Wednesday, April 17, 2013

A swan or an Ugly Duckling ??

In Feb 2012, the promoters of Numeric Power (now Swelect Energy Systems) chose to sell its core UPS business (roughly 90% of revenues and profits) to Legrand for ~ 825 cr through a slump sale.
After paying tax on the transaction and repaying all debt, it was expected that the company would still be left over with roughly 550 – 600 cr. Available at a market cap of 250-300 cr, wasn’t Numeric a screaming buy?? Well not really!! Mr. Market probably did not like two things 1) The slump sale as against the sale of the company itself side stepped the takeover code regulations thereby leaving the minority shareholders at the mercy of the promoters and 2) While a special dividend was declared and absorbed roughly 135 cr, the balance sale consideration was retained in the company for seemingly unrelated diversification (solar energy in this case). Those seeking a value trap might still find the stock interesting at an odd 50% discount to cash on books.

Ofcourse Numeric was not the first and nor the last that this theme has been played out in markets. Names which come immediately to mind are Kanoria Chemicals, Amrit Banaspati, Borosil Glass, Carol Info, Piramal Healthcare and more recently Strides Arcolab. While Amrit and Carol have since been delisted, some others are still available at near/large discount to cash.

Is this case any different??

While Mr. Market may be understandably worried on the above counts, to us it would seem that the same yardstick has not been applied in the matter of Clariant Chemicals (CMP 470, Mcap 1250 cr), a case similar in some areas and even more brazen in others.

After nearly 3 long months of silence accompanied by roughly 25% destruction in market capitalization, details while insufficient are finally beginning to emerge on the divestment of certain businesses of Clariant Chemicals to SK Capital. Ever since we raised some apprehensions on the deal in this post, we have been following the developments.

First, in a meeting in end March, the BOD of the company approved the slump sale of the textile chemicals, paper specialities and emulsion businesses together with their dedicated assets for a princely sum of 209 cr. While minority investors hungry for information should be grateful that the board chose to share how much the company will get from the sale, if they also expected to be informed simultaneously what was getting sold (revenue, profit, capital employed), they had reasons to be disappointed. The media release had little for them other than some strategic rhetoric.

The CY12 annual report however had some important pieces of information to offer. It disclosed that the divested businesses account for roughly 35% of the net sales of the company which should thus be in the region of 375 cr. Ideally, the annual report could have come clean with the profit and capital employed data as well but shall we say they again ‘missed’ the fat pitch.

In a surprising decision to say the least, the company has now chosen to send the postal ballot notice without this important data. While it is stated that all material information has been provided, we beg to differ. In effect, the company expects shareholders to assent/reject a sale of business telling them what they will get (209 cr) as compensation but not what they are selling/giving away (profits, capital employed). How only the revenue number is considered to be material and sufficient data for decision making leaves us baffled. However, we must move on with some assumptions since markets will not necessarily wait for all information to emerge.

In the annual report, while the directors expectedly in their judgement have assured shareholders that the sale is in their best interests, other interesting takeaways from the Management Discussion are reproduced for the benefit of readers.

The industry is increasingly shifting to Asia in consonance with the shift of its key consumer industries. This has led to share of Asia in the global chemical industry increasing from 31% to 45% between 1999 and 2009. With Asia’s increasing contribution to the global chemical industry, India emerges as one of the focus destinations for chemical companies worldwide.

Compared to the developed countries, the current penetration of specialty chemicals within India’s end markets is low. However, the huge potential of domestic demand and low per capita consumption in each of its industry segments compared to world average provide a strong potential for overall performance for Indian chemical industry. With an increased focus on improving products, usage intensity of specialty chemicals within these end markets will rise in India over the next decade.

Majority of global dyes and pigment manufacturers are shifting their operations to India and China, as REACH regulation is increasing their cost of production in majority of the European countries.

The dyes segment is highly fragmented in India due to excise concession provided for the market participants. This segment has an inherent element of value addition to a wide variety of products like textiles, leather, paper etc. The Indian textile industry which accounts for about 4% of Gross Domestic Product (GDP), accounted for 14 percent in Index of Industrial Production in 2010 and acts as one of the main drivers of the economy. The industry consumes about 80 percent of the total dyes consumed in India. The growth of the dyes sector thus depends considerably on the performance of this industry. Clariant is a major player in the filed of dyes and chemicals and plays a key role in providing innovative and sustainable solutions throughout the entire supply chain and all segments from fiber to finishing of textiles and retanning to finishing of leather. Clariant provides knowledge and expertise in the management of whiteness, coloration, special coatings and strength and offer products to improve optical and functional properties of all kinds of paper and board.

On reading the commentary, the following thoughts come to our mind (Our views in italics)

  1. While cautious on certain counts, it seems to us that the management is generally positive on the future of the divested businesses in India. This is backed by the common knowledge that India along with China & other South Asian economies is fast emerging as the global hub for textiles. Even in paper while developed economies are witnessing volume contraction, India is expected to show reasonable growth. While the divestment could be good for Clariant at the global level, is it right for the India business?? Maybe not...
  2. Had the Indian business been kept out of the deal, could there have been a risk to the deal itself?? Probably Yes..
  3. If that be true can the sum of 209 cr considered to be fair consideration?? We think not..
  4. And lastly the tricky one!! Does a 2/3rd business owner have the right to sell a material part of the business at a huge discount without sharing complete information and showing total disrespect to the value attributed by the market?? While in letter yes but good governance is all about the spirit isn’t it??

On what counts can this case be compared to Numeric Power & others?? In the case of the others, while revenue contribution of divested businesses was higher, we think 35% contribution is material nonetheless. Also, in those instances, businesses divested were generally at a large premium as compared to market perception of value and thus the sale was justified in some sense. In the case of Clariant no such comfort can be derived since the divestment has happened at a huge discount. And last but not the least, while at the mercy of promoters, the residual cash in the earlier mentioned cases is atleast still in the listed entity. The same cannot be said in the case of Clariant where it can be argued that the India business was one of the jewels the acquirers were courting and willing to pay a premium for, while the promoters have already been merciless by providing inappropriate consideration. While the parents strategic and financial goals may have been met through the deal, minority shareholders in India are probably wondering who ate my cheese!!

In our eyes, what we thought to be a swan all along turned out to be an ugly duckling!! Infact the ugly ducklings in comparison are beginning to look like swans.

Was it an ugly duckling all along??

Did we miss calling a spade a spade?? What lead to the perception that the quality of governance at Clariant Chemicals is the best in class to start with??

We think the reasons are primarily two

  • The fantastic track record of the company in the payment of dividends as a % of distributable surplus and
  • The fact that it is an MNC

Out of the two, while many might believe that the primary is the first ie dividend record, we think it is the latter ie the foreign parentage. If healthy dividends were to be a measure of good governance alone, PSU enterprises would automatically top most of the charts which they probably don’t. However, most companies with foreign parentage are blindly considered to be high on governance. While Indian governance is considered guilty until proven innocent, MNC governance is considered innocent until proven guilty.

This in our view is a classic case of Representative Bias. The same unfounded reason why blondes are considered less than smart and some communities are considered stingy while some others are considered enterprising. For the record one of us is a Marwari while the other is a Gujarati... : )

It would be interesting to see the reaction of markets to MNCs if for example Nestle chooses to sell Maggi globally at global valuations or likewise Unilever were to sell its oral care business. We have generally been wary of paying a premium on account of MNC parentage.

Cut the chatter!! I am a Clariant shareholder..

Existing shareholders of Clariant might be tiring of our ranting and theorizing by now and more interested in a discussion on the future course of action. Actually this post was more from a perspective of raising an issue we thought to be of relevance as compared to a stock view. Nevertheless, emboldened with the success of our previous guess, here is how we would have looked at the stock had we been shareholders.

The company in CY12 made an EBIDTA of ~135 cr with a margin of 12.6%. Using similar margin % for the divested business on a revenue of 375 cr gives us an EBIDTA of ~ 50 cr which the company will now forgo, thus leaving us with an EBIDTA of ~ 85 cr. Given that 1) The halo for the company has worn off in our eyes 2) The company is reported to be looking to sell its leather chemicals business at a global level for which minority shareholders should expect similar treatment and 3) Better available opportunities in the current market environment, we would not be keen to value the company at a premium to its parent valuations ie. ~ 7x EV/EBIDTA translating to an EV of ~ 600 cr. Clariant India (CMP 465) is available at an EV of 800 cr (post inflow from the divested business). Broadly speaking, we would not be surprised if the stock were to lose a further 25-30% from current levels. As always investors are requested to make their own judgement before buying or selling.

Those choosing to hold, may wish to consider rejecting the slump sale in the postal ballot.

Best of Manufactured Luck!!


  1. Replies
    1. Thanks Anil,

      As always you are unduly kind with your words :)

  2. I am a shareholder of Swelect energy formerly Numeric Power and it is not an ugly duckling:
    1.As against other companies, Swelect gave a decent dividend of Rs 100. Intelligent Mr Market was valuing a company with cash of Rs 500-600 crore at Rs 300 crore on record date. After 100 crore was subtracted, the market was valuing it at Rs 140 crore. In one day the discount increased from 50% to 75% i.e. potential returns became 300% instead of 100%
    2.The promoters were already into clean energy sector. UPS manufacturing was getting tough competition from China and Numeric itself was buying from China and trading in Indian market.
    3.They have targeted Solar EPC market in India (thereby reducing Solar commodity risk)
    4. They have bought majority control of HHV Solar,a one of its kind company in India which exports Solar cells; at a dirt cheap price of Rs 22 crore.
    5. The promoters have not talked much in the past but they are professional. Chellapan is the patron of local chapter IEEE and his daughter is a Phd in Solid State Electronics. They know what they are doing.
    6.Solar Industry is a hugely capital intensive industry although with assured returns.

    Please revert back if you have further insights.

    1. Hey Bagdu,
      The post is actually about Clariant and Numeric is only used as a valuation example. We do not have any specific views on Numeric

  3. Hey - hopefully, there's still a way out. Personally, I loved what happened for Atyant Capital and other shareholders wrt International Paper/ AP Paper -
    It's quite interesting - the kind of risks in investing; this one is actually quite absurd but still believable. Best wishes man.

    1. Hi Tirath,
      Thanks for the interesting link. The question of course is who will bell the cat..
      One tricky difference in the AP Paper deal and this one is that there the non compete was quantified, in this case it is in the domain of judgement as to whether India business has been sold intentionally cheap and promoter shareholders have benefited unduly..
      cheers and Best of Luck

  4. i know you guys have tried to do a rational valuation, but my thought process is that how can one do a rational valuation if you business partner is a thief ?
    the list of such MNC is endless...look at how money is being taken out by so called royalties by some MNC, unlisted subsidiaries in some cases, all kinds of delisting and now these slump sales. the list goes on and on

    as the saying goes - in rome do as romans do. MNC have decided to follow the indian corporate governance ethic. frankly they are worse than some of the shady promoters we have ...atleast the shady guys dont claim to be full of virtue !

    end of rant :)


    1. Hi Rohit,
      Even if a rant, its always good to hear your views :) Agree with your thought that conventional valuations are meaningless when management integrity is a question mark..