Paushak: Has The Stock Gotten Way Too Ahead Of Itself?
Paushak is India’s largest phosgene-based specialty chemical manufacturer. It belongs to the storied Alembic Group of Companies which set up one of the first pharmaceutical plants in India. Paushak enjoys an unblemished track record of over 35 years and has established itself as a market leader across much of its product portfolio.
A 10-Year Revenue CAGR of 19% and 10 -Year Profit CAGR of 31% have led to handsome returns for investors, a 10-Year Stock Return CAGR of 60%!
Paushak’s Business Model:
Paushak’s business model has been relatively resilient due to the hazardous nature of Phosgene Chemistry, and the subsequent government regulations that act as entry barriers. The company supplies phosgene-based derivatives (intermediates) to the Pharmaceutical, Agrochemical, and Performance Chemical industries.
Let us quickly understand what Phosgene is and why it enjoys strict regulation.
What is Phosgene?
- It is an organic chemical compound that exists in the form of a colorless gas, which is highly poisonous and is considered a viable chemical warfare agent. Phosgene can cause pulmonary edema and suffocation.
- It finds use in a vast multitude of areas – Organic synthesis, Dyes, Pharmaceuticals, Herbicides, Insecticides, Synthetic Foam (roughly 30% of entire Phosgene market), Resin, Polymers.
- All phosgene plants manufacturing over 30 tons of phosgene a year need to be declared to the OPCW (Organization for the Prohibition of Chemical Weapons). It is relatively easy to produce when compared to advanced chemical warfare weapons.
The toxicity as well as the relative ease with which it can be produced have led to a scarcity in the manufacturing permits that are issued. Hence, this stringent government regulation deters competition from entering this segment. Existing players too face an arduous process in procuring the required permits for expanding manufacturing facilities.
Paushak’s business strategy over the past few years can be summed up simply into three core areas:
- Vertical Integration
- Backward integration into Phosgene Gas.
- Forward Integration into newer complex Phosgene based derivatives. Paushak has been working on improving its ability to handle multi-tier complex reactions for high value products which are generally required by innovator companies.
- Low-Cost Producer
- Backward integration into Phosgene Gas has aided the company in controlling costs. However, it is still reliant on crude (thereby exposing it to some price volatility) for some of the raw materials.
- Over the years, the company has worked towards driving higher yields and improving efficiencies of the manufacturing processes it undertakes. In 2017, it commercialized a new solvent free manufacturing process which helped cut down on energy costs associated with solvent recovery in the older process.
- It has actively worked on lowering its Power & Fuel costs. A breakthrough came in 2016, when they were able to improve the thermal efficiency of their boilers from 62% to 74%. The company has set up a windmill for captive consumption and is looking towards harnessing solar energy in the future. Such improvements along with continuous efforts on running a tight ship have helped lower overall costs.
- The company recently got approval for tripling their Phosgene capacity from 4,800 MT to 14,400 MT (This approval process took about 3 years to get approved) at a total approximate cost of INR 120 Crores which is being funded entirely by internal accruals. The company hopes to attain economies of scale and become highly cost competitive on a global scale.
- Import Substitution
- Paushak has been working on developing and scaling indigenous technology for some of their products. This has helped them become highly competitive and has allowed them to plug some imports coming from China.
Paushak’s Business Segments:
The company has a vast plethora of products in their portfolio list; however, they are not forthcoming about which products constitute their core!
The Contract Manufacturing segment has only recently started seeing interest. The company is in talks with one global agrochemical major (there have been no updates on the progress yet).
End User Industries Served by Paushak:
- Legacy Business Segment.
- It supplies pharmaceutical intermediates to Generic Pharma companies in India.
- This segment has been prone to demand stagnation and pricing pressures in the past due to Generic Pharma companies’ woes in the US.
- New Business Segment launched in 2017.
- It supplies agrochemical intermediates and manufactures pesticides.
- This segment has been a growth driver since inception. Today, the company is looking to partner with global agrochemical majors (most likely for multi-tier complex reactions catering to innovators).
- Performance Chemicals
- Legacy Business Segment.
- It supplies intermediates to the dye and pigment industries (textiles, paint, coatings).
Competitive Advantages & Economic Moats Enjoyed by Paushak:
- Vertical Integration
- Low-Cost Producer (however, it is yet to establish itself as ‘the’ Lowest Cost Producer)
- Economies of Scale
- Barriers to Entry further heightened due to stringent government regulation and arduous process in getting licenses (for new entrants and for existing capacity expansions). On an average, any approval takes between 4-5 years.
- The key market of Paushak is the phosgene-based specialty derivatives catering to the Pharmaceutical and Agrochemical industries. These markets contribute to roughly 10% of the entire Phosgene market. Hence, the market may be too small and too specialized (due to high quality requirements) for the larger players to enter. This could be one of the reasons why Paushak has been facing competition from limited players (primarily from China).
Risks Faced by Paushak:
- Hazardous chemistry that necessitates the need for heightened levels of vigilance. Furthermore, any mishaps at the company’s facilities could spell long lasting trouble.
- A lot of the company’s raw materials are derivatives of crude, thereby exposing the company to crude oil price fluctuations.
- Foreign Currency Exchange Fluctuations.
- Despite being cost competitive, Chinese imports continue to provide stiff competition, leading to pricing power erosion. Key competitors are; Domestic – Atul & UPL, International – Covestro, Yantai Wanhua, BASF, DowDuPont.
- Slowdown in end-user industries will affect the company’s performance.
- Delays in capacity expansion execution.
- Current Proposed Expansion – 4,800 MT to 14,400 MT.
- Previous Largest Expansion (2014) – 1,440 MT to 4,800 MT.
- Massive difference in scale!
- The company changed its policy for recognition of receivables, payables, and working capital in 2018-2019. I dug deeper into the new policy, but found no change in the explanation (it was the same as that of the previous year). The company did adopt Ind AS 115 in 2018-2019 (maybe this caused some change in recognition policy, you may dig deeper through this link – https://mca.gov.in/Ministry/pdf/INDAS115.pdf). In some circumstances, changing recognition policies are a way of covering up certain business shortcomings.
- Related Party Transactions (RPT) galore! RPT’s are a natural occurrence when dealing with group companies. However, the group seems to use Paushak as a piggy bank at times.
- Potential to grow revenues substantially following completion of proposed capex (full ramp up expected by 2022-2023).
- Generic Pharmaceutical companies have been faring favorably which is a positive boost to Paushak.
- The ‘China + 1’ strategy is something that Paushak hopes to leverage going forward.
- Agrochemical and Pharmaceutical demand generally tend to be fairly steady.
Paushak is a debt-free company (has been near debt-free for the past 8 years) and expects to continue this trend.
The key valuation driver for Paushak is the new capacity coming online. Unfortunately, we do not have any data regarding the revenue potential. In my valuation, I decided to use a Fixed Asset Turnover of 3.5 which is slightly below the 8 year average of 3.94. This leads me towards a 10 Year Revenue CAGR of 16% (I feel that I am being quite optimistic in this scenario).
I believe that operating margins above 30% are not sustainable in the future. I have modeled margins to remain rangebound between 21% and 26%, with Terminal Year stable margins at 22%.
Cost of Capital (Terminal Year) stands at 8.81% with an ROIC of 10.81%.
My estimates lead to a valuation of INR 2176.95 to INR 2436.79 per share, well below the current market price of INR 7971.65
Paushak has generated tremendous wealth for its shareholders over the past decade surging from a high of INR 122.7 in 2011 to a high of INR 9479 in 2021 (as of today).
Over the course of a year, the stock has skyrocketed from a low of INR 1301 to a high of INR 9479, triggered by the approval for tripling of capacity along with a relatively well-moated business.
My biggest concern surrounding my valuation would be the lack of data about: Revenue Potential from New Capacities, Timelines, and Key Products. The lack of information and the ensuing uncertainty is a key risk when investing in smaller companies, justifying an explicit application of Margin of Safety.
To recapitulate, Paushak does seem significantly overvalued, with the ‘overvalued’ nature being largely contingent on the capacity expansion coming to fruition!