Clariant Chemicals and BASF India-Updates And Why EBITDA is used for Valuation

Clariant chemicals ran up decently to 440 from 275 when it was advised last time in Nov-2019 (Click here for old post). At that time it was expected to sell its Masterbatches and Pigments business to focus more on high margin specialty chemicals business. I was expecting to sell the same at anywhere around 1500 cr to 2000 cr valuation excluding land bank which was around 15 times its last year EBITDA and around 1.5 times to 2 times of the turnover of 1000 cr while it was available at just .6 times of turnover. So the valuation discount was massive.

And it finalized the deal in dec-19 to sell its Masterbatches business to PolyOne for Rs. 426 cr. Global parent Clariant has entered into two transactions with Polyone-first it sold its global business for Swiss $ 1.56 billion which is 12 times its EBITDA. Then it also sold its Indian business (as it is listed separately and parent has 51% share) to Polyone for 426 cr which is around 17 times its previous year EBITDA just as per our expectations. The turnover of Masterbatches business was 284 cr so it got the valuations of 1.5 times of turnover. The proceeds will be used to invest in innovative and technically superior products, to give dividends to shareholders. At parent level they have plans to retrun back some $1 billion (almost 60%) as dividends so we can expect the same in India also. If after tax proceeds in India are 350-380 cr then we can expect some 200 cr as dividends which is around Rs. 90-100 per share. This is from the sale of Masterbatches business and Clariant is expected to sell its pigments business also by the end of 2020. Its Pigment business in India is much bigger than Masterbatches and so we can hope for another big dividend this year. Sale of masterbacthes business is expected to be closed by Mar-2020.

Clariant is going to concentrate on three core Business Areas Care Chemicals, Catalysis and Natural Resources and I think they will do the same in India also. After the sale of pigments and Masterbatches, Clariant is focusing on chemicals for consumer products likes soaps and shampoos, the oil and gas industry, and catalysts that help speed up chemical reactions.

Clariant Dec-19 results

After the result of Dec-19 quarter, clariant has fallen to 340 levels all the way from 460-470. I think perhaps market misunderstood the results of clariant chemicals. It was not that bad as they are looking. It has shown a loss before tax of 3 cr this quarter but the same is due to the impact of showing of masterbatches business under discontinued operations. As they have entered into an agreement to sell the same so the performance of this segment is shown under discontinued operations and if we add the same into the normal business then the figures will start to look much better:

(Figures in Rs. Cr)	Dec-19	Dec-18
Continuous business Turnover	188.33	171.09
Add: Discontinued business Turnover	91.75	78.83
Total Turnover	280.08	249.92
PBT	3.25	-3.53
PBT after adding outgo of 1.36 cr on tax amnesty scheme	4.61	-3.53

     

Further this year they have opted for amnesty schemes of various state and central governments in respect of outstanding indirect tax litigations and paid around 10cr this year otherwise the figure of profit of 9 months this year would have been higher by 10 cr (45 cr vs 10 cr up to Dec-19). The expenditure under this head in Dec-19 quarter is 1.36 cr.

I think this one is a great buy at 340.

BASF India: Another gem at massive discount

In the same post on clariant in Nov-19 (click here), I have also mentioned the great prospectus of BASF India as the same was also looking to sell its construction chemicals business to focus on speciality chemicals business. Earlier, BASF has also sold its pigments business for euro 1.5 billion to Japanese chemical giant DIC in order to focus on new age specialty chemicals. In dec-19, BASF has entered into an agreement with Lone star which is a global private equity player to sell its construction chemicals business for $3.52 billion (around Rs 25,000 crore). So the same is also being divested from Indian arm also. Its indian construction chemicals business has been sold for Rs. 595 cr which is having turnover of Rs. 484 cr so the valuation is 1.2 times of turnover. Its global business is having revenues of $2.5 billion so at transaction value of $3.52 billion the valuation is 1.4 times of turnover.

So taking 1.2 times as the basis- total turnover of BASF India is around 8000 cr so it should be valued around 10000 cr although its remaining specialty chemicals business is of higher margin business. Right now at current market price of 900 it is valued at just 4000 cr which shows the gross undervaluation.

BASF expanded in construction chemicals in 2006 but it has struggled to build the scale in this complex sector since local construction techniques can differ even from country to country. So this unit was not the star performer for BASF and that’s why I think the rest of the businesses of BASF are much more valuable.

Its results in Dec-19 quarter were great. Its topline has grown to Rs. 2000 cr from 1400 cr last year but I am surprised that market is caring more for profits when scale and market share is more important in chemical sector. BASF India is having minor losses due to high raw material costs but it happens due to product differentiation and it being predominately a specialty chemical player while most of Indian chemical companies are commodity or basic chemicals companies. Its raw material prices are high and it is trying to lower the same. Another listed indian player Aarti industries trades at valuation of 4 times of its revenue only due to low raw material costs although Aarti is mainly a commodity chemical player. Its turnover is around 4000 cr and it trades at 17000 cr market cap. Aarti's raw material costs are 60% of turnover whereas the same are 80% for BASF. So one can assess the scope of growth for BASF with turnover of 8000 cr and it just need to solve the raw material equation. Higher oil prices and currency fluctuations are the main issues hitting its raw material costs as it sources the same from group companies across the globe.

BASF has made significant investments in China. Recently it has planned for $10 billion investment in China for engineering plastics and thermoplastic polyurethane (TPU) and first unit has started production. Very few knows that BASF is a significant player in electric vehicle battery segment (Cathode material) and global electric, electronics and automotive players look towards BASF for the innovative solutions. Its indian investments are not that high but recently it has upped the ante in india and announces a mega JV with the likes of Adani to start a Rs. 16000 cr chemicals plant in India. Its turnover in china is $8 billion whereas the same in India is around $1 billion. But it has invested big in India in last 5-6 years as compared to last 100 years so as India is going to be the global hub for chemicals I have no doubt that BASF is going to increase the investments in India big time.

BASF is one of the best chemical player in the world and have several innovations to its credit including supply chain. Supply chain plays a major role in chemical sector because quality plays a lesser role in affecting sales. The major factors which affect the chemical sector are price, volume, currency and portfolio of products. So raw material costs and supply chain efficiency are the major factors which drive the profits. BASF is only company from chemical sector which is counted amongst the global best in most innovative supply chain.

BASF has one of the most innovative and advanced constructed supply chain where the byproducts of one operation get converted into starting materials of another operation. In Germany they call this concept “Verbund”. When by-products of one plant can be used as the starting materials for another, chemical processes consume less energy, produce higher product yields and conserve resources.

The Ludwigshafen site of BASF having an area of ten square kilometers, is the largest chemical complex in the world where 110 production facilities and 200 production plants are interconnected. Byproducts and products flow through 2850 kilometers of pipes, 230 kilometers of rail, and over 100 kilometers of road. An astounding 39,000 employees work at this site. On its six Verbund sites across the global, BASF achieves annual savings of more than $ 1 billion through its Verbund.

So BASF is a great buy at CMP of 900.

Reason for recent M&A activity in Chemical sector

I have covered some details as to why the likes of Clariant and BASF are divesting some of their chemical business in the last post in Nov-19 (click here). Actually as I have shared in chemical sector raw material and supply chain create the biggest space for margins hence size matters in this sector so over time what happens is that all the companies try for the capacity expansions which result in the excess supply in the sector. The only way to absorb this excess supply is to acquire capacities and then merge or align the same with your existing business because if one company plans for shutting down one of its existing facilities due to excess capacity the same is going to benefit the rivals the most because this will lead to lesser supply. For growing scale and margins, it is easier for companies to shut down plants of much larger entity formed after acquisition of rival capacities and by keeping the most productive plants with best raw material linkages and supply chain.

So M&A in chemical industry creates the value for buyers but as in M&A most of the value accrues to seller and that’s why I think both clariant and BASF have got good prices for their divestments. And if we can see, when both the buyer and seller are fighting for getting the synergy and benefit out of sale, the other players in the industry who have done nothing are also going to gain from this transaction as this will reduce the overall capacity in the industry. This is very complex set of creativity and planning and that’s why sometimes I say that businesses are just like creation of a piece of an art like a painting or music.

Further, as there is general slowdown in the global economy so demand is low for chemicals also and they are growing at 2-3%. So many global players have increased their focus on mergers and acquisitions in order to create the scope for growth, realize cost and revenue synergies, and enhance their product basket and their value proposition to the customer.

EBITDA for Valuation of Business

Many readers have asked me why EBITDA is used for valuation rather than PE especially while acquiring businesses. First of all, there is not a perfect valuation of a business. Valuations are always subjective (50% subjectivity) and extreme hard work, capability and vision is required to make acquisitions work. Hence, most of the times (99%) selling firm shareholders derive most of the benefit not the buying firm.

If one can see, accounting these days has become so complex that it has lost its utility for valuation of business. There is huge involvement of complex accounting treatment of various business entities along with subjectivity in using or assuming accounting policies. I always say that profit we see in the books of account is mainly accounting profit not business profit. The books of accounts primarily serve the purpose for taxation or accounting profit and loss figures. Apart from this, another important factor is the presence of situational or positional factor at a particular point of time for an organization which are unique to that organization only and these factors may have no or  different presence for the entity who is acquiring the business.

So if we can see that the profit of an organization is derived after accounting for some factors which are unique for that organization only and for the buying entity it is necessary to eliminate these individual factors in order to arrive at figure of profit which is more general and realistic. Like, for example, depreciation has a big impact on the profits of a manufacturing organization but depreciation charge depends upon the age of machines. So if there are two firms with same topline, say 1000 cr, but as one firm has installed new machinery its depreciation charge is much higher at 100 cr while the other one has much lower depreciation charge of 30 cr due to old machines. So as we can see, for same turnover ,almost same raw material and employee costs the profit of new machine firm will be much lower than the other. So this situational factor will change the profit figure significantly without affecting the business performance or profits. Same is the impact of tax rates and leverage (interest costs due to debt/loan while other may have higher equity and nil debt). The selling firm may have higher interest costs due to lower credit rating while the buyer firm may have much higher credit rating so it can keep the same level of debt although at much lower interest cost.

So the buying firm may have very different capital structure, tax rates or different asset base which necessitates it to have a more realistic evaluation of performance of the selling firm by eliminating these individual factors. So EBITDA figure is the contribution from the business irrespective of the asset base, capital structure or tax rate. In other words, it is more generalized version of the performance. Firm specific factors color the real performance but as the firm is being sold to another firm so selling firm specific factors will no more color the performance in the future so it is necessary to eliminate their impact.

Further, EBITDA valuations provide the enterprise value (EV) of a firm which means that this value also includes debt in it as interest is also included in EBITDA figure. So in order to arrive at shareholder's stake value we need to deduct the quantum of debt from Enterprise value.

Using Net profit (PE ratio) as a base for acquisition will give very misleading results and may spoil the game for a potential bidder. Net profit figure is arrived after accounting for all the complex accounting and taxation laws and firm specific capital and asset structure which will distort the real performance indicators. I have almost stopped using PE ratio while doing the analysis long time back. Many times I don’t even look at the Net profit or EPS figure. This is just like small children are taught in school. “A’ for apple is only used to make them understand the sound of A not apple. As their understanding grows, they can make new words with A. Similarly, PE is just “A” for apple and it is not the only metric to judge the performance of a company. It is just the starting point.

DCF-Any Merit?

I do not have much liking for DCF (discounted cash flow) method for valuation of business although the same is used widely and in fact in many research papers I have seen authors arguing in favour of DCF and heavily criticizing EBITDA method. Actually, one thing which I find worth mentioning is that there is not any perfect objective formula or method to evaluate businesses and one reason for the same is uniqueness of every business. So, two firms can have same figures of top line and bottom line but with different modes of operations like one is outsourcing entire manufacturing (asset light like Bajaj electricals) while the other may be having its own manufacturing capacities, assets etc. So customization is required at every stage. Further, the fact that most of M&A fails is a testimony to the wrong price discovered and paid (still DCF is used widely, recently for valuation of defense arm of Tata power, Tata Power SED, PWC has used DCF method valuing the firm at 1780 cr) and shows the limitations of any linear method in the valuation.

DCF- one very important problem which I find in DCF is that it tries to value the future business performance but if we can see what we are getting is “what the previous owner has done/created in business till date”.  so past performance should be the basis for evaluation not future. Past profits are what the previous owner has achieved. This is just like we are getting a chicken but as we want to make Bar be que chicken in the future so we are ready to pay the price of Barbequed chicken!! I think that DCF over-value a business and buyers end at paying much higher price. Second, DCF requires too much guesswork with regard to everything. If we leave alone the complexities in assessing the future cash flows for next 10-15 years (which requires estimating the growth rate etc.) still even the estimation of discount rate is very complex. Discount rate requires estimation of interest rates, inflation rates etc. which I think even best economists, central banks across the globe has never been able to forecast even with 50% accuracy. In DCF future forecasting for cash flows there is never a bad year or down year…all the time there are positive cash flows which I find hard to believe. Industries and businesses go through periodic variability every now and then. Then there is complexity in assessing the terminal growth rate.

 So amid so much melodrama, I am surprised how people can have any sort of confidence in the valuation figure we get from DCF. In the end, DCF fails to offer any practical value (in my view)…but still it has immense theoretical and conceptual value because even in other valuation methods the inherent logic is the cash flows. It is surprising that even after 300-400 years of equity markets we are yet to develop a workable real life business valuation formula…even 70% accuracy is more than enough.

But still, DCF can offer valuable insights when valuing annuity type of business. Like, that day I was checking Mukta arts ltd which has a library of some 30-35 films (some of the most hit hindi movies like Karz, Khalnayak, Saudagar, Pardes,Ram lakhan etc.). Mukta arts is selling the rights of their 35-40 movies for some 60 cr for 5-6 years which means that yearly cash inflow is some 10 cr…after tax is around 7-8 cr and as this require zero maintenance (as compared to commercial lease/real estate) so 7%-8% is good risk adjusted return for this one which makes the minimum value of this content assets at some 80-90 cr and this is the current market value of Mukta arts!!! But apart from this library, they have much valuable business in the form of India’s best media university (Whistling woods international, revenue 50 cr High margin) and their cinema brand A2 cinema (revenue 100 cr mostly share of revenue/advertisement with 65 screens), they have 2 properties in Bandra valued some 40-50 cr, they have high growth content production business after the onslaught of OTT. The movie rights were sold for some 40 cr 3-4 years back…so instead of depreciation the value of these assets kept on increases. And they are carried at Nil value in the books.

I am not saying that Mukta arts is worthy of investment but still it looks much undervalued. As we can see, in annuities types of business DCF will have its worth like lease rentals firms.

Once one of my friend explained a case to me to show the fallacy of EBITDA valuation. He studied the same in many research papers and articles proving the worthiness of DCF and fallacy of EBITDA. In those articles, authors have given an example where two companies of the same size have different levels of EBITDA- one (A) has 35% EBITDA margins while the other (B) has 30% so one can say that A is better and should be valued more as per EBITDA. But then they revealed that firm A has invested massive sum (1000 cr) for expansion while B has spent some 200 cr for repair etc. of old plant and machinery. So if one can look at 1000 cr investments then B is more valuable because the ROE of B will be much higher than A.

But i think there are some most basic flaws in the estimation work and because it is estimation so one can prove it any way. First of all, I find it hard to believe that a firm with 1000 cr assets is only having 5% more EBITDA margins than firm with 200 cr assets…I mean firm A should have massive depreciation charge and that should raise EBITDA to very high levels as compared to B. Then, EBITDA is not a gun in the hands of a child who can shoot anything. If both the assets have same age then it is so foolish on the part of firm A to invest 1000 cr just to earn 5% more by putting 5 times more….but why a business will be so foolish? We know it is not the case…we need to treat businessman as rational while taking hypothetical cases…we can’t imagine one man as fool and then reach at some rational conclusion.

So if firm A is rational than it means that assets of A are much more valuable and will last much longer and this is where the difference will arise. People try to present EBITDA as one tool which does not care for the age difference of assets and cost of capital. But I think this is gross miscalculation because in EBITDA valuation, EBITDA is just one of the variables…it is not the entire universe. Because the second very important variable is the “valuation multiple” and if you ask me this multiple is affected by the age difference of assets and cost of capital. Firms with much costlier, advanced and new assets get higher valuation multiple. But still this depends upon the industry we are dealing with like branded FMCG has lesser impact of production assets because maximum value is derived by the Brand strength of the company and people buy their products even if they are costlier than the competition. So there may be a case where one firm with large assets (firm A) is compared to same size firm with outsourcing model (firm B). If we take all other factors affecting profits as equal then firm A should have higher EBITDA because the firm B will have higher cost of production because in any case the assets are created by third party manufacturer who will charge the same to the firm B in production cost as overheads besides direct costs. So as we can see, firm A EBITDA will return profits in the shape of depreciation for financing the future investments for expansions or replacement.

I can’t believe that two hospital chains-where one is having its own hospital buildings and other is having leased assets- can have same (or little difference) EBITDA levels (let’s ignore IND AS 116 on lease accounting for time being) because lease rent will be charged as expense and will not be a part of EBITDA while owned assets will retain a part of profits in EBITDA figure as depreciation. So EBITDA of asset firm will be higher and when multiplied by the valuation multiple the difference will be significant.

Turnover for Business valuation

Further, EBITDA has different implications for different set of buyers. Like, if a new player is buying the business (like a Private equity firm) EBIDTA will be more relevant for him. But for a firm which is also into same line of business then the turnover figure will be more relevant as they may have their own raw material sourcing at lower costs, different organizational structure resulting in low employee cost etc. They will also get the positive synergy impact after merging the both businesses due to lower administrative costs, common IT costs, efficiency in sourcing of raw material, lower supply chain costs as it can leverage its present supply chain much better. So many times instead of EBITDA, turnover figure is used because this is the figure where there is no impact of subjectivity and individual factors. Further, there is very less scope of play (not fraud) with turnover figure like depreciation rates etc. So due to these reasons many times turnover figure is taken as basis for valuation especially in case of brands because due to brand strength turnover figure will not have much variations and this will be stable for the most of foreseeable future like Maggi noodles.

But turnover as a basis for business valuation is not used frequently although I find it a very valid method and I use this quite often. In my view, this is best suited for businesses which are operating in mature markets (mature does not mean saturated but maturity related to information and demand and supply of the product), high margin products so that there is not much complexity involved in calculating the impact of factors like raw material, labour and energy costs because in low margin product businesses any significant move in the cost factors can drastically change the business performance hence turnover alone can’t be the basis of business evaluation here. Then comes the market share- firms with high market share in the mature markets. Further, high margins businesses often do not need to offer large credit to distributors/retailers so if we can see the factors which can affect the margins coming out of topline figure are very less in high margin businesses due to high entry barriers in the forms of technology, monopoly or brand strength hence turnover figure alone can represent the true worth of the business. Like, in services business it is very easy to use this metric as it satisfies the conditions of high margins and lesser impact of cost factors (IT industry).

So many times I use both EBITDA and turnover based valuation methods for the valuation of a stock as both give valuable insights. Still, EBITDA and turnover are just the base materials and the major complexity is in the deciding the valuation multiple- whether the same should be 15 times or 20 times of EBITDA or 1 time of turnover.  

I have done some work on valuations multiples and want to write more on this with more real life examples but for the time being due to length of this article I am leaving it here. I’ll take up this valuation exercise in detail in some other post.

(Views are personal and should not be taken as a recommendation for buying or selling a stock. Stock markets are inherently risky so kindly do your Due Diligence before investing. I am not a certified Sebi Analyst and holding the shares discussed in this Post).