Description

Piramal Enterprises 

Elevator Pitch: Clear catalyst (demerger) to unlock value in two large growth businesses: Global pharma and Indian financial services, run by a wonderful owner-operator who has compounded investor wealth at 24% CAGR over the last 32 years. Valuations are attractive with the finance business available at <0.5X Price/ Book with strong equity ratio for growth (Debt: Equity < 2.0)!

Investment Thesis:

Piramal Enterprises is an Indian conglomerate with two main business segments – Financial services and Pharma. The firm has created huge value for shareholders over the last 3 decades, compounding net profits at 28% CAGR. For much of those years, it primarily focused on the Pharma business. Ajay Piramal, the owner-operator of the firm, has been known to be a shrewd deal maker who consolidated the Indian domestic formulations market through M&A and sold it off to Abbott in 2010 at a huge profit. 

You can read more about this phase in this detailed blog post, https://fundooprofessor.wordpress.com/2011/03/26/the-grand-strategy-of-ajay-piramal/

The current businesses of the conglomerate have primarily been built over the last 8 years or so. The firm has rebuilt a large pharma business post the Abbott transaction in global CDMO, complex generics and Indian OTC segments. On the financial services side, while the firm initially used the capital from the Abbott sale for equity investments in Vodafone, Shriram group etc, Piramal then forayed into structured financing, alternate asset investments, wholesale construction finance and finally retail financing. The firm has continued to deliver healthy shareholder returns even post the Abbott transaction. 

Three major reasons why this asymmetric investment opportunity exists?

Complex Holdco/ Accounting structure – 

I believe that a complex Holdco structure combined with two very divergent business segments obscures the true value of the business. For a large Indian business with a market cap of 4.5 Billion USD, it has very limited sell-side coverage. The stock also does not screen well because of the complications of consolidating pharma and finance segments line items (Pharma is a P&L business, Finance is a Balance sheet business). There has also been several changes or one-offs over the last few years that makes analysing the financial statements difficult such as DRG analytics sale, Shriram Transport monetization, Pharma fund raise, Deferred tax assets, QIP issuance, Upfront provisioning for COVID, Shifting loans from Holdco to HFC etc. 

The management has clearly stated that their medium-term ambition (hopefully 3 years) is to demerge and list the two segments separately. They have also been simplifying the Holdco structure with the sale of non-core assets like DRG Analytics, Shriram Transport stake etc. The only other large asset left to be disposed of is Shriram Capital stake (expected to happen in the next financial year) and post that the Holdco would only have two solid Opco’s which can be demerged and listed separately. With the induction of a minority private equity partner in the Pharma subsidiary who would demand an exit, the eventual demerger would happen sooner rather than later. 

India’s Lehman moment - 

Indian NBFC's (Non-Bank Financial Companies) were on a tear until 2018 when the collapse of a large financial institution (IL&FS) froze the credit markets completely. The Indian bond markets have been dislocated for over two years now as there has been a spate of large financial bankruptcies that followed: DHFL, Yes Bank, Reliance Capital, Religare, Franklin credit funds, etc. All NBFC's had to vacate the short-term CP (Commercial Paper) market as firms were not able to roll over these liabilities and shift to longer tenure funding with an increasing dependence on banks. This essentially broke the back of wholesale financing NBFC’s business models. 

India's central bank and the finance ministry has put in place multiple initiatives to heal the credit markets and revive NBFC lending. As the central bank pumped in a huge liquidity surplus to tackle the market stress, there have been signs of bond markets reviving. As interest rates have fallen significantly (over 200 bps), the spread between AA bonds and AAA/ G Sec bonds has started to compress and I believe that the search for yields would help in better liquidity going forward. Meanwhile, Piramal has also modified its business model with a higher focus on originating retail assets and using co-lending partnerships or sell-down models for its wholesale portfolio. 

Piramal has been able to weather the crisis because of the group’s reputation in the marketplace along with its ability to raise equity and have a solid balance sheet. Almost 3 of the top 5 housing finance companies in India and almost every wholesale focused lender has been left impaired during this bad phase. It is also clear that the firm has always lent to the cleaner/ well-managed real estate developers as they believed in the consolidation theme (though some of their clients have a leverage issue). This ability to pick the right partner and find solutions when things go bad has helped them to manage credit costs reasonably well in a very tough environment. 

Real estate credit cycle -

Indian economy had been slowing down even before COVID with 8 quarters of continuous reduction in GDP growth rates on the back of a tight monetary and fiscal policy. The country had also gone through several resets in terms of Demonetisation, GST, RERA, IBC, etc which exposed firms who were swimming naked. The credit costs across financial institutions are creeping up and the Indian financial sector has one of the largest pile ups of non-performing loans globally. The massive COVID disruption has only added to the credit woes of financial institutions especially in the real estate financing space. Mumbai real estate is considered overpriced and the inventory has been very slow moving, causing stress on the balance sheets of developers. 

Piramal has been prudent in ensuring that they are the sole lenders in all their projects with proper ring-fenced structures and personal guarantees from promoters. The biggest risk with the real estate lending portfolio is projects getting stuck midway because of liquidity constraints. Real estate lending is a business of ensuring the buildings get constructed and completed. Liquidity issues escalate quickly as the retail buyers do not want to buy into a slow-moving project and as construction halts, there is value destruction for every stakeholder involved as cash flows get strained and the project becomes an NPA. Piramal has been able to keep funding its developer partners even during the stress period, providing confidence to buyers, leading to better project sales/ cash flows. The risk keeps getting lower as the project portfolio matures and moves towards completion.

Piramal Enterprises as well as a few other smart wholesale lenders have shown that their ability to step into a project and change developers if they do not deliver on their promises has been well established during this crisis. If the projects do not get stuck, I believe there will always be an exit option for the lender. In good projects, they would get refinanced as the projects near completion and in bad projects which get completed, they would probably need to take a haircut, but they can still exit by selling the completed inventory in bulk to alternate investment funds or someone else who can then slowly liquidate it. The firm has the right systems and processes for early warning signs and starts managing the risks earlier by planning resolutions.  

Since, almost the entire book of Piramal Finance is collateralized against land parcels and have strict step-in rights in bankruptcy remote structures, I believe that Piramal's expected loss given default in most of their deals would be sub 20% and the resolution timelines would be quicker than the NPA's that sits in Indian public sector banks. Also, the firm has already aggressively provisioned for potential slow-moving projects and this mitigates risks for investors meaningfully. The provision coverage ratio for Piramal stands at 237% and the firm also has total provisions of 5.9% of loan book as provisions while Gross NPA’s stands only at 2.5% of AUM.

Piramal’s Pharma Business:

Piramal has built a high-quality pharma business worth 2.7 Billion USD even after the Abbott exit and this shows the value creation ability of the management in their pharma business. I believe that market participants understand Mr. Piramal’s ability in this sector and the standalone pharma business if demerged would trade at a significant premium to peers. Piramal’s current pharma revenues have compounded at 16%+ CAGR and EBITDA has grown 14X in the last decade.

Piramal’s pharma business is well diversified with a strong position in each of its core segments. The firm operates an integrated model in the global CDMO business in which its reputation and partnerships are its biggest strengths. The firm partners with larger firms to help them bring their products faster to the market. Piramal’s quality audit process has ensured that it has a spotless track record of US FDA compliance compared with their Indian peers. 

All the sub-segments of its Pharma business have grown at an impressive pace. Their Indian consumer healthcare business still has untapped operational leverage as they can use the current built distribution infrastructure to roll-out multiple products. The pharma business is a big beneficiary of rupee depreciation and hence provides a natural currency hedge for foreign investors in Piramal enterprises. The firm can also re-enter the domestic formulations segment going forward as the management’s non-compete clause with Abbott has ended. 

Piramal had sold 20% of their stake in the pharma subsidiary to Carlyle a few months back at an enterprise value of 2.7 Billion USD. Stock markets have improved the valuation multiples of Piramal’s Indian pharma peers strongly (25%+) post the transaction as the industry continues to benefit from the tailwinds of increased healthcare spending globally post the pandemic. We continue to use the PE transaction valuation as an anchor for this segment. 

Piramal’s Finance Business:

Piramal Capital grew its loan book too fast over the 2015-18 phase and took high concentration risks. It has huge exposure to few stressed Mumbai based real estate groups such as Lodha and in general has a very high construction risk exposure to the Mumbai property market. The sharp liquidity squeeze over the last 2 years has led to massive industry consolidation. 

While corona virus related economic weakness was expected to further exacerbate the slowdown in housing sales, recent data points on home sales are showing the opposite trend. Since working from home has become a trend, a lot of families are looking at upgrading their homes and this combined with the all-time low mortgage rates has inflected home sales to a strong growth path. More importantly, Piramal’s developer partners who typically tend to be large branded real estate firms have seen strong sales velocity with improved market share. 

The firm’s top exposure Lodha has been able to generate strong sales momentum and this reduces the credit risk on Piramal’s balance sheet substantially. Piramal has also been able to get almost 80%+ of its exposure to Lodha in completed projects inventory and this provides strong certainty of lower credit losses. Similarly, the firm has also been seeing traction in other large exposures like JM Baxi group and this would enable the firm to use the release of capital from these loans to extend newer wholesale loans at attractive risk-reward. 

Even in the non-real estate lending segments, the firm’s exposure has been primarily in renewable project lending. The collateral values of these projects have not only held up but have also improved substantially post the pandemic. The areas of weakness in the lending portfolio would be hospitality projects and under construction commercial real estate, but Piramal’s exposure to these sub-segments would be in single digit. The firm has fully operational hospitality assets as collateral for all its under-construction hospitality exposures. In the commercial segment, its largest exposure is to a fully constructed building in BKC which has high collateral value even in extreme stress scenarios. 

As over 35% of the residential construction finance loans are still under principal moratorium, I believe that it will take a few more quarters to really see the impact of the current credit crisis on Piramal's books. Also, as collateral damage, even if the projects continue to do good sales, collections might be an issue as several large housing finance companies from which the retail users have taken home loans are under stress and hence disbursements have been delayed to the developers. Hence it will take some more time for complete clarity to emerge on the firm's book quality. 

Piramal group has also de-levered at the promoter level with the sale of Piramal Glass for almost 1 Billion USD. I believe that this cash would provide fire power for their private real estate business, Piramal Realty and this would indirectly help them in the real estate financing space as stuck projects can be executed by a group arm at an arm’s length basis. As of today, Piramal Finance has zero exposure directly or indirectly to its group firms as a prudent measure of corporate governance. 

Since banks have withdrawn from the real estate construction space and several other NBFCs have gone bankrupt, there are very few large lenders left in the construction financing space. This provides very attractive deal flow for established lenders like Piramal. The firm would use a mix of both on-balance sheet and off-balance sheet lending (AIF structures, Co-Lending partnerships etc) to slowly grow its AUM overtime. The firm’s nimble culture along with an end-to-end financing model (equity lending through AIF structures) would enable it to develop deeper partnerships with top tier real estate developers in the country. As the real estate cycle turns, I believe that Piramal Finance would be well positioned to grow along with its partners and benefit from the consolidation in both the real estate development and lending space. 

I think that the firm's planned diversification into retail lending would keep the return ratios subdued as it would take a long time to achieve meaningful diversification for a large book like that of Piramal's and meanwhile it would need to continue investing to build the retail franchise, leading to a high Cost/ Income ratio. The firm has hired the CFO of Axis Bank who built a large retail lending business to help it in its expansion plans. The current market dislocation should allow the firm to capture the retail opportunity if it executes well. I believe that their retail roll-out plan looks very credible and this is a large optionality embedded at zero cost at the current market price. 

At a time when large financial organizations have turned conservative, Piramal with its strong balance sheet has been on the prowl for attractive M&A opportunities. Mr. Piramal has a history of value accretive inorganic growth in the Pharma segment and hopefully he brings some of those deal skills to pull off attractive acquisitions like DHFL’s retail portfolio which can fast track the development of its retail business by a few years. These M&A activities would also help in optimising its balance sheet quickly as the finance firm is currently over capitalized with a debt/ equity of less than 2.2:1. The firm has been able to generate around 12-15% ROE at the current leverage. 

I believe that markets have overpriced the credit risks and uncertainties with respect to its real estate portfolio. The promoter continues to own around 46% of the firm and has huge skin in the game. They participated in full force during both the rights issue-based fundraising at the firm. Ajay Piramal's son Anand Piramal who runs the firm's real estate division has become actively involved in the financial services segment. If the young team can take back the right lessons from this crisis and continue to build the organization and diversify, there is massive potential to create a large-scale financial conglomerate over the next 2 decades as the Indian public sector banks will continue to cede market share to efficient lenders and bond markets would evolve to fund larger balance sheets.

Attractive Valuations:

I am valuing Piramal’s pharma business at the same level as Carlyle did 4 months back. If I assume that Piramal pharma post the cash infusion would have a debt burden of 1000 Cr, the equity value of the business would be around 18,000-20,000 Cr. Since Holdco has 80% of the firm, I am using an equity value of 15,000 Cr for the pharma business (>50% of the current NAV). This pharma valuation corresponds to an EV/ EBITDA multiple of less than 14X which is reasonable for a high quality-high growth business (for instance, the Piramal-Abbott sale deal happened at 30X EV/ EBITDA). I believe that the value of this segment can continue to compound at 15%+ due to healthy revenue growth in all sub-segments.  

I am very comfortable underwriting the Shriram investments at the current price. One of my largest investment positions at this point is Shriram City Union Finance. Shriram Capital's investment is carried at investment price in Piramal's balance sheet. The unlisted insurance business of the Shriram group has grown tremendously from the time Mr. Piramal has invested. Since the majority of the value of Shriram Capital is derived from its two listed entities, I can approximate the value of Piramal's Shriram capital stake.  Hence, I believe that the value of the Shriram Investments (Shriram Capital - 20% stake + Shriram City Union Finance - 10% stake) is around 4000-5000 Cr (15% of NAV). Since the underlying portfolio companies are compounding at 15%+ in value terms, I am comfortable even if the monetization takes more time. 

This would mean that the remaining Finance business is currently valued by the market at less than 10,000 Cr Rs. The book equity of the Finance business would be around 20,000-22,000 Cr with the deferred tax assets, meaning the finance stub is currently valued at less than 0.5X Price/ Book which I believe is a very attractive valuation to buy into a growth business run by a smart owner-operator. The Net debt/ Equity on the financial services business would be less than 2: 1 and hence there is enough firepower for future growth both organically and inorganically. Good NBFCs in India with the right mix of wholesale and retail assets do trade at 2X+ Price/ Book.

Even more simplistically, the net equity in the consolidated enterprise is 34,800 Cr post the fund raise. So, the consolidated business is trading at around <0.85X price to book. The pharma business is capital light and hence would trade at a healthy premium to book value and hence it is clear that the deep discount to book value of the Financial service business is what is bringing down the consolidated Price/ Book multiple. As the firm’s earnings from both the pharma and financial services business grow, I believe markets would eventually re-rate the stock. While the pharma business provides healthy downside protection as it is economically less sensitive, the financial services business provides strong upside in an economic rebound. Since there is enough liquidity in the stock, an investor can be nimble and adjust his position size as the situation evolves. 

Catalyst

Demerger, M&A of DHFL's retail assets, Retail credit scale-up, Jio Partnership, Mumbai real estate comeback