Description

Greenpanel (GREENP IN) is an overlooked spinoff in an industry with secular tailwinds that is going through temporary overcapacity. GREENP is a market leader (#1 player) with a clean, highly incentivised management/owners (51% ownership). The stock looks fairly priced on trailing (depressed) earnings, but looks cheap on 2 year forward earnings (3.2x EV/EBITDA, 3.6x EV/EBITDA-MCX and 4.3x EV/EBIT). The product (MDF) has long-term structural growth drivers, with the end market expected to grow 15-20% for several years, giving the business the opportunity to compound earnings at a healthy rate in the medium to long term. There are several triggers for the value to get unlocked: (1) high earnings growth from operating leverage as capacity utilisation ramps up, (2) aggressive debt pay-down adding to equity value, (3) possible government intervention on cheap imports from South East Asian countries and (4) higher visibility over time as sell-side coverage and investor interactions with the company increases.

Background:

GREENP spun out of Greenply Industries (MTLM IN) and listed on 23^rd October 2019. For simplicity, MTLM will focus on plywood, while GREENP will focus on medium density fibreboard (MDF). It seems the primary motivation behind the spinoff was a family split (two brothers), apparently an amicable one. As part of the restructuring, GREENP also got a minor plywood manufacturing unit, although they have no plans of growing that part of the business. Similarly, MTLM will not enter the MDF market. Post the spinoff, the majority of the market-cap has stayed with MTLM, as the market seems to like its more capital light business model and non-leveraged balance sheet. GREENP on the other hand is the ugly duckling with low return ratios in an over-supplied industry and (at first glance) has a somewhat uncomfortable leverage position (~4.5x net debt / EBITDA). MTLM stock (pre spinoff) had been under pressure over the past 18 months due to excess capacity fears in MDF: some investors have chosen to stick with plywood and sell-out of GREENP when they finally got the chance.

The MDF industry in India has been struggling with overcapacity for the past 18-24 months (ironically, primarily due to a huge expansion by GREENP) which increased their capacity from 180,000 CBM per year to 540,000 CBM (which raised industry capacity ~40%). The new GREENP MDF plant is the largest in Asia, and the 5^th largest in the world. There were also (smaller) capacity increases from the other two main competitors: Action Tesa (private) and Century Ply (CPBI IN). What followed was a series of aggressive price cuts, with GREENP’s average price realisation in the domestic market falling from INR 26,700 in FY16 to 23,000 today. GREENP also switched part of the new capacity to the export market at a barely profitable realisation of INR 12-13,000, which dropped the average total realisation to ~19,400 in H1 FY20 due to the adverse mix. Given the entire production was geared for the domestic market in FY16-FY18, the average price realisation for GREENP has fallen dramatically by ~25% since FY16. Domestic pricing has now stabilised, with GREENP actually taking a 4% price hike in mid-June, which has stuck. CPBI and GREENP have both publicly stated (in conference calls and TV interviews) that domestic prices will not fall further. There seems to be an “understanding” between the three players now, especially in the North Indian market, seemingly borne out of economic reality and rational thinking. Even if price cuts were to re-start, GREENP, with its manufacturing heft (~38% of total domestic capacity), is the lowest cost producer in the market.

Reasons why I think this is an interesting investment today:

1/ You are getting the #1 MDF player in India. MDF is likely to grow 15%+ for several years due to structural growth drivers. Unorganised furniture manufacturing is giving way to organised brands. MDF is the preferred material for organised manufacturing for multiple reasons, but especially because: (i) MDF is 30-50% cheaper than premium and mid-range plywood and (ii) MDF is more environmentally friendly (MDF trees require fewer years to mature and MDF manufacturing creates less wastage with approximately 90-95% input-output ratio vs. 60-65% for plywood). GREENP claims 100% of their wood raw material is from sustainable sources. MDF is rapidly taking market share from cheap plywood, which makes up ~30% of the total plywood market. Globally, approximately 80% panel products are made using MDF vs. only 20% in India today. GREENP and CPBI expect the Indian market to also trend towards the global ratio over time. The plywood market is ~10x bigger than the MDF market in India today (ply is INR 180bn vs. 19bn for MDF). Hence, MDF is expected to grow 15%+ for several years due to the share gains from cheap plywood and organic growth in the broader panel industry. This, in the extremely slow real-estate market backdrop in India today. If the underlying real-estate market picks up in the coming years, that will be an added bonus.

2/ The current earnings are significantly below potential. EBITDA could more than double in 2 years (from FY20 to FY22) and nearly triple vs. the FY19 base, as capacity ramps up and more products are sold in the domestic market vs. the barely profitable export sales. In FY20 (March YE), GREENP expects to have ~65% capacity utilisation (vs 39% in FY19), with ~35% of the output exported. Capacity is expected to be fully utilised by March 2022, with a much lower export component (~20%). Assuming no increase in domestic pricing, but assuming the mix improves, average price realisation should improve from INR 19,500 in H1 FY20 to approximately INR 20,500 in FY22. EBITDA should improve from INR 960m in FY19 to ~INR 2,700m in FY22, driven by volume ramp-up. The main assumptions (vs H1 FY20) are:

                                                              i.      100% capacity utilisation vs 52% today and 39% in FY19.

                                                             ii.      Export mix falling to 20% in FY20 vs. 35-40% today

                                                           iii.      No change in pricing in the domestic or export markets

                                                           iv.      Plywood EBITDA settling at INR 360m vs INR 440m in FY18

The exit EBITDA margin is ~21% vs 16% in H1 FY20 for the MDF division. This may be conservative. The operating leverage may well be higher, given incremental margins could be 30%+ for the remaining capacity, once utilised. My base case is full capacity utilisation in FY March 22. This is company guidance (which I think is realistic). This could be delayed by a quarter or two, but won’t change the big picture.

3/ There will be approximately INR 2,600 of debt repayment between FY19 and FY22. That translates to approx. INR 21 per share (44% of the current market cap). The company plans to repay INR 1,000m in FY20, followed by INR 720m each scheduled repayment in FY21 and FY22. The company has indicated they may pay back more than the scheduled payments in FY21 and FY22, and I am modelling INR 800m in each of the two years. The somewhat uncomfortable debt position today also takes care of the capital allocation question for the coming years – debt paydown will be the first use of FCF and should directly add to market cap, and may even mean a higher multiple in the future.

4/ The business has decent underlying economics. Maintenance capex of INR ~200m is much lower than depreciation of ~INR 700m. Management has communicated MCX to be INR 50-100m per year, but I am doubling the top end of their range to be conservative. The plant’s expected life is 25 years+ (GREENP uses German technology vs. Chinese for most of the competition). Therefore, once the company is at run-rate earnings in FY22, EBITDA minus maintenance capex will be approx. INR 2,500m. PPE and net operating working capital at run-rate should be ~ INR 12,500m and thus the ROIC would be ~20% at run-rate utilisation (give or take a couple of percentage points due to working capital changes). The ROIC will keep improving as the sales mix keeps trending towards the domestic market. We also get a free option of any increase in pricing in the domestic industry: I estimate that a INR 1,000 increase in domestic pricing will add approximately INR 400m to EBITDA (assuming 20% export mix).

5/ The is a strong likelihood of Anti-Dumping Duties (ADD) being introduced to protect the domestic MDF industry in India from dumping from South East Asian countries. The domestic industry alleges unfair government subsidies in those countries (Vietnam, Thailand, Malaysia etc.). The Government of India has officially started a review, and is expected to make a decision by March 2020. The official investigation announcement can be found here: http://www.dgtr.gov.in/sites/default/files/Initiation%20Notification_Fiberboards.pdf

This move will help accelerate GREENP’s sales mix to move towards the domestic market. Currently, approximately 25% of India’s MDF market is served by imports from these S. East Asian countries. Due to logistical reasons, the imports are mainly in the South India market; where GREENP’s new plant is set-up.

6/ GREENP is also a thematic play on the formalization of India’s economy. The government has taken multiple steps towards the goal of formalization, especially the Goods and Services Tax (GST). The price gap between the organized and unorganized sector has gradually reduced, benefitting the organized players with their better brands, quality and logistics. One of GREENP’s largest “competitors” are the unorganized low-quality plywood producers. The market share shift should accelerate as compliance and tax burden increases with the formalization of the economy. One of the larger consumers of MDF in India is likely to be IKEA in the future. GREENP is potentially a proxy play on IKEA too.

7/ Last but not least, the management and promoter group is decent. The insider stake is 50%+ and MTLM has created good shareholder value over the years. The promoters have a good reputation within the panel industry. Importantly for today’s market environment in India, the promoter stock is not pledged. Furthermore, I am not sure the brother that got GREENP would be too happy having 1/4^th the market cap of his sibling (it was meant to be an equal split!). One would think he has a point to prove, and won’t be happy with the status quo.

What is the stock worth? I think a 10x normalized EBITDA-MCX multiple is justified here, given the decent ROIC and growth prospects. MTLM and CPBI both trade at ~14x EV/EBIT (and have traded much higher in the past). They have higher ROIC currently, but lower growth rates. Looking two years ahead: FY22 EBITDA-MCX of 2,500m and 8x-10x multiple with ~INR 3,000m of debt gives us an equity value of ~INR 17,000 - 22,200m (122.6m shares), or INR 140-180 per share (+190-275% from the current price).

RISKS:

The biggest (known) risk is the new capacity coming up in South India in April 2020 by Rushil Décor (RDL IN) of 240,000 CBM per year. RDL is under financial stress at the moment (had a recent rating downgrade: https://www.indiaratings.co.in/PressRelease?pressReleaseID=36988&title=India-Ratings-Downgrades-Rushil-D%C3%A9cor-to-%E2%80%98IND-BBB%2FNegative%E2%80%99) and has announced a rights issue. Assuming this capacity does come up as planned (it was planned when the industry was going through better times), pricing in the Southern market may be impacted. I have spoken to both GREENP and RDL about this, and for what it is worth, they have both told me that prices are unlikely to fall much, especially if the ADD is introduced.

CPBI has also announced an expansion (in the North), but this is expected to be smaller and less disruptive (~170,000 CBM). No other capacity expansions have been announced. Any new expansion will take at least 18 months to come up, post announcement. The broader concern for the industry is precisely this: new capacity will keep coming, given the underlying growth story. MDF is a fairly commoditized product. The key mitigants to this argument are: (1) At current prices and capacity utilization, return ratios do not justify new capex, especially from new entrants, (2) GREENP has a very strong distribution and dealer network (5,000+ retail points and 1,100+ distributors) that is difficult to replicate, (3) GREENP, with its cost and size leadership will increasingly focus on building its brand and (4) Almost all industry participants agree that prices cannot fall much from here, even with the new capacity from CPBI and RDL on the horizon. In a few months, we will find out if the government too agrees with this view, and whether ADD comes in to protect the domestic industry. The new capacities were announced when domestic pricing was 26k+. The reality today is quite different. Even if this ends up being a cyclical, commodity industry (I disagree), it seems likely that we are near the trough of the cycle today.

Further stats on the industry (copy pasted from a JM Financial update report):

“The Medium Density Fibreboard (MDF) industry in India has a total capacity of 14 lakh cbm, of which 9 lakh cbm is in north India and 4.5 lakh cbm in south India. The total MDF demand in India is 9 lakh cbm, which is leading to an oversupply. Though the pace of capacity additions has slowed down, Rushil Décor is coming up with a new MDF plant in south India by FY21and Century Ply is planning a new MDF plant in north India by FY22. India imports c.25% of its MDF demand from Malaysia, Thailand, Vietnam, Sri Lanka etc. Unorganised presence is very minimal in the MDF industry, but few small plants with a capacity of 50,000 – 60,000 cbm has come up with a small capex of c.INR 0.5bn. Key competitive advantages in the industry is raw material procurement efficiency, lower logistics cost and finding the right end-consumer markets.

MDF prices were facing a sharp decline due to the high competitive intensity as the players were trying to cut prices in order to gain market share. MDF prices seem to have stabilised in 2QFY20, and the Greenpanel management has decided they will not reduce MDF prices further as it is just adding to the stress. Greenpanel MDF and Century MDF prices are at par, while Action MDF is c.1-2% cheaper than Greenpanel.”

Catalyst

Volume ramp-up and operating leverage

Debt pay-down

Anti-dumping duties