Foreword

Capital Ideas Online interviewed Mr. Asit Koticha, Managing Director & Chief Investment Officer, ASK Raymond James. The full transcripts of the interview are available below. We hope that you find the same readable, informative and useful. Whilst we would not like to take any responsibility for investment decisions that you may take on the basis of this interview, we would invite any comments that you may find would enrich the quality and perspective of this work. Capital Ideas Online will be regularly bringing you investment ideas from India's money masters.

We would like to thank Mr. Utpal Sheth for the time, energy, enthusiasm and commitment that he has demonstrated. We would be failing if we did not also thank Mr. Navin Aggarwal of Insight Asset Management for all the midnight oil that he so willingly burnt with Chetan and Utpal so as to make the work what it is.

Stock picking is about BMV and not BMW - Business, Management and Valuation

Mr. CHETAN PARIKH: Could you tell us something about your overall investment philosophy?

Mr. ASIT KOTICHA: If I were to say it in one word, our investment philosophy is: QUALITY. And basically, there are three criterion for selection of any stock:

1. Business

2. Management

3. Valuation.

Business - We look for investments where we understand the business very well, I mean, it should be very simple to understand. It should have good potential for growth i.e. long-term potential should be very good. We look for sustained competitive advantage. In a global scenario, we have to look for what the country is offering and what the company is offering in terms of competitive advantages. And we don't generally look at the profits. -- Our major focus is on cash flows. We are biased towards companies that generate cash flows.

Management - We like the managements that are well focused, who understand their core competence and are trying to leverage their core competence in their given areas. Obviously, they should be quality conscious and cost competitive, because that is the basic requirement for any business to be successful. We give emphasis to the fact that management has to be marketing oriented. They should be financially prudent and fair to all the stockholders. If we have understood the business well and we find the desired quality of the management, then the financial result has to be there. So, we try to do an objective analysis, and try to understand their results in numbers.

In a good business with a good management, the company should become a market leader, usually No.1 or No.2. Their return on capital employed should exceed 25 percent and their return on shareholders equity should exceed 20 percent. Normally the companies that we invest in have ROCE of 30-35%. Generally we look at free cash flows. We try to look at the capex of the company being less than the actual depreciation charged. Once in a while it is all right, but on a regular basis, we would like to see that their capex does not exceed their depreciation. Since they are highly ROI conscious and free cash flows are present, their debt levels are normally very low and most of the companies in our universe will be zero debt companies.

Then obviously, we look at the growth areas, how the company is performing. We normally expect a top-line growth of at least 15 percent and a faster bottom-line growth of at least 20 percent. Since they don't need lots of funds for their growth, the company should be distributing a large part of their cash flows, so the payout should at least be 20 percent. Normally you will find that our companies are paying out 30-40 percent. To increase liquidity, or to increase the shareholder value, the management should be committed to doing whatever is required. One of the things that could be done is becoming transparent, providing visibility to the company amongst the investor community. Bonus issues, we believe, play a significant part in increasing liquidity.

Valuation - Once we have filtered on the business and management parameters, and then passed our objective tests; we try to see that the companies offer a good valuation. We believe in growth at a reasonable price. We do not overpay for growth, and we give weightage to liquidity. For liquid stocks, we are tempted to pay a little higher price or valuation.

500 companies on the radar screen, 100 on the target list, and 30 to be focused on

So out of a universe of say 6000 companies, generally we find around 500 companies passing the business filter; and then we apply both, the business and management filters; narrowing it down to 100 companies. This then becomes our core focus list. Around 500 companies will always be on our radar, but only a hundred will be on the closely tracked focus list. Finally, after applying the valuation filter, no more than 30 companies remain. This is how, at any given time, we remain focused on our companies.

Mr. UTPAL SHETH: May I ask a small question? Could you also enlighten us as to how this investment philosophy has evolved over a period of time? It has evolved for the market certainly, but how has it evolved for you?

Mr. ASIT KOTICHA: Our present investment philosophy of looking at business and management - both reflected in terms of financial parameters, and valuation has evolved from our past experiences. Over a period of time, we have observed the opportunities, which we have capitalized and the opportunities, which we have missed and what were the differentiating factors. Besides, we identified the factors that lasted for long, and the opportunities where we sold and those companies continued to perform over a period of time. We have done lots of introspection and have tried to see the commonality of the factors; not only in our experience, but also the experiences of international investors or investing wizards like Warren Buffett. We have seen it working amazingly well in most markets and in most companies because there is a very good logic behind this. If the business and the management is good, and if that is reflected in the numbers, and if you have bought at a reasonable price; you will invariably get very good appreciation over the long-term.

We don't want to be guided by any one or two sectors. We apply this formula across the board. It may happen that the quality of some of the businesses are so strong, say sectors like pharmaceuticals or FMCG, that many companies in such sectors meet our investment criterion. However, we have found that this approach has worked very well in companies across various other sectors.

Discipline differentiates

Mr. UTPAL SHETH: Asit bhai, given that you are regarded as one of the smarter money managers in the country, what according to you have been the key differentiators of the intelligent money managers and investors?

Mr. ASIT KOTICHA: I think discipline is one, which really differentiates people. Lots of people understand the investment game very well, but they lose discipline and I think that is, in my mind, the main factor.

Mr. UTPAL SHETH: Resisting the institutional imperative?

Growth phase - neighbour's envy, owner's pride

Mr. ASIT KOTICHA: Yeah. I think that brings me to the other dimension of my investment philosophy, where we try to look for companies in a growth phase. Growth phase means they are going through some substantial change either in the sector or specific to the company or to the country as a whole. In that growth phase, usually the turnover or the profit of the company multiplies five times, 10 times or 20 times or even a hundred times in a small time frame. This business may not be very good over the long-term, or it may not satisfy all our criteria for quality business or sometimes quality management. But the growth rate is so strong that generally, you see a huge appreciation in these kind of stocks. And we try to capitalize on these kind of stocks too, but only once in a while.

Mr. UTPAL SHETH: Asit bhai, what are the key factors, which have triggered these kinds of growth phases? I mean, I do understand we cannot have a comprehensive list, but if you can give us an indicative list of factors which trigger growth phases?

Mr. ASIT KOTICHA: Management change is one of the very common factors. Government policy changes are seen very frequently in emerging economies. Sectors opening up or opportunities thrown up by global phases are some of the factors, which we have seen. Software is a classic example in recent times. But I think the management and the government policy changes are the most important and commonly seen factors for such growth phases.

Mr. UTPAL SHETH: Asit bhai, if I may request you to be a little more specific, what would be the typical portfolio composition for you between your consistent philosophy and the growth phase opportunity? Would that proportion be static, or will it evolve; will it change from time to time over the years, or will it change with your market perceptions?

Mr. ASIT KOTICHA: We generally do not look at the market as a trend indicator or something. But, we invest in both, the growth phase and quality companies. I think the companies keep on changing. If there is a sector which we could identify when it is entering a growth phase, then the weightage could be as high as 40 percent in the growth phase stocks or even 50 per cent where we can participate in more than three companies in the same sector. But, most of the time we find that the weightage is less than 30 percent in growth phase kind of companies and 70 percent in solid quality companies.

Mr. CHETAN PARIKH: What is typically the maximum amount that you would allocate to any one stock at a given time in your portfolio? Do you have any limits or any sort of benchmarks in terms of what is the allocation . . .

Mr. ASIT KOTICHA: The philosophy has evolved over a period of time. At present, we consider 10 percent as a limit for any one stock and 30percent as a limit for any sector at the time of the investment, however good we may think it to be. Most investors may find even this to be very aggressive. But this has evolved over a period of time. Earlier, we even used to have more than 40 percent in each stock and even hundred percent in one sector.

Market myopia

Mr. UTPAL SHETH: Asit bhai, what according to you have been the common pitfalls that you have observed amongst the money masters that you've known?

Mr. ASIT KOTICHA: As I told you I think that discipline is one . . .

Mr. UTPAL SHETH: It's been the biggest strength and the biggest weakness.

Mr. ASIT KOTICHA: Exactly, exactly!

Mr. UTPAL SHETH: All of them?

Mr. ASIT KOTICHA: All of them! You tend to go by the market trend and increasingly become more short-term, trying to play the market rather than trying to evaluate other factors that can be of longer-term importance. I think, partly, it is the market psychology or partly the weightage given to weekly performances, that bring them to this kind of dilution of their discipline.

Long-term vision, but not blind faith

Mr. UTPAL SHETH: Could you also give us an indication of the investment time horizon that you normally adopt at the time of entry? I do understand that your average holding period would be substantially different, but if you can throw some light on the investment time horizon up front, and later on, the average holding periods?

Mr. ASIT KOTICHA: Generally, it is never less than one year. It usually ranges between three to five years and we have found lots of our companies are worth holding for even a 10-20 year time horizon. And people who have kept on holding for those kinds of periods have immensely benefited in those kinds of periods.

Mr. CHETAN PARIKH: Asit bhai, what would be your criteria for divestment? As you have an investment criteria, what would be the criteria that would make you sell a company in the portfolio?

Mr. ASIT KOTICHA: Obviously, if a mistake is made, that's the first and foremost. If we have committed a mistake, we cut the losses and we get out of it almost immediately. Second factor is when we find something more lucrative. And for a quality business, I think it is very rare that they will become matured. But in growth phases, we have to sell when they mature. If we don't i.e. if we fail to sell when they are mature, we will probably see a sharp fall in those kind of stocks. I think one thing needs to be mentioned here. The growth phases that we try to identify and participate in are not normally commodity cycles and we do not participate in short cycles of six months, one years or two years. Generally, these phases are of three to five years or more and there is a substantial change by which their turnovers and profits are multiplied by 5 to 10 times or even, sometimes even 50-100 times. And a similar performance is seen in their stock prices.

Mr. UTPAL SHETH: Prima facie, would you say that information technology is in the growth phase right now?

Mr. ASIT KOTICHA: Yes, definitely, but unfortunately we could not identify that in time and we could not capitalize on this opportunity.

Mistakes always have a cost, but a hell of a lot more in illiquid stocks

Mr. UTPAL SHETH: Asit bhai, given that I have been one of your disciples, I am slightly surprised to see the liquidity imperative present in your aggregate investment philosophy. >From what I have seen over so many years, some of your best successes have come from some of the less liquid stocks and therefore could you throw some more light on that?

Mr. ASIT KOTICHA: I think it is a part of the learning curve. And we still believe that liquidity is not the most important criteria in our investment style. What we believe is that if the stock is more liquid then we are tempted to give a better price or valuation. It is not the criteria for investment, but it is a tool for additional premium to be given to the stocks. This is because we have observed that correcting a mistake in illiquid stocks frequently involves a huge cost.

Mr. UTPAL SHETH: Asit bhai, historically liquidity has followed quality. We have seen that in quite a few stocks and even in quite a few of your own picks in the past. So, so long as you get it right on the quality front, the liquidity has come through for you.

Mr. ASIT KOTICHA: You are absolutely right and we have seen that at the time of entering the stock sometimes it has taken months to accumulate the stock and while selling, it has taken a day or two to offload that stock. So I do agree that if you are proved right on the quality of the business and the management, the liquidity follows.

GARP (Growth at a reasonable price), not GAAP (Growth at astronomical prices)

Mr. UTPAL SHETH: Asit bhai, one more factor which you mentioned in your investment philosophy was not overpaying for growth, or GARP (growth at a reasonable price) as we call it. What are the parameters, which you use to value this growth and to determine that you are not overvaluing or overpaying for growth?

Mr. ASIT KOTICHA: Here our fancy is for following DCF and we try to discount cash flows for 10 years, discounted on the present value basis. We give a lot of emphasis to cash flows in the initial years which helps us a lot while trying to make a decision on the predictability of these kind of businesses. Generally, we have found that if they are discounted on a treasury basis, a 50 percent discount to whatever value arrived by this method offers a very good scope for their appreciation.

Mr. CHETAN PARIKH: Asit bhai, how do you arrive at the terminal value?

Mr. ASIT KOTICHA: In terminal value, we are a little flexible. We try to give them a PE. Say, in Cadbury, we try to see at what rate will Cadbury continue to grow even after 10 years, if the management is doing the right things and the business is progressing as we have predicted. If the company can continue to grow at 20percent after 10 years on a cash flow basis, then probably 20 PE is the right kind of a terminal PE.

Mr. UTPAL SHETH: Asit bhai, you mentioned that you look for a 50 percent discount to the DCF valuation on the basis of a treasury bill discount rate. Any particular reason for following the treasury-bill-discount-rate vis-à-vis a risk adjusted discounting rate?

Mr. ASIT KOTICHA: No, I think you can take any criteria. But I think a risk free return is the basic criteria that we apply here. You can take a risk-adjusted rate, but I don't know how much of a difference it will come to. We generally take it that if the investor is investing in treasury bills what kind of returns can he get over a period of 10 years or 20 years.

Mr. UTPAL SHETH: You know, my submission here is, if you are looking for a 50 percent discount of a treasury based DCF valuation, it effectively means that your ask rate of return is two times the treasury bill rate. Which means you are looking for a compounded annual return in the vicinity of say 22 percent given that the treasury-rate right now is around 11 percent. So that then becomes your return benchmark.

Mr. ASIT KOTICHA: Absolutely.

Focus on business and management risk, not market risk

Mr. UTPAL SHETH: Asit bhai, what parameter do you use for the risk benchmark? How do you measure the aggregate portfolio risk and do you measure that at all or any such . . .

Mr. ASIT KOTICHA: We believe that our risk is that of identifying the right kind of businesses and the right kind of managements. If you have passed through those tests, then, most of the times, you have controlled the risk element.

Mr. CHETAN PARIKH: So, basically what you'll be considering as a relevant benchmark is the business risk rather than the volatility in the market as such. In fact, I think that when you say you take a discount on a risk-free rate, you are basically adjusting even your risk premium over there. You would be taking maybe a low discount for an excellent or very predictable stream of cash flows vs. a higher discount if it is not so predictable. So is that 50 percent also variable in the sense that you might go up to 70 percent when your margin of comfort is very low, to let's say, even 30 percent for an extremely quality business. You know, higher discount for a company which you might...

Mr. ASIT KOTICHA: We apply the valuation model only on companies that meet the business and management criteria. Valuation is the third element. Our concern for predictability in this sample is not very high. And we generally feel that if we have understood the business well and if the management is right, and that they are following the right strategy; then the predictability factor is quite high. Hence giving differential discounting treatment to companies does not arise as it is already adjusted in cash flows and terminal value.

Mr. UTPAL SHETH: Asit bhai, given that you have given us how you look at returns and how you look at risks, can you also tell us what parameters you use for performance evaluation internally? Like, over a period of time, what according to you determines whether your portfolio has done well or not, I mean, do you look at absolute returns, do you look at relative returns, do you look at benchmark returns or do you look at risk adjusted alphas?

Mr. ASIT KOTICHA: No, we do not do this kind of evaluation. I think we are more driven by the companies which we select. Therefore, if whatever we have predicted about those companies at the time of the investment comes through, then we are more than satisfied with the process which we have followed. Yes, relativity is applied when you are investing and you see companies across the board, and you will be giving a priority to investing in those kind of companies which are offering very high potential. But it ends there. I mean, we don't take it further.

Mr. UTPAL SHETH: Sorry to interrupt you, but I meant performance evaluation of yourself.

Mr. ASIT KOTICHA: In terms of return per annum or . . .

Mr. UTPAL SHETH: Whatever. People use different parameters for that. So, how would you look back and say that, okay, over the past three to five years, because of this reason I think I have done very well for myself?

Mr. ASIT KOTICHA: Well, in the last one year, we have seen portfolios of most mutual fund managers returning hundred percent or even 200 percent. And if you look at their portfolios, I think more weightage is on software and the media and such companies. I am giving a good credit to them. But at the same time I take a full debit for not being able to identify those kind of stocks. We have got around 120 percent without investing in these kind of stocks and I feel pretty happy about it.

Mr. UTPAL SHETH: Without software...

Mr. ASIT KOTICHA: Without exposure to software and media companies. Of course, we have missed. I'm not saying we have done a very great job of not investing there, but I would like to say that software would have fallen in our growth phase philosophy. But we went into the classic error of always trying to evaluate on the basis of business quality and management quality along with a reasonable price rather than looking at the phase of the sector. And that is why, probably, I feel, we have not been able to participate in this boom.

So coming back to your question, we look at the absolute performance and not the relative performance for our evaluation purposes.

Mr. UTPAL SHETH: One last question on this subject, Asit bhai, you said mistake was the first reason for your divestment. Historically, what areas do you believe are mistakes liable to occur in?

Mr. ASIT KOTICHA: Obviously only in our two criteria - business and management

Mr. UTPAL SHETH: And valuation?

Mr. ASIT KOTICHA: Valuation generally gets reflected or gets corrected over a period of time. I mean you are generally over paying for this kind of companies for a while, but they are compensated in the long run. If you fail to see the risk element or if you fail to see the right points in evaluating managements, we have found it to be quite tricky, much more than going wrong on businesses. Businesses are relatively simple to understand and you can really predict a company's strategy, their placement, their positioning and where you can expect them to be in a few years time. But, management quality is one of the major factor where I would say we have failed more frequently than on any of the others parameters.

Mr. UTPAL SHETH: Asit bhai, in the context of shareholder activism that we now have, and the fact that over the past few years most money managers have played a significant role in enlightening companies, so as to say; when something does go wrong, or if your opinion changes on a company being fair to all stakeholders; then how you go about rectifying that or reacting to that?

Mr. ASIT KOTICHA: Most of the time we talk to management, we express our views, we try to see the genuine reasons for doing certain things and if they are ready to correct it or if they have valid reasons, we generally go along with them. Otherwise we have to exit and that is where liquidity is a major issue.

Macmillan - Too good to be true, and yet true

Mr. UTPAL SHETH: Asit bhai, given all that is said about missing the IT bus, you have actually not missed it as one of your recent stock picks, Macmillan, has given you everything that an IT stock has given to most other investors. Could you tell us more about Macmillan and how you came about identifying this - diamond in the coal mine kind of situation?

Mr. CHETAN PARIKH: Utpal, while you were talking about IT, I think that this stock has got even an Internet component in it.

All the right combinations . . .

Mr. UTPAL SHETH: Yes, partly it is in IT. I don't think that Asit bhai has really missed all the IT.

Mr. ASIT KOTICHA: I think this is one of the rare cases of a company which has all the right combinations in terms of the businesses they are in, in terms of the management team they have and in terms of the parent company's focus. And the valuation at which we bought, and even today, is attractive. Basically it is in two businesses. One is publishing. They publish schoolbooks for up to 11^th or even 12^th standard. The other business they are in is the typesetting, or as they call it data manoeuvring or data archiving. There are many buzzwords for it, but for us it is simple typesetting business that they do for scientific publications as well as for mathematical publications. It's a part of $2.5 billion HM Publishers of Germany.

. . . well placed to capitalize on the huge opportunity

Coming to their publishing business, they are in a segment, which comprises only 10 percent of the school books being published. They publish only English books that are used by the boards or the schools that are not given any aid by the government. It has around Rs.250 million turnover and is growing at 25 percent per annum. Last year they grew by 20 percent and we expect it to grow by 20-25 percent in the foreseeable future. It is the market leader, with a share of over 35 percent in this segment. It has immense potential to grow considering the pace at which educational standards or education parameters are changing in India. English medium is increasingly becoming popular among most of the parents and Macmillan is extremely well placed to capitalize on this huge opportunity.

Mr. UTPAL SHETH: Asit bhai, as regards the business part, clearly this segment of the business has a lot of similarity with Navneet's business. Could you compare or differentiate the two?

Mr. ASIT KOTICHA: I think Navneet is mainly in guides and similar kind of books and only 10 percent of Navneet's business is competing with that of Macmillan. Again, Navneet is also a very good company by itself, but they are only in the western region, mainly in Maharashtra and Gujarat. Macmillan is an all-India player. I believe Macmillan is superior in what they are trying to do despite the similarities in business.

Mr. CHETAN PARIKH: Is there no other comparable stock?

Mr. ASIT KOTICHA: I don't think so. And only 10 percent of that Navneet's business is comparable to Macmillan's business.

Entry barriers are very high in publishing

Mr. CHETAN PARIKH: Is there any competition from imports?

Mr. ASIT KOTICHA: If you really look at how these books are being selected, the entry barriers are very high for even a local player. You either find the writers first, or you first find a book or their curriculum and according to that you have to find the writers for writing those subjects. You have to get it approved at the board level, and then you have to get it approved by the schools and their respective school teachers. It's a very time-consuming process and you have to go through a long credibility curve. If anybody starts today, it will take at least five years to get approvals from any schools because education of young children is a very sensitive subject. Sensitivity factor is very high among the teachers, parents, trustees and at the government level. So, to be able to enter into this kind of a business, you have to be really credible among all of them.

Mr. CHETAN PARIKH: You see any threat in terms of e-learning or distance learning as the model is evolving in the US?

Mr. ASIT KOTICHA: I think e-learning has to come and most of the schools will adopt that. In India, for the primary school or a secondary school, it might take little longer than what other countries are taking. But definitely it will come. But it will not take away the printed matter out. Any ways, Macmillan is very well placed to be in that segment also. They are already preparing themselves to be in that segment.

In typesetting, like a solutions partner to publishers

Mr. CHETAN PARIKH: Could you now tell us about the second part of their business?

Mr. ASIT KOTICHA: Yes, the typesetting business. They have chosen scientific publications as well as mathematical publications as their domain area. That is where their niche area is right now. They have hired almost 35 to 40 Ph.D.s who help them in editing the pages that are given to them by any author in Germany, in UK, in U.S. either in written form or in electronic form. They convert it to the particular publisher's design or style. They correct the matter and sometimes go up to the level of even correcting the formula. So it's not only giving the correct transcripts, but it is also to get it corrected. Plus they give a lot of footnote help, reference notes or denotations that the author has not been able to put or give. And over a period of time they have proven to the publishers that they are like their partner in this kind of activity. As they are catering to magazines, they have a time bound schedule and delivering on time is a very valuable and a credibility factor.

They are also going for data archiving of books that are written to be made available on Internet. At present, they have 350 to 400 people working for them. Recently, they have got a new premise in Bangalore that will give them an additional capacity of 600 people. Further, it will be also result in a lot of productivity gains because of improved infrastructural facility. Right now they are only catering to European publishers. Recently, they established their sales office in USA and this market, I'm told, is five times larger than the European market for similar publications.

Large market to be tapped with the new facility

Mr. UTPAL SHETH: What is the sustainable growth rate expected for this business segment according to you?

Mr. ASIT KOTICHA: What they are catering to today is only 10 percent of the number of pages, which are published. They are doing anywhere between 300-400 thousand pages per annum and the market size is over 4-5 million pages. So I think they have immense possibility to grow. They were constrained by the supply, meaning they did not have enough capacity or space. They will be moving into a new premise next month and will have much larger capability to service. So, I think the growth rate for the next two years may be 40-50 percent, but sustainable growth would be 25-30 percent.

Mr. CHETAN PARIKH: Any competitors they have at the moment in India?

Mr. ASIT KOTICHA: There are competitors who are doing some part of this job, but these people are giving complete solutions to most of the publishers. That is where nobody is there right now in India or in other competitive countries except for the captive typesetting divisions of the publisher's. So, they are virtually competing with the publisher's own typesetting divisions. They are helping them outsource more and more of their needs from a cheaper source like India.

Publishing is the ultimate value driver, whilst typesetting is the current growth driver

Mr. CHETAN PARIKH: Between the two business segments, which according to you will add greater value in the long run to the stock?

Mr. ASIT KOTICHA: Eventually, I think publishing business will add greater value. Right now, growth in profits is driven by typesetting. And these profits are exempt from tax as this is entirely from exports. As a result, operational (excluding cash in the Balance Sheet)ROI is very high at over 70 percent. But eventually, value will be created by publishing.

Mr. UTPAL SHETH: In the publishing business does it plan to extend its capabilities beyond the school curriculum books?

Mr. ASIT KOTICHA: They have general publishing also. They had published titles like "You can win", etc. and recently they have done the biography of Amitabh Bachhan. But the focus would largely remain on schoolbooks in foreseeable future, given the immense opportunity to grow and given that the segment itself is growing quite handsomely.

Parent is the largest school books publisher in the world

Mr. UTPAL SHETH: After the business, can you tell us more about the management quality that you came across in Macmillan?

Mr. ASIT KOTICHA: As I told you, the ultimate parent company is HM Publishers of Germany. They hold 60-80 percent of Macmillan UK and Macmillan UK now holds 60 percent of Macmillan India. Their only listed company is Macmillan India. HM is also not listed nor is Macmillan UK listed. They have acquired quite a few companies in USA, around 25 to 30 companies, in the last year and they are growing quite fast. They are the largest school books publishers in the world. We are quite happy with the capability of the local management to capitalize on growth opportunities that are available. Their intent to create shareholder value is quite visible. And if you look at their strategy up to now, their focus is on creating free cash flows. Their payout has increased dramatically in the last couple of years. So you see, we are quite satisfied with the management.

Truly, Growth at a reasonable price

Mr. UTPAL SHETH: Asit bhai, coming to the third dimension of your investment philosophy, given that the management and the business are right, how would you look at valuations? I know that the valuations at the time of your acquisition must be appearing absurd, But at this juncture how would you look at valuations?

Mr. ASIT KOTICHA: They were absurd that time and, I believe, they are even more absurd today. Especially, if you look at the growth opportunity, the performance in the last two years, and the way they have rewarded the shareholders in last two years. They declared 2 for 1 bonus issue and they have, as I told you, increased payouts and dividends. Their growth rates have been pretty high and in the next two years, because of the new premises for typesetting that they are moving in, their growth rate will be better than what it was in last two three years.

1999-2000 will be a year of consolidation. But they will again grow at over 50 percent in 2001 and 2002. The current free cash flow is Rs.300 million per annum and they don't require very large sums of capital. They have already spent Rs.120-140 million on their Bangalore premises and they had Rs.230-250 million of liquid cash as of the date of last balance sheet. Their operational ROI is more than 70 percent and we expect it to remain above 50 percent in any case. So if you look at the current PE of around 22-23 on 1999-2000 earnings, it looks very low to me considering the growth rate in next two years. I see substantial upside in valuations. And one more thing that the management announced in the last AGM is that they are intending to get it listed on the NSE or BSE. This will add further fuel to the fire. The current price is around Rs.720-725 as against a DCF value of Rs. 1750.

Mr. CHETAN PARIKH: Asit bhai, if I could ask you, there are two separate businesses; one is the typesetting business and the other is the publishing business. If you were to do a sum of the parts valuation, what would be the values that would be attributed to these two businesses differently?

Mr. ASIT KOTICHA: If you ask me, I would value the publishing business highly. Going by the current rave for IT or IT enabled services, typesetting would probably be getting much higher rating and so we have not tried to go through that kind of approach. But overall as a company, it is offering great value for the current price.

Mr. UTPAL SHETH: Asit bhai, Do you see the relative proportion of the two businesses changing dramatically in the next few years?

Mr. ASIT KOTICHA: As I told you, the typesetting business will be growing faster than the publishing business in the next two or three years. But over a longer-term, I would say that the quantum will remain in favour of publishing over a period of say 10 years.

No major capex requirements . . .

Mr. UTPAL SHETH: This company outsources all its printing requirements?

Mr. ASIT KOTICHA: No, they have their own in-house printing facility. I believe, more than 80 percent of printing is done in-house.

Mr. UTPAL SHETH: Which means that any growth in the publishing segment might lead to capex on the printing capacity side?

Mr. ASIT KOTICHA: We have seen that even in the parent company they are resorting to more and more outsourcing. Since they have a printing facility for the last 15-20 years, they might continue with the same or upgrade it, but they will not put up a very large facility. They may even go for outsourcing.

Mr. UTPAL SHETH: Is there a very high concentration of customers in the typesetting business? Is it that bulk of that business is coming from few clients?

Mr. ASIT KOTICHA: It was that three years back and more than 50 percent of business was coming from one client. Now I think that has gone below 20 percent but the entire business still comes from Europe. Now they are expanding into US market.

Mr. UTPAL SHETH: Even now the top four should account for 70 percent of the business?

Mr. ASIT KOTICHA: I believe 60 percent

Mr. CHETAN PARIKH: Could you tell us something about the current valuation?

Mr. ASIT KOTICHA: Current PE is around 22-24 times. But if you look at the next two years growth rate, then it is available at a 2 year prospective PE of less than 10.

. . . or downsides to the business

Mr. CHETAN PARIKH: Asit bhai, what could make this investment a mistake at this price?

Mr. ASIT KOTICHA: I really cannot see anything going wrong in at least the next three to five years. Unless they blunder in the typesetting business or the technology changes or something else goes wrong with the typesetting business. I really do not see anything going wrong substantially even with the publishing business.

Mr. UTPAL SHETH: What is a cause for the very high volatility in the operating profits margins between quarters?

Mr. ASIT KOTICHA: I think publishing business is a very seasonal kind of business as various schools or various regions have similar academic cycles. Even for typesetting, since they are catering to publications, there is a lot of cyclical factor.

Mr. UTPAL SHETH: What has been the cause for its already exceptional of operating margin to improve so dramatically in the last three to four years?

Mr. ASIT KOTICHA: I think if you really look at the typesetting business, their rate per page has actually has come down. But margins have still gone up due to larger volume growth, productivity increases and some element of dollar depreciation. In publishing, incremental margins are definitely pretty high, so it is helping improvements in margins.

Quality imperatives overshadow liquidity considerations

Mr. UTPAL SHETH: That means, Asit bhai, this was one company, where you decided to risk liquidity, given the compelling rationale of the other three factors.

Mr. ASIT KOTICHA: Yes, positively, and not only that, we have gone ahead and bought more than 25 percent of the stock at Rs.220 (before 2:1 bonus issue) when the last traded price was Rs.12.

Mr. UTPAL SHETH: Okay, that was some conviction!

Mr. CHETAN PARIKH: To put it differently, this is a company which has a return on net worth in the mid-40s and is expected to have a book value of about hundred rupees by the end of the current fiscal year. So you are buying a company, which is giving you a 46 percent RONW at may be 7-7.2 times book?

Mr. ASIT KOTICHA: Yes, positive. If you really calculate ROI on operations, I think it is exceeding 60 percent.

Mr. CHETAN PARIKH: You back out the investments from the . . .

Mr. ASIT KOTICHA: Yes, if you deduct the investments that they have made in various preference shares and non-convertible debentures or government securities, probably their RONW is more than 60 percent. Plus their investments in Bangalore facility may have reduced ROI for a year, but eventually it will give a major boost to the ROI.

Huge free cash flows

Mr. CHETAN PARIKH: Asit bhai, I wanted to ask about the non-operating assets in the total balance sheet size just to get a framework of what could theoretically be the possibility of payout in the future...

Mr. ASIT KOTICHA: If you look at the last year's balance sheet, they have more than Rs.230 million in cash balance and about Rs.40 million in investments. They already have capital work in progress of Rs.115 million. In my estimate, they will not be exceeding more than a Rs.30-40 million in further investment for their Bangalore facility. And they will be generating cash flow of at least Rs.300 million in 1999-2000. So that will leave with them with another Rs.250 million of additional cash flow. If you deduct a dividend of at least Rs.100 million as payout, there will be cash of Rs.50 per share in the balance sheet. I don't see there any huge capex for them in the foreseeable future. Pay out, as it has indicated in the last two years, should be increasing dramatically in next few years.

Mr. UTPAL SHETH: Asit bhai, in your opinion the current operating margins are easily sustainable if not improveable in the foreseeable future?

Mr. ASIT KOTICHA: What we estimate is that in typesetting business, margins will definitely be under some kind of pressure. But the productivity gains and increased volumes should take care of that. And in publishing, we are clearly seeing an upward trend in margins.

Mr. UTPAL SHETH: So, by and large, easily sustainable?

Mr. ASIT KOTICHA: Easily sustainable.

Non-dilutive ESOP, that too 10 years ago!

Mr. UTPAL SHETH: Asit bhai, I see that Macmillan has an employee trust holding close to 9 percent of the equity. Would you please comment on this?

Mr. ASIT KOTICHA: I think this is one of the very rare companies which has drawn out a plan for the benefit of the employees probably more than 10 years before most of the people thought about ESOP's.. This company has come up with an employee welfare trust and they benefit the employees by holding stock in the employee trust, which is more than 9 percent of the current equity.

Mr. CHETAN PARIKH: In your opinion, therefore, this should be a superior method of remunerating or incentivising the employees than the conventional ESOP's because there would not be dilution to existing shareholders

Mr. ASIT KOTICHA: Yes, absolutely. I think without diluting the shareholder's equity at no additional cost. Your accounting is more prudent and you are benefiting the employees.

Pidilite - Already a multi-bagger and still a lot of steam left

Mr. UTPAL SHETH: Asit bhai, another multi-bagger pick of yours in the recent past has been Pidilite. This is possibly the only stock of its kind in terms of the kind of products that it has and the kind of restructuring that it is doing to unlock shareholder value. Amongst the many that are trying to achieve the same objective this company has succeeded in a very short time in achieving the objective. Could you please throw some light on this stock?

Focus on increasing branded sales and shareholder value creation

Mr. ASIT KOTICHA: As you have rightly mentioned the management has focused on two major changes – Focus on branded products as well as shareholder value creation. One is they are focusing more on branded products and they are focusing on shareholder value creation. They have become transparent in terms of disclosures to the investors, talking to the investors, making themselves more visible and approachable. They are also taking steps to make the business more attractive in terms of ROI, debt reduction, focusing on branded business by divesting commodity businesses.

These changes have created a kind of awareness, which has been partly reflected in the price. I believe there's lots of steam yet to go. This company is unique in terms of product line, as you rightly mentioned, that world over adhesive business is not run like this and there is no brand power in this kind of product. This company has successfully done it and proved over last 25 years the brand power of Fevicol. It is almost generic name for its product range and commands a share of more than 60 percent despite it being a very simple chemical formula. Lot of adhesives have come and gone and Fevicol has been able to sustain and increase its market share.

Fevicol is a strong brand with excellent pricing power

If you really look at the way in which business is being conducted in India, we do not have a large market for ready-made furniture and carpenters are buyers of this product. Compared to wood and other materials that carpenters use in making furniture, the adhesive cost is very minimal. And Fevicol is so synonymous with the quality and the product that most of the direct consumers or carpenters cannot take risk with this kind of product. This gives them pricing power. Despite falling raw material prices in recent past this company has been able to not only keep the market price steady, but increase the market price of their products and expand their margins. That is one example of the pricing power this brand is enjoying.

Outstanding marketing strategy

There are many pluses in this brand for which one needs to understand how this brand has been created, maintained and has increased in the power. First is the marketing strategy of the company and the product. They have resorted to direct marketing to various carpenters. They publish magazines and send it to almost three lakh carpenters every quarter. So they have direct dialogues with the carpenters. They conduct seminars and product awareness sessions with carpenters on a regular basis in various regions. And if you look at their ad campaigns, they are of excellent quality and there is very very cost effectively placement of their ads. These are two outstanding elements of the company's marketing strategy. If you noticed, in the recent cricket matches they have selected replays instead of going in for any time slots. And it had become a very very successful and effective way of advertising. At a very low cost they could get their name registered more frequently than any other ad at very very low cost.

Highly innovative product launches in a segments where no organised player

This company has come out with various other products The company has very good product innovation plans. I would not say it is comparable to 3M but I think they have adopted a similar strategy in terms of identifying products. Basically they believe that they service the needs of artisans. The strategy is to come out with either new products or products which are already there in the market, without any credible brand. For example, Recently, Pidilite came out with a "putti" which is used in car painting. There is no credible brand name available and Pidilite has just come out with a product, which is a huge market, but right now there's no organized player in this. They have come out with products like Feviquick and various art & stationary products also.

One of the roaring successes has been DDL, which is a white-wash-lime mixed with white glue. A lot of people in India still use lime as a white wash or lime as a paint for their houses or shops. To make this product lasting as well as to avoid spoiling of clothes, this company has come out with a glue which adheres the lime to the wall very strongly. It has created a huge impact on rural population and this product is growing by more than 40 percent per annum, despite a higher base of Rs. 35-40 cr. The growth rate is expected to continue due to wider penetration and rising income levels.

Increased focus on branded and consumer products . . .

A renewed thrust is now being given to consumer products, as I mentioned Fevicryl, Feviquick, Feviseal, stationery products like Fevistick. They have also come out with the new stationery range under Acron brand name – indicating increasing focus on branded consumer products. They have adopted acquisition as a strategy to grow and Ranipal is a recently acquired Ranipal. Such acquisitions would be complementary to the existing distribution strength of the company. They are catering to four lakh retailers and their penetration is going to increase further in next couple of years with the new products available for the distribution channel.

They are focusing on exports also. Right now their export is less than Rs.10 crores in branded products, which is targeted to reach Rs.100 crores in next to five years. They are exporting to neighbouring countries like Bangladesh, Sri Lanka, Middle East, where already these products are very well known.

Mr. UTPAL SHETH: Asit bhai, could you also tell us about the second segment of the sales mix which is the industrial part of the business.

Mr. ASIT KOTICHA: Yes, the industrial products business had become part of this company long back because it was helping them in product innovations and served as captive source for various chemicals or resins. In terms of integration their activity was strengthened. But management has realized and now they have decided to focus on branded products and consumer products and they have decided to either hive off this as a separate company and probably getting a joint venture partner or selling off this businesses.

Mr. CHETAN PARIKH: No major synergy is being lost due to this action?

Mr. ASIT KOTICHA: They expect that they will continue to be in close association with whoever they sell it to or whoever forms a JV. So, I don't think they will sacrifice on that part and they have already created that sort of facility to develop consumer products in the R&D center. So they will not be losing a lot by hiving off this division.

Mr. UTPAL SHETH: Asit bhai, could you give us the sales mix between industrial and branded segments.

. . . and their share will increase from 65% to 90% in 2 years

Mr. ASIT KOTICHA: As I told you, that management focus is on branded products which is visible in last three years. The branded products contribution has gone up to 65 percent from 40 percent of the turnover and in next couple of years it will be increasing to more than 90 percent. We expect a change in the structure of the company, mainly hiving off pigments and resins division will help in achieving it in next six months timeframe.

Mr. CHETAN PARIKH: There is still part of the business of Pidilite Industries where one hears that a lot of multinationals are planning to enter the market. Would heightened competition result in impact on margins going forward?

Mr. ASIT KOTICHA: Movicol of ColourChem is already there in the market for at least a year now. I don't expect them to give a very tough competition to Fevicol. People keep on hearing of Hindustan Lever entering into this. They have probably launched their product a year back in Kerala. But their parent company has moved out of this business. I feel Pidilite is doing lots of right things in terms of marketing. I do not see major threat to Fevicol brand in foreseeable future as distribution channel is quite different from the channel for FMCG goods. They may be able to get some market share in industrial products but in consumer products, I don't think they will have any major impact.

Mr. UTPAL SHETH: Asit bhai, the management has planned to amalgamate a couple of companies into Pidilite. Are these acquisitions synergistic acquisitions with the business?

All companies of the promoter are being consolidated under one umbrella

Mr. ASIT KOTICHA: Yes I think these are actually driven by the shareholder value rather than by business focus. Of course, they make sense because they are associate companies of Pidilite and they cater to Pidilite's needs so they are very synergetic to the company. However, the driving force is the shareholders demand to have all companies of the promoter under one umbrella and that is what they have probably tried to achieve.

Mr. CHETAN PARIKH: Is Parekh Marketing also been merged or is it still a separate entity.

Mr. ASIT KOTICHA: It is still a separate entity. Over a period of time Parekh Marketing’s role has come down dramatically and we are expecting in a couple of years time Parekh marketing either will be merged with the company or will be a negligible part of Pidilite.

Mr. CHETAN PARIKH: How important are raw material fluctuations to the operating margins of this company? One of the main raw material, I believe is VAM.

Mr. ASIT KOTICHA: I think raw material prices are not very relevant because Fevicol or any other products which are branded products can pass on any cost increases. In fact, they are benefited because the company has been able to exercise their pricing power in the recent past. Despite the raw material prices going down they have retained or increased their end product prices and they have been able to increase their margins.

Mr. UTPAL SHETH: Asit bhai, this company was not a free cash flow company until 95-96. But thereafter it has generated significant free cash flow. Bulk of this is because of the sharp drop in the capital expenditure. I presume that bulk of the capital expenditure was for the industrial segment of the business.

Free cash flow generation will be far higher

Mr. ASIT KOTICHA: Yes, bulk of the investment was, as you rightly mentioned, in pigments and resins business. The company is now focusing more on branded products and this kind of capex will not be recurring once the industrial products division is hived off. As a result, free cash flow generation will be far far higher.

Mr. CHETAN PARIKH: What is the kind of sustainable topline growth that you expect from the branded and consumer segment?

Mr. ASIT KOTICHA: In the branded segment their main brand, Fevicol, which is also their main contributor, is normally perceived as a mature product. However, people would be surprised that this brand is also growing at more than 15 percent in volume terms per annum and this will continue. If the economy improves further, this brand may even grow at 20 percent per annum. The overall growth rate will depend upon their speed of introducing new products and capitalizing on the products, which they have already introduced. I believe the topline growth would easily be exceeding 20 percent and could be in the range of 25 to 30 percent

Mr. UTPAL SHETH: Asit bhai, could you comment on the half yearly results that have come out, ad expenses have gone up sharply in fact the management has said that the ad expenses in the second half will be significantly less. Plus they have had voluntary separation schemes. A small amount has been put over there, so what would you have to say on that?

Mr. ASIT KOTICHA: I think they have spent extraordinarily high amount, compared to what they have been doing in the recent past, on cricket matches where the major thrust was not only creating or re-launching most of their products, but export markets like Bangladesh, Sri Lanka, Kenya and most of these matches were played with these countries. They have created tremendous awareness for their products, which in the second half, of course, they will not be repeating, and it is not a normal part of their ad expense. As I already mentioned, they do their ad campaign very very wisely in a very cost-effective way. One of the things that work in their favour is that they are not doing ad campaigns for sustaining but growing the market.

Mr. CHETAN PARIKH: Historically the aggregate selling and distributing expenses have been in the vicinity of 8 percent of sales. After this extraordinary first half, for the full year what kind of ad expenses to sales will you be expecting?

Mr. ASIT KOTICHA: Despite very high ad expense in the first half their overall selling and distribution expenses will be less than 10 percent of sales in the full year.

Mr. UTPAL SHETH: Asit bhai, this is a family run company at the moment would you have any comments on the management?

In the process of making it a much more professional company

Mr. ASIT KOTICHA: Yes, you have a valid remark. It is a family run company and we have seen management giving powers to professionals over a period of time. If you look at the last six months to one-year recruitment ads what Pidilite has been doing, I think they are in the process of recruiting lot more professionals and they are in the process of making it a much more professional company. Even otherwise I have met people in the company, various management levels and I have found to my surprise quite a few people are highly rated. I would also rate them highly as professionals and they are doing an extremely good job. Even in the family, most of the people are chemical engineers. So you can probably them a part of the professional team.. The management has noticed and realized the fruits of professionalizing the functioning of the company. We expect to see this happening much faster in next two three years time frame.

Mr. UTPAL SHETH: Asit bhai, any particular reason as to why Parekh marketing is still not being merged and would you hold that against the company?

Mr. ASIT KOTICHA: I believe there is lots of wisdom. It is in the interest of the minority shareholders of Pidilite that Parekh marketing is not being merged. Over a period of time they have reduced their dependence on Parekh Marketing, but looking at their people, the number of people as well as the premises that the company owns, I think it will be a much costlier affair and ROI will be much lesser by merging it. If you go by the Parekh marketing profits, less than 1 crore per annum, I think investing huge amounts for acquiring Parekh marketing will not be a very wise thing to do.

Mr. CHETAN PARIKH: Are all the brands are owned by the company?

Mr. ASIT KOTICHA: Yes, and I would give credit to the company as unlike most of the other companies , from the very beginning all the brands are owned by this company.

Mr. UTPAL SHETH: Asit bhai, Pidilite has made certain mistakes in the past in terms of a finance company or any such thing?

Mr. ASIT KOTICHA: I think they created a finance company but they have not done much business in that finance company. I believe this management is very very cautious. They have understood that each and every product launch or each and every marketing budget requires attention. If you look at the way they are professionalizing their team also, the management is very very cautious. But sometimes they are very slow in their process as they first commit very small resources in terms of management time or in terms of financial resources for any new activity. Once they taste the success and they feel the success coming forward, only then do they expand their range. I believe it is a very prudent way of doing things. There could be some mistakes but the mistakes will not be very large and whenever there's a success it would be translated or leveraged into very large opportunities by doing things this way. It will be much slower than most of the other ways of doing things.

Mr. CHETAN PARIKH: Any thoughts on the stake in the Vinyl chemical?

Mr. ASIT KOTICHA: The management has denied the merger in various forums. Given the reasons for the demerging the resins and pigment business, I see no reason for merging Vinyl Chemicals

Mr. CHETAN PARIKH: Is the management divesting its stake in Vinyl chemicals?

Mr. ASIT KOTICHA: I really do not see any reason for not doing that and it's a management prerogative. I would feel if import barriers or tariff barriers are getting lowered there is no necessity of owning any stake by the family as well. But, beyond this, I can't say anything.

Mr. CHETAN PARIKH: Nebula Chemicals also has been amalgamated but would Nebula Chemicals actually be a part of the industrial segment or will it be a part of the branded segment?

Mr. ASIT KOTICHA: I do not have much detail on that but I believe it is more on industrial adhesives segment. At the moment they are planning to hive off only resins and pigment business.

Mr. CHETAN PARIKH: What is the consideration that one could expect for the hive off of the resins and pigments business?

Sharper focus on ROI, higher payouts, zero debt & on the look out for brand acquisitions

Mr. ASIT KOTICHA: If you add up the debtors and inventories and all kind of accounts for those, I think the cash flow might be exceeding Rs.100 crores if they sell out the total stake in those companies. But if they keep it as JVs then probably you may not see very large cash flow coming in for Pidilite. Still, their business composition will change in favour of branded products. What has attracted us is this management focus on branded products. They have already increased their branded product sales to 65 percent from 40 percent and this would probably be 90 percent in the future.

The second positive is their focus on creating shareholders value by doing investor friendly things and placing the company in such a way that they can leverage larger gains for the company. They are merging most of their associate companies into Pidilite. They are demerging pigments and resins businesses, their focus is clearly on ROI, they are looking at everything now based on ROI. Previously also, their focus was there on ROI, but now it is a much sharper focus.

They are increasing their payout. Recently if you look at the last year's results they have increased their payout and as the cash flow is increasing they are going in for higher payouts. There won't be any major capex. Cash flow generation will be far higher, and they'll be probably getting a large cash flow from the selling or hiving off these companies. I believe the management is in the process of professionalizing their team. All these factors together make a very good case for the quality, which was perceived to be different a couple of years back. And I believe they are changing through conscious endeavours.

Mr. CHETAN PARIKH: After the proceeds of the resins and chemical business come in, probably this company would be debt free

Mr. ASIT KOTICHA: Even otherwise they will be debt free. One of their major focus is on acquisitions. They have recently acquired Ranipal brand and I think they are on the look out for lots of acquisitions in branded products.

Mr. CHETAN PARIKH: Incidentally Ranipal acquisition was done at one time sales

Good Opportunity - Ranipal has Rs.2 crores in sales against Rs.100 crores sales of Ujala, a recent player

Mr. ASIT KOTICHA: or two times sales, I believe, Rs.2 crores sales and Rs.4 crores price, something like that

Mr. CHETAN PARIKH: So, what will be the investment case for this company, given that net of the industrial, net of the resins business, this company will also be at two times sales as of now based on the growth opportunity. You can go into the numbers - how we are arriving at two times the sales, we have a Rs.850 crores market cap. On an equity base of approximately Rs.12 crores, given the current pricing level of Rs.700 plus we are talking of a market cap in the vicinity of Rs.850 crores which leaves us after excluding the Rs.100 crores approximate valuation of the resins and pigments business to a net market cap of Rs.750 crores. On an existing sale of the branded segment in the vicinity of Rs.250 to 300 crores we are talking of a 2 1/2 to three times sales multiple in any case. So from this point of time onwards what is the investment case and will Pidilite be utilising its market cap as currency for its acquisition strategy or only the cash hordes that it will have?

Mr. ASIT KOTICHA: They have large cash available right now, have free cash flows and are a a debt free company which gives them the leverage capability. Hence, I believe they will be using more of the cash than equity. To answer the second question first, acquisition strategy would depend on what kind of growth opportunity it is providing. Take the typical case of Ranipal - they are doing Rs.2 crores sale and Ujala, a recent player, is doing Rs.100 crores sale. There is a huge opportunity for growth for a good marketing company like Pidilite. I think spending Rs.4 crores for acquiring this kind of brand is not much. Ranipal is a major brand and most of the people are aware of this kind of product. I think it's a very very sensible price to be paid.

20+% topline growth, 25+% bottomline growth company available at 15x PE

Coming to valuation part, I think I'm looking at something like 15 - 20 percentage topline growth and 25 plus percentage bottom-line growth. The present ROCE is over 40% and RONW is over 30%. At current P/E of 15-16 times, I think I am seeing a huge upside. In our estimate, the discounted value of future cash flow exceeds Rs. 1500 per share.

The re-rating will happen in two ways. If you start discounting the branded business compared to other FMCG companies you will see a re-rating there. Secondly, as the company goes for major acquisitions you will see accelerated growth coming in, and the management is clearly focusing on that. So I'm seeing that happening in near future. At current price, I believe it is offering a very good investment opportunity.

Mr. CHETAN PARIKH: Maybe that is the reason why the company might not use its own stock as currency because it is under valued in relation to the overall FMCG business.

Mr. ASIT KOTICHA: Absolutely, and management is quite aware of the underpricing of the stock.

ITW Signode - Restructuring will lead to huge benefits

Mr. UTPAL SHETH: Asit bhai, I believe ITW Signode is another company that you are strongly backing. If you could give us some dope on this company?

Mr. ASIT KOTICHA: We have been tracking this company for a long time and we are waiting to see that change in management. The earlier management strategy we could not understand. But I think now, the recent team is doing pretty well.

80-20 principle

Mr. Ramakrishna, Managing Director, ITW Signode, is focusing on two areas, one is profitable growth and the second is an 80-20 focus. What they mean by 80 -20 is that 80 percent of their business is coming from 20 percent of the customers. Till now they had thousands of customers, they had 37 offices, they had eight factories and they had 2,000 manpower. What they are trying to do is that they are focusing on the 80-20 principle. They have retained 20 percent of the customers who are giving 80 percent of the business, the balance they have given to distributors for servicing.

Major restructuring completed

So they have come down to 300 customers today. From 37 offices they have come down to 15 offices. From eight factories they have come down to two factories and they have reduced their manpower to half. I think the recent changes or restructuring process should take the company a long way. They are going to retain this 80-20 as a philosophy for the ongoing business that their parent company is doing.

Rs. 10 billion turnover potential by partnering 300 corporates

Their target is that even if they have the top three hundred companies of India for their packaging i.e. for total packaging solutions, and if ITW services them and even gets Rs. 30 million business from each of the customer they will be getting a Rs. 10 billion turnover, which is today Rs. 1.75 billion turnover coming from thousands of customers. I think this is a big change, which is going to happen to this company over a period of time. Right now their business is that they are providing state of the art packaging solutions across the industries at lower total cost, right from packaging boxes, to consumables, to operating their machines, to maintenance. They virtually become partners of their customers, so that those companies can focus on their core businesses and this company can help them in getting their packaging solutions at a very cost-efficient way. Increasingly, packaging needs are becoming more crucial for customers of all kinds of industries, whether it is for the direct customer, in the domestic market or for export. I think every way packaging needs are becoming much more important.

Increased focus on pharma, FMCG and the consumer durable segment

Again business wise, their earlier focus was on metals and steels and 40 percent of their business is still coming from that. Now they are increasing their focus on pharma, consumer products and durables and this is a big change. To just give you one example, if Hindustan Lever is the largest company in FMCG business and their packaging needs are huge but ITW is getting less than Rs.1 crore of business from Hindustan Lever. Their target is that at least they should be getting Rs.25 crores worth of business from Hindustan Lever. Similarly, Reliance or any other large company that you look at, I think ITW is not providing any significant worth of materials or services or solutions to them, at present.

Huge benefits in future

At the same time, ITW is not doing away with those thousands of customers, in fact they are giving it to the distributors to service them. So they can focus much better on those kind of customers and this company can focus on those 20 percent of customers for contributing 80 percent of the business. I think it should work very well. It is a time-consuming process, restructuring has a cost, and the company is passing through that phase but it is moving in a determined way. Now, this is a huge exercise. I think it requires re-training of a thousand people, also, change in their mindset. But once this task is over, it will leverage huge benefits for this company, in cost, in servicing their customers better, or increasing their turnover, whichever way you want to look at it, ROI, every way this will be reflected in numbers over a period of time.

Parent’s portfolio could be tapped

Parent company again has a huge product pipeline, which this company has not been able to tap enough. So I think that is also going to be available. Again growth wise I think what existing customers can give, what new customers give, what product applications they are adding can all help in achieving that target. In line with the parent company, acquisitions will be one of the growth drivers for this company. Also, one of the major policies of the parent company has been - growing by way of acquisitions. I believe, last year, they acquired more than 45 companies in one single year. So that also might be one of the growth elements for this company.

Mr. CHETAN PARIKH: Do we have a sector wise break-up of their client mix?

Mr. ASIT KOTICHA: I think 40 percent in steels and metals, I don't know further break-up of the rest.

Mr. CHETAN PARIKH: Any target on how this will change?

Mr. ASIT KOTICHA: We believe that the company is customer focused and not sector focused as of now. They service sectors ranging right from steel to glass to consumer products. They are even servicing packaging needs of Floatglass.

Mr. CHETAN PARIKH: Which is the business line of the parent. The parent has got a number of products. What is a business line of the parent that you think will come into India through this company in the future?

Mr. ASIT KOTICHA: Right now anything which is related to packaging will come to this company. About welding electrodes or any other kind of businesses, I have my doubts. Right now, I am just betting on all packaging products coming through this company.

Mr. CHETAN PARIKH: How are the half-yearly results this year as compared to the corresponding period in the previous year?

Moving to US GAAP from current year

Mr. ASIT KOTICHA: Compared to last year, there is one major accounting policy change, and also there are lots of write-offs. So they have changed, with the change in management and all this is reflected in the financials. They have gone for the US-GAAP. In the current year, accounts will be based on US-GAAP and comparables of last year are based on Indian GAAP, so I think they may not be strictly comparable. Plus what they're going through is a restructuring, where lots of write-offs are there which management is not willing to spell out. The restructuring charges in the vicinity of Rs. 5 cr. may continue for another year or so. But the fruits of which we will start showing from next year onwards.

Mr. CHETAN PARIKH: The company has got small amount of debts still. This company will become debt free according to you?

Company is already debt free

Mr. ASIT KOTICHA: It is already debt free company.

Mr. CHETAN PARIKH: Of the total sales how much of it is consumables and service income and how much is the balance?

Mr. ASIT KOTICHA: Roughly 75-80% of the revenue is from consumables, spares and service income.

Mr. CHETAN PARIKH: Is it that the margins on the consumables and the service composition of the turnover will be significantly greater than that on the packaging machinery?

Mr. ASIT KOTICHA: Obviously, I think the consumables and servicing will be giving better margins.

Mr. CHETAN PARIKH: What are the net margins that the parent company enjoys?

Mr. ASIT KOTICHA: But the basic philosophy is that continuous focus is on cost-cutting and if they save two rupees they pass on one rupee to customers and that is how they have grown over a period of time.

Mr. CHETAN PARIKH: The bulk of the repayment of debt, actually the source of funds for that is the reduction in working capital or was it the rights issue?

Mr. ASIT KOTICHA: I think it was mainly due to the parent increasing its stake.

Mr. CHETAN PARIKH: That has helped. But write-offs might be the instrumental in reducing debtors and working capital. To what do you attribute management's reluctance to spell out the extraordinary write-offs and how much of it is still remaining and so on?

Mr. ASIT KOTICHA: I think what probably they are not clear about is that how much is dead wood, how much they still need to write-off. Further, of the thousand employees, how much would they like to get rid-off. For 175 crores turnover I think 1000 is a big number.

Mr. UTPAL SHETH: Asit bhai, what about the management, because I believe the earlier management was responsible for a lot of things. How is it changing?

Mr. ASIT KOTICHA: No I think lots of things are getting in place now and the state in which the company was put to was thanks to the old management. It has been a tough task for the new management to change a lot of things and bring the company on track. They are slowly and steadily coming on track. I believe, next year onwards you might see this translating into numbers also.

Excellent parentage

If you really look at this company, I think we have to also look at their parent company. If you look at the philosophy of Illinois Tools again focusing on 80-20 principle, they continuously focus on cost reduction - virtually every year they reduce their cost and reduce their prices. Their focus is on cash flows and on growth and on ROI. I think this sounds very good to investors like us. Also the parent company has grown through acquisitions. They are very very aggressive in acquisitions. I believe they have acquired more than 40 to 45 companies in the last one-year. Their focus is again on shareholder value. And the main thing about this company, which will result in higher margins, is the concentration on high-tech solutions. They are providing their customers total solutions and probably very few companies can provide the same technology level or same cost-effectiveness. I think if all this happens in India as well, you will see a very good growth rate.

Mr. CHETAN PARIKH: Which are the viable competitors?

Mr. ASIT KOTICHA: There are no direct competitors to ITW Signode, which can provide a meaningful comparison.

Mr. CHETAN PARIKH: This business has not really got good valuations if you look at companies like Paper Products, etc. . . .

Total solution providers will command good valuations

Mr. ASIT KOTICHA: I thing as a commodity they may not get value as there you are just manufacturers of films. But if companies are providing total solutions, like this company is doing, right from packaging materials to consumables to operating their machines and maintaining those for the customers, then those companies will definitely command good ratings.

Mr. UTPAL SHETH: Asit bhai, could you give us the valuation case for this company at the current price of Rs.85.

14-15 PE for a company which can multiply its turnover manifold

Mr. ASIT KOTICHA: We are expecting a current year EPS to be around Rs. 6. So it is available at around 14-15 PE and based on US GAAP accounting we expect the company to grow by 30-40 percent at least in bottom-line next year onwards for at least next two years. The current turnover is around Rs.175 crores and the company is already debt free. And I have already mentioned the long-term potential. If they're successful in getting three hundred customers which give them at least Rs.3 crores per annum turnover then with huge growth available they can reach five hundred crores turnover in 3-5 years from the current level of Rs.175 crores. It has the right combination of free cash flow, new products pipeline and acquisition track record of the parent company. At the current price I find it very very attractive.

Mr. UTPAL SHETH: Asit bhai, with the current price, the enterprise value to sales works out to something like 1.5 times if we include the debt which was there on the last balance sheet. But even after excluding that it goes to 1.25 or 1.3 times sales which is a fairly large number for a non-branded kind of company.

Mr. ASIT KOTICHA: As I told you I think when I am looking at this company, I am looking at it as a total-solutions providing company with high growth potential. I would give much better rating for this kind of a company because whilst considering Rs.1.75 billion turnover, you have to take into account the businesses they exited from, which was not profitable in terms of cash flows, and sharpening of their own focus through the 80-20 principle. So I think over a period of time, I see a different kind of rating for this company, given the good potential, good growth rate and their focus on ROI as well as the service element.

Mr. CHETAN PARIKH: What company would you compare this company to?

Valuations should be similar to those of service companies

Mr. ASIT KOTICHA: I would be tempted to compare this with any service-oriented company. I think if any company gives you that kind of growth rate with a service kind of background I would be tempted to rate it equally.

Mr. CHETAN PARIKH: Would Xerox be a company that you would compare this with?

Mr. ASIT KOTICHA: I think in Xerox you see a much larger element of machine cost and in ITW, machine cost is not very large but the consumables and the operating part is much larger even from the first day onwards. So I think that might be a difference.

Mr. CHETAN PARIKH: Of the present Rs. 1.75 billion turnover, in your estimate about two-thirds or more would be in terms of solutions?

Mr. ASIT KOTICHA: Roughly 75-80% of the revenue is from consumables, spares and service income. Balance is from sale of equipment.

Mr. CHETAN PARIKH: So far there was no scope for creating shareholder value at all in this company. But in future do you have any concerns on this, on the ability of this company to create shareholder values?

Mr. ASIT KOTICHA: Their focus, their clear focus is on creating shareholder value and even the parent company is insisting on this. They want Ramakrishna (Managing Director of this company) to focus on this benchmark. So I think they are very clearly focused and committed.

Mr. CHETAN PARIKH: What could turn this investment into a mistake at this price? What factors do you see?

Mr. ASIT KOTICHA: I think again if the present management team fails to deliver or it takes longer time than what one would normally expect, it may turn out to be not very rewarding experience. But the kind of things they have done in last one-year gives us sufficient confidence that chances of the faulting are minimal and upside is far superior.

Mr. CHETAN PARIKH: By when will all the initiatives on the cost structure start getting depicted onto the financial statements?

Mr. ASIT KOTICHA: Next year onwards.

Mr. CHETAN PARIKH: Any estimates of how much of cost reduction benefits will accrue next year onwards?

Mr. ASIT KOTICHA: We estimate that top line they might be growing by 15-20 percent, but bottom-line growth would be more than 35 percent for at least another two years or maybe 40-50 percent.