5/15/2017 The invisible gorilla in your living room – Value Investing Through Multidisciplinary Thinking

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Value Investing Through Multidisciplinary Thinking

The invisible gorilla in your living room

Christopher Chabris and Daniel Simons conducted a selective attention test in 1999 inwhich the subjects were shown a video of people passing a basketball back and forthand then asked to count the passes. More than half of the subjects failed to notice agorilla (just a student dressed like one) walking into the middle of the floor, thumpingits chest, and wandering off. This research has long been cited as a prime example ofthe limits of human observation.

There are so many things in our life, that often gets unnoticed. For example,

What is so special about the following pictures?

5/15/2017 The invisible gorilla in your living room – Value Investing Through Multidisciplinary Thinking

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Source: Pinterest, Homeedit.

Looks like an ordinary rooms? But take a closer look, what’s common between them?

Movie: The Graduate

This is where, this story starts. In a living room.

In December 2014, I wanted to purchase a few plastic chairs for my living room, sowalked into a retail store asking for them. This was my first brush with Nilkamal. Theshop keeper showed me a couple of chairs – most of them were that of Nilkamal’s.While I wanted to explore other brands, the shop keeper was quite insistent to proveNilkamal’s superiority and even threw a chair on the floor to prove its durability. Thatday, I walked out of the store with a couple of plastic chairs and a business (stock) toresearch.

My stock picking senses tried to rationalize the shop keeper’s behavior. May beNilkamal provided more commission compared to its competitors. If that be the caseand if Nilkamal is still able to create healthy cash flows either through higher margins

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or through higher turnover then its a worth a look. I decided to get to the ground tounderstand the business.

Going back to basics

First step is to disregard an unique experience. So, I revved up my engines and visiteda few more outlets to find out if my experience was unique.In most of the visits, hadsimilar experiences. This confirmed my first intuition that it would be the commissionthat’s resulted in dealership’s enthusiasm. Decided to understand its business andanalyze its financials in detail.

Nilkamal – the business

Nilkamal Ltd is the world’s largest manufacturer of moulded furniture like chairs, bins,crates, pallets, etc. Nilkamal became publicly listed company in 1991 . The corebusiness of Nilkamal can be divided into four:

1. Material Handling: It includes • crates, • pallets, • metal shelving & racking, •material handling equipment, • hospitality, • tool storage cabinets, • ice boxes, fishtubs, • vaccine carriers, • road safety products, • waste management tools, • coldstorage solutions

2. Furniture: It Includes • Living Room furniture •Storage Solution • Bedroomfurniture • Dining table set • Homeutility furniture • Office furniture • Plasticfurniture • School furniture

3. Chairs: It includes • Armless Chairs • Premium Chairs • High Back Chairs • Mid backChairs • Novells Series

4. @home retail: Home ideas & the home furnishing store

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Nilkamal in Numbers

In 2015, the material handling and moulded furniture together accounted for 84% ofthe sales, retail for 11% and others like mattress division,joint ventures accounted forthe remaining.

Material Handling and Moulded Furniture

Nilkamal also enjoys a leadership position in moulded furniture market with a marketshare of around 32% despite premium pricing with a lead of over two times its closestcompetitor. While this may contribute to the Nilkamal’s brand, it turns out that plasticfurniture is not the top contributor to its sales. Material handling products like crates,pallet trucks, stackers, fork lifts, etc.. which contributed to more than 50% of the sales.For a company like Nilkamal with a very strong positioning in plastics market with

5/15/2017 The invisible gorilla in your living room – Value Investing Through Multidisciplinary Thinking

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leading revenues in the industry, costs becomes a crucial element to determine itsprofitability. So lets analyze its costs in detail..

That which goes in…(the raw materials)

Raw material is the largest cost center. The key raw materials used for moulded plasticare high density polyethylene (HDPE) and Polypropylene. HDPE is made frompetroleum. In other words, crude oil prices and foreign exchange directly impact theraw material cost for Nilkamal.

This is quite evident from Management quotes in their annual reports.

“A further rise in raw material prices, if the crude gallops much above

the current levels, can result in a negative impact on the net realisations

in the forthcoming Financial Year.” – Annual Report, 2011

“The rise in the price of crude and the weakening of Indian Rupee will

definitely remain a major concern for the business” – Annual Report,

2012

The impact of raw material costs on sales:

Lets go a wee bit technical on the rawmaterial front. There is another way of makingmoulded furniture using low density polyethylene (LDPE) and it costs lower. In themarket there are quite a few unorganized players who use LDPE to make plasticfurniture. The difference is density of HDPE is marginally higher than that of LDPE,which in turn, provides higher tensile strength compared than LDPE. However, thedifference in strength exceeds the difference in density, giving HDPE a higher specificstrength. That is, HDPE plastics are harder and more opaque and can withstandsomewhat higher temperatures (120 °C/ 248 °F) for short periods of time. Though HDPEcosts more, the quality of the chair is at a higher level vis a vis LDPE. Because, Nilkamal

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uses HDPE, it ensures the quality and strength of the produce and in turn, adds to thebrand value.

That which is also goes in…(the brand)

I am sure you would agree with me when I say Coke or Intel have an enviable brand. Ifone has to evaluate such brands quantitatively, it is not the balance sheet where youhave to look for but the profit and loss statement. Usually Expenditures likeadvertising, commissions create such brands. But there are other cost line items alsowhich create brand. For instance Cafe Coffee Day has an enviable brand in india, but ifyou notice their cost line items, their advertising costs are minimal. SO what created abrand like coffee day. it is the huge rental expenditures which creates the Visibility. For a brand like Nilkamal, distribution cost is one of such costs that creates a brand byproviding access, availability and visibility to the customers.

With regards to

1. plastic furniture, it has appointed more than 30 DODOs (dealer owned, dealeroperated stores) across India. The company has robust network of 40 plus depots,more than 1,000 channel partners and over 12,000 dealers on a pan India basis.

2. material handling, it has pan India presence with 40+ regional sales office and salesforce strength of 300+, supported by 39 warehouses spread across India.

3. @ home outlets, it has 15 large format stores and one Go to Market (GTM) Store,spread across 12 cities, covering a retail space of over 2.46 Lacs sq.ft.

With such a wide spread of network it incurs significant transportation and marketingcosts. And it happens to be the second largest cost right below raw material costs.

Why is this cost significant? Buying Raw materials in bulk does give an advantageeither in price or credit period. So does establishing a pan India presence . Byexpending on average 6 percent of sales on transportation every year, it does providesNilkamal the pan India presence. Though the cost does not get capitalized as an asset(good will), it does create a brand equity when expended regularly. And the same isreflected through their market share.

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The brand it creates has an impact on material handling (B2B) market as well. A bit ofscuttlebutt helped me realize that many purchasing managers of companies preferpurchasing branded products for their company. They do so for two reasons,

1. Brand signifies quality of a product, and2. Accountability lies with the purchase managers

So, to reduce the risk of malfunctions (or bad quality) of a product, purchase managersprefer branded products.

Is Profit After Tax the actual profit?

The profits look as if they have not changed much, don’t they? But there is much moreto accounting profits, when you derive an intrinsic value of a company. That means, wegot to get down to owners earnings – net cash flows generated by the company, a keynumber to derive intrinsic value of any company.

If you observe, in the year 2014 & 2015, Nilkamal has generated 82 and 97 crore of cashpost capex respectively. But, in the previous table, which shows the accounting profitsdoesn’t indicate any change. The reason behind this stark difference is that theaccounting profit do not factor in the actual CAPEX and change in working capital,which are key to determine the cash profits of a company. Now the Question is whywas the CAPEX reducing and inventory getting well managed.

Getting the right footing

If you would closely read the annual reports, major growth capex done during theabove years were in retail and mattress division. According to the annual reports, the

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last growth capex invested in plastic division was in 2011.

“During the year under review, your Company has established a Green

Field Plant at Hosur in the state of Karnataka. Production has been

started thereat on trial basis and the plant is expected to become fully

operative during the current Financial Year”. – Annual Report, 2011

This 126,400 sq. meter factory complex has an installed capacity of 11,440 metric tonsper annum to manufacture molded furniture, injection molded crates and rotationalmolded products. After this, the company started investing in retail and mattressdivision, but soon realized they are losing or just breaking-even in this division andminimized the expansion spree. In 2012, Nilkamal had over 20 @home retail outlets,some of which were closed and some relocated. This change in strategy is quite evidentin their annual reports.

“The FY 2013-14 witnessed re-strategising retail business. During the

year the Company has closed operation of one store & opened one new

store while one store was relocated.” – Annual Report, 2014

Following table shows the strategy in action:

The company adopted ARS (Auto replenishment system) to mange its inventoryeffectively and the effectiveness of this system can be seen from the following metric:

Even with regards to mattress division, the company transitioned in this similarfashion from 2011 to 2015.

“The Company is planning to venture into activities related to

manufacturing, dealing and trading etc. of all kinds of mattresses made

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up of materials like coir, spring, foam etc. and other related products” –

Annual report, 2011

In 2013 “Company launched the mattresses in Eastern part of India during the secondquarter after establishing the production facility in Dankuni, Kolkata”, Also, it hasinvestments in production units in eastern and northern part of the country.

“Company is currently preparing itself to stabilize with a positioning of

an innovator and facilitator for the consumers in selection of right

mattress.” – Annual Report, 2014

While, the quote might not really mean much, the tone of the commentary clearlysignifies that it plans to pause investments in retail and mattress division whileconsolidating its operations. And the plan seems to be working (as seen in the ownersearnings table)

The indirect raw material..

As we saw earlier, crude oil prices, have a direct impact on raw material costs. But,how “direct” is direct? Let’s see…

The crude prices started cooling off from July 2014. If you notice closely HDPE andcrude oil are sometimes not directly proportionate.

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At times, oil prices and HDPE are decoupling. This could be due to demand supplyimbalance. In the graph, even though the oil has started dipping from July 2014, actualdip in HDPE prices were only noticed from December 2014. Similarly, the reduction inHDPE price, is not immediately reflected in raw material costs. This delay in the“direct” impact, is what is creating an imbalance.This is explained by the NayanParekh, Director, Nilkamal in the following video

STREET SIGNS- FROM THE BOARDROOM- NILKAMAL PLASTICSCNBC-TV18

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It key to note here that Nilkamal has average inventory days of 50- 60. This delayedimpact in raw material, is quite a catch because, it can help anticipating the trend ofraw material prices a bit in advance. Raw material going forward may remain lowgiven subdued oil prices. To this hypothesis, there is always risk of predicting oil prices,which is high risk assumption. To mitigate this risk, I took the shelter of valuation.

Value, check!

When I looked at Nilkamal as an investment on 30 june 2015, it was trading at a marketcap of 900 crores. On the basis of accounted earnings company was trading around 18PE, which seems fairly valued for a plastic business with a brand and loss making retailbusiness. But on the basis owners earnings (cash flows post capex & change in workingcapital) was trading at little less than 10 PE. A 10PE means, an investor buyingNilkamal is attaching a zero growth to a business. A business which is the largestfurniture maker, is a leading brand and is reducing the investments on loss-makingexpansions like retail and mattress. In addition to this, high chances of reduction inraw materials have not been factored in. We know that the reduction in RM cost canhave compounded effect on Nilkamal’s profits, because they are brand who I assumehave a pricing power (premium pricing model). By keeping the expectations low, therisk was factored in.

I deliberately did not include relative valuation with its peers,as i am not a greatbeliever of peer comparison  & rerating, when it comes valuation. In most cases everybusiness have their own DNA.

Cherry on the top

An interesting thing happened in 2014 -15, that rekindled my interest. Wim Plast(cello), one of Nilkamal’s competitor, bought more than 1% stake in the company.Personally, I assume that the competitor understands a business better than many ofthe investors and stakeholders. This need not always be true and this certainlyshouldn’t be the only criteria to buy a stock. But this could be a valuable data pointwhile researching a stock.

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While my research started out at the most ordinary moments, it turned out to beanother incredible journey in understanding value investing. I hope you enjoyedreading this and found the analysis helpful.

Author: Mallikarjun Gaddam Twitter: @arjun848

 

Acknowledgements: I gratefully acknowledge the help provided by Aparna in writingthis. You can follow her here

Disclaimer :I have a position in Nilkamal but not at current prices.  This is not arecommendation to Buy, Sell, or Hold. I am not a SEBI registered analyst. I am a facultywho teaches value investing and the above thoughts are a result of my analysis anddiscussion with students. I wrote this document to organize my thoughts and deepen myunderstanding about the company and industry. I am sharing it so that you can learnsomething from this.

Featured image source: NewYorkTimes

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Mallikarjun GaddamI am an investor seeking to buy companies below their intrinsic value.I am also a consultant withIndian School of Business and teach " Value Investing" at Premier B- Schools View all posts by Mallikarjun Gaddam

May 7, 2017 Mallikarjun Gaddam Value Investing

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