Analysis: Supreme industries

About

Supreme industries is a leader in the plastics processing industry and processed around 2.45 Lac metric tonnes in 2012. The company processes polymers and resins into various plastic products. The broad verticals for the company are as follows

• Plastic piping including CPVC pipes
• Consumer products such as molded furniture
• Packaging products such as specialty and cross laminated films
• Industrial products such as Industrial components and Material handling products
• Construction business wherein the company has developed a corporate park on some excess land in Mumbai

The company has around 22 plants across the country which has helped it in reducing the transportation cost for the products (an important factor for operating margins).

Financials

The company achieved a topline of around 2900 Crs and is expected to close the current year at around 3500 Crs. In addition the company earned a profit of around 240 Crs (8% Net margins) and should be able to achieve a single digit growth during the year. The lower growth in net profits is due to lack of sale of commercial property in the current fiscal.

The company has been able to maintain an ROE in excess of 25% for the last 6 years. The debt equity levels have dropped from around 1.5 to around 0.6 during this. The company has also been able to improve the asset turns from around 2.5 in 2007 to 3.5 in 2012 as a result of an improvement in working capital turns (mainly driven by lower receivables as a percentage of sales).

The company has also improved its net margins from around 4% in 2007 to around 8% in 2012 driven by an improvement in overhead costs and depreciation as % of sales.

Positives

The company operates in a commoditized industry and as a result several products of the company earn low margins. The company is now focused on developing new products (called valued added products) such as CPVC pipes, cross laminated files and composite cylinders which have a higher operating margin (17%) than the other commoditized products such as molded furniture. The company plans to increase the contribution of these value added products to around 35% by FY15 and expects to improve the overall operating margins to around 15-16% levels

The company has a wide distribution and production network and well established brands in the plastics product space. The management has been able to use these assets effectively in entering higher margin products while exiting the commoditized segments at the same time.

The per capita consumption of plastics is around 7 kg versus almost 30-70 Kg in other countries. As a result, the industry is likely to see sustained growth for sometime as the per capita consumption increases with a rise in the income levels. In addition to the demand tailwind, companies like supreme are likely to benefit further as the industry continues to consolidate and the market share shifts to the organized players.

Risks

The company operates in a highly fragmented and commoditized industry. Although the company has been able to maintain the margins and a high return on capital by constantly introducing higher margin products, the moat or competitive advantage is not deep.

Brand name and a wide distribution network provide some level of competitive advantage, but the resulting moat is not wide and deep. As a result the company will have to constantly innovate to keep the return on capital high. The profitability could get hurt if there is a rapid commoditization of the various segments.

Competitive analysis

The plastics industry is a fragmented industry with a large unorganized sector, especially in commoditized products. The company has different competitors in each segment of operations.

In the case of PVC pipes the key players are finolex, chemplast sanmar, Jain irrigation, astral poly etc. In the packaging products there are around 6-7 large players and several un-organized ones. In consumer products nilkamal and Wimplast are the two key players. Finally in the industrial component segment there are a wide range of players ranging from Motherson sumi to Sintex industries.

Most major players earn an ROE of around 13-14%, with high leverage , except for astral poly which has an ROE of around 22% with low levels of debt (due its focus on a high margin and high growth product – CPVC pipes).

Overall the industry does not have high return on capital- due to the commoditized nature of the products. Supreme industries has been able to break away from the pack due to a portfolio approach to products (exit low margin products and move into high margin ones).

Management quality checklist

-          Management compensation – compensation is around 5% of net profits. This is on the higher side, though not excessive

-          Capital allocation record – The capital allocation record of the company has above quite good in the last 6-7 years. The management has been investing in high return projects and has also used some of the cash flow to reduce the level of debt. The ROE as a result has improved from the 20% levels to 30%+ levels in 2012

-          Shareholder communication – adequate. Management provides decent amount of disclosure in the annual reports and also conducts quarterly conference calls to discuss about the performance.

-          Accounting practice – appears conservative

-          Conflict of interest – none appear to be of concern

-          Performance track record – the management has been fairly transparent about its performance goals (growth and return on capital) and has been achieving them consistently in the last few years. In addition the management has been in this business for the last 40+ years and understand it very well.

Valuation

A discounted cash flow with conservative assumption of around 7-8% margins and 15% topline growth (10% volume growth + 5% inflation) gives a fair value in the range of around 530-570 per share. The growth assumption appears to be conservative as the company has delivered a 12% volume growth in the past. The risk is mainly around net margins which could come under pressure if there is faster commoditization in the industry.

The company has sold between a PE of around 8-9 and 18-20 in the past. The current PE of around 15 is at a midpoint and as a result the company does not appear to be overvalued.

Finally the company has shown a higher growth and Return on capital as compared to almost all other players in the industry (except astral poly) and hence has a higher PE (but not much) than others.

In summary the company does not appear overvalued and may be undervalued by around 30-35% from its fair value.

Conclusion

Supreme industries operates in a growth industry (due to increasing demand for plastic products) where the average profitability is quite poor. The company has been able to perform better than the other players by being focused on the newer and higher margin products. The management is as focused on ROC (return on capital) as on growth as compared to several other players who are pursuing growth at low returns.

Inspite of the above average returns and competent management, the company is unlikely to enjoy very high valuations like the FMCG industry as the overall profitability of the industry is low and the pricing power of branded products not very high. Supreme industries appears to be modestly undervalued and the returns are more likely to come from a consistent increase in profits than from revaluation by the market.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.