Good Company, Bad Sentiments

On the surface, nothing seems good about SRF's prospects. The industry it operates in is also infested with sickness.

But dig a little deeper and you find a company going cheap.

There's a school of inve-stors who believe in the "vulture principle" -- waiting for bad times to hit a company and for the stock price to dip to be able to pick up the scrip cheaply. They normally target only those companies that are temporarily in the doldrums, but which have long track records and are no strangers to the stock market and once enjoyed good discountings. The trick here lies in estimating the assets of the company and the point at which the company is likely to turn around. The Smart Investor decided to find out if SRF which belongs to the Arun Bharat Ram faction of the Delhi-based Shrir-am family could be such a stock.

 

At first look, everything about the company appears bleak. The company's stock quotes at the BSE at about Rs 20. The recently declared results indicate that the net profit has almost halved from Rs 32.71 crore in 1995-96 to Rs 16.31 crore in 1996-97. The EPS on equity of Rs 44.25 crore is Rs 3.69. The nylon industry, in which the company operates, is infested with sickness with most players teetering on the verge of collapse. The major user industry, automobile tyres, has had a year of stagnant growth. To top it all, the product is an undifferentiated commodity product which competes with imports in a scenario where import duties are coming down every year.

But look again and the same figures indicate that SRF has posted an operating profit margin of an incredible 30 per cent. Net sales, at Rs 244.02 crore in 1994-95, has increased about 128 per cent to Rs 557.55 crore in 1996-97. Operating profit, at Rs 56.57 crore, has trebled to Rs 180.55 crore. SRF has grown by acquiring Ceat's nylon cord division ins-tead of setting up a greenfield project to expand capacity. The OP margins have improved from 23 per cent in 1994-95 to 30 per cent in 1995-96 and 1996-97. The return on capital employed for 1996-97 works out to about 16 per cent, this after the company has invested about Rs 323.40 crore in 1995-96 to acquire the Ceat division and another Rs 100 crore in the weaving unit in Jebel Ali.

The high OP figure translates to a meagre net profit because of a high interest burden of Rs 117 crore. A market player, who is accumulating the company's sc-rip says: "They have a large interest burden as they had to fund the acquisition of Ceat Tyres with short term funds for which they had to pay interest of 30 per cent at the margin. As long term funds are not available for acquisitions, in SRF's case it made more sense to acquire an existing plant than to add fresh capacity as this industry is not a high growth industry and extra capacity will lead to excess supply".

Back of the envelope juggling with the capital structure reveals that the company could easily save about Rs 40 crore of interest this year. This year's capital is Rs 900 crore and debt is Rs 560 cr-ore. This includes short-term de-bt of Rs 90 crore. The average interest rate is 21 per cent and the rate at the margins would have been 27-30 per cent. The sale of SR-FF infuses about Rs 55 cr-ore of cash to repay debt. Even 25 per cent on Rs 55 crore saves Rs 13.75 crore.

Also on the cards is a Rs 60 crore rights issue and private placement at a price of about Rs 25. This would take another Rs 20 crore off the interest burden. Ravi Sinha, managing director, SRF, scoffs at the high prevailing int-erest rates: "A company with turnover of $ 170 million with a capital structure similar to ours would pay an interest of $14 million while we end up paying $33 million. So we are considering raising loans overseas.

A company like ours should be able to raise loans at 10 to 11 per cent". A Rs 50 crore overseas debt would save another Rs 5 crore from the interest burdens. These calculations assume that the finances are available beginning of this financial year. Even if there is a delay till September or November, there could be savings of between Rs 20-30 crore.

These calculations do not include the possible cash inflows if the polyester and vision care divisions are hived off as seperate units or as JVs. Even from the assets point of view the company seems undervalued. The company has two subsidiaries, SRF Needle Bearings and SRF Bearings, which were acquired from BIFR at Re 1. Today they are thriving companies. It also has prime real estate like 100 acres of land at the Madras plant.

After the financial juggling ar-ises the crucial question: Are the products from company's two main lines of businesses going to survive in the long term? Seve-nty seven per cent of the company's revenues in 1995-96 came from industrial nylon and 20 per cent from refrigerant gases.

In the industrial nylon units the company manufactures both yarn and fabrics. Nylon 6, industrial yarn is manufactured from caprolactum which is then twisted into tyre cord (NTC). NTC is then woven into tyre cord fabric. The fabric is dipped into chemicals for smaller tyre manufacturers. The tyre cord fabric is used for re-inforcement of rubber carcass in a tyre. The tensile strength, resistance to abrasion, fatigue resistance and load bearing capacity of the re-inforcement material determine the longevity of the tyre.

The substitute products for nylon 6 are nylon 6,6 and polyester. Du Pont claims that although the molecules are similar, nylon 6,6 has a higher melting point. Higher melting point means that a tyre can be cured at a higher temperature which would results in reducing cycle time and thus increase productivity. But a tyre industry source says "It is true that productivity can be increased if a higher curing temperature is used. But in India we use natural rubber and synthetic rubber in the ratio of 90 : 10 whereas in the West, it is just the reverse. High temperatures cannot be used with natural rubber. Also current production lines at most tyre companies cannot operate at high temperatures". The nylon 6 producers' lobby also claims that there is a significant productivity increase only in the case of smaller tyres.

Another user industry source who feels that Nylon 6 will there for a long time says "Nylon 6,6 is expensive. Dupont, in India, is just going to weave Nylon 6,6 fabric and is going to import the yarn. SRF can do the same too here. Their Jebel Ali plant too can weave both Nylon 6 and Nylon 6,6 fabrics. Some tyre majors like Goodyear, Bridgest-one etc. are using Nylon 6 in Asia. It is in fact rumoured that Du Pont has bought some Nylon 6 plants in Asia". Sinha strengthens his company's case by citing the Indonesian example "A company called PT Filamendo used to manufacture both the yarns. Its Nylon 6,6 capacity has remained the same while the Nylon 6 capacity has multiplied".

Polyester is another substitute product. A tyre industry pla-yer says "Polyester does not loose shape easily. It will increasingly be used in smaller tyres. But in large truck and bus tyres Nylon 6 will be used". Radial tyres are another threat to the product. But truck and bus tyres in India may not turn radial for a long time due to road conditions.

SRF with its increased capacity of 21000 tpa of yarn has bec-ome a market leader with a 36 per cent share in tyre cord fabrics. The transition is apparent in the working capital cycle. The debtor days have reduced, creditor days have increased and the company increased prices twice in a year when international prices were falling. SRF's bargaining power with raw material suppliers is also evident. In the second quarter of 1995, the company's caprolactum purchase cost was 13 per cent less than the landed cost of imports.

The other business of the company is also an oligopoly in which SRF dominates with a 40 per cent share. According to the Mont-real protocol, CFCs have to be phased out by 2010. So this is a high profit margin cash cow. After the phase out, the same plant can be used to make HCFCs though the capacity will be halved. But Sinha expects that it will be offset by an increase in realisations. Two thirds of the same plant can also be used to make some HFCs which is the substitute for CFCs.

The company is on a strong wicket in terms of its products. But much is going to depend on how soon it can tie up its funds and come out with its rights issue. The benefits of the financial re-structuring will show fully 1998-99. Watch this scrip.