A potential multi-bagger from an unexpected industry

Imagine you are a senior employee, at a company, with several years of experience and you know things are going like this.

By year 6, you know that the company’s equity has been wiped out and it goes into BIFR, a fancy name for potential bankruptcy proceedings.

Once it is clear that the chances of survival are almost zero, in most cases, employees are the first ones to flee a sinking ship because it is easier to switch to a different job than to go down with the ship. To understand the scale of losses incurred, there were no employees in this co. earning more than a lac a month, in year 6, at a time when it incurred a loss of 5.4 Crs.

In this context, I present to you the story of an entrepreneur who managed to save a business from dying. The above numbers are of RACL Geartech, an auto ancillary company that was about to go belly up in 2001 (Year 6). But, due to one employee and his team’s persistence, managed to survive.

A few years later, due to a stroke of good luck, he met a potential client (Kubota, a leading Japanese player in tractors) on a flight and convinced them to give a small order. And that resulted in a domino effect of being able to thrive in a sector that is famous for a lack of pricing power.

Gursharan Singh
Turnaround was led by current promoter, Mr. Gursharan Singh

The company came out of BIFR in Nov 2007. And here’s how they’ve turned around a business that had almost gone to the grave.

Sales have grown at 12% between 2016 & 2021, despite Covid lockdown impact
Profits have grown at 42% CAGR between 2016 & 2021

Higher margins were led by exports growing faster than lower margin domestic sales.

Higher exports also led to better returns on shareholders’ funds.

Clients

Most of the company’s growth has come from BMW, Kubota, KTM & Piaggio, which are all giants in their respective businesses.

Clients Piaggio Yamaha Kubota BMW KTM Honda

Typically, in such situations, the supplier gets squeezed. But this is not what happened in RACL’s case, indicating there is something more to this business than being just an also-ran auto ancillary player.

What would a new entrant need in order to compete with RACL?

Moat # 1 – Peer Margins & ROE

I ran a screen to check which auto ancillary companies have the best margins in the industry. RACL is the only growing co. which showed high margins coupled with high ROE over the last 2 years. In an industry with low or no pricing power, high margins and high return on equity are good indicators of a presence of a sustainable advantage over competition. Why else would no other names show up on the list?

Moat # 2 – Technical know-how

Lets think about it. Why would multi-billion dollar companies let a tiny supplier like RACL make high margins and high ROE, when they might as well go to other auto-ancillary co’s and give them lower margins?

Thomas Phelps, in his wonderful book, 100 to one in the stock market, said “Know-how is a competition reducer. The longer it takes to learn how to do what your company is doing, the fewer competitors will be around to do it for less.”

And here’s what management said about technological know-how in their maiden concall in Feb 2021.

Basically, they were saying, employees at their manufacturing plants have built their skill set over several decades. Plus, the machinery is prohibitively expensive. Even if another ancillary co. does put up the money to buy costly machinery, they will need to go through a learning curve, which could take many years. The other option is to poach a ton of employees from RACL, which is less likely because a lot of RACL’s employees have been around for decades and seem to be quite loyal to the co. I speculate, this is perhaps because the co. went through potential bankruptcy at some point, and led to a closely knit team.

To a potential new entrant, this would be like a chicken and egg problem. “Do we spend a ton of money on the machinery first or do we poach employees first?” I am not saying a new entrant can’t accomplish that. I am saying chances are less. Another thing to note is that the count of employees has been more or less the same over many years, despite all the growth, which possibly indicates very few employees leaving the co. for better and potentially risky opportunities.

Moat # 3 – Plant location

This is from the book “The Unusual Billionaires”.

“In the 1980s, Maruti used to give its suppliers thirty days of notice for the components it needed. Now, it instructs the supplier the previous night about the specific two-hour slot the next day when the components have to reach Maruti’s assembly line. It takes a new entrant into the Indian auto market many years, sometimes decades, to create a supply chain as efficient as this. That’s the power of architecture— it brings different companies together into a common network with a common goal in mind.”

The supply chains of global customers are considered super-efficient. A BMW or a Kubota, would want their suppliers’ plants to be in and around their own plants. But that is not the case with RACL. Forget being close to the customer’s plants, their plants are not even close to the port. RACL’s plants are located around Delhi, which is hundreds of kilometres away from the nearest port. If large OEMs are okay with a gear vendor being located hundreds/thousands of miles away (which is reflected in RACL’s growth over the last few years), it tells us something about RACL’s competitive advantage. No?

Gears for High end bikes

Moat # 4 – The gears that RACL makes require very high precision

This is based on hearsay and from another video made by somebody I haven’t interacted with, and hence I don’t know the source. So, take it with a pinch of salt if you want to 🙂

In 2014, KTM decided to launch a bike by 2017. RACL was given orders in 2014 and they delivered parts the same year. Before launch, KTM planned to run a bike for 50,000 KMS. The part failed after 47,000 KMS. This led to a delay in launch by 6 months. So, instead of KTM saying, we’ll fix it as we go, they said, we will wait until RACL fixes the issue, which they eventually did a few months later. Given this level of clients’ focus on precision, a new entrant is likely to encounter several technical roadblocks, over several years, before he cracks a contract to make high precision gears for a BMW, a KTM, a Kubota or any other large player.

Risks

The buzz word in auto nowadays is electric vehicles. This is perceived as a major risk for auto ancillary companies. But is EV a real risk?

Imagine you are a European who aspires to buy a luxury bike that costs several thousand Euros. Even in Europe, most salaried folks, can’t afford such high-end bikes. If you’re spending a bomb on an expensive luxury bike, what are you more likely to consider? Would you even think about the fuel economy that the bike provides? Would you not prioritise style and power and thereby not even consider an electric bike? I would imagine, somebody who considers spending that kind of money would almost certainly not worry about whether the bike is electric or not.

That being said, consumer preferences can change faster than we expect and EV adoption would stay a key aspect to track while staying invested in this co.

Another risk is that of high receivable days. RACL’s receivable days have trended in the range of 90-110 days, over the last 5 years, up from 27 days in 2016. Although 3+ months is a long time to recover cash from their clients, the good thing is that the trend has been flat, since 2017.

As per management, one of the reasons for receivables being high is that their plants are not located close to the port and that adds 15 days to the number. The usual number for exports is in the range of 60-70 days.

Typically, when receivables are high, businesses have trouble converting profits into cash. However, that is not the case here. RACL has been comfortably converting it’s reported profits to cash. Had receivables been taking a toll on the business, we would see much shorter orange bars, in the below graph.

Cash flow from operations
CFO vs PAT

Addendum –  I missed to add a key risk yesterday. Debt to Equity is on the higher side and is another risk to this business’ future prospects. Also, the co. plans to take on more debt to fund Capex in the next year or so and one will need to watch how well the co. is able to monetize the additional capacity they will be putting up, most of it using debt.

Debt to Equity

The icing on the cake is that current debt is equal to 2 years of FY 2021 cash flows and has been trending downwards. I don’t expect the co. to pare down debt in the next few years, given the huge growth expected. The only case where I foresee debt being reduced is either, when future cash flows are better than expected or the management decides to increase equity by issuing new shares (Equity Dilution).

Debt to Cash Flow

Scalability

RACL has several multi-billion dollar clients. BMW, for example, sold bikes worth 21000 Crs in 2019. And RACL’s annual sales is a paltry 1% of BMW’s. And this is just from one client. Will RACL be able to scale up their business multi-fold across geographies and across clients? Time will tell.

Another interesting thing that happened was that Kubota recently did a JV with Escorts and despite Escorts being the local partner did not bring in their own gear manufacturer. Instead the Japanese partner, Kubota, roped in their supplier, RACL. This is important because RACL’s big client is taking them along, into whatever newer markets they are going into. This opens up a very wide range of possibilities for RACL.

Capacity expansion during an industry down cycle

The co. announced Capex worth 50 Crs in FY2020 AGM. This is at a time, when their fixed assets were 100 odd Crs. Why would a co. that sells non-compulsory goods, increase capacity by 50% during a pandemic? It is not like they are selling roti, kapda, makaan, or anything close to that.

I think it is because they have high visibility for future orders, from clients, which is why they are taking such a huge risk of putting up 50 Crs, that too, 3/4th of it through debt.

Valuation

When it comes to valuation, the best thing one can do is to keep things simple, instead of using fancy excel models. I like to compare the earnings growth rate to P/E and here’s how it looks.

RACL vs NiftyRACLNifty
EPS growth – 5 years37%9%
P/E1429

RACL compares well to Nifty and most other indices in terms of earnings growth as well as it’s valuation.

Disclosure – I have a position in this company and my views are certainly biased. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above business anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

Barath Mukhi
25th June 2021

Author: Barath Mukhi

Concentrated investor in Indian markets

11 thoughts on “A potential multi-bagger from an unexpected industry”

  1. For the valuation shouldn’t we compare it with Nifty Small Cap instead of Nifty? BTW, thanks for your work.

    On Fri, Jun 25, 2021 at 4:25 PM Big Vision Investing wrote:

    > Barath Mukhi posted: ” Imagine you are a senior employee, at a company, > with several years of experience and you know things are going like this. > By year 6, you know that the company’s equity has been wiped out and it > goes into BIFR, a fancy name for potential bankruptc” >

    Like

    1. Yes. That would be the correct way to compare. However, I haven’t been able to find a credible data source for BSE/NSE small cap EPS numbers till date. In the absence of that I took the liberty of using Nifty EPS instead.

      Like

  2. Hi Bharat,

    Good write up.

    The receivables used to look optically low few years back as the co used to get them discounted from bank for working capital. However with the change in accounting standard, they started showing the same at full value.

    Like

  3. Hi Bharat, Great Piece – emptied reading this article. Just have one query regarding the EV disruption risk you have mentioned – will RACL’s products not be used in end electric bikes ?

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    1. Hi Mandar. Yes gears will still need to be used in EVs. But will RACL have the same advantage and the same scale is yet to be seen. They already make gears for Mahindra Reva, for example.

      Like

  4. Financing the new Capex through debt may also be to take the advantage of low-interest rates in the present situation. May turn out to be a very good move if they execute well.

    Like

  5. Hi Barath Mukhi, Excellent write-up. I like the way you narrated the Story. This show how much passion you have towards what you are doing. You’re a true gift to the people in your life

    Like

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