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The Right Chemistry

Vidya Vishwanathan  |  BSCAL 

Clariant is one of the few fundamentally good companies still available at a cheap valuation. This makes it a good buy

A stock with very little downside and a very high potential upside is a dream stock for anyone's portfolio. Many stocks would qualify this criteria. But apply the condition that it should also be undervalued or at least rightly valued and the choice gets limited.

One stock that fits the bill is Clariant (India). Before we get into the valuation of the stock, let us understand the business of the company. The company has two business divisions and is a market leader in both the businesses. The first division produces dyes and chemicals for the textiles, paper and leather industry. This is currently a fragmented industry which is now consolidating. With increased concern about environmental issues, the industry will consolidate in favour of larger players where Clariant will benefit.

The second division produces dyes, coatings and chemicals for polymers, plastics, packaging, and printing inks. It is used in products like rexin, plastic containers, packaging material and even automobile plastic. All these industries have a high potential for growth in the country.

Its raw material costs are not very high and the raw materials easily available. So no supplier has a hold on it. Also it has a wide range of customers, so its business does not depend on any single customer. The labour component of the business is not high nor is skilled labour needed and the business is also not very capital intensive. The only thing critical to the company is the formula for mixing the chemicals, which is the technology component, in which the parent company is strong.

Clariant which exports 32 per cent of its turnover is one of the three global sourcing agents for the Rs 26,500 crore parent Clariant AG which operates in more than 60 countries. So the company is strongly positioned in the market. The company's annual report inspires confidence because it is extremely conservative.

Now let us look at the valuation of the company. This could be done in two ways. In the first method, we can take the free cash flow for the company for the next eight years and take a terminal value for the free cash flow. We calculate the present value of this cash flow then. This is done by discounting the cash flow by the cost of capital. The present entity value of the cash flow divided by the number of shares gives a valuation.

The second method of valuation is the market value method. Where one takes the average P/E that the stock has got and multiplies that by the projected EPS.

The idea is also to value the stock as conservatively as possible. So while projecting sales, a growth rate of about 15 per cent is considered. Take exports growth rate as inflation (at about 8 per cent) plus a devaluation of about 7 per cent which is again 15 per cent. Correspondingly, increase most of the costs at 15 per cent a year. Gross fixed assets grow at about 5 per cent and depreciation is 7.5 per cent of gross fixed assets. Effective tax rate is taken at 35 per cent.

To calculate the cash flow we are also assuming that debtors remain constant at about 66 days of sales. This is likely to reduce much more as the company grows in strength. We are also assuming that the creditors remain at 75 days of variable expenses. What is more likely to happen is that it the company would pay up earlier and get discounts on that payment.

What we find in the first method of valuation is that we get a present value of cash flow of Rs 57.50 crore for both the company's debtors and shareholders. Return the debtors their money and the enterprise value is Rs 49.70 crore. We have discounted the cash flow by 14.62 per cent, this leaves us with a per stock value of Rs 62.50 as on March 1997. The present value as of March 1999 would be much higher.

Now, change the domestic sales growth to 20 per cent and exports to 25 per cent in the same calculation and the entity value changes to Rs 203 crore resulting in a value of Rs 255 per stock as on March 1997. It would probably be lower than this if raw material cost were also to grow at 20 per cent. Implicit in this calculation is the fact that the investor is making at least 14.62 per cent every year. The company grew 26 per cent last year and again 26 per cent in the first quarter this year.

Let us take the second method of valuation at 15 per cent rate of growth in turnover. The P/E ratio that the market will give this stock remains at the historic level of 15. At 15 per cent growth rate, the stock should be Rs 210 by March 1999 and Rs 240 by March 2000. Now try and recast this figure at 20 per cent increase in domestic sales and 25 per cent in exports. The stock price should then be Rs 376 as of March 1999 and Rs 633 in 2000. It may be more subdued if costs are increased more but there is definitely potential in the stock.

Now this is a really conservative estimate. For one the sales growth could be higher. Second in, this model, the company is accumulating cash balances which are not being reinvested.

Even at the most conservative level of growth, Clariant has a return on capital employed (ROCE) ie the ratio of EBDIT to total assets of about 37 per cent. It has a much lower return on net worth (RONW) of 21 per cent. That is because it has a debt to equity ratio of as low as 0.8 in March 1999. This rate could be increased if the company takes on some debt and reduces tax. With figures like these, it is definitely a core portfolio investment.

First Published: Mon, September 14 1998. 00:00 IST