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Safal Niveshak StockTalk #7: Clariant Chemicals

Welcome to the seventh issue of Safal Niveshak StockTalk.

After covering Balmer Lawrie & Co. Ltd. last time, this time I delve deeper into another small-cap company, Clariant Chemicals India Ltd. (CCIL). Before we dive deeper into CCIL, here is a brief overview of the sections of this report.

  1. About CCIL
  2. Safal Niveshak’s 20-Point Checklist
  3. Intrinsic Value Assumptions
  4. Financial & Market Snapshot
  5. “Should I Buy CCIL?” Checklist

1. About CCIL

CCIL is a 63% subsidiary of Clariant International, the Switzerland headquartered global leader in the field of specialty chemicals. CCIL’s presence in India began in 1947 with the founding of Sandoz Products. The acquisition of the Hoechst specialty chemicals business in 1997 brought Colour-Chem Ltd. and its subsidiaries into its fold.

Then, the acquisition of BTP in 2000 led to the integration of a fourth company BTP India Pvt. Ltd. into the group’s operations in India. In 2006, four of the affiliates were integrated into Colour-Chem Ltd. and the company was subsequently renamed Clariant Chemicals (India) Ltd. (CCIL).

CCIL is India’s leading specialty chemicals company and is the leading player in the pigments, textile chemicals, leather chemicals, and biocides (for paints) industries.

The company classifies its range of products into two segments: Intermediates and Colors (39% of 2011 sales) and Dyes and Specialty Chemicals (61% of 2011 sales).


Data Source: Ace Equity, Safal Niveshak Research

The former segment is a leading provider of organic pigments, pigment preparations and dyes used in coatings, paints, printing, plastics and other specialty applications. CCIL’s product portfolio meets the demands for automotive and home decoration paints, household detergents, packaging labels, colorant used in ink jet and laser printers. Its key market segments are trading and non-impact printing, electronic displays, all plastics including films, fibers and special applications, detergent coloration, cosmetics, aluminum finishing, automotive, industrial decorative and architectural paints and coatings.

The second business of dyes and specialty chemicals comprises of products for the textile, leather and paper industries and performance chemicals for personal care and industrial applications. Key market for CCIL’s products in this segment include apparel, clothing of all types and fashions, home textiles such as towels, drapes, linens and furniture fabrics, technical textiles for applications including medical, construction, sports and industrial, carpets including indoor and outdoor floor coverings and fabrics in hard wearing transport applications such as planes, buses and trains.


2. Safal Niveshak’s 20-Point Checklist

Keeping in mind the simplicity aspect that is otherwise missing in other company analysis reports you would come across, I’ve analyzed CCIL by answering 20 important questions that span its:

  1. Business performance,
  2. Financial performance,
  3. Management quality, and
  4. Competition.

Here is the complete 20-point checklist with my explanations.

Before we move ahead, here are the symbols that I’ve placed against each checklist point and that will tell you at a glance whether I have a positive or negative view on that particular point.

   Indicates my positive view

   Indicates my negative view

Let’s get started.

A. Business

1. Can I, in simple words, explain what the company does?
Yes. CCIL is India’s leading manufacturer of specialty chemicals and caters to textile, leather and paper industries among others. It also serves the needs of industries like automotive and home decoration paints, household detergents, packaging labels, and colorant used in printers through its second business segment of intermediates and colors.

2. Does the business have high uncertainty?
CCIL’s diverse nature makes it less prone to future uncertainty. So in a year when one particular segment performs poorly, other segments do well to even out the negative impact. Also, the specialty chemical products that CCIL offers are not cyclical in nature, so the company operates in a relatively less uncertain business environment as compared to other commodity-like chemical companies.

3. Has the business got an enormous moat?
CCIL’s long history of leadership position in most of its client industries provides it with a good (though not enormous) competitive advantage over competitors. Also, specialty chemical is not a commodity business unlike general chemicals, and thus provides the company a good pricing power over its competitors.

This is clearly seen from the gradual rise in CCIL’s average realization (revenue per unit sold) across different product segments over the past few years.


Data Source: Ace Equity, Safal Niveshak Research

4. Does the business generate strong free cash flow?
Yes. Despite some volatility, CCIL has consistently seen positive free cash flows over the past 10 years (except a negative figure in FY11, due to rise in working capital requirements). A combination of improving operating margin, and a high return on capital has led to a positive free cash flow performance in the past.

Data Source: Ace Equity, Safal Niveshak Research

5. What is the bargaining power of suppliers and buyers?
As we discussed above, specialty chemicals is not a commodity business and thus enjoys some pricing power. Moreover, CCIL is a long standing and well-known brand name, which combine to provide some bargaining power to the company over its buyers. However, since the company uses crude-based derivatives as raw materials, it does not have much bargaining power against its suppliers (of raw materials) and has to be a price taker.

B. Financial Performance

6. Does the business have a consistent sales and profit growth history and is there room for future growth?
Yes. CCIL has grown its consolidated sales and net profits (FY11 net profit adjusted for one-time gain from sale of assets) at an average annual rate of 11% and 15% over the past 9 years, which is a decent pace of growth. As for the future, I see the company maintaining a good growth rate – largely led by rising demand for its specialty chemicals.


Data Source: Ace Equity, Safal Niveshak Research;
FY11 net profit adjusted for one-time gain from sale of assets

7. Are EBIDTA margins higher than 15%?
No, but I am not concerned much on this account. CCIL’s business is such that generate sub-10% margins. But despite this, what is more important is that the company has been gradually improving the same consistently and has also earned higher return on capital over the years.


Data Source: Ace Equity, Safal Niveshak Research

8. Is its operating cash flow higher than net profits?
Yes. CCIL’s operating cash flow has been consistently higher than its net profits (FY11 net profit adjusted for one-time gain from sale of assets) over the past 10 years (except 2 years when operating cash flow has been marginally lower than net profit). I see this as a positive as it indicates a good management of the cash flow situation.


Data Source: Ace Equity, Safal Niveshak Research

9. Is the debt to equity below 0.5 times?
Yes. CCIL has been an almost debt free company for the past 10 years, and it’s current debt stands at near zero.

10. Is the current ratio greater than 1.5?
Yes. CCIL’s average current ratio has been 1.6 times over the past 10 years, which is a comfortable number and shows an overall good working capital management.

As a general rule, a current ratio of 1.5 or greater suggests that a company can meet its short-term operating needs sufficiently. However, a higher current ratio can also suggest that a company is hoarding assets instead of using them to grow the business. While this is not the worst thing in the world to do, it is something that could affect long-term returns.

11. Does the company have a good dividend history?
Yes. In terms of dividend payout (amount of dividend paid as percentage of net profit), CCIL has averaged around 66% over the past 10 years. This is a very comfortable level from a shareholder’s point of view. What is more, CCIL’s dividend yield (dividend per share divided by current stock price) over the past five years has averaged around 7%, which is a very good number.

12. Is the Altman Z score > 3?
Yes. CCIL is absolutely safe against any possible bankruptcy. Read more on the Altman Z-Score.

13. How capital intensive is the business?
CCIL’s average capital employed per year over the past 10 years has been around Rs 2.5 billion. Against this, in FY11, the company earned net sales of Rs 9.6 billion. This suggests that the capital turnover ratio has been around 4.3 times, thus indicating that the business is not capital intensive.

What other conclusion can we draw from this analysis? When capital turnover ratio is high, the company can afford to have a low margin, and still deliver an exceptional return on capital (which has been the case with CCIL). In case of CCIL, we already know that Capital Turnover is around 4.3. So, even if the company operates at a 6% margin (its net margin currently is around 11%), it can continue to earn a return on capital of around 26%! Not bad at all.

14. Has it got a high and consistent return on capital and return on equity?
Yes. CCIL’s average return on equity has been around 20% over the past 10 years, which is a reasonably high number, and suggests the company’s good capital allocation skills.


Data Source: Ace Equity, Safal Niveshak Research;
FY11 net profit adjusted for one-time gain from sale of assets

C. Management Quality

15. Is the management known for its capital allocation skill and integrity?
CCIL has been a great performer on the capital allocation front all these years. The management has guided the company well over the past few years, so the track record in terms of integrity seems fine. Even as far as the capital allocation part is concerned, we have seen how the company has continued to maintain a high return in equity (average of 20% over the past 10 years; 32% in 2011). So, overall, I’m comfortable with the management and its capability to guide the company in the future.

16. Has there been any substantial equity dilution in the past?
CCIL has never diluted its equity capital in the past.

17. Are management’s salaries too high?
I could not find CCIL’s top management compensation for the past.

18. What has management done with the free cash in the past?
CCIL has reinvested a lot of free cash back into the business. A good part has also been doled out to shareholders as dividends.

D. Competition

19. Does the business face high competition?
Yes, most sectors that CCIL caters to through its chemicals business face moderate competition.

20. Has the management focused on market share or profitability in the past?
A combination of both, which is good.

3. Intrinsic Value Assumptions

Before I move into calculating the intrinsic or fair value range for CCIL, let me make one thing very clear.

Intrinsic value isn’t a definite figure but just a ‘calculated’ value. In fact, the calculation of intrinsic value of a business mostly throws up a highly subjective figure. And this figure changes as estimates of variable like future cash flows are revised (given that the future is unknown).

Anyways, what I have done here is rather than arrive at a single intrinsic value figure for CCIL, I have calculated the value using 5 different methods and then arrived at a ‘fair value range’ for the stock.

1. Net present value based on a 2-stage 10-year DCF
The discussion about the calculation of net present value using a discounted cash flow model (DCF) can be found in the 7th lesson of my free course on investing – Value Investing for Smart People.

I have done a 2-stage DCF analysis for arriving at the intrinsic value for CCIL.

But as a reference, here is the formula for calculating the NPV:

NPV = CFi / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year

I have calculated CCIL’s future cash flow for the next 10 years, assuming 2 different rates of growth in cash flows of 10% (years 1-5), and 8% (years 6-10).

As for the discount rate, I’ve assumed it at 15% assuming the average cost of capital for the company. My expected terminal growth rate for the company’s cash flows – expected growth in cash flow after 10 years and till eternity – is 2%.

Based on these numbers and after reducing the net debt (debt minus cash), the present or discounted value of future cash flows for CCIL is coming at Rs 672 per share, which is also the stock’s intrinsic value using this method.

2. Earnings Power Value (EPV)
After DCF, the second most reliable measure of a firm’s intrinsic value is the value of its current earnings. This method is known as ‘Earning Power Value’ or EPV. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past.

The formula for EPV of a company is:

EPV = Adjusted Earnings x 1/R

Here, ‘R’ is the cost of capital.

CCIL posted an adjusted EPS (earnings per share) of Rs 39 in 2011 (adjusted for one-time gain from sale of assets). Now, if the company’s profits were to stagnate and remain at Rs 39 per share going forward, and applying the EPV formula here, I multiply Rs 39 with 1/15% (15% is the approx. cost of capital for the company).

This gives me a value of Rs 258 per share, which is CCIL’s intrinsic value as per the EPV calculation.

3. Pricing relative to 10 year average P/E ratio
True value investors, as Graham has prescribed, won’t pay a price based on the stock’s latest P/E or the company’s latest earnings. They will take a much longer term view…as long as 10 years.

Here, I have attempted to estimate the intrinsic value of CCIL using the company’s last 3 years average earnings and last 10 years average P/E ratio. So the formula is:

Last 3 Years Average EPS x Last 10 Years Average P/E Ratio

CCIL’s average P/E ratio for the past 10 years has been around 16.2 times, while its last 3 years’ average EPS has been Rs 40.4 per share (FY11 EPS adjusted for one-time gain from sale of assets). Based on the formula, CCIL’s intrinsic value is coming to around Rs 656 per share.

4. Graham number
Graham number is the formula Ben Graham used to calculate the maximum price one should pay for a stock. As per this rule, the product of a stock’s price to earnings (P/E) and price to book value (P/BV) should not be more than 22.5 i.e., P/E of 15 multiplied by P/BV of 1.5.

But why did Graham specifically used a P/E of 15 and P/BV of 1.5? Why didn’t he use some other numbers?

Well, he thought that nobody should be willing to pay more than the AAA bond yield at that time. AAA bond yield at that time was 7.5%. Therefore, AAA P/E was arrived at 1/7.5 or 13.3, which was rounded up to 15. Similarly he thought that nobody should pay more than 1.5 P/BV for a stock.

Graham insisted that the product of the two shouldn’t be more than 22.5. In other words,

(P/E of 15) x (P/BV of 1.5) = 22.5

Put another way:

(P/E) x (P/BV) = 22.5

Price(sqr)/(EPS x BVPS) = 22.5

Price(sqr) = 22.5 x EPS x BVPS

Take the square root of both sides, and you get the equation for the Graham Number.

Fair Value Price = Square Root of (22.5 x EPS x BVPS)

Applying this formula, CCIL’s intrinsic value comes to around Rs 398 per share (FY11 net profit and thus EPS is adjusted for one-time gain from sale of assets).

5. Dividend discount model
As we have discussed in the DCF method above, the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate or discount rate. Now, as per the Dividend Discount Model or DDM, dividends are the cash flows that are returned to the shareholders.

Hence, to value a company using the DDM, you calculate the value of dividend payments that you think a stock will throw-off in the years ahead. Here is what the formula is:

Intrinsic value = Dividend per share/Discount rate

The modified formula for valuing a company with a constantly growing dividend is…

Intrinsic value = Dividend per share/(Discount rate – Dividend Growth Rate)

Given that CCIL has consistently paid higher dividends over the years, we use this ‘dividend growth’ formula for calculating the stock’s intrinsic value.

Assuming a discount rate of 15%, dividend growth rate of 13%, and the 2010’s dividend of Rs 30 per share (I have not used the latest year 2011’s dividend because it was extraordinarily high due to the one-time gain the company made on sale of some assets), and inputting these numbers in the above DDM formula, I get to an intrinsic value of Rs 1,500 per share.

Fair Value Range
I have calculated 5 different intrinsic values for CCIL using 5 different methods. So much for the ‘target prices’ you hear on business channels every day as if these were the holiest numbers!

As you can see from the above calculations, the ‘target price’ isn’t such a holy number and can differ based on the method used to calculate it.

Anyways, based on the above calculated intrinsic values for CCIL, I can arrive at a ‘fair value range’ for the stock. Here is how I calculate it:

High End of the Fair Value Range = [Average of above four intrinsic values]
Low End = [(Average of above four intrinsic values) – (0.5) x (Std Dev)]

Based on this, the fair value range for CCIL’s stock is Rs 460 to Rs 700. Assuming a margin of safety of around 25% to the higher end of this range, the comfortable buying price for CCIL’s stock comes to Rs 525 using the intrinsic values calculated above. However, considering that CCIL has around Rs 110 per share of cash on its books, and if I assume only 50% of this excess cash, I would be comfortable buying the stock at a price lower than Rs 580 (Rs 525+55), as the extra cash in bank adds to the stock’s margin of safety.

Given that CCIL’s current price of Rs 606 is just around 5% higher than my comfortable buying price, if I have surplus cash to invest, I would start buying the stock in small quantities (the stock’s 5% dividend yield, adjusted for one-time gain on sale of asset in 2011, will also add to my return).

The only point of technical concern regarding CCIL’s stock is its average daily liquidity (number of shares traded), which is on a lower side at around 6,300 shares. However, this is typical of small cap stocks, and one reason that makes this category more volatile than large cap stocks.

Warren Buffett once said, “Why is it that when departmental stores announce sale, people flock to the stores, but they do not put a dime when equities are on sale? Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

So, as a sensible, long term investor, your aim must be to purchase a slice of easily understandable business with consistent & predictable earning flow. Overall, I believe CCIL fits into that category very well.

If one is thinking of making a quick buck, this isn’t the right company. But if one has patience, the stock has the ability to give good returns over the long term.


4. Financial & Market Snapshot


Data Source: Ace Equity, Safal Niveshak Research


Data Source: Ace Equity, Safal Niveshak Research

    
Data Source: Ace Equity, Safal Niveshak Research


5. “Should I Buy CCIL?” Checklist



Your feedback is important
So that was my take on CCIL as part of the Safal Niveshak StockTalk initiative. I’ve tried to be as comprehensive in my analysis, while trying to keep the report very simple. Let me know what you think of this report and the improvements therein.

Do you think I’ve missed mentioning something specific here? Can the Safal Niveshak 20-Point Checklist be modified or expanded any further? Do you find this report simple enough for your understanding?

Your answers would help me in making the Safal Niveshak StockTalk report, and the entire initiative, more beneficial for you.

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Disclaimer: The author of this report, or any of his family members, does not own the stock(s) mentioned herein. The opinions in this report are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stock(s) mentioned or to solicit transactions or clients. The information in this report is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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