Gujarat Heavy Chemicals Limited has two segments – Soda Ash and Textiles. Soda ash finds applications in Glass and detergents. The company’s main customers include HUL, P&G, St. Gobain etc. Soda ash accounts for 57% of sales of the company. It’s a cash pumping machine with 450 cr of cash flows every year. The capacity of the company is 8.5 mn tpa. It has 23% market share in the domestic market. Nirma is the market leader with 25% share followed by Tata Chemicals with 24% share. Imports account for 24% share too.
It is also a backward integrated textiles player from yarn to textiles. The company has an installed capacity of 175,000 spindles in TN and home textiles manufacturing happens in Gujarat. Spinning accounts for 30% of the revenue in this segment while home textiles accounts for the rest.
| Inr cr | 2014 | 2015 | 2016 |
| Total Sales | 2248 | 2373 | 2559 |
| Soda Ash Sales | 1230 | 1416 | 1450 |
| Textiles Sales | 1017 | 957 | 1063 |
| EBIT | 355 | 448 | 551 |
| EBIT Margin | 15.79% | 18.88% | 21.53% |
| PAT | 108 | 182 | 258 |
| PAT Margin | 4.80% | 7.67% | 10.08% |
| ROE | 25% | 32% | 31% |
| ROCE | 17% | 21% | 24% |
| CFO | 343 | 467 | 507 |
| CFO/Net profit | 3.2 | 2.6 | 2.0 |
| FCF | 288 | 323 | 281 |
| FCF/Sales | 13% | 14% | 11% |
If you are aware of the promoter history of this company, then I am sure the name GHCL will send shivers down your spine. I do not blame you. That is the reason for the shear undervaluation even while other stocks are hitting the roof (Sugar speculation anyone?). While the promoter issues are legitimate, I believe the market will not ignore the positive changes in the underlying business for too long and hence this could be a good opportunistic bet for a potential re rating. Below are the 7 reasons why I like GHCL-
- Lowest cost manufacturer of soda ash – There are three main players in the domestic market – Tata Chemicals, Nirma and GHCL. GHCL is the lowest cost manufacturer of soda ash with EBITDA margins ranging from 28% to 33% over the last 10 years which is 3-4% more than its competitors.
There are two types of Soda Ash – Synthetic soda ash and Natural Soda Ash. Synthetic soda ash is made from salt, limestone, lignite and met coke. It accounts for 75% of the soda ash globally. Natural soda ash is made from large trona deposits which has lower processing cost. The only fly in the ointment is that there is only a limited amount of trona deposits in US and Turkey and hence it’s a natural advantage that these geographies have. This has had implications on the supply dynamics as explained later.
The reason for GHCL being the lowest cost producer is that it’s the only player in India with access to its own lignite mines (20% captive). It also has access to other raw materials like salt (55% captive) and limestone (30% captive). Further it uses briquette coke instead of met coke which is cheaper and on which they have a process patent (for the sceptics – http://www.allindianpatents.com/patents/224364-cost-effective-process-for-forming-coke-briquettes). These raw materials account for more than 50% of the total cost. The company also has the highest capacity utilization in the industry (88%). In the last 5 years the average EBIT margin of Tata Chemicals has been 21% as compared to GHCL’s 25%.
The question then is this- Can anyone else do it? The answer is yes BUT (there is always a but) the entrant will need its own supply of raw materials and scale to match the cost competitiveness. There is only limited supply of raw materials and that is mostly available in Gujarat. Each tonne of soda ash requires 5 tonne of raw material and being in close proximity to raw materials is the key. Also, the logistics cost of soda ash is really high and hence it can’t be transported cheaply. A player in South will find it immensely difficult to supply soda ash to customers in North India due to high costs of transportation and no access to raw materials. Power and fuel account for 20% of the total costs. This is also the reason why domestic companies (96% of production happens in Gujarat) are not able to cater to the markets in South and East India where the gap is filled in by imports (24% market share).
So what if one wants to set up a plant in Gujarat? Well there are only limited amount of natural resources. Even the plants located in Gujarat do not have enough resources to cater to their own needs. The government has not issued limestone mining licenses since many years due to strict regulations. Also the capital turnover ratio is unfavorable as 1 tonne of production requires Rs. 50,000 while it generates only Rs. 20000 of sales. Hence the entrant would require a large scale to remain profitable (60% of the costs are fixed).
This is the reason why the industry is oligopolistic in nature with 3 players accounting for more than 75% market share.
- Supply side dynamics
The soda ash industry supply cycle is extremely favorable. As mentioned, EBITDA margins for GHCL have been relatively stable in the last ten years despite soda ash being a ‘commodity’. This is because supply has always followed demand. In fact in India the demand has always been higher than the supply (see below).
There are two processes for manufacturing soda ash – Solvay process and Hou process (mostly used in China). Both these processes use raw materials like limestone, salt and coke. The biggest threat to these processes is natural soda ash. Trona is 70% soda ash and can be refined at a much lower cost. It is a natural mineral which is geographically restricted to US and Turkey. Turkey has reserves for about 40 years. Due to the cost advantage enjoyed by companies in these markets there have been many plant closures of companies employing Solvay or Hou process in other countries like Japan, South Korea, Taiwan etc. which have been a victim of cheaper imports. There have been 4 closures recently in other regions (shown below). Since 2009, more than 2.5 million ton of capacity has been shut down. In Feb 2016, the largest plant in China with 3 million ton capacity was shut down for a period of 6 months (http://www.chemweek.com/business/companies/Waste-water-issues-force-shutdown-of-major-soda-ash-plant-in-China_77090.html). All these factors have led to increase in realizations of soda ash globally and favorable supply dynamics.
Natural soda ash is a legitimate threat but India is relatively protected from it for a while. Companies in US have been exporting most of their produce to South America and Africa while companies in Turkey are focusing on European countries.
There are two reasons for that – Anti dumping duty(ADD) and as mentioned earlier high logistics costs.
The GOI imposed ADD on soda ash imports in 2012. The duty on US imports is $30 / tonne and Chinese imports is $36 / tonne. Also the freight cost from US is $56/ tonne while from Europe its $40/tonne. However, one must be cognizant of the fact the ADD will be reconsidered in July 2017. As per the management, there will be 5% reduction in price if the ADD is removed. Removal of ADD is not expected to have an extremely significant impact as even in the current market the cost of domestic produce is Rs.20000/tonne as compared to 17000 a tonne from imports. The fact is that there is just not enough supply currently in the market.
- Management efforts of improving Corporate Governance
For those of you who are not aware – type Sanjay Dalmia on google and you will realize the gravity of the situation. This is potentially one of the primary reason why the stock is undervalued.
However, GHCL is run by a professional management and Dalmia has no say in the day to day operations of the business. Mr. RS Jalan is the MD of the business and I couldn’t find any dirt on him. Lately, the management has been taking important steps to improve the confidence of the investors which I believe is critical. They have started doing concalls and are more transparent about their business. They have also formulated a dividend policy for the shareholders in FY 2016. Add to this the appointment of E&Y as its auditors. These are steps in the right direction. Second chance anyone? (Never ask this to your wife or girlfriend)
4. Improving margins in the textiles sector
Textiles is a sunrise sector in India. Textile companies have been showing great numbers too. GHCL made a late foray in the home textiles segment. It has been working hard to change its customer mix the result of which can be seen above.
The company operates at a lower capacity as compared to its peers. This company has enough room to grow in this segment. The margins will improve as the company utilizes more capacity and as home textiles starts accounting for more revenues in this segment. The management is targeting EBITDA margin of 16% in the next FY as compared to 13% in FY 16.
5. Improving debt situation
GHCL has been working on reducing its debt. The company had loss making subsidiaries and it had to write off substantial amounts thereby eroding its net worth. It has now shut down all its loss making businesses abroad (more than 15 subsidiaries). The company structure too looks a lot cleaner now. The management targets to get D/E ratio below 1 and looks on track given their cash flows
- Capex using internal accruals
The company is increasing its soda ash capacity by 1 million tpa. It will be spending 375 crore and it will get commissioned by 2017. This should further enhance the margins. The company will also spend 50 crores on debottlenecking its plant and another 50 on windmill capacity will increase margins by 1% as per the management- All this with no additional debt or equity dilution.
- Compelling valuations
The soda ash division did revenue of 1450 cr in FY 16 with EBITDA margin of 32%. Average EV/EBITDA of commodity chemicals companies is 9.
For valuation purposes let’s assume EBITDA margin of 30% and EV/EBITDA of 6.5.
Current Market cap of the company is 1700 crore. Essentially one is getting the textile business with 1000 crore topline for just 80 crore at conservative valuation. This looks gravely undervalued if we consider the expected improvement in margins, reduction in debt and strong free cash flows.
Learn and Compound! 