Tuesday, April 1, 2014

Kwality Dairy - household brand growing too aggressively (read "too much debt")

Its easy to confuse this company with Kwality ice cream brand. Now it has nothing to do with ice cream! The company has grown rapidly but is on a highly levered speed race with no signs of abatement. The company claims that the Indian dairy industry currently stands at north of 70 Bil USD and other reports claim that it will be 140 Bil USD by 2020. So the industry is promising and the business is such that once trust is established with the customer base the pricing can be driven up rapidly. The company plans to invest another 300 Crores to expand sourcing operations and launch value added products - this is going to drive up debt even further. 

1. How good is the moat?

Grade B moat
  • Overall I like the dairy business. It is one where companies like Nestle and Britannia are enjoying double digit margins and returns on capital of north of 50%. However this company is not doing so yet.
  • The management has shown a track record of the ability to grow revenue (at 58% CAGR for the past 4 years) albeit at the cost of margins. This is the primary reason for the moat to classified as grade B instead of C.
  • Margins are too thin - especially the value addition % (stands at 8%). The company needs to build a brand and spend money on marketing to really classify in the proper moat category.
  • There are some signs of brand building such as having Bipasha basu and Virendra Sehwag as brand icons.

2. Risks

  • Financial risk - very high. Debt to EBTIDA stands at 4x which must be giving the banker sleepless nights.
  • Debtors - Too high for my liking. If the company can fix this they will be cruising. Unfortunately I have been unable to find information about the creditworthiness of the customers with whom these payments are pending.
  • Overall risk on debt and Debtors is too high for me to swallow at the moment

3. Financials

  • Debtors - I have never seen something as spectacular as this - currently debtors are 82% of the invested capital and 25% of sales. This basically means that the loans the company is taking are going into lending to customers to buy the company's products.
  • Inventories stand at 3% of sales which is excellent
  • Raw materials stand at 92% of sales and yet the company is able to maintain a 5.8% net margin which is impressive
  • ROE stands at north of 30% for the past 5 years which is excellent but is on the back of 4x debt to EBITDA. Return on invested capital stands at 13.8%. If the company were to just get payments from customers in 30 days it would increase the ROCE to over 25% and the debt to EBITDA at less than 2x.
  • Minimal FX exposure - but net exporter of 1% of revenue or so.
  • Dividend % of earnings stand at 2% which is good for reinvested earnings but bad from a perspective of dividend discipline. Typically if the company has good corporate governance then this should not be an issue.

4. Soft factors

  • Promoters own 74.88% which is the almost the max amount they can own.
  • Individuals own 18% which is very large % for retail investors without much chat about this company
  • No warrants or ESOPs to dilute
  • There is a special resolution that allows the board to borrow or raise capital upto 1000 Crores - this is extremely scary given the level of debt
  • Corporate governance:
    • Director remuneration is around 1.4Crores for the MD and 1 Crore for the other executive director overall is around 2.5% of PAT which is ok for a company of this size.
    • Quality of Audit firm and internal audit firm is average
    • Director independence - Dr. RS Khanna seems to be fairly independent but I was unable to find information about the independence of Mr. Arun Srivastava

5. Pricing

  • Bottom line is that the earnings will grow at a rapid clip but the leverage is too high for me to sleep easy while owning this stock. Also what worries me is that bad credit from customers might end up meaning all profits are wiped out as the debtors are about 10 times annual profits. So instead of getting into pricing I will put this on my watch list to see if they can bring debt to EBITDA down to be below 2x to be considered.

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