Thread by @leading_nowhere

This thread below was an example of allocation policies you don't want to find when analysing a rights issue. Let's see the other end of the spectrum. Natural Capsules Limited (NCL) announced a rights issue on 05 Aug 21 to raise growth capital. (1/26)

Why NCL with 100 Cr market cap? There are many small manufacturers like NCL. Without economies of scale, smaller players suffer from high fixed costs, obsolete machinery and lower operating efficiencies, which generally depresses margins and constrains future growth.(2/26)

Small companies can take decades to grow to a size where economies of scale kick in, or where they are able to benefit from favourable supply-demand situations. The objective, thus, is finding companies at cusp of higher return on invested capital and economies of scale. (3/26)

Remember that not all companies doing capex or talking up the future will achieve it. In the land of the tiny, most fail. Maybe 1 of every 50 promising ones will pan out. The failure rate is high. (4/26)

Now, NCL manufactures soft and hard shell capsules for pharmaceutical purposes. Nothing extraordinary about the company for most of its history. Margins used to be higher a decade ago, and progressively fell over the years. FY21 has been a better year for NCL,though. (5/26)

NCL is expanding capsule capacity by investing Rs 36 crore, of which Rs 12 crore was invested during FY20-21 to increase capacity from 7.8 billion capsules to 10.8 billion capsules (+38%) per annum. (6/26)

Management commentary states new machines are more efficient and will expand marg ins. Assuming good utilization with better efficiency, investors can expect higher returns on capital employed. In fact, this already played out partially in the last 12 months. (7/26)

Quarterly financials show that operating margin (OPM) expanded significantly in last 9 months, with highest quarterly OPM margin of 17% in June 21 @ Rs 4.26 Cr. In fact, OP was Rs 13.62 Cr b/w Sep 20 and June 21 vs Rs 4.74 Cr (+300%) in Sep 19 to June 20 period. (8/26)

OPM increased from 8-10% in FY17-20 to 15% in FY20-21 and Q1FY22. The new capacity is also reflected in revenue run-rates, which increased from ~60 Cr in FY19-20 to ~80 Cr in FY20-21, and to ~90 Cr on trailing 12 months basis (including June 21 quarter). (9/26)

Do recollect, this is only 12 Cr expansion out of budgeted 36 Cr in capsule capacity. Extrapolation may tell you earnings can double. However, relying completely on extrapolation is risky because business isn't linear. Also, capsules industry is highly competitive. (10/26)

How does competition affect a small company? One effect is increased working capital, as company has to wait longer to receive payments. Trade receivables are high at 30% of sales and a large proportion are overdue (and seem unrecoverable). Write offs are also present. (11/26)

This is the background before the current rights issue. In 2020, NCL applied for the PLI scheme and in Feb 21 was granted approval for 3 API products with investment of Rs 100 crore. To finance this, the rights issue has been announced @ Rs 100 per share (CMP: 160). (12/26)

Exact entitlement ratio and amount of fund-raise not yet been announced, though I expect it will be at least Rs 30-40 Cr, accounting for 70% debt component. Interesting part, though, is that expected incentives under PLI will be Rs 65 crore over 6 years starting FY23-24. (13/26)

Important to note that PLI incentives are back-ended, applicant must exhibit threshold value of sales before release of incentive. If NCL does achieve the thresholds, the project should have excellent economics with almost 65% of capex cost being paid back as incentive. (14/26)

Management is confident on the prospects under PLI scheme and believes the project will do well as the selected drugs (methadexone, betamethasone, prednisolone) are import-substitution steroids. However, promoters don't seem to have experience in complex fermentation. (15/26)

Worthwhile to note here that approval under PLI scheme is for manufacturing through fermentation. Fermentation-based products have higher incentive of 20% vs 10% for other products under PLI. What does this tell us? More complex product, higher risk. (16/26)

NCL will take ~100 Cr debt (24 cr capsules, ~70 Cr PLI) with Rs 9-10 Cr annual interest outflow. However, PLI project will start paying out from FY23-24 onwards, so FY 21-22 and FY22-23 could see interest costs eating into improved cashflows from capsules expansion. (17/26)

This rights issue is an intriguing proposition for investors. Little to complain on governance. Related party transactions are minimal. NCL disposed noncore holdings (7.5 Cr) to finance 1st phase of capsule expansion. And it has improving cashflows to service future debt. (18/26)

The good part about a rights issue is that it is nearly certain the promoters will subscribe to the rights issue as per their shareholding in NCL. If they do not, I would view that as a big red flag, unless renounced in favor of a strategic investor. (19/26)

This current phase of capex is a big bet for NCL - the total fixed assets will increase to ~160 crore from the current ~37 crore, a jump of 4.3X in 18 months starting middle of FY20-21 till end of capex in Q4FY22. Execution risk is high and shouldn't be taken lightly. (20/26)

April 2021 credit rating update on NCL highlights this risk very clearly. Success will depend on management making a series of correct decisions in an untested field. Delays, cost overruns, quality issues, qualified manpower are some issues that can derail such projects. (21/26)

Many API players have struggled with decent returns on capital due to demand-supply mismatch, cheap imports, quality control issues, etc. This uncertainty can be mitigated with further research, but the final call is *always* clouded in more questions than answers. (22/26)

Further research points for investment decision:
-> Economics of capsules, technical advancements, demand-supply.
-> Economics & technical barriers for selected APIs.
-> Domestic production vs imports of selected APIs, cost differential, tariffs.
-> Management pedigree (23/26)

This is just an example of how to analyze a rights issue as a special situation in a small company, and how to gather and connect relevant dots. There are many rights issues going on all the time, worthwhile ones can be as few as 1 out of every 50. (24/26)

However, repetition of this process exposes you to different types of situations, each with its own underlying calculations and finer points to look at. The best part is all of this is live; and no analysis is truly ever wasted if it improves your skills even marginally. (25/26)

Covered a similar event in PG Electroplast recently, which involved PE funding through preferential issue to finance expansion under PLI scheme. PE took most risk (and pound of flesh), here it'll be current shareholders including promoters. (26/26)

All of this was sourced from public documents - Annual report, credit reports, government documents. NCL doesn't do concalls or presentations, yet. Still there were enough data points available to make this example possible possible. (/end)

Just to be clear, this isn't a recommendation to invest in the rights issue. The rights issue event just highlights ongoing change, the investor has to decide what price makes sense. A better time may be later after execution comes through.