Table 1

Polyplex is trading at extremely attractive valuations. As of 6 January 2012, the stock was trading close to its 52 week low with valuation ratios of 0.22x its tangible book value, 1.3x its price to ttm EPS (P/E), 0.45x its enterprise value to ttm EBITDA, 0.64x its price to ttm EBITDA and 1.5x its price to ttm free cash flow. All these numbers are adjusted and normalized to exclude any onetime, non cash and/or non operating items. With such low valuations the upside is huge. The industry P/E is 3.68x with Uflex and Jindal Poly films, the main competitors of Polyplex, trading at P/E multiples of 3.2x and 1.7x and P/B multiples of 0.7x and 0.5x, respectively. Though the entire industry is trading at very low multiples, Polyplex looks extremely attractive on the basis of its valuation and growth. A tangible book value of 0.5x or a P/E of 3x can easily double to triple the stock price from here. The return on investment can be anywhere between 50% and 200% in 1 to 4 years, with a yearly dividend yield of approximately 4%-4.5%.
Company description, business and industry overview, future projects and growth, risks, profitability, liquidity and management are discussed below and a detailed valuation model is attached.

VALUATION MODEL (click on the link and then click on download)

Company description:
Listed in NSE (National Stock Exchange of India) (POLYPLEX) Polyplex Corporation Ltd. together with its subsidiaries (Polyplex/company) is a global manufacturer and supplier of high performance plastic films (PET, BOPP & CPP) mainly used in the flexible packaging industry. The company has manufacturing plants in India, Thailand, Turkey and the US, apart from distribution channels in the US and China. It is the fourth largest producer of thin Polyester (PET) films. The company is also backward integrated to produce captive raw material for PET films. Polyplex has been paying dividend every year since 1993.
Source: Polyplex Corporation Ltd.’s 2010-2011 annual report

Business and industry overview:
Polyplex’s business is focused on producing high performance plastic films (plain and metalized…thick and thin), technically known as BOPET (Biaxially-oriented polyethylene terephthalate). BOPET is mainly segmented into Thin & Thick Films:
i) Thin Film: 50 Micron & Under (75% of total BOPET market)
ii) Thick Film: Over 50 Micron (25% of total BOPET market)

Source: June 2011 SET opportunity day presentation by Polyplex (Thailand) Public Limited Company

Source: June 2011 SET opportunity day presentation by Polyplex (Thailand) Public Limited Company

BOPET thin film is mainly used in the flexible packaging industry. Flexible packaging is the main market/segment of Polyplex and comprises of 81% of its total sales as of FY2011 (rest is 18% industrial and 1% electrical, both mainly being thick film applications).

Better packaging not only improves the shelf life of the products but is also essential for improving product appeal in a highly competitive consumer goods industry. Flexible packaging also reduces the cost of packaging as compared to the conventional packaging. This has resulted in shift from rigid forms of packaging to flexible packaging which has ensured higher-than-GDP growth rates in this industry across the globe. World demand for BOPET films (thick and thin) is expected to grow by 8.7% p.a. to 2015 and flexible packaging industry growth is estimated at 9% as per PCI films consulting Ltd and Polyplex estimates. PET film, being a higher-end substrate within packaging, has been among the faster growing substrates. An increase in the purchasing power in the developing countries has brought with it a large rise in the per capita consumption of packaging material. As a result, Asia (excluding Japan & Korea), is the largest market for PET films with 41% of the PET films produced being consumed in this region. However, per capita consumption of packaging material in developing countries is still very low as compared to the mature markets, which should help in sustaining the growth rates. The changing demographics of faster growing younger population and urbanization are also contributing to the growth in developing countries. The other drivers of demand and growth in these regions are the increase in the share of organized sector in consumer products and retailing, small serve packs arising out of need for inclusive and rural marketing, increasing consumerism and the resulting need for better packaging.

81% of the company’s products are used in food and consumer goods markets such as packaged foods. Demand for packaging is quite inelastic when it comes to food products, household goods and personal care products etc., which are to a large extent non-discretionary in nature insulating the industry from the global economic recessionary environment. For example, during recessionary period of 2008-2009 and 2009-2010 the top line growth of the company did not decline, though the margins contracted. This is taking into consideration that the company generates approximately 30% of its revenues in North America and 25% in Europe, where recession was most severe. Below are the numbers (fiscal year ending March).

Table 2

The demand for these products is also expected to grow in the future with better standard of living, increasing population, and increased longevity, especially in the emerging economies.

Products manufactured by the company also have electrical and industrial applications (19% of its total sales as of FY2011) and are used in solar power cells, touch-screen panels of mobile phones and flat screen televisions and some parts used in automobiles. Electrical/ electronic segment has maintained its pace of growth due to the demand from flat panel display screens used in LCDs and electronic displays. Films used for solar applications like photovoltaic (PV) products have also shown buoyancy in demand in the recent past. These products are in growth stage and hence demand would remain consistent with decent growth rates and room for expansion. OLED, which utilizes thin film plastic and is in its R&D phase, is the future for screens http://www.youtube.com/watch?v=NcAm3KihFho .

Similar to the shift in demand, the supply-side dynamics have also changed. Most of the new capacities are being added in low-cost developing countries, primarily in Asia. Most of this new capacity is also focused on the packaging segment, with an emphasis on high productivity and low operating costs. This has adversely impacted traditionally large producers of PET film operating with high cost structures, especially in developed economies. These producers are now emphasizing on developing niche technologies in PET films like films for LCDs, solar panels and specific high-end applications within packaging. While trade defense measures like anti-dumping, import duties and countervailing duties have been in use for the last two decades, they are unable to address the inherent problems of low-productivity assets/machines operating in the developed countries producing films for traditional applications. No new thin film line has been setup in the US or EU since 2003 until 2010 (the company has recently set one up which will begin operations in 2012) increasing the import intensity in these regions. Also, diversion of capacity by several large producers from packaging to industrial segment by conversion of thin film lines into intermediate and thick films along with closure of some old lines have added to the supply problem.

Out of the total new capacity added in the last 5 years, 56% has been added in China itself, which is significantly higher than the accretion in demand there. Since large exports from China are still not visible, it has resulted in below-average operating rates there. Operating rates in developed countries in the western world also tend to be lower than the average due to competitive market position (approximately 75%). On the other hand, most of the new assets in the rest of Asia would be operating at above average operating rates (approximately 90%) because of newer, better and efficient machinery used. Companies with better quality, access to international customers and a better supply chain model stand a better chance of emerging as winners.

India is one of the largest and fastest growing markets in the world for flexible packaging. The drivers for growth in India are similar to those of other developing countries with additional consumption coming from the widespread usage of small-serve packs due to its large lower income population. The thin PET film market in India is estimated about 230,000 tons for 2010-2011. However the ban imposed by Government of India on sales of gutkha (chewing tobacco) in plastic sachets in February 2011 has had a significant impact on demand for thin PET films in India. Estimates range between 25%-30% of the Indian market-size could be affected. Polyplex generates 20% of its revenues from India. A 25% reduction in size of the existing PET film market in India due to ban of gutkha would only impact the company’s revenues by approximately 5%. That said, the growth in the region is still above par. Considering the large market base and the expected annual growth rate of about 12%, the company estimates that 25%-30% of the additional global demand shall originate in India making it an attractive market. The total capacity of the company in India is about 400,000 tons, with the surplus production generally being exported to other regions.

Source: Polyplex Corporation Ltd.’s 2010-2011 annual report and June 2011 SET opportunity day presentation by Polyplex (Thailand) Public Limited Co.

Strategy:

For years the company has been following the below strategies which has helped it grow significantly.

1) Manufacturing or distribution presence in the key regional markets for an efficient delivery model, backward integration and providing better access to the global markets. The company has a large international presence with active sales in 87 countries across the world. It has plants in key locations such as India (to serve the Indian market), Thailand (to serve the South East Asian market), Turkey (to serve the European market), and the USA (to serve the North American market). It produces its own raw materials in all its plant location resulting in lower cost and better control of quality and availability. It also has strong global delivery capabilities with near-shoring and efficient onward distribution network. Acquisition of a distribution company in the USA in early 2006 has been a strategic move of the company in this direction. Setting up of a trading company in China in FY 2009-10 is another strategic decision to establish the company’s presence in one of the largest and fastest growing markets for its products. The company is also evaluating similar initiatives in other key regional markets like Latin America and Africa where its presence is limited.

2) Operating in tax free zones. Most of the company’s manufacturing units, in all countries in which it operates, are strategically located in tax free zones. Average tax paid by the company in 2010-11, 2009-10 and 2008-09 was 5.6%, 12.2% and 7.1% respectively. Its average tax rate for last 12 quarters is approximately 10%. The low tax rate makes them very competitive in terms of pricing their products and helps them maintain good margins. With the same strategy, the company has set up a new manufacturing facility in Decatur, Alabama, USA in 2011. According to a local news service, state and local government of Alabama have waived more than approximately USD 11m in taxes.

3) State of art manufacturing facilities and machines to lower cost per unit. State of art manufacturing facilities along with high capacity utilization rates of more than 90% has helped the company to price its products at competitive rates and maintain healthy margins. The company has been setting up these manufacturing facilities in its key locations (India in 2009, Thailand in 2010 and 2011, the USA in 2011) to take advantage of the inherent problems of low-productivity assets / machines operating in the developed countries by PET film manufacturers. In continuation with this strategy, Polyplex is currently setting up a plant in the US which would be operational by September 2012 with sophisticated machines and state of the art manufacturing facilities. As per plasticnews.com, established U.S. plants, some of which operate with a 15- to 20-year-old machinery, may face problems to regain manufacturing parity with Polyplex as its entering the US market with latest machines of 30,000-ton, 8-meter-wide [line], running at 400-500 meters a minute. Recently they have also entered a joint venture with a Japanese firm which has better technology to further reduce their costs.

4) Diversification of product offering. In the recent past, the company also has ventured into downstream businesses like silicone coating, extrusion coating and diversification into BOPP and CPP films, enabling it to offer a more complete package to the industry.

Future projects under implementation and capital investments by the company and its subsidiaries:

1) Thin PET film line, PET chips plant & metallizer in Alabama, USA

2) Improvements in manufacturing facilities in India

3) Thick PET film line & PET chips plant in Rayong, Thailand

4) Silicon coating line in Rayong, Thailand

5) Blown PP line in Rayong, Thailand

6) Thermal lamination line in Rayong, Thailand

All the above projects are described below:

1. Setting up of a new manufacturing plant in the US: Polyplex has set up a new manufacturing facility (PET film line, PET chips plant and metallizer) in Decatur, Alabama, USA with an estimated capital investment of USD 185m (Phase 1: USD 110m and Phase 2: USD 75m). The tentative completion is in September 2012. The plant has been set up primarily for two reasons: to overcome the trade defense measures like anti-dumping, import duties and countervailing duties in the US and to take advantage of the inherent problems of low-productivity assets / machines operating in the developed countries by PET film manufacturers. As per plasticnews.com, established U.S. plants, some of which operate with a 15- to 20-year-old machinery, may face problems to regain manufacturing parity with Polyplex as its entering the US market with latest machines of 30,000-ton, 8-meter-wide [line], running at 400-500 meters a minute. Another reason is that the traditional large producers are now emphasizing emerging niche technologies in PET films like films for LCDs, solar panels and specific high-end applications within packaging. Due to this we have seen diversion of capacity by several large producers from packaging to industrial segment by conversion of thin film lines into intermediate and thick films along with closure of some old lines. This has added to the supply problem. In addition, no new thin film line has been setup in the US or EU since 2003 until 2010, increasing the import intensity in these regions.

The facility has been set-up with backward and forward integration to reduce cost. As per plasticnews.com, the plant has been strategically located at Decatur, AL as facilities of BP Chemical and Indorama in and around Decatur would help a stable supply of resin and chemicals such as paraxylene. In addition, as per the news service, Polyplex plans to work with local partners to build on-site feedstock resin plant. Once operational, this plant will ensure faster deliveries and a reliable onshore supply chain solution to the existing and potential customers in Americas, which is approx 29% of the company’s market. According to a local news service, state and local government of Alabama have waived more than USD 11m in taxes for setting up a plant in the region.

2. Converting PET film line into specialty film line in India: The company is converting its first PET film line at Khatima plant in India into specialty film line with a capital investment of around Rupees 6,835 lacs (USD 15.3m). The modification of this line will facilitate the broad basing and diversification of product portfolio in India. The project is expected to start commercial production in December 2011. In addition in July 2011 the company added another metallizer at Bazpur plant in India with a capital investment of around Rupees 1,650 lacs (USD 3.7m). It is also debottlenecking and modernizing all its plants in India.

3. Thick polyester film project in Thailand: The company is in the process of setting up a thick film line and a Batch process chips plant (Polyester Resin Plant) with capacities of 28,800 MT and 23,500 MT, respectively in Thailand with a capital investment of Rupees 33,435 lacs (USD 75m) including working capital. This will enable the company to expand its product range to include thicker, more functional and specialty films strengthening its offering in industrial applications, where products are more differentiated and customized. This would help diversify sales into industrial and optical end use segments including new uses in Photovoltaic (PV) industry. Further thick film also offers a relatively higher margin and more stable business thereby mitigating the risk of volatility in earnings. The plant is expected to start commercial production by end of March 2013.

4. Silicone coating, Blown PP and Thermal lamination line in Thailand: Polyplex is currently implementing a silicone coating line (which will use PET film as an input, i.e. backward integration) in Thailand at an estimated capital expenditure of Rupees 10,274 lacs (USD 23m) as a push for forward integration and specialty and value added products. The work for the line was completed in June 2011 and the commercial start up is anticipated by January 2012. This is a high capacity line with capability of making silicon coated products for the entire spectrum of end-use and will help capture the high growth siliconised film market. The company would also add a Blow PP line in Thailand in 2012 which would enhance usage of this silicone coating line besides adding another end use segment of Peel & Stick liner in the product range.

Along with the above projects the board has approved a thin PET film line, PET chips plant and metallizer in Brazil. The company is undertaking these projects as it sees demand for its products in the future and room for expansion. Once functional, these new plants would not only increase the top-line but also depreciation, resulting in lower tax and increased free cash flow.

On completion of the ongoing / approved projects the total manufacturing capacities will increase by approximately 23%. Below is the table:

Table 3

Total market and market share of Polyplex:

The company is presently serving only 10% of the global flexible packaging industry (estimated to be 1545 KMT as of 2011) and even with all the above expansions, by the end of 2012, it is expected to serve approximately 11% of the industry (expected to be 1698 KMT by 2012). It not only has the potential to grow with the growing industry rate of 9%-10% but also to capture the market share by using the same strategies it has been using before.

Table 4

Profitability:

The company’s latest filing is as of 30 September 2011. The table below gives a glance of the company’s top-line growth and EBITDA margins.

Table 5

The above numbers depict the strong revenue growth, profitability and EBITDA margins. That said, in recent quarters the company has seen very high growth rates due to supply shortages. This might not be the case in the future. On a conservative basis, I have modeled a revenue growth of -5% and 10% for FY 2011-2012 and 2012-2013, respectively. Also, Polyplex may face margin pressures as a lot of companies in this industry have recently invested in adding capacities. This might negatively impact the industry margins and hence the profitability. Again, on a conservative basis, I have modeled high raw material costs and a low EBITDA margin of 18%, as compared to an average EBITDA margin of 29% in FY 2011. With these assumptions Polyplex is trading at a price to future EPS of 1.65x and 1.5x and a price to tangible book value of 0.2x and 0.18x for FY 2011-12 and 2012-13, respectively, making it extremely cheap. As of 30 September 2011 it had more 85% more cash on its balance sheet than its market cap. One has to keep in mind that in a year or two, once the above projects are operational, they can add significantly to the revenues (more than what I have modeled, I like to be a little conservative in my modeling) as the manufacturing capacities will increase by approximately 23%. Increased revenues with extremely low valuations make the stock very attractive with huge upside. A P/E of 3 or a book value of 1 can double to 5 times the stock price from here.

Management:

Promoters and promoter group shareholding (non-encumbered) as of the latest quarter ending 30 September 2011 was approximately 47%. Promoters have maintained their large shareholding showing their confidence in the company. Management understands the business pretty well and has consistently and opportunistically added plants in strategic locations to maximize profits and efficiencies. They have grown net fixed assets by 5x to approximately 17bn Rupees (USD 340m) in last 7 years by reinvesting cash in the company. EBITDA has increased by approximately 6.6x during that period.

Cash and liquidity position:

As of 30 September 2011, company’s cash position increased significantly by 767% to Rupees 9.8bn (USD 196m). This was mainly due to a gain of Rupees 6.37bn (USD 127m) on sale of 8% stake in March 2011 and 11% in November 2010 in one of its subsidiary companies (Polyplex Thailand Public Company Ltd. (PTL)). With this sale, the consolidated holding of Polyplex Group in PTL has reached 51.0%. The company is using this money for the projects mentioned above. Excluding the sale cash position increased by 209% on a Y-o-Y basis to approximately Rupees 3.5bn (USD 70m). As of 30 September 2011, company had a leverage of 1x, net leverage of -0.2x and interest coverage of 32.7x. It generated a free cash flow of Rupees 3.4bn (USD 69m, 14% of sales) for FY 2010-2011. Huge cash position along with strong free cash flows and large unutilized credit lines shall be quite adequate for the company in any kind of stress situation and gives it financial flexibility to take advantage of any opportunities in the future.

Other positives:

1) Appreciation of Yuan can make Chinese exports of PET films expensive, which may benefit Polyplex. As mentioned above, the company has manufacturing or distribution presence in the key regional markets for an efficient delivery model and to mitigate foreign exchange and export trade risk.

2) With technology out there to recycle plastic, it will only get better and more efficient.

3) Use of plastic will never go away. Its been growing and will keep growing in the future. A lot of metal automobile parts are now been replaced by plastic in ever growing efforts to reduce costs due to lower consumer spending in the developed world.

Reason for low valuations:

1) The Indian stock market can be trader driven, as a lot of stock markets around the world are. Recently traders have been driving stock prices lower, irrespective of company’s valuations.

2) As in any market, valuations can remain distorted. So is the case in the Indian markets. A lot of companies are trading at a significant discount from their 52 week highs due to global concerns, the US debt and its fiscal deficit, PIIGS overall and Greek debt in specific, Chinese economy slowing down, etc.

3) For some reason I have noticed that the Indian market just values (or puts more emphasis on) the stand-alone company/results and not consolidated. This doesn’t make sense to me as I always look at the company on a consolidated basis and also analyze its subsidiaries. My guess is that the Indian market is just valuing the Indian company as a stand-alone not giving weight to the point that the Indian company is the holding company and has 51% stake in its main subsidiary Polyplex Thailand Ltd (PTL).

Risks:

1) A lot of companies in this industry have generated huge cash reserves, which are reinvested in adding capacities. If demand doesn’t increase in the way that the companies are expecting, we might see overcapacity and hence ample supply in a few years, which could result in decline in prices and margins. The company expects global PET film growth rates to range between 7-10% in the years 2011-15, with demand in Asia growing faster at between 10-12%. From the spate of announcements and lines on order with the machine vendors, it is very clear that the overall capacity addition during 2011 to 2013 is expected to be much higher than the growth in demand. High capacity additions in anticipation of future growth would create periods of high competition and result in lower margins. This is the main concern in the industry. In short to medium term there is a likelihood of excess supply due to new capacities being added while the growth in demand would be linear resulting in reduced margins.

2) One of the main raw materials for the company is crude oil. With crude prices very high company’s margins would shrink. That said, this is a common risk to the entire industry as the raw material price movement affects all industry participants.

3) A significant and sustained one-sided movement could result in substantial inventory gains or losses.

4) 80% of the company’s revenues are from overseas markets and approx 20% from India. To break it down, 29% from North America and 25% from Europe. As these developed markets are matured and these economies may experience a relatively stagnant or slow growth, the company may not experience a lot of demand from these countries, which is the major source of its revenue.

5) International trade in PET film has been subjected to trade defense measures for more than two decades through the imposition of anti-dumping duties or countervailing duties. Anti-dumping duty (AD) can be imposed on imports if the ex-factory prices of such imported products are proved to be lower than the local selling prices of the similar products in the export countries. The important markets adopting this measure are the EU and the US against several countries. Countervailing duty (CVD) can be imposed if the domestic government or government agency provides subsidy to the exporter. Such tariff measures result in increased prices, making it difficult to compete in those markets. In the last US Anti-dumping petition against producers of PET film from Thailand, China, Brazil and UAE, duties were imposed against China, UAE and Brazil in the range of 3.5% to 76.7%, but exports from Thailand were found to be not causing any harm to the US domestic industry. As previously mentioned, Polyplex has a manufacturing plant in Thailand. The company undertakes all safeguards to insulate against the risk arising out of anti-dumping actions and other trade barriers imposed by the importing countries. A geographically well-diversified manufacturing and distribution portfolio helps mitigate the adverse fall-out of any such actions. The company has also started a manufacturing facility in Alabama, USA to overcome this problem. That said, if such import duties or countervailing duties and/or anti-dumping policies are further levied on the countries in which the company has manufacturing plants, it can significantly impact the company’s revenues.

Mispricing in valuations:

The company is underestimating the fair value of its assets on its balance sheet as compared to the price it would get in the market. This is evident by reverse-calculating value of its subsidiaries. Before doing that calculation lets first list the subsidiaries of Polyplex Corporation, to understand its company structure. Polyplex has 4 manufacturing companies:

1) Polyplex Corporation, Ltd., India

2) Polyplex (Thailand) Public Company, Thailand (PTL)

3) Polyplex Europa Polyester Film Sanayi Ve Ticaret A. S.(Polyplex Europa).

4) Polyplex USA LLC (PU/Polyplex USA) USA

These manufacturing companies are where the value is since they have the main assets. Other than these manufacturing companies, Polyplex has 2 distribution centers in the US, (Polyplex Inc. USA), and in China (Polyplex Trading Co. Ltd. China).

Polyplex Corporation Ltd India, which is the holding company, had 70% stake (directly and/or through investment companies) in Polyplex (Thailand) Public Company, (PTL). PTL is the most important subsidiary of Polyplex Corporation as it has (directly and/or through investment companies) 100% stake in Polyplex Europa (manufacturing plant) and Polyplex USA LLC (manufacturing plant), 100% stake in the distribution company in China and 80% stake in the distribution company in the US. Below is the holdco opco structure.

Source: Polyplex Corporation Ltd.’s 2010-2011 annual report (fiscal year ending March)

In November 2010 and March 2011 Polyplex Corporation Ltd, India (the holding company) sold approximately 11% and 8% stake in PTL, respectively, for Rupees 6.37bn (USD 127m). With these sales the consolidated holding of Polyplex Corporation Ltd, India in PTL decreased from 70% to 51%. The value of this 51% stake in PTL as per the above sale price = (Rupees 6.37bn *51%) / 19% = Rupees 17.1bn (USD 342m). This should be the buying price or the market value of the remaining 51% holdings of subsidiaries, as per recent transactions. Adding tangible book value of Rupees 3.8bn (USD 76m) of the standalone company we get Rupees 20.9bn (17.1bn + 3.8bn). So this can be considered as the total market value of the holding company (Polyplex Corporation Ltd, India) as per the recent market transaction. This market value divided by no of shares outstanding gives a share price of Rupees 653 (208,982 / 319.80 = 653.48), the stock is trading at 160, a clear upside of 309%. A Rupee 7 yearly dividend (4.3% dividend yield) makes it even better.

Arbitrage between the subsidiary and the holding company:

Recently Polyplex was on the best 200 Asian companies under a billion list published by Forbes. Here is the link http://www.forbes.com/lists/2011/24/best-under-a-billion-11_land.html (page 15). The irony is that PTL, 51% of which is held by the parent company Polyplex Corporation Ltd, India, had sales of USD 384m and a market capitalization of USD 399m (P/E of 3.4x and Price to ttm sales of 1.04x) while its parent company in India had Sales of USD 512m and a market value of USD 95m (P/E of 0.5x and Price to ttm sales of 0.19x) unadjusted for any one time charges. This shows a clear arbitrage. Below is the table.

Table 6

Conclusion:

The market isn’t pricing Polyplex rightly. The market cap of the company is less than its cash on its balance sheet. Theoretically, at this price, you can buy the company for Rupees 5.2bn (USD 100m). Pay yourself a dividend of the entire money invested with the cash on the balance sheet of Rupees 9.9bn (USD 190m). The company will still have Rupees 4.8bn (USD 92m) left on its balance sheet, more than enough to meet its working capital requirements. With this basically you ended up owning the company for free. In the future years you can pay the entire free cash flow generated by the company to yourself as dividends. For FY 2011, the company generated a free cash flow of Rupees 3.4bn (USD 69m), 67% of the present market cap. Assuming that the free cash flow doesn’t grow and remains constant, you not only ended up owing the company for free but also have a return of 69% (69m/100m) of your total investment every year, if you end up buying the company at this price and pay the entire free cash flow to yourself as dividend. Not to forget, dividend in India is tax free.

Polyplex is trading at extremely attractive valuations and the down side is limited but the upside is huge (Table 1). That said, you can get stuck in the value trap for a long time. Consider this as a long term play. In short run the stock can go further down due to margin pressures and/or global market conditions. That would be the time to accumulate at even lower valuations. In a normal scenario with a P/E of 2.5x the upside can be approximately 70% to 100% in 2 years. A little higher multiple of 4 gives a return on investment of 200% in 2 years. In case of a bull run the industry multiples can expand and the company multiple can even reach 7 to 9, which was the case in early 2010. In that scenario the upside could be 400% to 500%.

Market is not always efficient; it over reacts to news, sometimes fails to analyze cooked books, legal language and at times doesn’t anticipate the obvious. You will always find opportunities if you dig in deep. If it was efficient, nobody would have profit from it.

- Suneet Chandvani

Notes:

1) Consolidated Financial Results include the results of the subsidiaries as described in the group structure (holco–opco structure) above.

2) All numbers, including but not limited to, EBITDA, Net income etc are adjusted to exclude any one time, non operational and/or non-cash charges and hence may not match as reported by the company.

3) It is very important to read the disclosure and disclaimer before making any investments based on the above article.

Disclosure: Long Polyplex Corporation Ltd. (Ticker:POLYPLEX, in National Stock Exchange of India a.k.a. NSE )

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

People were talking about 1500 on S&P (GS had a target of 1450 on S&P for the year end 2011). When everybody was bullish, I was bearish and pointed out disconnects in my previous article, by analyzing in-depth risks within the economy and globally. When people were talking about low P/E’s and attractive valuations, I wrote in my article that the US economy may enter recession soon and there might be another leg down. I have understood one thing; the street is in the business of making predictions based on the last quarterly and/or monthly and/or weekly data. Few people look at the trends and analyze different sets of data as a whole.

Situation in the US

Consumer in the US is still weak and is still deleveraging from the massive increase in credit (below is the chart). Along with the deleveraging process the population of the US is aging at a significant pace as compared to the working population. As per Census, the age group between 20-64 will grow by 5.4% from 2010 to 2020 and 4% from 2020 to 2030, while the population aged 65 and older will grow by 36% and 32% in the same years, respectively. Not to forget, to get the fiscal debt in place, government has already started cutting spending which would definitely have a negative impact on the economy. In addition, foreclosures are increasing at 2.5x than houses in foreclosures are being sold and the total inventory of 90+ days delinquent loans and loans in foreclosure, is 51.9x of monthly foreclosure sales. This ratio will increase, as more foreclosures are added to the inventory than they are sold. The super low interest rate hasn’t helped. Besides, still 30% of current loans that are making payments on time are at risk, as they have negative equity due to falling house prices. All this data was as of May 2011. These risks were analyzed in detail in my previous article.

All these factors have a negative impact on the economy slowing the growth. Programs like Cash for Clunkers, First Time Homebuyers Tax Credit along with inventory adjustments (refilling), and enormous stimulus (QE1 and QE2) didn’t help. All these programs have now ended.  Imagine, if that didn’t do much, now we have spending cuts which will only make things worse.

I think, we will see depressing numbers on the job front in the coming months due to following reasons:

i) To cut spending, government is reducing its workforce. In 2011, until May, government has already downsized its work force by 188k, approx 80% of what it did in the entire calendar year of 2010. This figure is expected to go up to 400k by the end of the year.

ii)We have recently seen banks cutting jobs. BOA and UBS plan to cut jobs by 3500 each. GS has been reducing its workforce quietly. In the anticipation of the Euro debt problems and the US recession, the banks, which are most sensitive to these issues, would cut jobs even more.

iii) With the overall worries in the economy, small businesses, which create most of the jobs in the US, would also be skeptical in hiring and would again, face the same issue of tightened lending standards from banks with banks turning more cautious.

iv)  Productivity has declined for straight two quarters. To maintain margins we might see some lay offs.

In addition, personal savings, as a percentage of personal disposable  income, increased by 0.4% to 5.4% in June 2011. A 0.4% increase in savings rate  can have a 1.2% decline in personal consumption. There is a possibility that  the 1.3% increase in GDP for 2Q11 might be revised lower. Besides, weekly mortgage  applications for new purchases are weakening further and the much anticipated Philly Fed survey dropped to -30.7,  which is extremely bearish. Not to forget, the Europe contagion is spreading.

In 1996, Japan’s GDP growth was approx 4.4%. This was mainly due to government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, Japanese economy experienced five consecutive quarters of negative growth. The recent fiscal stimulus in the US and UK was approx 10% of GDP.

The US is going through a slow growth and not liquidity or solvency crisis like peripheral Europe. Every country has its cycle. From 1980’s until 2000, the US had a strong growth and main reasons were right demographics, credit expansion, and hence increase in asset prices. All these factors have reversed and now we have excessive debt, high fiscal deficit, deleveraging by consumers, aging population and declining asset prices. The US situation is not out of hand and the fiscal deficit is solvable with right policies, cuts in spending and entitlements, and increase in taxes. The best thing would be to de-lever and let it go through its cycle. This might result in slow growth in years to come. That said, deleveraging and innovation, which always leads to new cycles, would make the country stronger again. (http://www.ted.com/talks/geoffrey_west_the_surprising_math_of_cities_and_corporations.html)

One has to understand that with ratings downgrade nothing has changed. In fact, treasury yields have moved even lower. Peoples’ thinking has changed, which is good, that the US can never be downgraded irrespective of its fiscal situation and debt.

Is everything priced in?

1) Market overeats to data. As previously mentioned, the data out of the US in the coming months might be depressing and markets might overreact to that, as that would confirm their belief that the US is heading towards a recession.

2) Markets are expecting some kind of QE3, if that doesn’t happen we might see a sell off.

3) Market is cautious about the European debt crisis but definitely hasn’t priced in a default/haircut. If that happens we could see a massive selloff.

4) So far markets have seen companies beating expectation. If that turns, even for a quarter, markets will panic and start selling assuming that the economy is now affecting the bottom line of companies.

5) It is very important to keep in mind that the mutual funds are all invested. With mutual fund cash levels at 3.4% as of June 2011, historically the lowest, if they start selling we can see a huge sell off.

Understanding Europe:

Understanding Europe is not difficult if you just look at the numbers. As per Eurostat, as of 31 March 2011: (debt and GDP growth rates are on a Y-o-Y basis as of 31 March 2011)

Greece’s debt to GDP was 150%, its debt is still growing at approx 10% and GDP is declining by approx 2.8%.

Italy’s debt to GDP was 120%, its debt is growing by approx 4% and GDP by approx 2.5%.

Ireland’s debt to GDP was 103%, its debt is growing by a whooping 28% and GDP is declining by approx 2%.

Portugal’s debt to GDP was 94%, its debt is growing by approx 14% and GDP by approx 1.8%.

Spain’s debt to GDP was 64%, its debt is growing by approx 17.5% and GDP by approx 1.7%.

France’s debt to GDP was 84%, its debt is growing by approx 7% and GDP by approx 2.8%.

Germany’s debt to GDP was 83%, recently its debt has grown by approx 17% (due to support extended to Greece) and GDP by approx 4.6%.

Are these numbers sustainable? Below is the table

Would there be a default / haircut or can it be avoided? What about Euro Bonds?

With funds in EFSF and ECB’s commitment, we have seen some buying of Spanish and Italian bonds. That said, they can’t do it for too long as the total consolidated debt of Ireland, Greece, Spain, Italy, and Portugal is approx Eur 3.2tr (71% of Germany and France’s GDP combined, excluding their own debt), as of 31 March 2011. The amount is too big for anyone to bail these countries out. Also, as mentioned above, debt of these countries is still growing at a significant pace. Its politically and financially not feasible for Germany and France to backstop all this debt as that would not only affect their financial health but can also cause social unrest in these countries. In last two quarters, 4Q10 and 1Q11, Germany’s debt has grown by 18% and 17% on a Y-o-Y basis, respectively, due to support extended to Greece.

The haircut on Greece is inevitable. Debt/GDP ratio of Greece is already at 150%. As of 31 March 2011, even with all those austerity measures, debt is increasing at 10% on a Y-o-Y basis. Austerity would only reduce country’s revenues and growth, which is evident in the GDP growth of negative 2.8%, as of 31 March 2011 on a Y-o-Y basis. Growing debt and negative GDP can never solve a country’s problem, irrespective of austerity measures taken. A simple math shows that the debt to GDP ratio will only increase. The problem of debt can’t be cured with more debt, be it public or private. Companies have tried it and even countries have tried it (example Japan). None of them have been successful in doing it. Japan now has a debt to GDP of 200% and still growing, declining population, almost no immigration, increasing aging population, and declining tax revenues. At least Japan has the ability to print its own money and issue its own debt and sell 95% of that in its own country. Greece can’t do that.

What about the idea of Euro bonds? Can that be done? That would be the biggest mistake. EU itself is a mistake as the countries in EU can’t print money and there is no mechanism for ensuring fiscal discipline. The basis of different currencies is its ability to get weaker or stronger depending on that country’s productivity, competitiveness and growth. That entire basis was removed with the formation of the EU. Imagine having a Euro bond. That would take away further liberty from countries in EU to issue debt, if and when they needed. Also, if you allow all countries in the Euro zone to get access to cheap capital at the expense of the strong EU countries by issuing Euro bonds, you basically give the weaker countries a free ride and they wouldn’t adhere to the austerity measures. Euro bond would be like a mortgage backed security (MBS), wich is pool of good and bad loans. Only in this case it would be a pool of good and bad countries. Every time a financially unstable country has a problem the financially stable country would bail it out. That way the financially stable country not only has to use its money to bail them out but also has to pay higher interest rate on its debt (now there is just one Euro bond, so all countries in EU pay the same interest rate) due to mistakes made by financially unstable country. I don’t know how long would that continue. A haircut is necessary, inevitable and healthy. If they avoid it, they would just delay the consequences.

Pushing Greece out of the EU could also be an option. This would solve the current problem of EU and would be a lesson to the other EU countries that fudging data, reporting wrong data (that’s how it all started), having huge deficit and fiscal imbalances could have serious consequences. That said, Greece being removed out of EU would also mean a default. Where would the Greek Euro denominated debt that banks/financial institutions/central banks hold go?

Understanding the consequences of haircut on the market

Approx USD 135bn of Greece debt matures between now and the end of 2013 and an additional USD 82 bn in 2014. They are planning to roll over this maturing debt held by banks and ECB. That would be considered as default or selective default by the credit rating agencies. If the credit agencies consider it as a default, the ECB and banks can’t hold them anymore. Even if they provide an exception to this rule, the ECB and banks can’t use the Greek debt as collateral. Also, if rating agencies consider it as a default, the banks and ECB have to write down that debt on their balance sheet.

We are talking about USD 493bn of total Greek debt. As per Eurostat, Debt to GDP of Greece as of 31 March 2011 was approx 150%. To bring it down to even 100% levels, Greece would need a hair cut of approx 50%. Even if we consider a hair cut of just 20%, we could see a hit of approx USD 99bn (493 *20% = 98.7) in the system. This is just the hair cut. A more important concern appears to be the threat of short-term liquidity as a result of the hair-cut. The biggest European banks receive an average of USD 64bn funding through the US money market. This flow would be the first to dry up in case of any crisis faced by the European banks, reducing the liquidity and fueling the crisis.

Also, the stronger banks in EU would cut back their lending to the weaker banks further exacerbating the process. Not to forget, this could lead to breach in covenants resulting in acceleration of debt and/or additional capital/collateral requirements.

The overall effect could be large and the big banks would feel the pain but would be able to handle it as they have trillions of dollars of assets. Also Greek debt is pretty well diversified and not one bank holds a lot. The maximum amount of exposure that a non Greek bank holds is Eur 6bn. Here is the list of estimated top 40 holders of Greek government debt. http://www.zerohedge.com/sites/default/files/images/user5/imageroot/draghi/Barclays%20Top%20Holders.jpg. It is the small banks having direct or indirect exposure to Greek debt, which might be in serious trouble.

Though this would be good for the system as it would be a clean-up of excessive debt, markets, as usual, would overreact and fall significantly. As mentioned, the repercussions would range from losses on balance sheets of European banks, CDS’s being triggered, breach of covenants, fall in global stock markets , drying up of liquidity and banks being conservative and hence reduction in lending resulting in slower growth. Also, market always overreacts due to short term traders and computer trading. If one thing triggers, the other follows and there is massive selling. Besides, they all use the same risk metrics and hence they all sell at the same time when the risk goes up.

Understanding the long term macro picture and spotting areas for long term investments

That would be the time to buy. Think about it, there is so much more money in the system now than it was a few years ago. Once there is a selloff, which would be global as the markets are interconnected, it would be an opportunity of the decade to buy, especially in the emerging markets. In some of these markets, some stocks are extremely cheap and market in general is trading at its 52 week low (I have been following Indian market on a very regular basis). The fall would further bring down the prices making them super attractive. If you logically think from a 3 to 5 year perspective, you would be investing in i) fundamentally good and less levered economies ii) growing at a good pace with strong and growing middle class population iii) with cheap valuations due to the fall in the global markets.

Once investors realize that the growth in the US and the Euro zone is stagnant or very timid, a lot of that money will start flowing to emerging economies driving up asset prices in those places. This is what exactly happened in Japan. After the Japanese crash, a lot of Japanese money moved to the US markets for a decade. This was because of low growth and ample liquidity; the same conditions which we are now seeing in the US. Japan’s stock of FDI since 2001 has nearly tripled, from ¥6 trillion to over ¥18 trillion. (Source: http://www.state.gov/p/eap/rls/reports/2009/125605.htm#fdinus ). That’s a compounded annual growth rate of approx 15% for 10 years. I think, these are the growth rates at which we will see money flowing to the emerging economies. Cheap valuations, good fundamentals, strong growth, and increase in inflow of money are simple ingredients to great returns, on a long term basis.

Safe investments with good returns (making a low risk 10% return)

The best thing would be to keep money on the sidelines and wait for the right opportunity. A very small amount can still be invested in some carefully analyzed, not overvalued, put options on the market. The downside would be small, as a small amount is invested, but if the market falls, the returns could be huge. To play safe one can buy emerging market government bonds and still get a good yields. 5 year Indian government bonds yield 8.3%. If you lever up 20% here and invest there you can easily get a yield of approx 10%. Lock-in period is approx 3 years. You can enter into a FX swap to hedge the currency risk. It is a pretty safe investment as Indian government is extremely conservative and will not default on its bond as that would collapse the entire economy. Nobody is talking about this, but I guess soon investors will. I don’t know about other emerging market government bonds as the only emerging market I follow is India.

The central banks efforts of trying to push up asset prices by artificial stimulus and quantitative easing have failed. Now they are using the same methods to protect financial institutions from losses. We will see how far they succeed in that.

Understanding the macro economy globally to understand the direction of the market, and then picking markets and securities (stock, bonds, derivatives, commodities, etc) would be the best way to play in these times.

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

Disclosure: Investments in  Indian markets

-Suneet Chandvani

Source: Bureau of Economic Analysis http://www.bea.gov/
The above table shows nominal GDP growth rates for years it was less than 2.5% (highlighted in red) and the growth rates for next 2 years. The last row in the table is the addition of all 3 years. The growth rate from 2008-2010 is not only the lowest but significantly lower than previous recessions. Not to forget, the growth in 2010 was boosted by programs like Cash for Clunkers, First Time Homebuyers Tax Credit along with inventory adjustments (refilling) and enormous stimulus (QE1 and QE2). Now that most of the government programs have ended and so has QE2, will we be able to sustain the recovery?

The systemic risk which bought down the world markets in 2008 has been transferred from the private sector to the public sector. In terms of stock market, extremely aggressive fiscal and monetary policies, some of which, not to forget, have ended recently, have pushed the prices up. The 2010 stock market rally is a classic case of newly-created money bidding up asset prices along with the notion that valuations are cheap. Though
the latter was right but the question is will stock prices keep increasing from these levels? I don’t know, but if you think logically the answer is clear. Market goes up in anticipation of future profits. Future profits come from increased investments by businesses (capital expenditure) and governments which drives the personal income. Both of these don’t look very promising, especially the latter. Lets analyze each component of GDP, i.e.  Consumer spending + Investments + Government spending +(Exports – Imports)… [C+I+G+(X-M)] to better understand the situation.

(C) Consumer spending  (real annualized growth on Q-o-Q basis, unless mentioned):

Consumer Spending (70.8% of GDP) grew by 2.5% in 1Q11, which is a very subdued taking into consideration we are in a “recovery”. This is when the savings rate has gone down from 5.4% in 4Q10 to 5.1% in 1Q11 and 5% in May 2011. It is imperative to analyze the breakdown of personal income and expenditures which is the heart of consumer spending. Wages and salaries from private industries, 41% of total personal income in the economy, increased by 4.14% in April 2011, on a Y-o-Y basis, with a 10 year average of 2.76%. This shows that the private sector is improving and hiring. However, wages and salaries from government sector, 9% of total personal income in the economy, decreased by 0.13% in April 2011, on a Y-o-Y basis, with a 10 year average of approx. 4%. Looking at just one quarter or a month wouldn’t be very right. A lot of analysts’ base their assumptions based on the latest monthly or quarterly data, without understanding the future dynamics. Below is the breakdown of personal income by each category with 5 and 10 year increases in the same.

Table 1: Source: Bureau of Economic Analysis http://www.bea.gov/

The data clearly shows that increases in government wages and salaries and government social benefits have been significantly higher as compared to other categories. An increase of 17% and 50% in government salaries and social benefits, respectively, as compared to just 8% for corporate in last 5 years. The question is will this be the case in the future. Will government be able to sustain the huge debt and the fiscal deficit, which is approx. 10.5% of GDP and is growing? U.S. is  6^th in the list among countries with highest fiscal deficit as a percentage of GDP. This will only increase as the aging population would make the large future structural deficits of Social Security, Medicaid and Medicare even worse. Below is the chart:

Table 2: Source: World Bank

The answer to the above questions is a simple no. Government spending cuts are imperative and will happen. In fact, we are seeing it. Government spending, approx 19% of GDP, contracted by 5.8% in 1Q11 and 1.5% in 4Q10. The point I am trying to make is that in the future we may see a drag in government spending which will be the main cause of downcast in GDP growth.  States are in crunch and we are already seeing cuts in spending from local and state governments. This would have a double negative impact on the economy. First, decline in government spending and second, decline in consumer spending due to cuts by government spending [table 1 shows that 9% of the total income is from government salaries and 18% from government social benefits]. Also, one thing to keep in mind is that most of the money earned by government employees and from government social benefits to people is spent, unlike that from corporate. Besides, there is a huge difference in the savings rate between the emerging/less developed (approx 20%) and developed economies (approx 5%), the main reason being Social Security and Medicare. In emerging and less developed economies there is no such concept of Social Security and Medicare and so people save for old days. So if the U.S. government reduces social security and Medicare benefits, people would save more which is again not good for the economy.

(I) Investments:

Yes, balance sheets are stronger and companies have taken advantage of the low interest rate environment and have refinanced their debt. They have good amount of cash, and margins are better as they are leaner. With all that cash on the sidelines due to debt issuances and better earnings we have seen decent capital expenditure. Below is the chart:

Source: Bureau of Economic Analysis http://www.bea.gov/

The increased investment in capital expenditure is because of 2 reasons. First, during recession companies had cut down on their capital expenditure significantly. For almost 2 years, to cut cost, they did not invest in capex. Now that we are out of recession and companies have cash, they are investing in capital expenditure. Second, 100% depreciation allowance along with all the government programs and stimulus, as mentioned above, contributed to investment in capital expenditure. Due to these reasons we have seen a spike in capex. However, businesses spend depending on anticipation of future demand. The main question is will there be a sustainable growth in demand? Bank lending is still low. The sluggishness of loan demand in spite of recent improvements in bank lending attitudes highlights the weakness in demand and hence consumer spending. To some extent, the authorities have addressed the supply side problem by injecting massive amount of liquidity and capital. However, nothing much can be done on the demand side of it, which is still weak. Weakness in demand would mean lower businesses spending in anticipation of lower growth.

So where would all that cash on hand go? It might go in buying back stocks, reducing debt, m&a and probably in emerging economies where the huge population of middle class is driving growth. That said, none of these activities create jobs domestically. To reiterate, what drives job and income creation is domestic capital expenditure by companies and spending by government. The labor force has fallen consistently to 64.1% as of June 2011 and is at its 26 year low. Below are the two charts comparing reported unemployment rate (U-3) and labor force as a percentage of total civilian population.  With all talks about jobs being added in the economy and the job market is improving, it is the same problem of looking at one month’s data of making conclusions. With government cutting spending, we will see layoffs in the government sector, which will mitigate hiring in the private sector, if any. Government employs approx 22m people, which is approx 14.4% of the labor force.

Source: Bureau of Labor Statistics  http://www.bls.gov/

Source: Bureau of Labor Statistics  http://www.bls.gov/

(G) Government spending:

Government spending, approx 19% of GDP, contracted by 5.8% in 1Q11 and 1.5% in 4Q10. This shows that the government is cutting spending to get the fiscal deficits under control. As mentioned above, government employs approx. 22m people, which is approx 14.4% of the labor force.  Below is a table highlighting yearly increase/decrease in government employees.

Source: Bureau of Labor Statistics  http://www.bls.gov/

To cut spending, government is reducing its workforce. In 2011, until May, government has already downsized its work force by 188k, approx 80% of what it did in the entire calendar year of 2010. This figure is expected to go up to 400k by the end of the year.  Also, Increased lay off or retirement means increased outflow of money due to higher pension further stressing the cash flow situation of states and municipalities. Though that’s a sensible thing to do and will help in long run, it would have a negative impact on the economy in short to medium term. Now we are seeing the impact of massive shift of debt from corporate to public. With infrastructure getting old, baby boomers retiring and the population of 65 years and older estimated to increase significantly as compared to the working population, need for government services will only increase and the cost of programs like social security and medicare will only swell. In the midst of need for government to increase expenditure, we are seeing spending cuts by government. This is expected to continue, which means more layoffs, less government spending and hence lower economic growth.

Federal government has had deficits for a long time which have only been by increasing. Below is the chart highlighting difference between federal government’s receipts and expenditures.

Source:Bureau of Economic Analysis http://www.bea.gov/

Source:Bureau of Economic Analysis http://www.bea.gov/

The above chat shows that the federal government spends approx 60% more than it earns. This is big number. It will take a lot of time cuts to balance such a big number. Its not only just federal government. We are hearing about states like NJ using the bridge loan by banks to fund their
operations and California using IUO’s to pay its vendors. With the end of the federal stimulus to all states by the end of this year the picture wouldn’t be that rosy. Federal funding for Medicaid will decrease by 13 percent for the fiscal year starting 1 July 2011. The health reform law signed by the president in 2010 prohibits states from reducing their eligibility requirements for Medicaid through 2013. This means the funding is reduced by the federal government but the states cannot cut back on Medicaid. Medicaid represents the single largest component of state spending. States are cutting Medicaid payments to physicians and other health care providers and establishing higher copayments. Bottom line being, reduced government spending, more layoffs by government resulting in reduced consumer spending and hence lower economic growth.

It is important to note that if spending is reduced and/or taxes are raised, it would give investors confidence in the U.S. economy. It might slower
the growth of the economy but will fundamentally strengthen it. If the market reacts to this and falls, it would be an opportunity to invest, especially in those companies which generate most of their revenues from emerging markets.

If right policies like raising taxes for wealthy, allowing the corporate money which is parked abroad (approx USD 3tr) to be repatriated back to the U.S. at low (5% to 10%) tax rates, reducing social benefits like SSN, Medicare and Medicaid, increasing immigration of wealthy and middle class to increase population and consumption, etc are implemented, the US economy and market has the potential to outperform the expectations.

Analyzing the risks:

The reduction in government spending is the main risk to the economy which has been discussed in detail above. Below I have highlighted the other risks, internal and external, to the global market:

Internal risks to the economy

1)     Aging population:

As per Census, there will bea shift in the age structure, from 13 percent of the population aged 65 and older in 2010 to 19 percent in 2030. The age group between 20-64 will grow by 5.4% from 2010 to 2020 and 4%  from 2020 to 2030, while the population aged 65 and older will grow by 36% and  32% in the same years, respectively. Below are the numbers:

Source: http://www.census.gov/prod/2010pubs/p25-1138.pdf.        http://www.econdataus.com/workers.html

The U.S. has large future structural deficits of  Social Security, Medicaid and Medicare which will only get worse by the aging  population. This would also weigh heavy on corporate profits with a rise in  health and pension expenditure. The counter argument to this point is that you can always increase immigration of young and productive people from other countries which would earn and pay taxes increasing the government tax revenue. That’s a fair point but this would make sense if there are opportunities in the country. The economy is growing at a very slow pace and is expected to be that way. Also, the unemployment number is high. With the emerging economies getting wealthier with better standard of living the motivation of the young and the brightest, which always moved to the U.S. for success, would decline significantly.

2)      Appreciation of Yuan and China’s internal growth:

China has depended on its exports and real estate for growth. It has been able to grow its exports by artificially keeping its currency value low. China plans to increase its minimum wage by at least 20 percent annually in the next five years, more than doubling it by 2015. This was reported by the South China Morning Post on 21 September 2010 quoting government adviser Huang Mengfu. The idea is to increase domestic demand to ease dependence on exports and narrow the gap between rich and poor. This is good for China as it would boost its internal demand but at the expense of increased price of Chinese good in USD terms. With pays in China increasing more than 100% in 5 years, cost of goods would increase too making the end product expensive. This accompanied by stronger Yuan or weaker USD would make Chinese goods expensive. As of 2010, US exports to China were 91.9bn and while its imports from China were USD 364.9bn (source: http://www.uschina.org/statistics/tradetable.html). This would mean higher cost of goods for the already distressed U.S. consumer and hence lower consumer spending.

3)      Mounting foreclosures:

Information provided by LPS Applied Analytics. Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

The above chart gives a summary of whats happening in the U.S. housing market. Foreclosures are increasing at 2.5x than houses in foreclosures are being sold. This was as of May 2011. To put this in perspective, if in a month 1 foreclosed home is sold, 2.5 more enter the foreclosure inventory. Total inventory of 90+ days delinquent loans and loans in foreclosure is 51.9x of monthly foreclosure sales. This ratio will increase, as more foreclosures are added to the inventory than they are sold. Even if we assume that the inventory remains constant, it would take approx 4.5 years just to clear it. I guess this chart explains everything about the present housing situation in the U.S. and I wouldn’t need any more data. However, the situation is not as bad as it was a year back and is improving. The growth of delinquency and foreclosure is negative now. Fewer houses getting delinquent and going in foreclosures, delinquencies and foreclosures as a percentage of total loans are declining. Below is the chart.

Information provided by LPS Applied Analytics.

Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

However, its far from over due to the huge inventory overhang. Also, still 30% of current loans that are making payments on time are at risk, as they have negative equity due to falling house prices. Below is the chart. Besides, a lot of option arms have already defaulted but still second half of 2011 has the maximum and a huge increase in resets. In addition, there is still skepticism to lend especially in the housing market by banks. This is fair on the banks part as no one wants to lend against a depreciating asset and if they do, they are only considering good credits and increasing the down payments to save them against the depreciating house value. This is not helping generate the demand even though house prices have declined significantly and are still declining.

Information provided by LPS Applied Analytics.

Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

4) U.S. debt:

The growing U.S. debt which stands at approx. USD 14.3 tr is a topic of concern. U.S. has a current account deficit of approx 9%. The debt has increase by 147% in last 10 years while revenue only by 29%. The U.S. is spending approx 31% more than its revenues. Below two charts highlight receipts and expenditures of the U.S. and the difference between receipts and expenditures as a percentage of receipts.

Source: Bureau of Economic Analysis and Treasury Direct

Source: Bureau of Economic Analysis and Treasury Direct

As mentioned above, the U.S. is spending approx. 31% more than its revenues. Never in history we had such an imbalance. To fix this either you increase taxes or cut spending or a combination of these, none of which are good for economy. With the U.S. now on negative watch by credit agencies, even a one notch downgrade by any rating agency can result in sudden flight of investors from the U.S. treasury and USD. Both of these would have negative effect on the economy. Reduction in demand for treasury would result in increase in interest rate for treasuries and hence higher interest expense. Depreciation of USD would mean imports getting expensive, as the U.S. imports most of its items for daily use, which would mean stagflation.

Interest rate on the U.S. debt is at its historical low (chart below). Increase in interest rates would have a negative impact on the growing U.S. fiscal deficit. There could be various reasons to increase in interest rates such as, but not limited to, downgrade by any rating agency/agencies and demand supply factors. To sustain the growing fiscal deficit, the U.S. has to issue approx. USD 1.5tr of debt every year. With the end of QE2, the supply of the U.S. treasury might increase or remain the same while the demand may decline which might result in increased rates. Also, the relatively low risk that the market attaches to US public debt makes the market more susceptible to a fall.

Source: Bureau of Economic Analysis and Treasury Direct

5)     Mutual fund cash levels:

Market is still at elevated levels due to i) FED pumping in money in the market , ii) fund managers expectations of corporate profits continue to be good, and iii) fund managers have this notion that P/E levels are low so the market is cheap. I don’t buy it for all the reasons I have mentioned above, in fact I am a little skeptical. Mutual fund cash levels are at a historic lows and QE2 has now ended. With over USD 10tr in assets, stock-based mutual funds are the big boys of the investment world and a decent benchmark for the herd. If they are fully invested in the market, this means there are few buyers left to push stocks higher as now the FED has withdrew the support.

Source: http://home.comcast.net/~RoyAshworth/Mutual_Fund_Cash_Levels/Mutual_Fund_Cash_Levels.htm

Market rallied in 1974, 1982, and 1990 when mutual fund cash levels were greater than 11%. While S&P declined in 1973, 1976, 2000 and 2007 when mutual fund cash levels were below 4.5%. A low of 3.9% in cash levels occurred in May 1972 and the markets topped in December 1972 (approx. 7 months lag), following which it declined 46%. The next historical low in cash levels was 4.0% in March 2000. September 2000 is when the market peaked (approx. 6 months lag) and then sold off for a year declining by 43%. The next historic low of 3.5% in cash levels was in June 2007. S&P topped in October 2007 (approx. 5 months lag) following a 1.4 year sell off and declining by 56%. In May 2011 mutual fund cash levels were at 3.5%, pretty close to its historic low. However, cash levels have been in a range of 3.4% – 3.8% for a year now while stock prices have continued to rise. S&P is up 99% from the 9^th March 2009 low of 676. Historically, market may have seen a fall off from here but the prices going up can be explained by QE2, which has ended now, fund managers expectations of corporate profits continue to be good, and the notion
that P/E levels are low and hence the market is cheap. Also, the chart below shows the level of leverage in the financial system: essentially how much borrowed money exists relative to actual capital, which is at pretty elevated levels.

Source: Diapason Commodities Management    http://www.investorvillage.com/smbd.asp?mb=4143&mn=200551&pt=msg&mid=10691384

A combination of leverage in the system along with low mutual fund cash levels isn’t a good indicator. The point being, there is not much money to be invested, leverage is high and there are a lot of underlying risks in the U.S. and global economy. This doesn’t make the market attractive even if expected P/E’s are low.

Analyzing external/global risks:

1)     Chinese real estate:

Watch these video:

 http://www.sbs.com.au/dateline/story/watch/id/601007/n/China-s-Ghost-Cities

http://www.insidermonkey.com/blog/2011/01/18/hedge-funds-short-china/

To verify this I spoke with a few of my friends who are from China and travel home frequently. Their response was this is true but there is a lot of wealth in China and those wealthy people think that real estate is a safe and good investment. According to them there is so much demand that people are ready to pay the entire house value in cash, no loan at all. Wealthy are buying second, third and fourth homes for investment purposes. Property values have almost tripled in 6 years. Sounds like a bubble?

The analyst in the video already mentions that there are approx. 64 million apartments empty in China. According to him, there is a massive oversupply and overvaluation of houses in the market. Also, a lot of buying is done by the speculators who are in for quick profits. Famous hedge fund manager Jim Chanos, who is known for his bearish calls, is short Chinese real estate. For last 21 years China has maintained an average quarterly GDP growth of 9.3%, which is now increasingly dependent on the real estate market. Investing in large infrastructure projects has become a notable method of maintaining the GDP growth rate. In the process a huge oversupply is built.

Chinese authorities are considering all the policy options available to them to put an end to the property bubble as that is one of the main reasons for inflation in China. They have repeatedly raised interest rates, increased bank reserve ratios, increased the down payment for homebuyers to 30–40% and have tried to cut off the credit supply to real estate companies by restricting their access to loans from banks. To counter that, Chinese real estate companies have turned to overseas funding sources, especially Hong Kong, for their finance. However, the foreign capital is coming at an increased cost but because the profits and the margins for these real estate companies are so high, they don’t mind the increase in cost of capital.

Household leverage is low in China, savings are high and down payments for houses are high. Due to these reasons we won’t see a U.S. style bubble burst. Also, need of house for millions of people would help in capping a significant price decline. That said, if the bubble burst or if there is a significant slowdown in demand and hence the house prices go down, not only the real estate companies would be affected but also the Chinese local governments which rely on real estate related revenue. In that case, we may see losses and an increase in nonperforming loans by Chinese banks, resulting in tighter lending conditions further slowing of the Chinese economy.  Recently China’s finance ministry failed to sell all of the three-year debt offered at an auction on behalf of local governments. This was mainly because of concern about revenues of Chinese local governments and the secondary market for debt not being liquid.

If Chinese economy decelerates, the Chinese government will provide the needed longer-term support with fiscal and monetary policy. With USD 2tr of reserves and the authoritarian economy, I think, the Chinese government is well equipped to handle such crisis. But if occurred, it will do the damage of bringing the world markets down.

2)     European debt crisis:

On 1^st July 2011, Greece got euro 12 bn (USD 17 bn) installment of bailout loans from the European Union and the IMF. The loan was on the condition that Greece will cut spending and raise taxes by euro28 bn (USD 40 bn) over the coming five years. A simple math shows that this is just to divert people/media’s attention and is not sustainable. As per Eurostat, as of 31 December 2010, Greece had a debt of Euro 328.5bn (USD 476bn). Its increasing at a rate of approx. 10% every year. Because of austerity measures, to be a little optimistic, lets assume it will only increase by 6% for next 5 years, which comes to USD 638bn. This is an increase of USD 161bn in next 5 years while the condition is that Greece will cut spending and raise taxes by just USD 40bn in these 5 years. There is no way the debt will reduce. Also, its just a condition and we are not sure if it will be implemented. Increased tax collection and privatizations previously promised by Greece were never implemented. Besides, cutting spending and raising taxes wouldn’t help as that would mean lower growth, and hence lower tax collection which would make it even more difficult for the country to pay back the debt. The unemployment rate has soared to 16.2%, compared to 11.6% in March 2010.

Approx USD 135 bn of Greece debt matures between now and the end of 2013 and an additional USD 82 bn in 2014. They are planning to roll over this maturing debt held by banks and ECB. That would be considered as default or selective default by the credit rating agencies. If the credit agencies consider it as a default, the ECB and banks can’t hold them anymore. Even if they provide an exception to this rule, the ECB and banks can’t use the Greek debt as collateral. Also, if rating agencies consider it as a default, the banks and ECB have to write down that debt on their balance sheet. Greece has already effectively defaulted by making it clear that it cannot meet its July debt repayment. The debt and the interest rate on debt is extremely high. The only way out is an orderly restructuring. Below is the table.

Source: Eurostat

We are talking about USD 476bn of debt here, of which ECB holds approx Euro 80bn or USD 113bn. Debt to GDP of Greece as of 2009 was approx. 138%. To bring it down to even 100% levels, Greece would need a hair cut of approx 40%. Even if we consider a hair cut of 20%, we could see a hit of approx USD 72bn (476 – 113 = 362 *20% = 72) in the system, excluding the debt that ECB holds. This is just the hair cut. The repercussions would range from losses on balance sheets of European banks, CDS’s being triggered, fall in global stock markets , and banks being conservative and hence reduction in lending resulting in slower growth. The bail-out is not about saving Greece, its about savings large banks who hold Greek debt and to avoid the above repercussions. But, its inevitable. This is just Greece, if we add all the debt of Ireland, Greece, Spain, Italy and Portugal, we are talking about approx. USD 4.5tr of debt. Above is the table.

3)     Japan’s debt and aging population:

Everybody knows about Japan’s enormous debt. Japan has been able to sustain itself by borrowing internally, from its people and corporations. Domestic buyers hold about 95% of the nation’s debt, according to the Japanese Ministry of Finance. It is very important to understand Japan, before analyzing it.

Understanding Japan: Until 1990, before the Japanese property and stock market burst, Japanese households saved money and businesses borrowed. When there were not enough borrowers for the available savings, the economy would weaken and BOJ would lower the interest rates. When there were too many borrowers, the economy would overheat and interest rates were raised. The end result in either case was that savings were borrowed and spent, which resulted in growth. When the market collapsed in 1990’s, prices of assets plunged, while debt was still on corporate balance sheets. The fear resulted in deleveraging by corporate world. This led to a situation where there were not enough borrowers regardless how far BOJ lowered interest rates, creating a surplus of private savings. To reverse the situation and to stimulate spending, BOJ borrowed those surplus private savings and started spending in the form of stimulus. Its been borrowing and spending since them, which has inflated BOJ’s debt to very high levels. On the other hand, Japanese corporations have been saving and deleveraging. So previously, BOJ’s debt was funded by private savings and now its been a mixture of private and corporate savings. For more than 10 years the institutional base in Japan has agreed to buy 10 year bonds and receive less than 1.5% in nominal yield. Investing in Japanese government bonds (JGB) with such low yields have not been a bad option for them as the yearly 1%-3% deflation in Japan has provided them with a real yield of 2.5%-4.5%.

Now here is the main question: is this sustainable? It is important to analyze data for each moving part. First in the list is savings, below is the graph.

Source: World Bank

The data is from World Bank, which calculates savings as gross national income less total consumption, plus net transfers. Japanese savings, which fuels BOJ’s debt, has dropped significantly. Here savings are calculated as GNI − Consumer spending, which ideally in a closed economy is Investments and Government spending. This means, the above graph shows that government and business spending has been decreasing which mean less fuel to fund BOJ’s issuance of JGB’s. A lot of people argue that analysts only take into consideration the private savings rate of Japan and not corporate. This graph takes into consideration both. Savings has declined because of many reasons, main being the aging population in Japan and low birth rate. Below is the graph of aging population and birth and death rates in Japan.

Source: World Bank

Source: World Bank

Japan’s population age 65 years and above has grown exponentially and is highest as a percentage of total in the world. Its birth rate has fallen significantly over the years, and is the second lowest in the world after Germany. Besides, the birth rate is now lower than its death rate. This means negative population growth and an exponentially aging population, which is a recipe for disaster. This can have following consequences:

i)                   As more population continues to age and the population declines, the dependency of work force would increase.

ii)                 Aging population means more pressure on government in terms of higher social security and medical expenses.

iii)               Aging population means more pressure on corporate due to more pension outflow. A lot of pension funds in Japan hold JGB’s. They are now selling them to pay for growing number of retirees. This trend may continue putting pressure on JGB’s.

iv)               Private savings will keep declining and probably at an increasing pace, which is evident from Japan’s savings graph. As aging population doesn’t save, in fact they utilize the savings, it would mean less fuel to fund the BOJ.

In last 5 years Japan’s tax revenues have fallen by 15% but its debt has grown by 12%. This proves declining revenues due to aging population, which is unsustainable. This is not taking into consideration the effect of earthquake which would further bring down tax revenues and increase debt. Japan’s debt to tax revenue ratio is 23x: highest in the world. Below is the chart and a table.

Source: Bank of Japan

Source: Bank of Japan

Here is another graph showing that tax revenues collected by Japan are not sufficient to cover even the basic non-discretionary expenditure.

Source: MoF, SG Cross Asset Research.  http://www.zerohedge.com/article/dylan-grice-what-weimar-republic-popular-delusions-can-teach-us-about-japans-upcoming-hyperi

Also, it is important to highlight that pension funds in Japan, who are one of the biggest holders of JPG’s, are selling JPG’s to pay pensions for growing number of retirees. This trend will continue as the population ages and age group 65 years and older increases as a percentage of total population, putting pressure on JGB’s. If interest rates rise due to this Japan could face severe problems. As of 2010, Japan paid 24% of tax revenues as interest expense. Japan’s average interest rate is approx 1.2%. An increase of 50 bps would increase interest expense as a percentage of tax revenues to 35%. An increase of 11% with rise of just 50 bps. Not to forget its tax revenues are declining. Below is the chart.

Source: MoF, SG Cross Asset Research.  http://www.zerohedge.com/article/dylan-grice-what-weimar-republic-popular-delusions-can-teach-us-about-japans-upcoming-hyperi
We shouldn’t forget that to boost the economy Japanese government can print money and lower taxes, which it has done previously. However, with such high debt Japan is vulnerable. A small increase in interest rates could potentially increase the expenditures significantly resulting in worsening the fiscal imbalance. So far this has not happened.

The central banks are trying to push up asset prices by artificial stimulus and quantitative easing and are protecting financial institutions from losses. The resultant rise in asset prices represents a liquidity driven price increase. The question is whether the real economy can keep pace with the increased asset prices. The end of quantitative easing combined with the austerity measures which are still to come by the U.S. government due to large fiscal imbalance and hefty debt position could be the reasons for the decline in asset prices. Besides, the other risks to the global economy as mentioned above are significant. If the asset prices were to go down it would affect the balance sheet of financial institutions, which in turn would tighten the credit and lending standards, further depressing the overall growth of the economy. Some people argue that the recovery is too young to die. In 1996, Japan’s GDP growth was approx 4.4%. This was mainly due to government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, Japanese economy experienced five consecutive quarters of negative growth. The recent fiscal stimulus in the US and UK was approx 10% of GDP.

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

-         Suneet Chandvani

Valuation:

Polyplex is trading at extremely attractive valuations. As of 10 June 2011, it was trading at 0.28x its book value, P/E of 1.48, EV/TTM EBITDA of 0.65, and Price / TTM EBITDA of 0.83. All these numbers are adjusted and normalized to exclude any onetime, non cash and/or non operating items. With such low valuations the upside is huge. A tangible book value of 1 or a P/E of 3 can easily double or triple the stock price from here. The return on investment can be anywhere between 50% to 200% in 1 to 4 years, with a yearly dividend yield of approx. 4%.

Business, industry growth and overview, future growth and projects, risks, profitability, liquidity and management are discussed below and a detailed valuation model is attached.

VALUATION MODEL

Business, industry growth and overview:
Polyplex’s business is focused on producing high performance plastic films (plain & metallized) which are mainly used in the flexible packaging industry. Better packaging not only improves the shelf life of the products but is also essential for improving product appeal in a highly competitive consumer goods industry. Flexible packaging also reduces the cost of packaging as compared to the conventional packaging. This has resulted in shift from rigid forms of packaging to flexible packaging which has ensured higher-than-GDP growth rates in this industry across the globe. PET film, being a higher-end substrate within packaging, has been among the faster growing substrates. An increase in the purchasing power in the developing countries has brought with it a large rise in the per capita consumption of packaging material. As a result, Asia (excluding Japan & Korea), is the largest market for PET films with 41% of the PET films produced being consumed in this region. However, per capita consumption of packaging material in developing countries is still very low as compared to the mature markets, which should help in sustaining the growth rates. The changing demographics of faster growing younger population and urbanization are also contributing to the growth in developing countries. The other drivers of demand growth in these regions are the increase in the share of organized sector in consumer products and retailing, small serve packs arising out of need for inclusive and rural marketing, increasing consumerism and the resulting need for better packaging.

Three-fourths of the company’s products are used in food and consumer goods markets such as packaged foods, solar power cells, touch-screen panels of mobile phones and flat screen televisions and some parts of automobile. Demand for packaging is quite inelastic when it comes to food products, household goods and personal care products etc., which are to a large extent non-discretionary in nature insulating the industry from the global economic recessionary environment. For example, during recessionary period of 2008-2009 and 2009-2010 the top line growth of the company did not decline, though the margins contracted. This is taking into consideration that the company generates approx. 20% of its revenues in North America and 30% in Europe, where recession hit the most. Below are the numbers (year ending March).

The demand for these products is also expected to grow in the future with better standard of living, increasing population, and increased longevity.

Also, electrical/ electronic segment of end-use has maintained its pace of growth due to the demand from flat panel display screens used in LCDs and electronic displays. Films used for solar applications like PV products have also shown buoyancy in demand in the recent past. These products are in growth stage and hence demand would remain consistent with decent growth rates and room for expansion. OLED, which utilizes thin film plastic, is the future for screens http://www.youtube.com/watch?v=NcAm3KihFho .

Similar to the shift in demand, the supply-side dynamics have also changed. Most of the new capacities are being added in low-cost developing countries, primarily in Asia. Most of this new capacity is also focused on the packaging segment, with an emphasis on high productivity and low operating costs. This has adversely impacted the traditionally large producers of PET film operating with high cost structures, especially in developed economies. These traditional large producers are now emphasizing emerging niche technologies in PET films like films for LCDs, solar panels and specific high-end applications within packaging. While trade defense measures like anti-dumping, import duties and countervailing duties have been in use for the last two decades, they are unable to address the inherent problems of low-productivity assets operating in the developed countries producing films for traditional applications. No new thin film line has been setup in the US or EU since 2003 increasing the import intensity in these regions. Also, diversion of capacity by several large producers from packaging to industrial segment by conversion of thin film lines into intermediate and thick films along with closure of some old lines have added to the supply problem.

Out of the total new capacity added in the last 5 years, 56% has been added in China itself, which is significantly higher than the accretion in demand there. Since large exports from China are still not visible, it has resulted in below-average operating rates there. Operating rates in developed countries in the western world also tend to be lower than the average due to competitive market position. On the other hand, most of the new assets in the rest of Asia would be operating at above average operating rates because of newer, better and efficient machinery used. Companies with better quality, access to international customers and a better supply chain model stand a better chance of emerging as winners.

India is one of the largest and fastest growing markets in the world for flexible packaging. The drivers for growth in India are similar to those of other developing countries with additional consumption coming from the widespread usage of small-serve packs due to its large lower income population. The thin PET film market in India is estimated about 228,000 tons for the year under review. Notwithstanding the somewhat flat growth during 2009, considering the large market base and the expected annual growth rate of about 15%, the company estimates that 25-30% of the additional global demand shall originate in India making it an attractive market. The total capacity of the company in India is about 360,000 tons, with the surplus production generally being exported to other regions.
Source: Polyplex Corporation Ltd.’s annual report

Growth and future projects:
Following Projects are under implementation by the subsidiaries of Polyplex:
1) Project: Thin PET Film Line, & Metallizer Location: Corlu, Turkey Status: Relocated to North America
2) Project: PET Chips Plant Location: Corlu, Turkey Status: Progressing satisfactorily
3) Project: Thick PET Film Line & PET Chips Plant Location: Rayong, Thailand Status: Progressing satisfactorily
4) Project: Silicon Coating Line Location: Rayong, Thailand Status: Start up in Q2, 2011-12 (i.e…June 2011). The project has an estimated outlay of USD 22 million. The company is implementing this project as a push for forward integration and specialty products. This is a high capacity line with capability of making products suitable for the entire spectrum of end-uses for silicon coated products.
Also, the board has approved a thin PET film line, PET chips plant and Metallizer in Brazil. The company is undertaking these projects as it sees demand for its products in the future and room for expansion. Also, new plants, once functional, would not only increase the top-line but also depreciation, resulting in lower tax rate and increased free cash flow.

Other positives:
1) The Company has a large international presence with active sales in 87 countries across the world. It has strong global delivery capabilities with near-shoring and efficient onward distribution network. Acquisition of the distribution company in the USA in early 2006 has been a strategic move of the company in this direction. The company has plants or distribution centers in China, India, Singapore, Thailand, Turkey, and the USA.
2) Appreciation of Yuan can make Chinese exports of PET films expensive, which may benefit Polyplex. As mentioned above, the company has manufacturing or distribution presence in the key regional markets for an efficient delivery model and to mitigate foreign exchange and export trade risk.                                                                                                                                                                                                                                                     3) All manufacturing units of Polyplex, in all countries which they operate, are strategically located in tax free zones.  Average tax paid by the company in 2011-10, 2009-10 and 2008-09 was 5.6%, 12.2% and 7.1% respectively. Its average tax rate for last 12 quarters is approx. 10%. The low tax rate makes them very competitive in terms of pricing their products and also helps maintain good margins.
4) With technology out there to recycle plastic back to petroleum, it will only get better and more efficient.
5) Use of plastic will never go away. Its been growing and will keep growing in the future. A lot of metal automobile parts are now replaced by plastic in ever growing efforts to reduce costs due to lower consumer spending.

Profitability:
The company’s latest filing is as of 31 March 2011. Below table gives you a glance of the company’s top-line Y-o-Y growth rates.

In recent quarters, the company has seen very high growth rates due to the supply concerns. This might not be the case in the future. On a conservative basis, I have modeled a revenue growth of -5% in 2011-2012. That said; once the above projects are fully functional in a year or two, they can add significantly to the revenues.
Polyplex may face margin pressures as a lot of companies in this industry have reinvested in adding capacities. This might negatively impact its profitability. Again, on a conservative basis, I have modeled a EBITDA margin of 18% in 2011-2012, from 31% in 2010-2011.

Management:
Promoters and promoter group shareholding (non-encumbered) as of the latest quarter (31 March 2011), was approx. 47%. Promoters have pretty much maintained their shareholding, which is significantly large, showing their confidence in the company. The management understands the business pretty well and has grown net fixed assets by 4.3x to approx. 15bn Rupees in last 7 years by reinvesting the cash generated by the company. EBITDA has increased approx. 5.9x during that period.

Cash position:
As of 31 March 2011, the company’s cash position increased significantly from Rupees 1.29bn to 8.6bn. This was mainly due to a gain of Rupees 6.37bn on sale of 8% stake in March 2011 and 11% in November 2010, in one of its subsidiary companies (Polyplex Thailand Public Company Ltd. (PTL)). With this sale, the consolidated holding of Polyplex Group in PTL has reached 51.0%. The company is using this money for the projects mentioned above. Excluding the sale, as of 31 March 2011, cash position increased by 72% on a Y-o-Y basis to approx Rupees 2.23bn. Besides, the total debt decreased by 15% to Rupees 7.28bn. Increase in cash position and decline in debt shows the strength of company’s earnings and its balance sheet.

Risks:
1) A lot of companies in this industry have generated huge cash reserves, which are reinvested in adding capacities. If demand doesn’t exceeds the way companies are expecting, we might see overcapacity and hence ample supply in a few years, which could result in decline in prices and margins.
2) One of the main raw materials for the company is crude oil. With crude prices very high, company’s margins would shrink. Oil prices have gone up significantly and are at USD 120 per barrel, as of 10 June 2011. Brent crude is now 25% more expensive than at the start of the year. That said, the raw material price movement is common for all participants of the industry.
3) 85% of the company’s revenues are from overseas markets and approx. 15% from India. To break it down, 20% of company’s revenues is from North America and 30% from EU. As these developed markets are matured and the economy in these countries may experience a relatively stagnant or slow growth, the company may not experience a lot of demand from these economies, which is the major source of its revenue. The company has to focus on emerging economies and technologies where its products can be used.
4) There are some concerns about state government in India banning Polythene bags. Also, Supreme Court in India has imposed ban on Poly packing of Gutka (chewing tobacco). That said, the company only has 17% of its revenues in India. These bans may affect only 20%-30% of its business in India, which at the most, would have a 3.5% to 5% affect on its total revenues (20%-30% of 17% = 3.5% to 5%).
5) International trade in PET film has been subjected to trade defense measures for more than two decades through the imposition of anti-dumping duties or countervailing duties. Anti-dumping duty (AD) can be imposed on imports if the ex-factory prices of such imported products are proved to be lower than the local selling prices of the similar products in the export countries. The important markets adopting this measure are the EU and the US against several countries. Countervailing duty (CVD) can be imposed if the domestic government or government agency provides subsidy to the exporter. Such tariff measures result in increased prices, making it difficult to compete in those markets. In the last US Anti-dumping petition against producers of PET film from Thailand, China, Brazil and UAE, duties were imposed against China, UAE and Brazil in the range of 3.5% to 76.7%, but exports from Thailand were found to be not causing any harm to the US domestic industry. This has lead to non-imposition of any special duties on exports from Thailand to USA. As mentioned above, the company has a manufacturing plant in Thailand. Exports from India are subject to AD and CVD duties, totaling to 6.4% – 36.4% in EU and 7.17% to 65.59% in the US, apart from the normal import duty rates. Polyplex’s exports from India to the US and EU are subject to AD and CVD duty rates of 8.6% in EU and 7.6% in the US. The company undertakes all safeguards to insulate against the risk arising out of anti-dumping actions and other trade barriers imposed by the importing countries. A geographically well-diversified manufacturing and distribution portfolio helps mitigate the adverse fall-out of any such actions. That said, if such import duties or countervailing duties and/or anti-dumping policies are further levied on the countries in which the company has manufacturing plants, it can significantly impact the company’s revenues.

Conclusion:
The valuations for Polyplex are low because of following reasons:
1) Indian stock market can be trader driven, as a lot of stock markets around the world are. Recently traders have been driving stock prices lower, irrespective of company’s valuations.

2) As in any market, valuations can remain distorted. So is the case in Indian markets. Presently  a lot of companies are trading at a significant discount from its 52 week high due to global concerns…the US debt and its fiscal deficit, PIIGS overall and Greek debt in specific, Japan’s recovery from tsunami and its massive debt, Chinese economy slowing down, etc.

3) There are some concerns about state government in India banning Polythene bags. Also, Supreme Court in India has imposed ban on Poly packing of Gutka (chewing tobacco). That said, the company only has approx. 17% of its revenues in India. These bans may affect only 20%-30% of its business in India, which at the most, would have a 3.5% to 5% affect on its total revenues (20%-30% of 17% = 3.5% to 5%). This ban has been one of the reasons for its falling stock price in the Indian stock market. The market is mispricing this as it is not taking into consideration that 83%-85% of the company’s revenues are from countries outside of India.

If the management successfully implements the above 4 projects, revenues can increase significantly. Anticipation of increased revenues with extremely low valuations makes the stock very attractive with huge upside. Also, the company is underestimating the fair value of its assets on its balance sheet as compared to the price it would get in the market. This is evident by reverse calculating value of its subsidiaries. Before doing that calculation lets first list the subsidiaries of Polyplex Corporation, to understand its company structure. Polyplex has 3 manufacturing companies:

1) Polyplex Corporation, Ltd., India

2) Polyplex (Thailand) Public Company, Thailand (PTL)

3) Polyplex Europa Polyester Film Sanayi Ve Ticaret A. S.(Polyplex Europa).

These manufacturing companies are where the value is as they have the main assets. Other than these manufacturing companies, Polyplex has 2
distribution centers in the US, (Polyplex Inc. USA), and in China (Polyplex Trading Co. Ltd. China).

Polyplex Corporation Ltd, which is the holding company, had 70% stake (directly and/or through investment companies) in Polyplex (Thailand)
Public Company, (PTL). PTL is the most important subsidiary of Polyplex Corporation as it has (directly and/or through investment companies) 100% stake in Polyplex Europa, 100% in the distribution company in China and 80% stake in the distribution company in the US. Below is
the holdco opco structure.

Source: Polyplex Corporation Ltd.’s annual report

The holding company, Polyplex Corporation Ltd, in November 2010 and in March 2011, sold approx. 11% and 8% stake in PTL, for approx. Rupees 6.37bn. With these sales, the consolidated holding of Polyplex Group in PTL decreased from 70% to 51.0%. The value of this 51% stake in PTL as per the above sale price = (Rupees 6.37bn *51%) / 19% = Rupees 17.1bn.

This should be the buying price or the market value of the remaining 51% holdings of subsidiaries, as per the recent transaction. Adding tangible book value of the standalone company to it, we get Rupees 17.1bn + 3.18bn = Rupees 20.28bn. So this can be considered as the total market value of the holding company (Polyplex Corp), as per recent market transactions. This market value divided by no of shares outstanding gives a share price of Rupees 634.07 (202,775 / 319.80 = 634.07), the stock is trading at 193.5, a clear upside of 228%.

A Rupee 7 yearly dividend, which the company has recommended on 30 May 2011, makes it even better. That said, you can get stuck in the value trap for a long time. Consider this as a long term play. In short run the stock can go further down due to margin pressures. The upside is anywhere between 50% to 200% in 1 to 4 years.

Don’t trust ANYONE’s analysis, do your own. Buy good companies at low valuations.

Notes:
1) Consolidated Financial Results include the results of the following subsidiaries – Polyplex (Asia) Pte Ltd. (PAPL), Polyplex (Thailand) Public Company Ltd. (PTL), Polyplex Singapore) Pte Ltd. (PSPL), Polyplex Europa Polyester Film Sanayi Ve Ticaret A. S. (Polyplex Europa), Polyplex (Americas) Inc. (P.A.) and Polyplex Trading (Shenzhen) Company Ltd. (PTSL).
2) All numbers, including but not limited to, EBITDA, etc are adjusted to exclude any one time, non operational and/or non-cash charges and hence may not match as reported by the company.
3) It is very important to read the disclosure and disclaimer before making any investments based on the above article.

Disclosure: Long Polyplex Corporation Ltd. (Code:POLYPLEX, in National Stock Exchange of India  a.k.a. NSE )

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

-Suneet Chandvani

Dinakar Singh, TPG-Axon
• “Beta trade is over.” We are in a stock-picker’s market. Valuations and margins recovering, but when the stimuli is pulled away we get to see what the real economy looks like. Look for companies with structural growth and separately, companies that are undergoing internal restructuring. He wants to buy stocks when margins and valuations are already at cyclical/secular peaks (i.e. truly improving stories)
• ORKLA (ORK NO). Norwegian conglomerate. Thinks upside is 65-80 (30-60%). Overcapitalized. Change is underway. 3 Key segments: premier consumer staples biz, legacy alumni-related biz, and high quality investment portfolio. “Bell has rung” – separation of businesses is on the horizon, will look to return money to shareholders. Major shareholder Canica. Trading at 9/10 PE; 1x Book, 5% yield, and has a good balance sheet. In general, Europe was slower to cut costs in this most recent downturn, so more upside from here. In addition, 22% shareholder is fed up with performance and is now on the board.
• Zhongpin (HOGS); US-listed, Chinese pork processor. In the last 6 months there has been significant underperformance of Asia stock versus US. Chinese P/Es are below that of the S&P. HOGS is a good example. Basically now the growth-in-Asia stories are on the clearance aisle. The industry in which HOGS participates is consolidating (50-80% of capacity is coming out of the market by 2015). HOGS has inflation risk to it, but has the ability to pass that on to the Chinese consumers. Margins will be sustainable, as the Chinese government, which is sensitive to price increases to the end consumer, is even more sensitive to rural Chinese, and will always choose farmer over urban dweller. Buying it today 7-8x earnings and will be 4-5x in a couple of years
• Spring Nextel. Basically thinks it is super-cheap. The company has both low margins and a low valuation which will make returns explosive to the upside if things turn around. US cell market is attractive and being #3 in tri-opolgy ain’t bad. Will get chance to buy cheap assets because of forced divestitures on ATT/Tmobile (also T Mobile is their weakest competitor). Also they are fixing their networks and will have the opportunity to pursue a number of good JV deals due to consolidation in the market. There is upside here as Sprint’s strong network is an attractive acquisition candidate for CTL, AMX or CMCSK. Stock currently trades at 5x EBITDA. Should trade at 6.0x-7.5x implying a value of ~$8.50 to ~$14.00/share.

Jeff Aronson, Centerbridge Partners – “CIT Group: An Event Waiting to Happen”
• Aronson noted they are not traditional stockpickers. With that said, they have been buying CIT, a post-reorg equity, of late. They started buying the pre-Chapter 11 bonds and have been buying since. Think stock’s intrinsic value today is $59; $45 3/31/11 BV plus $7 in future accretion from fresh start accounting (FSA) write-down, plus $7 in NPV of $2.1bn of DTA which they have taken a valuation allowance on gets them to $59. Will reverse the VA after they lower their cost of funding and start making more money. Using a 10% discount rate assumption in PV calc. So, cheap on an as is basis versus $41 share price. Thinks value if they acquire a deposit-funded institution, or vice-versa is ~$64-65. Value creation comes from marrying higher yield assets at CIT (8% vs, 4.6% for commercial banks) with cheap funding (7.2% cost for CIT versus 1.0% for banks). Thinks stand-along 2012 EPS is $1.76, can pick up another $3.03 by putting the 60% of their assets that are bank eligible (Corp, Vendor, Trade) in a bank, plus $1.04 in operating synergies gets you to Adj. 2012 EPS of $5.83. At 10x comp multiple get $58 stock plus $7 in NPV of DTA = $65 stock. If instead is the acquirer, thinks they could pay up 15% for VLY, combine the two, and at 1.1x BV = $64 stock. Listed US Bankcorp, WF, HSBC, and TD Bank as potential acquirers of CIT. His concluding comments were short and to the point: At 0.7x book value, and a normalizing funding environment, CIT is completely misunderstood by the market.

Robert Howard, KKR Equity Strategies
• KKR Equity Strategies looks for situations that are not well understood by the market (he cited lack of history as a main culprit) that “fly under the radar”
• Pitched WABCO (WBC), a global supplier of electronic and mechanical components to the commercial vehicle industry. Spin-off with a long history (invented ABS brakes). Play on cyclical recovery in Europe and US truck production, tightening safety and emission requirements and EM growth. The company also has a dominant market share in China and India. $100 share PT. The CEO is eating his own cooking, owning $200M of economic exposure
• Second pitch was HSNI. Howard sees 40% of upside here. The company trades a little less than 6.0x, which is well below the retail universe that the street usually compares the company to. The company is under levered AND overcapitalized and could pay a $950M dividend. Margins here are well below HSNI’s larger competitor QVC and a consolidation makes sense. In fact QVC’s parent, Liberty Media Interactive, owns 32% of HSNI. 65-90% upside in a merger.

Phil Falcone, Harbinger Capital Partners
• While equity investors cannot play it (yet), there is debt out there. The 12% Term Loan trades at 102-103 as of today. Thesis is 50% increase in data from 2009 to 2014, not enough spectrum in the mkt. He is acquiring spectrum and has a terrestrial network with a satellite overlay. All about “building the pipe”
• Falcone then went on to discuss one of their larger holdings Crosstex Energy (XTXI). XTXI is one of the only publicly traded General Partner interests in a C Corp structure. Crosstex owns 100% of the GP interest and 32% of a publicly traded entity XTEX (Crosstex Energy LP) and 100% of the distribution rights. There are no corporate level income taxes at the LP. The publicly traded entity is expected to increase its distribution by 30% which, because of leverage, could increased the GP distribution 3x higher than that. Falcone sees at least a double to a 2.5x return on this position

Jim Chanos, Kynikos Associates – “Does Solar + Wind = Hot Air?”
• Before crushing alternative energy, Kynikos founder, Jim Chanos went on about how he was “NOT” going to talk about a particular country in Asia that he is short. The country turned out to be Japan. He is bearish on China as well (of course) and India (didn’t want to piss off a billion people like he did last year)
• Bearish on Alternative Energy; Solar + Wind = Hot Air. Unreliable baseload power, geographically limited sources of power. Intermittent power generation creates significant issues. Not the job growth provider the politicians like Obama want you to believe it is – Installation, not Innovation. Low R&D, putting people to work in the construction industry basically. Environmental benefits are questionable: marginal impact on CO2, NIMBY, noise pollution, wildlife impact.
• Wind is 50% more expensive than natural gas and solar is even more expensive. In addition, we have a ton of coal.
• Short Vestas Wind Systems (VWS DC ). Accounting is gimmicky (that’s how they first found it), pulling revenues forward and deferring costs. Have changed auditors = red flag. Low ROIC, and increased competition in both US and China. $600M of cash has burned in the last 6 months.
• Solar mkt fundamentals are deteriorating. Feed-in tariff policy is not sustainable particularly in Spain and Italy. Capacity growth is relentless, driven by easy credit in China (solar cell production capacity increasing 30-50% while installations are down 40-90%).
• Short First Solar (FSLR) – Uses thin film technology instead of next generation poly technology. The company is burning cash this year. Management has been selling stock – Chanos LOVES when management sells stock. New management team is new to the solar business.

Source: distressed debt investing link: http://www.distressed-debt-investing.com

Criminal Investigation: on 29 April, Justice Department opened a criminal investigation of GS in connection with its trading activities. Federal prosecutors in New York are investigating the matter to determine whether to pursue a criminal fraud case. It seems likely that this was initiated on a referral by the SEC, which the SEC had indicated was a possibility when it filed its civil lawsuit. History shows that most such probes end up with no charges. Also, GS has ongoing cases with the ENRON litigation since 2001. The cases may go on for years, if not settled, and the stock price goes back to normal.

Here are a few reasons why I think GS’s stock is undervalued and has a decent upside.
i) Locking testimony of the key employees: Goldman made a smart move by locking in testimony of the key employees involved in the litigation process. Tourre’s public statements make it less likely that he could change his statement later for a lesser penalty with the SEC in return for information that could be detrimental to Goldman Sachs.
ii) Reputational Risk: People talk about reputational risk. Most of GS’s revenues is derived from its trading business (72% of total revenues in 1Q10 and 60% on avg for last 2 years), which is immune to reputational risk. I mean, reputation is important in Investment Banking (IB) business but GS’s IB business, on average for last 2 years, has been contributing 14% to their total revenues. Their IB business was just 10% of their total revenues in 1Q10. Even if GS losses 20% of its IB business due to a negative impact on their reputation, it would hardly effect their bottom line and their EPS. Just to give you a gauge, if this quarter’s (1Q10) IB revenues declined by 20% their quarterly EPS would have declined by a meager 0.4 per share, from the present 5.59 to 5.19. Multiple that by 4 and we get a yearly decline in EPS of 1.59 from its present TTM EPS of 23.96. source: GS analysis
iii) Worst case scenario: According to Brad Hintz, an analyst at Sanford C. Bernstein & Co. , the “worst-case liability” for GS if the SEC succeeds would be USD 706.5m hit to net income, or USD 1.2 in their EPS. That is a small figure as compared to their present TTM EPS (as of qtr ending 31 March 2010) of 23.96. Also, GS had USD 38.3bn cash and cash equivalents as of 31 Dec 2009. An outflow of USD 706.5m wouldn’t have a significant impact their balance sheet.(source: http://www.bloomberg.com/apps/news?pid=20601087&sid=aLeACVxGpmT4)
iv) Adding reputational risk and the “worst case scenario”: Adding the decline in EPS from both the above scenarios (1.59 + 1.2 = 2.79) and deducting that from the current TTM EPS of 23.96 (23.96 – 2.79 = 21.18) we get 21.18. Dividing that by current stock price of USD 145.2 (as of 30 April 2010), we get a P/E of 6.85, very close to 6.7, GS’s 5-year avg. of low P/E’s. So even in its worst case scenarios GS’s stock is pretty much at its lowest and is definitely not a bad deal.(source: GS analysis)
v) Sovereign Debt Issues: In case markets crash due to sovereign debt issues in EU, GS will make money as their bets will go right. Also, more volatility is usually good for traders. This will boost their trading revenues, which is, on average, 60% of their total revenues.
vi) Markets overreaction: Market always overreacts and the price of GS has gone down significantly as compared to its fundamentals. Once the situation is back to normal, GS’s stock should shoot up and cover the gains it lost after SEC filed a case against them. Even though Bank of America and S&P analysts have downgraded GS to sell, I think there is a huge upside to the stock and a limited downside. If one wants to really take risky bets on GS they can invest in GS Jan 2011 call options (aka leaps). This position will give a lot of time for the stock to recover and the returns can be tremendous. Obviously there is a lot of volatility in the stock and option price is driven by volatility.

Disclaimer: Please read the Disclaimer.

-Suneet Chandvani

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