HLE Glascoat Equipment – Stock Analysis

Given GMM’s steep valuation of 6000 cr (and wide coverage), there has been a lot of curiosity around HLE / Swiss Glascoat amalgamation and how it stacks up against GMM. I had written the note below to myself back in November 2019 before investing into the stock (I hardly write detailed notes like this – but wanted to be a bit more clearer in my mind before I increased position). Hopefully, this note answers many of the questions that exist currently.

Before I proceed with the note, please note that I am NOT a registered investment advisor. This is NOT a stock recommendation. This is NOT an advise to buy/sell. This is just to layout my readings and learnings about any particular business in a couple of pages – and hope to learn from the blog readers if there is any new angle to this. To reiterate, I have written this note in November 2019 and don’t know if it is a Buy or a Sell today/tomorrow – in that sense, as is the case with all my blogs, it’s pretty useless to read anymore from hereon. I have avoided mentioning any future financial projections in the post deliberately (making it utterly useless to scroll to the bottom immediately to check the projected numbers).

Disc: I own a position. No buys/sells in the last 30 days.

–note starts

Risks (or why should one not invest in this company)

• Fortunes of this business are tied to fortunes of its customer industries- Pharmaceuticals, Agrochemicals and Specialty Chemicals. If you believe that these industries are not going to invest and grow, one should not invest in this business
• There are massive tailwinds visible due to China shift. There is a tremendous amount of capex that’s being incurred by all the chemical/agrochemical companies due to this marginal China shift. If you believe that this capex will stop all of a sudden / slow down considerably and this shift from China is only temporary, one should not invest in this business
• If you believe only in liquid large cap (or liquid any cap), then one should not invest in this business as this is illiquid (although there is enough liquidity at a price)

 However, if you are interested in understanding (and/or investing) an Oligopoly business with a visible China shift resulting in strong tailwinds in a relatively robust capital goods equipment company serving this tailwind, please read on.

What does this company do?

First of all, HLE Glascoat is a merger of 2 companies – HLE (which was unlisted, and is a market leader in filters & dryers) which bought Swiss Glascoat (which was listed and is the 2^nd largest player in the reactors equipment space)

First about Swiss Glass (given it was listed earlier), and we will then proceed to HLE.

Swiss Glascoat Equipments (SGEL) specializes in design and manufacturing of carbon steel glass lined equipment [GLE] (reactors, receivers / storage tanks, columns, valves, pipes & fittings). These products are sold to Pharmaceutical / API, Specialty Chemicals, Dyes/ Colours, Agro Chemicals, Food Processing and allied industries.

SGEL manufactures both smaller sized reactors and very large reactors and the general replacement in this industry happens over 7-10 years. Corrosive conditions and client mistakes determine replacement.

Glass Lined Equipment (GLE) are used where lot of chemical reactions are to take place. Any other material would get corroded in those harsh conditions.  Glass lined equipment is a corrosion resistant material used in varying processes of operation from production of pharmaceuticals to specialty chemicals and polymers. Glass lined equipment prevents materials exposed to harsh chemicals (acids, alkalis, water, and other chemicals) from getting corroded and thereby preventing failure in the equipment.

GLE is an integral part of Pharmaceutical, Agrochemical and Specialty chemical companies. Removing & replacing it is not an easy process & downtime in case of quality issue costs the companies a lot of money. As a result, companies don’t compromise in quality for GLE.

A 4 minute video on SGEL – https://www.youtube.com/watch?v=uDz3y7575ZE&t=1s

GLE equipment is an oligopoly, with GMM being the market leader (50% market share) and Swiss Glascoat being the 2^nd largest player (25-30% market share). The remaining market in the GLE segment is captured by Die Dietrich (acquired Nile Ltd’s glass lining business in 2012 – and now up for sale – either will be bought by GMM or HLE), Sachin Industries and Standard Glass lining – all these 3 players have marketshare in lower single digits.

What are the industry tailwinds?

Fortunes of this business are tied to fortunes of its customer industries- Pharmaceuticals, Agrochemicals and Specialty Chemicals. All these industries are growing at 10-15% CAGR due to various industry-specific factors –

• Very well-known news that China has been making its pollution norms stricter, which is making India as the new hub for Chemical Industry. Even a 5-10% shift will lead to significant volume shift to India. GMM in one of its concalls stated that Gharda Chemicals (one of the largest agrochem companies in India earlier used to order 10 GLEs per year, but have now started ordering 30-40 GLEs per year)
• Cost of production in India is significantly lower than the developed world which gives it a competitive advantage and hence, a strong boost to outsource work (make/ produce/ do R&D) in India
• India has among the world’s lowest usage of Agrochemicals and initiatives from the government and agrochemical companies is increasing the awareness in farmers, thereby boosting the agrochemical usage
• 100% FDI is allowed in the Chemical industry
• The current run rate of capex in these segments in FY20 should be around 6,000 odd crores and of that around 2% to 10% should be coming for the GLE players. Another 2-10% will flow to filtration and drying equipment. In all, looks like about ~600 cr worth of GLE and Filtration equipment per year that is majorly going to flow to 2 oligopoly players (GMM – market leader in GLE and Swiss/HLE – market leader in filtration/drying). This opportunity (if the China shift continues) will grow by 10-15% atleast for the next 2-3 years

So – what changed and why now?

SGEL was run by Mr. Sudarshan Amin till Nov 2016. Mr. Amin was the promoter of the company with stake of around 35% in SGEL. Due to succession issues (both daughters living in the US), he sold the business to HLE Engineers. HLE Engineers (run by Mr. Himanshu Patel and Mr. Aalaap Patel) took a majority stake in Nov 2016. HLE Engineers is a leader in Filtration and Drying equipment in India (> 50% market share) with a similar set of customers as SGEL (in fact, there was a 60-70% overlap in customers between HLE Engineers and Swiss). HLE Engineers decided to amalgamate SGEL in Jan 2019. Post all shareholder/SEBI/lenders/NCLT approval, HLE Engineers business will now be a amalgamated entity within the listed entity SGEL starting 25^th Nov 2019.

SGEL had 65 lakh shares. HLE Engineers valued itself to ~150 cr (very reasonable in my opinion considering it’s a market leader in a growing segment) for amalgamation (including preference shares). HLE Engineers amalgamation will add another 65 lakh shares – thereby taking the total equity base to 1.3 cr shares (apart from preference shares (which will result in a 1 cr outflow every year starting FY20)). From multiple secondary checks and cross-references with customers, there appears to be no corporate governance issues in the group.

Essentially, our estimate is that the tri-criteria of lower sales, lower margins and lower multiple will move to higher sales, higher margins and higher multiple leading to decent returns over the next 2-3 years

Ok, tell me more about HLE Engineers?

Introduction

A 2 minute video to start with on HLE engineers – https://www.youtube.com/watch?v=xkw0Y6bH31U

Initially, HLE Engineers started with the name Indosal chemicals based out of Thane by Dr.Kushalbhai Patel (got doctorate in chemical engineering from USA) in 1950. Indosal used to manufacture salicylic acid (Aspirin) and faced lot of issues due to labor and political issues.  Hence, moved to Navsari. Based on Indosal’s requirements, the management slowly started manufacturing equipment needed for our chemical manufacturing and gradually, started catering to others as well. Over the period of time, Indosal have gained knowledge and leadership in Agitated Nutsche Filter (ANFD) and Rotary Vacuum Paddle Dryer (RVD). Therefore, Indosal started the journey as a chemical manufacturer and eventually evolved as an engineering company in HLE Engineers.

Why is HLE Engineers exciting?

HLE Engineers are market leaders in India in the Filtration and Drying equipment with more than 50% market share in this segment. ANFD and RVD which contributes eighty percent of engineering segment (the rest 20% being contributed by the chemical segment which is run with minimal capex and working capital). HLE sells about 350-400 units every year which is increasing at a rapid rate due to the ongoing chemical/agrochem/pharma capex. Every API, agrochem, and specialty chemical plant needs this product. These products are evolving by replacing centrifuges. This ANFD and RVD products used to be exotic previously (being bought only by larger companies) but due to ongoing increase in complexity of chemical reactions across the value chain, almost all companies have started using this (and higher the complexity, higher are the realizations for HLE filtration and drying equipment). There are operational efficiencies as well in using ANFD/RVD over centrifuges due to which demand is expanding exponentially. For example, multiple centrifuges have to be employed to clear out single GLR (glass line reactor) reaction batch, whereas with the use of ANFD, the entire batch can be processed in one go. Centrifuges also require regular maintenance with the bearings breaking down frequently, which is not the case with a ANFD/RVD.

So, clearly, a market leader with exciting economics in an increasing opportunity.

What are the economics of this business?

Based on the complexity and volumes in chemical/pharma/agrochem plants, ANFD/RVD products give higher cost advantage over the time. For a 100 crore plant, both products cost can anywhere between 2-10 percent based on corrosiveness, usage of exotic material etc. Unlike Swiss Glascoat (or GMM), these filtration and drying equipment are completely order driven business although, HLE Engineers are trying to get lower-priced standardized equipment to sell at a mass scale for the smaller and medium sized enterprises who cannot afford a customized order (for its price point and advances that need to be secured to HLE).

And market share?

From a market share perspective in the filtration and drying equipment space, HLE has a > 50% market share, and Bifriends Filters having 10% market share. Advances for this business range anywhere between 0% and 30% depending on client relationships. Currently, only 10% of HLE business is coming from exports. There is a renewed focus on exports, and HLE is quite confident of making deeper inroads and grow exports significantly from hereon.

The expectation from HLE business (filtration and drying) is that they will grow at 15% CAGR in revenues with increasing realizations and can grow till 300 cr revenues without any further capex. The management in the AGM mentioned that “It is not about physical infrastructure, skilled people availability is big issue. We need to maintain quality with through inspections. Along with capacities, organizational culture needs to improve. Every project is different. With increasing ticket sizes, sense of urgency in capex, significant increase in number of enquiries, we are confident of scaling this business along with growing our team and culture”

The other business within HLE Engineers

HLE Engineers also has a chemical business. However, all these are old products with minimal margins and running at 40-50 cr turnover. Given that the chemical plant is in the same shared infrastructure as HLE engineers, the management has decided to run it minimal capex, minimal working capital and at breakeven till they shut it down eventually in short order. They are focusing on improving yields and running at high capacity. They primarily manufacture Sodium Nephthionate, Dichloro aniline (DCA) which is an intermediate used in food colors, dyes and pigments.

Back to Swiss Glascoat. How does HLE coming in change things here?

HLE management, post taking over SGEL have undertaken multiple initiatives (as the previous management was not very focused on efficiencies and capturing the opportunity):

• Spent 15 crore capex and increased capacity by 30-40 percent. Initially SGLE used to have 900-1000 units capacity, but now increased to 1400 units and will further increase to 2000 units in short order. At maximum capacity utilization, SGEL can reach 250 -300 crore turnover and given the industry tailwinds, will also have increasing margins
• SGEL under the previous management was dependent on a single supplier for raw materials (specialized carbon steel) and therefore pricing was dictated by the supplier. Inventory days in SGEL were always high due to this reason. However, post HLE taking over, they have developed one more supplier and are slowly bringing the inventory days down. HLE would require stainless steel for filtration equipment and the management opines that they can get buying efficiencies due to a larger scale and a consolidated list of suppliers for both
• Installed gas furnaces instead of electric which will improve cost efficiency as well as quality of the end equipment
• Spares contributes 5 percent of the turnover (vis-à-vis 10-12% in GMM). HLE management is actively trying to increase the percentage of spares sales
• Substantial debottlenecking done in the plant
• Changed lay out of the plant for better operations

Competition

The main competition is GMM – who is a market leader in GLE (50% market share) and competition in the filtration/drying equipment of 20%. Enough and more reports are available on GMM, along with multiple quarterly conference call notes over the past few years. GMM has 2800 units capacity for GLE (while Swiss has ~1600-2000 units depending on state of current expansion). With similar industry dynamics and tailwinds, market leader in Filters/Dryers and close competitor in GLE, HLE Glascoat (on an amalgamated entity basis) quotes reasonably.

The other competitors (unlisted) is Suryamani in GLE equipment and Bifilters (unlisted) in Filtration and Drying apart from Die Dietrich who is reducing its presence in India (and the plant may be bought by either GMM or HLE – and given it’s plant’s presence in Hyderabad, might work very well to serve as a hub for all pharma companies in Telangana, AP and Karnataka).

A quick comparison of past financials tells a story:

Few observations clearly stand out:

• The gross margin profile of GLE equipment is very similar (+/- 100 bps). Indicates that on ‘product selling to various customers’, there is very little difference in terms of pricing/customer profile/product range
• PBIT or EBITDA margins are much better in GMM compared to Swiss. This boils down to efficiencies of operations and the plant. With the new management at Swiss taking over and incorporating changes, expanding capacities, changing layouts, gas furnace instead of electric furnaces etc., and therefore should ideally expect Swiss margins to trend up
• There are other operational efficiencies that come with scale of operations – GMM has 2.2x sales of Swiss, which points to and validates the market leadership of GMM

Summary of Amalgamated Entity

 As per AGM interaction:

• They expect SGEL to clock a 30% CAGR growth for the next 2-3 years with increasing margins (~op margins of 15% are achievable)
• They expect HLE Engineers to clock a 15% CAGR growth for the next 2-3 years with increasing margins
• They expected to reach 500 cr turnover by FY22, but looking at the wave of orders, they are expecting a combined 500 cr turnover by FY21

As an aside, we continue to see medium-to-large capex from all pharma and agrochem companies – referencing multiple EC documents along with the Govt. announcing a lot of sops for taking advantage of the China shift in the near future.

The core of the thesis is as below:

• Given that we don’t have to track any chemical prices but still want to participate in the chemical/pharma/agrochem tailwind story, we are comfortable investing in an Engineering company – where we might get more predictable earnings and returns if the capex for these companies continues to happen with not many variables
• This seems to be the classic capital goods story where pricing power increases basis market tailwinds and valuation multiples can re-rate  given HLE Glascoat is a market leader in the non-GLE segment and a close 2^nd in the GLE segment.

–note ends

Please note that the above note was written in November 2019. Kindly don’t base your Buy/Sell decisions based on the above note. I am NOT a registered investment advisor and this is NOT a buy/sell recommendation.