Fine Organics: Everything looks rosy, but where's the cash?

I have been studying Fine Organics lately.

The company appeared on my radar as its valuation looks reasonable (the price fell from a high of Rs 7000 a few months ago to Rs 4500 currently) but the business seems to be doing well. Its financial ratios look excellent (as I discuss below).

The company is one of the top 6 global manufacturers of a set of chemicals known in technical parlance as oleochemicals. Put simply, these are chemicals made either from vegetable oils or animal fats and find use in a wide gamut of industries including plastics, food, cosmetics, pharma, coatings, and rubber.

In plastics, for instance, oleochemicals helps reduce friction (think bottle cap!), or remove electrical resistance so dust does not accumulate. In food, it helps lengthen the shelf-lives of products (for instance, it prevents breads from getting fungal early).

What makes Fine Organics unique in its industry is that its new product introductions take a long time (typically 3-5 years) to get approval from clients since oleochemicals are so critical to the quality of the end-products. This, along with the fact that high capital expenditure is required to set up relevant equipment used to manufacture these derivatives from base materials, provides tough entry barriers for newer entrants.

The company also enjoys decent pricing power, partly evident from the fact that Fine’s oleochemicals make up only 1% of the molecular weight of these products. Why would this be an indication of pricing power?

Well, remember that one of the characteristics of a business enjoying pricing power is its product does not make up a large part of the consumer’s budget. When a product makes up a large part of the consumer’s budget, the consumer has incentive to find alternative vendors who may help cut costs. But going through the hassle of finding a new vendor, especially when (1) it takes 3-5 years to approve, (2) is critical to the quality of the end product, and (3) does not make a significant part of the end-product, does not make economic sense for the clients.

Third, Fine’s oleochemicals are also known as green chemicals as they are produced from vegetable oils and therefore environment-friendly. They may act as good substitutes of some petrochemicals used in plastics or automobiles, for instance.

What about bargaining power of suppliers? Well, oleochemicals are made from vegetable oils such as crude pal, oil, soy oilseeds, rapeseed, and so forth. These are often imported from Indonesia and Brazil and so their prices may affect the cost structure of Fine Organics. In fact, in the recent quarters the increase in vegetable oils have eroded the company’s gross as well as operating margins.

This is because the company had long-term contracts with its clients due to which it was tough to increase prices earlier. To the company’s benefit, however, it indicated that it has moved to spot pricing where the prices may be revised in case of raw material price volatility.

Even though the price of palm has reduced compared to last year, it still maintains a high trajectory. The United Nation’s FAO says this: “After falling for three consecutive months, international palm oil prices rebounded in March 2023. Besides lower output levels in Southeast Asia due to unfavourable weather and floodings in some growing regions, palm oil prices received further support from limited global exportable supplies amid temporary export restrictions imposed by Indonesia.” [link: https://www.fao.org/worldfoodsituation/foodpricesindex/en/]

WHERE'S THE CASH?

As for financials, the company has everything going for it except one: we discuss that below. The company is trading at an attractive valuation of a price to earnings ratio (PE) of 24 – much below its 5-year median PE. It has negligible debt and has return ratios to envy of. For instance, its return on capital invested (ROIC) of 29.3%. Even assuming a 15% cost of capital, this is an enviable number. Why?