Contract manufacturing is the outsourcing of certain production activities that were previously performed by the manufacturer to a third-party. For the company under this model, the manufacturing units are utilized for various client companies in order to manufacture part of their requirements.

Hindustan Foods Limited (“Hindustan Foods” or the “company”) presents an indirect play in the Indian consumption story. This company is one of the largest and most diversified contract manufacturing companies across various FMCG categories like Food & Beverages, Home Care, Personal Care, Fabric Care, Leather products and Pest Control.

What makes Hindustan Foods interesting?

1. Growing opportunity in the Indian contract manufacturing space in India:

• According to a report by Indian Brand Equity Foundation (IBEF), India’s FMCG market is expected to grow at a CAGR of 27.86% to reach USD 103.7 Billion by 2020 from USD 53.8 Billion in FY18. Contract manufacturers are expected to aid this growth.
• Rising cost of raw materials, logistics and labour have become a global concern, and in order to reduce costs across the value chain, FMCG companies continue to look for organized partners for outsourcing their production.
• New evolving brands may not have the necessary expertise or ability to setup manufacturing facilities and would prefer contract manufacturing.
• Due to the US-China trade war, India’s exports of consumer goods to the US are increasing, leading to more companies turning towards India for contract manufacturing.
• GST implementation has led to decentralization of manufacturing facilities and has given more opportunities to this sector to cater to the needs of the FMCG companies looking forward for expansion.
• Hindustan Foods represents an attractive opportunity for domestic and international brands seeking to prospect marketing opportunities in India without spending extensively in setting up manufacturing facilities.

2. Diversified Business Portfolio & Strong Clientele Profile: Most of the contracts with the below clients are long term in nature leading to revenue visibility.

Plant Location	Goa	Pondicherry	Mumbai	Jammu	Coimbatore	Hyderabad
Key Clients	Danone, Pepsico, Marico	TBS, Jomos, Gabor, Bata, Hush Puppies, US Polo, Arrow	Espirit, Saks Fifth Avenue, Dune, Myntra, Lollipop, Flipkart.	Reckitt Benckiser	Hindustan Unilever	Hindustan Unilever
Brands	Farex, First Food, Easum, Kurkure Puff-corn	-	-	Mortein	Tea: Taj Mahal, Lipton, 3 Roses Coffee: Bru	Surf, Surf Excel, Rin, Wheel, Comfort
Products	Baby food products and snacks	Shoes for men, women and juniors & uppers	Shoes for men and women	Coils, Vaporizers, Aerosols	Tea, Coffee	Detergent Powder, Liquid Detergent, Shampoo

3. Experienced Promoters: Hindustan Foods was founded in 1984 and was promoted by the Dempo Group. In 2013, the Vanity Case Group acquired a controlling stake in the company. They are one of the largest FMCG contract manufacturers in India. By end Q3FY20, they together own 61.12% of the company.

4. Expansion and acquisition:

• Hindustan Foods has a vision of growing 20x by 2020 to reach a turnover of INR 1,000 Cr., through various organic and inorganic strategies.
• The process of demerger of the Hyderabad facility of Avalon Cosmetics Private Limited with the company has been successfully accomplished.
• ATC Beverages Private Limited, an associate of the company, has successfully ramped up production and is expected to reach its optimal capacity utilization in Q4FY20.
• The company is proposing to set up a liquid manufacturing facility in Silvassa, Gujarat for a leading home care liquid brand. The board has authorized an investment of up to INR 30 Cr. in this facility which includes buying out the existing factory of the promoter group and additional investments.

No competitive Advantage/economic moat

Although the opportunity ahead for Hindustan Foods is huge and untapped, I believe the company do not have any competitive advantage in the near future to sustain growth in the long term.

Hindustan Foods is having business model like of Fabrinet (US company), one of the world’s leading manufacturer of outsourced optical components. Even though they are a contract manufacturer, Fabrinet’s business is highly profitable due to its strong competitive position in the industry. They are able to avoid competitive bidding for contracts due to the following reasons:

• Economies of scale relative to optical component OEMs: Fabrinet's largest customers are optical component original equipment manufacturers (OEMs). These customers decided to outsource part of their production to Fabrinet because Fabrinet has the scale and technological know-how to manufacture optical communications components at a lower cost and higher quality.
• High Switching Costs: OEMs who work with Fabrinet take great risks if they decide to switch to another contract manufacturer who might have less scale, less experience in small batch manufacturing, and less technical expertise with optical communications equipment.

But Hindustan Foods do not enjoy similar competitive advantage as Fabrinet due to the following:

• Most of the company’s clients are large FMCG companies whose products are not as complex as the optical components. Since these companies cater to the needs of a huge population, chances are high that most of them use multiple contract manufacturers.
• The company do not own any brands
• Intense competition for contracts

This is also evident in the company’s performance and profitability.

INR Cr.	Mar-10	Mar-11	Sep-12	Sep-13	Mar-14	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19	Cumm. Total
PAT	(0.61)	0.05	(1.64)	(1.2)	(1.33)	2.5	1.44	0.67	6.28	10.2	16.36
Operating Cash Flow	0.1	-0.9	0.07	-1.03	3.26	0.97	0.59	-5.32	-5	-3.01	(10.27)

• Hindustan Foods has reported a negative operating cash flow in 5 out of the last 10 years.
• The company has reported a cumulative PAT of INR 16.36 Cr. However, the cumulative operating cash flow is INR (10.27) Cr.
• The company is not able to convert reported profits into cash.

INR Cr.	Mar-10	Mar-11	Sep-12	Sep-13	Mar-14	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19
Sales	3	4	7	6	3	17	24	38	139	237
% Growth YOY		11%	77%	-10%	-47%	450%	37%	59%	266%	71%
Expenses	4	3	7	6	4	23	22	35	128	216
% Growth YOY		-18%	112%	-18%	-39%	532%	-7%	62%	268%	68%

• Although the top line has been growing at an exponential rate; the expenses have also been increasing at a similar rate. Raw material costs have been around 45-65% of the sales in the past 10 years.
• This has been keeping the margins low.

	Mar-10	Mar-11	Sep-12	Sep-13	Mar-14	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19
Operating Profit Margin	-23.2%	8.7%	-9.4%	-0.3%	-15.5%	-32.8%	9.5%	7.7%	7.3%	8.7%
Net Profit Margin	-17.9%	1.3%	-24.5%	-20.0%	-42.0%	14.4%	6.0%	1.8%	4.5%	4.3%

 

INR Cr.	Mar-10	Mar-11	Sep-12	Sep-13	Mar-14	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19
Debt to equity	130.3	81.5	-6.0	-5.8	-4.0	-6.1	-85.2	0.2	0.9	1.1
Interest Coverage	-1.2	1.4	-1.3	-0.2	-0.9	2.6	0.9	1.9	7.0	4.4
Receivable Days	282.62	258.31	161.15	203.53	390.11	56.75	43.48	49.3	47.15	49.76
Inventory Days	23.53	62.97	60.39	71.82	132.14	38.94	30.98	34.79	39.79	45.66
Payable Days	63.82	98.47	82.36	118.64	176.4	70.97	71.93	78.09	74.74	73.03

• The management has been very local about raising debt to meet future expansion plans. At the current levels this seems to be manageable given the debt to equity and interest coverage ratios.
• Receivable days have reduced substantially over the years. However, inventory days have increased given the company has been opening new manufacturing facilities and entering new product categories.
• Payable days have been rangebound between 70 – 79 days over the past 5 years.

	Mar-11	Sep-12	Sep-13	Mar-14	Mar-15	Mar-16	Mar-17	Mar-18	Mar-19
Net Profit Margin	0.013	-0.245	-0.200	-0.420	0.144	0.060	0.018	0.045	0.043
Asset Turnover	0.39	0.61	0.40	0.16	0.94	1.30	1.07	1.63	1.56
Financial Leverage	87.55	-7.22	-5.56	-4.76	-11.84	-141.00	1.10	2.27	2.46
ROE	45%	0%	0%	0%	0%	0%	2%	17%	16%

• The impact of financial leverage on RoE can be seen in the above table.

Other Key Risks:

• Client concentration: Top 2 customers contribute to 65% of the total revenue.
• Key Man risk: As most of the activities controlled by MD Sameer Kothari himself, his absence at any stage could seriously dent the company’s fortunes.

The management has indicated very ambitious revenue targets and expansionary plans. While most of this will come from transferring business from Vanity Case to Hindustan Foods, the ability to have more long-term OEM contracts in the pipeline is yet to be seen. Although the top line has been improving over the past years, the company has struggled to convert them into profits and in turn into cash. It would make sense to just be a patient observer and wait for a hardened business model to emerge.

Team 3C Capitals

Sources:

• Screener.in
• Investor Presentations
• Blogs