KRBL - Practical thought on practical thought - A misapplication

Disclaimer: I am not invested in KRBL or any other companies mentioned in the post below. I am not an investment advisor. I love thinking about investing, businesses and entrepreneurs, and this blog is just an expression of that love. This is an article I wrote in the past and is close to my heart. I thought it worth republishing here.

One of the titans of the investment world and one of my heroes Charlie Munger passed away recently. I will miss him. I have always admired his deep wisdom and his extraordinary ability to get to the heart of even the knottiest of the problems rapidly.

He left a large body of knowledge and wisdom to the world. To my mind, the best way to give him a tribute is to attempt to emulate his approach to living and thinking.

The below - my write-up on KRBL is one such attempt.

One of the books I enjoy reading and re-reading is Poor Charlie’s Almanack. It is perhaps the best publicly available sample of the formidable Munger mind. It is as difficult to understand as it is enjoyable to read. I have never yet completed the book. I keep re-reading specific talks again and again as each re-reading sparks new ideas.

In the midst of Covid 19, I was reading one of his more difficult speeches ‘Practical Thought About Practical Thought’ (which is his investment thesis of Berkshire’s investment in Coca Cola), and at the same time working on KRBL a leading rice company in India.

As most investors will remember, Covid was a time of immense uncertainty and my thinking was that there are few things as certain as Asians’ consumption of rice! The certainty of revenues and earnings seemed high.

I was struggling to understand Munger’s speech on Coca Coal and I concluded the best way to understand the thesis was to try and apply it to KRBL.

Repeat Disclaimer: I do not own any shares here because of the risks I perceive in the management. I am not comfortable with certain things which I have tried to capture in the ‘Risks’ section.

This note was written for my personal consumption in 2020 and I have not updated it as I think it conveys the lessons adequately.

In fact, with hindsight, it is clear that LT Foods, the competition of KRBL has done much much better in scaling up its business. While KRBL has been struggling with legal and other issues (discussed below), LT has been able to scale up its rice and other businesses as well.

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Let us understand KRBL by attempting to emulate Munger's famously educational speech on Coca Cola.

First, the problem of extreme scale - How do you turn a capital of  less than 200 crores to Rs. 100,000 crores in a few decades? And that too in a commodity industry with cyclical characteristics like rice? 

Now the above outcome is a lollaplooza outcome. In order to achieve a lollapallooza outcome in business, it would be essential to build a franchise. As Buffett says, a franchise is a business that sells a product, 1) which is needed or desired by the customer, 2) has no close substitute in the customer's mind, and 3) has no price regulation.

Keeping this in mind, we simplify the problem and decide the big 'no-brainer' questions. 

• It is extremely hard to create a franchise worth 100,000cr by selling a generic commodity. Therefore, considerable efforts should be made to ensure the development of a strong, legally protected trademark(s). 

• Next, it is obvious that success cannot be achieved unless the product is sold in multiple countries. Here, it helps that rice is a staple food in many of the Asian countries. Indeed the per capita consumption of rice varies widely between rice consuming countries - ranging from 25kg per year to 70 kg per year. The total rice consumption in the world is >450 million tons a year; India itself is a market of 100 million tons per year. Even reaching 0.5% of the global addressable market (2 million tons) can generate disproportionate value provided the earnings are of high quality. Runway is not an issue.

• Given the intent to avoid price or any kind of regulation (export restriction for example), which is common in agriculture, focus should be exclusively on high quality or premium rice, whose total sales globally is a few million tons a year.

• Also, rice is a heavy agri commodity that is 1) grown locally, 2) has large transportation costs, 3) requires considerable processing facilities and 4) is one of the major staple foods in India. In this context, it would be intelligent to dominate in the large home market of India. Given the large number of variants in rice in the country, and the large logistics costs, it would also be intelligent to focus on segments that are more amenable to premium pricing.

Given the aspiration for a lollapalooza, the problem should be attacked with every favorable factor as only a powerful combination of many factors can cause an lollapalooza outcome.

Choosing the basmati rice market:

Basmati rice satisfies all of the conditions laid down above.

• It is akin to champagne / scotch whiskey - only rice grown in certain regions of India and Pakistan, which have certain specific characteristics like - long grain, fluffiness and aroma when cooked can be called basmati rice. Thus competition is naturally restricted due to its nature as a GI crop, which also enhances the scarcity premium. 

• Aged basmati rice gives out a pleasant aroma when cooked and the grains are long and fluffy. Due to neural programming of man under Darwinian natural selection, smell, taste, texture act as stimuli for consumption. Quality basmati rice is noticeably distinct from all other rice variants and the nature of the rice itself (in addition to the calorific value) can act as an operant conditioning reward. 

• Chains of habits are too light to be felt till they are too strong to be broken. And there are few habits stronger than staple food habits, which probably have genetic and geographic forces playing together. Basmati rice is the staple food in many Middle-Eastern countries like Saudi, Kuwait, Qatar, Iraq and Iran. 

• In India, basmati has been accepted since the beginning as a premium quality rice. It was previously cooked only for royalty due to its scarcity and above-mentioned special features. At present, in India it is used in preparation of special foods like biryani and during celebrations. The aspirational and celebratory nature of the product are positives. The existing perception and features can be leveraged upon to create a strong trademark. It is easier to create a trademark for a product when it has favorable underlying features itself.

• Basmati is also not subject to material regulation by the government (exports restricted once in late 2000s and retracted). There is no MSP or no mandatory procurement from adjacent farms as seen in sugar.

Basmati has a few other important features:

• It is broadly beneficial for the farmers. It uses 50% of the water that normal rice uses while growing. It matures in a period of less than 120 days, thus allowing the farmer to grow other crops on his farm.

• The quality of the basmati rice is determined the by the time period for which it is aged. It is aged for a minimum of 6-9 months generally. Basmati rice aged for 2 years tastes considerably better than that aged for 1 year. 

• Thus, the crop is procured during a period of 2-3 months (November to January) after harvesting. Then it has to be aged for a period ranging from 6 months to two years. And only then can it be sold. This implies a long working capital cycle which in turn leads to the conclusion that a strong balance sheet and low interest costs can be a major competitive advantage.

• Also given the industry is purely market driven, there can be cyclicality in paddy prices. High paddy prices in one year can lead to higher sowing and push the paddy prices in the subsequent year. This cyclicality in the context of long inventory holding can be very dangerous. And the only antidote to this problem is to develop a strong brand which allows pricing power.

Developing a strong trademark is thus imperative for two reasons - to ensure survival by tempering the effect of cyclicality, and to generate stability of demand and pricing power which would increase the quality of earnings. To develop a strong trademark it would be advisable to use all forms of honorable Pavlovian conditioning. Human beings are social beings who like to celebrate. We will use celebration and togetherness coupled with taste and authority bias to condition our customers to stick to our brands.

Given flavor is an important part of the product, it is extremely important to ensure quality paddy is procured and aged for the right amount of time.

While such conditioning (through advertising and other means) and ageing of paddy will cost a lot of money, it would benefit to spend material money for as far ahead as possible. As we expand steadily in the premium rice market, the competitors would encounter vast disadvantages of scale in buying advertising and in ageing to harness the Pavlovian and operant conditioning they need. Scale is a major competitive advantage in any business. And so we will harness this fundamental force in other ways as well - like procurement, processing capacities and distribution. We will do this while maintaining a strong balance sheet to avoid risk of ruin.

It would make sense to create a distribution network as wide as possible. Given the scattered nature of buyers of the product , and the high logistic costs per unit for the product, the higher volumes can provide extreme cost advantages for distribution. Another advantage of ensuring the product is available as widely as possible is to ensure that the operant and Pavlovian conditioning created by us is not will not be extinguished by competing products.

So how did KRBL do?

KRBL followed all the prescriptions above so far and maybe more. While they did flirt with normal rice briefly, they spent majority of their energies into the basmati industry building up scale prudently. They acquired the largest rice processing plant in the world at Dhuri at a distress price of 15cr and then upgraded it by spending a good sum of money. 

They also foresaw the potential of Pusa 1121 as a grain which required less time to mature, required less water, had better yields and was more disease resistant over the traditional basmati, while maintaining the aroma and the length. Understanding the potential, they marketed it heavily and got it recognized as basmati variant. This had a major impact on the fortunes of KRBL.

Today they are the largest player by far in the basmati industry with the largest procurement, processing capacity, warehousing capacity, basmati seeds business, distribution network, which all led to considerable market share. 

Today they possess 35% market share in the domestic branded basmati segment with volumes approaching 400,000 tons. In fact, they are the largest advertisers by far in the basmati industry with more than 50% advertising spend share. KRBL is the largest or among the largest players player (through their brands) in many export markets as well - Saudi Arabia (#2), Kuwait (#1), Qatar (#1), UAE (#1) and others. Their cumulative volumes (domestic and exports) are together approaching 6 lakh tons which compares with the total India basmati sales of  44 lakh tons. They are by far the largest player in the niche basmati market. 

While the volume market share is 14%, we can be reasonably sure that their profit share in the industry is much higher than 50%.

KRBL today has a wide portfolio of brands targeting different customer segments of which perhaps India Gate (65% of current sales) and Unity are the strongest. In fact the strong brands that they have developed, particularly India Gate - which is almost a household brand in India and certain export markets - allows for brand extension. The company is doing brand extension to enter other related areas like regional specialty rice, super foods to leverage the brand strength. The intent is to position 'India Gate' as a premium health brand. The strong brands thus provide interesting optionality.

In addition to being the largest with the strongest brand, they have further strengthened their competitive advantage by having the lowest cost structure as well. This was achieved in multiple ways:

• Economies of scale leading to lower per unit costs: The scale benefits are really important and provide considerable competitive advantage. And KRBL enjoys the benefits across the entire value chain.

• Partnering with the best-in-the-world rice processing equipment manufacturers: They have long-term partnership with leading equipment manufacturers through which they get customized machinery that maximizes the head rice production. Processing of paddy results in production of head rice and broken rice. Head rice is the higher realization rice and only head rice can be exported. 

• Contract farming of 250,000 acres which allows them to control both quality and reduce costs.

• Basmati area mapping which allows them to procure high quality crops at low prices. They know what prices are possible in the current year and which area is producing higher quality crops.

• Integrated operations where all by-products are utilized to generate revenue. Husk is used to generate power which is internally used. Other by-products are used to produce rice bran oil, furfurral alcohol, etcetera.

Note on procurement advantage: 

The procurement and logistics network form a really vital leg of the company's competitive advantage. KRBL scores highly over the competition here. 

India has a fragmented farm base and so it is not easy to procure a large volume easily. Next, it is not easy to figure out the quality of rice. While in many other markets, one needs to just ask a trader to dispatch the required quantity of paddy and not worry about the quality. But in India, particularly in agriculture, trust cannot be that blind. Almost every paddy bag has to be checked to ensure that the right variant of rice was dispatched and that the quality of the variant is good. This is not an easy endeavor. 

Through its system of mapping the entire basmati growing area (which allows them to figure which area has better quality basmati in any year), its large scale of volumes, its deep institutional knowledge of the industry, its contract farming network (250,000 acres), its seeds business (30% of basmati seeds sold in the country) and its extensive warehousing facilities (2.5 mio sq ft for rice and >5 mio sq ft for paddy) it enjoys a much lower cost than the competitors. Its policy of paying farmers quickly (payable turnover of >15x) is also a major advantage.

The procurement and the warehousing capability provides KRBL further low cost advantages in addition to the scale driven low unit cost advantage.

Indeed, it is the extremely difficult procurement coupled with the working capital intensive nature of operations that has led the industry to be the graveyard for many companies. The business has hitorically seen the entry and quick exit of many multinationals including ITC, HUL, Cargill, Olam, Pepsico. Pepsi in fact spent years in the business but could not succeed. Even new entrants like Patanjali and Adani are unable to crack the market successfully. 

It is not just MNCs who are unable to succeed. Many other basmati focused companies too have fallen by the wayside - REI Agro, Kohinoor, Shaktibhog, Pari, etcetera have become extinct due to the nature of the industry and their lack of focus (diversification, over leverage, fraud etcetera).

It says something about the barriers to entry and success of the industry when both MNCs with large wallets and local with seeming skill are unable to succeed.

GST Benefit: The government levied a 5% GST on branded agri commodities while non-trademarked products did not have to pay any GST. 5% is a huge difference in price and many brands decided not to trademark themselves to avail themselves of the price advantage. This led to many copycats entering the market which led to an adverse impact on many brands. KRBL trademarked its 'India Gate' brand and it is a testimony to its pricing strength that it has seen volumes increase after an initial dip despite the price disadvantage.  Thus GST had a dual advantage: it killed much of the competition while confirming the pricing power strength of KRBL brands.

Things to be avoided:

Maintain independence / Never outsource the core part of the business: In basmati, the quality of paddy procured, the cost of procurement, the proper ageing (ensuring crops are not lost due to pests or other reasons) for the appropriate amount of time is pivotal. Quality paddy aged well ensures quality end-product which enhances customer stickiness. Low cost of procurement and careful storage are required to ensure profit margins.

As Deden says, independence is a major component of durability for a company. In that context, KRBL should never attempt to outsource this critical component of their business at any point in time in the future.

Envy and pride: Basmati industry has seen many upstarts who have increased volumes quickly (and eventually not survived). The management of KRBL has shown considerable skill in navigating the basmati industry which has historically been a graveyard for many companies. It has also seen many incumbent FMCG players enter the segment as well (some of whom have failed). This can understandably lead to the all-too human emotions of envy and pride. The below commentary provide some comfort that the mgmt is on the lookout for this risk:

"We looked at many other companies and how they have fared in their diversifications in the past also. There was a group called Kohinoor, they started all these pulses, atta, rice, tea and all, and they failed miserably and lost everything and lost focus on rice. Similarly there is a recent example of a company called Shakti Bhog which was excellent in atta. THey came into tea, pulses and plenty of other products. They lost their focus in rice, in atta and they are also in big trouble. We feel there is big scope in rice. 

We are thinking about other products, it is not that we are not thinking, we want to ensure that we start it properly. We do not want to end up in the same shoes as Kohinoor, Shakti Bhog and others. Whenever we come into new products we will come into it in a very scientific manner."

"From the beginning, we have been basmati people. Now (2018-19) we have started looking at other segments because the brand has become so strong. And it is the want of the retailers and distributors that we should enter the premium segment of non-basmati. I'm again repeating, premium segment of non-basmati where MRP is 100 plus. I'm entering those specialized segment, non-basmati rice, which are specialties of certain regions. We want to go into those varieties only. I am not doing everything non-basmati - only segments where I can make reasonable margin."

"It is easy to increase volumes in basmati if you loosen the credit terms. But for us, the margin can be anything, we will not give any goods on credit. It is through LC or cash against document that we do most of our business. In our history we have not had any bad debts."

The study of the history of basmati industry indicates that self-control and discipline is a major competitive advantage in the industry, and here the mgmt of KRBL score quite heavily over others.

The capital allocation of the promoters has been quite above average as they have raised funds when needed and with strategic partners. For example, the funds they raised from Balsharafs (a large distributor in Saudi) helped them in two ways - funds to strengthen balance sheet and also incentivized one of the largest distributors in one of the largest basmati markets in the world to ensure the success of KRBL. 

The focus on only branded business while the competition was doing a lot of unbranded and private label business also indicates their capital allocation intelligence and discipline.

However the capital investment in the power business can be assessed as good or bad. The rice business was generating excess cash which the mgmt decided it best to invest in renewable power due to the incentives at that time which gave them IRR of above 20%. But the argument could also be made that it is outside their circle of competence.

The management has also bought back shares in the past and have never pledged their stake in the business. The promoters stake has increased from ~50% in 2007 to 60% today and might increase to 63% soon. This shows real skin in the game and avoidance of unnecessary risks.

Financials: 

Since 2000, KRBL's sales has increased from 215cr to 4,100 cr in 2019. The operating pre-tax profit has increased from 12.5cr to 715cr. It is important to note that the tonnage sold has increased only from 340,000 tons in 2006 to 590,000 in 2019. 

This disproportionate increase in profits despite not so high increase in tonnage was helped primarily by the improving product mix (higher basmati, higher head rice, and higher branded), increased efficiency of operations (in-house power, better machinery), increased scale of operations and strong balance sheet (allowing for low interest costs).

It is interesting to observe that the KRBL's cost structure is much, much superior to its competition. Their COGS (due to better procurement), per unit operational expenses (scale and efficiency) and interest cost (excellent balance sheet management) all together create a strong advantage over the competition.

All this together come together in the strong quality of earnings as indicated the pre-tax RoE which has increased from the range of 14%-20% last decade to around 30% in the last few years. There has been dilution only two times, way back in 2005 post which there has been no dilution. In fact, as mentioned there was a buyback in the beginning of the decade.     

Why KRBL numbers can be trusted

• The market share data is calculated by AC Nielsen and is used by competition as well.

• Company has paid an amount of 1,650cr cumulatively as cash taxes, cash interest and shareholder return since 2012. Given the amount of scrutiny, it is difficult to fake these.

• Total debt levels at each year end ranges between 1,000cr-1,400cr and then reduces to almost 0 by September. Once again, given the base rates of the industry (bankruptcy pattern) and the amount of scrutiny at KRBL, this indicates actual cash coming in and debt paydown.

• The company's cash outflow for taxes has increased 4x since 2013, and DTLs are not material. Why would the company pay increasing taxes if they are fudging numbers?

• Promoters have never pledged stake, and have only increased their ownership steadily over the years.

Valuation:

Since 2006, KRBL's pre-tax realization per kg has improved from 21 to 72 currently, the pre-tax PBT per kg has increased >10x to 13. The sales volume does not seem to have increased a lot but the quality of volumes have become better with more branded volumes, higher basmati sales (as compared to non-basmati) and  steady increase in domestic volumes.

The key questions are - in 15 years, what can happen to the pre-tax PBT per kg of branded rice? Can it double? Will increasing barriers lead to better pricing power?

Next, can the total volumes of basmati sold increase over time and can KRBL reach a volume of 1.5 million tons due to increasing per capital income of Indian consumers and other factors? 

Risks:

When you mix raisins …: KRBL has had a pattern of mixing up with not so great people. 

• The long-time auditor Mr. Vinod Bindal was in the CBI list of undesirable contacts. The auditor was subsequently changed to Walker Chandiok.

• The erstwhile board member, Gautam Khaitan has been arrested for kickbacks for arms deals. He was on the board of KRBL for 5-6 years. Due to his involvement with KRBL, it has been subject to IT raids (2 to 3 times) and has come under the scanner of ED (which has annexed land worth 15 cr in Punjab).

• The above could also be the reason the IT dept filed a 1,200cr tax suit on the company.

• The whole thing culminated in the ED (Enforcement Directorate) arresting one of the founders Anoop Gupta in a money laundering case (and subsequently released).

There is no smoke without fire. While the mgmt seems to learnt its lessons, it is difficult to come out of ED and similar department scrutiny once you fall into it. This is a major risk as there is uncertainty on how this will pan out.

Agri business related risks of politics and rain: Politics is a huge deal in agriculture. In the name of farmer protection (and vote-bank) illogical things have been done in the past. That is an ever-present risk in the investment. Similarly rainfall is a major necessity for agriculture in India. This is also a major risk.

Iran and Middle-east: Iran imports 1/3 of basmati rice exported by India. Given the geo-political risks if something happens in Iran it can impact the industry heavily. Similarly, if oil weakens, it can impact middle-east demand which together forms 75% of basmati exports.

Can habits be changed? What if reducing oil prices coupled with high basmati prices lead to other rice variants replacing basmati? While not an immediate risk, it cannot be discounted. It seems like basmati itself replaced rice varieties from America and other places a couple of decades back. (link)

Execution issues in Saudi Arabia: Saudi Arabia is a major basmati rice market and KRBL’s brands used to dominate the country. But over the last many years the company has lost its position due to the business weakness of its distributor there. They had one distributor to distribute all their products in Saudi who went through business issues and they have not been able to find an effective replacement. The reliance on a single distributor in a major market and the inability to find a good replacement is a risk.

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