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Toffees Can Be Great For Your (Financial) Health

This toffee company's shares are very cheap but its warrants are even cheaper
Before you read this article, you should know that I have a large investment position in this
company. This means that a significant conflict of interest exists because I am wearing two
hats at the same time: (1) as an investor who wants to see the market value of his holdings
appreciate; and (2) as a columnist who is recommending his readers to buy a position in this
company. Under the circumstances, full disclosure is the best I can offer you.
The Company
There is a recession going on in the Indian industry. But somebody forgot to tell Parrys
Confectionery Limited (PCL). The company which makes and sells "Parry" toffees has been
making truly remarkable progress in recent years. As Table 1 shows, it's total post-tax profits
for the last three years alone were almost thrice the total post-tax profits of the previous eight
years. And the best is yet to come.
Table 1: The Progress in Parrys Confectionery
Eight Years Three Years
Ended 31 March Ended 31 March
1994 1997
(Rs Cr.) (Rs Cr.)
Total Gross Income 272 336
Post-tax Profits 6 17

The figures in Table 1 need not necessarily be considered impressive. After all, earnings
can be easily be created simply by pouring capital into a poor or a mediocre business.
However, if you take a look at Table 2, you will find that this is not the case here. PCL has
been showing rapidly rising earning while consistently producing exceptional returns on its
shareholders' funds.
Table 2: Parrys Earns Exceptional Returns on Shareholders' Funds
Opening Post-tax Additions to Dividend Closing Return Dividend
Net Worth Earnings Net Worth Due s Net Worth on Payout
(Rs Lakhs) (Rs to Issuance of (Rs (Rs Lakhs) Opening Ratio
Lakhs) New Shares at Lakhs) Net Worth
Premium
(Rs Lakhs)
(1) (2) (3) (4) (5)= (6)= (7)=
(1)+(2)+(3)-(4) (2)/(1) (4)/(2)
1991-92 290 70 - 17 343 24% 24%
1992-93 343 136 264 33 710 40% 22%
1993-94 710 170 - 37 843 24% 22%
1994-95 843 345 - 43 1145 41% 12%
1995-96 1145 634 1623 81 3321 55% 13%
1996-97 3321 743 - 108 3921* 23% 15%
* This figure does not agree because the 10% tax on dividend paid has been ignored.

Why I like The Confectionery Business


One, the confectionery business is simple and easy to understand, unlike many other
businesses, such as petrochemicals, which I am afraid, I do not understand.

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Two, the confectionery industry produces a product which humans will not stop consuming
no matter what happens in the world. (During the Second World War, Parry's sweets were
supplied to the Red Cross in aid of war victims.) For long-term investors like me, the
presence of this clear continuing demand is crucial. I have no interest in investing my money
for the long term in here-today-gone-tomorrow-companies such as windpower companies,
leasing companies, teak plantation companies and timeshare companies.
Three, the confectionery business is not a commodity business; it's a consumer franchise
based on brands. People don't buy toffees by the kilo; they buy by asking for their favourite
brands. Brands which become popular, therefore, enjoy tremendous pricing power which
naturally translates into superior operating profit margins for the owners of those brands. This
pricing power is simply not available to commodity businesses such as steel. An Indian steel
manufacturer has to worry about not only what prices its local competitors are charging for
their steel, but also the prices charged by steel manufacturers in other countries. No such
worries for branded confectionery manufacturers.
Four, the capital-turnover ratios (sales divided by capital employed) in this industry are
high which means that a confectionery business is not capital-intensive.
Five, there are significant barriers to entry for new players. Apart from having the
protection of established brands, well-entrenched players in this business have widely spread
out distribution networks which were built over many decades. For a new participant to grab
market share from existing players, the presence of a wide distribution network is essential.
But building such a network takes a huge amount of time, effort and money.
Six, because of all the above points, the economics of the confectionery industry is very
good. That's why the average industry player is able to earn a return on its capital in excess of
long-term yields on government bonds. The average confectionery company, therefore, is an
economic success instead of the average Indian listed company which does not earn a return
on its capital in excess of the interest rate on government bonds.
Seven, the prospects of volume growth in this industry have never been better. This point is
important because of point six. I have no interest whatsoever in investing my money in an
industry such as the airline industry, where growth prospects may be huge, but the prospects
of earning decent returns on capital are non-existent. The best business to own is one which
can employ large amounts of incremental capital at very high rates of return. The worst
business to own is one which will do the opposite, i.e. employ large amounts of incremental
capital at very low rates of return.
Why I Like Parrys Confectionery Limited
Having said what I wanted to say about the confectionery industry, let me now get down to
telling you why I like PCL. My reasons for liking PCL can be divided into (1) scope for
earnings growth from products made by PCL; (2) new earnings streams from confectionery
products made by others; (3) management factors; (4) valuation.
Earnings Growth From Products Made By PCL
Above, I mentioned that the prospects of volume growth in this industry have never been
better. The reason is simple: economic liberalisation. Economic liberalisation and demand for
confectionery products go together. As the 1994-95 annual report of PCL said:
"Gone are the days when Mom & Dad decided what toys you played with, what clothes you
wore, what sweets you ate. In fact, wonder of wonders, moms and dads are eating the sweets
that children buy. Research shows that confectionery consumption is distributed almost
equally among kids and adults today.
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"The attitudes of people have undergone a sea change. The average Indian today is not the
average Indian that has been around for decades. With the advent of satellite television,
e-mail, paging systems and the like, the Indian is more aware of things around him than ever
before."
A study of the National Council of Applied Economic Research (NCAER) found that in
developing countries, rising disposable incomes results in a larger proportion of the income
going to food products including confectionery.
These are no tall claims. Table 1 shows PCL sold (in value terms) 24% more confectionery
in the three years ended 31 March 1997 than in the whole of the eight years prior to that.
Take a look at Table 3 which shows the growth in PCL sales volume as well as value.
Recent increase in sales have averaged 27% a year. But toffee sales which account for more
than 90% of the total sales have been growing at 40% a year. PCL has increased the prices of
its toffees by an average of 10% a year which is 2% more than the rate of inflation.
Moreover, sales volume in toffees has been growing at 34% a year which is way above the
historical growth rate of the industry of only 6% a year. The main reason for this volume
growth, as mentioned earlier,
Tableis3:simply
Growtheconomic liberalisation. Sales
In Parrys Confectionery's
1993-94 1994-95 1995-96 1996-97 Average Annual
Growth Rate
Total Sales Value 6266 9267 10880 12787 27%
(Rs lakhs)
Toffee Sales Value 5116 7712 9951 ???* 40%
(Rs lakhs)
Toffee Sales 114587 162686 184332 ???* 34%
Volume (Quintals)
Average Toffee 4465 4740 5398 ???* 10%
Price (Rs/Qunital)
* These figures are not yet available.

Clearly, PCL has recently recorded volume growth in its existing lines of activities at a rate
which is way above its historical growth rate. Moreover, PCL has enjoyed the power to raise
the price of its toffees more than the rate of inflation. This, in turn, has resulted in an increase
in PCL's profit margins Table
(See Table 4).Confectionery's Margins Are Rising
4: Parrys
1991-92 1992-93 1993-94 1994-95 1995-96 1996-97
Profit Before Depreciation, Interest 7.52% 9.03% 8.47% 7.59% 10.07% 11.27%
and Tax as % of Gross Income

Apart from generating volume growth from existing brands, the management of PCL has
been introducing new brands such as Nut House and Crumble. Also, PCL has tied up with
Walt Disney to launch a range of sweets with Disney characters printed on them. This deal is
very attractive for PCL because it will enable it to cash in on the popularity of the world's
most loved comic characters such as Mickey Mouse, Donald Duck and Pluto.
To satisfy demand for its existing and new products, PCL has recently built a new toffee
plant at Nellikuppam and has modernised existing units at Nellikuppam and Maraimalai
Nagar.

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New Earnings Streams From Confectionery Products Made By Others
Earlier, I mentioned that the best is yet to come for PCL. That's because the PCL's
management has taken some excellent long-term decisions to create earnings from new lines
of business. These can be broken down into two categories: (1) Distribution arrangement
with Wrigley India Private Limited; and (2) Joint venture agreements.
Wrigleys Hires PCL's Distribution Network
Mention chewing gum to anybody, and chances are the name that comes to mind is
Wrigleys - the world leader in the industry. Until recently, all Wrigleys chewing gum
available in India was imported. As a result, a pack of 5 chewing gums cost Rs 12. Now,
Wrigley India Private Limited has set up manufacturing facilities in India and has tied up
with PCL for the distribution of its products all over India. Each Wrigleys pack of 5 chewing
gums now costs just Rs 6. Here's why I like this arrangement:
PCL's distribution network consists of 2.7 lakh retail outlets monitored through 26
computerised stock points spread out all over India. It built this network over the last many
decades. On its own, Wrigleys could not have reached so many outlets in even ten years. By
renting PCL's distribution network, however, it has quickly ensured that its products are
available in almost every nook and corner of the country. Clearly this deal is a huge winner
for Wrigleys.
It is a huge winner for PCL too. Every time you buy a Wrigleys chewing gum, you end up
paying a few paise to PCL. But paise add up. Indeed, they have been adding up rather
quickly. The arrangement with Wrigleys started in March 1995. During the year 1995-96,
PCL earned Rs 86.46 lakhs from "commissions and amounts received in respect of sales." In
1996-97, the first full year during which the distribution arrangement was in force, the
relevant figure has soared to probably more than Rs 1.5 crores (This figure is an estimate
because the break-up of PCL's total other income is not yet available.) This means that within
1 year, this arrangement is contributing more than 10% of PCL's gross profit. During this
period, however, PCL was distributing Wrigleys only in South India. It is only now that
Wrigleys chewing gums are being distributed all over India through PCL's distribution
network.
PCL's distribution network is already there. The incremental costs of distributing Wrigleys
products are borne by Wrigleys. Therefore, almost the whole of the commission received by
PCL from Wrigleys will increase its pretax profits.
Here is the beauty of this arrangement: The more Wrigleys chewing gums are sold, the
more money PCL will make from distributing them. And PCL will not have to spend a penny
in manufacturing the chewing gums nor in advertising them. All these costs will be borne by
Wrigleys. And Wrigleys is yet to start its all-India advertisement campaign for its products.
Another reason why I am so impressed by this arrangement is that the size of the Indian
chewing gum market has exploded in the last few years, again due to economic liberalisation.
In 1992-93 the size of the chewing gum market was just Rs 35 crore. In 1996-97 it was
around Rs 200 crores. That's a growth rate of 500% in four years.
You can be certain that in the next few years the demand for Wrigleys chewing gums will
rise exponentially because: (1) The Wrigleys brand name is well known in India; (2) the price
of Wrigleys chewing gums has been reduced by 50%; (3) Wrigleys products are now more or
less readily available all over India, thanks to PCL; and (4) Wrigleys is yet to launch a major
advertising campaign. If everything goes well between PCL and Wrigleys, you can be sure
that PCL is going to make a lot of money from this distribution arrangement.

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This arrangement shows that one of PCL's biggest competitive advantage comes from its
distribution network. Incidentally, it will interest you to note that this very valuable asset, for
the use of which Wrigleys is willing to pay a lot of money, does not even appear on the
balance sheet of PCL.
Joint Venture Agreements
Until recently, PCL's confectionery products were designed to appeal to the mass market.
Now the company is planning to strengthen and increase its presence by occupying every
segment in the sugar confectionery market. In this respect, it has entered into two joint
venture agreements which will create new sources of earnings for PCL in future years from
speciality confectionery products.
First, PCL has entered into a joint venture agreement with Huhtamaki Oy Leaf of Finland.
Leaf is the 10th largest confectionery manufacturer in the world and owns popular brands
such as Jolly Rancher, Lo, Tayday, Lakerol and Elizabeth Shaw. This is a 50:50 joint venture
in which PCL has invested Rs 6 crores. The returns on this investment will come from three
sources: (1) Distribution commission - Like in the case of Wrigleys, PCL will handle the
distribution for all the products made by the joint venture company; (2) Dividends received
from the joint venture company; and (3) Earnings retained and reinvested by the joint venture
company on behalf of PCL.
Second, PCL has entered into a joint venture agreement with Chupa Chups SA of Spain
which is one of the world's leaders in the manufacture and sale of lollipops. PCL holds a 49%
stake in the joint venture company with the remaining 51% held by Chupa Chups. PCL's
investment in this company is Rs 6 crores and returns on this investment will come from
three sources: (1) Distribution commission - Like in the case of Wrigleys and Leaf, PCL will
handle the distribution for all the products made by the joint venture company; (2) Dividends
received from the joint venture company; and (3) Earnings retained and reinvested by the
joint venture company on behalf of PCL.
Management Factors
The management factors which have a bearing on the attractiveness of this company can be
divided into: (1) operating skills of management; (2) capital allocation skills of management;
and (3) the honesty of management.
w Operating skills. The people who run PCL know the toffee business in and out. Over
the years, these managers have build some of the best brands in the business such as
Coffee Bite, Lacto King and Coconut Punch. These managers know very well that the
long-term prosperity of their company depends on building a strong consumer franchise
as well as a wide and efficient distribution network. And they are doing whatever is
necessary to achieve those goals.

PCL is one of the largest spenders on advertising with advertising expenditure


constituting nearly 5-6% of sales. This ensures that its brands are continuously on top
of the mind of the consumer.

PCL is investing money in its distribution network. For the first time in India, the
availability of sweets is monitored through 26 computerised stock points, all networked
with on-line information available at any point of time.

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PCL's management is aware of the pricing power enjoyed by its brands and it has taken
full advantage of that power by periodically increasing the prices of its products
without fear of loss of unit volume or market share.

PCL has recently completed it's modernisation plan by importing and installing the
most modern confectionery making machinery in the world. It's manufacturing
facilities are now world class.

PCL management is taking full advantage of a liberalised economy by regularly


introducing new brands in the market which cater to all segments.

Perhaps one of PCL management's greatest operating skills is demonstrated by the fact
that they know the value of their distributing network. By renting out that network for
cash to giants like Wrigleys, Leaf and Chupa Chups they are not only making money
for their company. They are also ensuring that the inevitable entry of foreign
confectionery manufacturers in India actually helps their company rather than hurt it.

The fact that PCL's management is skilful in operations can be seen from the
consistently rising profit margins enjoyed by the company (see Table 4).
w Capital allocation skills. For a business to be a long-term winner the management
needs to have not only superior operating skills but also superior capital allocation
skills. PCL management has both.

PCL's management has not taken any stupid decisions to diversify into unrelated areas
or to go in for backward integration by making its own sugar. In other words, PCL's
management knows what it does best and it sticks to it. It is always trying to direct its
capital towards its most productive uses. It's decisions to invest in the joint ventures
with Leaf and Chupa Chups are examples of such decisions. At the same time it has
taken sensible decisions to withdraw capital from unproductive uses. For example,
anticipating severe competition from other players and worsening economics, it
recently withdrew from the biscuits segment of the confectionery industry.

PCL's management uses debt judiciously to enhance returns on shareholders' capital.


It's cash generated from operations are several times higher than annual interest
payments. PCL is conservatively financed. Even severe economic downturns cannot
impair it's ability to service its debt.

One of PCL management's best capital allocation skills can be seen in Table 2. PCL
earns high returns on its shareholders' funds and has been able to increase annual
dividend payments, while gradually reducing it's dividend-payout ratio (dividends paid
as a percentage of profits earned). For every 100 rupees earned by the company only Rs
15 or so are paid out as dividends and the remaining Rs 85 are retained in the company
for reinvestment at rates of return which are much higher than what its shareholders can
earn elsewhere. This policy of retaining cash for reinvestment at high rates will reward
PCL's long-term shareholders through significant capital appreciation.
w Honesty of management. PCL is managed by the Murrugappa group of South India.
The other group companies are EID Parry (India) Limited, Tube Investments of India
Limited, Carborundum Universal Limited, Cholamandalam Investment and Finance
Company Limited and Parry Agro Industries Limited. The Murrugappa group enjoys
good reputation and appears to be honest.

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Valuation
The above points relating to PCL's growth prospects and its management have a bearing on
the valuation of PCL. In addition, it should be noted that over the years, PCL has displayed a
remarkable stability of earning power. During the last eleven years, for example, PCL has
had only one year in which its earnings actually fell as compared to the previous year's
earnings. Moreover, in nine of the past ten years, PCL increased its total dividend payments.
The only exception was 1991-92 when it maintained its dividend payment. Therefore, there
have been no dividend cuts for at least the last ten years. This shows that PCL is in a virtually
recession-proof business and means that the market should assign higher multiples on its
earnings, book value, and cash flow than is the case in a typical business prone to cyclical
downturns. The good news is that it isn't.
PCL has 21,63,350 shares outstanding which are currently quoting at Rs 174 each. It also
has 16,22,513 warrants outstanding which are currently quoting at Rs 41 each. The market
value of the total equity claim (the market value of the shares plus the market value of the
warrants) comes to approximately Rs 44 crores.
Here is a company operating one of the most attractive publicly owned businesses in India
and it's entire ownership interest can be bought for a mere Rs 44 crores, even though this
company earns, on average, a return on its shareholders' funds of more than 30% a year, had
a gross income of Rs 131 crores in 1996-97 alone, generated a cash profit of Rs 12 crores in
1996-97, has a stated net worth of Rs 39 crores and has seen its post-tax profits grow at an
annual average rate of 40% in the last 5 years!
At the current market prices of the shares and the warrants, PCL's price earnings ratio
comes to 5.9, price to book value ratio to 1.1 and price to cash flow ratio to 3.7. (All these
ratios have been calculated after taking into account the dilution on the exercise of warrants.)
These ratios are so low that it appears that Mr. Market is offering PCL's equity claim on a
platter.
Here is an indication of just how cheap PCL is. In 1996-97, PCL earned a post-tax profit of
7.42 crores. These are real profits not just "accounting profits." Assume, for a moment, that
PCL stops growing and from now on it merely maintains its existing volume of business and
is able to increase it's prices in line with inflation. Under these assumptions, from now on
every year PCL will earn Rs 7.42 crores. At current interest rates of 13% a year for
government bonds, the present value of these future earnings of PCL comes to 57 crores. This
means that if PCL stops growing then its equity claim would be worth Rs 57 crores. Even this
number is 30% higher then the actual market value of PCL's equity claim. In other words, by
valuing PCL's equity claim at Rs 44 crores, Mr. Market is suggesting that PCL's earnings
will shrink, not expand. He is, in effect, predicting that people will suddenly stop eating
Parrys toffees. Sorry Mr. Market, it ain't gonna happen.
One way of estimating the minimum intrinsic value of PCL's equity claim is to compare it
with the "average Indian company." Capital Market maintains a database of 5373 companies.
The current average price to book value ratio of this huge sample is 1.7 (as against 1.1 for
PCL) and the current average price to cash flow ratio of the same sample is 8.7 (as against
3.7 for PCL). In other words, PCL is selling at a price which is a lot cheaper than the price
commanded by the average Indian company, even though PCL is far superior than the
average Indian company. In fact, given PCL's long term record of demonstrated consistent
earning power as well as it's future growth prospects, one can say with confidence that PCL
should sell for at least twice the multiples applicable to the average Indian company. Using
this method, PCL's equity claim is worth at least in the range of Rs 133 crores and Rs 174
crores. Taking the average of 154 crores, one can see that PCL is currently selling at discount

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of 71% below my estimate of its minimum intrinsic value. For the long-term buyer of this
business, this discount of 71% represents a huge margin of safety.
Moreover, note that my estimate of the minimum intrinsic value of PCL's equity claim is
very conservative. This can be gauged from the fact that companies which show similar
financial characteristics (consistently high returns on shareholders' funds, excellent long-term
prospects and a long record of uninterrupted dividend payments) such as Colgate, Hindustan
Lever and Ponds are selling in the market at much higher price to book value ratios and price
to cash flow ratios than those used for valuing PCL.
Stock Vs Warrant
PCL's shares are very cheap. But its warrants are even more cheap, and therefore, more
attractive than PCL shares. This is true for three reasons:
One, the warrants are currently quoting at Rs 41. Each warrant gives a right to its holder to
buy 1 share of PCL at a fixed price of Rs 110. The time of exercise is to be decided by the
management of PCL which cannot be later than 15 May 1998.
Therefore, so long as the stock is selling at Rs 174, the warrants should sell for at least Rs
64 each, being the difference between Rs 174 and Rs 110. The fact that the warrants are
actually selling for Rs 41, or a discount of 36% shows just how irrational Mr. Market can be.
Two, I have already argued that the stock itself is worth a lot more than Rs 174. Therefore,
each warrant should not be viewed as a right to buy a share for Rs 110 when its market price
is Rs 174. Rather each warrant should be viewed as a right to buy one share of PCL for Rs
110 when it's intrinsic value is a lot higher than Rs 174.
Three, according to the terms of the issue, at the time of exercise, the warrantholders will
not be required to pay the whole of Rs 110 exercise price at one time. There will be a
schedule of payments which will be indicated by the management of PCL. This means that
warrantholders will continue to earn interest on their cash not yet paid to PCL.
The Negatives
Every investment has its possible pitfalls. To my mind, the following points are worth
noting.
One, the warrants are not protected from bonus and rights issues. What this means is that if
the management of PCL really wants to make it unattractive for warrantholders to exercise
their warrants, all it has to do is to declare a bonus issue in the ratio of 1:1. The stock price
will fall to Rs 87. No one will exercise a right to buy shares at Rs 110 when they are selling
in the market at Rs 87. The chances of such a thing happening are remote given the fact that
the Murrugappa group is reputable and also because many of the warrants are owned by its
group companies.
Two, given the track record of joint ventures of other Indian companies, it is not impossible
to think that things could sour between PCL and it's joint venture partners. Even if this
happens, a long-term investment in PCL should still produce satisfactory results because: (1)
it's prospects even without the joint ventures remain good; and (2) the price of the equity
claim is so cheap.
Three, things could sour between PCL and Wrigleys. This would hurt PCL. The present
value to PCL's shareholders of the potential future income from distributing Wrigleys
chewing gums is large. However, such an eventuality will not be disastrous for PCL.

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Four, a far more serious problem often occurs when the management of a great company
gets side-tracked and neglects its wonderful base business while it diversifies into all sorts of
other unrelated businesses. Should such a thing happen to PCL, the prudent thing to do would
be to sell your shares.
Conclusion
PCL operates a simple and understandable business with exceptionally good fundamental
economics. It's business has very good growth prospects. It's management is competent,
shareholder-oriented and appears to be honest. Finally, PCL's shares are selling at a very
cheap price relative to their calculated minimum intrinsic value. However, it's warrants are
even cheaper than its shares. For long-term investors, a position in PCL - preferably in
warrants, otherwise in the stock - at current prices should work out very well.
Because the warrants are listed only on the Madras Stock Exchange and are very thinly
traded, I give this warning to potential warrant buyers: Don't buy these warrants for selling
them later in the market. Buy them with the intention of exercising your right to acquire PCL
shares for Rs 110, and then hold on to them for a long time.
Note
This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New
Delhi based company called Corporate Investment Research Private Limited.
© Sanjay Bakshi. 1997.

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