S.H.Kelkar &Co. Ltd. Buy. Proxy FMCG Play. Outlook & Valuation. November 16, 2015

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1 November 16, 2015 Buy S.H.Kelkar &Co. Ltd Industry: Fragrance and Flavor Industry View: Overweight Initiating Coverage Proxy FMCG Play SHK is the largest domestic fragrance manufacturer with ~ 20.5% market share in the Indian fragrance industry and exports to over 52 countries. It is also an emerging flavor producer in India with ~ 2% market share and exports reaching 15 countries. SHK has over 4,100 customers which include leading national and MNC FMCG companies, blenders and producers of fragrances and flavors. Total manufacturing capacity is ~ 19,819 tons p.a. with 3 plants in India and 1 in The Netherlands. It has a research team of 18 scientists based in Mumbai and Barneveld. It also has 12 perfumers, 2 flavorists, evaluators and application executives at their 5 creation and development centers in India, The Netherlands and Indonesia. Its SHK, Cobra and Keva brands enjoy substantial brand equity. Strong reputation built on quality and continual R & D to help sustain market share. SHK is the 3 rd largest fragrance player in India with a strong reputation built over 90 years of its existence. With a solid business model, an 8,000 wide product range and effective sales & marketing capabilities as demonstrated by its 95 member robust sales team, we believe that SHK would be able to sustain its market share in the ~ 20 bn Indian fragrance industry which in itself has witnessed a CAGR of 10.1% over the last 4 years. Low financial risk on account of reduced leverage and no significant capex plans. SHK plans to use ~ 2 bn raised in its IPO to pay off its working capital loans and other long term debt. Also, SHK has already completed its capex cycle for the next 3-5 years with its Indian plants working at 35% - 45% capacity. Thus we expect that the repayment of significant debt post issue combined with an absence of material capex plans would ensure that financial risk is contained over the medium term. Favorable demand side dynamics continue to support the top-line. With a growing FMCG sector in Asia, North Africa and Middle East which constitutes ~ 83.7% of SHKs revenues, favorable demographics in place & customer diversity both in terms of low client concentration and ~ 43.5% of revenues coming from exports, we expect SHK to be an effective FMCG proxy. Potential upside offered by branded small packs and flavor businesses. SHK plans to deepen its distribution network, introduce new products and new application methods for its fragrance small packs business. With capacity available in its flavor manufacturing facility, established brand equity and a growing clientele currently over 400, we expect SHK to increase its market share in the flavor industry which has grown at a CAGR of 10.4% over the last 4 years. Outlook & Valuation We believe SHK to be a proxy FMCG play and should trade at premium valuations akin to FMCG companies. We initiate coverage on SHK with a BUY rating and a 15 month price objective of 280 (40% upside) Stock Data Current Market Price ( ) 201 Target Price ( ) 280 Potential upside (%) 40 Market Cap ( bn) 29.4 Bloomberg Reuters Share Holding (Post-Issue) Fiscal YE YE Mar SHKL IN NA FY14 FY15 FY16E FY17E FY18E Revenues 7,614 8,370 9,375 10,640 12,236 Material Cost 3,991 4,656 5,109 5,852 6,840 Others 2,252 2,521 2,834 3,181 3,579 EBITDA 1,370 1,193 1,431 1,607 1,817 Depreciation Other Income EBIT 1,261 1,133 1,283 1,499 1,739 Finance Cost Tax PAT ,045 1,214 Key Ratios YE Mar Noninstitutional 43.3% Promoter & promoter group 56.7% FY14 FY15 FY16E FY17E FY18E EPS EBITDA Margin 18.0% 14.3% 15.3% 15.1% 15.0% PAT Margin 10.3% 7.5% 8.4% 9.7% 9.8% P/E P/B EV/Sales EV/EBITDA ROCE 22.9% 20.6% 16.3% 17.4% 18.5% ROE 16.4% 12.6% 10.1% 12.2% 13.0% Yashas Bhat yashas_bhat@lkpsec.com

2 Company Profile S.H.Kelkar &Co. Ltd. SHK is the largest domestic fragrance producer commanding ~ 20.5% market share in the Indian fragrance industry with over 9,700 fragrances, fragrance ingredients and flavors created, manufactured and supplied as on FY15. It has a long standing reputation developed over its 90 year history as a supplier of quality fragrances for use by FMCG companies in personal and home care products, food and beverage industries with exports to over 52 countries. It is also an emerging flavor producer in India with exports of its flavor products reaching 15 countries. SHK has a large and diverse mix of over 4,100 customers which include leading national and MNC FMCG companies, blenders as well as producers of fragrances and flavors. It has 4 manufacturing facilities, 3 of which are located in India and 1 in The Netherlands, the total annual installed manufacturing capacity being ~ 19,819 tons. It has a dedicated research team of 18 scientists operating out of their facilities located in Mumbai and Barneveld. It also has a team of 12 perfumers, 2 flavorists, evaluators and application executives at their 5 creation and development centers in Mumbai, Bengaluru, The Netherlands and Indonesia. The SHK, Keva and Cobra brands through which it sells its products enjoy substantial brand equity in India. Brands of SHK LKP Research 2

3 S.H.Kelkar &Co. Ltd Investment Argument Proven track record, continual introduction of new fragrances, high product quality standards to help SHK sustain its market share Strong reputation built on high quality standards and continual R & D to help sustain market share. SHK is the 3 rd largest fragrance company in India by revenue, with a market share of ~ 20.5%. Its competitors are mainly MNCs such as Givaudan SA, Firmenich, International Flavors and Fragrances Inc. and Symrise SA which collectively hold a 57.0% market share of the global fragrance and flavor industry. Market Share of fragrance industry players in India. Others 15% Givaudan 26% IFF 7% Symrise 10% SHK 21% Firmenich 21% Source:Company, LKP Research SHK has always pushed its boundaries with new unique offerings to help enhance user experience of FMCG products containing these fragrances. In FY15 itself, SHK developed over 502 new fragrance and flavor compounds which have been sold commercially. Its research team developed 12 molecules over the last 3 years, out of which it has filed patent applications for 3. It combines its innovation efforts with a strong quality control system which enables traceability and repeatability for each batch of its products. This has led to a contribution of ~ 14.3% of revenues in FY15 from product launches of the last 3 financial years. We believe that SHK has built a very strong reputation through delivery of quality products and customer satisfaction in the 90 years of its existence. With a solid business model, an 8,000 wide fragrance product range and strong sales & marketing capabilities as demonstrated by its robust sales team of 95 people from 9 centers in India and overseas, we believe that SHK would be able to sustain its market share in the ~ 20 bn Indian fragrance industry which in itself has witnessed a CAGR of 10.1% over the last 4 years. Inelastic demand, high switching costs and a diversified customer base to support top-line Favorable demand side dynamics continue to support the top-line. The fragrance industry is primarily a niche market. Customers majorly include FMCG players who mainly use these fragrances in the manufacture of demand inelastic daily utilities like home and personal care products. This $ 47.3 bn Indian FMCG industry which has witnessed a CAGR of ~ 13.0% from FY07 to FY15 is expected to continue its stable growth phase on account of a large consumer base, shift of households to a more aspirational lifestyle and a clear uptrend in the share of non-food expenditure in India because of rising income levels. This coupled with demand inelasticity is expected to drive demand in the Indian fragrance industry. LKP Research 3

4 S.H.Kelkar &Co. Ltd Demand Drivers in Indian fragrance industry. Others 31% Home Care 21% Personal Wash 15% Hair Care 11% Source:Company, LKP Research Beauty Care 11% Fragrance manufacturers are involved from an early stage of product development and there is a requirement for consistency in its smell and quality. Most FMCG companies depend on the reliability & quality of service of fragrance producers and their knowledge & understanding of their products and needs. In addition to this, fragrance procurement has a relatively small share in overall production costs for FMCG goods. Thus, there is an element of customer stickiness on account of these factors which helps fragrance producers in long term client retention. Notable Clients of SHK for fragrance offerings Fabric Care 11% SHKs fragrance business has a diversified customer base of over 3,700 customers consisting of leading national and MNC FMCG companies, blenders as well as producers of fragrances. A distinct advantage it enjoys is low customer concentration. Out of the net revenue from operations of ~ 8.4 bn and ~ 2.2 bn in FY15 and Q1FY16E, revenue from SHKs largest customer was ~ 240 Mn and ~ 88 Mn respectively. This amounts to only ~ 2.9% and ~ 3.9% of revenues from SHKs biggest customer in FY15 and Q1FY16E. Thus, with a low concentration risk, SHK has managed to effectively mitigate the adverse effect of client loss on its topline and bottom-line. Revenues from exports form a significant part of SHKs top-line. Its revenues are majorly driven by FMCG and fragrance consumption in emerging markets comprising of Asia, Middle East and North Africa (A & MENA). LKP Research 4

5 S.H.Kelkar &Co. Ltd. FY15 - Domestic and Exports Revenues FY15 - Share of A & MENA in Revenues Domestic ( 4.7 Bn ) 56.5% Overseas ( 3.7 Bn) 43.5% A & MENA ( 7.0 Bn) 83.7% Others ( 1.4 Bn) 16.3% Source: Company, LKP Research Q1FY16E -Domestic and Exports Revenues Q1FY16E- Share of A & MENA in Revenues Domestic ( 1.4 Bn ) 64.1% Overseas ( 0.8 Bn ) 35.9% A & MENA ( 1.9 Bn) 85.9% Others ( 0.3 Bn) 14.1% Source: Company, LKP Research Low financial leverage and sufficient capacity for the medium term to keep financial risks subdued Thus, with a growing FMCG sector in India and other emerging markets, favorable demographics in place as well as customer diversity both in terms of low client concentration and significant exports, we expect SHK to be an effective FMCG proxy. We believe that the top-line of SHK will continue expanding at a considerable pace which in turn may augment profitability. Low financial risk on account of reduced leverage and no significant medium term capex plans. Out of the ~ 5 bn IPO issue in Oct 15, ~ 3 bn was towards a partial exit by Blackstone Capital and the remaining ~ 2 bn is to be used to retire working capital loan and other debt of SHK and its subsidiary KV Arochem. With negligible debt and consequent low interest burden, SHK would enjoy the benefits of reduced financial risks and low leverage. This would help the company sustain its high growth phase where its bottom-line has grown at a CAGR of 15.4% from FY11 to FY15. Details of manufacturing plants of SHK Location Annual Capacity (tons) Utilisation (%) Raigad, Maharashtra 10, % Mumbai, Maharashtra 4, % Vapi, Gujarat 2, % Barnveld, The Netherlands 1,650 (metric) 77.2% LKP Research 5

6 S.H.Kelkar &Co. Ltd The company has 4 fragrance manufacturing facilities, 3 in India and 1 in The Netherlands. The manufacturing facilities in India are working at a 35-45% capacity as SHK has already completed its capex cycle for the next 3-5 years and is looking to achieve economies of scale with increased demand and production. Thus the repayment of significant long term debt post issue combined with an absence of material capex plans would ensure that financial risk is contained over the medium term, further cementing the case of SHK as an effective FMCG proxy. Branded small packs provides a steady stream of cash flows independent from FMCG industry, flavor business is largely untapped Potential upside offered by branded small packs and flavor businesses. SHK also has a small pack fragrance business which it operates through its Cobra brand. This business includes sales of its fragrance products in package sizes ranging from 25 gm to 25 kg to several hundred traders and resellers spread country-wide. The contribution of this business to the top-line is given below. Pack Size FY15 Q1FY16E mn % of Revenues mn % of Revenues 25 gm gm gm- 25 kg Total 1, Snapshot of Indian Flavor Industry. Recognizing the potential of this revenue stream, SHK aims to deepen its distribution network and introduce a new sales strategy which would include a dedicated small pack sales team. With plans to introduce new products and new application methods for its fragrance products in the small packs business, we expect the Cobra brand to grow and support its top-line growth. Demand Drivers in Indian flavor industry Share of market players in Indian flavor industry. Oral Hygiene 12% Others 24% Beverages 41% SHK 2% Firmenich 6% Symrise 10% Others 42% Bakery 23% Givaudan 19% IFF 21% Source:Company, LKP Research SHK is also an emerging player in the flavor industry with exports of this business reaching over 15 countries. With a diverse portfolio of 1,100 flavor products, this business has over 400 customers including manufacturers of beverages, confectionary, dairy products, bakery products, pharmaceuticals, oral hygiene, etc. It manufactures these products in its Raigad facility, details of which are stated below. Facility Installed Capacity Capacity Utilisation FY15 Q1FY16E Raigad, Maharashtra 1,164 34% 31% LKP Research 6

7 S.H.Kelkar &Co. Ltd Notable Clients of SHK for flavor offerings SHK has a small 2% share in the Indian flavor industry which is dominated by global leaders. With capacity available with SHK to take advantage of an industry growing at a stable CAGR of 10.4% over the last 4 years, established brand equity with its fragrance and flavor products and a growing clientele of its flavor products currently over 400, we expect SHK to increase its market share in an expanding industry thereby further augmenting its growth. LKP Research 7

8 S.H.Kelkar &Co. Ltd. Financial Performance FMCG growth, continual R & D, increased focus in flavor and small pack businesses to drive revenues. Revenues ( mn). Revenues Revenues of SHK have grown at a healthy CAGR of ~ 13.0% from ~ 4.7 bn in FY11 to ~ 8.6 bn in FY15 driven by consistent demand for its fragrances from FMCG companies in India and overseas where it has a significant exposure in A & MENA. 14,000 12,000 10,000 8,000 6,000 4,670 5,740 6,677 7,692 8,603 9,455 10,736 12,345 4,000 2,000 - FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E Source:Company, LKP Research Efficient raw material sourcing essential to maintain and improve EBITDA margins The fortunes of SHK depend of the level of FMCG consumption in India and overseas. With average household incomes of SHKs target market expected to significantly expand with an increasing share of disposable income, a favorable population composition and expansion of modern retail formats, consumption of FMCG products is all set to follow a healthy growth trajectory. Also, in order to keep up with changing preferences of the ultimate consumer, SHK consistently invests in research and development. It spent ~ 264 mn and ~ 62mn in FY15 and Q1FY16E which comes to ~ 3.1% and ~ 2.8% of revenues respectively. We believe that a scenario of a thriving FMCG industry, continual innovation, introduction of new products, increased focus on developing its flavor and small pack fragrance businesses would benefit SHK and help its revenues grow at ~ 13.5% to ~ 10.7 bn in FY17E and ~ 15.0% to ~ 12.3 bn in FY18E respectively. EBITDA and EBITDA Margins SHK has been delivering decent EBITDA margins consistently from FY11 to FY15. It witnessed a fall in margins from ~ 18.0% in FY14 to ~ 14.3% in FY15 primarily because of increased material cost which went up from ~ 52.4% of operational revenues in FY14 to ~ 55.6% in FY15. It sources ~ 40%-45% of raw materials from countries like Indonesia, Germany, Brazil and US. EBITDA ( mn).and EBITDA Margins (%) 2,000 1,800 1,600 1,400 1,200 1, % 18.3% 17.7% 18.0% 14.3% 15.3% 15.1% 15.0% 838 1,044 1,180 1,370 1,193 1,431 1,607 1,817 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Source:Company, LKP Research LKP Research 8

9 S.H.Kelkar &Co. Ltd Given the nature of fragrance and flavor industry, quality and specifications of raw materials used in its products is of high importance. With long standing relationships with its suppliers, we believe that SHK can economically source its raw materials. Efficient material costs coupled with effective control of employee benefits and other expenses are essential for SHKs sustainability in its margins. We expect that SHK would earn absolute EBITDA and margins of ~ 1.6 bn and ~ 15.1% in FY16E and ~ 1.8 bn and ~ 15.0% in FY17E respectively. Lower depreciation and negligible interest burden FY17E onwards to bolster PAT and PAT margins PAT and PAT Margins PAT and PAT margins for SHK stood at ~ 791 mn & ~ 10.3% in FY14 and ~ 644 mn & ~ 7.5% in FY15 respectively. This is the direct effect of an increased burden of higher material costs and depreciation post significant investments in fixed assets up to FY14. With SHKs capex cycle completed for the medium term and negligible interest burden after repayment of debt post issue, we expect PAT and PAT margins to steadily improve to ~ 1.0 bn & ~ 9.7% in FY17E and ~ 1.2 bn & ~ 9.8% in FY18E respectively. PAT ( mn).and PAT Margins (%) 1,400 1,200 1, % 9.2% 9.7% 9.8% 8.4% 7.2% 7.5% 6.7% ,045 1,214 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E 12% 10% 8% 6% 4% 2% 0% Source:Company, LKP Research Peer Group Analysis SHK has no real domestic peer as the Indian fragrance and flavor industry is dominated by a few global players like Givaudan SA, Firmenich, Symrise SA, IFF etc. Comparative price ratios of SHK with its global peers are given below. Particulars SHK Givaudan Symrise Country India Switzerland Germany Bloomberg SHKL IN GIVN:VX SY1:GR P/E P/S P/B LKP Research 9

10 S.H.Kelkar &Co. Ltd. Risks & Concerns Most fragrance and flavor companies are now placing greater focus on emerging markets of Asia- Pacific, South America, Middle East and Africa due to growing urbanization and changing lifestyles which is expected to directly benefit FMCG companies and their fragrance & flavor suppliers. A trend of increasing consolidation is also being witnessed in these emerging economies with local established players being viewed as attractive acquisition targets. This is leading to intense competition in these markets which can adversely affect companies like SHK, with global players equipped with financial strength and international expertise. This can be witnessed by the fact that Givaudan SA has planned to invest FF 55 mn ( 3.7 bn) in a new manufacturing facility in Pune, Maharashtra which is expected to be operational by FY18E. SHK earns its revenues primarily from the FMCG sector. Thus, the fortunes of SHK are tied to the prospects of this industry inspite of SHK enjoying a low customer concentration. With events like the Nestle Maggi controversy having the potential to shake up entire product categories across the FMCG industry, this dependency may play out against SHK, especially where it is looking at its flavor industry to give impetus to its growth prospects. SHK has 12 perfumers, 2 flavorists and 17 skilled equipment operators. The company depends on a few specialized employees, which may be poached by its global counterparts, with better remuneration and the MNC appeal. SHKs failure to acquire and retain right talent may adversely affect product consistency, quality and its ability to introduce new fragrances and flavors. ~ 43.5% of its revenues come from exports, and ~ 40.0%-45.0% of raw materials have been from suppliers outside India, exposing the company to significant forex risks. Outlook & Valuation We believe SHK to be a proxy FMCG play and should trade at premium valuations akin to FMCG companies. We initiate coverage on SHK with a BUY rating and a 15 month price objective of 280 (40% upside) LKP Research 10

11 Financials (consolidated) Income statement YE Mar ( Mn) FY14 FY15 FY16E FY17E FY18E Net Revenues 7,614 8,370 9,375 10,640 12,236 Total Materials Cost 3,991 4,656 5,109 5,852 6,840 Employee Benefits 1,029 1,150 1,288 1,436 1,597 Others 1,222 1,371 1,547 1,745 1,982 EBITDA 1,370 1,193 1,431 1,607 1,817 EBITDA Margin (%) 18.0% 14.3% 15.3% 15.1% 14.9% Depreciation Other Income EBIT 1,261 1,133 1,283 1,499 1,739 EBIT Margin (%) 16.4% 13.2% 13.6% 14.0% 14.1% Finance Cost PBT 1, ,138 1,493 1,735 PBT Margin (%) 14.1% 11.0% 12.0% 13.9% 14.1% Tax PAT ,045 1,214 PAT Margin (%) 10.3% 7.5% 8.4% 9.7% 9.8% Diluted EPS Cash Flow YE Mar ( Mn) FY14 FY15 FY16E FY17E FY18E PBT 1, ,138 1,493 1,735 Depreciation Finance Cost Other income (78) (233) (80) (96) (109) Change in Working Capital (2,438) (671) (700) Less: Tax (294) (304) (341) (448) (520) CF from Operations (a) 1, (1,348) Capital Expenditure (548) (169) (107) (125) (125) Goodwill on Consolidation (121) Change in /Investments (25) (25) - Other income CF from Investing (b) (179) 114 (52) (54) (17) Free Cash Flow (a+b) 1,002 1,009 (1,400) Issue of Equity Shares - - 2, Long Term Debt 214 (298) (361) (6) (6) Interest paid (175) (186) (146) (6) (5) Amalgamation adjustment (782) Payment of Dividend (150) (149) (187) (260) (361) DDT (25) (31) (37) (52) (72) CF from Financing (c) (919) (664) 1,369 (324) (444) Net Change (a+b+c) (31) Closing Cash and CE Source: Company, LKP Research S.H.Kelkar &Co. Ltd. Balance sheet YE Mar ( Mn) FY14 FY15 FY16E FY17E FY18E SOURCES OF FUNDS Equity Share Capital 132 1,323 1,446 1,446 1,446 Preference Share Capital Reserves and Surplus 4,669 3,688 6,402 7,135 7,917 Total Net Worth 4,810 5,103 7,848 8,582 9,363 Total Long Term Debt Total Liabilities 5,499 5,493 7,877 8,605 9,380 APPLICATION OF FUNDS Fixed Asset 2,189 2,065 1,944 1,865 1,804 Goodwill on consolidation Investments Others Current Assets Cash and Bank Inventories 2,788 3,175 3,552 4,050 4,705 Sundry Debtors 1,794 1,947 2,183 2,478 2,850 Loans & Advances Others Current Liabilities and Provisions Trade Payables 879 1,016 1,127 1,277 1,518 Short Term Borrowings 1,149 1, Other Current Liabilities Provisions Net Current Assets 2,267 2,362 4,799 5,556 6,373 Total Assets 5,499 5,493 7,877 8,605 9,380 Key Ratios YE Mar FY14 FY15 FY16E FY17E FY18E Per Share Data (Rs) EPS CEPS BVPS DPS Growth Ratios(%) Revenues from operations 14.3% 9.9% 12.0% 13.5% 15.0% EBITDA 16.1% -12.9% 19.9% 12.3% 13.1% PAT 28.5% -18.6% 23.7% 31.2% 16.2% Valuation Ratios (X) P/E P/CEPS P/B EV/Sales EV/EBITDA FCF/EBITDA (1.0) Profitability Ratios (%) ROCE 22.9% 20.6% 16.3% 17.4% 18.5% ROE 16.4% 12.6% 10.1% 12.2% 13.0% Dividend payout 19.0% 23.2% 23.4% 24.8% 29.7% Dividend Yield 0.5% 0.5% 0.6% 0.9% 1.2% LKP Research 11

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