The Relaxo Lecture

Posted on by fundooprofessor

Many readers have responded to my blog on the Relaxo Cinderella Project. Thanks for that.

On Friday 20 Sept, my friend, Ravi Purohit and I gave a talk to my students in MDI on the company. A modified version of the transcript can be seen from here.

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Published by fundooprofessor

I am Distinguished Adjunct Professor at Flame University, Pune. Previosuly, I was Adjunct Professor at MDI, Gurgaon, where I taught MBA students two popular courses titled “Behavioral Finance & Business Valuation"(BFBV) and Forensic Accounting and Corporate Governance (FACG) for many years. I am also Managing Partner at ValueQuest Capital LLP— an investment advisory boutique which helps its clients invest their capital in good quality businesses.

77 thoughts on “The Relaxo Lecture”

  1. Thank you Sanjay Sir and Ravi for sharing your analysis and thoughts. I have been eagerly waiting for your thoughts since those questions were posted. I have learnt a lot from it, specifically the way to think and analyse. Thank you once again. You made my Sunday ! Cheers.

  2. Sir,

    Brilliant stuff…what a treat on an unassuming unsuspecting Sunday afternoon…no wonder u said in one of your interviews- some of best things in life come for free.

    Thanks a lot. Looking forward to many such treats..

  3. thank you and Ravi Purohit! not only for being generous with the idea but also sharing the thought process.

    2 quick questions
    about the brand ownership. i had read (sometime back) that the brands are not completely owned by the company. a quick scan of the annual report did not yield much to answer that question. not sure if you know anything about that?

    this is less of a relaxo question, but more a long term industry question. it’s pretty rare for an clothing brand to last a generation. there are definitely clothing brands out there that do, but it’s hard to predict who will do well 10 years out. the main reason i think is the un-predictable/fickle nature of consumer tastes. i was wondering if you think shoe brands are more durable over the long run?

    1. Rishi, the brands are co-owned by the company and a promoter owed company. No royalty is being paid on the brands. Moreover, there is a plan to transfer the brands to the listed entity. This was disclosed by the management in the AGM, I am told.

      As for your other question, what about Nike, Reebok etc? They have been around for decades. So has, for that matter, Havaianas.

      1. Regarding brand ownership a friend of mine was pointing out that Relaxo could lose the Sparx brand to Bata.

        http://www.business-standard.com/article/companies/bata-drags-relaxo-to-court-over-brand-infringement-109120400172_1.html

        In page 44, the annual report for FY13 says: “The lawsuits in respect of certain intellectual Property Rights & Trademarks are pending in Courts. The proceedings are going on before appropriate authorities and the ultimate outcome of the matter cannot presently be determined. No provision for any liability that may result has been made.”

        Can this have a substantial impact?

          1. Thanks. I (and probably the learned counsel too) didn’t know that the law requires more than just being first to register a trademark.

      2. Nike does make shoes, but its more of a sporting/fitness brand. Which I think is different and very hard to replicate. I dont think its right to put Nike in the same bucket with the Clarks, Crocs, Skechers of the world. It does seem to me that there are extended period of time when the later set of companies seem to do very well. Both in terms of profitability and the share price. And then something happens, and they stop doing well. They might not disappear, but they are not the very cool anymore. Clothing brands also seem to suffer from this problem.

        There will be exceptions. And there are people who are able to predict with high level of confidence which brands will remain cool, but I dont think I can.

        Anecdotally – when I was growing up, there were a lot of Action Shoes adverts. I dont hear of them these days. Not sure where they are these days.

  4. Dear Prof. Bakshi,

    In Red Queen Effect, you comment that Owners Earnings is not the same as FCF(F). Could you please explain the difference?

    Also, the link for the following didn’t work:
    “I will defer that for a later date but if you’re curious, you may want to read up this.”

    Regards,
    Satyajeet

    1. Thanks Satyajeet. I fixed that broken link.

      FCF and Buffett’s concept of owner earnings are different. The best source I found for understating Mr. Buffett’s thoughts on owner earnings is this document written by him in his 1986 letter. Elsewhere in his reports, he adjusted his computation of owner earnings to account for the fact that in some businesses money spent on advertising is in the nature of capex. For example, in his letter for FY99, he wrote this about ad spent in GEICO:

      “I want to emphasize that a major percentage of the $300-$350 million we will spend in 2000 on advertising, as well as large additional costs we will incur for sales counselors, communications and facilities, are optional outlays we choose to make so that we can both achieve significant growth and extend and solidify the promise of the GEICO brand in the minds of Americans.”

      In his 2005 letter, he wrote this again about GEICO:

      “While our brand strength is not quantifiable, I believe it also grew significantly. When Berkshire acquired control of GEICO in 1996, its annual advertising expenditures were $31 million. Last year we were up to $502 million. And I can’t wait to spend more.”

      In his 2006 letter, he wrote this, again about GEICO:

      “Tony has delivered staggering productivity gains in recent years. Between yearend 2003 and yearend 2006, the number of GEICO policies increased from 5.7 million to 8.1 million, a jump of 42%. Yet during that same period, the company’s employees (measured on a fulltime-equivalent basis) fell 3.5%. So productivity grew 47%. And GEICO didn’t start fat. That remarkable gain has allowed GEICO to maintain its all-important position as a low-cost producer, even though it has dramatically increased advertising expenditures. Last year GEICO spent $631 million on ads, up from $238 million in 2003 (and up from $31 million in 1995, when Berkshire took control). Today, GEICO spends far more on ads than any of its competitors, even those much larger. We will continue to raise the bar.”

      One of things that Buffett looks out for, and all investors too should look out for, are decisions which are likely to expand the moat of a business — decisions which hurt near term earnings. One of things that the Managing Director of Relaxo Footwear told me was that he can very quickly increase earnings by simply pulling the plug on ad spent but he won’t do that because he is trying to build a business for the long term.

      I think one should give good marks on corporate governance to managements like that.

      Having said that, there is a limit to how much a business should spend on advertising. There are companies out there which sell poor quality products and services, but which get sold because of very aggressive marketing and advertising. Any time you see high-pressure sales tactics where the intermediaries get very fat commissions (e.g. time shares, toxic financial products) to push poor quality products or services and/or heavy advertising to create demand from consumers, you should become wary of such businesses.

      1. Dear Prof Bakshi,

        Completely buy your points about branding and economies of scale – and how they translate into numbers.

        Just wanted your opinion on one point – competition from other branded players.

        Agreed, unorganised players can’t get Mr. Salman Khan nor the scale. But why can’t Bata or Liberty? Is Relaxo really protected from an attack from them?

        Should we study these competitors to figure out why they aren’t already swarming the jar of honey? Is the answer to be found from their financial positions and the quality of their managements?

        Also, can some of these insights be also applied to Page Industries (Jockey inner garments)?

        Regards,
        Satyajeet

        1. Yes of course Satyajeet one has to study existing competitors. Ravi’s and my lecture covered only some of the important aspects relating to the quality of Relaxo’s business. There’s only so much you can cover in 90 minutes. I am sure there are fascinating insights to be derived by comparing Relaxo with, say, Bata. Both companies follow different strategies and both are successful. At the minimum, the comparison will show that the Relaxo strategy (of largely manufacturing its products, using mostly multi-brand outlets not owned by it for distribution, and spending significant money on brand ambassadors) is not the only successful strategy to operate in the Indian footwear market.

          My overall view is that oligopolistic industry structure with a few branded players and a large unorganised sector dominating the industry but losing market share consistently to branded players, and a product or service being offered to India’s lower or middle classes, is quite attractive a combination to find good companies to invest in. I will be doing more cases on this theme in my class.

        2. Hi Satyajeet,

          Your point is taken on competition. Don’t think relaxo is protected from an attack from the more established players. But, It’s quite fascinating to see what some of them are doing or rather focusing on when compared to relaxo:

          1). Bata – focus is largely on leather footwear. Its non-leather footwear is a fifth of relaxo’s in terms of volumes. Realizations on leather footwear are very high, compared to its own non leather biz and that of relaxo. The current realization that relaxo earns (I.e. 100 bucks per pair) is very unattractive to players that earn significantly higher. Even if these were to go upto say 150 per pair, which will be massive for relaxo and it’s shareholders 🙂 , but that price point might still be unattractive for competitors at the higher end.

          2). Paragon, which is a larger player than relaxo in terms of volumes is also increasingly focusing on selling tyres!

          3). Liberty is focusing on getting the mall crowd and is positioning its shops next to the likes of nike, puma, pavers England, etc it’s is also now selling sanitary ware, competing with the likes of cera, roca, etc.

          4). Action shoes is in the process of commissioning of 2.5 million ton steel plant at a capex of 7000 cr and is also scaling up its inverter business (okaya brand).

          Of course there is a still a lot to learn and understand about competition, both existing and emerging, but being singularly focused on doing one thing well helps a lot in competing. And, relaxo is doing just that.

          3. A dissenting view:

            “Realizations per pair”..: So long as segmentation is done well, I don’t see how realizations per pair is protection. Bata (or some other competitor) will care about its return on capital not about any other metric, least of all price point. Hard to understand, then, how Relaxo has any advantage over the long term. Borrowing from Bezos, “your margin is my opportunity”.

            Anyone with capital can hire Bollywood stars, set up factories, gain access to third party distribution networks and so on. That they haven’t done so yet is not an indication that they won’t. What matters in Relaxo’s line of work is relative scale and/or absolute differentiation. The latter is also partly a function of scale.

            Relative scale is sturdiest in small static markets and weakest in large, rapidly growing markets. It seems to me that Relaxo operates in the latter. And in any case, Bata turns over its assets at almost twice the rate that Relaxo does (4.4x versus 2.5x).

            Could Relaxo succeed over the long term? Sure. Is it likely to? I doubt it.

            Thanks for the very good blog and the interesting discussion.

      2. Sir, how much of the money spent on marketing or R&D should be treated as capex ? How do you come to conclusion on number years to spread such expenditures ?.

  5. More than the business that is discussed, what’s interesting here is to learn is what questions great investors ask while evaluating a business.Thank you Prof. Bakshi and Ravi. However some questions specific to Relaxo that i have which might not lead to the same conclusion as the article:

    1. Isnt the business Capex intensive? Every rupee of sale needs atleast a rupee of fixed asset as is evident from the numbers. Such businesses that aren’t current or prospective free cash generators find it difficult to attract and retain premium PEs. So its probably safe to assume that the future returns will be in line with EPS growth?

    2. CAGR in sale price/unit is in tandem with CAGR of RM prices and inflation. So the prices increases haven’t really flowed through to the share holders? In the absence of voluntary price hike its hard to argue that the business has pricing power? As explained this just-above-its-cost-price approach also gives Relaxo its moat – to capture the unbranded market driven by brand building. But will this strategy work long enough given the fact that unbranded market is fast dwindling to make way for branded players like Relaxo and as most of the market becomes branded – is Relaxo taking away its own moat? See next point.

    3. Relaxo is essentially like an unbranded player within the branded space? Google for flip flops and you’ll find Pumas, Nikes and a host of other trendy brands starting from 300 bucks. I think just like people trade up from unbranded to Relaxo, they will also trade up from Relaxo to Puma, Nike and so many other trendy in house brands. So Relaxo customers of today might not remain Relaxo customers of tomorrow? Essentially replacement demand is not guaranteed. Don’t think Relaxo is as aspirational a brand. If Relaxo gets into the Rs.300-400 market ROEs will go down given how crowded the space is?

    Just some food for thought and debate. Prof. Bakshi and Ravi – please correct me if i am wrong.

    1. hi Prabhakar,

      @ point #1:

      This is a capex intensive business but not as much as you mention in your comment. The average sales to capital employed ratio for Relaxo stands a little above 2 times. Further, the management at the AGM mentioned that its infrastructure as of today is capable of generating sales of around 1500 cr, which gives u a sales to capital employed of over 3 times! while the earlier capex were done towards low priced products such as Hawaii slippers incremental capex is on stuff like Sparx and Flite, i think the asset turns in these products is much higher.

      @ point #2:

      There has been a massive 1500 basis points expansion in gross margins over the last 8 yrs, indicative of the fact that the company has been able to move up the value chain in terms of product mix and as well as raise prices. I dont think the Company has the kind of pricing power which you and i see with brands like gillette, colas, etc. But, with most of the distribution chain willing to pay in advance for relaxo’s products, I’d assume Relaxo to have some brand power, which would mean some pricing power as well. Also, a lot of this gross margin expansion has not yet translated into higher EBDITA and PAT margin…..given that co is spending a lot on building brands, investing in supply chain, etc. Its still evolving, so we will see whether it is able to create long lasting durable brand and therefore create strong pricing power in the long run! As they say, picture abhi baki hai mere dost …

      @ point #3:

      the lower to middle income market is humongous today! the trade up currently happening is probably that of people who were hitherto buying from the unorganized market to now buying from people like Relaxo, Paragon,….etc. No doubt these may aspire to own a pair of Nike shoes some day….but my guess is that the lower to middle income market is very large and expanding and we are still far far away from a time when most of the people in India can afford and own pairs of nike shoes!

      1. Thanks Ravi.

        Overall can we say that Relaxo is a mediocre business that has the potential to grow reasonably fast if they try hard?

        Another way to put it would be : Would you recommend Relaxo for a very concentrated portfolio? ( Or One of the 20 punches you have for your lifetime of investing.)

        1. @ point #1:

          I like what Relaxo has achieved in the past 10 years and I further like the steps they are taking to take their business to the next level. I dont know whether they will succeed in that and I dont know whether 10 yrs from today they will be a mediocre, good or great business. As Prof. Bakshi said at his lecture, its an evolving movie!

          @ point #2:

          this started as a study of business & i’d like to refrain myself to discussing only that.

            1. I agree with you that the agenda here is not about whether this is investment worthy or not.

              Like i said in the beginning of my post “More than the business that is discussed, what’s interesting here is to learn is what questions great investors ask while evaluating a business.”

              May be the opportunity cost angle that i brought up will come in later. It has been the most important concept I’ve learnt in whatever little i have learnt till now. Having read Prof. Bakshi earlier i am sure it will come up 🙂

              Thank you both Ravi and Prof. Bakshi for being so generous with your thoughts. I wish i could think like you guys.

  6. Professor,

    Great post – how does one watch out for structural changes in the industry. I agree with your part on the moat for relaxo – but a lot of moats do not get transgressed by competitors but are disfigured by slow moving forces of nature – for eg., natural juices eating coke’s moat slowly, SaaS companies eating into infosys/TCS.

    How does one identify that threat and figure out how robust the company is ? If we had looked at premier padmini 20 years back, we would have thought of it as having a giant moat – oligopolistic industry, high margins, stable product (used to be !) but a flash flood, swept away the moat once the industry got opened.

    What explains ?

    1. Thanks Varadha.

      I would look out for decline in market share and unfavorable changes in the structure of the balance sheet— particularly the working capital situation. When competitive conditions become uncomfortable, usually the first sign is a deterioration of the working capital situation, in particular the receivables and inventories. If a new entrant or an existing competitor, for example, starts offering better credit to industry customers, then your investee company usually has two choices: (1) refuse to match the new terms; or (2) match the new terms. If (1) leads to loss of market share and (2) leads to more investment in the business with no extra incremental returns resulting in higher receivables/turnover ratio and lower profit/capital ratios, and if those developments are not short term turbulences one often finds in most industries, then one could conclude that the competitive dynamics is deteriorating.

      So, I would watch a sustained loss of market share and/or a sustained deterioration in working capital situation.

      I would also watch out for developments in the industry by meeting with knowledgable people in that industry to warn me about changes happening in the industry which could affect its competitive dynamics.

      I would also watch the growth rate of the industry because if the growth rate becomes small or negative and the industry starts shrinking, the fight for market share is likely to become somewhat vicious.

      I would watch out for what Competition Commission of India is doing, for example, in the cement industry and would be cautious about projecting future earnings based on historical cartel-driven industry profitability.

      I would watch out for decisions taken by companies which narrow their moat (e.g. reduction in R&D spending or marketing spending) but help near term earnings— decisions taken by companies to maintain profitability.

      The above is not an exhaustive list. I am sure, if you ask yourself questions like “what signs should I expect to see if there is deterioration in the competitive dynamics of a company or industry?” you’ll come up with more indicators to look for.

      You cite the example of Premier Padmini. That was a duopoly but caused by a government regulation which changed. I would speculate that there was plenty of time for someone to figure out the seriousness of the competitive threat to Premier by new entrants like Maruti even after the new entrart was allowed to enter the market. So, markets, in general are slow to react to long-term changes, in my view.

  7. Thank you sir for sharing your valuable work with us. I have noticed one thing that the company was generating very high net cash flow from operations in FY 02, FY 03 and FY 08 which was more than 3x of PAT. Does it signify that the underlying economics of the business was excellent and had certain inherent advantages right from the beginning ? Scalibility and branding just acted as the catalysts to bring the company to this level of what it is today.

    1. Thanks Saurav. Operating cash flow from operations (after taxes) should be adjusted for maintenance capex and interest before comparing it with PAT.

      For FY03, operating cash flow after taxes, as per the company’s cash flow statement for FY03 was Rs 11.27 cr. Deduct depreciation of Rs 3.24 cr. as proxy for maintenance capex and another Rs 3.63 cr as interest and we get a figure of Rs 4.4 cr. PAT for FY03 was Rs 3.49 cr, so the difference is not as much as your comment mentions.

      In FY02, operating cash flow was boosted because of a huge reduction in loans and advances from FY01. At the end of FY01, these stood at Rs 9.41 cr. At the end of FY02, they were just Rs 0.27 cr. Because most companies (Relaxo included) treats loans and advances as a working capital item, you see this effect. Not all loans and advances are of a working capital nature, so as a practice, when I study cash flows, I pick inventories, receivables, and trade payables. I take loans and advances only when I am sure that the nature of the advance is that of a working capital item e.g. advance given to a supplier to deliver raw material. If advance is of a nature of a loan given on interest, then clearly that loan is not a working capital item but is a treasury item. If you remove the influence of that item in FY02, things will fall back in line with reported earnings.

      It’s easy to pick up changes in working capital from just eyeballing the cash flow statement. But one should also check the changes each line items of inventory, receivables, other current assets and liabilities from the balance sheets of two years to reconcile the changes with those reflected in the cash flow statement.

      I haven’t done a similar exercise for FY08, so I won’t offer any “explanation” to your comment on that year’s figures.

  8. Thank you sir for clarifying my doubt. Sir can you suggest any book which explains how to analyze cash flow statement for investment research including detection of manipulation in cash flow statement.

  9. Dear Prof Bakshi,

    Assuming Relaxo gets to the 250 million pairs of sales in a decade, assuming a price hike of 10% every year starting from Rs. 100/pair:

    Sales in Year 10: 6500 cr

    Assuming net profit margin jumps to 6% for the first 5 years and 8% in the next five years driven by operating leverage.

    Net Profit in Year 10: 520 cr

    Total profit (approx) accumulated from year 1 to year 10 assuming no payout: 2600 cr

    Asset turnover has remained more of less constant at 3 in all these years, so fixed assets needed to achieve sales of 6500 cr: 2200 cr

    So essentially all the profit will need to be pumped back to support the growth.

    How do you view a business like that which grows at a decent pace but needs ever increasing doses of capital for every incremental rupee of sale.

    From an opportunity cost perspecetive, is there a case where such a business can be better than another business that grows at a similar rate but needs much lesser capital? Is it only valuation that clinches the game for the former? Or is there something else too?

    1. Profits being pumped back to support growth makes sense only if incremental ROE is high, which happens to be the case in Relaxo. If incremental ROE was poor, even if overall ROE was good, retention of earnings would have been value destructive. As Warren Buffett put it:


      “Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.”

      Obviously, if a business can deliver incremental earnings without requiring incremental capital, then it would be very nice, but only if the earnings were paid out as dividends so that money could be redeployed in other similar businesses. Mr. Buffett could do that as a control investor in companies like See’s or Scott Fetzer. But if you are not a control investor in such a company and the company does not distribute the earnings to you as dividends, then you’re going to end up, over time, with a great business and a much bigger treasury. Markets don’t like such companies, usually for pretty good reasons.

      On the other hand, if a business can take in capital at incremental returns that are excellent as compared to AAA bond yield, then such businesses will continue to become more and more valuable over time. Moreover, since there is no extra cash being thrown off, the temptation to squander it away in foolish acquisitions and diversifications is also absent.

      Mr. Buffett wrote this many years ago:

      “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”

      Mr Buffett has invested in both of these high-quality business categories but when he has invested in high-ROE, low capital intensity businesses, he usually bought controlling positions so he could control the dividend policy or create incentives which would work towards a sensible dividend policy. For example, this is what he wrote about Scott Fetzer, a business which came in the category of high ROE, low capital intensity and able to grow earnings without requiring incremental capital.

      “In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls. When capital invested in an operation is significant, we also both charge managers a high rate for incremental capital they employ and credit them at an equally high rate for capital they release.

      The product of this money’s-not-free approach is definitely visible at Scott Fetzer. If Ralph can employ incremental funds at good returns, it pays him to do so: His bonus increases when earnings on additional capital exceed a meaningful hurdle charge. But our bonus calculation is symmetrical: If incremental investment yields sub-standard returns, the shortfall is costly to Ralph as well as to Berkshire. The consequence of this two- way arrangement is that it pays Ralph – and pays him well – to send to Omaha any cash he can’t advantageously use in his business”

      Also see Mr Buffett’s essay titled “Businesses – The Great, the Good and the Gruesome” in his letter in Berkshire’s FY07 annual report.

      Overall I think it’s ok to look at either of two types of businesses- (1) capital intensive, high sustainable ROE with excellent growth prospects (businesses where you have to put up more to earn more but at incremental rates which are enticing); and (2) non capital intensive, high ROE businesses which have the ability to grow without requiring much incremental capital, provided there is no unnecessary hoarding of cash on balance sheet.

      And, its quite important to avoid those highly capital intensive, growing but having low incremental ROE businesses.

      That’s just the business screen. Then, of course, you have to have a management screen and a valuation one as well before deciding where to invest.

      Thanks.

      2. I went back and checked how many businesses are there in India that are employing a net block of more than 3000 cr and making ROEs in the north of 25% while the net profit margin is below 10%. I found two: Tata Motors and Hero Moto Corp.

        Does this tell us anything about how difficult it is to achieve this feat?

        1. Prabhakar,

          Thanks. There is also M&M but that’s not the key point I want to make here.

          We already know that once upon a time, Relaxo was a contract manufacturer for Nike. We also know global brands like Nike do not manufacture anything. And we know Bata too has moved away from manufacturing to outsourcing. So we know the direction of the journey for Relaxo as it moves up the value chain. We just don’t have a roadmap. If and when Relaxo moves towards outsourcing, its investment in fixed assets as a proportion of revenues will fall. Think of the economy as an ecosystem where there is places for a number of players with different business models. If Relaxo can become a much more successful brand company, then over time, its ability to outsource manufacturing will be pretty good in my view.

          I appreciate the points you’re making however. There is nothing wrong in being averse to businesses where you have to put up more to earn more and focus only on those businesses which throw off distributable cash which is much more than growth capex requirements. It’s a smaller universe to work on and specialisation can often produce exceptional results.

          Relaxo is just one example of a high ROE business which must put up more capital to earn more profits and where putting up more capital, so far, has worked very well for shareholders. Moreover, the company’s future growth won’t require issuance of new shares which is a very crucial fact to focus on when analysing such companies.

          Soon, there will be cases on companies where growth comes without putting up significant capital too…

          Thanks.

          1. Thank you Prof. Bakshi (and Ravi) for patiently answering all the questions. Looking forward to more such cases.

            Thanks again for being so generous with your thoughts.

  11. Prof Bakshi / Mr Purohit,

    As always, your article has provided a great exercise in research work and a perfect start for the week, Thanks.

    I have a question which I request you to answer / share your opinion on.
    As a disclaimer, I would like to state the my intention for putting up this query is purely academic.

    The company VLS Finance Ltd (listed), directly and through one of its 99.9% owned subsidiary holds close to 14.37% of the shares outstanding of Relaxo Footwear Ltd. This translates into a Market Value of Rs 136 – 137 Cr based on today’s closing price. Their cost of acquiring these shares was around Rs 76/- a share.
    The market cap of VLS itself in Rs 41 Cr. Its balance sheet shows that it is a zero debt company and they have been in the financing and investing business since over a decade and a half (if not longer). In addition to its investment in Relaxo, it has other big and small investments like a part holding in Sunair Hotels (which owns the Niko Metropolitan Hotel in CP, New Delhi) and a profitably running Stock Broking and Merchant Banking business.

    My question to you Prof is that how would you as an investor view this situation? Would you act on it? If not, what would be your reasons that would make you decide against investing in this company?

    Again, I propose this question as an an academic exercise. Thank you sirs.

    1. Ben Graham used to talk about a metaphorical “frozen corporation” whose charter prohibited it from ever paying out anything to its owners or ever being liquidated or sold. He used to ask, what’s that corporation’s shares worth to minority stockholders?

      VLS is the functional equivalent of a frozen corporation. The company was underwriter to Relaxo’s IPO and the issue devolved on VLS. Lucky VLS.

      It’s a frozen corporation because it does not pay a dividend and it is unlikely to be liquidated. Promoters officially own 39%, which is sufficient deterrent against a bid.

      My advice? If you like Relaxo, buy it direct and not through VLS. I learnt this lesson the hard way (in other situations) and as Munger says you don’t have to pee on an electric fence to learn not to do it. 🙂

  12. Dear Sir,
    I Cant help but compare Relaxo with Jockey….Its has been on a stupendous course of its own..But it still is a good business, with good brand, and non-perishable business.
    It too has kept its margins low, and re-invested its profits into brand building.
    Cant we draw a parallel.

    1. Yes we can. Indeed, the whole idea of investing is to look for patterns that exist across industries. The patters that I am finding very interesting are companies that have the following features in common:

      1. Home grown companies;
      2. Run by owner-oriented managements (OO1s and OO2s). See https://fundooprofessor.wordpress.com/2013/10/12/oo1-to-oo3/ and backed by a solid track record of creating value for minority stockholders over the long term quantitatively substantiated by applying Buffett’s earnings retention test;
      3. Profitable (as measured by owner earnings/operating assets) and growing businesses where growth comes from multiple sources (e.g. participating in the growth of an industry and yet growing faster than the industry due to ability and demonstrated track record of taking market share from competitors on a sustainable basis);
      4. Strong entry barriers from one or more sources;
      5. Businesses meeting basic needs of customers and their aspirational wants, the existence of which 50 years from now, is something one is very confident about today.
      6. Ability to pass on input inflation to customers without fear of loss of market share;
      6. Strong balance sheets; and
      7. Reasonable valuation.

  13. Thank you for sharing the transcript. Very thought provoking!!

    One thing that seems odd about the business is the high leverage. The Debt / Equity ratio has gone from 0.3 to 1.04 over the last 10 years. Also, the interest coverage ratio has been between 2 and 5 over the 10 years. In a business with strong free cash flows, these ratios seem odd. What would be your thoughts on this aspect?

  14. Hi prof
    just a thought …coursera.org hosts lectures and online courses on a lot of topics. have you thought of posting your course on it or some such place where a much wider audience can benefit from your lectures ?

    rgds
    rohit

  15. Dear Sanjay Sir,
    I am software engineer and hence from non-finance background(not interseted in MBA). But really want to become like WB(I mean rational allocator of capital).
    I am learning slowly about stock market investment.

    Like, I learned about working capital importatnce when I decided to start franchise store and started evaluating options from JumboKing Vadapav to Fasttrack showroom(ultimately never started anything :)).

    Your assigment for Relaxo have now added new ASTRA in my stock market investment skills. It taught me practically what should I look for in past annual reports and what Q.s we should ask in AGM. I am planning todo this exersize on some small consumer companies(although once upon a time, I tried to read Philip Fisher’s common stocks and uncommon profit, but I was not able to go beyond 1st chapter 🙂 ).

    I hope u will keep teaching like this for your non-MBA online followers.

    Regards
    Sameer

  16. Firstly, Thanks Prof Bakshi and Mr. Purohit for sharing your thoughts and giving all of us an opportunity to learn from you.

    The segment where Relaxo operates is at the bottom of the value chain in branded footwear – sandals, hawaii’s, low end sports shoes etc. From my experience, this segment is more driven by retail presence than by brand recognition. More people would buy a hawaii at the nearest footwear store that provides an option at their price point. If this assumption is true, then shouldn’t Relaxo be focussing more on increasing their distribution channels rather than spending a lot on celebrity endorsements? For them, is distribution the moat (I think so) or is it more of brand recall?

    1. Quite a valid observation Abhishek. I think branding by RELAXO is to fighout unorganised players and not other brands and hence this is going well for their strategy. Let us wait for Prof to comment on it.

  17. Sir, the following link does not seem to be working.
    “I will defer that for a later date but if you’re curious, you may want to read up
    this.”

  18. Many thanks for the excellent insights…great insights and logical explanation. thanks for the share professor.

    Most of the textile companies falls in similar league: High Sales, low profit and good brands….worth of studying deep OR falls under kinda commodity players? but not found quality of promoters promising, may be some exemptions which I am not aware of.

    1. Most textile companies have commodity-type businesses. Of those that don’t, there are some whose their brands aren’t worth anything because they have failed to deliver high owner earnings/capital employed ratios.

      A brand can have value only if it creates value for owners.

  19. Thanks a lot Prof

    This case study helped me to understand the importance of a) focusing beyond reported numbers b) Scalability of business c) Size of opportunity and d) Looking at business from 10-15 years perspective. I think many investors [including myself] are not able to visualize beyond 3-5 years and hence for stocks like Relaxo would wait till earnings get hit because of steep increase in raw material price. Thanks a lot and please keep sharing such case studies in future.

    I am struggling with one question and would be great if you could help me with this. Do you think its a good strategy to buy stocks only when there is some temporary problem and everyone hates the stock [like what John Templeton and Irving Khan suggest] or will it be too narrow focus.

    1. Buying a great business at a bargain price will deliver better results than buying it a fair price. The flip-side of that advice is that the number of opportunities to buy such businesses at a fair price are likely to be far more than the number of opportunities to buy them at bargain prices. And the cost of waiting for a bargain to emerge in an inflationary world is quite expensive.

      The flip-side of THAT is that the extra returns for investing in great business at bargain prices may offset the cost of waiting, but I have no way to help anyone predict whether this will happen in the future as well…

      My inclination is that if you have money, and good opportunities, then should let them meet provided you can think in terms of decades…

  20. Dear Prof. Bakshi,

    Firstly, thank you again for being a teacher even to those of us outside your classroom.

    I walked into a local shoe store to look at the products made by Relaxo and found them to be sub-standard on a general scale. But the financials seem to indicate a high quality business. Should not a good business produce a good (or great) product? As you can see these are conflicting points – high quality business but not a high quality product. How does one gain confidence that a situation of this nature holds a promising future (or as Buffett-Munger say, good in the long run)?

    1. Nikhil, did you compare with Nike (or other global brands) or with unbranded products?

      Personally speaking, I recently bought a pair of sandals (shifted from woodlands) and found them to be very very good.

      Personal experiences apart, one should pay attention to the aggregate buying patterns i.e. the track record. If the quality is really bad, the product will stop selling as the company is not in a monopoly business and its customers will shift to other brands if they did not get the quality they desire at the prices they are willing to pay.

      The fact that the quantity of footwear sold keeps growing (without price cuts) probably means that customers like what they are getting.

      Data on repeat customers, if it was available, would help in substantiate or disconfirm what I just wrote.

  21. Professor – do check out Prof Aswath Damodaran’s blog – where in he compares two cola makers – Coke and a generic cola manufacturer and brings out the power of a brand name and hwo it improves fin metrics like RoCe.

  22. Dear Professor

    thanks for sharing this great lecture / analysis

    I have some questions and would be greatful for your answers

    1. why is the Cost Of Goods Sold (per pair and COGS as %) falling in a year of stable oil prices and falling rupee ?

    2. are their expenses (other than COGS … operating expenses) catching up .. ?

    3. advertisement year on year with high costs continuing : still investment and NOT expense ?

    my brief workings (as a screen shot) are here http://flic.kr/p/gBmyfN

    thanks in advance
    best regards

    Subu

    1. hi subu,

      Thanks for your questions. I will try to address some of them:

      #1 ~ gross margins expanded in FY13 thanks to lower material prices (EVA & Natural Rubber) and increased contribution from higher GM products. the decline in INR you are referring to happened in FY14, not in FY13. This is there in the transcript of the lecture.

      #2 ~ other expenses include things like consulting & professional fees to Accenture, higher labour costs given that they just commissioned a new plant.

      #3 ~ Prof. bakshi explained it well here:
      https://fundooprofessor.wordpress.com/2013/09/22/the-relaxo-lecture/#comment-1341

  23. one more question professor :

    if you took total capex + dividend = inv & capital cash outflow and compare that the rough and ready cash inflow from ops, i.e. net profit + depreciation , I feel the company is negative on cash flow in 4 out of last five years

    I may be VERY wrong here, but how long can you continue squeezing customers , suppliers to gain cash flow ? and in a growing company

    Assuming flat working cap (which can’t be true for a growing company) this co is cash negative in 4 out of 5 years ? isn’t it ?

    again a link is given here http://flic.kr/p/gBrzCe

    or here http://flic.kr/p/gBrzCe

    TIA & regards

    Subu

    1. Yes, the FCF as reported in the balance sheet is negative, and that will generally be true for a rapidly growing company that has its own factories and is also creating supply chain infrastructure for a significant transformation in business, etc. The current scale of capex can support a turnover that is much larger than what is being done today….so in effect, the Company is spend capex for tomorrow drawing upon todays cash flows…the FCF should improve substantially over the next few years…where the absolute level of EBDITA will be much higher than today and the annual capex requirements, much smaller in proportion.

      It might be useful to think about this in terms of Owners Earnings, as described here (link was posted by Prof. bakshi in response to some of the comments earlier):

      https://db.tt/yYTLJxLj

  24. Dear Professor,

    Thank you for sharing the case study. I have a couple of questions / doubts.

    1. If we remove the impact of debt, the returns don’t appear as attractive. Is it possible that Relaxo is a case of a good company operating in an industry with poor economics (highly labor and capital intensive, over-capacity, potential union problems, largely commoditized at the end where Relaxo is operating)?

    2. The management compensation in 2013 is 7 crs (including commission). Given the size and profitability of company, it appears a little too high especially in light of the fact that the management are already majority shareholders. How should we view this? Can this be a corporate governance red flag?

    Best,
    Amit

      1. Sir,

        Over the 10 yr period (2004-13) and 5yr period (2009-13), Relaxo earned total EBIT of 419 & 331 crs. respectively over total funds (debt+equity) of 2,045 & 1,562 crs, implying a return of 20.5% and 21.2%. If entirely equity funded, and assuming a tax rate of 34%, this would result in post-tax ROE of 13.5% and 14% respectively. While still respectable, it is considerably lower than the 20.3% and 23.2% post-tax ROE that it has actually achieved with (if I may add) a judicious mix of debt & equity over the same period (total funds to equity ratio of 2.3 over both periods)

        Thanks.

        1. Amit, your numbers are slightly different from mine but never mind that. I agree that pre-tax ROCE is about 20% now. I think that’s impressive because: (1) 20% is far more than pre-tax AAA bond yields of about 11% at present; and (2) this is one of those “put-up-more-to-earn-more” business models meaning that this business has the ability to grow by using incremental capital at high rates of return. The return on incremental capital employed also comes to about 20% p.a. I am reminded of a wonderful quote from Mr. Munger:

          “If a business earns 18% on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

          The use of cheap debt, as you correctly pointed out, spikes the ROE even higher. However, I would rather see Relaxo move further up the value chain enabling it to earn somewhat higher margins than now, and use little or no debt.

          One more thing. Our calculations (yours and mine) are based on reported earnings numbers and one of the key points of the lecture was that those numbers understate true economic earnings, so the picture would look much better if you look at owner earnings. That’s something I will be discussing in class post mid-term exam (which happen next week and explain the pause about progress in this case over here…).

          Thanks

          1. Thank you for the explanation. As for the quote, I guess in India we need to modify it to 25% – to paraphrase Benjamin Franklin, “nothing is certain but death, taxes and high inflation” 🙂

  25. Great Work Professor Bakshi !! Thanks for the analysis you have done and the story you have built with great examples and data . Capt. Deepak Sharma

  27. Thanks a lot Prof. Re-read the entire blog and realized there is so much to learn. Some of your replies on a) How to detech structural changes in Industry b) Business which generates lof of FCF and business in which one needs to continue to invest c) Looking for companies with specific patterns are worth posting separately on a new post.

    My question in on net working captial. Receivable colletion seems to be improving and with new policy of no credit it will improve further. But what appears to me there is structural decline NWC as % of sales from 8-10% during 1999-2010 to 13-15% during 2010-13. Not sure on why inventory holding period is increasing, but regarding payables I guess it might be because there is a consolidation going on in synthetic leather industry lead by Mayur Uniquoters and other organised players. And as this players clout increase, advantage from receivables may get partly negated….

    Workings
    A) NWC as % of sales have increased from avg of about 9-10 during 1999-2009 to avg of about 16% during 2010-13. B) This is lead mainly by inventory and payables. C) Inventory days have increased from 30 days during 1999-2006 to 40 days during 2007-10 and further to around 58 days during 2011-13 [for simplicity calculated on sales] d) Payables as a % of sales is again declining from around 6% during 2005-10 to around 4.7% for FY12 & 13.

  28. Dear Professor,

    I agree that acquisition has not given return to Co.

    As I believe that when you start any business or acquire any business

    You have to have many thing on your side. Like

    (1)Finance cost

    (2)Raw Material Cost

    (3)Finished Product sale value

    (4)Employee , Energy or any related variable cost.

    This all cost can be adjusted against BRAND VALUE Cost and PROFIT can

    be improved or reduced.Without BRAND VALUE product It may take few more years

    to get good returns.When We invest by paying tax We know that 60 -80 % of TAX

    PAID get wasted but When We invest for long term investment may not perform

    for few years also.After all since I can not run business and hence I have made

    investment and ready to accept or exit from investment at loss if I find new

    better avenues of investment.I have seen many investment doen not perform for 5

    years or more but starts performing after some years also.I am not a finance guy.

    Ashok Shah ashokkeval@yahoo.com

  29. Dear Prof Bakshi,
    I was curious when I read about Relaxo Footwear in one of your blogs/articles. As far as I know its a relatively new brand in the footwear space compared to Bata. I have limited knowledge of Relaxo, so I recently tried to compare Relaxo and Bata for the last 5 years.

    I found the following: –
    1) ROCE (Ive taken the min and max in the last 5 years – the %ages are rounded off)
    Relaxo – 13-21% (approx)
    Bata – 21-36%

    2) ROE
    Relaxo-22-41%
    Bata – 20-37%

    3) Book Value Growth (last 9 years)
    Relaxo – 20.3%
    Bata – 14.9%

    4) Margins (last 5 years)
    Op. Margins
    Relaxo – 10-14%
    Bata – 9-15%

    Net Margins
    Relaxo – 3.5-6.8%
    Bata – 5.7 – 11.6%

    5) Debt Equity & Debt to Net Cash Flow
    Debt Equity
    Relaxo – 0.96
    Bata – 0 (debt free)

    Debt to Net Cash Flow
    Relaxo – 3.7
    Bata – 0

    Bata’s cash conversion cylce is better than Relaxo but Rexaxo is still good on that front. On working capital days Relaxo is better than Bata.

    Bata was earlier seen as a cheap or low-level shoe company but its nation-wide distribution, brand appeal, etc is unmatched. Contrary to popular opinion Bata has also positioned its brands such as Hush Puppies, Power, etc. Though the high-end crowd may not visit Bata stores, they may be buying these brands from swanky retail outlets. Moreover, Bata is also an international company with presence across the world.

    I have a few questions below:-
    1. Why not pick Bata stock since it has its advantages and a large brand franchise?
    2. Relaxo is good in several parameters but it fails in the net margin metric. What has caused this? Will this improve in future?
    3. Bata is debt free but Relaxo still has debt (though not worrisome), but I feel that a bad year or season and low margins could worsen its debt situation, which cannot be ignored?

    The major issue with Bata is image makeover, and if they get it right then they can target various customers ranging from mass to the premium segments.

  30. Dear Professor, I am a new visitor to your blog. Hugely impressed with the quality of discussions and the openness for listening to all the views. Thank You for sharing your knowledge.

    Regards,

    Nikhil

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