Analyzing Deemerger Strategy for OCCL

Namaste investors, this is Dhruv Bajaj from SmartSync Services. Deemerger is an interesting strategy through which you can generate new ideas and at the same time, historically it is proven that deemergers generate far superior alpha than any other strategy. So in today's video, we will talk about such an interesting deemerger, which is a market leader in its space, which has very high entry barriers and whose margins are currently at almost 10 years low. So it's not like that the stock is performing well, we are presenting it. And at the same time, interestingly, in the last 10 years, that stock has given negligible returns. So I will just discuss the good and the bad about the business so that you can understand more about this business and why it trades in a particular valuation and what is the key catalyst which makes it interesting. Again, standard disclaimer, I have no investments in this business. It is just a case study. So with that being said, let's start the session. Sir, there is a famous quote by John Templeton The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell Since the market is doing well at the same time there are certain pockets which are performing so well So we are looking for some companies where there is a lot of under performance and a lot of pessimism in the current market and one such company is Oriental Carbon and Chemicals Limited which we will call in this video as OCCM OCCL came on our radar because a demerger was announced like 2 years back Where they are demerging their investment business Again to understand it more briefly They have 2 key business segments One is the Chemicals business where they make family insoluble sulfur And the second segment is where they have investments in a listed company called Duncan Engineering Which is the same group's company where they have 75% stake At the same time, they have a lot of investments in other AIFs and startups like Bira. So, its cumulative value is around 100 crores. So, one division is where they have invested. And the other division is where they operate chemicals. Now, generally, the issue in such a structure is that when you have a holding structure, wherein you have investments in a particular business or startup, then the value of your market and investments It gives you market valuation on a discount. So for example, if I have an investment in a particular business, let's say 100 crores. And if I want to list it, then the market will not give me 100 crores market capitalization in the value of 100 crores. If it gives me a 50-60% discount, then my market capitalization will be only 40-50 crores. Even though my investment value is very good. And the problem with this structure is that many times when your two... different types of businesses are structured together then your other business may not be valued by the market that much because your demerge entity means your investment business for example in this case you have invested a lot of capital in it no doubt but your earnings are not that good because when its majority value comes that comes from appreciation in investments or whenever we sell investment so at one place your investment or your total capital employed will be high But at the same time since all your earnings and profits are coming from only chemical business So naturally your overall blended ROC will be less And the valuation multiple that your chemical business could get Or the market capitalization that your investment business gets by discounting That is not available because of this complex structure So what they are doing is that they will list their chemical business separately Into OCCA Limited and their other business which is investments will remain in the existing listed entity. Now with that being said, the investment business of this DIMM will be handled by Abhimanyu Kumar who has a good grip in finance. And July 1st is the record date for this demerger. And the record date basically means that if you have OCCL Limited's share on that particular day, then the resulting entity, which in this case is chemical business, you will get its shares when that business is listed separately. So again the idea here is that since the business is going on in a complicated structure, so if we de-merge it, then better, I mean, efficiency will come in operations as well, and at the same time, it will also give market valuation multiple. Now if we look at the industry's overview, which is its chemical business, then they make insoluble sulfur, which primarily has an application in radial tires. Now there are generally two types of tyre, radial tyre and bias tyre. And the cost of radial tyre is generally a little more versus bias tyre. However, because of its certain properties, like radial tyres, their life is very high. So naturally, the adoption is increasing from bias tyres to radial tyres. And since as the adoption of radial tyres increases, then naturally insoluble sulphur manufacturers like OCCL will benefit. Now this particular industry or its chemical In this case, it is being understood that its demand That will be dependent on tyre consumption And this industry is very niche There are very few producers in the market of insoluble sulphur Now the major work of insoluble sulphur is It works like a vulcanizing accelerator in rubber industry Due to which more adhesion comes in rubber and the rubber that can break apart generally does not happen so more endurance and strength comes and resistance improves Now in this particular segment Indian, Japanese and American companies are the key players Asia Pacific is the largest market and the market was consolidated for many years However, recently China has added a lot of capacity in this particular industry due to which many issues are also coming in the past 3-4 years and pricing In the last 2 years they have been in a downward trend And since Auto cycle is not performing so well in the last 2-3 years At the same time The supply has increased a bit So naturally demand supply scenario Is not working out so well for the producers Of this particular chemical And exports have also become very difficult for them Because India's market is very small And in this OCCL has a market share of 55-60% Currently So naturally If your exports are hurt because when Red Sea Crisis came, many exporting clients like Europe, USA, for them Europe is majorly, they were delaying their orders because of this crisis. And naturally, since your demand also decreased and your freight cost also increased because of this Red Sea Crisis, then your volumes were getting hurt a lot. And market is again very mature. There is not going to be a very fast growth in this. So this is not a very fast growth story. Now if we understand about the company, this company is a market leader in insoluble sulfur in India. This is a company of JP Goenka Group. Their manufacturing facility is in Mundra, that is in Gujarat and Haryana. Now they are following all the key regulations and policy compliances for a long time. And this company is listed for a long time and their past track record is very good. You can see that in the last 15 days, their Kager Revenue is 13% and packed. or 19% and their key market share in India alone is 55-60% and globally their market share is 10% so again this is a market leader in insoluble sulfur space now if we try revenue mix money so their 88% of the revenues come from insoluble sulfur and the remaining 12% comes from sulfuric acid historically they used to get good revenues from sulfuric acid But because in the last few years, its pricing has gone down a lot, so naturally its contribution to the overall revenues have reduced. Now if we look at their total manufacturing capacity, then Insoluble Sulphur has 39,500 MTPA and Insoluble Sulphur has 88,000 MTPA. And since I discussed that the benefit of the domestic market is very small, so 50% of the revenues come from export. We try to understand their business and why it is not looking interesting from a competitive advantage positioning. So their clientele is very strong. So all the major global tyre manufacturers like Goodyear, MRF, Bridgestone They all produce products from this and then producing this particular chemical by themselves. And since I told you that this is a commodity type C, it has end-user tyres and you can't bring much differentiation assets in the product. So if we have to analyze a commodity business, so key competitive advantage for any commodity business is their cost competitiveness. So this company as per the investor presentation tells that they are very cost competitive. Because they easily get the raw material supply. Secondly, since they have a plant in Mundra, so naturally it is a little more simple to export for them because they have the port. Then again, they have been operating the business for many years and operating on a good scale. Global market share is 10% So naturally fixed cost will increase And they get benefit of economics of scale And they are working on power cost optimization And bringing renewable energy Overall, their power cost will be reduced. And since their plant is in Mundra, Since it is an SEZ, that is Special Economic Zone, They got tax benefits too. As we discussed before, this is a very niche market. And if I am a insoluble sulphur manufacturer today, It will take me 2-3 years to get approval from any tyre manufacturer. So since customer approval is very tough, You will have to do a lot of major capex if you want to bring its capacity. Initially, you have to spend a lot of money in R&D to make this chemical. So, naturally, the entry barrier is very high in this. So, in India, there is no domestic manufacturer of good scale in insoluble sulfur except OCCL. And we can see that their domestic market share is 55-60%. Now, we understood this from the point of view of business competitive advantage. But a key mental model may be applied here if this successful idea is made. So that is revision in ROIC. We had previously discussed in a video that when you buy a business on lower ROIC that is return on capital employed and by the time it matures as an investment its ROCE or ROIC increases. So then your best returns come versus buying a stock which already has a good ROCE. And ROCE has one key driver, one key variable, that is margins. So, if we see its case, so we can see that now, whatever margins are there in the last 2-3 years, if we see their 10 years margins or median margins, for example, then they are trading below that. So, for example, their median margins are roughly 25%. So, currently, they are trading around 20-22%. And since we have given this particular company top... margin that is 30% margin so we have a good understanding that margins can be bottom in the near term and if demand side improvement comes and positive characteristics come in industry so these margins can go upward so that is what I mean that margins is at an all time low that is your ROIC can also trade at all time low now the important thing to understand is that margins Why did they fall in the last 2-3 years? So, the key part that I got from the credit report was that there has been a lag in transferring the price increase to customers due to which the company's margins were impacted materially in 2022. So, I got the idea of 2022. But why are the same issues coming in the last 2 years? So, some key issues plaguing this business is the demand side scenario is going very poor recently, as I have discussed earlier. and naturally if your demand is poor, then your realization will also be lower and since China is getting a lot of capacity and China was not a very dominant player in this particular industry so naturally if they are getting a lot of capacity and existing players have enough capacity to service the entire industry's demand so naturally your supply side will be much higher than demand side so from there also you will get a lot of pressure and the price that you want to pass to customers where the price of your raw material increases you will not be able to do that. So your bargaining power which should ideally be there for any business which has high entry barrier, that is not saved. And again as I discussed before, the prices of their key raw materials are also increasing and their freight cost is also increasing a lot. And this is a major issue for them because around 50-60% of their revenues come from exports. Now one interesting part I found regarding this business is that EVs can't disrupt them. Whether it's an ice automotive vehicle or an electric vehicle. Tires are required for everything. So naturally, if there is a disruption of electric vehicles, then also insoluble silver manufacturers won't have that much effect because they cater to the tyre industry. And in their business, basically, it's a B2B business. So the relationship is key. And since they are one of the largest players in the industry and they have been operating in the business for many years, Naturally, their relationship with B2B is very strong. So, there is an entry barrier. And again, in the last 10 years, their ROC has been greater than 12%. So, we have understood that even though the business is good from a competitive standpoint, ROC is able to maintain it well. And the best part here is that the management team is very interesting to me. They have done a very good job in the capital allocation side. So, when they were starting the business, they were... They also made carbon black, which is used in tire applications. But gradually they realized that they don't have 14 and they don't want to make such a good business. So they sold that business to someone else. And their focus is always to make good ROEs And if they see, as they announced earlier that they are doing capacity expansion of 11000 MTPA So in phase 1, they had made a capex of 5500 MTPA But as phase 2 was about to start, they realized that although we are increasing the capacity But the demand side is very poor and the utilization of our existing capacity is not that good So they aborted phase 2 at least for that particular moment So that shows that their primary focus is only not to bring revenue growth rather their focus is on how you can generate good ROEs on a particular revenue and since promoters have 51% stake in the business so there is skin in the game too and the recent effort to do demerger also shows that they are very much focused on shareholder wealth creation so if we understand their capital allocation more then they have generated roughly 50% of their capital in cash flows They are doing payback in the form of dividends or buyback. And as I discussed before, they have curtailed their CAPEX major. And their next year's plan is that whatever cash flows they generate, they will first pay off the debt. After that, they will think about buyback, dividend or any new business segment. So in that sense as well, capital allocation looks pretty interesting. And again, the best part for me here is demerger. Where they are trying to create a clean business structure. So I actually asked this question to the management that what is your plan regarding demerger and why is it important? So he clearly said that since the current structure is very complicated so demerger is essential to unlock value and give our shareholders and investors clean companies to invest in. So today if I want to invest in a chemical business only then I can invest in a different business like a chemical business. And similarly if I feel that the price appreciation of their investments can be very good and market is not giving him such a good valuation so I can buy it separately but at least I am getting an opportunity to choose which business I want to invest in so in that sense demerger is very interesting and as I said before demerger will be a good capital allocation now why will it happen? in the past few years, the issue in the business was that whatever was generated in their chemical business in cash flow, instead of paying out completely as dividends or doing capex in their core business They were using the cash flows of that business to make investments in other places. As we have discussed earlier, there is a risk in investments whether your investment is successful or not. And secondly, whatever investments you make in that business, the market does not give you a good valuation multiple. It gives a discount to it, which we call holding company discount. So naturally, the issue that was coming in the past was that they were using the cash flows of the chemical business in the investment business. So, maybe there was not as good shareholder wealth creation as it was possible. So, I wanted to know that even if their investment business is listed separately, then how much cash flows did they get to reinvest in that particular business? So, are they planning to use the investment business after the cash flows of the chemical business? So, the management has explained it very well that whatever investment they did in that segment, they will sell it after demerger and the cash flow that will come from it, they will reinvest it again. And... OCCL, the chemical segment, whatever the cash flows will be, they will use it separately. So, the fast-paced risk of capital allocation that the chemical business's cash flow is going towards investment instead of dividends, will be resolved further. So that again, the structure of capital allocation, the strategy, will be improved a lot from the investors'point of view. So in that sense, it looks very interesting. But we have discussed a lot of positives, but still, I am not invested in this business. So what major risk I am facing due to which I am currently just tracking this business and not investing So let's find out So the first key issue here is again dumping from China China has got a lot of good key players in insoluble sulfur space And as I have discussed earlier that globally Oriental carbon is one of the major players in this industry However in the recent past 2-3 years especially China has got a lot of good capacity expansion in insoluble sulfur segment And we will see that the total addressable market size of Insoluble Sulphur is as it is very low And its growth will also grow according to the tier industry And tier industry is slated to grow at 3-4% in the coming year So if we think that the radialization will improve and the growth of Insoluble Sulphur will be better Still it can be around 6-7% growth So your industry's growth is not that high and at the same time new players are coming in the industry So someone actually mentioned that China Sunshine is a China based company which 30,000 tons capacity and the company's own capacity is only 39,000 tons. So it shows that there are going to be a lot of issues in the capacity side. And management actually mentioned in their ER that is annual report that dumping of insoluble sulfur by China into India is a key risk for them. And the main issue is that it is not clear when it is going to stop because every quarter I feel that the situation is improving now, the bottom is made. But then we get a surprise that more dumping is starting from China or demand is not good enough due to which more fall in pricing can come. So, management had mentioned in a recent corn call that when their Q4 corn call happened that the prices in export have fallen in the last particular quarter, which flow through will come in the next quarter. So, it is likely that in the next quarter their realization for insolvent sulfur will not look so good. So, this is an issue that is being faced that now One of the management's point is that as demand in China itself revives, so maybe the issue is that China is not performing well in the local industry and since they have a good capacity, they are dumping the same capacity in other countries. But if the local capacity is revived, the domestic demand is revived, so maybe the issue of global oversupply and demand can be resolved. So again, this can be an interesting thing to plot, but currently there is a situation where oversupply is present, no doubt. And another key risk is again, supply is greater than demand. Which I mentioned earlier, that the market size is very small. So if more dumping comes from other players, like American, Japanese, and Chinese, then there will be a lot of issues for these Indian manufacturers. Since the demand for insoluble sulfur comes from tires And tires are dependent on the automotive sector And automotive sector is a highly cyclable one So this can also be a volatility going forward And their raw material i.e. sulfur and coating oil They are also volatile And as we saw during 2021-22 period Because the raw material prices increased But they couldn't pass on the same thing So they had a major hit in the margins And their working capital intensity, capital cycle is a little elongated whereas their inventory days are around 120 days so if there is a major fluctuation in their raw material or suddenly they have made finished product of insoluble sulfur but globally the pricing of insoluble sulfur suddenly falls so there can be some issue in their margins and naturally ROC will also be less if your working capital cycle is very large And the biggest risk for me is again low growth business. Here volumes are not going to grow much because in industry OCCL itself is at a 10% global market share. And in India it has a market share of 55-60%. So although in India there is a scope that people should increase the market share which I will discuss later. But globally their aspiration is that they should increase it from 10% to 12%. Because USA is a very uncharted territory for them. So from there if growth comes good then growth can come there. But still if it reaches 10% or 12% then I don't see that there will be a good volume growth in this business in the coming decade And the export scenario is currently going slow because of the issues in Europe and the Red Sea crisis So overall the situation seems very benign and with China dumping in Indian markets recently Issues have increased more And as I discussed before, its total addressable market size that is very small. So, I actually recently company has filed anti-dumping duty in Indian markets wherein they believe that producers from China and Japan are dumping that insoluble sulfur in India at a much lower price. So, I wanted to take this understanding that if domestic capacity suppose demand is 40-50 thousand MTP and your own capacity is 30 thousand MTP then naturally supply will come from outside so, there is a scope that anti-dumping duty will not be successful because there is a scope So I asked this question. So management has explained that domestic demand itself is only 20 to 25, 2000 tons per annum and their own capacity is 39,000 tons per annum. So if they want, they can cater to the demand of India alone and still they will have 50% capacity that they can use in export. So total addressable market size is very small and margins which is my The thesis was initially that maybe there can be a mean depression wherein the current margins of these people are trading at a decade low and since if the industry rebounds, then margins can improve. So, management has said in the con call itself that in the next 2 years, we don't think that there will be any improvement in the margin. In fact, the margin of the next year will be poorer than FY24. Now, there is a case that since the business is not operating so well since last 1-2 years and thereby, management may have tried to over deliver under the promise and became a little pessimistic. Because naturally, if you handle business on a daily basis, you will become a little pessimistic during poor times. And when the good times are going on, you will also be more optimistic. So it is a natural human tendency. But one major risk is that our initial thought process was that mean reversion can happen and margins can improve. But at least according to management, it is not visible in the next 1-2 years. So why does this make business interesting? I have made so many negative points but still we are very interested regarding this particular business. So the answer here is valuations. But before we talk about valuations, it is important to understand the terminal value perspective. I have discussed earlier that the trend of radialization that is the shift of the bias tyre in radial tyres that is the value migration is improving a lot and it will keep on increasing so the insoluble sulphur content in radial tyres that is around 1.7 times and as the radial tyres keep on increasing the demand of insoluble sulphur will also keep increasing so in that sense there are some prospects of growth and the trend of redialisation is increasing every 5 years gradually and the scope of it is increasing now why this part is interesting or important is because in the biased tyres similarly a different type of chemical is added which is called Nylon Tyre Cord Fabric now this is not exactly a chemical type but there is a similar type of application from this insoluble sulphate now this is a listed company called Century Inca which market leader in NTCF. Now, same issues are coming in NTCF that there is a lot of dumping from China in the industry. But, one more interesting thing I have to say about this is that, their volumes are getting a major hit because of the increasing trend of radialization in commercial vehicles. So, Manfred has actually mentioned that the radialization that is happening, because of that, overall their NTCF market is in a declining trend. Because of which, they have to go to new segments like PTCF. So now there is a risk that if their existing segment which is currently very profitable But in next 5-10 years, its market is in downtrend Then what will you ascribe its terminal value? Because there is a scope that after next 5-10 years, their current cash flows will not be maintained Unless they add new verticals So in that sense, OCZL is a very interesting business because We can see this assurity that when EVs will come Then tires will not get disrupted And in tires also, adoption of radial tires will keep increasing So naturally, the cash flow they are generating now, it is highly likely that they will be able to generate cash flow of this level in the future. Maybe the growth will not be that strong, but current levels can be sustainable. Provided industry demand supply scenario is very poor. Now in that sense, if we look at its valuation, then first of all, the investment business in which they have a stake of 75% in Duncan Engineering, how can we value it? So, Dunkin Engineering is a listed company which manufactures pneumatic products such as air cylinders, valves and accessories. And the industry itself is going through a very good period where the industry's growth is improving a lot. And Dunkin Engineering itself is turning around. So, if we see their cash flows or operations or their crediting report, So, sir, I am saying that management is also focusing on capital allocation where their loss making business, like the tire tube business, They have closed it completely and started focusing on their core business. Because of this, their cash perform operations are improving a lot in the last 10 years. And current market value of investments in Dunkin is 50% stake in their business. So 75% stake is in promoters in the whole business. 50% stake is of OCCL and 25% stake is of promoter. So in that sense, it was a 70% stake. Now the market value of investments of this 50% stake, that is around 85-90 crores currently. And since I discussed before, they have invested a lot in AIS or startups. They have invested a lot in that. So the value of that, at least according to AI23, that was around 95 crores. And they have a lot of current investments too. Which have realization in less than 12 months. Generally, short term mutual funds for example in that around 100 crores of their investments are there so my assumption was that if the market gives 50% discount in this which is the value of their investments So minimum 100 crores market cap should be given to it post listing And mind you, current market cap of OC series is only around 700 crores So implied market cap of chemical business seeing the current market cap will be around 650 crores Because if I assume that current market cap is 700-750 crores And my investment business will give me around 100 crores market cap So I will minus 100 crores So around 600 So, I will get this amount of 650 crores Implied OCCL value Which is the value of chemical business If I see their financials in last 5 years Despite having poor margins Around 100 crores They have generated cash flow from operations regularly And since their plan is that Next year they will completely pay off their debt Which is around 50 crores So, I foresee that in FY25 Their enterprise value Now enterprise value is nothing but Market cap plus debt minus any cash or cash equivalents like current investments. So if I minus it, then it is trading at a conservatively around 600 crores enterprise value according to FI25. So according to that, if I take out its cash flow yield, that is around 15%. If I inverse its cash flow yield, then my price to cash flow, we take out price to earnings, that is PE. And if we take out price to cash flow, then it is trading at around 6 times price to cash flow. which is very cheap. Now again, this is also the reason why it is cheap. What we have discussed earlier that in the last 5-7 years, there has not been any major growth in the revenue side. Their margins have increased from 30% to 20%. But still, if we try to value it separately and if we assume that after 2-3 years, industry prospects can improve and margins can revert back to the median level of 25%. And according to that, if my current revenues It remains the same. I am not expecting any major growth for example. So according to that, my implied EVA beta will be around 4.8 times in bull case. In bear case, that is 15% OPM, it will be around 8 times. And in base case, it will be around 6 times. Which is very cheap. At least statistically speaking. And if I put exit EVA beta, so for example I am assuming that if their margins are good, then market will give them better value in multiple. And if their margins are in poor range, So, the last 10 years, they used to get the poorest valuation multiple. If I take that too, then in my bear case, my returns can be 10% less. If I look at the base case, then I can get a return of 41% if all scenarios are plotted. But again, I am very skeptical about these findings because recently management has shown a lot of pessimism. But just to think that if these things are successful, then what can be the key triggers for success? So, in my opinion... Their operating margin is the key going forward If they touch 25% and get 10 times EVA beta which they got during good times So their only chemical business can get around 12-15 crores enterprise value which from F525 levels can be around 100% up Recently key trigger in their business is that they have done anti-dumping investigation basically filed in India market because they felt that dumping from chinese and japanese players so if this anti dumping duty is successful now if this dumping is successful then it takes 12-18 months to get approval but if it is successful then the margins of indian domestic market can be improved so one key trigger is that there can be improvement in margins at the same time but since china is increasing its capacity so their export market can fall with the margins So, there is a lot of uncertainty at the current point of view. But, their current margins are at least 20%. I think it should be sustainable, as the management has also said. But, I see that next 1-2 years are a little poor. And because of that, I am avoiding the business for now. But at the same time, this business is trading very cheaply at least according to the cash flow yield or overall valuation multiples. And there is a lot of pessimism surrounding this particular business because of the points that we have discussed before. So again the idea here is not to say that the company is cheap, buy it or this company can't do well because there is no growth prospect. But the idea here is to study the companies where some interesting catalysts are plotting. And then see what are the key drivers due to which your returns can be made. And then put probability. Like if I discussed that if there is an improvement in its margin of up to 25%, then what probability will that be? And then what returns can I get if that probability is plotted? So in that sense, I think risk reward is... It may not seem that favourable, but with that being said, I personally believe that it can be an interesting case going forward. so i hope you like this particular session and you can share your views and comments in the description box below thank you so much for watching goodbye

So it's not like that the stock is performing well, we are presenting it. And at the same time, interestingly, in the last 10 years, that stock has given negligible returns. So I will just discuss the good and the bad about the business so that you can understand more about this business and why it trades in a particular valuation and what is the key catalyst which makes it interesting. Again, standard disclaimer, I have no investments in this business. It is just a case study.

So with that being said, let's start the session. Sir, there is a famous quote by John Templeton The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell Since the market is doing well at the same time there are certain pockets which are performing so well So we are looking for some companies where there is a lot of under performance and a lot of pessimism in the current market and one such company is Oriental Carbon and Chemicals Limited which we will call in this video as OCCM OCCL came on our radar because a demerger was announced like 2 years back Where they are demerging their investment business Again to understand it more briefly They have 2 key business segments One is the Chemicals business where they make family insoluble sulfur And the second segment is where they have investments in a listed company called Duncan Engineering Which is the same group's company where they have 75% stake At the same time, they have a lot of investments in other AIFs and startups like Bira. So, its cumulative value is around 100 crores.

So, one division is where they have invested. And the other division is where they operate chemicals. Now, generally, the issue in such a structure is that when you have a holding structure, wherein you have investments in a particular business or startup, then the value of your market and investments It gives you market valuation on a discount.

So for example, if I have an investment in a particular business, let's say 100 crores. And if I want to list it, then the market will not give me 100 crores market capitalization in the value of 100 crores. If it gives me a 50-60% discount, then my market capitalization will be only 40-50 crores. Even though my investment value is very good. And the problem with this structure is that many times when your two...

different types of businesses are structured together then your other business may not be valued by the market that much because your demerge entity means your investment business for example in this case you have invested a lot of capital in it no doubt but your earnings are not that good because when its majority value comes that comes from appreciation in investments or whenever we sell investment so at one place your investment or your total capital employed will be high But at the same time since all your earnings and profits are coming from only chemical business So naturally your overall blended ROC will be less And the valuation multiple that your chemical business could get Or the market capitalization that your investment business gets by discounting That is not available because of this complex structure So what they are doing is that they will list their chemical business separately Into OCCA Limited and their other business which is investments will remain in the existing listed entity. Now with that being said, the investment business of this DIMM will be handled by Abhimanyu Kumar who has a good grip in finance. And July 1st is the record date for this demerger. And the record date basically means that if you have OCCL Limited's share on that particular day, then the resulting entity, which in this case is chemical business, you will get its shares when that business is listed separately. So again the idea here is that since the business is going on in a complicated structure, so if we de-merge it, then better, I mean, efficiency will come in operations as well, and at the same time, it will also give market valuation multiple.

Now if we look at the industry's overview, which is its chemical business, then they make insoluble sulfur, which primarily has an application in radial tires. Now there are generally two types of tyre, radial tyre and bias tyre. And the cost of radial tyre is generally a little more versus bias tyre.

However, because of its certain properties, like radial tyres, their life is very high. So naturally, the adoption is increasing from bias tyres to radial tyres. And since as the adoption of radial tyres increases, then naturally insoluble sulphur manufacturers like OCCL will benefit.

Now this particular industry or its chemical In this case, it is being understood that its demand That will be dependent on tyre consumption And this industry is very niche There are very few producers in the market of insoluble sulphur Now the major work of insoluble sulphur is It works like a vulcanizing accelerator in rubber industry Due to which more adhesion comes in rubber and the rubber that can break apart generally does not happen so more endurance and strength comes and resistance improves Now in this particular segment Indian, Japanese and American companies are the key players Asia Pacific is the largest market and the market was consolidated for many years However, recently China has added a lot of capacity in this particular industry due to which many issues are also coming in the past 3-4 years and pricing In the last 2 years they have been in a downward trend And since Auto cycle is not performing so well in the last 2-3 years At the same time The supply has increased a bit So naturally demand supply scenario Is not working out so well for the producers Of this particular chemical And exports have also become very difficult for them Because India's market is very small And in this OCCL has a market share of 55-60% Currently So naturally If your exports are hurt because when Red Sea Crisis came, many exporting clients like Europe, USA, for them Europe is majorly, they were delaying their orders because of this crisis. And naturally, since your demand also decreased and your freight cost also increased because of this Red Sea Crisis, then your volumes were getting hurt a lot. And market is again very mature.

There is not going to be a very fast growth in this. So this is not a very fast growth story. Now if we understand about the company, this company is a market leader in insoluble sulfur in India. This is a company of JP Goenka Group. Their manufacturing facility is in Mundra, that is in Gujarat and Haryana.

Now they are following all the key regulations and policy compliances for a long time. And this company is listed for a long time and their past track record is very good. You can see that in the last 15 days, their Kager Revenue is 13% and packed.

or 19% and their key market share in India alone is 55-60% and globally their market share is 10% so again this is a market leader in insoluble sulfur space now if we try revenue mix money so their 88% of the revenues come from insoluble sulfur and the remaining 12% comes from sulfuric acid historically they used to get good revenues from sulfuric acid But because in the last few years, its pricing has gone down a lot, so naturally its contribution to the overall revenues have reduced. Now if we look at their total manufacturing capacity, then Insoluble Sulphur has 39,500 MTPA and Insoluble Sulphur has 88,000 MTPA. And since I discussed that the benefit of the domestic market is very small, so 50% of the revenues come from export. We try to understand their business and why it is not looking interesting from a competitive advantage positioning. So their clientele is very strong.

So all the major global tyre manufacturers like Goodyear, MRF, Bridgestone They all produce products from this and then producing this particular chemical by themselves. And since I told you that this is a commodity type C, it has end-user tyres and you can't bring much differentiation assets in the product. So if we have to analyze a commodity business, so key competitive advantage for any commodity business is their cost competitiveness. So this company as per the investor presentation tells that they are very cost competitive.

Because they easily get the raw material supply. Secondly, since they have a plant in Mundra, so naturally it is a little more simple to export for them because they have the port. Then again, they have been operating the business for many years and operating on a good scale. Global market share is 10% So naturally fixed cost will increase And they get benefit of economics of scale And they are working on power cost optimization And bringing renewable energy Overall, their power cost will be reduced.

And since their plant is in Mundra, Since it is an SEZ, that is Special Economic Zone, They got tax benefits too. As we discussed before, this is a very niche market. And if I am a insoluble sulphur manufacturer today, It will take me 2-3 years to get approval from any tyre manufacturer.

So since customer approval is very tough, You will have to do a lot of major capex if you want to bring its capacity. Initially, you have to spend a lot of money in R&D to make this chemical. So, naturally, the entry barrier is very high in this. So, in India, there is no domestic manufacturer of good scale in insoluble sulfur except OCCL. And we can see that their domestic market share is 55-60%.

Now, we understood this from the point of view of business competitive advantage. But a key mental model may be applied here if this successful idea is made. So that is revision in ROIC. We had previously discussed in a video that when you buy a business on lower ROIC that is return on capital employed and by the time it matures as an investment its ROCE or ROIC increases. So then your best returns come versus buying a stock which already has a good ROCE.

And ROCE has one key driver, one key variable, that is margins. So, if we see its case, so we can see that now, whatever margins are there in the last 2-3 years, if we see their 10 years margins or median margins, for example, then they are trading below that. So, for example, their median margins are roughly 25%.

So, currently, they are trading around 20-22%. And since we have given this particular company top... margin that is 30% margin so we have a good understanding that margins can be bottom in the near term and if demand side improvement comes and positive characteristics come in industry so these margins can go upward so that is what I mean that margins is at an all time low that is your ROIC can also trade at all time low now the important thing to understand is that margins Why did they fall in the last 2-3 years?

So, the key part that I got from the credit report was that there has been a lag in transferring the price increase to customers due to which the company's margins were impacted materially in 2022. So, I got the idea of 2022. But why are the same issues coming in the last 2 years? So, some key issues plaguing this business is the demand side scenario is going very poor recently, as I have discussed earlier. and naturally if your demand is poor, then your realization will also be lower and since China is getting a lot of capacity and China was not a very dominant player in this particular industry so naturally if they are getting a lot of capacity and existing players have enough capacity to service the entire industry's demand so naturally your supply side will be much higher than demand side so from there also you will get a lot of pressure and the price that you want to pass to customers where the price of your raw material increases you will not be able to do that.

So your bargaining power which should ideally be there for any business which has high entry barrier, that is not saved. And again as I discussed before, the prices of their key raw materials are also increasing and their freight cost is also increasing a lot. And this is a major issue for them because around 50-60% of their revenues come from exports. Now one interesting part I found regarding this business is that EVs can't disrupt them. Whether it's an ice automotive vehicle or an electric vehicle.

Tires are required for everything. So naturally, if there is a disruption of electric vehicles, then also insoluble silver manufacturers won't have that much effect because they cater to the tyre industry. And in their business, basically, it's a B2B business. So the relationship is key. And since they are one of the largest players in the industry and they have been operating in the business for many years, Naturally, their relationship with B2B is very strong.

So, there is an entry barrier. And again, in the last 10 years, their ROC has been greater than 12%. So, we have understood that even though the business is good from a competitive standpoint, ROC is able to maintain it well. And the best part here is that the management team is very interesting to me. They have done a very good job in the capital allocation side.

So, when they were starting the business, they were... They also made carbon black, which is used in tire applications. But gradually they realized that they don't have 14 and they don't want to make such a good business.

So they sold that business to someone else. And their focus is always to make good ROEs And if they see, as they announced earlier that they are doing capacity expansion of 11000 MTPA So in phase 1, they had made a capex of 5500 MTPA But as phase 2 was about to start, they realized that although we are increasing the capacity But the demand side is very poor and the utilization of our existing capacity is not that good So they aborted phase 2 at least for that particular moment So that shows that their primary focus is only not to bring revenue growth rather their focus is on how you can generate good ROEs on a particular revenue and since promoters have 51% stake in the business so there is skin in the game too and the recent effort to do demerger also shows that they are very much focused on shareholder wealth creation so if we understand their capital allocation more then they have generated roughly 50% of their capital in cash flows They are doing payback in the form of dividends or buyback. And as I discussed before, they have curtailed their CAPEX major.

And their next year's plan is that whatever cash flows they generate, they will first pay off the debt. After that, they will think about buyback, dividend or any new business segment. So in that sense as well, capital allocation looks pretty interesting.

And again, the best part for me here is demerger. Where they are trying to create a clean business structure. So I actually asked this question to the management that what is your plan regarding demerger and why is it important? So he clearly said that since the current structure is very complicated so demerger is essential to unlock value and give our shareholders and investors clean companies to invest in. So today if I want to invest in a chemical business only then I can invest in a different business like a chemical business.

And similarly if I feel that the price appreciation of their investments can be very good and market is not giving him such a good valuation so I can buy it separately but at least I am getting an opportunity to choose which business I want to invest in so in that sense demerger is very interesting and as I said before demerger will be a good capital allocation now why will it happen? in the past few years, the issue in the business was that whatever was generated in their chemical business in cash flow, instead of paying out completely as dividends or doing capex in their core business They were using the cash flows of that business to make investments in other places. As we have discussed earlier, there is a risk in investments whether your investment is successful or not. And secondly, whatever investments you make in that business, the market does not give you a good valuation multiple.

It gives a discount to it, which we call holding company discount. So naturally, the issue that was coming in the past was that they were using the cash flows of the chemical business in the investment business. So, maybe there was not as good shareholder wealth creation as it was possible. So, I wanted to know that even if their investment business is listed separately, then how much cash flows did they get to reinvest in that particular business?

So, are they planning to use the investment business after the cash flows of the chemical business? So, the management has explained it very well that whatever investment they did in that segment, they will sell it after demerger and the cash flow that will come from it, they will reinvest it again. And...

OCCL, the chemical segment, whatever the cash flows will be, they will use it separately. So, the fast-paced risk of capital allocation that the chemical business's cash flow is going towards investment instead of dividends, will be resolved further. So that again, the structure of capital allocation, the strategy, will be improved a lot from the investors'point of view. So in that sense, it looks very interesting.

But we have discussed a lot of positives, but still, I am not invested in this business. So what major risk I am facing due to which I am currently just tracking this business and not investing So let's find out So the first key issue here is again dumping from China China has got a lot of good key players in insoluble sulfur space And as I have discussed earlier that globally Oriental carbon is one of the major players in this industry However in the recent past 2-3 years especially China has got a lot of good capacity expansion in insoluble sulfur segment And we will see that the total addressable market size of Insoluble Sulphur is as it is very low And its growth will also grow according to the tier industry And tier industry is slated to grow at 3-4% in the coming year So if we think that the radialization will improve and the growth of Insoluble Sulphur will be better Still it can be around 6-7% growth So your industry's growth is not that high and at the same time new players are coming in the industry So someone actually mentioned that China Sunshine is a China based company which 30,000 tons capacity and the company's own capacity is only 39,000 tons. So it shows that there are going to be a lot of issues in the capacity side.

And management actually mentioned in their ER that is annual report that dumping of insoluble sulfur by China into India is a key risk for them. And the main issue is that it is not clear when it is going to stop because every quarter I feel that the situation is improving now, the bottom is made. But then we get a surprise that more dumping is starting from China or demand is not good enough due to which more fall in pricing can come. So, management had mentioned in a recent corn call that when their Q4 corn call happened that the prices in export have fallen in the last particular quarter, which flow through will come in the next quarter. So, it is likely that in the next quarter their realization for insolvent sulfur will not look so good.

So, this is an issue that is being faced that now One of the management's point is that as demand in China itself revives, so maybe the issue is that China is not performing well in the local industry and since they have a good capacity, they are dumping the same capacity in other countries. But if the local capacity is revived, the domestic demand is revived, so maybe the issue of global oversupply and demand can be resolved. So again, this can be an interesting thing to plot, but currently there is a situation where oversupply is present, no doubt. And another key risk is again, supply is greater than demand.

Which I mentioned earlier, that the market size is very small. So if more dumping comes from other players, like American, Japanese, and Chinese, then there will be a lot of issues for these Indian manufacturers. Since the demand for insoluble sulfur comes from tires And tires are dependent on the automotive sector And automotive sector is a highly cyclable one So this can also be a volatility going forward And their raw material i.e. sulfur and coating oil They are also volatile And as we saw during 2021-22 period Because the raw material prices increased But they couldn't pass on the same thing So they had a major hit in the margins And their working capital intensity, capital cycle is a little elongated whereas their inventory days are around 120 days so if there is a major fluctuation in their raw material or suddenly they have made finished product of insoluble sulfur but globally the pricing of insoluble sulfur suddenly falls so there can be some issue in their margins and naturally ROC will also be less if your working capital cycle is very large And the biggest risk for me is again low growth business.

Here volumes are not going to grow much because in industry OCCL itself is at a 10% global market share. And in India it has a market share of 55-60%. So although in India there is a scope that people should increase the market share which I will discuss later.

But globally their aspiration is that they should increase it from 10% to 12%. Because USA is a very uncharted territory for them. So from there if growth comes good then growth can come there.

But still if it reaches 10% or 12% then I don't see that there will be a good volume growth in this business in the coming decade And the export scenario is currently going slow because of the issues in Europe and the Red Sea crisis So overall the situation seems very benign and with China dumping in Indian markets recently Issues have increased more And as I discussed before, its total addressable market size that is very small. So, I actually recently company has filed anti-dumping duty in Indian markets wherein they believe that producers from China and Japan are dumping that insoluble sulfur in India at a much lower price. So, I wanted to take this understanding that if domestic capacity suppose demand is 40-50 thousand MTP and your own capacity is 30 thousand MTP then naturally supply will come from outside so, there is a scope that anti-dumping duty will not be successful because there is a scope So I asked this question.

So management has explained that domestic demand itself is only 20 to 25, 2000 tons per annum and their own capacity is 39,000 tons per annum. So if they want, they can cater to the demand of India alone and still they will have 50% capacity that they can use in export. So total addressable market size is very small and margins which is my The thesis was initially that maybe there can be a mean depression wherein the current margins of these people are trading at a decade low and since if the industry rebounds, then margins can improve. So, management has said in the con call itself that in the next 2 years, we don't think that there will be any improvement in the margin.

In fact, the margin of the next year will be poorer than FY24. Now, there is a case that since the business is not operating so well since last 1-2 years and thereby, management may have tried to over deliver under the promise and became a little pessimistic. Because naturally, if you handle business on a daily basis, you will become a little pessimistic during poor times. And when the good times are going on, you will also be more optimistic.

So it is a natural human tendency. But one major risk is that our initial thought process was that mean reversion can happen and margins can improve. But at least according to management, it is not visible in the next 1-2 years.

So why does this make business interesting? I have made so many negative points but still we are very interested regarding this particular business. So the answer here is valuations. But before we talk about valuations, it is important to understand the terminal value perspective.

I have discussed earlier that the trend of radialization that is the shift of the bias tyre in radial tyres that is the value migration is improving a lot and it will keep on increasing so the insoluble sulphur content in radial tyres that is around 1.7 times and as the radial tyres keep on increasing the demand of insoluble sulphur will also keep increasing so in that sense there are some prospects of growth and the trend of redialisation is increasing every 5 years gradually and the scope of it is increasing now why this part is interesting or important is because in the biased tyres similarly a different type of chemical is added which is called Nylon Tyre Cord Fabric now this is not exactly a chemical type but there is a similar type of application from this insoluble sulphate now this is a listed company called Century Inca which market leader in NTCF. Now, same issues are coming in NTCF that there is a lot of dumping from China in the industry. But, one more interesting thing I have to say about this is that, their volumes are getting a major hit because of the increasing trend of radialization in commercial vehicles. So, Manfred has actually mentioned that the radialization that is happening, because of that, overall their NTCF market is in a declining trend. Because of which, they have to go to new segments like PTCF.

So now there is a risk that if their existing segment which is currently very profitable But in next 5-10 years, its market is in downtrend Then what will you ascribe its terminal value? Because there is a scope that after next 5-10 years, their current cash flows will not be maintained Unless they add new verticals So in that sense, OCZL is a very interesting business because We can see this assurity that when EVs will come Then tires will not get disrupted And in tires also, adoption of radial tires will keep increasing So naturally, the cash flow they are generating now, it is highly likely that they will be able to generate cash flow of this level in the future. Maybe the growth will not be that strong, but current levels can be sustainable. Provided industry demand supply scenario is very poor. Now in that sense, if we look at its valuation, then first of all, the investment business in which they have a stake of 75% in Duncan Engineering, how can we value it?

So, Dunkin Engineering is a listed company which manufactures pneumatic products such as air cylinders, valves and accessories. And the industry itself is going through a very good period where the industry's growth is improving a lot. And Dunkin Engineering itself is turning around. So, if we see their cash flows or operations or their crediting report, So, sir, I am saying that management is also focusing on capital allocation where their loss making business, like the tire tube business, They have closed it completely and started focusing on their core business. Because of this, their cash perform operations are improving a lot in the last 10 years.

And current market value of investments in Dunkin is 50% stake in their business. So 75% stake is in promoters in the whole business. 50% stake is of OCCL and 25% stake is of promoter.

So in that sense, it was a 70% stake. Now the market value of investments of this 50% stake, that is around 85-90 crores currently. And since I discussed before, they have invested a lot in AIS or startups. They have invested a lot in that. So the value of that, at least according to AI23, that was around 95 crores.

And they have a lot of current investments too. Which have realization in less than 12 months. Generally, short term mutual funds for example in that around 100 crores of their investments are there so my assumption was that if the market gives 50% discount in this which is the value of their investments So minimum 100 crores market cap should be given to it post listing And mind you, current market cap of OC series is only around 700 crores So implied market cap of chemical business seeing the current market cap will be around 650 crores Because if I assume that current market cap is 700-750 crores And my investment business will give me around 100 crores market cap So I will minus 100 crores So around 600 So, I will get this amount of 650 crores Implied OCCL value Which is the value of chemical business If I see their financials in last 5 years Despite having poor margins Around 100 crores They have generated cash flow from operations regularly And since their plan is that Next year they will completely pay off their debt Which is around 50 crores So, I foresee that in FY25 Their enterprise value Now enterprise value is nothing but Market cap plus debt minus any cash or cash equivalents like current investments.

So if I minus it, then it is trading at a conservatively around 600 crores enterprise value according to FI25. So according to that, if I take out its cash flow yield, that is around 15%. If I inverse its cash flow yield, then my price to cash flow, we take out price to earnings, that is PE.

And if we take out price to cash flow, then it is trading at around 6 times price to cash flow. which is very cheap. Now again, this is also the reason why it is cheap.

What we have discussed earlier that in the last 5-7 years, there has not been any major growth in the revenue side. Their margins have increased from 30% to 20%. But still, if we try to value it separately and if we assume that after 2-3 years, industry prospects can improve and margins can revert back to the median level of 25%. And according to that, if my current revenues It remains the same.

I am not expecting any major growth for example. So according to that, my implied EVA beta will be around 4.8 times in bull case. In bear case, that is 15% OPM, it will be around 8 times.

And in base case, it will be around 6 times. Which is very cheap. At least statistically speaking.

And if I put exit EVA beta, so for example I am assuming that if their margins are good, then market will give them better value in multiple. And if their margins are in poor range, So, the last 10 years, they used to get the poorest valuation multiple. If I take that too, then in my bear case, my returns can be 10% less. If I look at the base case, then I can get a return of 41% if all scenarios are plotted.

But again, I am very skeptical about these findings because recently management has shown a lot of pessimism. But just to think that if these things are successful, then what can be the key triggers for success? So, in my opinion...

Their operating margin is the key going forward If they touch 25% and get 10 times EVA beta which they got during good times So their only chemical business can get around 12-15 crores enterprise value which from F525 levels can be around 100% up Recently key trigger in their business is that they have done anti-dumping investigation basically filed in India market because they felt that dumping from chinese and japanese players so if this anti dumping duty is successful now if this dumping is successful then it takes 12-18 months to get approval but if it is successful then the margins of indian domestic market can be improved so one key trigger is that there can be improvement in margins at the same time but since china is increasing its capacity so their export market can fall with the margins So, there is a lot of uncertainty at the current point of view. But, their current margins are at least 20%. I think it should be sustainable, as the management has also said. But, I see that next 1-2 years are a little poor. And because of that, I am avoiding the business for now.

But at the same time, this business is trading very cheaply at least according to the cash flow yield or overall valuation multiples. And there is a lot of pessimism surrounding this particular business because of the points that we have discussed before. So again the idea here is not to say that the company is cheap, buy it or this company can't do well because there is no growth prospect. But the idea here is to study the companies where some interesting catalysts are plotting. And then see what are the key drivers due to which your returns can be made.

And then put probability. Like if I discussed that if there is an improvement in its margin of up to 25%, then what probability will that be? And then what returns can I get if that probability is plotted? So in that sense, I think risk reward is...

It may not seem that favourable, but with that being said, I personally believe that it can be an interesting case going forward. so i hope you like this particular session and you can share your views and comments in the description box below thank you so much for watching goodbye

Transcript for:Analyzing Deemerger Strategy for OCCL

Transcript for:
Analyzing Deemerger Strategy for OCCL