Friday, November 6, 2009

Thoughts on Gwalior Chemicals

Gwalior Chemicals is an interesting special situation. Please see Ninad Kunder’s excellent blog for background.

Brief recap: The company entered into an agreement to sell their chemical business, on a cash and debt-free basis, to Lanxess in June, with the equity being valued at Rs.380 crores. The plan for the cash from the sale:

Consider a buy-back/dividend/some combination thereof for Rs.100 crores

Investment in a new power generation business and a specialty chemicals business. The company retained one plant in Ankleshwar for the latter.

The company announced on September 1, 2009 that the deal to sell the chemical business was completed. The company’s shares closed at Rs.96/share the day after this announcement. At that time, the company had a total of 246.8 lakh shares outstanding, with pre-tax cash from the deal worth Rs.380 crores (approx Rs. 154/share). Intriguing situation with what seemed like a fairly short-term and highly likely catalyst with a reasonable margin of safety.

Fast forward a couple of months. After a postponement or two of the board meeting to consider the dividend/buy-back, we finally got an announcement. No one-time dividend, which is a good thing as far as I am concerned. The buy-back, however, would be restricted to Rs.48.6 crores (because of legal restrictions that don’t permit the buy-back of more than 25% of the paid-up equity capital and free reserves of a company in any single financial year) for 40.5 lakh shares at Rs. 120/share. From talking to investor relations at the company, I gathered (since we don’t typically get a balance sheet every quarter down here) that the company’s cash receipt from the sale post-tax would be Rs.350 crores and that management would be tendering their shares as part of the buy-back offer so as to keep their percentage holdings the same post buy-back. Also, it turned out that a pre-tax amount of Rs.61.89 crores was being held in escrow subject to fulfillment of certain business targets as part of the Lanxess acquisition.

Given all of this, let’s take a look at some math here:

Public shareholdings: 98.8 lakhs (40%)

Promoter shareholdings: 148 lakhs (60%)

Assuming that management tenders enough shares to keep their percentage holding in the company the same, these are the likely numbers post buy-back:

Public shareholdings: 82.5 lakhs

Promoter shareholdings: 123.7 lakhs

So, the minimum percentage of public shares that are likely to be accepted in the buy-back (under the assumption that every shareholder tenders all of his/her shares) is 16.5% (16.3 lakh shares out of a possible 98.8 lakhs).

Optimistic and pessimistic scenarios re. the escrow amount, post buy-back:

The company receives all of the money that’s currently in escrow. This means that the company will have cash of Rs.301.4 crores and 206.3 lakh shares outstanding with a cash/share value of approximately Rs.146.

The company does not receive any of the money that’s currently in escrow. This means that the company will have cash of Rs.239.5 crores post buy-back (ignoring taxes on the escrow amount, the inclusion of which will increase the cash amount) for a cash/share value of approximately Rs.116.

Also, the company has no business operations at this point, with just land and buildings for the proposed specialty chemicals business at Ankleshwar. I don’t have a handle on what these might be worth, so consider this value an additional margin of safety.

The company’s shares closed today at Rs.90.4/share. In other words, an investor can buy a 1000 shares today for Rs.90,400. When the tender offer commences, he is guaranteed to have 165 shares redeemed by the company at Rs.120/share for a pre-tax gain of 32.7%, with the rest of the shares retaining a cash value of Rs.116/share under the pessimistic scenario outlined above.

Some quick math on what staff expenses might be under current conditions:

Staff cost for the quarter ended September 30, 2009: Rs.241.9 lakhs (2 months of operations before business was sold)

Staff cost for the quarter ended June 30,2009: Rs.304 lakhs, indicating a normal business staff cost of Rs.101.3 lakhs/month.

So, an estimate of current staff costs works out to Rs. 39.3 lakhs on a monthly basis. This costs approximately .19Rs/share post buy-back. Not material at this point.

Risks:

Since not all of the shares tendered are likely to be accepted in the tender offer, the chief risk here is that you’ll end up owning shares of a company that possesses a fair amount of operational risk as they make investments in 2 new businesses. The question then is whether the discount to cash is sufficiently compelling in order for this to be a risk worth taking.

Management’s impressed me so far with the offer to only buy-back shares at this point. Given that they will be tendering shares in the buy-back, the fact that they are not offering more than Rs.120/share is noteworthy. They certainly don’t seem greedy for a fat payoff and also look pretty rational with their capital allocation decision to buyback stock up to the maximum permissible limit. Also, their ownership percentage (60%) is sufficiently high to ensure that they’ll be plenty motivated to make the new business operations work. We’ll see how this situation plays out.

Disclosure: Long Gwalior Chemicals at the time of this writing. This is my first, and so far, only individual equity purchase in India, so please consider yourself suitably warned before you reach any conclusions as to the attractiveness of this idea based on this post.

Ragu