Portfolio Review – 4Q FY22

Reviewing Q4 FY22 at Itus (March 22 Numbers)

The quarter went by saw strong annual growth in revenue and profitability across our portfolio. There were a few interesting trends in our portfolio companies which we highlight in further detail below:

Note: For the year-on-year (YoY) measurements, we have taken a rolling 4 quarter format, i.e., Q4FY21 to Q4FY22, as compared to Q4FY20 to Q4FY21. This helps us track growth of our portfolio better, without overt dependence on cyclicality in the quarter.

We also measure the health of the portfolio with the following metrics, that give us a summary of the earning capability of our holdings.

In our communication this quarter, we find it imperative to highlight a few themes that have a material impact on risk.

Generic Pharmaceuticals – Gross Margin Contraction (Update):

In our communication last quarter, we spoke about how Indian pharmaceutical manufacturers are heavily reliant on China for API (active pharmaceutical ingredients) or KSM (key starting materials) procurement. As a result, the generic pharmaceuticals industry had started to notice an increase in input costs, as cost of imported APIs and excipients, as well as transportation and packaging materials, were already rising in the industry for the last 12-24 months, which along with supply crunch caused by China’s power crisis exacerbate the pricing of the industry.

We expect this to last over the next 2-3 quarters. We have seen companies adopt 2 varying strategies during this period.

On the one hand, our portfolio companies are growing their top-line aggressively, though this has come at the cost of a drop in Gross Margin (Varying between 1-3%). We expect the market share the companies we own gain during this period, to result in significant operational leverage post the normalization phases over the next 4-6 quarters.

On the second hand (companies we do not own), we are seeing significant margin erosion along with lukewarm growth as the companies have production bottlenecks and are not completely reliant on China for their raw materials. We expect these companies to continue to struggle in this phase.

During Q4FY22, to highlight the severity of the price increases – KSMs like Para-Amino Phenol, Meropenem, and Metformin, an anti-diabetic, have risen by 80%, 127%, and 124%, respectively. It is important to keep in regard that the change in gross margins of the companies depend on the segment or basket of generics, or which market or molecule is affected.

On the other front, IPM data for FY22, revealed robust growth in prescription sales value of the overall industry (14.6% growth) with Acute generics growing 19.8% in the period (for the portfolio companies we own)

Fig 2: FY22 growth sales value of prescription

At Itus, our positioning of the portfolio has been to account for the businesses with the ability to either pass on the prices to the end consumer (focused on branded generics) or those manufacturing molecules where they have a less of an import reliance on China. This has helped managed the downside experienced across a range of pharma companies.

Agri-Chem:

One of our largest exposures in our portfolio continues to grow its top line and margins ahead of competition. The company was able to maintain and grow its margin at 38.1% which expanded by 1% against the rest of the industry which saw a margin compression of 3-6% While we have seen a margin erosion for competitors across the board, Sumitomo Chemicals continues to expand its margins in a seasonally weak quarter. The company continues to expand its presence in Latin America as the region now contributes more than 45% of its export volume.

Separately, the capex plan for the company continues as per plan, and we expect this to add to the top line growth over the next 2 years (to the tune of 20% once capex goes live).

Global Shipping Prices – Update:

In the last 2 quarters, we had communicated about the raw material inflation and shortage of containers in the global shipping industry. In certain shipping routes, the cost of freight had soared, for example – from China and East Asia to Northern Europe and North America have risen 7 times since the beginning of 2020. This had exacerbated raw material price inflation but also put at risk companies that are reliant on global supply chains.

Fig 1: Freightos Baltic Index (global shipping container cost)

During the past 3-6 months, the prices of shipping and transportation have reduced by 25%, as supply-side constraints in various industries led to lower volumes of overall exports on a monthly basis, as well as the pricing increases passed down to consumers risk tapering demand. Moreover, container production has increased 30% in 2021 over 2020, allowing for a larger supply of containers on the ground and lower wait periods at congested ports. However, it is important to note that while this crisis still weighs heavily of businesses that are either import/export oriented, we expect that the pricing should normalize over the next 2-3 quarters.

In moments like these, it is all the more important to be disciplined around the kind of business we own and minimize risks where we see them. A crucial aspect we search for – is a company’s capacity to raise prices over inflation without affecting sales or losing existing clients.

In the next section, we briefly cover the investment changes made in the portfolio alongside the rationale for each.

Investment Changes

This past quarter we made a few changes to our investments. We shall highlight our reasoning and thesis for our decisions.

Hindustan Zinc:

Hindustan Zinc is the largest and proxy-monopolistic miner of zinc and silver in the country. The company has had a consistent Return on Capital of 25%+ across the last 10 years. The company continues to pay a healthy dividend of 5.5% (at our acquisition price) and is a zero net-debt company.

Currently, the EBITDA the company generates annualizes to 28,000 Crores (normalized for average prices of Zinc over the last 1 year) and the company is available at an EV/EBITDA of 5.5x.

We believe the downside at these valuations for a FCF growth at 22% and for a company which operates at a margin of 70% is limited.

To summarise, here is the health of our portfolio as of FY22 (with the snapshot as of March 2022)

Team Itus

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