These both sets of blogs are one of my favorite reading on connecting business growth, financial numbers, management claims and on ground realities. Must read for those looking forward to learn forensic accounting and financial analysis. Both the article were originally authored by team at 2 Point 2 Capital. I strongly encourage everyone to read their all the articles at: https://2point2capital.com/blog/
1 - Growth from Thin Air (Manpasand Beverages)
"in the food and beverages market, building a new brand can be exceptionally difficult. A new player must garner market share from incumbents that have (1) a high brand loyalty amongst consumers, (2) a large distribution footprint built over decades, and (3) benefits of scale due to a portfolio of brands (distribution, advertising, overheads etc.)"
"Over the last 10 years, the number of new brands built in the food and beverages segment are quite low."
"There have been a few exceptions though. For instance, Paper Boat by Hector Beverages has been quite successful. However, Paper Boat is still a niche product and generated less than 100 crs in revenue in FY16. Other success stories (like that of DS Group’s Pulse candy) have primarily been in segments with higher market share churn."
"However Manpasand beverages,which sells fruit drinks/juices under the Mango Sip and Fruits Up brands, in a short period, the company has seen rapid growth in revenues and profits. In FY16, Manpasand generated 557 crs in revenues and 51 crs in profits"
"growth was achieved despite fierce competition from incumbent players like Coca Cola (Maaza), Pepsi (Slice/Tropicana), Parle Agro (Frooti) and Dabur (Real)."
"The packaged fruit juice market in India is estimated to be in the range of 9,000 to 12,000 crs in value terms (including retailer and distributor margins). Mango juice is the largest category accounting for ~85% of fruit juice sales. Maaza, Slice and Frooti dominate the fruit juice market with over 60% market share in volume terms."
"In FY16, Parle Agro (Frooti owner) and Manpasand generated 1270 crs and 550 crs in revenues respectively from fruit juice. Considering Manpasand’s higher trade margins (35% vs Parle Agro’s 25%), it was already 50% the size of Parle Agro in FY16 (in volume terms). It also has a negligible presence in South India which accounts for ~25% of the fruit juice market."
"This is a phenomenal achievement considering Parle Agro’s Frooti is a 30-year old brand with a large advertising budget and extensive distribution reach. On the other hand, Manpasand spends precious little in terms of advertising and has a limited retail reach whereas likes of Coca Cola, Pepsi and Parle Agro have a retail presence in every nook and corner of the country (either directly or through the wholesale channel)"
"We did a telephonic survey of 100+ retailers across states like Gujarat, Punjab, UP, Uttarakhand and Bihar. These states are considered Manpasand’s core markets as the company has plants in Baroda, Varanasi and Dehradun and has a higher distributor density in these states (as per its IPO documents).
The survey results show that Manpasand has negligible retail penetration in even its core markets. Less than 10% of the retailers carried Manpasand’s products while the number was ~50% for Frooti. How has Manpasand reported more than 50% of Parle Agro’s volumes despite a significantly lower retail presence in even its core markets?"
"The company claims to generate a part of its sales from the Indian Railways/IRCTC vendors. Could this explain Manpasand’s large scale? Seems unlikely. As of 30th Sept 2016, Fruits Up (accounts for ~20% of Manpasand’s revenues) had not yet been approved by IRCTC. Additionally, Mango Sip is only classified as a “Category A” supplier by IRCTC while Maaza, Slice and Frooti are all classified as “Category A Special” suppliers. This means that Manpasand is not allowed to sell its products on premium trains while competition can. Clearly, Manpasand’s competitors are better placed in selling on the Indian Railways."
"In July 2014, Manpasand launched its non-Mango products under the Fruits Up and Manpasand ORS brand. Fruits Up comprises (1) fruit-based carbonated drinks (think Appy Fizz, not Mirinda)"
" Fruits Up and Manpasand ORS together generated over 115 crs in revenues in FY16 (i.e. in less than 2 years of launch). In Q2 FY17 alone, Fruits Up is reported to have generated revenues of over 40 crs. Parle Agro’s Appy Fizz (launched in 2005) was largely responsible for creating this category and is considered the clear market leader. However, if Fruits Up’s numbers are to be believed it is already larger than Appy Fizz. This has been again done without any advertising support while Appy Fizz has run national TV ad campaigns featuring Priyanka Chopra. That too within 2 years of launch."
" abysmally low senior management compensation - In FY15, Manpasand’s median senior management compensation was 4.6 lakhs!! Such low compensation for senior management of a company of this scale is completely unheard of. At these compensation levels, how could Manpasand retain these executives who have led a 6x growth in revenues over the last 4 years? Given their performance, wouldn’t competitors look to hire them for even 4-5 times their current compensation? We are unable to comprehend why that hasn’t happened yet."
"SEBI requires companies to disclose if they or their family members have any interests in competing businesses. This ensures that investors are aware of any conflict of interest of the Promoters/Managers of a company. Companies with Promoters having competing interests is considered negative from a governance standpoint.
Mr. Satyendra Singh (MD’s brother) and Ms. Renu Singh (MD’s wife’s sister) are the Directors of Hansraj Agro Fresh (started in 2014) which manufactures the same products as Manpasand.
This information should have been disclosed in the IPO offer documents. This information was not disclosed in even the recent QIP documents. Promoters choosing to not disclose the existence of a competing business run by immediate family members is a serious red flag. A LinkedIn search shows that ex-employees of Manpasand now work for Hansraj Agro Fresh. As such, it is unlikely that the company was unaware of the existence of Hansraj Agro Fresh."
2 - Related Party transactions, absurd margins Vs industry averages and secret of cash balances (Kitex Garments)
"Apparel manufacturing is an intensely competitive business as large customers (brand owners and retailers) have significant bargaining power and product differentiation is fairly low. Likes of WalMart, Gerber and Toys“R”Us have suppliers across the world and they set the prices. As such, the apparel manufacturing industry has struggled to generate a high ROE over the long term. This has been broadly true for the last 100 years."
"Kitex, however, seems to be an exception. The company has an exceptionally high profit margin and ROE. Kitex is probably the world’s most profitable apparel manufacturing company (measured by ROCE – return on capital employed). In fact, Kitex which is a B2B company is more profitable than even B2C apparel companies which have strong brands (like Page Industries which owns the license for Jockey in India)."
"Kitex’s high profitability is a source of mystery. The only way a company can then continue to enjoy super normal profits is if it has a sustainable competitive advantage (say brand, network effects, economies of scale, switching costs). Companies that don’t have such an advantage (also referred to as moat) will see an eventual decline in their profits."
"Kitex’s investors believe that its customers are willing to pay a premium because of its high standards of quality & labor compliance AND also due to high switching costs of its customers – buyers spend a lot of time in selecting, evaluating and approving vendors. "
"Kitex is largely dependent on 5 customers for a large majority of its revenues, Kitex accounts for less than 1% of supplies (rough estimate) to these companies and is one of 100s of empanelled suppliers. Why would customers with a high bargaining power knowing that Kitex is dependent on them (and they are not) still allow it to make supernormal profits? Even if Kitex has some pricing power, despite the one-sided dependence, is it likely to be so high as to allow them to have profit margins that are 2-3 times that of peers and even higher than B2C companies?"
"Over the last 5 years, the company has generated over 340 crores in free cash flow (FCF). It has paid out very little cash as dividends over the last 5 years (less than 30 crs) and its debt has surprisingly increased in this period. This is quite odd because debt needs to be regularly serviced with interest payments of as high as 11.9% while cash deposited in even long-term FDs earns typically less than 8% per annum. It is not clear why a company would continue to pay high interest costs when it has cash available to repay the complete debt."
"Kitex actually does not earn any interest on its cash balance as it has not converted its foreign exchange earnings into INR and instead kept it in a current account earning zero interest. This is because Kitex’s CEO (Mr. Sabu Jacob) believes he will generate higher returns by converting $s at a later date when the INR depreciates. It is amazing that Mr. Jacob believes that he can generate returns higher than 11.9% (the interest cost on debt) per annum by indulging in currency speculation"
"RBI mandates that all foreign exchange earnings need to be converted into INR within a month (Read here – https://goo.gl/DRcuOV). We discussed with banking experts if there was any way for companies to hold $s for more than a month and did not find any alternative option. "
"One of the reasons given by the Kitex management for not reducing its debt burden is the subsidy it gets under the Technology Upgradation Fund Scheme (TUFS) of the government. As per Kitex, the TUFS subsidy effectively reduces the interest cost on their debt (bringing it down from 11.9% to 7%). While it does not make sense to incur even a 7% interest cost, the TUFS subsidy does reduce the negative impact of the debt burden."
"Kitex has only recognized a TUFS subsidy income of INR 12 crs over the last 7 years. Most of this subsidy income actually came in the earlier period of 2010-2012. In fact, over the last 3 years when Kitex has seen the highest cash accretion it has received a TUFS subsidy of only INR 2 crs. This data conflicts with the management assertions of TUFS subsidy driving down net interest costs. If Kitex does receive sizable TUFS subsidy, why doesn’t it show up in its audited accounts?"
"But wait, (as always) this is still not the most surprising part here. As of March 2016, Kitex had an outstanding TUFS subsidy receivable of INR 8.7 crs. This means that of the INR 12 crs of TUFS subsidy income, Kitex has so far only been able to collect INR 3.3 crs. In fact, over the last 2 years Kitex has not been able to collect even 1 rupee of TUFS subsidy!!! This is all a bit bizarre. "
"Kitex’s promoters have related entities which are engaged in the same activities as Kitex Garments Limited. Kitex Childrenswear Limited (“KCL”) which is 100% owned by Kitex’s promoters uses the same infrastructure, has same management, makes similar products and pretty much sells to the same customers as Kitex. In fact, ICRA in its credit rating of Kitex’s debt takes a consolidated view of Kitex and KCL’s financials due to the strong operational linkages between the two entities"
"In 2015, Kitex’s foray into brand retail in US was done as a JV with KCL – which further increased the operational linkages and the conflict of interest. Considering the similarity in the business of Kitex and KCL, it might be expected that their fortunes move in tandem. But that does not seem to be the case. KCL’s revenues and margins have see-sawed compared to the one-way improvement in Kitex’s financial performance. KCL though does share Kitex’s penchant of hoarding cash despite a high debt outstanding on its books."
"Over the last four years, Kitex has been the first listed company in India to report its audited financial results (Reporting dates: FY16 – 4th April, FY15 – 6th April, FY14 – 3rd April, FY13 – 4th April)."
"In order to ratify the accounts, the auditor needs to gather substantive audit evidence which includes – physical inspection of assets (machinery, inventory), obtaining confirmations from third parties (banks, suppliers, customers), examining transaction records, checking assumptions and calculations. Completing all these activities within 3-4 days of the end of the financial year while theoretically possible has several practical challenges (for eg. In FY16, April 1st was a bank holiday followed by a weekend which limits ability to get third party confirmations)."
"Kitex’s auditor is the Cochin-based Kolath & Co which does not audit any listed entity other than Kitex. Given Kolath’s limited experience in auditing large businesses, its ultra-quick completion of Kitex’s audit raises concerns about the comprehensiveness of the audit. While Kitex’s audited results demonstrate a high level of efficiency, its secretarial compliance reports show delays in its filings (P&L, Balance Sheet, Modification of Charge, Changes in Directors) with the Registrar of Companies. Kitex’s selective efficiency in financial reporting is quite puzzling."
Also, please do read comments by Ashwini Damani - clarifying on margins scenario, reply by Amit Mantri to Ashwini Damani on the same, Post by Janarthanan Natarajan on Forex Holding and Amit reply to the same clarifying when $ can be kept in bank"