In 1987, Achal Bakeri, moved into a new house in Ahmedabad, Gujarat. Unable to air condition some parts of the house due to high ceilings and long passages, he purchased an air cooler. It worked perfectly and he was extremely satisfied with its performance. But he did not like its looks and he instantly came up with an idea of making a better air cooler. In 1988, he introduced an air cooler into the market under the brand name Symphony. He made it exactly look like a window air conditioner and sold it for Rs 4,000.
By tapping into the human bias for associations, he was able to charge double the price compared to other air coolers. But this price was dirt cheap compared to an air conditioner which costed Rs 35,000 at that time. This price difference created a contrast effect and Symphony’s air coolers were selling like hot cakes. In 1994 he took the company public and rest is history.
1. A 2500 Bagger after wiping out shareholders equity
On 30-Jun-2004 Symphony’s stock was selling for Rs 0.87. As of this writing the stock is selling for Rs 2,208.60 representing a CAGR of 110.98%. In other words the stock doubled every year for almost 11 years. But I doubt if most of us would have bought the stock on 30-Jun-2004. Why is that? The company was debt ridden and it had negative equity. Take a look at the snapshot of its balance sheet given below. Why did this happen?
After going public the company fell for the institutional imperatives and started developing other products like washing machines, water heaters, and air conditioners. There were couple of sensible reasons for venturing into other product lines (1) air cooler was a seasonal business as lots of sales happens in summer and the company wanted sales to happen throughout the year (2) to avoid single point of failure. But these ventures did not turnout as expected and the company burnt Rs 50 crores. The company learnt a hard lesson and directed all the focus on a single product; air coolers. Peter Lynch would have summarized this lesson in one word: diworsification.
2. Source of Moat
Any business that earns above average returns on invested capital (ROIC) is considered to be a great business. Let us find out if Symphony’s business is great. Given below is Symphony’s pretax ROIC. In the last six years it’s pretax ROIC averaged about 83.41%. This tells me that it has a fantastic business model. Let us find what makes the company earn such a high rate of return. In order to do that we need to analyze its components operating-asset-turnover and operating-profit-margin separately.
The company on average turns over its operating assets 3.3 times in the last six years. When will such a high asset turn over happen? When a company has a very minimal investment in fixed and working capital then such a high turn over is possible. For the year 2014, the company invested only Rs 77.86 crores in fixed assets. How is it possible to have such a minimal investment in fixed assets and still generate sales of Rs 532.69 crores? The company outsourced 100% of domestic production through tie-ups with nine OEMs. By partnering with nine OEMs for manufacturing air coolers the company remains asset light and has a low cost advantage achieved via process and scale. This is a moat. Also dividing the work among nine OEMs eliminates single point of failure. The company calls this partnership as hub-and-spoke model. All the design, research, quality control, marketing, and distribution is completely owned by the company. This business model reminds me of Nike.
Let us look at its investment in working capital. The company carries only 8% of its sales as receivables. Most of the sales done by the company happens through its traditional trade channels; dealers and distributors. It does business with them on a cash-and-carry basis. This means that the dealers and distributors will make an upfront cash payment before taking the delivery of goods. Its air coolers are selling like hot cakes which enables the company to turn its inventory very fast; around 5.5 times in 2014. Also some portion of its inventory is funded by trades payables which reduces the carrying costs.
Take a look at the profit margin of the company given below. In 2014 its gross profit margin is 54.92% which is a lot compared to its 2007 gross margin of 35.90%. Why did this happen? There are several reasons and some of them are (1) its air coolers commands 5-12% premium over competitors (2) its average realization per unit went up from Rs 4,504 to Rs 6,382 in five years (3) it was aggressively cutting costs through scale advantages, product innovation and hub-and-spoke model.
The next question is why does the customers pay premium price? There are few reasons that I can think of (1) its brand awareness (2) its focus on quality (3) broad selection of coolers. Customers paying up for a premium brand is a moat. Also the company spreads its fixed costs on advertising, marketing, and employees over larger volumes of sales which gives some operating leverage. I did a search for air coolers in snapdeal.com and Symphony dominated the best sellers list. This tells me that the customers love Symphony’s products. Take this result with a pinch of salt as I might be under the influence of confirmation bias.
3. Tapping the International markets by acquiring IMPCO
In 2014 around 25% of Symphony’s revenue came outside of India. Take a look at the revenue split between India and Rest of the world. You should clearly see that international sales tripled in 2011 compared to 2010. Why did this happen? In 2010 Symphony acquired a Mexican air cooler company named IMPCO. This helped the company to expand its global presence and the sales tripled. This company was founded in 1939 by visionary brothers Adam, Gust, and William Goettl. What is so special about them? They patented the evaporative cooling technology based on which air coolers work. Also Achal Bakeri visited this company in 1992 to learn more about air coolers from the experts. After reading this I thought it’s a small world. At the time of acquisition IMPCO’s balance sheet was debt ridden and struggling. Remember Symphony was in the same boat early 2000? This experience helped Symphony to acquire IMPCO and clear its debt.
International sales helps the company to reduce the impact of seasonality. At least some parts of the planet will have summer and the company can sell its air coolers throughout the year. IMPCO specializes in central air cooling solutions and the opportunity for growth is huge.
Central Air Cooling Solutions business of the Company though still in nascent stage had been able to strengthen its operations. The focus was to have adequate representation and therefore the required manpower structure has been employed. Subsequently, the aim is to create a base of dealer network across the country. The dealer network is increased by more than 75% indicating the confidence now the business drives amongst the trade. Your Company has made some major breakthroughs in terms of entry into prestigious clientele covering various customer segments like auto industry, packaging, places of worship, FMCG, paint industry, logistics, sugar mills, hospitals, distilleries, railways, commercial applications etc. There were repeat orders from some customers which establish their trust in the Company and its products. – 2014; Annual Report
4. What can go wrong?
Air coolers will stay for a very long time and the technology it operates on is 85 years old. Compared to an air conditioner it has several advantages (1) consumes 0.18 units of energy per hour compared to 5.5 units (2) costs less and available in prices ranging from Rs 5,000 to Rs 18,000 (3) it is portable and can be used in open spaces (4) uses fresh air and environment friendly. Also air coolers are superior compared to a normal fan. Human nature aspires for upgrading their life style by moving to the next best thing. Hence people using fans will be purchasing air coolers. Hence I do not see the air coolers getting obsolete at least for a decade.
Most of the sales in India are done to the dealers and distributors on a cash-and-carry basis. This results in cash sales and very minimal accounts receivable is needed for operations. But in India organized retail is growing at a rapid rate. This means organized retailers like Reliance, Croma, Big Bazaar, Spencer, FlipKart, and Amazon will take the product on credit and pay only after 30 to 90 days. This will result in an increase in invested capital and decrease ROIC.
Symphony operated on negative working capital. Over 89% of its domestic sales were routed through the traditional trade channel on a cash-and-carry basis, while the balance 11% was through modern retail chains on a 30-90 day credit period. Similarly, all export sales through distributors (50-60% of total exports) were executed on a cash-and-carry basis, while sales through modern retail chains (40-50% of total exports) were on credit. This asset-light operation, zero-debt and cash–and-carry model ensured that the Company remained cash-rich, with the bulk of profits available for distribution. – 2014; Annual Report
Air cooler market in India is highly fragmented with unorganized players controlling 70% of the market in terms of value. The remaining 30% of the market is controlled by organized players. Also the total air cooler market is growing at 10-15%, while the organized segment is growing at the rate of 25%. Symphony controls 50% of the organized segment and it was able to increase the price of air cooler for the last five years. Since the overall pie is growing everyone is behaving nicely and they are not competing on prices. What if the pie stops growing for sometime and one of the competitor goes nuts and reduces the price? Will Symphony’s brand be able to command premium price? I don’t know the answer but we need to keep a close eye on average realization per unit.
5. On Valuation
For the year 2014 the company made a pre-tax operating profit of Rs 126.12 crores. Since the organized air cooler segment is growing at 25% we can expect at least an operating profit of Rs 157.65 crores (126.12 * 1.25) for the year 2015. Applying a 10% cost-of-capital we can arrive at a zero growth valuation of Rs 1,576.50 crores. As of this writing the market capitalization of the the company is Rs 7,748.44 crores. So the zero growth valuation represents 20% of current market capitalization and the remaining 80% is being paid for future growth. If you want to understand the thought process behind this take a look at this. This type of valuation gives a feel for growth expectations of the market. What I want to know is that if I pay the current price and hold the stock for 10 years what returns I will get? This method does not answer that question clearly. We need to look at it another way.
There are three sources of revenue for the company (1) domestic residential cooler market (2) international residential and industrial cooler market (3) domestic industrial cooler market. The company has a lot of room to grow in all three areas. Let us look at the growth potential for the domestic air cooler market. Symphony sold around 6.2 lakhs air cooler in 2014. This represents 10% of the total air coolers sold in India.
The next question is how many residential air coolers can be sold in India? If 30% of 164 million households with fans buys an air cooler then the total number of residential coolers than can be sold in India is around 5 crores. If Symphony can increase the unit volume by 15% every year (historical volume growth is 12%) then after ten years it would be selling around 25 lakh coolers. So there is a plenty of room for everyone to grow even after 10 years as the market size is huge.
Along with the unit volume growth there will be some price increase. Also we need to account for sales growth from international and domestic industrial markets. If we take all of these into account then expecting a 20% growth in operating profits seems reasonable. In 2014 the company made a pretax operating profit of Rs 126.12 crores. Applying a 20% growth for the next 10 years will give us an operating profit of Rs 780.90 crores in 2023. If the market pays a multiple of 20 times earnings then the company will be valued at Rs 15,618 crores. This represents a CAGR of 7.26%. As of this writing I can get 9% returns by parking my money in fixed deposits. Hence I would not buy Symphony at the current market price. As of this writing I do not own any shares of Symphony.