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India’s Greatest Cash Generation Machines Keep Compounding

Marcellus’ CCP Portfolio delivered earnings growth of 74% YoY in 4QFY21 which led to a 11% earnings growth for the full year FY21, almost fully offsetting the drag from nation-wide lockdowns during April and May last year (2020). Unlike the trend for the broader market, CCP portfolio companies’ earnings growth was supported by a strong revenue growth of 34% due to further acceleration in market share gains for our investee companies. These market share gains for CCP companies are likely to continue over the next 12 months due to the better preparedness of these firms during the ongoing second wave of COVID-19 and due to their high pricing power amidst a sharp inflation in commodity prices. Over the past 1 year, 5 years, 10 years and 20 years, most CCP companies have compounded their free cash flows consistently at around 25% CAGR inspite of several disruptive events impacting the industries in which they operate.

Performance update – as on 31st May 2021

We have a coverage universe of around 25 stocks, which have historically delivered a high degree of consistency in ROCE and revenue growth rates. Our research team of eleven analysts focuses on understanding the reasons why companies in our coverage universe have consistently delivered superior financial performance. Based on this understanding, we construct a concentrated portfolio of companies with an intended average holding period of stocks of 8-10 years or longer. The latest performance of our PMS and offshore fund (USD denominated) portfolios is shown in the charts below.

In 4QFY21, CCP companies have delivered 74% YoY growth in profits, backed by 34% YoY growth in revenues
After the first wave of COVID-19 related nation-wide lockdowns were lifted in May 2020 (12 months ago), Marcellus’ CCP companies have demonstrated great resilience in demand for their products and services.
As highlighted in Exhibit 2 below, in 4QFY21 Marcellus’ CCP portfolio delivered earnings growth of 74% YoY, backed by revenue growth of 34% YoY. This helped our portfolio deliver 11% YoY growth in earnings for the full year FY21 almost fully offsetting the massive decline in earnings growth reported in 1QFY21.
 

There are several themes that emerge from the recent fundamental performance of our portfolio companies.

Acceleration in market share gains witnessed across the portfolio

The resilience in demand for CCP companies’ products and services over the past 6-9 months has been mainly because of market share gains from both organized as well as unorganized competitors (click here for our 1st March 2021 newsletter highlighting 3QFY21 performance of CCP companies).

For instance, the three lenders in our portfolio have delivered stronger loan book growth in 4QFY21 compared to the industry average (see Exhibit 3 below). The capital adequacy ratio of the three CCP lenders has been significantly higher than that of the banking industry and also compared to the regulatory requirement. In fact, lenders like SBI, Bank of Baroda and PNB, who together control 36% of total industry’s advances, have a tier-1 ratio of only 11%, 12.7% and 10% respectively. In contrast, the three CCP lenders – HDFC Bank, Kotak Bank and Bajaj Finance – have tier-1 ratios of 18%, 21% and 25% respectively. Remarkably, these differentials between the capital adequacy ratio of CCP lenders and their peers exist despite significantly more aggressive provisioning carried out by CCP lenders over the past 12 months.

Moreover, as shown in the exhibit below, over the past 12 months the drop in cost of funds for CCP lenders has been greater than that of the overall industry. Unsurprisingly therefore, CCP lenders are likely to continue gaining market share from their peers with improving net interest margins and superior operating efficiencies.
 

The decorative paints industry in India has faced challenges during the pandemic, both from the demand side as well as supply side. In larger cities households have deferred repainting projects due to the paranoia around the virus, residential societies have not allowed refurbishment activities for several months during the year and contractors faced labour workforce shortage last year due to workers’ migration away from larger cities during the March-July 2020 lockdown. In an industry where supply chain efficiencies in the distribution channel is one of the biggest drivers of competitive advantage, lockdowns have created substantial operational challenges, especially for the smaller unorganized paint players. Amidst these headwinds, as highlighted in Exhibit 4 below, Asian Paints and Berger Paints have reported resilient revenue and profit growth during the year backed by substantial market share gains both from unorganized as well as organized players like Akzo Nobel and Kansai Nerolac.
 

Amongst the diagnostic labs, as shown in the Exhibit 5 below, Dr. Lal Pathlabs has reported far more resilient fundamentals compared to other large listed national chains. Moreover, revenue growth of organized players is likely to have been significantly higher than that of standalone / unorganised diagnostic labs.


Expected impact of the COVID-19 second wave and raw material cost inflation

Our portfolio companies sell products and services which are small-ticket day-to-day essentials. These firms have also made superior investments in systems and processes compared to their competitors over the past 12 months. Hence, their better preparedness in dealing with the lockdowns related to COVID-19 second wave over the last few weeks has further accelerated the prospects of market share gains.

There is significant inflation in raw material costs for some of our portfolio companies. This again has more positive than negative implications for their fundamentals due to two reasons. Firstly, as the classical text book definition of pricing power goes – ‘Companies with high pricing power are able to hike their product prices to offset the impact of raw material cost inflation on their margins, without losing market share in the process’. CCP companies have, time and again, demonstrated superior pricing power vs competitors. Secondly, as we had highlighted in our 1st June 2020 newsletter, several firms in Marcellus’ CCP Portfolio avoid hiking product prices meaningfully. These companies focus on deriving incremental operating efficiencies, thereby negating the need to hike product prices, which in turn suffocates their competitors over time. For instance, the MD & CEO of Asian Paints said in the firm’s 4QFY21 results announcement – “The huge inflationary trend in raw material prices has been worrying. However, its impact on profitability has been negated with some path-breaking work on sourcing and cost optimization.”

Investment implications – ‘Consistent Compounding’ of free cash flows in an uncertain world

There have been several black swan / disruptive events for the broader economy over the last five years – demonetization, GST implementation, the IL&FS financial crisis, the Covid-19 pandemic, etc. As we had highlighted in Exhibit 4 of our 1st March 2020 newsletter (click here), whilst there was no profit growth for Nifty50 companies over FY15-20, our portfolio companies delivered around 20% CAGR in profits over the same time period.

In addition to healthy earnings growth in the past, our portfolio companies have also maintained their ROCEs (Returns on Capital Employed) at around 35% on average. Over time, these ROCEs have increased due to an improvement in asset turnover and reduction in working capital cycles, without compromising on the rate at which profits are re-invested back into the business. The combined effect of expansion in ROCEs with healthy earnings growth rates is reflected in the rate at which free cash flows have grown for our portfolio companies historically – as highlighted in the table below.
 

The consistency of FCF compounding at healthy rates highlighted in Exhibit 6 reflects: a) the ability of CCP companies to offset the adverse impact of macro or micro headwinds either through market share gains or through additional revenue growth drivers over time; and b) the ability of CCP companies to participate in a benign environment, conducive for growth. Historically, the share prices of CCP portfolio companies has been fully explained by the compounding of their free cash flows.

Disruptive events like COVID-19 offer substantial opportunities for high quality management teams to incrementally strengthen their competitive advantages, to radically disrupt their industries, and to add new growth drivers. Several of our portfolio companies have tried to capitalize on these opportunities over the past 12 months – e.g. Bajaj Finance is planning to launch  a new digital offering to its customers; Dr. Lal Pathlabs has invested in home collection infrastructure; Asian Paints has invested in home décor services; Pidilite has acquired Araldite and has invested heavily in manufacturing process automation; Berger Paints is massively capitalizing on the shift from unorganized to organized products at the economy end; and almost all our portfolio companies have upgraded their systems and process to manage working capital better. We expect such initiatives to keep driving a healthy rate of compounding of their free cash flows in future.
Regards
Team Marcellus
 


 

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