Kiri Industries – Heads I win; Tails I don’t lose much

Mohnish Pabrai in his highly acclaimed book ‘Dhandho Investor’ popularized the following concept:

• Investors should constantly look for mis-priced situations where loss on downside is capped while potential upside is multi-fold (Heads I win, Tails I don’t lose much).
• One must bet big when the odds are overwhelmingly in his favor.

While screening for bargains in Chemicals industry (If you want to make the industry sexy, then add “Specialty” before it :-)), I accidentally stumbled upon Kiri Industries.

Background:

Kiri Industries is one of India’s largest and integrated manufacturer of dyes intermediates and reactive dyes which are used in dyeing cotton fabrics, synthetic fabrics, bed-sheets, carpets etc.

Value chain: Basic Chemicals [Oleum/Sulphuric Acid/Chloro Sulphonic Acid] —> Dyes Intermediates (Vinyl Sulphone/H-Acid) —> Reactive Dyes (Colorants for Textiles). The company is vertically integrated across the value chain from basic chemicals to reactive dyes.

I. Rapid rise (2007-2011):

Manish Kiri (2nd gen promoter with MBA from USA) took over the company.  This period was marked by rapid expansion of manufacturing facilities, overseas acquisition, equity fund raising via IPO & QIP and debt binging.

• In March 2008, company came out with the IPO to raise about 56 crores. The funds was principally meant for capacity expansion of basic chemicals and dyes intermediates.
• In March 2010, Kiri industries (37.57% stake) formed a JV with China-based Longsheng group (62.43% stake) and acquired German-based DyStar from bankruptcy proceedings. The JV was based out of Singapore and raised about 100 million euro (Debt to equity of 65:35) to fund the acquisition. DyStar (Formed through the merger of dyes operations of BASF, Hoechst, and Bayer) is a leading player in dyes solutions with a 21% global market share and with sales of 800 million euro. It acquired the net assets of 291 million euro in addition to fully depreciated fixed assets of 140 million euro at replacement value. It avoided taking over all liabilities, including employees and bank liabilities in Germany.
• In November 2010, Kiri industries raised about 240 crores at the price of 590/- to fund DyStar acquisition and also expand manufacturing facilities of standalone business.

During this period, revenues of standalone operations jumped 4X to 572 crores. However, debt also jumped from 60 crores to 410 crores.

II. Hard fall (2011-2015): 

• Delay in turnaround of DyStar: Initial turnaround plan was to replace high cost german manufacturing base with lost cost manufacturing in India & China and be cash positive from 2011. Management also guided DyStar IPO by Q1 CY 2013 at an international market. Even the best laid plans goes awry due to multiple factors. Euro zone crisis and resultant slowdown hit DyStar hard. Hence, Kiri Industries had to fund the company through term loans & working capital loans (around 100 crores) raised in foreign currency in FY’12.
• Derivative loss: During the Rupee crisis in 2013, Kiri Industries encountered derivative losses (82 cr) and loss on conversion of foreign currency loans to Indian currency (30 cr) following restructuring of loans by banks [Similar to many Indian firms at that time who didn’t hedge foreign currency]. All of them piled into giant debt of 750 crores!!
• Volatility in crude oil prices (principle raw material) and dumping from Chinese competitors [Unlike Indian counterparts, Chinese manufacturers do not have effluent treatment plant – hence they could produce at low cost]  resulted in losses even at operating levels [Closest competitor Bodal Chemicals also faced similar problems – suffered both operational & forex loss].
• Corporate Debt Restructuring: Shares pledged with the lenders were dumped in the market resulting in drastic drop in promoter shareholding from 58% to 30%. Also, JV partner blocked the IPO of DyStar and thereby preventing value unlocking. Local banks also closed funding tap following the debt ballooning & operational losses. Hence, the company ran out of options and admitted into CDR.

III. Slow Recovery (2015-Present):

When the company is headed south, we investors have an option to abandon the ship and move to better investment opportunity. However, promoters does not have that luxury. His fortunes are intimately tied with the company. He has to wither the storm and do the hard grind to reach his desired destination.

• Promoter fund infusion: In FY 2015-16, promoter infused around 50 crores in 2 tranches by subscribing to 37.5 lakh warrants at 135/- per share. Consequently shareholding increased from 25 to 37%. In October 2016, board approved 35 lakh warrant to promoters at the price of 363/- which can be converted at any time during the next 18 months. At the time of allotment, promoter has to pay 25% upfront i.e. 32 crores. Promoter shareholding may jump to 44.64% at the end of the process. Warrants at both instance were priced at slight premium to the prevailing market price. As of date, they infused 80 crores along with commitment of 90 crores over the next 18 months.
• Debt restructuring by lenders: In exchange of promoter’s fund infusion, lenders agreed to restructure the debts. April 2016 announcement: “Kiri Industries Limited has executed agreements for settlement of all its debt by the end of financial year March 31 , 2016. This has resulted in significant reduction of the borrowing. The total borrowings of the company have been reduced from Rs. 853.13 crores to Rs. 410.62 crores, which is about 51.87% reduction compared to the previous financial year. The initial installments under the agreements are also paid before the end of the financial year 2015-16. Further, as per Settlement Agreements executed, the Company is committed to settle and repay majority of the balance debt during the current Financial Year 2016-17. Hence, the company has now achieved a major landmark for its shareholders by fully addressing its debt burden, which had been weighing down the Company’s performance over the past several years. On one hand the realization of its products have significantly improved, on the other hand there would be huge savings in the finance charges from the current financial year i.e. 2016-17. The debt has been addressed majorly with the asset reconstruction companies, private lenders, as well as NCD holders.”
• Tailwind for Indian dye intermediates manufacturers: Closure of chinese plant (Hubei Chuyuan – Largest player of Dyestuff in China) resulted in 2-3X increase in prices of dyes intermediates (Vinyl Sulphone/H-Acid) resulting in windfall gains. In addition, Indian dyes industry faces structural tailwind due to china’s pollution problem (See below).

Heads I win – Value unlocking in Dystar subsidiary:

Beginning FY’14, DyStar subsidiary started to show turnaround in performance and is now generating profits consistently for the past 3 years. This associate profit from the JV gives an EPS of 70-80. Principal reason for the low PE in the screening table above is that Mr. Market ignores DyStar associate profit completely. With no access to the DyStar profit pool, Mr. Market believes that Kiri’s investment became kind of dead-end.

In June 2015, Kiri Industries initiated legal proceedings in the High Court of Republic of Singapore against JV partner Longsheng to enforce its rights as a significant minority shareholder and unlock value of the company’s share (37.37% stake) in DyStar.

Company is hopeful of completing litigation by end of Sept’17. Based on the timeline of recent Daichi-Ranbaxy arbitration at Singapore court, I would say it is very much possible. Also remember, JV (DyStar global holdings) entity was registered in Singapore.

Daichi – Ranbaxy arbitration timeline

Best-case scenario: If Kiri Industries win in litigation, then JV partner has to purchase its 37.37% stake on the basis of court mandated independent valuation or else to liquidate DyStar and distribute assets as per investment ratio of both shareholders. Even if we assign a PE of 10-12, its 37.37% stake will yield around 2000 crores.

Worst-case scenario: Company’s investment will remain blocked till it liquidate to a 3rd party.

Tails I don’t lose much:

• Industry tailwind for the standalone operations:

[Source: Bodal Chemicals Investor’s presentation]

[Source: Bodal Chemicals Investor’s presentation]

• Quarterly performance in FY’2017:

On a steady-state basis, company should yield around 70-80 crores of net profit [Note: Quarterly interest cost fell from 20 cr to 2.5 cr]. At a PE of 10-12, standalone operations of Kiri Industries should support the current valuation of 900 crores.

Management:

Ultimately we are partnering with promoters in a belief that they will share the proceeds with minority shareholders. Hence listed factors for & against promoters:

Concentrated bet can go wrong:

I strongly believe that few outsized bets are necessary to build a sizable corpus before switching to diversified portfolio to protect the corpus. Once a favorable odd was identified, we have to gather courage to bet big. If everything goes well, investment should conservatively yield 3X in 2-3 years time frame. If not, will incur huge opportunity costs due to the outsized nature of the bet.

Worked: Buffet invested of 40% of his fund in American express during salad oil scandal.

Went against: Bill Miller investment in Financials during 2008 crisis and Bill Ackman’s investment in Valeant pharmaceuticals.

Disclaimer: Please note that this is my investment journal. The main aim is to expose my investment thesis to the scrutiny of fellow investors and improve the process thereby. It shall not be construed as an advise to buy/sell the stock.