Portfolio Review – 4Q FY23

Reviewing Q4 FY23 at Itus (Mar 23 Earnings Quarter)

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., FY23, as compared to FY22. This helps us track growth of our portfolio better, removing dependence on cyclicality in the quarter. Our portfolio companies continue to demonstrate healthy growth and profitability.

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

At Itus, our positioning of the portfolio has been to account for the businesses with strong balance sheets and a focus on growth. A consistently higher Return on Capital Employed (ROCE) on a portfolio-level tells us about our companies are efficiently performing on a business note.

Over the last 5 years, our portfolio companies have shown a proven track record of consistent return on deployed capital – a noteworthy sign. In turn these returns reinvested within the business have led to higher Cash Flow growth compounding.

Fig: Return on Capital Employed (ROCE) for Itus Portfolio and Nifty 50

Fig: Cash Flow Growth for Nifty and Itus Portfolio

To illustrate, in comparison with the benchmark (Nifty50), our portfolio has a consistently higher ROCE, which when reinvested in the underlying businesses, significantly outperform in generating Cash Flow growth.

In our communication this quarter, we were keen to highlight a few themes that we have exposure to-

The 3 sectors that contribute 60% of the market weights of Nifty include Financials, IT and Auto. Last quarter, we detailed the earnings growth of the 3 and the broad implications for the market. This quarter we provide a short update on each and our portfolio positioning across the same.

IT: Slowdown in growth

        Fig: Net Additions for IT companies (quarterly)                            Fig: Revenue for IT companies (quarterly)

On IT, last quarter (Q3FY23), we spoke about the mixed signals we saw with the slowdown in net additions (headcount) and revenue growth while margins were compressed. Q4FY23 saw revenue growth muted on a QoQ basis (Infosys declined -2.3%; TCS grew 1%) while commentary from management reflected the weakness they see on the ground.

“… for example, some of the clients decided to slow down or stop some of the projects. So, these were things we had not seen at the start or at the end of last quarter, and that’s what we felt. We have also seen some of that stabilizing in March, but the demand environment is uncertain. So, we are making sure that we keep that in mind as we look ahead and remain agile as we look ahead.”

– Salil Parekh (CEO, Infosys)

The headwinds in the services based IT companies need to get priced in the valuations of the companies for us to want to build an exposure in these businesses. We continue to monitor the earnings and do work on the ground but have no exposure in our portfolios.

Financials:

               Fig: Advances of HDFC, ICICI and Axis bank                                        Fig: Deposits of HDFC, ICICI and Axis bank

The three largest private banks – HDFC Bank, ICICI Bank & Axis Bank have all seen an increasing net interest income over the last four quarters coupled with healthy growth in advances and deposits.

While we have seen Net Interest Income growth, we believe in a higher interest rate environment, the advances growth would be slower than what we have seen in the last 2.5 years, leading us a cautious view on investments in banks. Private sector banks continue to be aggressive on garnering deposits alongside increasing the rates on CASA. While this is an extremely healthy trend in the medium term, this should put a ceiling to the growth of NIMs in the near term. In our previous update we spoke about our latest addition in the BFSI sector – IndusInd Bank and our thought process on our expectation and growth of the bank. We continue to be underweight banks today in comparison to the indices and would look to be selective in adding risk in selective names at the right valuation.

Auto & Ancillaries:

Looking at registration data for Medium & Heavy Commercial Vehicles (M&HCV) and 4W vehicles, gives us a clear trend. The M&HCV volumes increased by 37.5% in FY23 over FY22, while volumes on a monthly basis continue to be strong.

Fig: M&HCV registration volumes in India (VAHAN)

Fig: 4W registration volumes in India (VAHAN)

The 4-wheeler registrations in India have reached the pre-covid levels (2018-19) largely led by the passenger cars. It is worth noting that 2-wheelers registrations have seen a drop of nearly 5.7% as against Feb’2018.

Rather than invest in OEMs to play the auto theme, given the cyclicality in the demand cycle, we prefer to look at Auto-ancillary companies where the companies have a sticky B2B relationship with the end-clients and can protect/pass on margins (depending on the value-addition they provide in the supply chain).

To highlight, we hold companies that make engine and chassis components that cater to M&HCV and Industrial vehicles (Craftsman, Bosch), a global automotive cable manufacturer (Suprajit) as well as a precision gears and shaft manufacturer that caters to the higher-end 2W market (RACL Geartech). We continue to position ourselves in pockets where we see a core process engineering based volume growth in our portfolio companies (allocated 15% in Itus Portfolio vs 5.6% weight in Nifty 500).

Reviewing our portfolio investment and revisting our conviction

This quarter we highlight one of our positions where we built our conviction despite stagnant return period over the last 8 quarters

Syngene:

Syngene is an integrated Contract Research, Development, and Manufacturing Organisation (CRDMO) providing Science as a Service—from early discovery to commercial supply. Their expertise lies in areas such as discovery chemistry, biology, toxicology, drug metabolism and pharmacokinetics (DMPK), formulation development, and analytical research and development. They cater to clients from around the world, including large multinational corporations, small and medium-sized enterprises, and academic institutions. Syngene has a strong track record of successful collaborations and partnerships with global pharmaceutical and biotechnology companies.

Why did we hold on to Syngene – when returns were stagnant

Fig: Share price of Syngene between 2018-2023

Syngene share price between Jan’21 – Apr-23 was almost flat and gave no/minimal return. We wanted to explain how our process helps in our conviction in holding businesses where the fundamentals compound and the business continues to gain market share, but this may not reflect in the share price.

The period between 2018-20

During the period between 2018-20, Syngene gave us 0 returns, and this was accentuated by the fact that the PAT growth over this period was a meagre 12%. This caused the PE to optically look high at 55. 

However, over this period, Syngene had a revenue growth of 19% due to its growth in the services-based R&D business. This translated into a CF (Cash Flow growth) of 19.4% over the same period which gave them significant muscle to invest in capex (for their manufacturing scale-up). The comfort around valuations came from the diligence we did in the investments Syngene was making and speaking to some of the large outsourcing Pharma companies and their 3-year plans. 

The period between 2021-23

This period was a very different period of Syngene’s growth. Though the revenue growth of the company was at 21%, this period saw a PAT growth of only 7% accrue to the EPS (on a CAGR basis). This coincided with their Cash flows compounding at 8.4% (which was poor from a headline perspective). However, Syngene was maintaining a higher-than-normal working capital as it was taking its manufacturing capacity live (for their animal health contract they won). 

Today, as we speak, we are seeing this accrue into their bottom-line and cash-flows too and we expect this to continue in the medium term 

It is important to appreciate that looking at the numbers without understanding the core value proposition of the business and the people who are allocating capital will continue to test the conviction of every short-term investor. This is where having a strong process will provide the ability to hold good businesses though the short-term returns may not accrue always.

Fig: Syngene’s Gross block over FY16-22 (in crs)

By setting up commercial manufacturing facilities, Syngene now offers one stop service to clients who have been involved in the discovery and development process because it helps to make the transition into commercial manufacturing more efficient and faster. Partnering with a single service provider eliminates the need for knowledge and technology transfers throughout the process accelerating time to market. The recent 10-year deal win with Zoetis is a good case in point to highlight the same. Syngene’s collaboration with Zoetis started in 2011. Over the past 11 years, Syngene has undertaken development work on several monoclonal antibodies for use in animal health, including developing and manufacturing clinical supplies of a treatment for allergic or atopic dermatitis, now widely used, and Librela. This agreement, initially centred on Librela, paves the way for development and manufacturing of other molecules in the coming years and is expected to be worth up to US$ 500 Mn to Syngene over 10 years, subject to regulatory approvals and market demand. Further deal wins will only enhance Syngene’s credibility and establish itself in the CDMO space.

Today, we see several business conglomerates (Like the Murgappa Group, Nirma Gorup) etc. which are non-related to pharma & CRO space, speaking about the opportunity in CDMO in India.

“The reason really is that we see CDMO as a huge growth opportunity for the country itself. As you know, globally, a lot of it has been done in China. and the large CDMO people in China, I would say, are almost like 10 times the size of the largest player in India. With what’s happening kind of geopolitically, a lot of that is beginning to shift now towards India, and I would say, strongly in India’s favor. So our belief is that over the next decade, it is a good opportunity to kind of grow in this business. And like I said again about the businesses – – we are really taking — a 25-to-30-year view, so that is our thinking kind of going into this”

– Mr. Vellayan Subbiah, Vice Chairman, Tube Investments of India (Q4FY23 Earnings call)

CDMO space is characterised by highly capital intensive, long gestation period, strong collaborations and relationships with the clients. Hence, Syngene’s two-decade experience & track record of working with innovators positions the company for scaling up the CMO business should only result in further large deal wins and capitalise on the growing opportunity in the CDMO space.

To summarise, the below table gives an overview of the health of our portfolio as of Q4FY23 (with the snapshot as of March 2023)

* Companies exited during Q4FY23

** RHIM numbers are adjusted by removing the exceptional item (one-off impairment on goodwill) due to the Acquistion. However, the numbers include one-off expense incurred in Q4FY23.

Team Itus

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