Summary: I believe Aarti Industries is a great value pick at current levels because it has sound fundamentals and should be able to give handy returns to shareholders. Personally, I have unrealized losses in the scrip and based on this analysis  right now I am committing myself to the company instead of booking losses, because staying put will give me better returns…

My Holdings:

My Present Holdings
Avg. Purchase Price	Holding period	Highest Purchase Price	Lowest Purchase Price	Unrealized Profit/Loss
57.42	LT  1 Year	73.5	45.5	(20.75%)

About Aarti Industries:

The company is a chemical manufacturer with Specialty Chemicals being its specialty. In the last FY, more than 68% of its revenue came from Specialty chemicals, with remaining coming from Basic, Agro and Pharma chemicals. In August 2011, the company reclassified its business segments with the new segments being Performance Chemicals (Mostly comprising of erstwhile Specialty Chemicals), Agri Based, Pharma Based and Home and Personal Care Chemicals.

The company was incorporated in 1984.

Aarti’s Ecosystem: Aarti Industries is into supplying chemicals as raw materials to other businesses. Some of the businesses Aarti caters to are resilient to the short term fluctuations in the general economic activity (Pharma and Agro). However, this is a small component of Aarti’s portfolio. The bigger pie of its portfolio (erstwhile Specialty Chemicals or the new Performance Chemicals) is indeed dependent on the general economic activity.

Aarti’s position in its ecosystem: We have more than 90 companies in the Indian Chemical Industry (excl. Pharma and Petroleum) with an average gross sales of more than Rs. 500 crores for the last 3 FY. With an average gross sale of 1390 Cr. over the last 3 FY (with 2 years of more than 1500 Cr), Aarti is in the top 45. It can be said that as of now it is a solid middle level company and an old hand in business.

With this perspective, I believe that Aarti’s fortunes are impacted by the global economic uncertainty only to the extent that the uncertainty impacts the general Indian chemical industry (both in terms of revenue and margins). Nothing more and nothing less. Hence, I believe its position is secure and not under threat and so to that extent its owners tend to sleep better than most of their competition.

Reported Financial Performance: The in the last FY2010-11, the company’s total revenue increased on a YoY basis, but the actual PAT decreased. The change was in the standalone statements and not in the consolidated statements, which indicate that there were factors indicating the company itself, and not its subsidiaries.

As per the company itself, the two factors for this were increased input costs due to commodity inflation and increased interest expense it has to incur due to the additional debt the company took to do so called “de-bottenecking”. In hindsight, that makes sense when one looks at how the commodity prices featured last FY and that how the company’s debt increased by more than Rs. 89 crores in FY 11.

Below is a high level view of the company’s finances as reported In its annual report.

FY	2008-09	2009-10	2010-11
Net Sales	1436.04	1285.48	1451.52
Capital WIP	15.49	14.49	28.07
Total Expenses	1451.29	1302.94	1492.13
Reported pat	83.32	70.02	66.68
Average Net Worth	311.1	369.7	422.5

Free Cash Flows to Equity Owners:

Along with the above finances, one can look at the below measures from the company’s annual financial statements.

FY	2008-09	2009-10	2010-11
Increase in Cap Ex from previous FY	65.68	13.63	23.59
Dep + Amortization	39.52	44.56	47.76
Absolute change in Non-Cash W/C	-67.89	13.02	-123.12
Total Increase in Debt	53.28	-46.1	89.8
Total Increase in Deferred Tax Liability	5.54	5.9	1.83

One can see that the company’s debt has fluctuated on a year to year basis and has increased in FY 11 (indicating company took additional debt) while it reduced in FY 10 (indicating company repaid it). To make an average performance more reliable, I have normalized the debt changes over the past 6 years.

The same story has repeated itself w.r.t. Cash Flow on Non Cash working Capital, which also changes its sign each year. This means that the company is spending on inventory/receivables/payables in one year and not doing that at all in the next year. To get an average performance, I have normalized this too over the past 6 years.

To be on a conservative side, I am assuming that Deferred Tax Liability is indeed a liability and so cannot be assumed to be the property of the owners.

When I normalized the above factors, removed the extra ordinary incomes and expenses the company reported (thankfully they were not many) and calculated the FCFE, I get the following data (all amounts in Rs. Cr):

Average last 3 FY Sales	1391.01
Net Profit	66.68
Cash Value	7.77
Latest FCFE after Normalization of Debt and Capex	45.64
Latest FCFE before Normalization of Debt and Capex	60.74
Average FCFE after normalization for the past 3 years	39.73
Average FCFE before normalization for the past 3 years	64.41

Clearly for Aarti, the average amount of Cash the company is returning to its equity owners in the past 3 years is less than it’s reported PAT or its present year’s stand alone nos. No wonder the stock dipped.

Fit vs Flab: The company has just over 7.7 Cr. of Cash in its hand. One can say that a manufacturing company does not need too much cash in its hands, but I believe that the amount it has is on a lower side. Despite this crunch, the company paid about 33% of its income to shareholders in the last FY, which leads to a healthy yield of over 2%. Clearly the company thinks:

1. It is a company in a sector that will grow in the near future, albeit not exponentially.  The reinvestment needs are therefore moderate.
2. It can afford to pay the shareholders back. The new projects can be financed with debt.
3. The money it holds is good enough for its operations.

The company had a historical interest coverage of 4.8 to 2.2 in its last 6 FY and so it can be assumed that it is in its nature to se debt extensively. With the current interest coverage of just over 2.8 in FY11, the company has not behaved abnormally.

In terms of fit vs flab question, based on above analysis I believe that the company’s nature is to be more Jeetendra than Dharmendra, and so the company is fit in its own way.

Ownership Structure: 49.93% of the company is in the hands of its promoters. This to me is ok. Based on the longevity of the company, the promoters obviously know what they are doing and based on finances, their actions are resulting in decent results.

Return on Net Worth:  The PBIT/Avg. Net Worth for Aarti has fluctuated between 63.6% and 23.5% in the last 6 FY and for the last FY it was 34%. In bad times, this is good. I believe Aarti is making good profitable investments in its core business and the trend is likely to continue.

Value Judgment: Based on my analysis till now, I can conclude that Aarti is a consistently profitable company and can be considered a viable investment opportunity. However, no opportunity is worth paying infinite price and so one has to see how does the present market price of the company stacks up against its value.

The BSE closing price on 5^th October was 45.5 for Aarti. When compared with various parameters I believe dictate the worth of a company, we see:

Company	Aarti Industries Ltd.
Latest BSE closing Price	45.50
P/E Reported	5.24
P/FCFE Updated (After Normalization – Latest)	7.48
P/FCFE Updated (Before Normalization – Latest)	5.62
P/FCFE Updated (After Normalization – Last 3 FY Avg)	8.59
P/FCFE Updated (Before Normalization – Last 3 FY Avg)	5.30
P/Trailing 4 Qtr Earnings	5.41
P/Bv	0.83
Current Assets > Current Liabilities	TRUE
Interest Coverage	2.81

With most of its debt capacity utilized already and with high commodity prices behind us, the company is trading at 8.59 times of its last 3 years average FCFE (net of cash) and at 17% discount on its book value. That gives us a sufficient margin of safety. Moreover it is trading at 5.4 times its trailing 4 quarter earnings which indicates that there is a chance that earnings may improve subsequently.

In terms of value, I believe the company is worth 20% more than it is now (to get even with its net worth) and so the price will catch up to that value.

In terms of investment opportunity, I believe this company satisfies all the qualities of it being a god investment. In terms of trends, the prices have bottomed out and I believe that they have gone down more than they should have. The company deserved some beating, but not this much.

In terms of timelines, I am not sure when the prices will catch up. It could be in the next results announcement or may be 9 months down the line when the world becomes a better place to live in. I don’t prophesize when that will happen.

Verdict: I believe Aarti Industries is a great value pick at current levels. I have unrealized losses of about 20% in this company, but I believe I am going to make that up sooner than later. Selling the share now, assuming that the company is bad, is stupidity. Alternatively, if I were investing for the 1^st time, Aarti at present levels would be a great opportunity for me.

Note on Consolidated Statements: Above analysis is based on only the standalone statements of Aarti, and not the consolidated ones. The consolidated statements for this company do not differ much from the standalone statements indicating that the impact of subsidiaries is not significant. For e.g., sales for this FY change from Rs. 1542 to Rs. 1564 crores. Also, the consolidated profit margin is slightly better than the standalone one! Hence, for the purpose of this analysis and to arrive at a value judgment, I have taken only standalone figures as the shareholders are paying whatever they are paying primarily for Aarti industries only.

Personal Note on Aarti Industries: I invested for the first time in Aarti in Nov 2010 when the price was about 72 Rs. I had started to invest only recently and was very new to the concept of investing in terms of maintaining one’s discipline. I thought it was a great buy (based on that quarter’s reported financials) and invested a significant amount of money into the scrip. I would not have done that if I knew then what I know now about the importance of averaging/normalizing/capitalizing and the importance of free cash flows. Once I learnt them, I found out that Aarti was in the mid 50’s sometime this year and then it became a geat buy again. I have been steadily increasing my holdings since then in the scrip at these levels.

Lessons learnt:

1)        Never look at only 1 year’s financials

2)       Never commit a lot of money upfront. Observe and invest. Otherwise, it becomes difficult to bring the average holding price downwards later on.