“Rebellious schoolboys are unwelcome in a technologically advanced, moralistic, exam-oriented society. We prefer a polished Bill Gates to an eccentric Einstein. Eccentrics do unpredictable things, and we have become afraid of the unpredictable”
― Ruskin Bond, The Whistling Schoolboy
Prior to the sell off triggered in the month of February 2018, the Indian stock market continued to rise relentlessly month after month, ignoring all the negative news flows about the likelihood of the government overshooting the fiscal deficit target, the rebound of crude, soaring current account deficit, faltering tax revenues, likelihood of a hike in the repo rate, underwhelming earnings, unwinding of quantitative easing etc.
It seemed that the party would never end.
I had raised some concerns about the bull run in my previous post, ‘Reflections of an argumentative investor’.
Here are the few questions that I had raised in that post:
Q) Is the Indian market soaring without wings?
Q) Are the Bulls being irrationally exuberant? or are the Bears being overly pessimistic?
Q) Have the DIIs finally emerged as the principal movers and shakers of the Indian stock market?
Q) Is India finally making the shift towards financial assets from physical assets?
Q) If yes, then is this shift backed by enlightenment or pure greed?
Q) Has the fear of losing out sedated our rationality?
Well, the search for the above answers led me to a phenomenal book named, “The Hour between the Dog and Wolf” by John Coates, a derivatives trader-turned neuroscientist. Apart from many things that the book talks about, one thing that I really liked was the fascinating insights on human physiology; how investors when on a winning streak tend to become intoxicated and irrationally risk seeking. Conversely, investors show extremely timid behavior while they incur losses. The pessimism is often so extreme that many lose their risk appetite completely and decide to remain on the sidelines even when the market falls significantly leading to appealing valuations. The book explains in detail how the two steroid hormones; testosterone and cortisol play an important role during the excesses of bull and bear markets.
The below infographic conveys the essence of the book:
In the midst of this Euphoria, a value picker, riding high on recent wins from turnarounds and catalyzed with testosterone, tipped me Omax Autos Ltd as a compelling turnaround story. I was given a couple of rationales as well; the company is poised to benefit from the robust growth expected in automobile demand in FY19 backed by revival in the rural demand. It has an annual turnover of over INR1,050 Crore, however its market cap is just about INR350 Crores.
The Company had recently bagged an order from the Indian railways for installing 24,000 bio toilets worth INR250 Crores. Post this news, the stock went up a whopping 36% within six trading sessions! I was also told that due to its good track record (a criteria in Railway tenders), it might bag couple of more orders from the Indian Railways in the near future (so, it still had the potential to go up). This information turned out to be true as it was confirmed by the management later on in an interview given to CNBC TV18, that they are expecting another order from the Railways worth INR200-250 Crores.
Finally, although Omax’s EBITDA margin stood just at 2.50% , the company was aggressively cutting employee costs by handing out VRS to its employees (this too turned out to be true, Omax expanded its EBITDA margin by 580 bps in Q3 FY17).
I did some research and the findings turned out to be quite interesting, hence I decided to write about it.
Since we know that the company has poor fundamentals ( a turnaround story!), let’s first look at the price charts.
Five Years Price Chart
One Year Price Chart
As the chart depicts, the stock ran up from INR70 levels in December 2017, to over INR210 in January 2018!
Well, a 3x gain in less than two months! Something fundamental must have happened, I thought. I decided to dig deeper to find out the trigger (if any!) behind the sudden up move.
“Almost always, it’s the unexpected that delights us, that takes us by the throat and gives us a good shaking, leaving us gaping in wonder.”
― Ruskin Bond, Notes From A Small Room
A) The Business
Omax Autos Ltd is primarily an automotive component manufacturer. The company has eight plants and has been operating in the Industry for 33 years catering to various industry segments such as Automotive (2W, 3W,PC,CV), Homeware, Railways & Heavy Fabrication. The demand for the auto ancillary products is derived from original equipment manufacturers (OEM) as well as the replacement market. The Indian OEM market is extremely competitive and component manufacturers often have to compromise on margins to bag large orders. The annual report mentions that the Company specializes in sheet metal components, tubular components and machined components.
a) Sheet metal components: Sheet metal simply means any metal that can be formed into thin and flat pieces. Sheet metals can be cut, bent and stretched into a variety to shapes to create various components. Examples of sheet metal components used in automotive would be chain cases, sprockets, footrests. Sheet metal component business is extremely competitive and has limited value-add nature of operations. About 65% of Omax’s revenues are derived from 2-wheeler auto components.
b) Tubular components: Examples of tubular components used in automotive would be handles, fuel pipes, front guard, side and main stands.
c) Machined components: Machined components means basic/elementary components of a machine, example spark plug shells, transmission shafts; shafts which transmit power from the source of the power (engine) to the machine (wheels).
Apart from auto components, it also manufactures coaches, bogie bolster, fuel tanks, dual cab and bio toilets for the Indian Railways. But we will get back to the Railways business in a couple of minutes.
The Company’s performance over the past five years has been anything but impressive. Its revenues have been stagnant and its operating profits have fallen over 50%.
Let’s have a look at Omax’s past five years annual reports
*The 2016 annual report quotes PV segment revenues at INR113 Cr. However, in the 2017 annual report, PV sales for 2016 is quoted at INR205 Cr; a discrepancy of INR92 Crores. I could not calculate the YoY growth, since the base figure was altered without any note on revision of sales numbers.
Five major observations from the annual reports of the past five years:
1) Low margin and highly competitive business: Sheet metal component business is extremely competitive and has limited value-add nature of operations. A simple search on “Sheet Metal Component” on India Mart website lists dozens of manufacturers. Therefore, this segment is a low margin business by nature (corroborated by the management in the annual reports).
2) Single segment, single client dependency: Omax’s business is dependent on a single segment (2-wheeler) and a single client (Hero MotoCorp) , about 60-65% of its revenues are derived from 2-wheeler auto component business.
3) Lack of geographical spread in customer base: In the 2-wheeler segment, the customer base is mainly concentrated in a particular region (Delhi NCR). According to the management, “due to high competitiveness, these customers may shift their business base to other parts of the country. Further, to derisk business, they may also rely on more than one suppliers”, may be this is precisely the reason why Omax’s revenues from the 2-wheeler segment have been falling over the past five years.
4) Diversification attempts in the past have failed: The management has repeatedly accepted the fact that they need to diversify their business. They entered into home furnishing and railways business. Home furnishing business could not succeed due to thin margins offered by Omax’s global clients, the businesses suffered losses and it was finally shut down.
5) Railways segment doing well lately: The revenues from the railway business grew 140% YoY in 2017. However, one needs to analyze the profitability (margins) and sustainability of this segment revenues. Let’s discuss this segment in detail under the next section.
B) Economic Moat:
“Well, it often happens that people with good eyesight fail to see what is right in front of them.”
― Ruskin Bond, Delhi Is Not Far
Omax has made some serious progress on its Railway business. Most of the growth came from few products such as retention tanks (bio toilets), end walls and long Hood.
As discussed, the stock has rallied 36% in six trading sessions post bagging the bio-toilets order.
Let’s find out whether Omax possesses any competitive advantages in this segment, will the management be able to sustain the segment’s profitability?
Q1) What is the technology behind bio toilets? Is it a value-added product?
Bio-toilets are supposed to work as small-scale sewage-treatment systems, where the bacteria placed in a compost chamber digests human excreta, leaving behind water and methane as by products. These bio-digesters originally used a bacteria ‘imported’ from Antarctica! The defence scientist who originally found the bacterium got a patent on its use.
But there are experts who claim that the so called bio-toilets are no better than septic tanks!
For instance, in an article published by First Post, a DRDO scientist who was part of the e-loo project claimed that the toilets are, “nothing but gobar gas plants involving no technology“.
Another article by the New Indian Express quotes the same scientist saying that the bio-toilets involve no technology and can be built by a village mason and the imported bacterium from Antarctica is already available in cow and buffalo dung!!!
IIT Madras, IIT Kanpur and Lucknow-based Research Designs and Standards Organisation (RDSO) also hold similar views about bio-toilets.
If bio-toilets are just simple gobar gas plants which do not require any technical expertise, can we expect the bio-toilet manufacturers to earn decent margins?
In terms of profitability, will this segment turn out to be any different from the auto component segment for Omax?
Q2) What is Omax’s market share in this segment?
Well, we don’t know the exact market share but in a recent interview given to CNBC, the management claimed that it is already one of the largest suppliers of bio-toilets to the Indian Railways.
Does this status give Omax an edge?
Not necessarily, according to the New Indian Express, the DRDO has made transfer of technology agreement with 56 companies, which are producing bio-toilets at a cost of INR15,000 to INR75 lakh.
Moreover, during the 3rd week of December, when Omax Autos went up 36% in 6 trading sessions, it was not just Omax which had bagged the order, there were 8 other companies which had bagged the order as well, but Omax’s kitty with an order 24,000 bio toilets worth INR250 crores was the deepest among the other eight.
Q3) How good is the quality of bio-toilets produced being produced by Omax?
Well, we are not experts in auditing the quality of such products, therefore it wouldn’t be wise for us to take matters in our own hands. But since this product is procured by the government, we can take the help of the Comptroller and Auditor General of India (CAG), the auditor to the govt. of India.
It turns out that the CAG has already done a detailed audit of bio-toilets fitted in the Indian Railways. In a report titled, “Induction of bio-toilets in passenger coaches in Indian Railways, March 2017″, the CAG has stated that it found multiple defects and deficiencies in the bio-toilets manufactured by the seven out of nine firms, including Omax Autos ltd.
Here are two observations made by the CAG:
1) “It was observed that out of the nine firms on which orders were placed by Railway Board for supply of 20,000 coach sets, seven firms viz. M/s JSL Life Style Limited, M/s Omax Auto Limited, M/s Mohan Rail Components Private Limited, M/s Rail Fab, M/s Amit Engineers, M/s Hindustan Fibre Glass Works and M/s Rail Tech, had complaints pending against them regarding quantity and quality of material supplied against Purchase Orders placed by the Zonal Railways during 2015-16 and 2016-17.”
2) “In RCF, 58 complaints relating to 351 bio-toilets due to ball valve jammed, clutch wire rusted, choking, leakages etc. were pending mainly against M/s JSL Life Style Limited, M/s Omax Auto Limited, M/s Mohan Rail Components Private Limited, M/s Rail Fab, M/s Rail Tech, M/S Oriental Veneer Products Limited, M/s M.K.P Metal Parts and M/s Amit Engineers as on 31 March 2017.”
Q4) How much margins does Omax make in this product?
The management gave an interview to CNBC in December 2017, they refused to comment on the margins on bio-toilets but the annual report of Omax gives us some insights on this.
Here is a snip from Omax’s annual report for 2016.
The words “a better price” implies that they did not enjoy impressive margins on bio-toilets in 2016.
C) The Management
“Nothing is insignificant; nothing is without consequence in the intricate web of life”
― Ruskin Bond, White Clouds, Green Mountains
There are two observations under this section which are quite interesting.
1) Promoters selling stake when Omax is supposedly turning around!
It is really amusing that when the markets where in a Euphoria, when retail investors were buying the story of Omax’s turnaround, the promoters were actually offloading their stakes, albeit in a staggered manner!
Let’s have a look at the BSE insider trading data:
As mentioned in the table, the promoter stake has been falling quarter over quarter but what is really baffling is the selling that happened in December and January.
During the month of December, while the stock gained about 35%, the promoters sold their stakes 17 times!
Again, during the month of January , while the stock gained over a 117%, the promoters sold their stakes 12 times!
2) Management passing a special resolution to increase their remuneration beyond the 11% limit set by the Companies Act, 2013
According to the section 197 of the Companies Act, 2013, a public company can pay remuneration to its directors including Managing Directors and Whole-time Directors, and its managers which shall not exceed 11% of the net profit as calculated in a manner laid down in section 198 of the Companies Act, 2013.
However, a public ltd company can exceed the limit of 11%, if it makes a request to the Union government after obtaining approval from its shareholders through a special resolution.
In 2015-16, Omax took this route and passed a special resolution in this regard. Generally speaking, hiking the remuneration of directors beyond the 11% threshold, especially when the company is going through tough times doesn’t seems to be a prudent decision. Proxy advisory firms advise that in such cases, the onus is on the shareholders to vote against such proposals and not allow the company to further drain its funds due to increased remunerations.
In Q3 FY17, Omax has reported quite impressive numbers; its revenues and PAT grew 21% and 316%, YoY, respectively. Its EBITDA margin has expanded by 580 bps!
Since the sell off triggered in February, Omax has been hammered down to INR150 levels from the peak of INR210. At a first glance, Omax looks cheap; at a market cap of INR350 Crores with low debt and eight plants churning out over INR1,000 Crores. However, the sheet metal business which is the main segment of Omax looks thoroughly commoditized with very poor operating metrics and cut throat competition limiting any scope of improvement.
It appears that value investors are betting on a turnaround driven by margin expansion in the main segment and incremental orders from the railways business. However, long term vision of the business and the sustainability of earnings remain questionable. In addition, the repeated stake sales by the management is baffling, especially at a time when the business is supposedly turning around. Therefore, the risk reward payoff appears highly skewed towards the risk.
“For the most time I’ve followed instinct rather than intelligence, and this has resulted in a modicum of happiness”
― Ruskin Bond, A Little Book of Happiness
Disclaimer/Disclosure: This post is not a recommendation to buy or sell Omax Autos Ltd. Please do not base your investment decisions on this post. I don’t have any position on this stock.
- First Post, “Railways’ bio-toilet project deeply flawed, need 3,350 truckloads of cow dung at Rs 42 cr”
- Indiaspend, “Railways went ahead with a failed bio-toilet model”
- Indian Express, “Bio-toilets choked with complaints”