While I posted all good about SRF recently, considering some new learning in recent past, and the fact that I'm finding new, supposedly better opportunities, and the fact that SRF represents 11%+ of my portfolio currently (and when I get 100% invested, it'll still be 10% of my portfolio), a reality check is needed.
Let's see what all can go wrong with this business and the stock.
Business Moat
1.
Strong Brand: SRF is a leader in its industry - man-made fibres. However, since this industry has a small barrier to entry, there's no strong brand, but yes, SRF does enjoy a leadership position.
2.
Distribution network: Searching for 'SRF distributors' does bring up many links on Google, and considering they're growing sales at a decent pace of 20%+ in last 3-5 years, SRF does have a moderately strong distribution network.
3.
Intellectual Property: Yes, SRF has a strong team of chemical scientists and does have some strength of IP rights. As mentioned, all business verticals are engaged in development of newer molecules, and this will help SRF bring newer products with better quality that competition can't bring, and hence some moat here as well.
4.
Lowest Cost: Not really, but yes, operating margins are improving.
5.
Barrier to switching: Somewhat. Since the consumers are into industrial businesses, it is not safe to change the suppliers without risk of quality issues, and hence SRF does enjoy a protection against losing existing customers, provided they maintain quality and competetive pricing.
Ok, so business moat is decent to moderately good, and given cheap valuations, risk of a significant downgrade in Intrinsic value of the business is limited, if not zero.
One risk is that of increasing debt, due to expansion and which could eat into profits and hence dividend yield. Let's consider a bear case. If profits were to decline by 40%, with current dividend payout rate of 20% of profits, there's a good deal of risk to lower dividends, given the outflows in increasing interest and debt payments.
Second is that due to an economic slowdown. If industrial output falls further, there'll be a hit on topline growth, or even a decline in topline for SRF.
Market re-rating is another risk. Historically, the P/E ratio for SRF has on an average been around 3-5 range, and hence scope for a large increase in P/E is unlikely.
However, the good part is that SRF stock has seen a steep fall in prices due to recent quarter poor performance. Current P/E of 3.88 is against an annual PAT of Rs 326 cr. However, assuming best case, the profit can jump back to 400+ levels, and then at a P/E of 4, the stock price can come back to 300 or so levels.
Having said that, it is unlikely that SRF will ever trade above the Intrinsic Value, which is significantly higher at Rs 450+.
All in all, it makes sense to hold this to milk the nice 3.5% half-yearly dividend due in November and then the rest 3.5% in March (this is the annual track record of dividend payment by SRF), and sell it when it starts tading at PE 4.5 or higher, simple reason being that chances of this stock generating low returns is larger than anything. It may not crash further, but it is a kind of stock which trades mostly undervalued, at a discount to the IV, and hence, the only gain possible is through dividends & increase in IV, with market price discount remaining constant.
So, the final action is to wait and watch - no reduction in stake given dividend income and improving market sentiments, and the very attractive purchase price of Rs. 207, but the change is that I won't hold it for very long term...
