“A company should be viewed as an unfolding movie and not a still photograph.” - Warren Buffett.
We often tend to give disproportionate importance to the current picture of the company, but not enough to the journey that led the entrepreneur and the business to its position today. This is understandable given that we are studying the business at a point in time. But as Buffett says, a business is not a still picture, it is an evolving movie where the story in the future is not clear and would be impacted by a multitude of factors. The past or the movie that has already played so far is extremely important as it gives glimpses on how the business and the entrepreneur has reacted to various circumstances - both good and bad. This is because while times and circumstances do change, it is important to remember that history rhymes and habits are curiously persistent.
Whenever we try to understand a business, we go back as early as possible - if possible even to the beginning of the movie (from IPO) or at times even the other / previous movies directed by the director.
Rain Industries is a business we have studied in detail and covered here. As mentioned in the model study, Rain is a really complex business. While Jagan Reddy Nellore does exhibit some traits of intelligent fanaticism, he has taken huge risks in the past. His journey led to this conclusion - " So, is Mr. Nellore an intelligent fanatic and an outsider capital allocator? Our answer would be we don’t know. Maybe he both is and is not."
The recent developments in Rain’s business and the management’s response to it make for an interest learning. The below is taken from the concalls of the last three to four quarters.
Towards the end of 2018, the Supreme Court restricted the import of GPC (Green Petroleum Coke), which is primary raw material of Rain’s calcining business. It also banned the import of CPC which hit Rain’s business further. The reason behind the Supreme Court’s decision was to reduce pollution.
These decisions restricted the availability of raw materials and severely impacted Rain’s business as its plant (500,000 ton capacity) in India and the US were running at lower than optimum capacity due to the order.
To add to this, the raw material prices globally started coming down at a time when Rain was stuck higher cost inventory.
To add even more salt to the injury, Rain was constructing a new calcining facility (370,000 ton) in an SEZ (special economic zone), which would require additional GPC for functioning. The existing allocation of the raw material, due to the Supreme Court ban, was enough to satisfy only 70%-80% of the requirement of its original plant of 500,000 tons. This implied there would not be enough raw material for the new plant which was already a year into construction and tens of millions of dollars already spent.
The impact of the above is visible in the financials of the last few quarters - Rain has seen huge suppression in margins. It even generated a net loss in a quarter.
Times like these are crucial. As the old saying goes, it is adversity that is the true test of character. One of the best ways to judge a management is to see how they behave in times of stress (as an aside, applying the principle of duality, we believe even the opposite is true - the true test of character is evidenced in the behavior during good times as well).
Many managements in India have the habit of cancelling concalls or avoiding questions or giving vague answers at times of stress. In case of Rain, the concalls continued as usual and the management was very frank and detailed in the responses to the questions raised by the shareholders.
So what did they do? How did they deal with the setbacks?
They approached the Supreme Court and pointed out that their plant was among the best in the world in terms of pollution reduction. They had installed FGD (flue gas desulphurization) facility which substantially reduced harmful emissions. This was in contrast to almost all other competitors in India who did not have this facility. So Rain requested the Supreme Court to mandate FGD facilities for all calciners in the country in the interest of reducing pollution.
It also requested inclusion of the new facility in the SEZ to be included in the calculation of import quota.
Unfortunately for Rain, the Supreme Court rejected both their requests. However, the silver lining is that the Court decided to let the Central Pollution Control Board and the Ministry of Environment and Forest finalize the standards and place it before the court in 6 months. If the new standards mandate the installation of FGD, it is probably a major positive for Rain as majority of calciners do not have the facility and it can be quite capital intensive, which would put the competition’s viability in question.
There was also a plan B.
Rain also decided to procure GPC from Indian sources, which were available in limited quantity.
Rain, due to its acquisition of CII Carbon more than a decade ago had access to specialized technology which allowed it to mix some amount of lower grade raw material (available in plenty in India). Through its research efforts, the proportion of low grade material that could be mixed was slowly increased. So, to counteract part of the remaining shortfall, it also decided to leverage this patented ICE (Isotropic Coke Experiment) technology to produce CPC.
While this plan was being implemented, unknown to most, there was a Plan C as well.
The Plan C and the court order can both be viewed in the company disclosure here.
Rain developed a proprietary new raw material which it had been working on since 2011. This raw material, named Anhydrous Carbon Pellets (ACP) which requires a highly specialized manufacturing process, has been patented in multiple countries. These pellets are used to produce Calcined Carbon Pellets (CCP), whose quality is claimed by Rain to be better than the CPC that is used currently. Aluminium plants have high electricity costs, and as per Rain, using CCP can reduce the electricity requirement. CCP is also supposed to cause lesser pollution as well. A pilot plant to produce ACP was set up in 2017 and is already operational. Rain is setting up full-fledged commercial plants for these in India and the USA.
The interesting part about this is that the raw material used to produce ACP is available in India in reasonable quantities and thus is not facing any particular import restrictions.
In effect, it has developed a raw material which derisks its business model, gives a better value proposition to its customers and increases its competitive advantage at the same time.
This is something that we like to see in businesses. The relentless focus on derisking. There are not many businesses out there which have multiple options open in case of adverse developments.
Recall that quality GPC is in relatively short supply globally. And then there was this ban on GPC.
Rain had been working on alternate sources for more than a decade now. First there was the ICE technology which allowed them to mix some portion of low quality coke but still produce high quality CPC. Then there is this research that they did to seemingly bypass GPC altogether. Both are patent protected.
And this is not an isolated strategy. The steady derisking focus is visible in their coal tar pitch business as well. While coal tar is still the primary raw material, the Rain plants can now include some amount of petro tar as well.
The derisking is evident in their Advance Carbon business too. This business, which is primarily commodity like in nature, is being converted to a higher quality one through the set-up of a new plant. The new product would use commodity raw materials and produce specialty chemicals (hydrogenated hydrocarbon resins) which are in short supply, thereby improving margins and returns.
Willingness to let go, and relentless focus on costs
Most entrepreneurs have the tendency and a special love for making their businesses bigger. They consider growth at any cost to be holy grail of business. But growth should be pursued only when the returns on the incremental capital invested is attractive.
But what is more difficult but immensely rational, is to shed assets which are non-remunerative.
It is in this context that Jagan Nellore’s decisions are unusual. Below is an excerpt of a response by Gerard Sweeney, President of Rain Carbon, the major subsidiary of Rain Industries:
“We are taking aggressive steps – unprecedented steps in the history of RAIN – to restore our legacy calcination business to a world-class competitive position. To drive this effort, Jagan Nellore has stepped down as Managing Director of Rain Industries Ltd, and the two of us will devote our combined energy to rationalizing our business activities, especially calcination, so that this business is once again performing at a level we know it can.”
To sharpen focus on the Carbon business, Jagan Nellore stepped down from his role as the MD of whole company and took over as the CEO of Rain Carbon, the subsidiary. This is unusual.
The management then went on to shut down a plant in Netherlands and consolidated the operations in their larger facility in Germany. They also decided to shut down an idle facility in the USA. Here is Jagan Nellore’s comment on the US shutdown:
“We are selling the entire facility, because it costs us money as we do not operate it, to maintain that for the security and for the utilities and other things it does cost almost $500,000 - $600,000 for us every year. So basically, we want to avoid that. So, with the sale we will be able, that will also be a saving apart from the realization we are going to receive from the buyer.”
For a company with sales of almost $2 billion and cash flows of $150-$200 million, the focus on costs of even $500,000 says quite a lot. As Mr. Nellore further says, they are really serious about
“carefully managing our spending and we are determined to eliminate expenses that don’t add significant value for our company, customers and shareholders. Moreover, we’ve demonstrated a willingness to walk away from unprofitable business and close unprofitable operations.”
Listening to the shareholders
A major concern of the shareholders is the large amount of debt - of almost a billion dollars. As mentioned in our note, the debt is structured very intelligently - it was refinanced in 2017-18 and is required to be repaid only in 2025. The interest cost is also low at 5%. As per Mr. Nellore, it did not make sense to pay down debt when they could set up plants which gave them returns of upwards of 15%-20%.
But given majority of the capex is done, the management has, in its most recent concall, mentioned its intention to bring down the leverage of Net Debt to EBITDA to below 3X by end of 2020.
The movie that is Rain Industries is still evolving. It faced strong headwinds and seems to be coming out stronger than the competitors. But of course, there is a major villain that is looming in the future - in the form of inert anodes for Aluminium manufacturing, which if successful, can seriously jeopardize its business model. While the commercial viability of the technology is still probably many years away, it would be interesting to see how Rain deals with this challenge.
All-in-all, it has been an interesting movie so far, and we intend to continue watching with interest on how the journey unfolds.
Disclaimer: We may/may not have positions in the companies mentioned in the blog. This case study/article is not a stock recommendation. We are not SEBI registered investment advisors. Our Intelligent Fanatics Case Studies and Articles are meant to retell the stories and strategies used to create exceptional businesses so that we can learn from them.