Paper Products Limited (PPL / The Company) - Recommend BUY

At current levels of Rs.77.40 per share, Paper Products Limited seems like a good buy to me. According to my model (attached), the DCF valuation ranges between Rs.91 and Rs.100 depending upon assumptions we make primarily about (a) Working Capital - Inventory, DPO, DSO, (2) CAPEX in FY2014 and 2015.

Since PPL is a dividend paying company, one may consider using DDM - Gordon Growth too but I find it unfair to value the company using this method as the company does not pay out a large part of its earnings as dividends. Further, the retained part of earnings are not all used to make investments in order to support on going activities or expansion to support the growth in revenue and sales. The company regularly invests in financial instruments like Mutual Funds and other schemes as well. I believe the DDM/Gordon Growth model should apply to those companies which have a long history of dividend pay outs, and the amount of dividend would be that part of earnings which is not used or retained to make investments for expansion or continuing operations to support revenue stream. In this case, PPL's valuation is at approximately Rs.27 per share which in my opinion is far below the fair value.

The company's shares may seem overvalued compared to its domestic peers but what we need to consider is that PPL has very little debt in its capital while all the other domestic players are highly leveraged with Essel Propack's Debt-to-Equity being above 1. PPL's EBITDA is a mammoth 171 times Interest Expenses as compared to Indian peers' and AMCOR's at below 8 times the same. Clearly there is less risk associated with PPL than there is with its Indian and international competitors.

RISKS:

Input Costs Escalation: In FY2010, input costs rose sharply due to hike in price of raw materials. Although most of the other materials were volatile within a narrow band, PET Films prices rose by more than 150% due to global shortage of supply following shut-down of few major suppliers' units, delay in capacity additions and diversion of thin films to higher value added thick films for electronics industry. Other key raw materials that saw sharp rise in price were inks, adhesives and solvents. 

Competition, Margins and Pricing power: In absence of long-term contracts with buyers, PPL seems to be on the disadvantageous side of the negotiation table. Adding to that, competition has been increasing with new players entering and capacity additions with existing ones. In such environment, escalation in raw materials prices and other inputs like fuel and energy costs may undermine margins and cash flows. 

Inflation: PPL primarily serves the food processing industry. Due to recent inflation especially in food prices, PPL's customers have become price conscious and initiated cost cuts in their packaging expenses by compromising on packaging quality as well as by putting pressures on packaging suppliers' margins. Additionally they had resorted to reverse auctions, hard negotiations using consultants. 

Regulatory risk / Plastic ban on Food Processing Industry

OPPORTUNITIES

India – Economy, infrastructure & Rise in organized retail: Having been partially insulated from global meltdown, India saw a robust GDP growth of near 8% and is expected to see the same in the coming year. Economic Times - "When larger wheels in a machine start rotating, the smaller ones automatically gain momentum. The same is true of the Indian packaging sector too. Strong growth in sectors like fast moving consumer goods, pharmaceuticals, liquor, cosmetics etc. has had a positive rub off on the packaging industry. Growth in consumer goods and organized retailing mainly drives demand for packaging." -

Growing in size of middle class population means shifting form traditional grocery shopping and buying habits at the corner grocery store to supermarkets and organized retail outlets. This adds potential to flexible packaging industry as packaging is and will be an important strategy of product placement on the shelves of such supermarkets and stores where customers walk around and try to judge the contents/product by their packaging and/or brand. It is the least we should remember that PPL's customers are some of the leading FMCG brands who occupy shelves at such supermarkets and stores. The FMCG brands are in general bullish on the scope India offers further through infrastructure development in rural areas and underdeveloped towns which means establishment and growth of organized retail in those areas in the coming decade.Government of India - Ministry of Food Processing's Vision 2015: Although we need to discuss the quantifiable benefits of this plan for PPL, at the first thought PPL should directly and indirectly benefit from this initiative subject to GOI's proper execution of this plan. Under this scheme the Ministry aims to (a) Become the Food Factory of the World, (b) Triple the growth of Food processing industries, (c) Increase the value addition from 20% to 35%, (d) Increase contribution to the world's agri-business from 1.5% to 3%. Further research on the Vision-2015 plan and discussions with the IR/Management of such companies would give us insights into the quantifiable benefits to PPL which may be in the face of Tax exemptions, subsidies, export incentives (kick-backs), minimum pricing power/protection, raw material quotas and rebates, etc. 

STRATEGY AND OPERATIONS:

NASP (New Applications, Structures, Products and Processes): In the long run, moving more business to value added segments, Innovation and new products, exploring new markets are seen as critical to profitable growth. The company's endeavor to renew innovation program will continue to be the cornerstone of PPL's strategy. NASP initiatives which contributed to 27.2% of total 2010 sales would get added thrust in the current year and years to come. Organizational measures to further accelerate the NASP efforts are in place with the CEO directly overseeing the company's innovation programs and strategy. PPL has been expanding its supplier base for critical raw materials and introducing alternative materials for its products as part of the innovation drive. 

Operations: The Company is making efforts to optimize existing capacity utilization and add units to plants that expect growth in their products. They have seen success in measures to cut operating costs and overhead expenses. To enhance capacity utilization, they initiated de-bottlenecking in supply chain and inventory controls. However, efficient management of Working Capital (Inventory, Receivables and Payables) is critical for favorable valuation in the light of rising materials prices. The DCF Model seems highly sensitive to these assumptions/inputs and further discussion with management regarding this would be vital to arriving at the valuation with more accuracy. Further, the valuation is also highly dependent on the company's ability to preserve or dictate sales margins (Cost + Input or Fixed Price) and Raw materials purchase price in the short and medium terms via contracts or expanding supplier base