Key Investment Rationale
OCCL is one of the top 4 producers of Insoluble Sulphur (IS) where only 4 players hold 90% market share globally. Demand for Insoluble Sulphur is dependent on the production of rubber or tyres which is related to the auto industry and replacement tyre market. Demand for tyre through Auto OEM’s consist only 30% of the industry and 70% is a replacement market which keeps the demand stable. The tyre industry is expected to grow at 3-4% over the next decade and there are no structural changes that would affect the manufacturing of tyre or rubber. Use of IS has increased due to shift from bias tyres to radial tyres. India still has large growth potential for radial tyres in the Commercial Vehicle segment as only 50% of the industry has adopted to radial tyres. While the industry is growing at a smaller rate, OCCL enjoys high barriers to entry with competitive advantages that allow them to maintain significant operating margins. OCCL has prudent management that has consistently innovated in higher grades of IS as per customer demand.
At current capacity with optimum utilization, OCCL generates 90 crores of owner’s earnings after maintenance capex. At 11% discount rate, it should command a minimum market cap of 900 crores i.e. 850 crores for OCCL and 30 crores for its subsidiary Schrader Duncan with no growth in future. Assuming a mediocre growth of 5-7% starting FY 2022, brings intrinsic value at 1300 Rs/share on DCF basis. Thus, current market cap of 700 crore provides enough margin of safety and downside protection for such a high quality, low uncertainty and low risk business.
Management has clarified that FY2021 has been negatively impacted due to auto slow down and expect the sales to drop by 25%, profits to drop by 50% for Q2FY21 at least. They are optimistic about demand picking up in Q3FY21. The first phase of the latest expansion has been delayed its commissioning to Q1FY2022 from Q4FY2021.
Eastman chemicals USA controls the Insoluble Sulphur pricing. Any change in the pricing can affect OCCL’s margins and return on capital. Secondly, Chinese players have not come to global market due to their lack of innovation and product inconsistency. They can drop prices to grab market share which can affect overall margins for the industry.
OCCL manufactures Insoluble Sulphur which is an essential vulcanizing agent used in rubber manufacturing and majorly tyre industry. OCCL earns 90% of its revenue from insoluble sulfur sales, 10% from Sulphuric acids and oleum. OCCL controls 60% market share domestically and 10% global market share with presence in 21 countries. OCCL has two major plants strategically located in Haryana and Gujrat from where 70% of its production is exported and 30% is sold domestically. OCCL currently has 35,000 MT of Insoluble Sulphur capacity with another 11,000 MT expansion due completion by 2022. The company has presence in all continents across the world with more than 40 customers. Its major customers include Continental, Bridgestone, JK Tyre, Pirelli, CEAT, Goodyear, Apollo, MRF, etc.
There are only 4 major players in the world who command 90% of the global market share. Eastman chemicals, USA has 70% of the global market share, OCCL, and Shikoku chemicals, Japan share 10% market share each. There is an upcoming player China Sunshine who serves domestic Chinese market and has not been approved by tyre manufacturers outside china
The company has a subsidiary Schrader Duncan Ltd (SDL), where it holds 50.01% stake, is engaged in the manufacturing of automotive tyre valves and pneumatic products such as hydraulic and pneumatic cylinders, pneumatic valves, and accessories. The company has recently turned around profitable and contributes to 10% of the company’s revenue.
The tyre market is major consumer of rubber and thus, Insoluble Sulphur. Demand of tyres set to grow at 3-4% globally with most of the growth coming from Indian and Chinese tyre manufacturing companies. The global demand currently stands at 340,000 MT and 21,000 MT in India. While the Auto industry is cyclical, the tyre industry has a 70% share of the replacement market which makes IS demand stable over a business cycle.
Insoluble Sulphur is an essential component of tyre manufacturing and there has not been any substitute in the last 30 years. Since the 1940s, there is a structural change in place towards radial tyres over cross-ply tyres due to its multiple advantages such as lower transverse slip, greater power transfer, reduced fuel consumption, etc. Radial tyres require a higher percentage of Insoluble Sulphur relative to cross-ply tyres and domestically, a significant portion of commercial vehicles still run on cross-ply tyres which, when shifted to radial tyres will create demand for IS in future
- Insoluble Sulphur is a very niche business with guarded technology. It would take at least 2 years of R&D, plant set up and another 24 months of gestation period to get approval from customers. Thus, high technology barrier coupled with the exhaustive approval process of tyre manufacturers act as high entry barriers.
- As Insoluble Sulphur is only 1-2% of the cost of a tyre, customers demand the highest quality product and usually need 1-2 suppliers ready to avoid any supply chain issues in production. Thus, OCCL can raise their prices easily every year. Moreover, this has allowed OCCL to increase its global market share from 3% in 2006 to 10% by 2020. Company is often referred to as a secondary supplier which is a reputable status in an industry with only 4 major players.
- The company is easily able to pass on the raw material prices to the customer via quarterly contracts and maintain operating margins.
- Indian Tyre industry is set for structural growth due to anti-dumping duties on Chinese imports.
- There are only 4 major players who control the market and the overall pie is merely growing at 3-4%. Entry of any new player will reduce the returns for all the market participants in the industry which deters new entrants from entering this business.
Key Drivers for growth
Shift towards utilization of radial tyres and stable demand for rubber are the main drivers of growth. Tyre manufacturing is being shifted to developing countries like India and china as major tyre manufacturers are trying to cut the costs. Moreover, there is anti-dumping duty for Chinese tyres in India. Thus, OCCL is strategically placed to capture the growing pie of the global market as well as India where they already control 60% market share. Management must innovate on different grades of Insoluble Sulphur to augur the future growth opportunities.
The company cannot generate additional sales unless they expand and put up new capacities. Management has mentioned several times that they expand capacities only when the IRR is above 20% and there is enough certainty that they can utilize additional capacities. This can be verified looking at historical expansions which have grown at the same rate as growth in sales.
OCCL is a medium growing stalwarts’ type of business per Peter Lynch’s definition of businesses. The end market is growing at a slow pace, 3-4 players control the industry and have no space for another player. Eastman chemicals, USA control the pricing and has the largest market share so there is some risk as they can cut their cost and reduce prices but this is counter-intuitive as they would rather prefer to increase their margins by maintaining IS prices as high as possible. OCCL mostly caters to existing customer’s increased demand by taking a share of the growing pie and not by taking anybody else’s share.
Globally, Eastman Chemicals – USA, Shikoku – Japan and China Sunshine are the three largest players other than OCCL. Insoluble Sulphur is comparatively smaller percentage of revenue for other players than OCCL. China Sunshine is the largest IS player in china and majorly serves the domestic market. Their volumes have grown from 10,000 tons to around 50,000 tons by 2019 and are expanding another 30,000 tons by 2022. They have not been able to become a global player in the last 10 years due to domestic demand and OCCL/Eastman have consistently been innovating on improved products. There is a potential risk with China sunshine becoming a global player and reducing margins for the overall industry.
Historically, Insoluble Sulphur business has changed lot of hands over last 20 years. Originally, ‘Flexsys’ was a 50/50 joint venture between Monsanto and Akzo Nobel. Monsanto diverged ‘Solutia’ which had the 50% stake in Flexsys. In 2008, Solutia bought out the remaining stake from Akzo Nobel. At the time, Flexsys was headquartered in Brussels, Belgium. In 2008, Solutia had to file for bankruptcy as it had pension liabilities of Monsanto over $1.2B. Eastman bought Solutia in 2011 for $3.44B which was approximately 15 times earnings at the time.
Flexsys had to fight multiple legal battles against other companies producing insoluble sulfur in other countries including Korea, China, and Europe. Vice versa many complaints were filed against Flexsys challenging their patents but by 2005 all complaints were deemed invalid and Flexsys held all its patents since then. However, companies outside the US were able to copy and produce IS.
Overall, Insoluble Sulphur has been a sustainable business over the last few decades with very few players. OCCL is a focused player which is embarking on global demand for IS.
This is a high capex business where management must upgrade their facilities, add more capacities to meet the demand, and maintain their market share consistently. Additionally, they must innovate for different grades of IS. It is also important to make sure no other player puts up a huge capacity in place which can drop prices and reduce profits for the rest of the industry. This is a possible threat from Chinese players, but they have not been able to meet global standards of IS and export outside of china YET.
- Huge Capex by any one player, especially Chinese players can lower prices and reduce overall returns on capital for the industry.
- Management’s lack of focus on innovation of IS and quality
- Execution risk to produce existing or newer products due to delay in regulatory approvals
- Key-man risk since management has been the key differentiator for identifying opportunities and executing the production process.
- Any major accident that can lead to a ban or stricter norms for IS production.
- Loss of key client due to relationship/product quality issue
- Loss of competitiveness due to currency fluctuation, high labor cost, etc.
Management has been prudent in its capital allocation previously as they have made sure there is enough demand before they execute the Capex. They seem focused on optimum capacity utilization and healthy returns on capital when executing expansion. Their IRR for any expansion has been above 20% and that can also be checked as their returns on capital are above average. Also, Insoluble Sulphur does not have any toxic effluents so there is no environmental concern. OCCL hedges most of its currencies due to currency fluctuation.
OCCL is managed by the Goenka group of companies who have earned a big name as an industrialist over the last 3 decades. Management holds 51% stake, has no pledged shares, and has not issued any warrants as of June 2020. They have shown a consistent track record of executing successful projects from 1994 to 2020. Few of the projects have been executed ahead of schedule and under budget.
OCCL is a focused player on IS production while the rest of the competitors have only a small portion of their revenue coming from the sale of Insoluble Sulphur. Management has been prudent in not going after other specialty chemicals because every specialty chemical needs to have its separate supply chain and offers very few financial synergies which reduce overall returns on capital. There was no scam or fraud found in my search against the company and management. Management seems honest in setting future growth expectations through conference calls.
Management compensation has been in line with the ceiling limits of 10% of net profits but is above average. Both the managing directors have been taking 7% of net profits in last 5 years. Usually promoters pay is about 2-3% of net profits. The only good thing is that there are no stock options, so the equity is not getting diluted. While remuneration policy lays out incentives for increasing shareholder wealth, there were no KPIs mentioned such as return on capital or increase in book value to incentivize management performance. Refer to page 78 of the FY19 annual report. Performance of the company declined in 2013 from 2012, while management salary increased by 12% which is not very appealing.
OCCL has been lending money (5-6 Cr) to its subsidiary Schrader Duncan Ltd as they were trying to make it profitable, but these are not interest-free loans. SDL has paid back all the outstanding loans to OCCL with interest as of March 2019 and the company has become profitable.
Arvind Goenka, the key personnel behind OCCL’s success is still the man in charge and he is gearing up his son, Akshat Goenka to lead the future growth. Akshat was leading the charge in setting up Mathura plant in Gujrat and recent upgrades that have come under budget and are executed ahead of the schedule. Overall, management seems to have integrity in place, is talented and energetic.
Sales have been growing at 13% CAGR for the last 10 years which shows that OCCL is growing at 2 times the overall industry. OCCL currently claims to have 10% global and 60% domestic market share. 70% of their revenue come from exports and 30% is sold domestically. Their current capacity of 34,000 MT can produce sales worth of 383 Crore per FY 2019. They have mentioned in Sept 2019 conference call that they expect domestic demand to be around 10% and international demand to stay around 3-4%. If you extrapolate that, then sales could grow by 5-6% annually.
Historically, OCCL’s global market share grew from 3% 2006 to 11% in 2018. Management clarified that their market share is increasing because they are taking share of the growing pie by tapping into new geographies such as China and North America as a secondary supplier of Insoluble Sulphur and not by taking away the market share of any existing leaders.
If we assume 10% sales growth for OCCL in next 10 years. The IS demand would have to increase up to 408,000MT by 2029. OCCL would have approximately 16% market share which is not outrageous. Given that OCCL is a focused player compared to rest of its competitors
Thus, my forecast of 7% sales growth seems reasonable with a baseline demand growth of 4% and assuming that OCCL is a focused player tapping into newer geographies.
Operating profits and net profits have grown at similar rate. One can observe some criticality in sales as well as margins related with auto industry however, company has been able to keep respectable operating margins above 30%.
OCCL’s receivable days have been ranging around 75 days on average over the last 5 years. Inventory turnover is steady at around 8. They enjoyed tax benefits few years ago, but tax rate has been ranging at 28% recently. OCCL has a healthy balance sheet with a debt to equity ratio of 0.3. OCCL has a low asset turnover due to constant capex but it can be improved with company’s de-bottlenecking measures in future.
One would be happy to observe that OCCL has more cash coming out of the business than net profits. Cumulative operating cash flows for last 10 years are 693 crores while net profits are 527 crores only. The net profits have been getting converted into cash flows which shows no accounting gimmicks. Company uses 65% of its cash flows in capex and generates 35% of free cash flow.
OCCL has above average returns on capital over 16% for a business cycle. I prefer calculating returns on capital as owner’s earnings/invested capital which I think is a more accurate measure than NOPLAT. The owner’s earnings are calculated by subtracting maintenance capex from operating cash flows. Management has clarified in conference calls that their maintenance capex is in single digits. I have conservatively assumed maintenance capex as 15% of OCF. Invested capital is the sum of short term and long-term debt plus equity minus excess cash. The average return on invested capital is ranging at 16-17%
Return on capital is a measure of Profit Margin (owner’s earnings/sales) and Invested Capital Turnover (sales/invested capital). In OCCL’s case, the company must reinvest about 0.87 Rs to generate 1 Rs of sales. Their impressive returns on capital are due to high margins that OCCL can command and not by asset turnover. If they could generate higher sales out of each dime invested, ROCE can potentially improve.
|Return on invested capital||14%||10%||15%||16%||20%||18%||17%||17%||17%||19%|
DCF Calculation with Free cashflow approach.
OCCL has cash of 117 crore and long-term debt of 135 crore, so net debt is 18 crores. It currently generates about 110 crores of operating cash flows out and 39 crores of free cash flows at optimum utilization. It would be fair to assume optimum utilization levels to be back up by end of 2021. The demand should remain stable after 2021 and OCCL would maintain its market share with growth of 7%. OCCL’s intrinsic value comes at market cap of 550 crore after adding 30 crores for Schrader Duncan.
DCF Calculation with Owner’s earnings approach
I prefer owner’s earnings approach as it considers the actual cash that business can produce after all the maintenance expenses. As stated earlier, OCCL’s maintenance capex is assumed at 15% based on company research and conference calls. Thus, at current capacity with optimum utilization, OCCL can throw around 90 crores of owner’s earnings. It would take FY21 to get out of Covid19 and tyre demand to pick up as we get out of the auto to slow down. Chinese player might enter the global market, but prices and margins remain protected as the company continues to innovate new products and quantity of Insoluble Sulphur per ton increases. Thus, owner’s earnings can steadily grow at 5-7% for next decade. Assuming discount rate of 11%, the intrinsic value comes around 1200 Rs/share.
|Operating Cash Flow (cr)||70||68||77||87||89||108||83|
|Maintenance capex – 15% (cr)||10||10||12||13||13||16|
|Owner’s earnings (cr)||59||58||66||74||75||92||71|
Stress Test – The tyre demand remains stagnant, Chinese competitors get global market share and reduce overall returns for the industry by dropping prices. The current owner’s earnings shrink by 20% and do not grow at all and we sell the business at 10 times its owner’s earnings in 2029. In this case, the Owner’s earnings would act as a bond and at a 11% interest rate, the market cap would remain at 700 crores after you include 30 Cr for Schrader Duncan Ltd
Mohnish Pabrai Approach
Mohnish has a very simple valuation approach described in Dhandho investor. For a pessimistic scenario, let us assume no growth in owner’s earnings of 90 crore for next 10 years at 10% discount rate. We also plan to sell the business at 10 times it cash flows in 10th year. The intrinsic value comes at market cap of 900 crore. The current price reflects market expectation of OCCL’s owner’s earnings to not grow more than 90 crores for next 10 years.
If we are to use more realistic approach and assume 7% growth in owner’s earnings for same discount rate, the intrinsic value comes around 1,350 Rs/share. In this case, our assumption is that business shall be worth 15 times its 10th years owner’s earnings
Overall, the current market cap of 700-800 crore seems to provide reasonable margin of safety if we assume nominal growth. Any growth above 7% is a cherry on the top and provides further upside. The intrinsic value after testing all the above scenarios lands somewhere between 900 to 1400 Rs/share
I introduced the cognitive biases into my investment checklist after reading about Charlie Munger. These are psychological barriers that impede our rational thinking. Following are some of the biases I tried to answer to avoid blind spots.
1. Anchoring Bias – Relying heavily on the past performance of the business to make future decisions
Many things can go wrong with OCCL which can change the investment thesis and while I think it’s a great business at the current prices, I would like more margin of safety in case margins are to be compromised in future with Chinese competition entering the global market. My realistic scenario presents reduced growth for OCCL at 5-7% after we get out of auto slowdown and includes Chinese entry into the global market. I would be very comfortable to buy more at prices around 500-550. In a sense, I am not expecting past performance of 10% sales growth to be reflected in the future. If it does, that is the icing on the cake.
2. Neglect A probability – We tend to neglect an outcome by overestimating the present information into the future. Being ignorant of risks does not reduce them
Eastman controls 70% global market share and sets up the prices that OCCL has been benefited so far. Plus, the Chinese have not been able to enter the global market. Both events are possible that can reduce margins and return on capital for OCCL. If this scenario is to materialize, intrinsic value can drop up to 500 Rs/share. Thus, I have kept OCCL a small position at the moment.
3. Bandwagon effect – Following the herd mentality.
Mohnish Pabrai bought this stock in 2017 and sold within a year when it jumped from 520 to 1150. HDFC fund bought a 5% stake in August 2015 around 600 Rs a share. HDFC made additional purchase at 685 Rs a share in August 2016. Recently, LIC has taken a stake in OCCL in June 2020 around 750 levels.
I follow Mohnish Pabrai closely and while I could have his anchoring bias, this was an independent research stock personally. I feel good that brokerage houses have bought around the same levels. However, I have not gone all in all this stock to avoid anchoring bias and bandwagon effect. OCCL jumped 15% in July first week.
4. Hindsight Bias – Tendency to look at past events and think they were predictable than they originally were. Hindsight bias can prevent investors from learning from their mistakes. Thinking every investment, they made because of their keen judgment can impede future returns that are could very well be dependent on luck.
Insoluble Sulphur business looks very promising in hindsight due to multiple entry barriers discussed above however, the future may not unfold the same. This thesis is to help me in the future about what I thought about the business at the time and how it turned out to be.
5. Oversimplification – Investors try to oversimplify things they do not understand. Sticking to a circle of competence is important to avoid oversimplification bias. A great example of oversimplification bias is rain industries.
OCCL is a very simple business to understand, they are a pure play and does not have supply limitations. They need consistent innovation and Capex to expand capacities to meet the demand and business is worth owning due to high entry barriers, and high returns on capital.
6. Incentive Caused bias – Management outcome is highly dependent on what their incentives are. Review if the incentives are performance-based. Lucrative stock options can result in short term performance and not a long term
Management incentives are performance-based but not clearly defined. I am planning to reach out to investor relations to understand what the performance-based compensation is and will update this post. One thing that I noticed is that Management compensation increased even when business declined in 2013.
8. Confirmation bias – Seeking information that only confirms the belief we have and avoid looking at blind spots.
This is a big one and a hard one for me to overcome! I always try to seek out information that supports my thesis. I listed several risk factors above and want to make sure that I acknowledge them if they are to materialize and act, rather than stick my thumb in my mouth.
The key factors and events that could change my investment decision are as follows
- Management stops Capex or fails to execute expanding their capacity. If the company does not expand its capacities, it will not grow its sales.
- Management stops product innovation.
- Eastman drops Insoluble Sulphur prices due to competition or to become a low-cost producer. This could be seen through quarterly operating margins and conference calls.
- China Sunshine gets the global market share.
- There comes a substitute to Insoluble Sulphur
OCCL jumped out as a very simple business to understand after knowing its high entry barriers and global positioning. There is no substitute for the rubber or Insoluble Sulphur. The use of radial tyres is going to increase in the future. The global market share of tyre production is shifting from western countries to eastern countries, predominantly in China and India and OCCL commands 60% market share in India. While the auto industry is cyclical, tyre manufacturing is much stable business due to 70% share of recycled market. OCCL is a shark in a pond type of business that is a slow grower but can command high margins and high returns on invested capital which reflect many of its competitive advantages. The key driver for future growth depends on the Capex executed by the company. At current capacities, OCCF can generate owner’s earnings of 90 crores which shall command a minimum market cap of 900 crore for a 11% discount rate. Add a little bit of growth and there could be huge upside. Possibility of permanent loss of capital seems very low. Company generates enough cash flows to funds its capex and still leaves money on the table for shareholders. OCCL’s ability to become a significant player in such a niche market makes it an attractive proposition.