Please mind the Gap

First up a disclosure – This post is about a company whose business falls way outside our circle of competence (its more like a dot of competence J in our case). However, we are still inclined to stick our neck out because Mr. Market’s behavior (or rather the lack of it) has surprised us. Your views are sought to lend greater clarity to our thoughts.

Commanding Respect

Clariant Chemicals (CMP 635) is one of India’s leading specialty chemical companies and is the No.1 player in Pigments, Textile Chemicals, Leather Chemicals and Biocides for paints. Majority held (63.4%) by the global giant Clariant AG, the company in India employs more than 900 people across various facilities and generates roughly 1000 cr of topline. Clariant is widely respected in the Indian investor community for its transparent governance and a clean capital allocation record. The company has been extremely liberal in its dividend payout policy having distributed between 60-80% of its annual profits to shareholders in recent years. More details on Clariant can be found on their website

Let us first look at some broad financial metrics of the global listed entity and its Indian subsidiary. Global figures have been converted at 1 CHF = Rs. 60/-. Figures have been approximated for easier reading.

All figures Rs cr	Clariant AG	Clariant India
Sales CY 11	44000	1000
EBIDTA CY 11	4700	175
EBIDTA Margin	10.6%	17.5%
Net Debt	10000	(200)
MCap	22000	1700
EV	32000	1500
ROCE%	8-10%	25-30%
Mcap/Sales	0.5	1.7
EV/Sales	0.7	1.5
EV/EBIDTA	6.8	8.5

As is evident, the India business enjoys substantial premium valuations as compared to its parent. Reasons are not difficult to attribute. Higher growth outlook, better margins, absence of leverage and clean balance sheet, healthier ROCE and probably many more. So far, so good..

Interesting Developments

The reason for this post is the recent divestment at a global level of Clariant’s textile chemicals, paper specialties and emulsion business to a PE investor SK Capital (link). The details of the deal encompassing the whole R&D, applications, sales & marketing organization along with production plants and sites is as under.

All figures in Rs cr	Clariant Global
Divested Business Revenue CY12E	7200 cr (~15% of overall)
Divested Business EBIDTA CY12E	480 cr  (~ 9% of averall)
EBIDTA Margin	6.7%
Sales Consideration	2750
Debt to be transferred	250
EV	3000
EV/Sales	0.4
EV/EBIDTA	6.3

At the outset, it is evident that the deal has been struck at valuations which are closer to the global parent valuations and are at a substantial discount to valuations of the Indian operations.

Also, these valuations are not out of line with transactions which have happened in the similar space in recent years.

Is the deal good for Clariant India’s minority shareholders??

Being part of a global divestment, the respective business, as well as the facilities of the India subsidiary are part of this deal. This is ofcourse subject to legal requirements like shareholder consent (which given the majority promoter holding is unlikely to be a major hurdle).

Firstly, what does Mr. Indian Market think about this deal?? While not rejoicing, markets seem to be largely unconcerned. The stock went up 4-5% in the intervening last week but is now back to levels similar to the those on the date of the announcement.

Infact, given that the deal has happened at substantial discount to India valuations, the fact that markets are not worried is surprising and could only mean one of the following in our view.

1. The divested businesses are an insignificant part of the India business, thus the market thinks that the transaction is irrelevant or
2. Divested businesses are a significant part, but the Mr. Market expects Clariant AG to pay top dollars to Clariant India in line with Indian valuations (at a substantial premium to deal valuations) and Clariant India in turn to reward shareholders handsomely as in the past

So, firstly are the divested businesses a significant part of the India business?? Unfortunately, we don’t know for sure. Clariant India has so far chosen not to put out basic information like revenue, profitability, capital characteristics of the divested business in the public domain. They must be having their reasons, but all we can say is that such lack of transparency in data which is critical and should normally be shared is not befitting the high standards of governance displayed by the company in the past.

What we do know however, is that the sold businesses are a subset of the Dyes and Speciality Chemicals segment with CY11 revenues of 577 cr (60% of India revenue) with an EBIT of 86 cr (57-58% of EBIT) and are produced at their plant in Roha.

Given the large size of the textile & paper industry in India, the companies leadership position in the textile & paper chemical industry and anecdotal evidence like the emphasis given in the AR to these businesses, we think that it is safe to believe that the divested businesses are a significant part of the overall business.

Our educated GUESS at this stage (if you have other views, pls do share) is that they should be contributing in the region of 300-400 cr (30-40% of overall) sales. Assuming 10% EBIT margin on a conservative side, this still gives us 30-40 cr of EBIT (20-25% of overall). If the above be conservatively true, then the attributable value should be roughly 350-400 cr for this business (average of 1.7x sales and 8x EBIT, assuming uniform capital characteristics for the business) as per current valuations.

Is Clariant AG likely to cough up this sum?? We remain unsure..Why??

1. The India piece is likely only about 5% of the global divested business. A sum of 350 cr is 12-13% of sales consideration. Would the global company be willing to value India at a substantial premium. Put differently, are they under any compulsion to keep in good humor the Indian market’s valuation judgement? If India business eats some extra food, who goes hungry??
2. The parent has high debt and one of the goals of the divestiture is to delever and  improve profitability. Sending money to India to distribute amongst minority shareholders does not serve the purpose. One can argue that a hefty dividend in India will go back to the parent. But this will involve forex risk, time, process as well as dividend distribution tax. We consider this improbable.

Conversely, if India valuation be done in line with global valuations, then only 150-175 cr should be forthcoming, which could finally surprise markets negatively and lead to a base case collapse of 200-300 cr (higher/lower if revenue/profit contribution of divested business is higher/lower that assumed) in market capitalization. This does not take into consideration any accompanied pass through effects of the wearing off the good governance halo.

Ofcourse, all this assumes that markets efficiently priced Clariant India pre event correctly to begin with. Which by itself may be asking too much from Mr. Market J

On a broader note, the events have taught us about a risk which till date atleast we never considered while investing in MNC stocks ie possible implications of M&A activity on stocks with a large difference in parent and Indian subsidiary valuations…We are sure one can discover quite a few examples of wide gaps in valuation.

We are keenly watching the space, if only from an academic interest.

Best of manufactured Luck !!