A paper trail to value? – Due Diligence on JK Paper (Part 2/2)
In my previous [post](https://www.reddit.com/r/IndianStreetBets/comments/17ytgyz/a_paper_trail_to_value_due_diligence_on_jk_paper/), I talked about the attractiveness of the paper and paperboard industry. In this post, I will share my views on JK Paper’s valuation and why I feel that it’s currently undervalued. I will try to keep this section as instructive as possible so that people can understand the structured way of thinking about the valuation of a company.
# Key financial metrics
Whenever analysing any business these are the first metrics that I would like to look at: Revenue, GP margin, OP margin, NP margin, ROCE, and current ratio.
For the uninitiated, ROCE essentially tells you how much money the business generates with each rupee of capital employed in the business (equity and debt). So, a ROCE of 26% would mean for each Rs. 100 of capital employed, the firm generates Rs. 26.
From what we observe, JK Paper has continuously improved its operating efficiency, which is evident from its healthy profit margins.
[Revenue numbers are in INR Crores; Years are FY](https://preview.redd.it/qsl4qzd7u91c1.png?width=762&format=png&auto=webp&s=be18c70132f3a39ccbc707046c430f273f52760e)
The year 2020 and 2021 sticks out as a sore thumb as it halted a great track record of continuous growth. No prize for guessing the reason why this was the case, COVID-19 19 lockdown disrupted the paper industry causing a massive drop in demand.
Another point that I would like to point out here is the profitability metrics for the year 2023 are an outlier and were observed industry-wide. The key reason is the sharp increase in the demand globally post the COVID-19 crisis which led to a sudden increase in paper and pulp prices. Since JK Paper is an integrated player it was able to benefit in the form of better margins off the increased market price for the products. As seen from unaudited half-yearly results, the operating margin has come down to 25% which is considered to be business as usual.
The current ratio has also improved continuously except in 2020, which signifies a strong short-term debt payment ability of the company.
Additionally, the business tends to retain most of the earnings, which is a positive sign implying that they are simply not chasing high ROE by increasing the dividend payout ratio. Rather, they’re using the cash to fuel further growth and expansion.
Looking at the product mix, it’s a healthy share of all major segments of paper and paperboard industry. The packaging paper will be the key area of focus for JK Paper.
If you remember, in my previous post, I talked about the imminent consolidation in the industry. On that basis it seems fair to compare JK paper to its biggest competitor as both will be eventually fighting for the same assets. One side note, Andhra paper is a subsidiary of West Coast.
Before we start off, just wanted to quickly remind you that the 2023 profitability numbers (although, revenues were as expected) are an industry wide effect and would not be something usual for normal operations in the industry due to higher global prices.
1. Revenue – It’s quite clear that JK paper is the leader, although the gap decreased during the COVID 19 crisis, it has considerably gained the lead over West coast. As things stand in the first half of 2024, JK paper is winning undoubtedly.
2. Profit margins – As you can see, the operating margins have already started to normalise for both the players in first half of 2024. Additionally, while both the companies have almost similar margins, it is during 2020-21 that we observe a significant difference which points towards the robustness of the JK paper even during the downturns.
3. ROCE – Now this is where things become interesting. You might be curious as to how West coast has a higher ROCE even though the margins are the same. Well, the key reason for that is the difference in the sizes of the two companies. JK paper has more capital employed as compared to West coast while their operating margins remain the same. This is quite typical of paper manufacturing as the margins are going to be the same regardless of the size after a certain point and so as West coast increases in size, its ROCE is expected to converge with JK paper. Even then the difference is not significant, barring the exception of 2023 which did not happen due to firm specific reasons.
4. CCE – I wanted to compare CCE as well since a key assumption for this thesis is the inevitability of consolidation in the market and I’m using this as a proxy to show the current buying power of the firms. As things stand, JK paper is slightly ahead of West coast in terms of CCE. However, if we account for the two acquisitions that were done JK paper in the corrugated segment (Securipax packaging and Horizon packs) along with a greenfield project for a corrugated plant which added a total of 8 plants for the segment alone to their assets. The cash used for the acquisition was INR 586 Crores. With this acquisition, JK paper became the market leader in the packaging paper segment (which accounts for 70% of the entire paper market)
For the valuation, the approach that I have taken is to use it provide myself a baseline for the value of the firm as if there were no acquisition, i.e., organic growth-based value of the firm. The reason for this is it’s difficult and frankly futile to predict the size and timing of acquisitions. My rationale is given that consolidation is imminent, the inorganic value generated combined with the organic growth would be higher compared to just the organic growth.
With all the inputs from the industry and historical performance, here is my story for valuation of JK paper.
1. Growth: Estimating the revenue involved using the expected industry growth and aligning it with the results we have observed in 2 quarters of FY2024. So, the first year in the table points to my estimate of FY2024 results. Given that over time, the industry growth will slow down, I have reduced the growth rate to 0 as it approaches the terminal year.
2. Profitability: Operating margins were a bit of an outlier for the previous year. Hence, I’ve normalised it to align with the half-yearly observations and industry average during usual business operations. Over time, the margins will drop as markets might become competitive as reflected in the gradual decline for OPM to 15%.
3. Reinvestments: I have used a sale to capital ratio of 1 throughout the year as there’s no expectation of massive efficiency improvement or degradation to back-calculate the reinvestment required for X% of growth in the subsequent year. The global average for the industry is around \~0.95. However, I have assumed that due smaller size of JK paper, It will be slightly higher than the global average. Again, I have tried to be as conservative in this as possible.
4. Inorganic growth: While I have not priced this aspect into the model, I will touch upon this as it holds some weight in the thesis. I had mentioned previously that I expect the market to end up in the state of an oligopoly with 3-4 major players. Given what we have observed (financial standing and initiatives), JK paper seems to be the most likely to end up in that group. Of course, you could make a similar case for West coast, but it is still considerably smaller and seems less initiated compared to JK paper.
As a value investor, I would have a much better sleep knowing I have JK Paper in my portfolio given its considerable competitive edge. Then again, the enterprising would say why not have both? Though, that would be a topic for another day.
*Disclaimer: This is my first attempt at writing down my thoughts about an investment and by no means I am a financial advisor. Please feel free to share your feedback on how I can improve on this as I’m planning to do more of these posts.*
*I have a beneficial long position in the shares of JK paper*. *Do your own research and this post should not be considered as investment advice*