Stock Story : Dharamsi Morarji Chemicals Co Ltd

Today we are here to discuss on a small chemical company by the name of “The Dharamsi Morarji Chemical Company Limited” (DMCC, henceforth).

Vital Stats

As on Date 23.04.2016.

Source: 

Market Cap.: 137.66 Cr.
Current Price: 65.75
Book Value: 14.53
Stock P/E: 8.85
Dividend Yield:0%
Face Value: 10.00
52 Week High/Low: 99 / 15.80
Days Receivables Outstanding : 201.32
Debt to equity: 1.18
WCap to Sales: 0.29%

Price to Book ratio: 4.46

Sales growth 5Years: 15%
Profit growth 5Years: loss to Profit
OPM last year: 14%
NPM last year: 12% (not paying taxes due to earlier losses)
Return on equity: 27.41%
Return on capital employed: 16.91%

Promoter shareholding: 48.73%

About

Source:   (Emphasis mine)

The Dharamsi Morarji Chemical Company Limited (DMCC), established in 1919, was the first producer of Sulphuric Acid and Phosphate fertilizers in India. Over the years, the brand of the Company (“Ship”) came to be recognized as the quality standard for Single Superphosphate (SSP).

Until recently, DMCC was known primarily as a fertilizer producer, with over 75% of revenue from SSP. As a strategy, DMCC structured itself to Specialty Chemicals. With focused Research and Development efforts, processes for downstream sulphur-based chemicals were commercialized. Simultaneously, the Marketing team engaged with customers in India and overseas to meet their requirements.

Through a painful restructuring process, DMCC exited the manufacturing of fertilizers almost entirely. What is visible now is a culmination of efforts by the entire team: sustainable performance with zero dependence on Government policy, net foreign exchange earnings, and sales to over 25 countries in 5 continents. 

Core Technology

• Sulfonation & Sulfation
• Chlorosulfonation
• Friedel Craft Reaction
• Esterification
• Methylation
• Ethylation

The Story – In a Nutshell

One of the oldest fertilizer companies in India, was mostly into fertilizer making. Given the vagaries of the govt. subsidiary dependent fertilizer business was forced to Corporate Debt Restructuring. Company took a long and painful step and has finally come out of the loss making and working capital straining Fertilizer business. Have sold some old plants and assets related to that. Now focusing strongly on growth opportunities in specialty chemicals catering to export markets.

Because of CDR in 2006-07, company has huge accumulated losses. Have redeemed strategic investments it received during troubled times. Banks have converted substantial equity and still have 8.8L preference shares and preference dividend to be redeemed from the company. There will be no free cash flows for some time.

Company is carrying forward substantial losses and also Deferred Tax Assets, so no taxes to be paid for some time. The turnaround and price action around that has happened as stock price moved 8x (almost 10x considering the 52W peak). Henceforth, company’s focused progress into specialty chemicals and deleveraging of liabilities will determine the price going ahead.

Recent News and Price Surge

Last 1 year: 3X

Last 3 years: 8X

No Recent News. Check for latest news

Last 5 Years:

What happened in Fiscal FY2014 ?

Sales (net of excise duty) grew from 85.6 Cr to 101.3 Cr majorly brought about by Specialty Chemicals which grew from 45Cr to 63 Cr or by 40%. Exports grew from 32 Cr (FY13) to 47 Cr(FY14).

In short company’s sales were boosted by exports of specialty chemicals from 2 products commercialized from own R&D earlier, which were accepted by clients. Also cutting down on SSP fertilizers with strained working capital helped. Company has significant carry forward losses and not paying tax.

Observations (AR FY2014):

1)      The Company’s fertilizer business viz. Single Superphosphate (SSP) could not be continued on its own inter-alia, due to strained liquidity and shortage of Working Capital. The turnover of Commodity Chemicals during the current Financial Year ended 31st March, 2014 was marginally higher at Rs 30.03 crores as compared to the turnover of Rs. 29.73 crores during the previous Financial Year.

2)      The turnover of Specialty Chemicals during the current Financial Year ended 31st March, 2014 was Rs. 63.17 crores as compared to Rs.44.78 crores in the previous year. The Export turnover of the Company during the current Financial Year ended 31st March, 2014 was Rs. 46.66 crores compared to Rs.31.70 crores for the previous Financial Year. Your Company continues to make efforts to develop new markets and customers.

3)      The SSP Fertiliser Industry continues under the stresses and strains of the huge working capital requirement arising mainly out of the delays in receipt of the subsidy amounts from the Central Government and other related procedural issues

4)      While the bulk chemicals are an intrinsic part of our operations and are essential for the growth of the specialty chemical segment, the profitability of the bulk/commodity chemical is limited due to continuing competition and logistical restrictions. Therefore in case of bulk/commodity chemicals, our focus is on cost reduction, effi cient sourcing, overall supply chain optimization and developing value added/ pure grades of bulk/ commodity chemicals which would have a niche domestic market.

5)      In the specialty chemicals business, your Company has commercialized two products which had been developed earlier by the Company’s in house Research and Development team. (Note : Spend on R&D is miniscule 0.10% of sales)

6)      The Company expects to increase the capacity utilization of its Chemical Plants at Roha, by carrying out some internal financial and business restructuring and improving the availability of working capital finances. Your Company is setting up flexible manufacturing facilities termed “Multipurpose Plants” which can be utilized for several different products, the transition between products being rapid, the new products can be commercialized at short notice.

Observations (AR FY2015):

1)      The Corporate Debt Restructuring undertaken by the Company a few years ago is reaching its logical conclusion and the accumulated losses of the Company have reduced over the last 3 years. 

2)      The turnover of Commodity Chemicals during the current Financial Year ended 31st March, 2015 was higher at Rs. 39.88 crores as compared to the turnover of Rs. 30.03 crores during the previous Financial Year.

3)      The turnover of Specialty Chemicals during the current Financial Year ended 31st March, 2015 was Rs.74.46 crores as compared to Rs. 63.17 crores in the previous year. The Export turnover of the Company during the current Financial Year ended 31st March, 2015 was Rs. 51.76 crores as compared to Rs. 46.66 crores for the previous Financial Year.

4)      The Company’s fertilizer business viz. Single Superphosphate (SSP) could not be continued on its own due to various economic considerations, and hence there is no turnover of SSP fertilizers during the current fi nancial year ended 31st March, 2015.

5)      The Management of your Company has also decided to lay emphasis on improving technical expertise in Sulphur and Ethanol chemistry. Efforts are being made to have long term alliance with key customers to develop tailor made processes/products to meet their specifications and expectations.

6)      Your Company has already set up flexible manufacturing facilities termed as “ Multi-purpose plant ” which can be utilised for manufacture of various Specialty Chemicals which are the future growth areas. Your management is therefore contemplating further investment in this segment.

7)      The Company has also set up a Solar Plant in Roha with an initial capacity of 500 KW which will gradually be increased over a period of time. The solar energy is expected to partially replace expensive grid power with cheaper green energy and reduce marginally the Company’s energy cost.

8)      R&D Expenses incresed from 10L(FY2014) to 1.01Cr(FY15, 0.85% of sales)

9)      Principal Business:

• Production of Benzene Sulfonyl Chloride (31% of turnover)
• Sulphuric Acid (24% of turnover)

 10)   Preference Shares outstanding : 8.80L

a.       600000, 8% Redeemable Cumulative non- convertible Preference Shares of Rs.100/- each aggregating to Rs.600 Lacs were to be redeemed in 5 Equal yearly installment of Rs.120 Lacs each commencing from Financial Year 2008-09.

b.      The Preference Share-holders have agreed for further extention of time for the redemption of the said Preference shares any time upto 31 st March, 2018.

c.       The cumulative dividend on these Preference Shares aggregating to Rs.576 Lacs (Previous year Rs.528 Lacs) is to be paid as and when declared by the Company

a.       280000, 2.5% Redeemable Cumulative non- convertible Preference Shares of Rs.100/- each aggregating to Rs.280 Lacs are redeemable in 16 Equal yearly installment of Rs.17.5 Lacs each commencing from 1st April 2012.

b.      further extention of time for the redemption of the said Preference shares any time upto 31 st March, 2022.

c.       The cumulative dividend on these Preference Shares aggregating to Rs. 50.81 Lacs (Previous year Rs. 43.81 Lacs) is to be paid as and when declared by the Company.

11)   Consequently, there is virtual certainty of realization of “Deferred Tax asset” mainly resulting from unabsorbed depreciation and carried forward losses. Accordingly, the recognized “Deferred Tax Asset” of Rs. 2654.15 Lacs as at 31.03.2009, without any addition, is being carried forward.

Notes

Work in progress. To be revisited after few quarters. More clarity awaited from 2016 Annual Report.

Food for thought

Consider the consolidated financials for last 10 years.

Portfolio stocks: Annual stock performance against Earnings and Expectations.

Post the NDA win at the center the euphoria has touched upon almost all stocks, with most small and midcaps rallying 50-100%. Here's a quick look at the performance of portfolio & watchlist stocks over the past one year period.

Note: Adjusted EPS is arrived at by adjusting for one off expenses and revenue items. As obtained from screener.in

The stock price growth being a resultant product of earnings growth and expectations growth, some stocks have rallied on the basis of superior earnings growth supported by moderate PE expansion (Ajanta, PI Industries) while in case of others there is huge increase in expectations (Astral, Mayur) with moderate earnings growth. 

Perhaps the showcase example from this lot is that of Kitex Garments, which shows a strong earnings growth(95%) coupled with huge P/E expansion(98%) is the best recipe for success. The stock posted a 1 year trailing returns of 286% !!!

Also, stocks with muted earnings growth and high expectation look expensive but only on a trailing basis. Their low earnings base will help them post superior earnings growth, which at the existing P/E too will yield superior returns. Case in point being Hawkins Cookers.

One might argue that trailing P/E being meaningless as the market tend to discount forward earnings only. However, in cases like Astral Poly - where a lot of expectations are already priced in - significant upside in price terms can only be realized if the company is able to sustain and build upon the already expanded P/E backed by superior earnings.

The "business" of investing and the role of asset backed leverage

Our fellow investor and blogger Dhwanil in this excellent post has highlighted the merits of considering investments in good businesses as an overall better venture than setting up your own business. 

It is often repeated by seasoned investors to stay away from borrowed money of any sort and invest only the surplus you don't need into equities. This might be true if you consider equities as just another asset class of highest risk and return, however if this is your primary source of earnings and a business, will you shy away from use of leverage in a prudent manner ? Let's explore.

Most of the growing businesses, where we are invested employ leverage in some form of other, either for longer duration asset building or meeting short term working capital needs. Many large FMCG giants and brand plays thrive on the ultimate leverage of "float" or "OPM" (Other people's Money). Read this brilliant post by Prof. Bakshi to understand this.

In case of businesses, the optimum level of debt is often determined by the capacity of the company to service the debt in terms of principal and interest payments, in good and specially during bad times. Prudent level of financial leverage is necessary specially as interest payments are tax deductible. We as individuals do not have the luxury of such tax deductible interest payments in our business of investing, hence leverage should be weighted in the context of merits and increased risks alone.

Loan Against Securities (LAS): Asset backed leverage

LAS or Loan Against Securities is a commonly available form of financing where you pledge your securities and get an overdraft limit to a certain cutoff percentage which is usually 50% or lower. For e.g. if one owns HDFC bank shares worth 2 Lac, he can pledge those and get a limit of around 1 Lac, which can be used as fresh capital for the investment business. 

This is akin to pledging your plant and machinery as collateral in obtaining a working capital loan, here the core assets of the business are "part ownership in other businesses" which is pledged. 

Here is the product info and details from ICICI Bank and Axis Bank who offers this facility at decent rates of interest. Note that all stocks are not acceptable as pledge. Hence, make sure to go through the latest available list of approved securities ( which are periodically revised) to see if you have enough pledge worthy stocks in your portfolio. Here's the latest list from ICICI Bank.

Servicing the Debt: Serve the interest every month.

Now the key concern here is the debt servicing. Like in case of many businesses, you can make monthly interest payments and pay the principal at the end. Businesses need to make sure that the Interest Coverage ratio is high, meaning even during worst times their cash flows should meet the interest payments effectively.

The biggest advantage of regular cashflows (as in salary/ rent received etc. ) is that you are free from the volatility of business cycles and hence can deduce a monthly interest payment as a moderate percentage of your monthly cashflow. It will be safe to target a monthly Interest Coverage ratio of 16-20 times, so that interest outflow in 5-6% of your net monthly cash flow.

Serving the interest will make sure the loan do not compound on itself and you do not pay further interests on interest, a key differentiator over longer tenure.

Optimum debt with enough margin of safety

As we know Leverage is a double edged sword, hence protecting the downside is of critical importance. Assume that only 60-70% of your portfolio holding is pledge worthy only. Hence, max loan you can take, with a 50% haircut is only 30-35% of your net equity portfolio. 

So portfolio value : 10 Lac
Pledge worthy portfolio value: 7 Lac (70%)
Maximum loan limit: 3.5 Lac (50% haircut)
Assume loan availed as 2 Lac (20% of total portfolio, around 57% of the max loan limit)

Now assume the worst case, a look at last 20 years of annual Nifty returns shows a worst possible drop of 52%. Assume a 60% drop in stocks, 

So portfolio value now : 4 Lac
Pledge worthy portfolio value: 2.8 Lac (70%)
Maximum loan limit: 1.4 Lac (50% haircut)
Loan availed : 2 Lac. 

Hence,  the value of pledge worthy portfolio is still double the loan availed. Of course, the loan limit is now : 1.4 Lac, hence bank will ask for more collateral or sell off your stocks. Note however, that total portfolio value in general and un-pledged stocks in particular can be sold off  to meet the liabilities. 

Also we are considering a once in 20 years event. Note that the reduced portfolio value still meets the criteria to take up to 14% leverage. Thus 10-20% at max will be the prudent leverage or a max gearing ratio (D/E of 0.2) will be considered safe.

Is it worth the risk ?

The obvious question comes in mind, that does the returns justifies this risk and all the headache of all paperwork, maintaining collateral, serve monthly interests and all. 

Let us see. Here are the indicative returns on investment of Rs 1000, without leverage, with leverage at 10% and with leverage at 20%.

Capital : Rs 1000, No leverage

	Capital	Return CAGR
	1000	15%	18%	21%	24%	27%	30%
Tenure (Years)	3	1,521	1,643	1,772	1,907	2,048	2,197
	5	2,011	2,288	2,594	2,932	3,304	3,713
	7	2,660	3,185	3,797	4,508	5,329	6,275
	10	4,046	5,234	6,727	8,594	10,915	13,786
	12	5,350	7,288	9,850	13,215	17,605	23,298
	15	8,137	11,974	17,449	25,196	36,062	51,186

Capital : Rs 1000, 10% leverage

	Capital	Return CAGR						@ 13%
	1100	15%	18%	21%	24%	27%	30%	Cost of Funds
Tenure (Years)	3	1,673	1,807	1,949	2,097	2,253	2,417	39
	5	2,212	2,517	2,853	3,225	3,634	4,084	65
	7	2,926	3,504	4,177	4,958	5,862	6,902	91
	10	4,450	5,757	7,400	9,454	12,007	15,164	130
	12	5,885	8,016	10,835	14,536	19,366	25,628	156
	15	8,951	13,171	19,194	27,715	39,669	56,304	195

Capital : Rs 1000, 20% leverage

	Capital	Return CAGR						@ 13%
	1200	15%	18%	21%	24%	27%	30%	Cost of Funds
Tenure (Years)	3	1,825	1,972	2,126	2,288	2,458	2,636	78
	5	2,414	2,745	3,112	3,518	3,965	4,456	130
	7	3,192	3,823	4,557	5,409	6,395	7,530	182
	10	4,855	6,281	8,073	10,313	13,098	16,543	260
	12	6,420	8,745	11,820	15,858	21,126	27,958	312
	15	9,764	14,368	20,939	30,235	43,275	61,423	390

Thus, one can see, a small leverage will add a significant boost to your overall returns over the longer term. 

Note: The minimum cost of this facility is around 13%. Hence one should only consider using this option when the potential returns are much higher than the cost of funds. 

Where it is readily useful

There are often scenarios, where there some sudden news driven sharp corrections. Being at the mercy of month end cash flows, it is often not possible to take a large position at one go. LAS often comes handy in such situation, where one can load up 10-15% of one's portfolio in a particular stock at one go.

One can later pay off the debt through monthly saving and contributions to equity. Since this is a debt with no payment commitments, foreclosure charges the overdraft facility is more helpful than other similar debt obligations. 

Another important case is while applying in IPOs/FPOs etc. Since you will most likely apply using ASBA, only a small part of the overall application money would be used in all practicality. Hence, you can avail LAS funds and return the excess back, without disturbing any of your long term debt or equity investments. 

The business of stocks

Coming back to where we started off, optimum leverage with adequate margin of safety and interest coverage will enable us to buy larger stakes in businesses we like to own. Further if we are not averse to the use of optimum leverage in our portfolio companies, why oppose to using that in our own business ?

Views invited.