Monday, 27 January 2014

My Investment Thesis on Rain Industries

The depressed valuation of this leveraged, underfollowed, niche market, stable margin, and oligopolistic natured business provides an opportunity for a serial capital compounder. 

Investment Thesis

The investment idea presented in this report is a little known industrial business based out of India with global operations called Rain Industries Limited (“Rain”). What started as an Indian cement producer in the early-70’s, is now a global conglomerate with over US$2 bln in annual revenues. Rain can be split into three primary businesses: petroleum coke calcining (36% of revenues), RÜTGERS’ primary coal tar distillation and chemicals production (58%), and the cement business (7%). The company’s two main products of calcined petroleum coke (CPC) and coal tar pitch (CTP) – combining for ~47% of revenues – are used by aluminum smelters in carbon anode production.
Recent Events. On Oct-21-2012, Rain announced the acquisition of the leading coal tar distiller in Europe called RÜTGERS. The acquisition for a gross enterprise-value of €702 mln (₨59.6 bln) was the company’s second overseas leveraged buyout (LBO), and with it Rain became the largest ‘carbon’ supplier to the aluminum industry globally. The acquisition was completed on Jan-04-2013 and yet for nine months ending Sep-30-2013 Rain has earned ₨10.03/sh versus ₨13.22/sh for the same period in 2012. At the time of the announcement, Rain had a market capitalization of ₨14.9 bln (US$280 mln) and based on 2012 earnings, was trading at a P/E of 3.2x. Currently Rain trades 2.7x 2013E earnings with a market capitalization of ₨12.0 bln (US$195 mln). While a margin squeeze in the company’s calcining business explains most of the earnings compression, a number of factors have contributed to Rain’s depressed valuation, namely: i) despite an acquisition valued at ~4.0x Rain’s market value investors have not seen any earnings accretion to date; ii) investors are worried of the company’s leverage ratios; iii) the aluminum industry is out of favour with aluminum prices falling 25% since Jan-2011; iv) the Indian market is out of favour – in 2013 the BSE Sensex index rose 9% while the Indian Rupee depreciated 12% whipping out any gains for foreign investors; v) the company operates in a niche carbon industry with few publicly traded comps; vi) it is an Indian stock with a market capitalization under US$200 mln removing it from most investment manager’s universe; vii) portfolio managers are wary of fraud in all foreign listed equities; and lastly viii) it is fairly challenging for non-Indian Residents to invest in Indian listed securities. All of these factors combine for an inordinately cheap valuation and attractive risk/reward opportunity.
I believe Rain is a potential “triple play” – essentially you’re buying a quality business, trading at a depressed valuation, and one that is operated by a competent and well-aligned management team – providing several avenues for capital appreciation.
  1. Quality of Business. Rain operates as a market leader in both pet coke calcining and coal tar distilling, which are best described as oligopolistic. Barriers to entry for these businesses include: regional markets created by notable transportation cost, longstanding customer and supplier relationships, strategically located facilities, and trademarks and patents. The carbon business operates on a cost pass-through business model, where the operator earns a stable return for sourcing and processing raw materials. Similarly, both pet coke calcining and coal tar distilling take by-products from crude oil processors’ and steel manufacturers’ and turn them into value-add products for the aluminum and chemicals industry. In an economic downturn Rain is able to offset lower selling price with cheaper raw materials; however the recent period has been exceptionally challenging with aluminum prices falling 25% since Jan-2011 and energy-based raw materials cost remaining relatively flat (green petroleum coke and coal tar). Despite volatility in the aluminum prices, from 2008-2012 the calcining business earned 22-25% EBITDA margin (18% in 2013E) while RÜTGERS has earned 11-12% over the last four years (10% in 2013E), demonstrating the business’s low operating leverage.
  2. Business Value. Over the business cycle, Rain is capable of earning ₨26.80/sh in EPS, US$387 mln in EBITDA, and US$204 mln in unlevered free cash flows per year. With lower selling prices combined with compressed margins in its two main products sold to the aluminum industry, I expect EBITDA to come in at US$267 mln (approximately 23% lower than 2012 inclusive of RÜTGERS). The impact on earnings will be much greater – while Rain has acquired businesses with low operating leverage, the company does employ leverage in its capital structure. My 2013 EPS estimate is ₨13.48/sh (40% lower) compared to the consolidated profits of ₨22.42/sh in 2012 if RÜTGERS earnings were added and adjusted for changes in exchange rates. Rain’s valuation on these depressed earnings is still depressed. Using 2013 numbers Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which for simplicity sakes we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA multiple of 4.2x. I believe Rain is worth in the ball park of ₨177/sh or ~4.9x its current share price based on a discounted cash flow valuation approach using normalized earnings and 10% discount rate.
  3. Management Plans and Interest. Rain is operated by a well-aligned management team with a track record of prudent capital allocation. Jagan Mohan Reddy is the CEO of the company co-founded by his father, and overall the Reddy family owns ~40% of Rain Industries providing significant alignment of interest. Management is well aware of its depressed valuation and plans to return capital to shareholders while de-leveraging the corporate structure. From 2007 to 2012 Rain reduced its net-debt from US$728 mln to US$413 while returning 12% of income to shareholders.
The Special Situation. The key catalyst for Rain will be the management’s plan to pursue a U.S. listing of the carbon business (calcining, coal tar distilling, and chemicals) in late 2014. While details of the listing are still up in the air, it creates a special situation in Rain’s corporate structure – creditors have provided the company with ~US$1.3 bln at a cost of ~8%, while the equity currently yields over 70%! It is relatively easy for a small cap, leveraged, and niche industry Indian stock to be mispriced, but a partial U.S. listing of the carbon business (which I believe is worth ~US$1.9 bln) should provide a material re-rating in the valuation and also help de-leverage the company.

Back on the block (blog)

Last year I took an hiatus from blogging as most of it was spent working on the sell-side, which provided several regulatory restrictions and very little time to maintain a blog. Now having learned some of the technical skills required to understand and value a business, I hope to find a home at a value-minded shop where I can do what I love on a daily basis. While my search for a home on the buy-side continues, I will post any interesting investment ideas I come across. 

I've also started to manage money (pro-bono basis) for a couple of friends and a family member and this blog provides an ideal medium of communication with them as well. Since the funds are small and liquidity is not a concern at this point, I will try to update all buy/sell decisions in a timely manner - hopefully my "clients" can also gain some transparency into how their money is being invested.

Results and lessons:
Being based out of Canada and having no particular desire of investing in commodity based businesses, I will use the S&P 500 Index as my general benchmark. Last year was a great year for most equity indices and I'm obviously pleased by a year in which my holdings gained +40% while beating a fast rising market - however the year wasn't without its share of mistakes.

Key mistakes: 
  • Investing in a risk arbitrage situation (fancy word for buying a stock trading below its proposed acquisition price). Last summer I made a purchase of a stock offering 8-16% (tender offer had a range) in this situation despite reading warnings from several great investors on why these situations should be avoided - limited upside, much greater down-side, uncertain timing, and a lot of work for the usual 10-12% reward. I rationalized the purchase with the following: i) extremely cheap valuation - the stock was trading at under 5x EV/EBITDA at its takeout price; ii) stable/non-cyclical business - the company provides a niche equipment rental service to hospitals; and iii) well-aligned management - an activist investor stepped in the year before to replace the company's handsomely paid management team - in fact it was the activist investor acting as the company's Chairman that made the offer. Much to my dismay, two weeks after the initial offer the board rejected the bid citing "too low of a price". A couple of months go by and the stock now traded at 25% below my initial purchase. Since the underlying business did not change, and the valuation became much more attractive, I was happy to purchase shares on the way down while being cognoscente that shares could languish until the company decided to start returning cash or another buy-out offer comes by. Luckily, Mr. Market corrected the disparity between the company's price and value much sooner - shares closed the year at $2.14, with my initial purchase coming at $1.73 and average price of $1.49, I was able to walk away  from this lesson relatively and absolutely scot-free. 
  • Seeing a "special situation" through - last year I invested in my first spin-off - I provided a brief write-up on the situation in my Deans Foods post. This particular spin-off offered a bit of everything - a partial listing, spin-off of a high-growth business (WhiteWave), a residual leveraged-stub (remaining Dean Foods), cyclically depressed earnings, corporate restructuring (Dean Foods had also sold its Morningstar business and was aggressively paying down down), and  the promise of shareholder friendly capital allocation going forward - essentially, no matter what I did I should have made money. I realized a gain of 8% in just under 6 weeks - if I had held onto my position until the remaining spin-co shares were distributed, I would have made 28% in 9 weeks - however I was much more concerned about the "DF Stub" valuation and wasn't able to see the bigger picture transformation that was happening at the company. 
  • I'm not sure how to categorize this next mistake other than "once you find a compelling idea - invest in it", don't be an idiot and wait for your other positions to reach a selling price. Last fall I wrote a report for the annual value investing contest hosted by SumZero, with naturally my most appealing investment idea at the time. However, instead of taking a sizable position I waited for the opportunity to exit one of my other positions. The company received a go-private offer in the following weeks and shares ended the year 62% higher than my initial price write-up price.
Other errors include: a purchase of a competitive and deteriorating business, numerous omissions of decent businesses at great prices (debatable if errors), and my initial over-concentrated portfolio (2 positions). As you might imagine, still having a shirt on my back despite all these mistakes made me quite pleased with the 2013 results, and even more excited about future investments. 

Returns to date: I will continue to post my personal returns on a quarterly basis, other portfolios I manage will track these results extremely closely.