Should you be worried about Pledged Shares & a lack of Free Cash Flows in Laurus Labs?

Firstly, I have been invested Laurus Labs since 600 odd levels and added more on the day this company declared Q1 FY2021 Results. Currently this co. forms a little over 10% of my portfolio.

Here’s how I thought about the company before investing.

Firstly, sales had been growing well.

I love straight lines, particularly the ones that are goin’ up and indicating there’s something nice cooking there.

Q1 FY2021 Revenue sources

Cumulative cash flows vs Cumulative profits are good.

Quarterly Sales were showing a nice uptrend. The co. had been on my radar since Mar 2020 because it had shown 2 quarters of growth in sales as well as Profits. In retrospect, I could have bought it a little earlier.

Anyway, the below increase in sales and profits should be seen in the context of the current Covid19 situation where every other business is struggling.

But see what was happening here, at Laurus.

5 quarters of increasing sales and profits in an environment where lockdowns and job losses are the norm, at least temporarily. Wow!

What got me worried though, was the trend in receivable days. Almost a third of the companies sales are being done on credit and not cash.

So, I came across a superb thought by another investor who said, receivables in the pharma sector usually don’t end up being bad debts and write offs because transactions between the seller and the buyer are usually over several years and customers are likely to be dependent on Laurus for future supplies. A data point to validate this would be the company’s sales growth. So there seems to be good demand for the company’s products and write offs seem unlikely.

High debt

Debt is 3 times cash flows generated by the co. If good times continue, then the co. may be able to pay off their debt in due time.

Debt to Equity at 0.6x. The cost of debt as per the company’s latest concall is 6.6% which provides some comfort because it is way lower than the Return on Equity of 15% delivered by the co. in FY 2020. And this ROE was delivered despite a significant amount spent on Capex.

Free Cash Flows – From the company’s FY2020 Annual Report

Changing Revenue Mix

Booming Generic Finished Dosage Forms Business (FDF)

In Q1 FY 2021 alone, the company’s Generic FDF division delivered sales of 351 Crs compared to 46 Crs in all of FY 2019 and just 6 Crs in all of FY 2018.

Growth expected to continue in FDF as per Q1 FY2021 Concall

Booming Contract Manufacturing / CDMO / CRAMS Business

Growth in CRAMS expected to continue as per Q1 FY2021 Concall

Pledged Shares

There are concerns that promoters have pledged shares and this combined with the fact that this co. is based out of Hyderabad (rings a bell, fellow investors?) seems to make a lethal combination. Doesn’t it?

So as per a recent disclosure the 3 promoters who have a cumulative 1 Cr shares pledged out of their total holding of 3 Cr shares, recently got 25 lac shares released from Axis Finance Ltd.

The below graph shows the 3 promoters still own a lot of unpledged shares in the company. Besides, promoters of fast growing manufacturing companies are often expected by lenders to pledge shares to ensure skin in the game. So the promoters pledged a third of their stake to do capex and grow the business, which is fine, in my view.

I bought the stock at a little below 20 times FY20 earnings. For a fast growing co. with a reasonable ROE of 15%, and with tailwinds due to global supply chain disruptions, this is an attractive valuation in my view.

Free Cash Flow vs Growth

Some investors recently raised a red flag about the company lacking free cash flows, on Twitter. This is the typical debate that occurs between a value investor and a growth investor.

Growth investors want the co. to keep reinvesting as long as there are good opportunities for high return on capital growth.

On the other hand some value investors look for companies with cash on their books. I counter that by saying that the markets reward companies that can reinvest all that money and keep the ROE above the critical threshold of say, 15%. Mr. Market doesn’t like companies keeping cash in the bank and I have a ton of such examples.

Promoters

Day to day affairs of the co. seem to be headed by Dr. Satyanarayana Chava. He started the co. in 2007 by investing Rs. 60 Crores of his own money.

Dr.Satyanarayana Chava, @Economist India Summit 2017

It is a phenomenal achievement to have reached 3000 Crs + Revenue in a span of 13 years. So, the gentleman certainly knows what he’s doing. In the past, he was the COO of Matrix Laboratories and has a few decades of experience in the Pharma industry. It always excites me to partner with first generation businessmen who’ve come up the ladder despite all the challenges they might have faced in their entrepreneurial journey.

Risks

  • Around 15 to 20 Crs out of Q1 FY2021 profit of 172 Crs came from Forex gains. So Forex gains contributed about 10-11% of last quarter’s PAT. This may or may not continue depending upon currency movements.
  • Increase in interest rates could lead to pressure on margins, if debt is not reduced.
  • If demand tapers off, then Capex cost may not translate into profits.
  • Who succeeds Dr. Chava in the future will decide the growth trajectory of this co. whenever the time comes from him to step down.

Disclosure – I and my clients have substantial positions in this company and my views are certainly biased. This blog is not to be construed as an investment advice. Please consult your investment advisor before investing.

Disclaimer: This is NOT investment buy/sell/hold advise. I am not SEBI registered. May change stance on above business anytime with new developments and/or new insights, and/or overall market conditions. May NOT be able to update periodically. Please do your own diligence and/or take professional advise, before investing.

Barath Mukhi

5th August 2020

Author: Barath Mukhi

Concentrated investor in Indian markets

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