77 thoughts on “The Relaxo Lecture”

1. f0084ri says:

September 22, 2013 at 18:10

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?

o fundooprofessor says:

September 22, 2013 at 20:58

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.

 NR says:

September 23, 2013 at 14:16

 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?

 fundooprofessor says:

September 23, 2013 at 14:38

See this:

http://www.ipab.tn.nic.in/023-2013.htm

Thanks.

 NR says:

September 23, 2013 at 15:35

Thanks. I (and probably the learned counsel too) didn’t

know that the law requires more than just being first to
register a trademark.

 f0084ri says:

September 23, 2013 at 16:19

 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.

 fundooprofessor says:

March 31, 2014 at 23:18

Update: http://www.bseindia.com/xml-
data/corpfiling/AttachLive/Relaxo_Footwears_Ltd_310314.pdf

Relaxo now owns the brands.

2. Satyajeet Mishra says:

September 22, 2013 at 19:23

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
o fundooprofessor says:

September 22, 2013 at 20:50

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 thisdocument 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.

 Satyajeet Mishra says:

September 22, 2013 at 23:15

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

 fundooprofessor says:
 September 23, 2013 at 06:51

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.

 Ravi Purohit says:

September 23, 2013 at 08:09

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.

 fundooprofessor says:

September 23, 2013 at 08:14

Thanks Ravi. You said all this in class but the “transcriber”

was inefficient.

 Satyajeet Mishra says:

September 23, 2013 at 10:53

Thank you, Ravi sir, for the fantastic explanation. Added

even more clarity

 red. (@theredcorner66)says:

September 24, 2013 at 01:04

 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.

 Jazz says:

January 30, 2014 at 11:54

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 ?.

3. prabhakarkudva says:

September 22, 2013 at 21:38

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.

o Ravi Purohit says:

September 23, 2013 at 12:02

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!

 prabhakarkudva says:

September 23, 2013 at 12:48

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.)
 Ravi Purohit says:

September 23, 2013 at 16:17

@ 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.

 fundooprofessor says:

September 23, 2013 at 16:21

Agreed. The scope of this project is not about investment

attractiveness or otherwise of the stock. Rather, it was
about the quality of the business model.

 prabhakarkudva says:

September 23, 2013 at 16:35

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.

4. Varadha R says:

September 23, 2013 at 03:35

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 ?

o fundooprofessor says:

September 23, 2013 at 07:17

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.

5. Saurav Jalan says:

September 23, 2013 at 06:17

 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.

o fundooprofessor says:

September 23, 2013 at 08:11

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.

6. Saurav Jalan says:

 September 23, 2013 at 10:04

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.

o fundooprofessor says:

September 23, 2013 at 18:26

Saurav,

These are the ones I loved:

http://www.amazon.com/Financial-Shenanigans-Third-Edition-
ebook/dp/B0026HPHW6/

http://www.amazon.com/Financial-Warnings-Implementing-Corrective-
ebook/dp/B001NPEC8M/

http://www.amazon.com/Creative-Cash-Flow-Reporting-
Sustainable/dp/0471469181/

7. prabhakarkudva says:

September 23, 2013 at 11:44

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?

o fundooprofessor says:

September 23, 2013 at 13:42

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.
 kishoremarodia says:

September 23, 2013 at 15:54

Seems whole group has bumped up the stock for today atleast by 9% on a

day when market was bleeding high!

 prabhakarkudva says:

September 24, 2013 at 08:14

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?

 fundooprofessor says:

September 24, 2013 at 14:44

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.

 prabhakarkudva says:

September 24, 2013 at 14:54

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.

8. Dayanand Deshpande says:

September 23, 2013 at 15:29

This post has already raised Relaxo price by @ 11% today while sensex is down by 1.8%.
Cheers!
9. Harbeer Chadha says:

September 23, 2013 at 17:26

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.

o fundooprofessor says:

September 23, 2013 at 17:41

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.

 harbeerchadha says:

September 23, 2013 at 21:49

Thanks Prof.
I am amazed and impressed by your clarity of thought.

10. ashwinidamani says:

September 23, 2013 at 17:56

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.

o fundooprofessor says:

October 20, 2013 at 13:17

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.

11. abmahendru says:

September 23, 2013 at 18:53

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?

12. Rohit Chauhan says:

September 24, 2013 at 02:40

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
 o fundooprofessor says:

September 24, 2013 at 14:49

Rohit, inertia and opportunity costs prevent me, but the technology and its

scalability beckons me. Thanks for the nudge.

13. in time says:

September 24, 2013 at 10:28

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

o fundooprofessor says:

September 24, 2013 at 11:46

Of course I will Sameer. All the best.

14. Abhishek Basumallick says:

September 24, 2013 at 14:39

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?

o kishoremarodia says:

September 25, 2013 at 20:17

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.

15. wannabeinvestor says:

September 25, 2013 at 00:56

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.”

o fundooprofessor says:

September 25, 2013 at 06:38

 Fixed. Thanks.

16. Jagan Mohan Reddy (@JaganEngr)says:

September 25, 2013 at 22:17

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.

o fundooprofessor says:

October 15, 2013 at 08:44

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.

17. anil1820 says:

September 26, 2013 at 17:59

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.

o fundooprofessor says:

October 14, 2013 at 13:56

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…

 Anil Kumar Tulsiram (@anil1820)says:

October 14, 2013 at 14:19

Thanks a lot sir

18. Nikhil Eldurkar says:

October 8, 2013 at 23:26

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)?

o fundooprofessor says:

October 14, 2013 at 14:09

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.

19. Karthik Rajeshwaran says:

October 12, 2013 at 23:42

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.

20. supiramani says:

 October 13, 2013 at 18:42

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

o Ravi Purohit says:

October 15, 2013 at 10:33

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
21. supiramani says:

October 13, 2013 at 19:25

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

o Ravi Purohit says:

October 15, 2013 at 10:40

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

22. amit khetan says:

October 14, 2013 at 17:16

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

o fundooprofessor says:

October 15, 2013 at 00:57

Amit, please substantiate 1) with data.

As for 2) see https://fundooprofessor.wordpress.com/2013/10/12/oo1-to-oo3/

Thanks

 amit khetan says:

October 15, 2013 at 15:11

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.

 fundooprofessor says:

October 16, 2013 at 21:37

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

 amit khetan says:

October 16, 2013 at 22:33

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”