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.

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