Is Indag Rubber a CLASSIC Value trap? – May be, May be NOT

 Note:  If you are looking for a precise answer, please do not read further. Let me tell you all at the outset that I do not have an answer. I have tried to do gather various bits of information, analyse the past cycle and present few concerns. If these concerns prove CORRECT, it may result in Indag proving to be a  CLASSIC VALUE TRAP, where investors make a mistake of buying a commodity stock thinking it’s CHEAP right at the start of cyclical downturn.

Indag rubber, a company engaged in Precured Tread Rubber [listed on BSE,  Mcap INR 100crs and EV 75crs] is currently trading at ULTRA CHEAP VALUATION of TTM PE of around 4x, EV/EBITA of around 2x and moreover its average ROE for last six years is more than 30%. If this is not enough it also provides dividend yield of around 4% and is completely debt free. What more a value investor wants?

Just a year back if I had come across any stock with above characteristics, I would simply buy it after a brief analysis [was always fearful of price running away]. But of late I have realised that buying CHEAP IS NOT ENOUGH [ofcourse the tuition fees was pretty high in terms of some of the dud stocks, which I bought].

So here are some of my concerns

Industry suffered for almost a decade [1995-2005] due to excessive capacity addition

“So what, it happened almost a decade back and Its different now. Moreover past history does not matter”. I think this is what most of the readers might be thinking. Here I would like to quote favorite para of Howard Mark from ‘A Short History of Financial Euphoria by John Kenneth Galbraith’

“There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” and another favorite quote by Mark Twain “History doesn’t repeat itself, but it does rhyme.”.

My analysis suggest that Precured Tread Rubber industry suffered for almost for 10 years [1995-2005] due to excessive capacity addition, possibly both by organised and unorganized segment. This was aptly reflected in Indag Rubber ROE, which averaged less than 5% and EBITA margins which averaged only 2-3% [1998-2005].Being a highly unorganized sector, I could not get the exact data, but I have used listed companies as proxy and some corroborative evidence to arrive at this conclusion, so chances are that I might be COMPLETELY WRONG.

Out of five listed companies in the same field, we have two companies [Vamshi Rubber and Elgi Rubber] for which information is available to some extent. Summing up the sales quantity of all the three companies shows during 1995-2005, sales quantity increased  at a CAGR of only 3%.

The reason for pathetic performance by Indag Rubber during 1995-2005, might be due to expansion by MANY new players like Vamshi rubbers.  eg. Vamshi seems to have set up plant around 1995 of 3,000 MT. Vamshi sales quantity increased from ~120 MT in 1995 to 2,000 MT by 2001. Ofcourse Vamshi seems to have adopted irrational pricing which resulted in huge growth in volumes but pathetic ROE [avg of less than 5% during 1998-2001 and ROE remain depressed till 2006] Even Elgi Rubber sales during the same period declined from ~ 12,000 in 1995 to ~9,200 .  Now the new truck sales grew at close to 9% CAGR during the same period, but there was no capacity expansion by any of these three players. Despite flat capacity, growing market size, their combined capacity utilization averaged 68%.

Now the following question arise

1)       Despite expansion in market size, Indag rubber suffered for full decade because of rapid capacity expansion and irrational pricing by small and marginal players. What happens if again competitors adopt aggressive pricing strategy like during 1995-2001?

2)      We need to find out details of peers expansion capacity? If peers are expanding rapidly, then there is HIGH probability that in near term we may face repeat of 1995-2005 period.

3)      Producers in SSI sector enjoy excise duty exemption [as per Vamshi Rubber annual report]. So in case demand slows down or there is massive capacity expansion by SSI sector, ASP and capacity utilization may crash AGAIN like in 1995-2005?

4)      My understanding is that retreaders are not obliged by buy exclusively from one company. So if ASP crash due to excess capacity or unorganized segment reduces the prices in face of severe slowdown, what will be impact on Indag Rubber. Is the quality of product is such that consumer will be willing to pay PRICE PREMIUM for Indag rubber.

Is historical growth sustainable?

During 2005-13, Indag rubber sales and EBIT had grown at a CAGR of ~ 30% & 50% respectively. I think this growth should be also be evaluated in the backdrop that truck segment had a DREAM RUN during FY2003-08 and grew at 20% CAGR and even after SEVERE decline in FY09 & FY13, truck segment grew at a CAGR of over 13% during FY03-13. Vamshi Rubber & Midas Treads which were selling at an average discount of 15-20% during 1995-2005, started selling at prices same as Indag. Indag rubber was quick to sense the future opportunity and massively expanded its capacity from 3,500 MT in 2005 to around 14,000 MT by 2010.

2007-11 Sales performance was a combination of both price and volumes. But I think a major role was also played by appointment of new dealers , which as per management increased from ~175 to ~350 over 2007-11. Does this mean that majority of sales growth was driven by new dealers?  I am not very clear on this and I think one needs to think through following questions

1) What was the major contributor to historical volume growth a) Growth in number of dealers b) growth in sales from existing dealers?

2) What’s the same dealer volume growth and growth in new dealers over next 2-3 years?

3) Can Indag rubber grow at high double digit over next 2-3 years when a) small operators profitability is under severe stress due to high diesel prices and flat to declining freight b) declining M& H CV may not impact the immediate outlook. But over next 2-3 years reduce the market size.

What if China slows down?

I know most of Value investors will JUMP and SHOUT, macro analysis and value investing CANNOT be used in SAME SENTENCE. I DISAGREE. It’s one thing making a MACRO ANALYSIS and betting your investment entirely on that and its altogether different thing to analyse if the risk really materializes. See this EXCELLENT presentation by author of  Active Value Investing [& a must read if you must to understand why CHEAP IS NOT ENOUGH, in current UNCERTAIN WORLD]

If the so called ‘China Bubble’ burst then rubber prices may decline or best case scenario may stay flat, so no more growth from ASP. It will be interesting to note that during 1995-2005, their ASP growth was only 2% CAGR. As the table no. 2 shows, during the extended period of decline in rubber prices during 1996-2002, Indag performance was pathetic on all counts.

 China share in global commercial vehicle sales/capacity > 35% and accordingly China accounts for ~ 34% of global consumption of rubber. So any slowdown in China may result in dumping of tyres, fall in rubber prices etc etc. Just look at Philips Carbon Black  to understand what can happen even to a player who commands more than 45% market share in a commodity market once China start dumping. Despite levy of anti-dumping duty by GoI almost a year back, imports continues through proxy channels.

a) Need to find out whether there is any import of  tread rubber from China and if yes, what’s the proportion?

b) If China does slows down, then there will not be any boost from extended increase in rubber prices like 2007-11. What will be volume growth for next two years?

c) The risk of dumping of tyres by China has reduced for now, but it CANNOT be ruled out completely?

Indag product quality is far superior. It will be able to command premium pricing even if there is slowdown or excess capacity. Really?

Now one can argue that even if some or all of the above concerns does play out, it would not impact Indag rubber much, as its product quality is far superior and that’s the reason its EBITA margins is far superior to its peers. I do not have any meaningful data to dispute this. But lets try to analyse different bits of information:

1. Players like Vamshi were selling its product at steep discount during 1995-2005, which had hurt the profitability of entire industry. But during 2007-11, its ASP appears to be on par with Indag and may be at very nominal premium compared to Indag.
2. In one of the interview this is what management said “There is not much price difference between products from organised sector.”
3. Large part of superior EBITA margin of Indag is driven by economies of scale, which is reflected in lower overheads compared to Vamshi.
4. Average gross margin per KG post 2005 is marginally higher than gross margin per KG during 1995-2005 . Company was not able to pass on the entire hike in rubber prices to end consumers during 1995-2011 [raw material cost increased at a CAGR of 7%, whereas ASP increased only at a CAGR of 5%]. See the below table. [Error corrected]

If quality is really better than unorganised sector, then the company should have been able to pass on the increase in raw material prices. So quality assumption need to be rechecked and re-validated. See the table 3 below

But it’s ULTRA CHEAP?

I learnt this lesson hard way that buying CHEAP IS NOT ENOUGH. Buying CHEAP is one of the condition but NOT the ONLY CONDITION.  For my STRAIGHT EQUITY investments where my holding period target is about 3-5 years [unless value unlocking happens before that], my simple rule is what Warren Buffet often quotes

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

To be very frank, I follow this in a modified manner. I look for companies which I think I will be comfortable to hold for next 3-5 years. Whatever is your expected holding period is, the lesson is NOT TO BUY companies which you are not sure will exist or even if exist maintain its revenue growth or margins for next 5 years. This rule should be followed even if your holding period is less than a year, unless its a special situation where the outcome is based on occurrence of certain event.  I know many investors may like to take chances with buying so called ‘Cigar Butts’, simply in the hope that they can sell when price become from ULTRA CHEAP to just CHEAP. It’s fine and given a right opportunity, even I might do it. But then one should realize that it’s NOT an INVESTMENT but SPECULATION and should size the bet accordingly and should be prepared for COMPLETE LOSS OF CAPITAL.

I am not suggesting that its IMPOSSIBLE for Indag rubber to SUSTAIN PAST GROWH OR MARGINS. But for me, there are too MANY MOVING angles and history suggest that in the event of extended oversupply, the pain can extend as long as 10 years.

So, what you want to say?

Here I will repeat what Amitabh Singhi [if you haven’t heard his name, read this interview] mentioned about his reasoning in investment in Balkrishna Industries and other similar type of investments.

“This company has been bought as a part of group of companies which are all into expansion stories. If the expansion goes awry then the company may not do well, but the group as a whole should do fine”. In one of his interview he also quoted “25 to 30% of my portfolio is in companies that are growing very fast and they are all expanding 2X or 3X in capacity and trading at 4X forward or 7X current earnings. So, if the expansion happens we will make 3X; if the expansion does not happen then we will lose 30-40% of that individual stock, which is a big thing for us. That is why we have spread it over a basket of five stocks.”

So investment in companies like Indag rubber which does not enjoy any STRONG ENTRY BARRIERS and also do not have any STRONG PRICING POWER and risk of HIGH COMPETITION always remain from LARGE UNORGANIZED SECTOR should be made only when they are expected to grow HIGH DOUBLE DIGIT over next 2-3 YEARS.

Finally TELL ME whether Indag Rubber is a value trap or not?

I do not have any answer for that. But if one is able to answer most of the queries raised above, one should be able to take the call. Lastly, I would like to remind readers of three important Murphy Laws

1) If you perceive that there are four possible ways in which something can go wrong, and circumvent these, then a fifth way, unprepared for, will promptly develop 2) Anything that can go wrong will go wrong. 3) Everything goes wrong all at once.

All the three laws played out VERY WELL, after I bought a commodity stock, with big risk of dumping from CHINA.

For Indag, many of the risks highlighted above had been played out simultaneously during 2001. Have a look at the extract from MD&A. [click to enlarge image]

Disclaimer

• All the posts on this blog, including this one, are for educational and discussion purposes only.
• None of the material posted should be regarded as advice to buy/sell any stock. I DO NOT have any PROVEN stock performance record to talk about.
• As a professional investor, I may have positions in stocks discussed or buy/sell before updating my change of opinion on the blog.
• Main objective is to seek CONTRA VIEWS and NOT to recommend any particular stock as buy or sell.