Mar 6, 2012|
Supreme Petrochem: Poorly managed bad business
Taking the case of Supreme Petrochem, we would like to point out some very important lessons that value investors should keep in mind while investing in stocks.
The following is a brief financial snapshot of Supreme Petrochem Ltd (SPL) for the year ended June 2011. The company's sales and net profits grew by 20.6% (year-on-year) YoY and 44.8% YoY respectively. It reported a net profit margin of over 4%, its highest in the last decade. At 34%, the return on capital employed (ROCE) during the period was remarkable. It's debt to equity ratio stood at 0.6 times, which is a lifetime low. At the current price of Rs 48.5, the stock is trading at a trailing twelve month price to earnings (P/E) ratio of 7.9 times. The dividend yield at this price stands at 5.8%, which is pretty decent.
From the numbers, the company seems promising. But a deeper dig reveals something else altogether.
Is the business model sustainable?
Established in 1995, Supreme Petrochem is a joint venture between Supreme Industries Ltd and the Rajan Raheja Group. SPL is engaged in the business of manufacturing polystyrene, a thermoplastic polymer. Based on the grade of the polystyrene, it finds application in various things such as stationery, house ware, cosmetics, packaging, insulation, wall clocks, computer accessories, refrigerator components, washing machines, televisions sets and so on. The company has a leadership position in the Indian polystyrene market with a 50% market share. Some of its marquee clients include Haier, LG, Videocon, Godrej, etc.
But, the question is whether the business model is sustainable or not?
The Porter's five forces analysis is a very powerful tool to evaluate the fundamental strength of a business. Here is a brief analysis of SPL based on the Porter's model:
The business of SPL fares badly on all of Porter's five forces. It is a clear indication that it is not a great business to invest in.
- Entry barriers- Low. It is easy to enter this business as it is neither capital intensive nor technologically advanced.
- Bargaining power of buyers- High. Polystyrene is a low value commodity. It is difficult to pass on price hikes fully.
- Bargaining power of suppliers- High. Styrene monomer, which is the raw material for polystyrene, is a derivate of crude oil. Hence, the company has no control on raw material costs.
- Intensity of competition- High. It is a supply-driven market with high overcapacity.
- Threat of substitutes- High. Polystyrene can be easily substituted by other materials.
Management lacks a clear vision
SPL is the market leader in the domestic polystyrene business with a capacity of 272,000 tonnes per annum (TPA). But this is nothing to cheer about. The total domestic market is even less than that, at about 250,000 TPA. In addition, there are two other major players, LG Polymers Pvt Ltd and BASF Styrenics Pvt Ltd, both of which have a capacity of 100,000 TPA each. Because of the excess capacity, the company had no choice but to export its products abroad. But even then, the company operates at just about 60% of its full capacity.
The company is trying to reduce its exposure to the export market, while aiming to expand the share of domestic sales. The reason – the margins on export sales are very thin. The management is optimistic that one day in the future they will be able to operate at higher capacities. They are relying on customer education for this. This means that they would educate their customers into buying more of their products.
This is a perfect example of how a management with a poor vision can drive the company in a very wrong direction. The company's management went on an expansion spree believing that they would be able to create a market for their products. But they were extremely wrong in their calculations. Now, the company has little choice but to sit with a lot of idle capacity.
Lesson for investors
The case of Supreme Petrochem clearly shows that you should never judge a company based on the financial data of just a year or two. A long term financial history of at least 5-10 years should be analysed. Secondly, if a company chalks out big expansion plans and makes big promises about future growth prospects, do not give in to over-optimism. Equally important is the industry in which the company operates. If the market for a product does not already exist, there are sure reasons to be skeptical.
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