Lac) 5.47 2.72 2.01 1.64 0.86

Source: Company

  • Group Branch Network: 3800 Fincorp branches -currently as cash payment collection points
  • Operations Network: 29 Hubs; 8 MCS owned and 21 shared premises with Fincorp
  • Dealer Points: – 1200 @2-3% commission; Usually 1 Customer Sales Executive (CSE) at dealerships
  • Disbursements Concentration 9mFY14 (FY13): Kerala 54% (60%), Tamilnadu 15% (14%), Andhra Pradesh 10% (9%), Karnataka 16% (13), Goa 0.6% (0.6%), Gujarat 2% (1.5%), Mahrashtra 2% (1.5%)
  • Group Customer Base: ~3.2 Mn Fincorp customers; Not much active cross-selling at the moment because of absence of unified database. (planned availability FY2015)

Main Markets/Customers

  • Strong Kerala Presence statewide – 20-25% market share. Competes strongly with IndusInd Bank and HDFC Bank. No#2 in Kerala just behind IndusInd Bank. Total Kerala market ~40,000 vehicles financed per month.
  • Muthoot Fincorp branches in Kerala are pretty much all leveraged by MCS. Fincorp has 900 branches in TN and around 600-700 branches in AP and KN each which leaves lot of space for leveraging on.
  • Nascent presence in Tamilnadu, Karnantaka, Andhra Pradesh (historical stronghold of Shriram City Union Finance?). These 3 states are traditionally huge markets for 2Wh financing. The company plans to grow Sales substantially leveraging existing Fincorp branch strength (without incurring much by way of fixed costs) – which is pretty entrenched in these 3 states.

Bullish Viewpoints

As on Mar 2013/
Dec 2013
Muthoot
Capital
SCUF SHTF Chola Sundaram MMFS Bajaj Finance
Size (AUM Cr) 610  15800 49700 19000 17600 27900 17100 Dwarfed when compared to Industry
Years in Business
(Effectively)
20
(6)
28 (11) 35 36 60 23 27 Miles to go before proving itself
Capital Adequacy 19.61% 23.3% 19.9% 17.1% 17.7% 19.1% 20.9% Adequate; may need replenishing
3Yr Earnings CAGR 50% 45%  19%  74%  20%  39%  58% Robust growth
Cost to Income 46% 37% 26% 50% 37% 33% 45% High
Cost of Funds 13.10% 12.6% 9.8% 10.6% 10.6% 9.9% 10.3% Industry Highest
Employee cost/Avg no of Employee (Lacs)  1.66  1.75  5.36  12.19 Industry Lowest
Business Size/Avg no of Employee (Lacs)  38  92  385  553 Industry Lowest
Margins 14.69% 11.2% 7.0% 7.6% 8.4% 9.4% 12.1% Industry Highest
Yield 27.4% 22.1% 16.3% 15.4% 17.7% 16.4% 20.7% Industry Highest
Gross NPA  1.68%  2.4%  3.2%  3%  2.5% Industry Lowest
RoA 3.89%  3.2%  2.9%  2%  3%  3.4%  3.6% Industry Highest
P/B (CMP 87) 0.88   2.2  1.8  1.5  2.4  3.05  1.6 Attractive
P/E (CMP 87) 4.57   12.7  10.37  10.6  15.14  14.35  11.24 Attractive

Source: Company, Annual Reports

  • High Growth – Earnings have grown at an impressive 50% CAGR over last 3 years next only to Bajaj Finance – albeit on a much lower base. There is huge headroom to grow -provided the funding constraints get adequately addressed.
  • Highest Yields & Margins in the Industry – Again despite a declining trend, Margins (14.69%) and Yields (27.4%) for 9mFY14 are the highest in the industry, although on a much lower base compared to bigger competitors.
  • Highest Profitability in the Industry – Even with a declining profitability trend over last few years, MCS RoA at 3.89%  (9mFY14) is the highest in the industry. With the steps Management has been taking, RoA looks set to improve in near to medium term.
  • Stringent Credit Policy – As per the Management the primary reason for its strong showing and low NPAs is very strict adherence to the robust and detailed credit policy laid down by the company – extensive covering of different models and different customer segments (salaried, income-based, Asset-based, or NO docs financing with higher down-payments). Different Loan to Value (LTV) levels apply for different customer segments.
  • 85% of Loans backed by “Own House” documents – This is probably unique to Muthoot Cap that 80-85% of its disbursements follow asst-financing model – loan to folks with own-house document proof – either the borrower or the guarantor (usually close relative). This helps the company in collection/recovery process – as borrower is reluctant to run the risk of property attachment in case of default – especially for small loan sums < Rs 40,000.
  • Lowest NPAs in the Industry – Gross NPAs at 1.68% is the lowest in the auto-financing industry. All auto-financiers including Bajaj Finance have been seeing a spurt in NPAs in recent quarters. MCS has been managing the NPA situtation admirably. Collection Executives are focused on bringing down the ~15.75 Cr of likley NPAs substantially down by 31st March 2014 or, Gross NPAs to <1.5% or less. Senior Management is focused on closely monitoring stressed A/Cs (likely to become NPAs) and Collections on a daily basis.
  • Extreme Focus on write-offs recovery – MCS is again probably unique in its focus of trying to ensure recovery of every rupee that is written off. Post Arbitration (company has appointed arbitrators) 3-4% of cases vehicles are repossessed and sold off. Cases are filed and in due course company is confident of recovering loan amounts due along with legal costs and charges.
  • Big Productivity Improvements likely in FY15 & FY16 – With enterprise-wide automation being introduced and Profit Center benchmarks being established, company is embarking on a productivity linked budgeting exercise from FY15 onwards. Management opines this will help the company monitor income and expenses more granularly and modify policies for getting the best productivity – locations-wise and team-wise.
  • Cross-selling within Fincorp customer base – Fincorp has a customer base exceeding 3.2 Mn Customers today. Effective cross-selling may become possible once Fincorp group database becomes available (post automation) in FY15 and may provide a kicker to Sales growth.
  • Attractive Valuations – MCS is currently (CMP 87) trading at a discount to Book and ~4.5x PE with a 4.8% dividend yield – which looks reasonably attractive.

Bearish Viewpoints

  • Declining profitability trend – While 5 year Sales or Profit CAGR may look healthy, and FY14 Sales may register 40%+growth, FY14 PAT is likely to register flattish or negative growth. Return on Assets (RoA) have consistently declined and halved from ~9% levels 5 years back.
  • Employee Productivity bottleneck – If we examine the reasons, what strikes immediately is the nearly ~3 to 5-fold drop in Sales and Profitability per employee. The situation has got accentuated on 2 fronts. First, disbursements didn’t keep pace with recruitment leading to under-utilisation. Company was doing ~60 Cr disbursement by Mar 2013, but in 9MFY14 has managed to disburse only ~400 Cr. Secondly there is enormous duplication of excel-based data-entry work between Operation Hubs and Back-Office in the absence of enterprise-wide automation. Company has been cognizant of the second front and has been working to introduce fully-automated Loan Origination System covering Sales, Operations and Credit processes from April 2014 -planned to be fully operational by end of Q1FY14.
  • Delay in Bank Funding – Disbursements have been hampered by delayed funding availability from Banks. Typically Bank Limits are enhanced based on the current Balance Sheet. The BS gets ready by April/May with Banks taking another 2 months. So while company had a disbursement run-rate of 60 Cr by Mar 2013, it could disburse only ~40 Cr in Apr-Aug’2013 (up to 50-60 Cr for Sep-Dec’13) despite otherwise having ready sales/operations personnel – leading to under-utilisation. In earlier years this hadn’t proved a bottleneck (probably shareholders equity sufficed for first few months till enhanced bank borrowings kicked in) but it certainly has impacted disbursements and profitability significantly in FY14. For FY15 Company expects to kickstart approval process with banks within Q4FY14.
  • Deteriorating 3 Wheeler Market/Portfolio – MCS 3 Wheeler Loan market (primarily Kerala) has been steadily deteriorating. Monthly Sales at 7500 vehicles is now down to 3500 vehicles per month. Reportedly daily earnings of 3-wheelers down to 450/- from Rs 850/- earlier. The 4 wheelers Tata IRIS/ACE has also started doing well. 3 Wheeler Associations have written to prominent vehicle finance companies to stop issuing 3 wheeler loans in Kerala. Debt servicing capability of borrowers is badly dented and gross NPAs are on the rise [~5% in 9mFY14]. However, 2 Wheeler gross NPAs remain firmly under control and are probably the best in industry at ~1%
  • High Cost of Funds – MCS Cost of Funds is the highest in the industry at 13%+. Dependency on Bank Funding is high and  current A (negative outlook) rating by CRISIL (clubbed with Muthoot Fincorp) isn’t helping either. Public NCDs/other options are probably restricted till a ratings upgrade is in place.
  • A (Negative Outlook) CRISIL Rating – While the reasons and rating sensitivity cited by CRISIL in its negative outlook are mostly attributable to the Gold Loan business of Muthoot Fincorp, declining profitability on MCS count has not helped either. Senior Management is strongly of the view that they have proven in last 6 years that MCS 2Wheeler/3Wheeler Auto Financing is a successful, sustainable, and scalable business model. They have moved out completely from the Gold Loan business. They deserve a standalone MCS rating which they feel merits much better rating – that may alleviate its funding constraints in a major way. Discussions are on with ICRA and CARE.
  • Single Product dependency – MCS product portfolio currently comprises of only 2 wheeler and 3 wheeler loans. With 3 wheeler NPAs rising company is consciously cutting back on 3 Wheeler loans. Dependency is very heavy on 2 wheeler loans. Any adverse developments in the industry/economy could significantly affect the company’s fortunes. Going forward the company has to look at product diversification for better risk-adjusted growth profile.
  • Funding constraints – Tier I & Tier II Capital – Currently Capital Adequacy stands at ~19% (Min CAR of 15% as per RBI). If MCS continues to grow at 40-50% rates, it will need capital infusion in the form of Tier I or Tier II Capital pretty soon. Raising Tier I (Equity Capital) is probably not an active option for the company (cf. current valuations). For Tier II Capital MCS has options of either going the route of Sub-ordinated Debt or Preference Capital – which may get decided based on Group liquidity levels in 2015/16.
  • Hero/Honda Company Financing – MCS is hugely dependent on financing for Hero and Honda 2 wheelers. In the event that either of these start their own financing arms – and provide preferential access to financing from their dealerships – MCS prospects can be affected significantly.

Barriers to entry

  • Unique/Flexible cash payment schemes – Customers can pay from any Fincorp branch anywhere in the country. A web-based collection module of MCS provides access to customer details and payment schedules, etc. for all Fincorp branches. Customers can choose to pay the monthly EMI say Rs 1500/-, in even Rs 200/- or Rs 300/- flexi-instalments. Fincorp collects 0.5% (up from 0.2%) as collection fees from MCS from FY 2013.
  • Leveraging widespread Fincorp network – With a growing pan-india network of more than 3800 branches – this is at the heart of the efficient collection system for MCS. MCS can simply piggy-ride this expanding retail network and does not really need to set up this infrastructure of its own as it scales up. MCS does not need branch offices as sales originate primarily from Sales Executives placed at Dealer Points. [Operational Hubs are required for managing every 30-40 Dealer points – where again shared (but separate) premises with Fincorp is the norm. Out of 29 Operational Hubs only 8 are MCS-owned including the Head Office location.]

Interesting Viewpoints

  • Started taking Deposits – MCS has recently started taking 1-3 year deposits at upto 12% rates through Muthoot Exim which acts as the broker. ~40 Cr deposits have been mobilised so far. The company seems confident of mobilising ~150-180 Cr (the max limit – 1.5x Net Owned Funds) within FY15. This will go way a long way in ensuring Margin Requirements with Banks and pave the way for enhanced Term Loans availability for the company.
  • Impending introduction of Automation – As per the company major automation in Loan Origination System (LOS) – covering Sales, Operations and Credit processes – is set to be introduced across all company Hubs and Offices in 1QFY15. Part of a much larger group automation project standard operating procedures (SOPs) have been defined by IBM in consultation with functional departments over the last 2 years. 3I Infotech is the major vendor and implementation partner. Apart from providing single-source unified MIS views, this is likely to bring in huge operational efficiencies and savings in FY15.
  • Muthoot Fincorp Sales Agency model – With Gold Loan business volumes coming down, Muthoot Fincorp has started proactively sourcing customers for MCS on commission basis (2%). Started only a year back, all Fincorp branch personnel have now been trained. With Muthoot Fincorp intrinsically incentivised (low Gold Loan Sales) this is expected to be rolled out to all 3800 branches in FY15 – reducing the dependency and large costs incurred by MCS on Sales Executives at Dealer points. Model is working well and expected to start delivering ~7500 vehicles (avg 2) a month.

Disclosure(s)

Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months


Muthoot Capital Services Management Q&A: May, 2014

Management Q&A

1. THE BUSINESS, INDUSTRY & OPPORTUNITY SIZE

Muthoot Capital has chalked up a rapid growth rate only in the last 6 years or so, despite being listed from 1995. Kindly take us through the journey and the key success factors. What has changed, and how exciting is it to be where MCS is today?

As you are aware in 1994 Mr Thomas Kuruvilla (ex SEBI) was appointed as the MD & CEO of the company which was started for offering Capital Market Solutions, though the Company did not start the business. It did not have a NBFC license then. In ’95 there was a small but well subscribed Public Issue.

The company did not do well and was more or less dormant till 1997-98. It was revived in 1998 after getting the NBFC License. The company started doing business of Gold Loans. In 2005-6 the company started some 2 wheeler loans but did not succeed in making a mark – and was stopped. In 2007, 2-wheeler Loans were again started but this time only to Fincorp group customers (Gold Loan, Insurance products).

1st Mar 2008, Mr R Monomohanan joined the company as CEO. He had a Corporate Banking background – 20 yrs with SBT. He headed IndusInd Bank Kerala Operations from ‘1996-‘2003 and was with Exim Bank Tanzania from ‘2003-‘2007. The Company also brought in Mr R Balakrishnan – with over 15 years of hard-core 2-Wheeler industry experience in Operations, Sales and Collections spread over Integrated Finance and TVS. Mr Balakrishnan was given a free hand in setting up his team.

This was the time many players were vacating the 2 Wheeler financing space due to high default rates – like ICICI Bank, Citi Financials, UTI Bank. We saw it as an opportunity due to our reach and loyal customer base.

In Oct 2008 we started full-fledged operations. We started lending outside the group too. We disbursed Rs. 10 cr, Rs. 43 cr Rs. 138 cr, Rs. 288 cr and Rs. 431 cr respectively in 2008-2009, 2009-2010, 2010-2011, 2011-2012 and 2012-2013 respectively. In March 2009 we reached a loan book size of Rs.10 Cr, Rs. 40 Cr in 2010, and followed it up with ~Rs. 130 Cr in 2011. In 2012 we reached Rs. 290 Cr and ~Rs. 482 Cr in 2013.

We hope to keep the momentum going. We have laid strong foundations. We have been testing waters so far. In 5 years we have reached a level of ~650 Cr, where (we daresay) reaching 2000 Cr was not difficult.

We believe we have demonstrated a robust business model in the tough terrain of 2-wheeler financing. While we have grown rapidly, we have ensured high Return on Assets (RoA) and some of the lowest NPAs in the industry.

2Wh Loans constitute the bulk of the Loan Book. Post 2008 (2009-10) timeframes Private Banks mostly vacated this space. Also NBFCs like Fullerton (300 Cr Auto Loan book), CitiFinancial, GE Money scaled down operations drastically. Why has this business proved difficult in the past? Why were you confident of executing where others have failed before?

As mentioned before, this is a difficult terrain. There were very high defaults in 2008-9 time frames – Retail Banking was a numbers game being played out – anyone and everyone could avail of a loan – proper verification procedures were probably not in place, and credit policies were lax.

Because of our Corporate Banking background, we ensured we offered the Right Product.

And what is the Right Product?

Product that is first and foremost backed by a Robust & detailed Credit Policy. Policies that ensure a wide coverage of different models, different repayment schedules and different customer profiles – salaries based, income based financing, asset-based financing, and even a No-Docs financing (50-55% down-payment).

We started offering only for Honda and Hero vehicles – we are the preferred financiers for them today.

Secondly this is backed up by 3-level customer profiling and verification (which goes up to 5 levels in certain cases). First by the Counter Sales Executive (CSE) at dealer premises, followed up by an independent Field Investigation (FI) Verification Agency that confirms physical address proof and background check, and finally a CIBIL score elimination.

Thirdly we offer a product that is tailored just-right for its audience segment. Flexible Repayments. We do not take any Post Dated Cheques (PDCs). In what is probably a first-in-industry and unique to Muthoot we allow the customer to pay in cash – in any of the 3800 Muthoot Fincorp branches – all over the country. For an EMI of Rs. 1500/- say, he can even pay in Rs 300/- or Rs 200/- flexi-installments, any time he chooses. We call this facility “Ultimate Flexi Payment”.

Apart from these obvious Product structuring strengths, kindly elaborate on the key business tenets for MCS?

The core business tenet is “Asset Quality”. This is our primary concern for every employee of MCS. Nothing is outsourced – except the Field Investigation Agency. We follow a stringent system of concurrent audits (audits happening at the Operation Hubs concurrently with approvals).

For maintaining desired Asset Quality, we lay great stress on our people. Interestingly we do not follow the prevalent Agency model.  Unlike Direct Sales Agents (DSAs) we have a Counter Sales Executive (CSE) stationed at Dealer premises – an employee on our rolls. Every employee has been handpicked/recruited by referrals – no advertisements. Employees are assured great career advancement prospects – to ultimately retire with the company. From 15 employees in 2008 we have grown to 2100 employees today, in 7 states.

How well-placed is MCS in 2Wh/3Wh space? Who are your main competitors? Is your audience segment completely different from those served by Banks?

Our main competitors are IndusInd Bank and HDFC Bank. IndusInd Bank has higher expenses because of higher incentives for dealers at 4-5%. Their NPAs are also higher. HDFC Bank as you know has a separate vertical for Auto Finance. They are the bigger players.

We are a small player with ~2% market share. We have huge headroom to grow.

Where does MCS see itself 5 years from now vis-a-vis current competition?

We aim to become a significant player in this space in the next 5 years with atleast 10-12% market share. Major players have somewhere between 15-18% market share today.

What do you see as the biggest challenges to your growth plans?

Availability of Funds and maintaining our Yields at current levels.

How ready are you organizationally for the challenges ahead? And Why?

As you are aware, we are a small organisation. We have laid a strong foundation with the right people, right product and processes within the organisation. However in-order to enable us to scale up significantly from here, we have been taking following steps:

a) Complete Automation – major automation is being introduced in Loan Origination System (LOS) – covering Sales, Operations and Credit processes – set to be introduced across all company Hubs and Offices in 1QFY15. This is part of a much larger group-wide automation project where standard operating procedures (SOPs) have been defined by IBM in consultation with functional departments over the last 2 years. 3I Infotech is the major vendor and implementation partner. Apart from providing single-source unified MIS views, this is likely to bring in huge operational efficiencies and savings, starting FY15.

b) Productivity linked Budgeting –  Company is embarking on a productivity linked budgeting exercise from FY15 onwards – Profit Center benchmarks are being established  – this will help the company monitor income and expenses more granularly and modify policies for getting the best productivity – locations-wise and team-wise.

c) Arbitrator appointment – For speedier processing of loan recoveries appointment of Arbitrator has been started.

Muthoot Pappachan Group is a diversified conglomerate -Financial Services, Hospitality, Automotive Dealerships, Real Estate & Infrastructure, IT Services, Healthcare, Precious Metals, Global Services and Alternate Energy. Ev
en during the press release of MCS results update MD speaks about Muthoot Pappachan group and other businesses like MF, Housing, gold loan etc. – Which is the priority and how is promoter/management bandwidth?

We are a completely professionally run set-up. There is zero interference from the Promoters in day to day activities.

2. OPERATING STRUCTURE

Back-Office/IT systems/Risk Management

Entire Back-office, New automation system for Loan Origination System and other IT facilities, Document Storage, and Risk Management Team is based out of Cochin.

Business/Operations – Front Office

Sales originate from the ~1200 Dealer Points spread across 7 states.

Operations HQ is Cochin. There are some 29 Operational Hubs. These Hubs usually handle sales origination from some 30-40 Dealer Points. Operational Hubs usually house the Credit Team, Operations Team with Tele-Callers, Collection Team and a Concurrent Auditor.

Team Sizes

Sales – ~950-1000; Collections – ~800, Operations – 115; Credit -~50; Risk Management – ~40

3. BUSINESS PROCESSES

What is your Loan Eligibility process?

Around 80% of loan origination happens in non-metro regions – at rural location dealers.

Loan eligibility is decided on various parameters. Broadly the flexibility increases as the Loan to Value (LTV) goes down. If everything is in order, Loan Approval is sanctioned. 80% of loan disbursal is for Honda/Hero products. LTV is different for different 2-wheelers. Generally resale value for Honda/Hero 2-wheelers is higher, so there is better security.

Different combinations of LTV, proof of landed property, customer profile, income documents, guarantors, kind of 2-wheeler being financed, existing relationship with MCS/group companies and CIBIL score decides the loan amount.

More than 90% of the customers have a property in their or guarantors name. MCS takes copies of tax receipts of the property. This helps MCS in case arbitration/legal proceedings are needed for recovery of loan.

MCS can disburse a loan without income proof – where the LTV has to be lower than 50%. Less than 10-15% of accounts may be under this category. Of course 2 guarantors are signed-up for almost all cases.

When company/competition markets “100% funding” schemes – this is only smart product packaging. In such products advance EMIs of upto 5 months is collected upfront by anyone offering such schemes.

Generally 80% loans are based on assets owned by the client, 5% cases are based on his income proof, and balance are no-income/asset proof cases.

Kindly educate us on the Loan Sanction/RISK Management process?

Counter Sales Executive (CSE) does the first round of customer profiling by collecting details and documents from customers directly. The Tele-caller at Operational Hub makes the next round of residence and employment verification.

Field Invstigation (FI) agency does the address verification at customer’s residence and also does a background check by contacting neighbours, etc.

A CIBIL report is also generated.  CIBIL records are available for 30% cases. Though the score is not used directly, the repayment habits and current liabilities of clients are ascertained using the CIBIL report.

Whenever Loan to Value (LTV) is above 70% the risk team appraises the case before sanctioning. A Risk Team (stationed at HO) consisting of ~40 employees work closely with the Hubs. Risk team picks up cases through random sampling, references from credit team and on any other triggers/hints they get.

The trigger/hint may be in the form of abnormal number of defaults from a specific sales staff, dealer, area, segment of clients etc. There is a list of “negative” segments.

Flexible repayments is what is said to be MCS “real differentiator”. Kindly elaborate.

Very flexible installment payment options and various methods to evaluate credit capacity allows MCS to compete effectively. A customer can pay his installments partly or in full at any Muthoot Fincorp branch in the country. He need not give PDCs or ECS instructions.

In any PDC system 80:20 rule applies. 20% of the cases there is cheque bounce. When customers of competitors have to deal with penalties for cheque bounces i.e. defaults,  a MCS (defaulting) customer can make at least a part payment. He can pay daily/weekly or monthly.

The MCS Operations Team sends an SMS reminding them of the due date. The Collection Team then guides customers to the nearest branch for the payment.

Kindly educate us on Collection And Recovery Processes.

An SMS goes to the customer informing due date and amount for payment of installments.

If the customer does not pay in time, Tele-caller calls to check. Customer is persuaded for making the payment/even if partly, at any of the Fincorp branches.

The big Fincorp branch network ensures that collection team guides the customer to nearest Fincorp office. The flexibility to pay daily/weekly ensures collection of some amount happens.

Collection Team consists of ~800 execs with each Team Leader managing on an average 7 Executives.

What are the main advantages/differentiators vis-a-vis Competition?

Competitors employing collection agencies and using PDCs route for monthly payment are usually slower to start the follow-up as the trigger for follow-up is usually on cheque bounce being first reported.

Competitors would perhaps take around 45 days for collection process to start after the due date – once any PDCs bounce, and penalties are imposed. A large chunk of 2-wheeler customers may not be used to regular banking habits and PDC bounces might be frequent. The penalties will further irritate them.

MCS collection team works very closely with the customers and this also gives valuable information about the clients, their whereabouts, best way to collect from them etc.

How strong/influential is Customer Knowledge and the Relationship? And role of Guarantors?

With ~800 executives in the collection team and attrition being low at 1%, the long term relationship (in-place) with clients  is very important for recovery. Teams are very well versed with the area they operate in.

MCS strategy is to operate in areas around Fincorp branches, thus there is high possibility of a client being an existing client of Fincorp or being known to a client of Fincorp. Many a times Fincorp’s help is requested to know more about the clients of MCS.

Most clients do not want a collection agent to visit them, and/or interact with their colleagues, family members or neighbours. Hence in most cases recovery is successful through positive persuasion.

The 2 Guarantors usually are close relatives or friends. This also acts as a deterrent/strong persuasion point for defaulting customers. MCS can proceed with arbitration against Guarantors as well.

What is the process on payment defaults?

Whenever the customer defaults one of the first 3 EMI cheques are utilised. The Credit Team and CSE concerned are also utilised for persuading the client. This is because the client and his details/whereabouts are still fresh.

2-wheeler loans being low-ticket items most customers do not want recovery actions, especially when even their property can technically be at risk. MCS possesses the vehicle in case of default over 3 months. Some of them (25% in FY13) are released after collection of some amount.

When the company repossesses and sells vehicles, the balance un-recovered amount is written off immediately. But MCS is confident of recovering this amount through arbitration/legal proceedings.There are 550 Cases under arbitration now.

[Senior Management is very confident about the Arbitration/Legal process for recovery – due amount plus all legal fees/charges included. They opine “Every Rupee given out since 2008 will be recovered, there would not be any real “write-offs”.

MCS is very confident of its 2-wheeler loan book and gross NPAs are currently at 1%.] p>

What kind of skills-profile do you require for these jobs?

Normal graduates.

What kind of training do you equip employees to deal with – say the tough collection process?

Orientation training at HO. 1st-15th of the month training facilities are always booked. Whenever Credit Team or Operations Team visits – local trainings are conducted. Most of the learning though is on the job.

How do you create the right incentive structures? Loan growth vs profitability vs Collections?

We have an incentive structure which rewards the field level executives in both sales and collections according to their contributions. The structure also takes care of their supervisors, for keeping the field staff motivated and involved. For the senior staff, we have a flat 10% incentive structure plus a component based on quantum of disbursement. As mentioned before, we are bringing in productivity-led benchmarks that will help us to fine tune incentive structures in the near future.

 4. SALES/MARKETING

What is the total market size of 2 Wheeler Autoloans? What is the market share that MCS has in Kerala & overall?

Overall we have ~2% Market share. Some 40,000 vehicles per month need financing in Kerala Market. We are able to do ~10000 vehicles per month, so ~25% market share.

30 lac customers for the group and 2.25 lac for MCS. How do we plan to tap this base?

As mentioned before, major automation/ERP systems is being introduced within the group. Both MCS and Fincorp will have Loan Origination System (LOS) operational by Q1FY15. We should be able to leverage the group database fully from the coming financial year.

Do you share branches with Muthoot Fincorp? How many branches are company owned?

As mentioned before, MCS does not need conventional branch presence – Sales originate form dealer points where we maintain a Counter Sales Executive (CSE). What we do need is what we call Operation Hubs – which on an average manage some 30-40 dealer points. We have 29 Operations Hubs. 21 of these are shared (but separate) premises with Fincorp branches, and 8 belong to MCS.

There are 20,000+ staff working in the 3800 Fincorp branches all over the country. We are uniquely positioned to leverage on this group branch network that acts as Cash collection points for us.

So what is the relationship/arrangement with Fincorp? How do you account for the costs involved?

Fincorp branches also act as our Cash collection points. We pay them 0.5% as commission from FY14 onwards (revised upward from 0.2% earlier).

Any other synergies with Fincorp/Other group companies?

Yes. Sales Promotion activities for 2-wheeler loans are regularly arranged near Fincorp branches – to leverage the group customer base.

And of late Fincorp branches have started generating sales for MCS. We have provided required training to personnel at all Fincorp branches. This will be rolled out across all branches in FY15 – we expect significant traction from this going forward – roughly 2 vehicles per Fincorp branch per month run-rate is targeted by the end-of-year.

Why does this work for Fincorp? Why would they prioritise any Sales for MCS?

As you are aware the Gold Loan business is seeing a down-cycle. So it’s a win-win situation for the group companies.

New product lines – Company mentioned LAP, second hand auto loans, lease financing, tractor loans. What is the plan and opportunity size?

At the moment we are focused on 2-wheeler/3-wheeler loans. Other avenues will become available as we attain some scale and are also able to attract substantial funding.

What is your strategy around tie ups with more players besides Hero Motocorp and Honda?

We are the preferred financiers for Honda and Hero vehicles. They are growing at a rapid pace. At the moment we are focused on servicing this market.

How is you expansion plan playing out in Goa, Gujarat & Maharashtra? Do you expect to maintain the NPAs in these markets also? You would have had a better credit history of customers in your primary market because of group/historical customer relationships. Will this be an additional risk in the new markets?

Our recovery performance and low delinquency ratio in Kerala and the other Southern States are on account of our business model, which include strict customer profiling, flexi-payment option to borrowers, doing the business with own employees instead of engaging agencies, strict and vigorous collection measures, etc. We expect to continue the same collection performance and low levels of NPA in the other States also, by continuing the same business model.

You have presence across 1200 dealers? How will this number grow over time?

Currently we have ~1200 dealer points. If things go as planned this will reach 1600 dealer points next year and 2000 dealer points by FY16.

Will it be correct to assume a similar trend for disbursements?

Yes. We certainly hope to maintain a fast clip. As mentioned before, we think reaching 2000 Cr in disbursements  is not difficult – and a good target for us to achieve within next 2-3 years.

How much contribution comes from 3 wheelers today? What is the average yield, default rates and tenure of 3 wheeler loans? Does permitting play a role in terms of what the demand is like?

3-Wheelers constitute a very small portion of our product portfolio ~4%. 3-Wheeler Loan market (primarily Kerala) has been steadily deteriorating. Monthly Sales at 7500 vehicles is now down to 3500 vehicles per month. Reportedly daily earnings of 3-Wheelers down to 450/- from Rs 850/- earlier. The 4-wheelers Tata IRIS/ACE has also started doing well. 3-Wheeler Associations have written to prominent vehicle finance companies to stop issuing 3-wheeler loans in Kerala. Debt servicing capability of borrowers is badly dented and gross NPAs are on the rise [~5% in 9mFY14]. However, 2-Wheeler gross NPAs remain firmly under control and are probably the best in industry at ~1%

What percentage of your customers would have a CIBIL record? Do you initiate a credit check for all your customers before sanctioning?

Roughly 30% of customers have a CIBIL record.

What is the competitive advantage that you have over your competitors especially in areas where you don’t have your branches and Muthoot brand does not have a strong recall?

The Ultimate Flexi-Payment facility across 3800 Fincorp branches all over the country has proven to be our key differentiator. Also being a single-product company we are certainly more focused on this segment than our much larger bigger competitors (Banks like IndusInd and HDFC). Our products & processes are probably more finely-tuned to the requirements of the customer segment we serve.

How do you handle the Trade? 2-wheeler Dealers in metro cities are known to demand huge trade advances and higher commissions?

We are a small company. We can not pay 1 Cr trade advance! We offer between 10-15 lakhs as trade advance. While competition is known to offer 5% kind of dealer commissions we offer 2-3% commissions. But we do offer the best payment terms to the dealers – payments are processed immediately without any delays. Some of the bigger competition is known to delay payments by over 2-3 months.

What is the Rural/Urban Sales mix for Muthoot?

80% Rural, 20% Urban.

What is your current organization structure? What is the average tenure of the employee? What kind of attrition levels do you deal with

Sales – ~950-1000; Collections – ~800, Operations – 115; Credit -~50; Risk Management – ~40

1% Attrition levels. There is no retirement in Muthoot group. Post 58 years employees are offered gainful engagement on contract basis – based on the skills profile.

5. FINANCIALS/CONCERNS

Your borrowing costs are creeping higher over the last couple of years? What is the current cost of borrowing and do you expect it to further trend higher? How are you compensating for this rise in cost of borrow
ing?

Our average lending rate for 9m FY14 is at ~27.09% while average borrowing rate is at 12.39%. NIM is thus 14.69% and the highest in the industry. Maintaining yields is becoming a difficult task. We are in discussions with ICRA & CARE for standalone MCS ratings – that should help bring down our borrowing costs somewhat, in near future.

In the last quarterly results the Admin costs have increased from Rs 3 Cr to Rs 7 Cr YOY & Employee costs increased to Rs 9 Cr from Rs 6 Cr YOY? Why are such huge jumps happening?

There was significant scaling up on the Employee front which resulted in the higher costs. We had factored in higher disbursement rates for FY14 based on our Mar 2013 run-rate achieved.

Going forward what will your target NIIs, ROAs and expense ratios? Your expense ratios have been climbing sharply over the last 2 years?

Profitabilty was hit in recent quarters as expenses shot up but disbursements couldn’t keep pace. We expect RoAs to climb back to 4.5 to 5% levels.

How are your Gross NPAs faring? Is the incidence of NPAs increasing? What are the measures your are taking to reduce the overall incidence of NPAs?

Gross NPAs for 9mFY14 are at 1.84% levels. It has gone up significantly as compared to previous years. This is in line with the stress in the overall economy. However our NPAs are still the lowest in the industry and reflects the focus within the company to manage collections and customer relationships, identify stress areas early and work towards reducing likely NPAs.

Can you give us some sense of the increasing NPAs? Are some segments effected more than others?

As mentioned before 3-Wheelers constitute a very small portion of our product portfolio ~4%. 3-Wheeler Loan market (primarily Kerala) has been steadily deteriorating. Monthly Sales at 7500 vehicles is now down to 3500 vehicles per month. Reportedly daily earnings of 3-Wheelers down to 450/- from Rs 850/- earlier. The 4-wheelers Tata IRIS/ACE has also started doing well. Debt servicing capability of borrowers is badly dented and gross NPAs are on the rise [~5% in 9mFY14].

However, 2-Wheeler Gross NPAs remain firmly under control and are probably the best in industry at ~1%.

So how long is the pain going to continue in 3-Wheelers? Any plans of reducing/exiting this segment altogether?

We have already curtailed fresh 3 wheeler disbursements. The total disbursement in FY 13-14 for 3 wheelers was only Rs. 20 Crore, compared to Rs. 80 Crore in the previous year. The portfolio will be depleted substantially in another 2 years.

So is it correct to say 2-wheeler NPAs are doing just fine?

Absolutely, Yes. 2-wheeler (96% of the business) NPAs remain within ~1%

If the NPA recognition is reduced to 90 days from 180 days currently?

These were proposed in 2012. At the moment they remain as proposals only and we haven’t seen any indications/activity on that front.

However, if these norms do get introduced, it will affect the NPA situation significantly.

But that actually defies current trends in the 2-wheeler industry too? Why are your NPAs keeping so low when the whole industry’s/bigger player NPas are rising?

As mentioned before at the start of this discussion, this is a reflection on 3 things. Robust Credit Policy backed by Stringent Verification Norms and a Right-Fit Product flexibly tailored for the needs of the segment we serve. We have some unique differentiators in place.

At the same time, we maintain the highest focus on customer relationship and collections – tracking and helping them maintain their repayment schedules.

6. FUNDING/CONSTRAINTS

Raising adequate funding is probably a key challenge for MCS. There is probably heavy dependency on Bank Funding and options are rather limited? How will you ensure enhanced funding availability? Kindly comment.

We have started taking deposits recently – we have a deposit-taking NBFC License. We have reached a deposit base of ~40 Cr. Interest rates offered are upto 11.25% with a 1-3 year tenure going upto 5 years in some cases. Muthoot Exim is the broker and they are being paid a 2% commission.

We can raise a maximum of 150-180 Cr deposits as of now (1.5x Net-owned Funds). Seeing the current uptake we think reaching a 100-150 Cr deposit base is pretty comfortable. For Term Loans, Banks require us to maintain 25% with the Bank as our own Funds (Margin requirement).

Having this deposit base will take care of this margin requirement, free up tied capital and enhance our working capital limits.

You had this issue in each of the last 2-3 years – of delayed Bank Funding – sometimes by end of Q1? Why are you confident this situation will be better managed this year and will not prove another unnecessary constraint for disbursements?

We already have some sanctions from banks in place and some other facilities in advanced stages of sanctioning. We have adequate working capital for continuing operations in the first quarter of the financial year itself.

There is also the issue of A (Negative) Rating from CRISIL. Is it right to say that Public NCDs will be an option as & when (or if) Ratings improve to AA. Kindly comment

The rationale and rating sensitivity cited by CRISIL in its A negative outlook are mostly attributable to the Gold Loan business of Muthoot Fincorp. We are strongly of the view that we have proven in last 6 years that MCS 2Wheeler/3Wheeler Auto Financing is a successful, sustainable, and scalable business model. We have moved out completely from the Gold Loan business.

We deserve a standalone MCS rating which we feel merits much better outlook/rating. This will alleviate our funding constraints in a major way. Discussions are on with ICRA and CARE. We are pretty confident this will be resolved soon – even the CRISIL rating should get revisited.

Capital adequacy at 19.61% looks adequate at the moment. But you have set a fast clip in dealer point expansion and disbursements growth. You are looking at a disbursement target of probably 100-1200 Cr for FY15. Why wouldn’t you require enhanced Tier I/Tier II Capital in FY15 itself? Or would that become necessary only by FY16? Why or Why not?

We are projecting a loan book size of about Rs.1000 Crore for FY 2015. We may require enhancement in Capital for maintaining the Capital Adequacy Ratio above 15%. We are thinking of a Tier II issue of about Rs. 50 Cr during the FY 15.

What is the Management/Promoter thought on raising Tier I Capital at current valuations? And is it fair to assume Tier II Capital is the only real option in the near future?

You may be right, Tier I Capital at current valuations is not an option. For Tier II Capital we have 2 options. Either raise Sub-ordinated Debt (lock-in of 5 years and may need higher interest rates) or Preference Capital – which may get decided based on Group liquidity levels in 2015.

CFO Anil Kumar R resigned 30th Nov 2013? What were the circumstances?

He was 56 years old – had a bypass surgery. He resigned due to health reasons.

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Disc: Ayush Mittal, Vinod MS, Gaurav Sud and Donald Francis were involved in this extensive Management Q&A and follow-up discussions.

Ayush Mittal – Invested; <5% Portfolio allocation, from more than 6 months

Vinod MS – Invested; >5% Portfolio allocation from Jan 2014

Gaurav Sud – Invested; >5% allocation from more than 2 years

Donald Francis – Invested; >5% Portfolio allocation from Feb 2014


Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 6 months;
Gaurav Sud: More than 5% of Portfolio in the Company; Holding for more than 2 years;
Vinod MS: More than 5% of Portfolio in the Company; Recent Entry;
Donald Francis: More than 5% of Portfolio in the Company; Recent Entry;

PI Industries Management Q&A: Sep, 2013

Management Q&A

1. AGRI INPUTS

1.1 OSHEEN – DINOTEFURAN INSECTICIDE

Kindly educate us on OSHEEN product, USPs, advantage over competitive products,etc.

As you are aware Osheen is a 3rd generation systemic insecticide invented in Japan by Mitsui Chemicals Agro Group (MCAG).  PI Industries has registered and developed OSHEEN for the Indian market, in collaboration with Mitsui, Japan.

OSHEEN has been trusted as a most reliable solution to effectively manage the Brown Plant Hoppers in Rice for number of years in the leading Rice growing countries. It has also been tested and recommended by leading agriculture research institutes of Govt. of India on Rice crop and Cotton crop.

You are known for registering/introducing in-licensed products only after proper gap analysis. Is it correct to say OSHEEN is a uniquely positioned product, just like Nominee Gold was?

Yes of course. OSHEEN has been introduced through due process – has unique advantages of longer control period and better coverage. Because of its unique mode of action OSHEEN effectively controls the target pests which are not controlled by other molecules.

So what additional benefits does it bring when compared to other competing Insecticides?

OSHEEN has fast action due to which target pests stop damaging the crop after coming into contact of OSHEEN and start dying within few hours. It has systemic action and quickly gets absorbed into the plant, effectively killing the target pests present in the different parts of plant and provides longer and effective control on targets pests. OSHEEN has trans laminar action due to which spray done on the upper surface of the leaves gets translocated to the lower surface and controls the target insects hiding on the lower side of leaf.

But then it must be a more costlier product?

See you must realise for Farmers its not about a BRAND. For him the only thing that matters is cost of application/acre, and there OSHEEN delivers much better than many competing products.

So there has been enough efforts on farmer education?

Yes.

What about Data Protection? How many years will it have an uninterrupted run?

Well it has the usual 3 year data protection as per Indian laws. Post that a generic me-too source may be eligible to apply – depends on how good the product is. Even with a good product, effectively it will be 4-5 years before any effective competition emerges.

Any co-marketing efforts already on?

That will come later. First OSHEEN needs to be seen to be delivering the goods.

1.2 NOMINEE GOLD

Kindly update us more on Nominee Gold. You had allowed co-marketing of the brand with other MNC/innovative agrichem partners? What are the results?

As you are aware we had enetered into reciprocal co-marketing arrangements for Nominee Gold with a few MNC players. That allowed us access to some of their brands for co-marketing by us. We entered into these realtionships after due evaluation for optimising product portfolio in certain markets to offer complimentary product baskets. Results have been encouraging so far.

But you have also extended co-marketing to Rallis & Dhanuka too? Aren’t you diluting the BRAND if its available from everyone? What’s the deal there?

Again we evaluate these things from a relationship perspective too. They have reasonably big distribution network in certain regions and It ensures our presence in those markets.

You had mentioned last time if PI were to try and cover the whole market it would take us 10 years. Co-marketing would allow us to increase visibility and allow us faster coverage in 4-5 years? How far has that played out? How much additional sales has been generated for the product through co-marketing?

Should be 15 – 20%

Rice Herbicide penetration was mentioned last time at 5% levels? Where is that now?

It should be ~8-9% of total rice acreage.

So there is growth possibility definitely for next 4-5 years?

Much more than 4-5 years of good growth.

Now that Data Protection for Nominee Gold is over, what about emerging competition?

That was over last year itself. Few Companies have applied. It will take time before we see effective products on ground.

1.3 IN-LICENSED VS GENERIC IN-HOUSE PRODUCTS

In-licensed vs Generic products. Is the current ratio still 60:40?

It is about 65:35 right now

You had mentioned that this ratio will rapidly change, by now you had predicted 80:20 actually; going upto 90:10 eventually

That’s true, but take into account last year. Because of the pretty bad last year, we got behind. We should be there in the next one or two years.

You launched 2 in-licensed new products. Kindly educate us about In-licensed Pipeline vs Competition. What’s the process? How do you keep abreast/ahead?

We have ~8-9 products in development pipeline and several others at negotiation table. This is a continuous process and our Competitive Intelligence mechanisms giving us inputs long before products are actually out in the market. Our process cannot depend on assessment of pipeline of others. As you are aware, we have very strong in-house gap-analysis MIS culled from all over the country for prioritising our pipeline.

What’s the price/revenue mechanism with In-licensing Innovators?

It’s based on simple long term purchase contracts. We purchase the Raw Material – active ingredients or formulated product.

What’s the pricing strategy for new generation in-licensed products?

As mentioned before, end of the day the farmer has to see lower of application/acre and therefore, your product price proposition should be attractive for him.

There are quite a few new breed of competing products like Round Up and others. What kind of threats do you see for your product lines?

We think there is room for all to grow. We focus on identifying a gap and providing better yield/productivity for the farmer.

What kind of impact do you see of the Food Security Bill? Is that a positive?

This to my view should drive food production, productivity and yields have to go up substantially. Farmers will get incentivised. If Farmer is happy, we will be happy.

You have lot of exposure to the Rice crop. First through Nominee Gold and now Osheen. Have you seen much of Hybrid Rice? Is that growing rapidly? What’s the potential?

Yes this is true. However, Osheen is also doing well in cotton.  Also we have several other products in fruit, vegetables and other field crops.  Hybrid seed is rising and so is the research seed.  Next wave of growth in seed may come from corn.

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2. CUSTOM SYNTHESIS (CSM)

For the first time we have seen CSM overtake the Agri segment. Revenue Contribution in FY13 was 55:45 CSM:Agri. How long before this scales to 65:35? Strategically, is this a great development?

It’s certainly good to see CSM scaling up the way it has done in the last 2-3 years. However for us it is important to be able to grow both segments equally well. For two reasons:

1. This gives us a neatly de-risked/balanced business model
2. Agri segment – the domestic opportunity is huge. It’s a very low-capital intensive business. Given the strength of our model and the strength of the agri-business sector in India, this segment is poised for 30-40% kind of growths over the next 3-5 years horizon. This segment provides us the CASH to fund the scaling up of the CSM business.

Give us a sense of the split between Long term contract vs annual contracts  in CSM?

~60% is in Long Term contracts while roughly 40% get negotiated annually.

And the Long Term Contracts are all guaranteed off-takes model?

Yes, Take or Pay.

You have cited deliberately not expanding $300 Mn order book (static for 2 years) – for flexibility in accommodating higher value/volume molecules that had some visibility.

That’s right. Keeping the Order Book at an optimum level gives us the flexibility to balance investments required for sewing in long term contracts for say 10 years. Accordingly you need to invest in plant for tapping new opportunities.

So any success there?

That is what you are seeing today. The ramp up is from that success. We had promised 30% but we grew by 60%, isn’t it. This is happening because we have retained the flexibility.

14 molecules in Commercial stage. Please give us a sense of the longevity of Molecules – new vs old?

Both old and new molecules. Some have been there for long. Some have dropped off to be replaced by new molecules. That is why you need the Pipeline.

Pipeline of 28 molecules. With a 40-45% success rate you hope to see 10-12 going to commercial success? Is it right to say you have pipeline that provides visibility for next 4-5 years?

As you know Pipeline keeps getting refined on a continual basis. We have a robust Pipeline is what I can say.

Please give us a sense of existing Customers. How many in Commercial stage and how many at R&D/Pilot stages?

8-9 Customers at Commercial stage (14 molecules). Rest in R&D/Pilot stages

Please share with us the Competitive scenario currently? You used to be single, 2nd or 3rd alternate supplier. Is that still valid?

Yes there are no more than 2-3 suppliers. We continue to be the dominant supplier for many of our customers.

How is the geographical spread between customers – US, EU & Japan?

It’s more or less balanced.

What’s the typical commercial life-cycle for a CSM molecule? How much of useful patented life is left for commercialisation, typically? What’s the payback period?

We assume a typical 4-5 year payback. Which means it will need to be replaced with a new one. But in actual practice it turns out much longer usually 10+years.

Any new competition from domestic markets? Or all are overseas competitors?

Given the products we are in, all competition is mostly from developed markets.

Recently we have seen players like Hikal stating they have partnered with agrochem innovators for CSM? Kindly comment.

No comments.

Give us a break-up of Commercial Molecules – agri/pharma/fine-chem? Where is the Focus?

Currently 80-90% is from Agrichem. Focus is on balancing the Portfolio.

Is it right to say Pharma molecules have higher margins?

Yes. Higher EBIDTA margins but not necessarily high ROI because the investments are huge.

Pharma CRAMs players like DIvi’s have 30-35% EBITDA margins. PI Industries EBITDA margins are much lower. Kindly comment.

Yes Divi’s Labs has EBITDA margins of 30-35%, but Asset Turns <2. PI has EBITDA margins of 20-25% with Asset Turns 2.5 to 3.Things should be seen in that context.

You have today ~600 Cr coming from 14 CSM molecules. Is that ~40-45 Cr per molecule?

(Laughs). Well different molecules have got added at different stages. They come in different sizes. Having said that it’s not so skewed also as say 2 molecules contributing 500 Cr and rest 12 contributing 100 Cr.

Sony-PI/Update?

Nothing new to report.

Why are your R&D expenses so low compared to other players?

If you are engaged in innovation research/ANDAs your R&D costs will of course be at higher levels. We on the other hand are involved with process research where costs are much less.

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3. JAMBUSAR

We are starting to see good contributions from Jambusar. But project is delayed by 2 to 2.5 yrs?

All delays are attributable to delays in getting pollution clearances and the Environmental Clearances.

Given the 10 yr tax concessions already underway, is there a focus to ramp up subsequent phases?

Of course. We are already doing erection work for next phase.

First phase took 2 to 2.5 years. What’s the timeline for commercialisation of next phases?

May be 9 – 12 months.

Sterling SEZ progress. Would you say there are any risks to progress?

None at all. As you are aware Gujarat is a very progressive state. Everything is progressing normally.

We have already reached 90% utilisation at some 100-120 Cr. What happens to Asset Turn targets of 2-2.25x?

(Sighs). One must look at the total investment versus investment for Phase1 and then compute Asset Turns. Our existing Asset Turns are greater than 2.5x. Going forward you will see these numbers. Projects will come/being negotiated with these figures in mind.

What are you Long Term Debt goals. Do you intend to become Debt free in future? Interest Costs will continue to be low

Yes, that’s the goal. Interest costs will be low.

With Free Cash flows flowing in, are there inorganic moves being planned?

Yes, we are investigating.

We were visiting companies across Gujarat and came across your Panoli facility. We couldn’t help notice the severe smell/pollution?

We are not in the Perfume Industry, you know. (Laughs, from all around).

Did you notice it all along the highway? or only along our plant. This is a common feature across the belt.

So aren’t these things monitored by any Agency?

Let me state that India is at least 10 -15 years ahead of China in this aspect. We have been having very stringent norms since the last 15 years.

Gujarat Government has evolved even more stringent norms. There is online monitoring of air stream and water streams.

So how significant are the Pollution control/Environment Management Risks for your business?

We are at risk only if a) we are not adhering to Norms b) not investing to manage pollution/effluent levels. Environment Management is the largest component of our Costs.

—————————————-END OF DISCUSSION—————————————————————————————–


Disclosure(s)

Ayush Mittal: No Holdings in the Company; ;
Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 2 years;
: ; ;
: ; ;

SHRIRAM CITY UNION FINANCE

Background

Shriram City Union Finance (Shriram City) established in 1986, is part of the nearly four decade-old Shriram Group, and has its origins from the needs of the Chit Funds customers. The company started operations with truck financing. In October 29, 1988, the company became a public limited company and renamed as Shriram Hire Purchase Finance Ltd. In March 1990, City Union Bank Ltd. acquired shareholding 200,000 shares at par. Consequently, the name of the company was changed to Shriram City Union Finance Ltd. The company registered as a deposit taking asset financing NBFC with RBI and went public in 1994.

Prior to 2002, the company was exclusively engaged in transport finance with special emphasis on financing pre-owned commercial vehicles to small road transport operators. In 2002, the company discontinued the truck financing business (except for trucks > 10 year old) as that business was consolidated in its sister concern (viz. Shriram Transport Finance Ltd) and started as a separate business unit in year 2002 as Shriram City Union Finance Ltd.  Listed on BSE in 2003.

Today Shriram City offerings comprise finance for Two Wheelers and Three Wheelers, Four Wheeler Finance (both new and pre-owned passenger and commercial vehicles), Personal Loans, Small Business Loans, and Loan against Gold. This has made Shriram City the only NBFC to offer such a wide range of products under one roof.

Vision: Serving the under-served. Creating value at the bottom of the pyramid.


Main Products/Segments

  • Niche Diversified Product Portfolio
As on Sep 2013 MSME Loans Gold Loans 2 Wh Loans Auto Loans Personal Loans
Inception Dec 2005 Oct 2006 Dec 2002 Dec 2005 Jan 2006
% Loan Book  49% 22% 15% 10% 4%
Avg Yield 18-22% 14-18% 24-26% 22-24% 24-27%
Avg Ticket size 700,000 40,000 35,000 150,000 75,000
Avg Loan to Value NA 55% 70% 60% NA
Branches offering  493 (1021)  714 (1021)  832 (1021)  359 (1021)  396 (1021)
Gross NPA  1.4%  1.6%  3.8%  3.7%  4.8%
Net NPA  0.3%  1.4%  0.8%  0.4%  0.0%

Source: Company, CRISIL

  • Branch Network – 1021 Total branches, 724 Owned Branches, 297 Shared Locations
  • Geographic Concentration – AP [48%], TN [32%], MH [9%], KN [2%], OTHERS [9%]
  • Group Customer Base – ~4 Mn Chit Fund customers; 95% of MSME customers referred by Shriram Chits

Main Markets/Customers

  • Strong Positioning for the Niche Addressable Under-penetrated Market – primarily the Self-Employed – without formal credit history and/or future cash flow signature – primarily feeding-off the Chit Business and concentrated in AP, TN, MH – hugely scalable – completely protected (?) market – may continue to grow nicely
    • MSME Loans, Gold Loans, 2 Wh Loans and Personal Loans
  • A piece of the MSME Non-Chit action – primarily concentrated in North India – primarily leveraging regular credit worthy customers with credit history and adequate documents – Max 1 Cr loans – Avg Ticket size 20-25 lakhs – may see cautious growth – as this is untested market/untested models
  • Nascent Niche presence in the under-penetrated Housing Finance segment – focusing on Tier 2 & Tier 3 Cities and the under-banked – Avg ticket size 10 lakhs – insignificant currently, but growing rapidly – may become significant within 4-5 years

Bullish Viewpoints

As on Sep 2013/ Jan 2014 SCUF SCUF
(Dec ’13)
SHTF Chola Sundaram MMFS Bajaj Finance
Size (AUM) 15800  14937 49700 19000 17600 27900 17100 Small
Years in Business
(Effectively)
28 (11) 28 (11) 35 36 60 23 27 SHTF, MMFS have also grown AUM fast
Capital Adequacy 23.3%  24.26% 19.9% 17.1% 17.7% 19.1% 20.9% Industry best
3Yr Earnings CAGR  45%  45%  19%  74%  20%  39%  58% Robust
Cost to Income 37%  38.68% 26% 50% 37% 33% 45% Industry Median
Cost of Funds 12.6%  11.74 9.8% 10.6% 10.6% 9.9% 10.3% Industry Highest
Margins 11.2%  12.35% 7.0% 7.6% 8.4% 9.4% 12.1% One of Industry highest
Yield 22.1%  21.19% 16.3% 15.4% 17.7% 16.4% 20.7% Industry best by far
 RoA  3.2%  3.36%  2.9%  2%  3%  3.4%  3.6% One of Industry highest
 P/B  2.2  1.8  1.5  2.4  3.05  1.6
 P/E  12.7  10.37  10.6  15.14  14.35  11.24
  • Huge under-penetration in Target customer base – With only 9-10% penetration of the ~4Mn Shriram Chit Customer base, there is huge headroom to grow in its niche with virtually no competition
  • Improving Product Mix – With Gold Loan share coming down (expected to stay within ~20-25%), Product Mix decisively tilting towards higher tenure, higher yields
  • Strong Growth Drivers – Deeper Product Penetration into existing branches especially in high-yielding MSME, 2wheeler and Personal Loans will keep driving growth.
  • Dominant position in MSME Loans – As per a Frost & Sullivan study SCUF share in overall MSME Loans disbursals in FY11 was a dominant 53%. Shriram City concentrates on ticket sizes comprising Very Small Loans (sub Rs. 1 Lac), Small Loans (Rs. 1 Lac – Rs. 10 Lacs) and Medium Loans (Rs. 10 Lacs – Rs. 50 Lacs), with the bulk of its MSME book constituting Small Loans – 42% market share as per 2013 AR.
  • High Capital Adequacy – With the recent Capital Infusion, CAR at ~23% is the highest in the industry. Tier I Capital is at a comfortable~18%. This should be adequate to fund growth for next few years
  • High growth trajectory -While FY14E AUM growth will be muted – partly due to Loan Book recast and partly due to disruption in normal business in AP due to Telengana protests, next 2-3 years could see 25% CAGR growth
  • High Yields look sustainable – SCUF has the highest yield among similar NBFCs at ~22%. Given improving Product mix, yields likely to stay high
  • Operating Costs likely to come down – SCUF Cost to Income ratios had been climbing up mostly due to Employee expenses shooting up over last 3 years – from ~6% of Expenses in FY11 to over 13% in FY13. This was largely due to integration of Shriram Chit Employees into its fold (From ~3000 to just over 19000 in 2QFY14). With the process getting completed and conservative branch expansion targets hereon, this is likely to stabilise and head downwards in next 2-3 years
  • Valuations – Given the strong positioning in its niche, SCUF appears to be trading at reasonably attractive 2.2x P/B valuations (CMP 1030)

Bearish Viewpoints

  • Concentration of business in AP & TN – 80% of business currently comes from these 2 states with AP (48%) and TN (32%). Any disturbances and/or policy change in the key states could impact business significantly. The ongoing Telengana issue and protests had seen disruption in normal business activity and had affected disbursements to MSME customers. The impending bifurcation of AP and likely protests means SCUF remains vulnerable to disruptions again – and that may impact growth
  • Asset Quality seemingly deteriorating (Advancing recognition Norms)
SCUF SHTF Chola Sundaram MMFS Bajaj Finance
GNPA 2.4 3.2 1.0 1.0 3.0 1.5
Recognition Norm 150d 180d  180d 120d 150d 90d
  • SCUF’s NPA’s are on the higher side. This should also be seen from the context of significant share of Gold Loans (with low NPAs) in Loan Book. However to be fair, Recognition norm at 150d is conservative and keeping ahead of RBI stipulations/timeline.
  • Advancing Recognition Norms/Standards Asset Provisioning may be raised – As per Usha Thorat Committee DRAFT Guidelines, NBFCs may have to move to 120-day NPA recognition norm from April 1, 2014 and 90-day norm from April 1, 2015. Also Standard Asset provisioning may be raised to 0.40% from 0.25% effective March 31, 2014. This may lead to higher costs on provisioning impacting earnings. Eventual write-offs though could be lower (nature of customers/business). As per Management, in the entire 28 years history actual delinquency is <1-1.5%.
  • Gold Loan remains a significant portion of Loan Book. Gold price volatility may impact growth possibilities

Barriers to entry

  • Chit Model – 90% of the current business/addressable market is mostly insulated from competition. For its target segments a Shriram Chit customer will go out of the group only if SCUF is unable to meet the customer requirement
  • Strong Brand Equity – “Shriram Brand” has high brand equity within its target segment – leading to low spend on advertising in both existing and new geographies

Interesting Viewpoints

  • Leveraging/Piggy-Riding on parent/group – Shriram City Union completely leverages the groups strengths – Customers, Database, home-grown systems and processes for the self-employed, and IT systems. Expansion to newer geographies can be incrementally calibrated by piggy-riding on group ecos-system and branch network, with minimal capital outlay
  • Regulator view of NBFCs turning favourable? – Even 2 years back regulatory risk may have been cited as a key risk for NBFC businesses. However of late RBI is seen to be shifting its hawkish stance (as evidenced in say the recent Comprehensive Financial Services for Small Businesses and Low Income Households Report chaired by Nachiket Mor, Central Board Member, RBI) and acknowledging the key role and value-added contribution that NBFCs could make towards financial inclusion in India. Also recent 23 Jan 2014 Speech Non-Banking Finance Companies: Game Changers, by P. Vijaya Bhaskar, Executive Director, RBI
  • Only 7% of MSMEs seek external sources of credit, the rest managing with self-financing or with funding from informal sources. MSMEs have a total finance demand of Rs. 32.5 trillion, of which only 36% is widely considered as addressable by financial institutions. The remaining 64%, ordinarily considered unviable because of inadequate/poor credit profiles, preference for debt from informal sources, reliance on self-financing etc. presents a rich potential for NBFCs if adequate safeguards can be built in to protect asset quality[Source: Ministry of Micro, Small and Medium Enterprises, Company AR, MSME FInance in India IFC Report]
  • Shriram City for the most part caters to the Micro Enterprises segment. Their research indicates that in the event of the GDP growing between 4% – 5%, the MSME sector should see a long term growth of between 15% – 20%. [Source Company AR]
  • Shriram City Housing Finance – Incorporated as a fully owned subsidiary in Nov 2010. Currently 76.5% owned by Shriram City and 23.5% by Valiant partners. Focusing on Tier 2&3 cities and the under-banked with average ticket size of 10 lakhs, this business is at a nascent stage with Asset size of ~340 Cr as on Sep 2013. Growing rapidly with disbursements crossing ~215 Cr in Sep 2013 up from 40 Cr in Sep 2012 – a building block being laid for future disproportionate growth?

Disclosure(s)

Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months


Alembic Pharma Management Q&A: Jan 2014

Management Q&A

Alembic Pharma Management Q&A

1.1 INTERNATIONAL GENERICS

AR 2013 – “We climbed the filing value-chain – Para III to Para IV, Para IV FTFs and 505(b)(2) filings in the US”. Kindly demystify the jargons for us.

Para I,II, II, and IV pertain to what is called ANDA filings – Abbreviated New Drug Applications

Para III – Actually Para I, II and III filings all pertain to patent-expired drugs. Non-Litigation category

Para IV = These are allowed to be filed – post 5 years of a NCE patent grant by USFDA for a generic version of the Innovator drug

Para IV FTF = 180 day exclusivity = Para IV First to File is another category where even before the first five years are over a company can challenge. If approved that company gets an 180 days exclusive approval to market its generic version of the Innovator drug. This can prove very lucrative for the challenger if granted. On the other hand there are Litigation Risks where the Innovator tries to prove that the challenger has infringed on its patent/process while developing the generic version.

Then there are what are called NDA filings – under which 505 (b) (2) falls.

505(b)(2) = larger period exclusivity = These are meant for a bio-similar, but completely new product. It’s made from a different salt and/or a totally different process. The FDA in its discretion (depending on the benefits/costs of development) awards a higher exclusivity period. For example for our NDA Desvenlafaxine Base Extended Release (bioequivalent version of the innovator drug Pristiq by Pfizer) was approved with a 21-month exclusivity.

______________________________________________________________________________

1.2 INTERNATIONAL GENERICS PIPELINE/UPDATE

FILINGS APPROVALS COMMERCIALISED LITIGATION RISK
CUMULATIVE ANDA 59 25 17-18
CUMULATIVE DMF 62
PARA IV
PARA IV FTF
505 (B) (2) 1 1 1 NIL
PARA III
PARA II

What we understand is that Para IV, Para IV FTF and %05 (b) 2 filings are the most lucrative. They also carry Litigation Risk. Can you give us a sense of the proportion of Para IV and above filings among your cumulative ANDA filings?

Initially there were Para II & III also but increasingly this mix is in favour of more complex Para IV filings.

Any of the Para IV FTF are Solo?

None, at the moment.

Why have you chosen/not able to commercialise some 30% of your approvals?

Most of them due to API issues (not available/changed) or another DMF is now used. In one case product was found to be unviable.

How are you able to comment that future mix of filings is skewed towards Para IV and above ?

Well things like Sample Seeding for the products, preparing batch stability files, etc have to start ~3 years before filing. We are already working on the pipeline for FY 16-17-18-19

NDA Desvenlafaxine Base Extended Release – 21-month exclusivity, approval received in record 10 months. Congratulations for this super-achievement. What is the progress on this launch through Ranbaxy partnership?

What is key here is doctor conversion. Doctors are currently used to prescribing Pfizer’s Prisitiq – they have to be educated about the availability of our generic version. It happens faster when our product starts appearing in the approved product lists of some of the large insurance companies. It will take 4-5 months before an on-the-ground assessment can be made.

What kind of price erosions are expected? is it true that you will see a 40-50% price erosion immediately?

For the Succi Desvenlafaxine product there were 11 FTFs approved. However for Desvenlafaxine Base Extended Release product we are the only one with 21 month exclusivity. We should not see more than a 20% price erosion in 1st year.

And in next year?

May be 30% price erosion.

Can you share the revenue share arrangement with Ranbaxy for Desvenlafaxine?

No comments.

———————————————————————————————————————-

What’s the update now on Desvenlafaxine {Jan 2014}?

It is ramping up. But not upto expectations.

What are the issues?

Well we found out that patients using the innovator drug Pristiq on a regular basis – which is indicated for the treatment of major depressive disorders – are very reluctant to change the drug (generic version, even if cheaper). Someone (suffering depression before) who is now able to lead a normal life with regular Prisitiq medication isn’t going to risk lapsing back.

So what are the learnings from this whole episode? You had such a blockbuster technical breakthrough, but seems like not too much will come out of it.

We have taken it in our stride. These things happen. We have moved on. 

On the other hand we have seen a 100%+ growth in this segment in 9mFY14 with Sales doubling to ~329 Cr. What is this attributable to?

This is a result of a 2 pronged strategy. Building up on Contracts/Order Book and scaling up on manufacturing. We had a bulging orderbook, but were seriously short on manufacturing. Augmented capacity started becoming available only post July last year. The swift ramp up is on account of that.

1.3 INTERNATIONAL GENERICS – TEAM/MARKETING/STRATEGY

You had decided to set up your own Marketing Network in the US? How difficult is it going about this?

This is now the biggest challenge before the company. We are galvanised behind making this a success. This whole effort will take us the next 2-3 years. The first results are atleast 1 year away. 

This is a major effort. What will be the costs? Will it be around 10-15% of Sales or higher?

What are the costs? Mostly salaries and the sales+distribution costs. You should see it like this. Most of the Profits were being given away to the ANDA guys. Compared to that we will be incurring a fraction of the cost.

Kindly give us a sense of the leadership behind this strategic PUSH into US Market and the success in the International Generics business that we are seeing.

The whole International Buisness initiative is driven by Mr Pranav Amin our Director and President International Business. He is very dynamic and is pushing everyone forward with aggressive plans. He has not hesitated to bring in the right people with high salaries.

We have an US CEO who has been with us for last 5 years and assembled together a top Team in International Generics business. Success has come because of Product Identification ability. Year-wise market-wise plans are drawn up till 2024. We have to create very detailed Product Identification Files or PIFs. 8-9 people get to sign off – IP guys, Marketing guys and Strategy guys. And we believe next 10 years success will also because of this.

What about Litigation? How confident are you in handling the attendant Litigation Risks that come with an aggressive ANDA filing strategy?

We have built a strong IP Culture/Team over last 5 years or so. This Team comes up with identified products. Multiple Legal opinion is taken from 4 specialised Large US Attorney firms. Only if it is considered safe, we proceed.

Despite this caution if Litigation comes up?

There are always other options. If we subsequently find risks are high we need not go for a confrontation route. We can offer our product with royalty/other options.

Alembic has always been known as a pedigree company. But this aggression is new-found? While this culture may now be top-driven, what about the Team? How will the old Teams adapt?

Technical Team is 100% new – All IP/Research Team are new imports form other large organisations with relevant experience. On the strategy/marketing side there are a few top people who are new and a mix of folks like us.

———————————————————————————————————————

2.  INTERNATIONAL BRANDED

Kindly take us through the International Branded business. Does it cater to the ROW Markets?

Products are the same as our domestic branded formulations. Yes this segment caters to the ROW Markets like Russia & Africa.

Is there a country specific branding/sales strategy or it’s the same brands across geographies?

It’s the same brands being marketed in every country.

Competition must be intense in these countries as most Pharma companies from India have a significant presence in these markets?

Yes there is lot of competition. But we have formed a new team focusing on this segment.

We have seen a ~48%+ growth in this segment in 9mFY14 with Sales reaching ~46 Cr. Is there any focus to make this segment a significant contributor to topline and bottomline?

This is a 50-60 Cr Annual market. There is more focus. More filings – which also means more investment. Earlier filings cost $5000 , now these cost as much as $25000-30000.

What is a sustainable growth rate for the next 2-3 years?

We should see 25-30% kind of growth or 100 Cr in next 2-3 years.

———————————————————————————————————————-

3.  API

As we understood from you last, this is a segment that is completely fragmented, intensely competitive, and if weI remember correctly you planned to get out of this segment. However this is the segment showing highest growth by 20% over FY12. And thus increased contribution to Sales from 7 to 8%. Kindly comment

The API segment (Acute therapy) that we were present in is very competitive – it is in turmoil. Chinese products have flooded markets world-over and India is no exception.

We have done 2 things a) Shift Focus on our own products – increase Captive use b) Shift focus to cater to large pharma company ANDA API requirements – become their first or second source. We have seen successes on both these fronts.

So move has also been away from domestic market API requirements to developed Markets?

The focus is 95% geared to servicing our ANDAs (captive use). At the same time we are able to utilise this to service large pharma company requirements for EU and emerging markets also.

——————————————————————————————————————

4. INDIA BRANDED /INDIA GENERICS

India Branded formulations 1HFY14 Sales
Contrib
1HFY14 Sales Alembic Market
Share
Alembic Annual
Market
Alembic Growth Therapy Growth Alembic FY16E
Sales
FY16E Contribution
 Anti-Infective  36%  157.2  3.99%  314  3%  2%  334  28%
 Gastrology  18%  78.6  2.50%  157  16%  9%  212  18%
 Cold & Cough  12%  52.4  5.08%  105  11%  11%  129  11%
 Cardiology  11%  48.0  1.43%  96  38%  13%  183  15%
 Gynaecology  9%  39.3  2.08%  79  29%  7%  131  11%
 Orthopaedic  5%  21.8  1.14%  44  8%  7%  51  4%
 Anti Diabetic  5%  21.8  1.32%  44  31%  24%  75  6%
 Opthalmology  2%  8.7  1.67%  17  51%  8%  40  3%
 Nephro / Uro  2%  8.7  1.84%  17  37%  14%  33  3%

It looks like fast growing Specialty segments like Cardiology and Gynaecology are set to overtake the earlier dominant segments in a few years. Kindly comment

Ealier Anti-Infective and Cold & Cough segments used to account for 80% of domestic sales. Now this is down to 50%. Yes Cardiology and Gyneacology are growing fast and will contribute bigger share in coming years and will overtake some segments like Cold & Cough pretty soon. But the Investments needed are high.

What kind of investments? Is it correct to say this is a Marketing driven game and not so much on the technology side?

Absolutely, all investments are in Marketing. We need to ensure Quality and availability/mind share with Doctors. Form a very low base we have started growing the specialty segments. Fortunately Alembic enjoys a very very good brand equity with Doctors.  Brand recall is very high, so we are trying to cater to higher margin lifestyle disease segments. This strategy is paying off, as doctors are ready to accept new drugs quickly due to brand name and trust.

India Generics- some 86 Cr in 9mFY14? Why do we need domestic generic Sales? Is this profitable?

Well this is a ~100 Cr annual market for us. Some of the products here are negative margin to upto 10% kind of margins. Instead of the brand name drug, it is sold in the generic name. There is a big enough market for this in smaller towns. In a way it takes care of some of our fixed costs by generating additional sales. If we don’t sell it, somebody else will and take this.

5.  SOURCES OF PROFITABILITY

Operating Margins have seen a consistent uptick? What are the main sources of profitability?

The uptick in profitability is due to a few things.

1. Improving Product Mix – As mentioned before, we decided to shift focus and get out of Domestic API which was acute therapy focused and volatile. Anything less than 15-18% EBITDA we decided to get out of.

2. Shifting focus on Formulations – Both Domestic branded and International Generics

3. Process/Efficiency improvements

The depreciating Rupee also helps to an extent

How sustainable is this going forward?

This is set to continue for the next few years. Product mix improvements are already significant. We are able to leverage economies of scale with new plant. We are at ~20% EBITDA levels. There will be 1 to 1.5% margin improvements every year for a couple of years. In a few more years we could be in a different orbit.

—————————————————————————————————————–

6.  RISKS

What in your opinion are the major risks?

Regulatory Compliance. We are taking this very very seriously. When we were small it was easy to manage. But as we scale up we need to ensure systems and processes that take care of ensuring quality.

Kindly give us a sense of how seriously this is taken by Top Management?

The normal practice in the industry is to employ 1:2 Quality:Product personnel. At Alembic we are maintaining a 1:1 Quality: Product personnel ratio. We ensure everything is on the SAP ERP system. We have built a strong Quality Team.

When the Board meets, the first item on the Agenda is USFDA Compliance. And usually it takes 3-5 hours.

USFDA Inspections? Is this like a sword now hanging over Indian Pharma companies having/attempting a presence in US markets?

Not really. Some reactions/rumours spread that this time USFDA folks are coming to shut down 20 plants – that’s all nonsense. US has to rely on Indian manufacturing plants – we have the largest base outside of the US. Yes, they have very objective, very detailed worksheets. If there are some observations that come out, well they are not going to suppress them.

When did you have your last inspection? Were any queries raised?

1.5 years back. No queries were raised.

7. R&D SPEND

Likely to stay around 6-7% of Sales 

8.  WORKING CAPITAL MANAGEMENT

27% sales to 20% of Sales, to 17% of Sales? Debtors 62 to 47 to 56 days?

This is mostly on account of the API shift.

While Inventory levels haven’t changed much – implies that Payables also has improved significantly. What are the reasons?

Driven by Operations team focus. Some KRAs (Key Result Areas) demanded are to increase 30 days payables to 45 days and 45 days to 60 days.

9.  CAPEX/CAPACITY UTILISATION

Till when will current capacity suffice – FY15? When Next? Quantum

Actually we should be able to see through FY16 on current capacity. We are introducing a lot of automation at an initial cost of ~40 Cr.

What kind of Outsourcing do you resort to? What is the quantum?

India branded – Roughly 40% 

10.  FOREX/HEDGING

Simple 3/6 month forward contracts.

11.  TAXATION/TAX RATES

20-21%

12.  DIVIDEND POLICY

30-35% Payout.

13.   MAJOR CHALLENGES

 Next 2-3 years it is the US Marketing Challenge that will consume us.  


Disclosure(s)

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

Shriram City Union Finance Management Q&A : Jan 2014

Management Q&A

1.   THE BUSINESS, INDUSTRY & OPPORTUNITY SIZE

Kindly explain to us the key guiding tenets for your business. How exciting is it to be where SCUF is today?

As a group (Shriram) it’s in our DNA to look at Financing segments – where they find it difficult to get financing – typically the Self-Employed (non-salaried class).They face a shortage of credit – the formal Banking sector is not much interested in them – as they can’t provide salary slips or proof of regular/future cash flows.

But this does not mean we jump into every opportunity in this space. There must be SCALE and MARGINS must be PROTECTED. We get in when a) it is difficult to do b) there are higher margins adequate enough (for the inevitable bad eggs in the basket).

How important is the MSME space in overall scheme of things? How difficult or complex a business is this?

Success in MSME financing business is pretty simple, actually. It’s a plain vanilla labour-intensive game. There are 1000’s of middle level executives involved. It is their persistence and sweat. It will be wrong to say there is a big “classy” process behind this. It is the labour and the humility to relentlessly chase for collections. There is a process for sure, but that process is in building people (like a factory) – who can stay true to persistence and sweat and humility to chase – each situation is different!  80% of our success can be attributed to this patience and diligence at the branch level and only 20% to Intellect-driven systems/processes.

MSME financing is important. We have a dominant position in the small loans segment. MSME pie of the Loan book has been increasing. From over 35% a year back it is now at ~50% levels. It could reach 70% of Loan book in 2-3 years. Gold Loan has come down to ~25% levels – this business we will be doing at our own pace – we are certainly not getting out. There is also 2Wh and Personal Loans which are doing well. Depending on the environment, we will take our calls, we will be nimble.

How well-placed is SCUF in MSME NBFC funding space? When do we see Banks/FIs addressing this space in an institutionalised way?

Banks are not very active in MSME funding where the Risks are higher. When they do fund they are mostly funding “Manufacturing” businesses unlike us where our share is more on the “Services” businesses.

What about PSU Banks? And Credit Guarantee Shemes from the MSME Ministry where funds are available for upto 1 Cr without collateral.

Well these schemes have been there since almost a decade without much of an effect. Our sense is that Bankers are inherently uncomfortable lending where there is no collateral (as recourse to recovery is generally poor in our country). They are not well-trained to study and evaluate or rate a small business that can’t offer much by way of collateral. PSU Banks are used to the Customer coming to them for Loans. They are not used to go to the Customer (save Deposits). Look at the turnaround time – in CGSH schemes and in general practice, is 6-9 months. And then some of our customers tell us – the effective cost is the same.

Where does SCUF see itself 5 years from now vis-a-vis current competition?

We should do 20-25% CAGR over 3-5 years. As & when the economy spurts, we will also do better.

“Scalability” ( how long is the runway? What are the assumptions for growth for the next 3/5/10 years? Can you actually grow outside home base? ) and “Repeatability” (Can you simply keep doing more of the same and what could hinder this – i.e. Recruitment, training, technology, competition poaching etc. )

Scalability – In terms of opportunity there is space for even 100 players to step in and everyone can grow. We are only scratching the surface in terms of what we have touched so far. However this is hard terrain – Not everyone can step in and do what we are doing, as successfully.

Repeatability – As explained before, yes the whole thing is about repeating the same labour-intensive dogged pursuit of collections. At our core, we are an out & out collections company with humility, persistence and sweating as the key cornerstones for our success.

What do you see as the biggest threats to your growth plans?  e.g. government regulatory changes, etc.? Is increasing regulatory oversight a good thing/bad thing in the longer term?

We have a feeling things are changing at the regulator/RBI level. They are more willing to listen. The recent RBI report on Financial Inclusion chaired by Nachiket Mor actually speaks highly of NBFCs and the useful role NBFCs can play in India. There is lot of new ideas being brought in by eminent people like Shikha Sharma and Vikram Pandit and others on the panel. Even 2 years back, things were difficult. Now we are very hopeful that things are changing, the regulator will start playing a more positive role.

Our biggest risk is our own execution. As we scale up we should remain glued to the groups conservative ideals, processes and systems. That we do not fall prey to foolhardiness – cutting corners or taking shortcuts. The Economy has slowed down, credit is tight. A growing economy will help us scale faster.

You have applied for a banking license – what impact will this have on existing operations?

Let’s make it clear that we have made a conditional application. Because of our understanding of small business, we believe we can significantly contribute to financial inclusion aims of RBI and Government of India. As our group director has said recently, we won’t pursue our aspiration to become a bank at the cost of our existing business, but only if RBI is willing to support and facilitate us to lend to these segments appropriately.

And what’s the take on Shriram Housing Finance? Do you have big plans there?

Our plans are very clear. It will take 3-4 years before it becomes significant. As mentioned before we don’t do anything that CAN’T SCALE.

2.  OPERATING STRUCTURE

Kindly brief us a little on operating structure and major business processes? Why do you have 2 MDs, to start with?

Basically different skill-sets. Mr Sundararajan – MD – ex CMD Fullerton – he is the public face of the company – he meets the press, regulators, media.

Mr Duruvasan – MD – he has been there for last 35 years+ with the group. He joined after +2 level and got his degree by attending night college. He started as a collection executive in chit fund and rose to be its ceo. He was also MD Shriram Life Insurance.

He is a great leader and visionary. Much of what Shriram group is today can be credited to him.

Kindly tell us a little more on his early years, achievements and leadership style?

To give you a perspective in 1990 Shriram TN business was 10x AP business size. In the next 8 years from 1990-1998 he built up the AP business to 2x TN size. He is a great man with an eye for talent – right person for right job – and building teams.

From 1990-96, we used to add ~9-10 branches per year, as we had good teams throwing up good leaders. But from ’96-’99 we added ~25-30 branches every year. Team was flush with talent – we needed to accommodate ~75 people who had grown capabilities for next level of leadership within the teams.

Shriram chits acted as a distribution arm as well. We used to distribute CDs/Mutual Funds. People developed multiple skill-sets – market development, debt collection. Even today Shriram Life Insurance derives 70% and Shriram City over 45% of its business from AP.

Back-Office/IT systems/Risk Management

Entire Back-office, ERP, IT facilities including Centralised Cheque Printing facility is based out of Chennai.
CTO & CAO – Chandrashekhar. He is a cost accountant with IT skills. He handles all our home grown IT/ERP systems. The internal audit team reports to CAO as do the Account Heads at branches.
CFO – Subhashri Sriram. She handles Fund raising, Securitisation and interaction/ management with PEs. The risk management team reports to CFO.

Business/Strategy – Front Office

Operations HQ is Hyderabad and Business handled from respective regions.

COO – Y S Chakravarti – He handles Operations. The Business guys and the Credit guys report into the COO. The Product heads at branches report into the COO.

And Region-wise there are CEOs for TN/AP/MH and also for North and another for MP, Chhatisgarh, Kerala and Gujarat.

Role Clarity – Accountability

Roles are clear as is the accountability. In his own area, each is a MD, which also means no one can hide behind anyone’s back. There is no overseeing that is needed. No Senior Management reporting/briefing is necessary. The MD usually needs to meet Operating Heads at Board Meetings only. We are all home-grown, grown up on the job- with the business. We are like family comfortable with each other, with clear individual/team goals set for us.

3. MAIN BUSINESS MODELS

You have the MSME CHIT model running in AP/TN/MH primarily referred from Shriram Chits. Kindly brief us on the key characteristics.

CHIT Model -South

As you are aware this is primarily in Andhra Pradesh, TamilNadu and Maharashtra with Shriram Chits customers primarily. This has a run-rate of 250-300 Cr per month. Average ticket size ranges 10-12 lakhs. Some are in 18-20 lakhs. Maximum lending is upto 1 Cr. This is mostly secured business. In AP it is 65-70% secured.

Did the Telengana stir disturb normal operations?

Yes it was affected during that period as normal business was disrupted. However it is back to usual once the protests are over.

You are trying to replicate this same CHIT model in North India?

CHIT Model – North India

We are trying to replicate this CHIT model slowly in North India over last 2 years with small loans. Average ticket size is 2 to 2.5 lakhs. This is kick-started by mining our 2Wh Customer database. Small business owners like Stuffed-toy makers, Ice-Cream makers, Trinket manufacturers. In 2 years time this now has reached a run-rate of ~2 Cr/month.

Also you are trying out basically the regular (NON-CHIT) NBFC MSME funding model in North India.

External Model – North India

We decided to step into the regular CIBIL credit-scored MSME financing model in a slow cautious way, 3 years back. We recruited experienced executive level senior people for the job who in-turn recruited fresh talent for building the Team. In 3 years now this segment’s run-rate has reached ~20 Cr/month. Average ticket size is 20-22 lakhs.

How are you looking to scale this probably important segment?

This has been a learning phase for us. We are extremely cautious here as this was a completely new turf. One cycle of lending and closing is over. The Team is doing very well. Net NPAs are <0.2. Lending Caps were <1 Cr till now. Only recently this has been enhanced to <2 Cr. We don’t have any branch/numbers driven expansion targets. Our philosophy for expansion is – when we have next rung of capable people (home-grown) ready to take on branch leadership roles, only then. Maybe 2-3 years down the line we will have a good crop of capable leaders for expanding presence.

You have been integrating employees from Shriram Chits into SCUF fold now. Is the process complete? What are the overlaps now with Shriram Chit Fund?

OVERLAPS with Shriram Chits

Shriram Chits also plays the role of a distribution arm from group company products, also for SCUF. Employee integration from Shriram Chits is now mostly completed. Any shared office infrastructure (with Shriram Chits) is now owned and run by SCUF, shared by Shriram Chits.

4. MAIN BUSINESS PROCESSES

How do you employ customer knowledge from chit fund history? How is it used operationally? Is there a formal score? If not, how do you prioritise or incentivise better track record customers?

Customer look-up can be done from the Database. It can provide some rough pointers. We have what is called a CHIT Rating system. Customer consistently paying within the month (actual payment date is by 7th) are tracked. Very simply put, any customer with more than 15 installments paid within the month is considered credit-worthy.

When a Loan turns non-performing, what recourse do you have, how do you go about recovering?

We don’t have Big Clients (Big Defaults). Big Clients are not even approachable much of the time. And when you do reach them the refrain can well be “Business/Economy is not doing well. What can I do? You come back when business cycle recovers”. Small clients have an ingrained honour system. They want to preserve their reputation. Our people are able to sit with them in their house and work out a deferred plan (usually they are willing to pay the penalties for late payments). Payments get deferred, but rarely turn delinquent.

What kind of skills-profile do you require for these jobs?

We don’t need MBAs and financial experts. Normal graduates can do the job. We need local people familiar with the terrain. Understanding the customer comes first. People who can understand the customer, work on the relationship, gain their trust and imbibe the groups ethics of humility, persistence and sweat.

What kind of training do you equip employees to deal with – say the tough collection process?

It’s mostly on-the job! Our Management Trainees go through more than a year of exhaustive on-the ground training. Usually it’s baptism by fire from day one – collecting money from tough clients, with monthly reviews.

How do you create the right incentive structures? Loan growth vs profitability vs Collections?

First of all nothing in our business is outsourced! The one who sells/lends also collects. 60% of incentives are aligned to Sales and the balance 40% for Collections.

What about Manager level/Executive level Incentives?

For the Branch Manager it’s is an aggregate of different product lines – MSME, 2WH, Gold. Average of incentives collected by Teams under him. For the Divisional Manager again, it is an average of the Branch Managers reporting into him. Likewise for Zonal Managers.

Any discretionary powers in the Loan Hierarchy?

Not really. The only discretionary power is on the Processing Fees side – some 2% at Account Head levels – marked as deviation – requires Approval.

What is the experience over last 3/5 years versus last 10 years and is there is any clear trend? On collections and recovery of bed debts, say?

In our entire history (28 years+) Collections at Loan Termination has been over 97%. And 6 months from date of termination collections are 98.5% -99%. So terminated arrears are 1%-1.5%. Greater than 180d NPAs are <0.5%.

5.   RBI GUIDELINES AND NBFC BUSINESS

Kindly explain the current guidelines and its impact on SME business

Well these were proclaimed in 2012. We have learnt to adjust. As you might have seen we have been keeping ahead of the RBI timeline. We have advanced our NPA recognition norms to 150d from 180d.

As per the DRAFT RBI guidelines, NBFCs may have to move to 120-day NPA recognition norm from April1, 2014 and 90-day norm from April1, 2015. Also Standard Asset provisioning may be raised to 0.40% from 0.25% effective March 31, 2014. Kindly comment how are you prepared for this?

NPA recognition norms may move from 360d to 180d to 90d but as explained before, in our DNA we are a collections driven organisation. There will be delays, but hardly any delinquencies. Our customers are rarely defaulters.

Unlike say Banks (10x leverage) or NBFCs (upto 6x leverage) or even a Manufacturing Enterprise (3x leverage) a small service/trading business capital structure is usually the reverse. It is 3:1 Equity:Debt and in most cases 5:1. The intention to pay is there (as is the capability). Capital is always large (as compared to debt). Unless they have 5x losses they are able to service the debt.

So what kind of impact will these have on earnings?

TBD

What about the Securitisation cap impact?

While Securitisation may be the cheapest source of funds for us, does not mean our other source of funds are not okay. Securitisation is not a panacea. You must also look at the time factor involved – 9 months of seasoning vs instant availability. Today because of our reputation and Shriram groups standing we can have immediate access to Funds. If we require 900 Cr, we can get it.

Because of further restrictions on NCDs, etc. dependency on banking sector will increase? to what levels?

See as a group, we have access to comparatively lower cost Funds. Today we are at 15,000 Cr. Shriram Transport has already shown us the way to 50,000 Cr. Let’s reach that phase first. We believe we can reach there in the next 5-6 years without much issues. We can worry about next level of scalability then. By that time Shriram Transport might show us the way to 100,000 Cr.

6.  MARKET MAP/COMPETITION

Give us a sense of your market? How is the competitive scenario?

Market is huge. This is just the tip of the proverbial iceberg we have touched. There is room for more than 100 players if need be. We are really in competition with the customer (to accept debt).

Bajaj Finance and some others do Loan against property business for small business and get yield of around 13-14%. They classify it as MSME business. Isn’t that competition?

Loan against Property (LAP) is a different segment – the loan is secured against the property with lower yields like you mentioned. Most NBFCs who mention MSME financing are actually doing only LAP products.

So how is a LAP product different from MSME Financing?

LAPs are usually longer duration products. The customer is typically saying, I have a property. Unlike in our business where the customer is more likely to say I have a business…and I need a loan for my business for 6 months to 1 year (or 2 years).

Is it correct to say ~1/3rd of your MSME loan book is secured which is ~17% of your overall Loan Book (MSME Loans at ~50% of Loan Book)? The question is how do you compete effectively? Are your yields much more comparable to LAP rates for this segment?

TBD

7.  FUTURE GROWTH/PROFITABILITY DRIVERS

Shriram Chits customer base is your biggest strength. It also enjoys very high reputation with your customer base. Your customer acquisition costs remain low on account of this. But somehow “Chits” business generally has got an adverse image in India. Kindly comment.

There are some rotten eggs in every sphere in India. CHIT as a product is best suited for a country like India. CHIT is used both as a savings product as well as for borrowing for business. Sometimes by the same individual for different needs (savings for his wife) and the borrowing Chit for his business purposes. CHITS were popular even in China, Africa and Italy.

Is it correct to say Shriram Chit fund has ~ 3Mn customers? Is it correct to say currently more than 90% of MSME customers are through Chit fund customer database?

Shriram Chits base is ~4 Mn customers. Yes 90-95% of MSME customers are referred from Shriram Chits.

How much of this Customer base is already addressed for SCUF product portfolios? How much is still virgin opportunity?

Not more than 20% perhaps. So one can say 70-80% is still available for fresh addressal.

And this is a completely protected base – that is unlikely to go out to seek their financing needs?

Shriram group brand equity is very strong with this customer segment. This segment of customers are very keen on “who’s the lender?” Normally for our target product segments, they are unlikely to go outside to seek financing.

What is the overall growth expected in next 2-3 years? And MSME Loan book proportion expected?

Next 2 years may be tough for the economy. Having said that, we are probably better insulated than most, because of our diversified but niche product bases. We should be able to do 20-25% CAGR over next few years. MSME Loan book proportion could touch ~70% as we have both width (<50% branches currently offer) and depth (penetrate deeper into existing branch customer base) to explore.

What’s the broad mix of SME business which are being financed in terms of %?

We are completely industry agnostic. One can say we are more focused on Traders/Service Industry than Manufacturing industries.

How much of growth will be driven by higher penetration and how much from geographic expansion?

Growth will come from deeper penetration of customer base at existing branches and widening our presence. We have more than 1000 branches today. MSME Loans are currently offered at ~50% of the branches.Gold Loans at 70% of branches and 2Wh Loans – the earliest Loan product is offered from ~80% of the branches. More than 200 branches are shared locations. Incremental growth will also come from shared office space with group companies. We can expand reach at low incremental cost by putting up 2-3 people at shared locations without much capital outlay.

Plans to expand branches outside AP & Tamilnadu over next 3-5 years?

As explained before, we do not have formalised branch expansion targets/plans.

To what extent political disturbance in AP is impacting your growth in MSME loans?

It was only for that period of protests. Now operations are back to normal.

Because of the increasing mix of higher yield and higher tenure MSME Loans (vs Gold), is it likely we will see a higher margin picture in next 2-3 years?

It is possible. But we have to see that the Gold Product had lower NPAs. Net ROA is likely not changing much. Post-tax RoA should remain around ~3%.

8.  DIFFERENTIATION/OTHER NBFC MODELS

Do you see any benefit in developing specific industry expertise, relationships with machinery OEMs? And priortising/focusing based on growing industries, leveraging the machinery relationships, funding machinery assets?

As mentioned before, we are completely industry agnostic. We have a dominant position in the MSME Small Loans funding space. We are doing well in 2Wh and Gold Loan space. We see opportunity size before us as huge – we are just scratching the surface.

Any NBFC having such differentiation – how valuable is that expertise in the long term? Would you go so far as to say this is highly valuable and may create niche dominance in SME asset financing?

Definitely there is value for specific industry expertise. However one has to weigh the scalability front. Funding machinery as opposed to funding Individuals – Entrepreneurs. Besides there is lot of merit in product diversification of the kind SCUF has. Any mono-liner (including SHTF) product has to go through stress some time or the other, is inherently more risky.

Which are some of the other NBFC models that you admire?

Mahindra & Mahindra Financial Services. They have done a good job with rural penetration. REPCO Home Finance and GRUH in the Housing Finance space are other commendable success stories.


Disclosure(s)

Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months;
Tirumal Rao: No Holdings in the Company; ;
Davuluri Omprakash: No Holdings in the Company; ;
: ; ;

Avanti Feeds Management Q&A : July, 2013

Management Q&A

THE JOURNEY

We have been following Avanti from about 2009 when the aquaculture industry was at one of its worst time. Its really great to see that the company had at that time talked about the development of new specie – Vannamei which could be a game changer for the industry going forward. Things played out perfectly and the company has well capitalized the opportunity and has grown its turnover from just 96 Cr in 2010 to 648 Cr in 2013. Kindly take us through this journey.

Fundamentals for Aquaculture in India have always been strong. India is ideally suited – with a suitable tropical environment, a long coastline and land with brackish water that can sustain aquaculture.

In the last two decades and more we have seen a growing preference for fish and fisheries products, worldwide. Incidences of Foot & Mouth disease (primarily in EU), mad cow, and then Bird Flu in Asian countries have caused the slow decline in consumption of red meat and Fish was back in favour. Scientific evidence for Omega-3 Fatty Acid – found plentiful in fish – started to be cited for helping control cholesterol/heart diseases. Shrimps also were considered in the same category. And global demand for fish and fisheries products surged dramatically.

In the early 90’s aquaculture technology was not so perfected. Indian Government tried to usher in what is known as the BLUE REVOLUTION with a focus on Integrated Aquaculture. In 1994-95 many public limited firms were floated. Focus was on all 4 main activities – Feed, Processing, Hatchery, Farming in the integrated aquaculture.

We scouted for a suitable partner and were lucky to find Ping Tai Enterprises, a well known company from Taiwan, primarily into Feeds. 70-80% of their business came from Aqua Feed. They advised us to focus on Feed manufacture as that is the most important ingredient for shrimp culture.

By 2002, dominance of Taiwan in aquaculture had declined. Continuous upgradation of technology in feed product substitution which is a very dynamic activity (cost vs protein content substitution – Soya & then fish meal saw other countries like Thailand taking the lead. We tied up finally with Thai Union Frozen Products, Thailand which is into Shrimp Hatchery, feed and processing and export of shrimp, fish and other marine products and Thai Union group was a very established partner. It is one of the largest marine products exporter to US & Japan. In 2002 this started as a technology collaboration, the association has grown stronger and has seen equity participation by them in 2008-9.

In 2006-07, the whole aquaculture industry suffered big setback. Most companies folded up. We have managed to keep fundamentals intact and survive that period. We have been transparent to the investors about the state of the industry, our outlook and strategies planned for coping with the same. Having survived that torrid period, today we are onto better times!

As per the reports, the current favourable change in business is due to adoption of Vannamei species v/s the earlier black tiger. Why was black tiger popular before? Why is Vannamei better? What are the differences?

Yes, the increased volume of production of Vannamei shrimp which was introduced in India in 2009, has been the main reason for the turnaround since then. In 2012 and beyond, Indian shrimp farmers were able to increase their production.  Before introduction of Vannamei culture to tropical climatic conditions, it was Black Tiger which was the native specie and fast growing.  However, by genetic improvement, Vannamei which was cold water and slow growing shrimp has been made cultivable in tropical climatic conditions, and fast growing and specific pathogen free brood stock was developed.

Though Vannamei is a native to the Pacific coast of Central and South America, one of the major reason for its popularity is due to the availability of fast growing improved quality specific pathogen free seeds. Vannamei has the potential to grow under intensive culture conditions. For the same pond area, the production/density of Vannamei is much higher than black tiger (~ 2x) and hence the cost reduces and the activity becomes remunerative for the farmer. Also Vannamei tolerates a wide range of salinities & temperatures and requires lower protein diet. It is generally considered to be more resistant to diseases and can mate and spawn easily under captivity and the survival rates during rearing are generally higher. Also Vannamei, the white shrimp variety, is more accepted worldwide.

How long do you think this current journey with Vannamei is going to last? What has generally been the history, Is this likely to change, How soon? How long can this adoption and switch to Vannamei continue? What about disease risk. etc. in this species?

4 years back in 2009, there was lot of resistance for introducing Vannamei culture in India as it was not native species and the view was that domestication may become problematic. However, seeing tremendous success stories in Thailand, Malaysia, Vietnam and China various industry bodies like Sea Food Exporters Association, Hatcheries Association, Shrimp Farmers and Feed Associations made re-presentations to Government for adoption of Vannamei – essentially arguing the case – if it has been successfully adopted in Thailand, Malaysia, Vietnam and China, why not in India. The Govt. of India after careful study decided to introduce Vannamei Culture in India.

Vannamei Aquaculture industry in India is in a strong footing today, thanks primarily to steps taken by the Government and designated agencies such as Coastal Aquaculture Agency, MPEDA which have established processes, strict enforcement, and complete traceability in the system.

1. The broodstock – sourced only from specified broodstock sources approved by Coastal Aquaculture Authority (CAA)

2. Quarantine – MPEDA – Tested for disease by Rajiv Gandhi Center for Aquaculture  (RGCA) in Chennai, and only then released

3. Hatcheries – Registered with CAA

4. Seed sales Record – To whom it is being supplied, with complete traceability

The Coastal Aquaculture Authority (under the Ministry of Agriculture) ensures very strong systems and enforcement. They do checks and have the mandate to destroy hatcheries, if found in violation/non-compliance and also order for closure of Hatcheries.

With such strong systems, disease outbreaks will be rare & certainly controllable.

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INDUSTRY

Aquaculture was a fancy industry during late 90s and early 20s. But the industry self-destructed and hardly any major profitable player got left. What were the reasons and problems?

Prior to 2009, by and large, Aquaculture in India was poorly regulated. Industry was not  well organised, also there were no stringent  bio-security measures in place. Import of say specified approved broodstock to ensure shrimp quality, proper checks and balances in the system, and regulatory oversight was absent. The Industry dependent on the Black Tiger variety which was predominant, had very loose knitted policies in place for ensuring standardisation, quality and/or bio-security measures for prevention/control of disease out-breaks or rising up to any challenge collectively, by the industry as a whole.

Government support and state agencies such as the Coastal Aquaculture Authority, MPEDA, Rajiv Gandhi Centre for Aquaculture, the various industry associations as mentioned before have played a big role in taking the Industry to its robust position as it exists today.

Who are the biggest players of this industry? What is the total market size in India? Indian production of shrimps and total exports annually?

Mainly 5 players in the feed industry. CP Food Products is the No#1 player. AVANTI FEEDS comes next. Grobest, Water Base, Godrej have been other main players. In the last couple of years some 5-6 more players have emerged such as Cargill, Nexus Feeds, Growell, Unipresident Feed, etc.

AVANTI has produced 59,000 Tons feed in 2011-12, 105,000 MT in 2012-13 and expected to produce 125,000 MT in 2013-14. 20-25% growth is comfortably achievable overall in the industry.

Reports and your own figure of 150, 000 Tons in 2014-15 seem to suggest growth in line with growth in industry.

Kindly educate us on the role played by MPEDA in the growth and sustainability of this industry?

Covered before.

Cluster Farming/Contract Farming on a larger scale? Any possibilities on that front?

Yes this should eventually happen in India. We have had discussion with Micro Finance agencies. We said 10 or more farmers with small 2-3 acre land holdings can come together – they form a co-operative society, a legal entity. We told them that we will organise supply of Feed and Technical assistance to the farmers and  you provide the Finances and we will assist them in sale of their produce. The farmers can invest 20% of Seed Capital and Micro Finance can provide finance for infrastructure and operational expenses such as feed. So far these attempts have not succeeded, response has been poor.

EMS Shrimp disease – its impact and the global demand/supply game? Kindly educate us on that.

Researchers found that EMS Shrimp Disease or Early-Mortality-Syndrome is caused by a bacterial agent, which is transmitted orally, colonizes the shrimp gastrointestinal tract and produces a toxin that causes tissue destruction and dysfunction of the shrimp digestive organ.

As we understand it, EMS can occur thru infected broodstock and also can spread due to lack of  proper bio-security measures. A senior professor from Thailand, rated as one of the best Aquaculturists in the world has found that the spread of the disease has something to do with the Parent brood stock. Certain bacteria get transmitted from the Mother breed that attacks the intestines.

EMS was first reported in China in 2009, it has slowly spread to Vietnam, Malaysia and Thailand, and now causes huge annual losses in these countries. EMS outbreaks typically occur within the first 30 days after stocking a newly prepared shrimp pond, and mortality can exceed 70%.

What is the solution, then?

No specific solution seem to have not been found so far as a permanent solution. Still the research is going on.

Shrimp Info Systems (SIS) is considered to be one of the best broodstock supplier from which fresh broodstock can be drawn.

India seems to be in a happy position currently with the other big exporters floundering with EMS situation. How serious is the purported risk of spreading from country to country as it has in the Asian countries like Vietnam, Malaysia and Thailand?

Yes, in India we do not have the EMS disease problem, as of now. As mentioned before Government ensures import of broodstock only from well known suppliers. Also with proper bio-security measures in place and strict enforcement by Authorities, chances of outbreak of disease is considered remote and certainly controllable, we think.

The Coastal Aquaculture Agency plays a big role in containing the risk (check-destroy-closure powers vested in them) from rogue hatcheries or what are known as “Backyard Hatcheries”.

Do we have new markets opening up for Shrimp from India? We heard South Africa and Chinese are actively buying from India?

Yes, new markets such as China, South Africa and even Russia are developing.

How does it look for next 2-3 years for shrimp feed/processing business in India?

For India, next 2-3 years should be good. Shrimp prices have been going up, but RM has also been going up. We need to do a good balancing act.

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PRODUCT SEGMENTS

The two main product segments -Shrimp Feed and Shrimp Processing have different characteristics. 80% of the Revenue contribution comes from Feed and 20% from Processing. Shrimp Feed segment has much faster volume growth with low margins whereas Shrimp Processing has higher margins but comparatively lower growth. Kindly educate us on the characteristics of both segments.

Shrimp Processing and Shrimp Feed industry are inter-related. If shrimp prices globally are higher and shrimp processing segment does well, the Shrimp Feed segment can also do well as the farmer is inclined to grow more shrimp – requires higher feed consumption.  However, the Shrimp Processing market is more like a “Trading” market. Margin performance depends entirely on the Global Market prices and prevailing raw shrimp prices. These price changes can be very dynamic and very sharp. Raw material availability is very closely monitored (on a global level) by the big players.

Shrimp Processing is a seasonal industry. Depends primarily on 3 factors – Raw material availability, Labour availability coupled with the Demand in the Market. Nov-Dec-Jan-Feb are the lean months. With advent of Vannamei culture, now has become effectively a 10-month season from the earlier 8 months.

Currently global prices have been rising. Seafood Exporters Association monitors raw material prices. All members generally follow this maybe with +/- Rs 10/kg. But also consider the effect of dollar volatility, rising interest costs. Freight costs have gone up abnormally. We need to ensure the farmer too gets a fair price. It’s important for him to survive. On the other hand consider big raw material price volatility on the feed front. Soya meal prices have been going up tremendously. Even Fish meal prices are also steeply rising.

We have to ensure that the farmer still is able to make money after the price hike, so as to let this trade survive/prosper.

EBITDA margins is usually in the range of 8-10%. Sometimes can go down to even 5-6%. Depends entirely on this balancing act that we have to do depending upon culture scenario. Achieving 15% EBITDA margin is considered exceptional performance.

Shrimp Feed is a manufacturing industry and consistent quality to the farmer is very important – for different seasons and water conditions. Feasibility/cost to the farmer is of prime importance. But Raw material is not in our control at all.

Please educate us on the complexities of the Feed formulation technology? How difficult it is?

Feed manufacturing is not very complex, but at the same time, formulation cannot be made easily to manufacture feed because Feed formulation differ from region to region and within regions from area to area depending upon the water, soil and climatic conditions. Technical support/ensuring proper mix in Feed is very important.

Why is someone like CP such a dominant player? And how is Avanti placed in this segment?

CP is one of the largest Feed producer in the world and has strong market presence. AVANTI has also gained market reputation on par with CP now in India.

CP has a huge lead in terms of experience base around the world. It invests a lot in R&D. One has to be on top of RM trends and ensure timely substitution – COST vs PROTEIN content. And thirdly Feed productivity is very important. The farmer will always prefer the feed that provides the best FCR (Feed Conversion ratio) – quantity of feed consumed to shrimp meat production. AVANTI has also a need-based R&D facility and strong technical staff to support the farmer.

Shelf life of Feed product? and for Processed Shrimps?

3 months for Feed. Processed shrimp can be kept frozen for upto 2 years.

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BUSINESS AND OPERATING MODEL

Please give us an idea about your main export markets with break-ups?

80% of export business is with the United States.

Andhra Pradesh, Tamilnadu, Gujarat, Orissa, West Bengal Shrimp Feed markets. Kindly educate us more on the regional breakups?

As explained before the Feed market consumption in India by and large today is 60:40 Vannamei:Black Tiger. Andhra Pradesh is the fastest growing market with 80% conversion to Vannamei expected this year from earlier 60% levels. Gujarat with a 50/50 share last year is expected to race ahead to a 60 to 70% conversion this year. West Bengal has been 70/30 in favour of Black Tiger and will continue to remain a slow converter for Vannamei. Tamilnadu is expected to pickup in conversions this year.

Terms of the Feed Sales segment? How much is Cash sales and Credit Sales?

When we started Credit Sales used to be 90%, with 10% CASH. Today this is at 50/50. And for the 50% Credit Sales we ensure credit only in the last 60 days of culture. Typically it takes 120-130 days for the larvae to reach 40 gm size. The first 60 days cash sales ensures there is some upfront investment from farmer and progress to the 2nd phase ensures safety.

Please educate us on the the seasonality in Sales seen.

April -September (Q1 & Q2) used to be the main season contributing 60% of Sales. Now, also Q1 and Q2 continue to be major season and part of Q3 and Q4 also have culture due to Vannamei Culture.

The margins have been quite volatile in the history. What do you think would be realistic operating margins for longer term?

Anything between 10-15% EBITDA is considered exceptional performance on margin front for this industry. 5-8% margins is what is happening now. Over coming years, we see Feed and Shrimp processing segments contributing roughly 50:50 to EBITDA.

The volatility in margins comes due to raw material prices. We did a calculation of RM cost over the years. Please comment

Particulars FY13 FY12 FY11 FY10 FY09 FY08
RM/Sales % 76.38 70.30 87.56 81.01 72.31 71.71

Raw material price rise has been exorbitant last year – FY13. Soya prices rose more than 2 times in less than 6 months and hence the margins got affected. This is a major risk factor for us, where we do not have any control as mentioned before. We have increased prices marginally – that should help.

Fish meal avg prices Fy13- Rs 58/kg; fy 12 – Rs 50. Soya meal Fy13 avg – Rs 34 /kg fy 12 – Rs 22 . What are current levels? Will the industry be impacted badly from soya or fish meal pricing? What is the outlook for the year as the soya meal prices have corrected? And what about Fish meal pricing?

Though, Soya meal prices corrected back for a short period have gone up again. Similarly, Fish meal prices have also gone up dramatically from Rs 60/kg to Rs 87/kg. Fish meal likely to come down after Aug-Sep provided good catches are available otherwise expected to remain at high level.  These raw material prices are highly volatile and un-predictable.

The Shrimp Feeds business seems like a difficult business, and yet there are players like CP and Avanti which dominate the market. What are Avanti’s differentiators?

There are two main factors. First you need Top Quality product and secondly you need to be the Farmer’s choice. You can only do that by staying close with the farmer, assisting him with technical inputs and timely response to dynamic issues faced – we have discussed some of these before. AVANTI has established a good market reputation in respect of these factors.

Quality Feed is 50% of the job. There is something called FCR – Feed Conversion Ratio – 1 kg of Feed producing how many kgs of Shrimp mass. Typical FCRs vary between 1.35 to 1.5 for 1 kg of shrimp mass produced. Now if farmer gets a FCR of 2 he is going to be extremely unhappy. But if he gets to an FCR of 1.2 or 1.15 he is very happy.

There are many costs for Farmer. Feed cost followed by power costs and labour and overheads. Feed cost can be 60-70% of total costs. 

Timely technical guidance is the next 30%. Next comes Marketing skills which can account for say 20%.

Dynamically changing global shrimp prices, and Feed cost can play major spoilsports. This is a very price sensitive market.

What kind of technical staff do you employ?

150 Trained staff – mostly BSC/MSC Fisheries.

What kind of R&D do you have to engage in?

This is an ongoing process, mostly on feed raw material/substitution/technical support front. We have sufficient equipment in Lab for analysis. There is obviously no requirement for basic Genetics R&D.

You pay some Royalty to Thai Union for the Feed?

Yes we pay Royalty fees to Thai Union for their feed formulation. We also use Pro-Feed one of their brands.

Let’s talk about Shrimp processing segment. In shrimp processing Q2FY13 margins at 20 %. Kindly comment? Now since shrimp prices have gone up sharply, will it contract margins further from FY13 13% blended levels?

As mentioned before 13% operating margin is a good performance in a good year. Such margins are tough to replicate. We will be happy if we can do 10%.

Shrimp processing targets this year and next year?

6000T this year, and 8000T next year

Over last 5 years, Operating Cash flow has generally been poor and has not kept pace with Earnings, with the exception of FY12, kindly comment.

Actually 31st March figures are not indicative. Season starts in Feb, March so there is lot of Inventory build-up that starts happening in Jan-Feb-Mar for April-Sep which is our primary season. Besides there was big price volatility in fish meal, so we kept higher stocks. Our Debtors position is usually at 2 months.

There has been considerable increase in inventory and debtors this year. If Sales have increase by x, both Inventory and Debtors have increased 2x – also resulting into cash flow from operations becoming negative. What is expectation going forward?

Covered above.

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CAPACITY EXPANSIONS/PRODUCTIVITY

The FY12 annual report was very optimistic and the company had undertaken following expansions a) Shrimp processing capacity expansion from 2700 MT to 8000 MT/10000 MT b) Shrimp feed capacity expansion from 52,000 MT to 1,10,000 MT c) Buying of new land 5 acres to set up new plant of 50,000 MT but this plant hasn’t come up till now and as per latest AR, it would be available in Jan, 14. What is the latest status?

Shrimp processing capacity is at 8000 MT. Additional Shrimp Feed capacity will come on by Nov2013/Jan 2014 timeframes. Machinery is already there.

What is the current utilisation levels? Do we see greater ramp up speed in Shrimp processing segment?

Yes, this year we are seeing a lot of demand due to EMS in other Asian countries, there is shortage globally. China is a net importer today. There is additional demand from China. Hence we are seeing good opportunity in Shrimp processing segment and hope to do 6000 MT this year if everything goes well.

As the new Shrimp Feed capacity is not available during the peak season of FY14, will capacity be a constraint for growth in FY14?

We are at about 130,000 MT capacity today and did about 103,000 MT during 2012-13. This year we can do about 120,000-125,000 MT.

Fixed Asset Turns (2.4x to 12.7x) and Capital Turns (~1x to 4.3x) have seen tremendous improvements over last 5 years. Please share the company’s philosophy, processes, and how you have gone about implementing such extraordinary productivity and efficiency improvements.

Firstly we have been prudent in setting out initial good capacities. Preventive maintenance with periodic replacements ensure longevity and life of the assets. We keep making small improvements in incremental ways – like ensuring higher productivity by upgrading the Pellet Mill, or other de-bottlenecking measures. We have kept modernising/making small incremental investments over the years.

Is this an asset-light business model? Is this sustainable?

Sustainable – Absolutely.

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NEAR TERM PRICING/OTHER OUTLOOK

We came across shrimp pricing in international markets and it seems the prices have nearly doubled over last 6 months to $13 or so Is it right? If yes, isn’t this a game changer?

Steep increase in prices will have definitely impact on the market.

US Govt has recently imposed an anti-dumping duty of about 6%. How does it affect the co and long term prospects?

There are two components. First is the anti-dumping duty which is now at 3.49%.

Recently US has imposed Countervailing duties (CVDs) of 5.91%, also known as anti-subsidy duties, as trade import duties imposed under World Trade organisation (WTO) Rules to neutralize the negative effects of subsidies. It will be factored in the price mechanism.

What subsidy is the Indian Government providing?

We get 3.50% duty drawback and 5% under VKGUY – Vishesh Krishi Gram Udyog Yojana -scheme.

Because of the EMS disease spread in other exporting countries, are Indian exporters in a better position to bargain?

To some extent.

As per recent industry article, MPEDA has projected marine exports to be at $4.5 Bn vs $3.5 Bn last year and major driver for this growth is expected to be growth in shrimp exports. Does this indicate that we may see 30%+ growth in export of Vannamei in FY14?

There is possibility of 30% growth, provided, the favourable conditions continue.

When will the company go in for Value Added – Branded products/exports?

Efforts are being initiated to plan value added products but no specific date is set till now.

How strategic is the domestic value-added retail foray for Avanti?

Developing domestic market for both frozen raw shrimp as well as value added shrimps is essential in the long run for the Indian industry as the dependence on total exports is not desirable.

Is Thai Union with you for the domestic foray? Do they also believe in this?

Does TUF  have value-added processed shrimp products to offer?

Yes. They have value added products for their domestic as well as export market.

Does TUF buy processed shrimp from you in India?

Yes, sometimes.

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RISKS

On one hand there is volatility in raw materials, and on the other volatility in processed shrimp end-prices? Which is a bigger risk and why?

Some risks are controllable, and some are uncontrollable. On the costs front, RM cost is a major variable cost on which we have no control.  Feed pricing mechanism will take care of this aspect to some extent.

As far as end-prices of shrimp exports is concerned, that’s really uncontrollable. Pricing is completely dominated by global market.

Any long term contracts for RM sourcing in order to reduce risks

We have well known suppliers on our Vendors list and we source raw materials from them. Price depends on market rates.

This is a volatile industry. There are disease risks and there are RM and end-price risks – all of which are pretty dynamic in nature. Please educate us on how do bankers determine, evaluate and manage risks for your industry.

Till recently this was considered a Risky industry to finance by the banks.  However, now they have revised to favourable industry status for finance.

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CAPITAL ALLOCATION/FUTURE OUTLOOK

Your debt has increased? Reasons?

We don’t have any long-term debt. Only working capital requirements.

Your company has considerable investments in some power projects. One of them is doing decent but the other has been making losses. Kindly comment.

As you know the Power Sector has gone through a sea change in recent years. Market is not so good. Small projects are considered not so profitable. Only big projects are considered profitable.

What is the strategy going forward? Why don’t we sell them and get out of what looks like a non-core area?

Yes we are working on divesting this off.

Srinivasa Cystine ltd. – Subsidiary. What is the main business of this company? Is it correct that this company has announced a Biotech division catering to shrimp medicines, etc.?

Srinivasa Cystine Limited is not a subsidiary of AVANTI.  They are engaged in the business of Trading in Aquamedicines, Water sanitizers for mineral deficiencies in the water for shrimp culture.

Isn’t it true that this could be supplied to your same customers, why do this through a subsidiary?

This is not the main business of AVANTI nor is the business significant. It is only a small trading activity which we do not want to tag on to the main activities of shrimp feed and exports. It is not a mandatory requirement of the farmer to use medicines.

What is the expected size of business from this division?

8-10 Cr

Does TUF have any stake in Srinivasa Cystine as well? for what products?

No stake.

What is the reason for diminished presence in fish meal segment? How easy or difficult is it to get into related fields like Animal Feed, etc?

Fish feed is not a profitable business as of now.  Hence, no interest is evinced.

Any other market or vertical we are planning on entering? What are the sources of future growth?

Processing Plant expansion. Today we do 25-30 T/day. Plan is to go for 75 T/day in 2-3 years from a different location. And Hatchery – That has been in the planning and will be a good value addition to Farmer.

There has been lot of delays on the Hatchery front. We had got land but did not proceed? Kindly comment.

Yes, we had got very good land in Chennai but that had some legal issues, so we could not proceed with our plans. Now, we are in the process of identifying some other land.

Domestic Value-Added retail foray? How far off is that really?

No ready plans as of now.

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INDUSTRY SUSTAINABILITY/AVANTI FEEDS BUSINESS SUSTAINABILITY

So far we have discussed what is a very happy situation for Indian shrimp processors and feed manufacturers. This is due to a) EMS disease spread in China, Thailand, Malaysia, Vietnam and their inability to export in any bulk b) Shrimp prices going upto $8 from $6 before. The higher shrimp prices have ensured better pricing for shrimp processors from India and in turn better prices for shrimp farmers, leading to the production build-up in the country.

In our view, it is not correct to say that the happy situation for Indian shrimp culture prevailing to-day is solely on account of EMS disease spread in China, Thailand, Malaysia and Vietnam and their inability to export in any bulk. The good time for Indian Shrimp culture revived with introduction of Vannamei culture in India as the farmer was making good profit in Vannamei culture even before out break of EMS in those countries. We believe that in the long run the shrimp culture activity will be sustainable to all the stakeholders because there will always be balancing mechanism between export price and the shrimp prices.  It is important that the farmer continues with shrimp culture as long as the activity is profitable to him.

Now what happens when Shrimp prices correct back to $5-6 internationally – for whatever reasons? How does the economics of this business change and what effect does it have down the chain – profitability for farmers and hence production, feed demand, etc? Will the industry in India in general and Avanti feeds in particular, be able to grow volumes at a sustained level at these prices?

As stated in our answer to earlier question, we strongly believe that in the long run the shrimp culture activity would be sustainable to the farmer in view of the fact that the global shrimp demand will keep increasing and the price mechanism is only a balancing phenomena. The high export prices prevailing now is mainly on account of spurt in demand due to shortage of production due to EMS in some of the Asian countries which we believe will get settled in course of time and production increases will start balancing demand and supply. We strongly believe that the industry as well as AVANTI will grow in volumes both in respect of feed and exports.

Tell us something – The domestic feed market also is directly correlated to export demand/global pricing, right? So if export demand/pricing falters in a major way, its not only the shrimp processors that get affected, the local feed market will also falter, right? Isn’t that likely?

We do not foresee such a situation as mentioned by you as the demand for the shrimps globally keeps increasing and cost of production of feed as well as shrimp and also export price is dependent on dynamics of input costs and market demand from time to time and we do not believe that the export prices will crash to such an extent that the shrimp culture activity becomes economically unviable to the farmer in the long run.

Okay, understood. But if prices were to say correct tp $3-4 levels, that would significantly affect the overall economics for the industry, right? So how likely or unlikely is that event in the near-to-medium term given current visibility?

In our opinion, such a situation is most unlikely in the next atleast 3 to 5 years.

So what we are seeing is that the real issue is about aquaculture viability for Farmers. At what point does it really become unviable for the Farmer? What’s the cost of Production for the Farmer – $2.75? And could it happen again, like it did in 2008? why or why not?

The production cost would be around $2.75 to $3.00 per KG. In 2007 & 2008 India had different problems like outbreak of disease and high cost of production of Black Tiger in India compared to Vannamei in other countries which made Indian product non competitive in the global market which made the shrimp culture unviable to the farmer. However, the situation is different now and we do not foresee such a condition repeating.

But, what about a new country source emerging – what is Avanti Feeeds confident of achieving in such a scenario?

We believe AVANTI FEEDS would be able to retain its position by virtue of its quality, service and competitive pricing irrespective of new country source emerging in future.

Is there any case for a drop in buying from India/exports from India in next 2-3 years. why, or why not?

There is no reason to anticipate drop in buying from India in the next 2 to 3 years as the global shrimp demand keeps increasing and the production in other Asian countries likely to take time to recover from the effects of EMS and to regain their normal production levels. As such we do not foresee any drop in exports from India in next 2 to 3 years.


Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 2 years;
Tirumal Rao: No Holdings in the Company; ;
Davuluri Omprakash: No Holdings in the Company; ;
Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 1 year;

Poly Medicure Management Q&A: Sep 2013

Management Q&A

1. OVERVIEW

Your company has had a spectacular journey. Kindly give us a sense of how you see the Medical devices business, and Poly Medicure’s place in it.

There is a huge opportunity still to be tapped. From our participation/co-charing in several industry bodies like the CII we are siezed that medical benefits/availability is constrained near the top. Yet to percolate down to the masses.

Non Communicable Diseases (NCD) is a 6 Trillion $ market for next 20 years. NCDs like Diabetic/Cardiac/Cancer care will be a focus area. There will be a shortage of Services and Service producers (Doctors & Nurses) for next 40 years.

80% of medical devices are still imported. Generic devices that can be manufactured are still not being manufactured in India. While custom duty on imported devices is low, ironically duty on imported RM (plastics) is being hiked. Manufacturing in India is not highly incentivised like in China where you can have all approvals/agreements in place within 3 days.

Give us a sense of the Medical Devices/Technology Business, and opportunity from India? And Poly Medicure’s place in it?

Medical technology is a $3 Bn annual market and that includes MRI machines, Xray machines and even Stents.

All leading OEMs are looking at manufacturing out of India. There are huge distribution networks that are looking at outsourcing manufacturing from India. These people are looking at Polymed – as a leading manufacturer of a basket of products – IV Cannula, Safety IV Cannula, Blood Bags, Catheters. We are manufacturing something like ~95 different products, today.

Even if 1% of that global market is outsourced from India that’s a $300 mn market (as compared to $25 Bn of China).

Kindly educate us on your business segments? Given what you have shared above, OEMs must be a big focus area?

We have 3 verticals. Domestic, Exports and OEMs.
We are among the Top 3 in local market. We have recently invested in expanding the Haridwar facility for the domestic market and focusing more on the local market. Domestic business currently is only about 50-60 Cr, rest is Exports. We plan to scale up domestic business significantly.

OEM vertical is our focus area. We plan to scale up this vertical significantly. As mentioned before there is interest being shown by lot of global players. Let us see what emerges.

Kindly give us a sense of globally how we are placed. Who are the main competition?

B Braun, BD, Hospitec, J&J, 3M and Poly Medicure are among the main players. By next year we could be among the Top 3 after B Braun & BD.

2. SAFETY DEVICES

One of your major successes has been the patent challenge with B Braun on Safety IV devices. Kindly educate us on the challenges and opportunities that this throws up? How significant is this for Poly Medicure?

B Braun is one of the largest players in the Medical devices/disposables field. Safety IV devices itself is globally a $300-350 Mn annual market size today. This was a 20 year patent granted in 1999, so is valid till 2018.

We developed a novel process/mechanism for manufacturing the Safety IV Cannuala which we believe is non-infringing. We have been successful in the patent challenge in many markets like Germany and India. We have also lost in some like Malaysia and injunctions have been placed against us in Spain, recently.

There is a big opportunity to grow globally with that product range. We don’t have a foot on the ground abroad in many important markets. We will have to grow cautiously, step by step – our pockets are not deep.

So what percentage of Sales is Safety Devices likely to grow to?

10% of Sales is where we are – can go upto 25% of sales eventually, in next 4-5 years

3. OEM RELATIONSHIPS/LEARNINGS

You have been supplying to OEMs and pursuing the OEM relationships in a big way now. What has been the learnings?

There has been big learnings in terms of Knowledge acquired and the approach followed by the major OEMS. Learning on knowhow – how to improve systems and processes have been huge. There is much to learn from how the global majors go about developing Vendors. With more exposure we are incorporating Global Best Practices in the organisation.

4. INCREASING AUTOMATION

You have been making significant investments in Automation. Given the labour situation is this a likely trend we are going to see going forward too?

Yes, we have recently invested about 50-60 Cr in automation that should serve us well for next 10-15 years. There are several advantages to increasing automation. We can maintain 24/7 product lines with ease. As human intervention reduces, we are able to produce a better consistent product each time. Process and output monitoring is very high with automatic alert/escalation mechanisms that get built in. All of these result in higher quality.

At the same time, increasing automation may decrease your cost arbitrage/competitiveness with major players like BD?

We will still be far more competitive than BD. Much of the automation has been achieved through home-grown machinery.

5. ORGANISATION BUILDING

Kindly throw some light on how the organisation is gearing up for the challenges ahead. What kind of structures/processes are you putting in place?

We are fortunate to have a Core Management Team that is exposed to best practices in the world. We had engaged E&Y for improving on our processes. They have completed a study of all our processes and delivered complete SOPs (Standard Operating procedures) for all the departments. And are now engaged in creating proper DOA (Delegation of Authority) and Management by Objectives procedures.

The next 50 leaders in the company are being prepared.

6. CONFIDENCE – AT ALL TIME HIGHS?

As the company has started turning in Stellar results, there seems to be huge confidence all round. You are shrugging off the shackles of the recent past. Kindly comment

Yes. Last few years we walked with heads  low as we struggled to come out of the forex derivative contracts issues. We managed to successfully put that phase behind us by focusing on things within our control – bringing in process improvements and  cost-efficiencies wherever possible, plugging leakages and cutting wastage.

Consequently as you would have noticed, our margins are much higher. We expect good cash flows for next 2-3 years. We are actively looking at JVs and/or acquisitions.

7. PREPARED FOR THE MEDIUM TERM?

While the organisation seems quietly confident and gearing up for a promising future, how prepared would you say you are – for harnessing the opportunities before you?

We are fully prepared on all fronts. as you know the biggest factor in India currently is Land/Infrastructure – this is something that can be a real dampner for growth if not available, at the right time. We are fortunate that with our Jaipur facility and the additional land available at IMT Faridabad, we are secured on this front for the next 5-6 years.

We can do a 20-25% Organic growth easily for the next 5 years.

8. THE CHINA FACTOR

What about the China vs India manufacturing Edge? How do you see us placed today, especially in the context of your industry?

The main difference is in Raw Material and Labour situation prevailing in the two countries. Raw material (plastics granules) are today more or less at global parity. However while China Labour rates have crossed $300, in India Labour is still available at $100 levels.

Also with the recent Rupee depreciation going from 45 to 65 vs $, that’s a 40% plus depreciation. We should retain a 50% cost-arbitrage situation for next 2 years atleast.

9. LONG TERM FUTURE

How do you see the Future for Poly Medicure?

10 years from now, we will be selling Products/Knowledge/Patents. We will be much higher in the value chain. Even with higher escalations on the costs side – manufacturing + RM – we will still be making good money.

10. NEAR TO MEDIUM TERM OUTLOOK

Jaipur SEZ completion – by Mar 2014. Is everything on schedule?

Yes. We should be ready by March 2014.

What has been the impact of recent hike in Duties on plastics granules RM?

We also get RM import at concessional rates because of our exports. So there isn’t really much of an impact.

What is the current debt level and where do you see it for FY14?

Total debt should be below 50 Cr levels around March 2014

Given that much of Jaipur Capex has been funded through internal accruals, Interest costs for the year, likely to go up only marginally above last years 6 Cr levels?

Yes. Should be around 7.5 – 8 Cr

What about Depreciation spend for FY14,?

Should be below 16 Cr, or so.

Disclosure(s)

Ayush Mittal: More than 5% of Portfolio in the Company; Holding for more than 2 years;
Donald Francis: More than 5% of Portfolio in the Company; Holding for more than 6 months;
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