Earnings : Quality vs Quantum

One of our core holdings, SRF inched towards its lifetime high today crossing the INR 1400 mark & I was reviewing my position. As part of the process I looked back at my investment note made in January 2010 & compared the key metrics to today:-

	January'2010	April'2016	% change
Nifty	5200	7914	52%
Market Price (INR)	200	1400	600%
Market Cap (INR crores)	1200	8000	567%
Debt (INR crores)	940	2000	113%
Turnover (INR crores)	2200	4400	100%
PAT (INR crores)	300	400	33%
PE ratio	4x	20x	400%

The comparison is amusing & numbers surely don't justify the returns. There is no buyback/ management change that is underway or expected. There has been no sale of property or any non business income/ loss that the numbers hide within. This brings us to the most common question - 

                                                             

                                                     WHY HAS IT RISEN ?  

SRF has had three business divisions:- Technical Textiles, Packaging business, Chemicals & Polymer.  Let us compare the earnings contribution at EBIT level for these businesses :-

(INR crores)	FY'10	FY'11	FY'12	FY'13	FY'14	FY'15	FY'16
Technical Textiles	229	180	114	123	163	195	160
Packaging	40	346	25	6	-5	63	170
Chemicals & Polymer	276	289	594	346	191	298	350
TOTAL	545	815	733	475	349	556	680

Prima facie, none of the businesses indicate any consistency or predictability. But incase of Chemicals & Polymers the numbers tell half the story. From FY'05 - FY'13, 90% of the earnings came from the sale of carbon credits. The management was wise enough to realize that this cash stream will not continue forever & they invested heavily into specialty chemicals taking the capital employed in this business from 500 crores in FY'10 to 2500 crores in FY'16.

This expansion has resulted in a steady & predictable cash flow for the company. Their utilization & clientele is growing every quarter, it is an R&D driven specialist vertical thus steady margins unlike the other two businesses which are exposed to both raw material volatility & demand/ supply imbalance.

So while headline EBIT from FY13 to FY16 remains same for chemicals yet the stock is up 10 times since the QUALITY of EBIT has changed. Quality implies this cash flow is steady, sustainable & growing.  SRF, from FY'05 - FY'13 has roughly traded at a PE ratio of 4. Assuming this multiple continues for Technical textiles & Packaging where no fundamental change has taken place then the market is valuing the chemicals business at 36x its FY 16 earnings. Market values quality earnings very generously, thus if one can spot a transformation early then it can be a multibagger in the making.

Quality driven valuation tends to STAY, Quantum driven valuation tends to SWAY.

P.S: I must add a caveat,  market punishes degradation in quality as well. SRF's biggest investment now is a expansion of 356 crores in a greenfield packaging line as the focus on the chemical side moves to capacity utilization & up-gradation.