Updated: Nov 20, 2020
This is the first part of the Market Leader Series, in which I'll discuss companies that lead their respective sectors.
In this article, we discuss Polycab, a company with strong growth in sales and profits, rapid expansion in operating margins, low debt, high promoter holding, no shares pledged, and stellar return on capital employed over the years. The earnings quality and working capital management, however, have scope for improvement.
At the outset, please note that this article is only for informational/educational purposes and in no way meant to be a stock recommendation or financial advice. Please conduct your own analysis or consult a SEBI registered investment advisor before you undertake any investment action.
Polycab is India's leading manufacturer and supplier of wires and cables (W&C) with an18 per cent share of the organised market. This makes it a market leader in the segment. The company's product portfolio includes power control, instrumentation, building, solar, communication, welding, rubber, railways signaling and specialty cables.
Other prominent companies in this segment are Finolex Cables, Havells India, KEI Industries, RR Kabel and others.
Besides W&C, Polycab's other, relatively newer business segments also include FMEG or fast moving electrical goods such as electric fans, switches & switchers, LED lighting and luminaries, solar products, water heaters and more.
The company entered in this segment only in 2013, and therefore is a late entrant in a market dominated by the likes of Havells, Bajaj Electricals, Crompton Greaves, Finolex, Orient Electric, Surya Roshni, V-Guard Industries, Usha International and more.
The company's other, relatively minor segment includes EPC or engineering, procurement, and construction business.
Under this, it provides turnkey solutions for power distribution and rural electrification projects.
As a proportion of total revenues, the W&C segment comprises 84 per cent, FMEG 9 per cent, and others including EPC comprises a tad higher than 7 per cent.
As you may have realised by now, Polycab operates in a highly competitive industry.
But besides market dominance, what distinguishes the company from its peers are factors such as robust distribution network, backward integration, better profitability, higher return ratios, and a strong brand equity.
Let us discuss each of these individually.
ROBUST DISTRIBUTION NETWORK
The company has 3500 dealers and distributors, who in turn sell products to more than 1,25,000 retail outlets.
For perspective, note that KEI Industries has only 1600 dealers (as per their most recent investor presentation), Bajaj Electricals has 1000 dealers, and Surya Roshni has 2000 dealers. While both Finolex and Orient Electric have 3500+ dealers, their retail outlets reach is less than 1,00,000.
The only stronger player is Havells, which not only has 9500 dealers, far greater than Polycab's 3500, but also covers more retail outlets at almost 1,50,000+.
The primary difference between both companies is two-fold: (1) Havells is predominantly into FMEG products with W&C comprising only 32 per cent of its revenues, while Polycab's 84 per cent of revenues comprise W&C products. (2) Polycab's financials fare better than Havells', as we'll see below.
The company has built manufacturing capacities for all key raw materials such as copper rods, aluminium rods, various grades of PVC, rubber, GI wire and strip, and XLPE compounds.
Besides, the company used to have 50:50 joint venture with Trafigura Pte Ltd in Ryker plant, which manufactures copper rod in Waghodia, Gujarat. But recently it bought the other 50 per cent stake from Trafigura, making Ryker a wholly-owned subsidiary.
The company also manufactures 90 per cent of its FMEG products in-house. Out of a total of 25 manufacturing facilities spread across 7 locations in India, four units are dedicated for FMEG products. In-house manufacturing helps the company maintain quality as well as costs.
Before we look at the consolidated picture, let's discuss Polycab's segmental results (numbers below are in millions, so Rs 1000 million would be Rs 100 crore):
As you may notice, the company's W&C segment's sales have growth at an average of 9 per cent over the last five years, while the FMEG segment's sales have growth at an average of 44 per cent over the same period.
But the profit margins in the FMEG segment are far lower than those in the W&C segment. Profit margin is total profit divided by revenue from operations.
In FY20, for instance, the FMEG segment managed to reap a profit margin of only 2 per cent. In other words, the net profit from the FMEG segment, after deducting all expenses related to this segment, was only 2 per cent of revenues.
The profit margins in the W&C segment, on the other hand, are higher at 12.3 per cent.
Can you guess why the huge gap?
The answer has to do with high spends on advertising and marketing expenses for the FMEG segment.
Remember, as mentioned earlier, that the FMEG business is highly competitive with very less scope for product differentiation. Given this, companies in this industry focus more on building brand equity through advertising to differentiate themselves from the rest.
Here's Polycab's advertising spends over the years in absolute numbers as well as a % of its total revenues (numbers below are in millions, so Rs 1000 million would be Rs 100 crore):
So, the upside is that, despite being a late entrant in the highly competitive FMEG business, Polycab has been able to grow its sales by 44 per cent every year on average.
The downside is that the required spends on advertising and marketing have been eating off its operating profits, at least for now. But this may also provide the much needed operating leverage to the company once these spends start paying off.
This, by the way, may likely also reflect in the company's December 2020 quarter (Q3FY21) results as the company spent heavily on ads during the IPL season this year.
Having discussed segmental financials, let's dive into consolidated annual financials.
INCOME STATEMENT ANALYSIS
The company was listed in FY19.
Here's a look at its income statement covering last five years (numbers below are in millions, so Rs 1000 million would be Rs 100 crore).
Even though I've sourced the financial data from annual report and the company's prospectus as disclosed to exchanges during the IPO, I've adjusted the numbers to reflect a clearer and more conservative picture of the company.
For instance, in computing the gross profit, EBITDA, EBIT, EBT, and PAT, I have not included "other income".
"Other income" normally includes income accrued from non-operational activities of the company such as, for instance, dividends or interest accrued on investments.
Since I wish to know the profit strictly from operating actives, I've opted to exclude "other income" from our computation. If we do include it, the profit figures would be higher.
How do we interpret this?
STRONG GROWTH IN REVENUES, PROFITS, AND MARGINS
Take a look at the growth and margins below (Table 1):
Once again, remember that I've not included "other income" line item in our computation, otherwise each of these ratios would be higher.
As evident, Polycab has been growing revenues by a comfortable 14 per cent on average every year. The year FY20 showed moderation in growth mainly owing to COVID. For the company's W&C segment, the last quarter (Jan to March months) is normally very important for sales. If not for the pandemic related stress, the company's FY20 sales would have been higher than 11 per cent.
The company's net profit has been growing at a stellar 50 per cent rate on average every year. In FY20, the company registered 50 per cent growth in profits mainly owing to lower finance costs (see the income statement shared above), and lower raw material costs (as a proportion of sales).
ANALYSIS OF POLYCAB'S COSTS AS A % OF REVENUES
Here's a snapshot (Table 2) of the company's various expenses as a % of sales (notice the finance cost and raw material cost (RMC) in FY20):
Again, recall that I've not included "other income" in our revenues, so the denominator (revenues) is lower, thus inflating our overall costs as a % of sales.
Going back to Table 1, notice that Polycab has not only been consistently growing its revenues and profits but also steadily increasing its margins (profits as a % of revenues).
In my view, this can be attributed to two things:
(1) Polycab's success in backward integrating its manufacturing processes as discussed above, and
(2) Polycab's debt reduction efforts -- notice that the company's finance cost has reduced from Rs 116.7 crore in FY19 to Rs 49.5 crore in FY20. As a % of revenues, it has reduced from 1.5% to 0.6%.
Here's a look at the company's leverage ratios (Table 3):
Notice the huge bump in interest coverage ratio in FY20. For those who may not know, interest coverage ratio tells us how many times our operating profit (EBITDA) can cover the interest expense. A number of 22.9 means Polycab's operating profit can cover its interest expenses by 23 times.
In other words, the company's interest expenses are very low compared to its operating profit. The long term debt to equity ratio has reduced to virtually nil.
That said, Polycab's most recent balance sheet (H1FY21) shows an increase in long term borrowings (as shown below in Table 4) from Rs 10.6 crores as of March 2020 to Rs 130.6 crores in Q2FY21 (numbers below are in millions, so Rs 1000 million would be Rs 100 crore):
This is not because Polycab has increased its borrowings. It is only an accounting treatment likely resulting from the acquisition of Ryker plant. Remember, in consolidated financial statements, the debt of subsidiaries is added to the balance sheet.
(Numbers below are in millions, so Rs 1000 million would be Rs 100 crore)
We can also gauge this by looking at Polycab's cash flow statement. Remember that an increase in borrowings must show up as "proceeds from long term borrowings" under the 'cash flow from financing activitie's.
But as Polycab's cash flow from financing activities shows below, there is an increase of only Rs 2.6 crores, not Rs 196.5 crores, in cash borrowings in H1FY21.
(Numbers below are in millions, so Rs 1000 million would be Rs 100 crore)
This means there was only a minuscule increase in "cash" borrowings.
HIGH AND INCREASING RETURN RATIOS
Let's look at Polycab's return (or capital allocation) ratios in Table 5:
As you may notice, Polycab has been consistently increasing its ROCE or return on capital employed. Ideally, a company is considered to be doing very well if its ROCE is greater than the cost of capital.
Polycab's average cost of capital, as seen in the screenshot from its Q2FY21quarterly release, is 9.45 per cent.
This means that the company's operations are churning out enough operating earnings to not only cover this cost of capital but also leave much more on the table.
Its ROE or return on equity has also been rising since five years. This is especially positive given that it does not come on the back of high debt.
Remember, a high debt company may also show high ROE if the debt helps increase earnings. But that's not the case with Polycab.
EARNINGS QUALITY AND STRESSED WORKING CAPITAL
The one area where Polycab has scope for improvement is in managing its working capital cycle.
How do we know this?
One, by looking at its earnings quality, which is cash flow from operations as a percentage of operating profits or EBITDA. A company that is able to convert its profits into actual cash is said to be having good "quality" of earnings.
Remember, not all profits are in hard cash. Some line items such as depreciation expenses are non-cash. Some incomes are also "accrued".
For instance, interest income from fixed deposits may be due but not received "yet". At the end of the quarter, even though cash interest may not be received, the company must record it in the income statement.
At the end of the day, however, we want to exclude these non-cash expenses and incomes, so we know the actual "cash profit".
For Polycab, the earnings quality leaves much to be desired.
In FY20, for instance, Polycab's actual cash from operating activities (selling wires and cables and FMEG products) comprised only 22% of its operating profits.
Why so low? To know this, we must study the cash flow statement.
The cash flow from operating activities (CFO) section shows that the company has been paying bills to suppliers, reducing the trade payables and therefore also cash.
The company has also been reducing its non-financial liabilities -- these are mainly advance from customers. The company received less advances in FY20 compared to FY19, thus putting stress on working capital. While this is not a material issue, investors need to track these metrics closely.
On the company's working capital management efforts, here's an extract from the prospectus:
EXPOSURE TO FLUCTUATIONS IN RAW MATERIAL PRICES
Polycab is exposed to raw material price fluctuations -- especially steel, aluminium, and copper.
As evident in Table 2 above, raw material costs comprise as much as 72 per cent of total revenues. The company manages this challenge through several means, one of which is obtaining a 60-90 day window from suppliers to price its products.
Having manufacturing operations integrated backward also helps in controlling raw material costs.
This is an old extract. In FY20, the Ryker plant is not a joint venture. It is fully owned by Polycab. Even so, this is a risk that needs continued monitoring.
THE ROAD AHEAD . . .
Going ahead, the management expects to benefit from a host of factors: These include the government's national infrastructure pipeline (NIP) project, which is expected to boost India's infrastructure development with an estimated investment of Rs 1.02 lakh crore over the next 5 years, smart cities mission, affordable housing scheme, production-linked incentives scheme, corporate tax rate reduction, and also government's push to increasing the share of domestic manufacturing in the electronics sector.
As per LKP Research, the wires and cables industry accounts for 40-45 per cent of the electrical industry and 8 per cent of India's manufacturing sector. This industry has grown at an average rate of 11 per cent over last five years and was valued at Rs 58,300 crores in FY19.
At sales of Rs 7955 crores in FY19, Polycab made up for 13.6 per cent of the industry's total organised + unorganised sector sales.
With an increasing shift from the unorganised to organised market, strong export growth opportunities, and Polycab's market leadership, there seems a reasonable runway to make market share gains.