Shilchar Technologies 11/03/2024

Transformers, why are they important?

Business Model

Shilchar Technologies manufactures transformers. They make different kinds of transformers but most of the revenue comes from manufacturing power and distribution transformers. Most of their customers are private sector companies which want transformers to increase or decrease voltage on a grid. The company is now trying to increase its presence in foreign markets.

Founder and Management

The company is run by an 60 year old electrical engineer called Alay Shah. He started the company way back in 1991 or so. His sons are also involved in the management of the company. His elder son is also an electrical engineer. The family owns about 70% of the company and have no plans of reducing their equity. They do not have a very good second tier of management. But they have been able to retain people for many years without offering any kind of ESOPs. So I do think that the management is skilled in hiring and retaining talent which is needed for them to run a profitable operation. Alay has also a nerd’s resistance for doing cookie cutter stuff. He started tinkering with specialised transformers for the renewable industry a while back and therefore has been able to make a name for the company in this niche.

Product

This is a manufacturing operation. Their only product is called a transformer. A transformer plays a very important role in the whole electricity supply chain. It is responsible for collecting electric current from the power generating source like a solar farm. And then the transformer changes the voltage of the electric current such that the electric current becomes compatible with its onward journey on the electricity transmission grid. When the electricity reaches close to its destination, there is another transformer which now again modifies the voltage of the electric current so that the electricity becomes compatible with the device or appliance which is going to use up that electricity. Now there are different types of transformers needed for different purposes. For example a power generation plant using coal would require a different transformer as compared to a power generation plant using solar power. And our company specialises in building transformers for the renewable industry. Shilchar builds transformers, physically moves them to the site of their installation and then receives money from the buyer after a pretty long credit period. I am not sure if the company also get an Annual Maintenance Contract also for maintaining these transformers. Or if they have any software or app through which the health of the transformers can be measured in real time.

Distribution

I do not know much. I am assuming they have salespeople who go out and meet companies which are looking to put up captive renewable energy infrastructure to power their factories. Shilchar recently made some hiring in Europe too. I think they are trying to hire more salespeople across the world now to increase their sales to the export markets. With the new FTAs being signed with countries like UAE, Australia, Oman, Switzerland I think we should see more hiring in new foreign geographies.

Brand

This industry gives you a brand automatically if you have survived for more than 10 years. The buyer is very conscious of only buying from a reputable operator because the equipment being bought is very expensive and mission critical. This company has better margins than the industry. This is a good proxy for determining the power of any brand. They do not have much of a B2C brand which is also not needed. The company does not spend a ton of money on brand building or marketing. The company is trying to position itself as a manufacturer of customised and specialised transformers for the renewable industry.

Financials

The company is debt free. Capex is being done right now - all with internal accruals. OPM has increased from 7% a couple of years back to 20%. Revenue is going up 50% year on year. The main problem is that trade receivables are an also going up in the same ratio. And the cycle for trade receivables is not reducing. This sort of puts an upper cap on the growth possible because the working capital that the company can raise at competitive rates will always be limited. This ability to raise working capital will only rise as much as collateral (trade receivables) go up. So the company would have to may be dilute equity to support hyper growth. Company has a history of paying 10% of annual profits as dividends.

Bull case

The promoter will realise the massive opportunity in front of him and put up sales people across the world and also buy more land and other inputs to increase the potential of manufacturing to support the demand. The promoter will also start hiring higher quality second tier management and give them ESOPs to make them a true partner in the hyper growth of the company. The company will also start new product lines ( for eg higher rating transformers) and therefore get a larger share of wallet of their existing clients as well as open a new segment of the total addressable market.

The company would also use IoT to improve the ability of real time monitoring and diagnosis of a transformer. The company will be able to monetise this kind of monitoring by charging higher AMC prices. The company would also start hedging its currency risk and commodity price risk. The company will get into partnerships with other global manufacturers like Siemens to improve access to technology and distribution.

The company would use the additional cash generated to either build more capex or to do regular buybacks to increase long-term shareholder wealth. I would be happy if the company takes the first option.

Bear case

The company will continue to operate like a conservative family business minimising any risks that it takes. They will stick to their current product line and be satisfied with whatever growth falls into their lap. The promoter will figure out new ways to increase his share of the annual profits of the company. Interest rates may continue to stay higher for longer and therefore people would be less reluctant to put up more renewable generation capacity as it involves higher up front investment.

China could also make a comeback. The relationship between India and China or US and China will improve and the Chinese will again get unfettered access to these markets. Due to extensive Government subsidies, the Chinese manufacturers will be cost leaders and therefore the company will find it extremely hard to compete with them.

P.S. My internal blogs/drafts for this post are below.

Disclaimer: The views expressed in this blog are personal. I may or may not hold investments in the stocks mentioned.

Monday, 4 March 2024 at 8:17:41 AM

So I read about this company on Valuepickr. It has recently started generating very good YoY revenue and profit growth. But what caught my attention was that its expertise in connecting the grid to renewable sources of energy generation. And I started digging. Here is my understanding of the company and the industry right now.

First let’s go back. Let us talk about electricity. Let us first talk about the time when there was no electricity. We still had machines. Human beings understood that a machine is anything which reduces human effort. So imagine if you have a toddler who is crying because he is feeling too hot in the month of May in Delhi. Now try to generate a cool gust of air by using your hands. You make a lot of physical effort but the result is not that great. And you tire after a while. Compare this to a hand held fan. You apply a little force to the fan with your hand and you generate a lot more cool air as compared to your effort earlier. And you get tired very late. So human beings understood that they can increase the quality of their effort by using machines. They can use machines to reduce their effort or to increase the output or both. And so we started to build machines for everything. For example using a machine powered by water to grind grain into flour. In this machine water fell from a height and turned a mechanical turbine and that allowed physical movement of a millstone up and down. And you generated wheat out of grain.

So humans figured out that natural phenomena like wind and water had force. Physical force that could be used. Like when you stand under a waterfall and try to keep your hands raised in front of you. But the water falling from a height has such force that your hands keep falling down. Or when you are driving your car at a high speed, let’s say 90 kilometres an hour, and then you roll down the window and feel the force of wind in your hair. But along with this force, human beings also figured out something called a gear. A gear is basically a wheel which can turn and anything attached to it will also turn. Let us understand this with the help of a windmill. Suppose I want to extract oil from oilseeds. I can either manually use a blunt object to hit those seeds with force and extract oil. This is the most basic way to do it. Or I can setup a windmill. And connect that windmill to a gear with a rod (also called a shaft). And then connect a blunt object to that gear. Now whenever there will be wind, the blades of the windmill will turn, and then the shaft will turn and then the gear will turn and then our blunt object will go up and down and strike the oilseeds with force and extract oil which can then be collected in buckets and used. So we started figuring out ways and means to use gears in everything. And we also started to figure out that can you put together machines with multiple gears. We figured out that we can also adjust the force applied by using multiple gears. For example we figured out how to use multiple gears to build a compass which always pointed south. It was a non-magnetic compass. This compass always told you which direction was south because when you built the compass you set up the multiple gears in such a way that as your chariot moved, the gears also moved in a way to adjust the indicator such that it kept pointing south.

But then we found out that physical force is also present in other natural phenomena. Especially steam. If you physically store water in a kettle, and then put a lid on top of it without sealing the lid and then apply a lot of heat to the kettle by burning coal. What would happen? The water would turn into steam inside the kettle and the steam would start applying physical force (physical pressure) on to the lid. After some time so much steam would build up that it would demand that it be released and then the lid will come off. And the best part about steam was that we could get it by boiling water. We had already discovered fire by then. With windmills the problem was that they only worked when there was sufficient wind. But you could generate a fire by burning wood and you controlled the presence of wood. You can store wood. How do you store wind? And then we discovered that we have something even better as compared to wood. We have coal. Coal had a lot more carbon than wood. So you could generate a lot more energy by burning 1 kg of coal as compared to 1 kg of wood. So we started burning coal and generating energy and then using that energy/physical force to make other machines. The best example of this is a train powered by steam engine. You put people in boxes and the box in front of that train was known as the engine room. In the engine room you store a lot of coal and then keep burning that coal to generate physical force which moves the first box in a given direction and the remaining boxes are dragged along.

Ok. So now we found out that physical force can be generated using either phenomena like water and wind (which we can’t control) or coal (which we can control). And we obviously plan a lot better when we can control inputs. And therefore all machines started moving towards coal as the fuel. But we still did not have any way to use the energy generated by coal or firewood over long distances. If you wanted to use that energy in a machine then you had to be physically present with the machine where coal was. So we started thinking. Is there a way that we can generate energy at a single location and then transfer that energy over long distances to where we would eventually need to use that energy.

And then came electricity into the picture. Let me offer a simplistic way of understanding this. Everything in our world is made up of atoms. Each atom has a nucleus at its centre which is made of protons and neutrons. Each atom also has electrons orbiting the nucleus. Electricity is the energy we get from moving loose electrons from one atom to the next. When these electrons move through a transmission wire we call it electric current. We figured out that what we can do is that we can burn coal in a single central location, and then boil water and then use the steam from that boiling water to turn a turbine. What is a turbine? A turbine is basically a machine which has blades. When we push steam on to the turbine, the steam pushes the turbine at a very high speed. Or in other words you can say the turbine starts spinning at a very high speed. So let’s just pause here. We have reached a point where the turbine is spinning very fast. So coal burns and turbine spins very fast.

Now, there is a magnet linked to this turbine. This magnet also spins whenever the turbine spins. And there is a loop of wire around the magnet. This loop of wire (or coil) is usually made of copper. Copper atom has a very loose electron. This makes it very easy for electrons to move through a copper wire. So let’s pause again. Coal burns which makes the turbine spin which makes the magnet spin and the spinning magnet makes electrons travel very fast in the copper wire around the magnet.

Now from this copper wire the electrons are then put into a transformer. This is a machine which is like a toll booth. It basically understands the pressure at which electrons are being generated by the copper wire around the magnet which is attached to the turbine. Now the transformer then does its job. It transforms this incoming electric current. The transformer is connected at the other end to another wire which will now travel a long distance. May be 100s of kilometres. The transformer understands the push it needs to give the electric current so that the current can move along the transmission wire without much of the current being lost in between. Ok let’s pause again. So coal burnt, steam got generated, a turbine spun, a magnet inside the turbine spun, electrons (or electric current) got generated in the copper wire around the magnet, transformer took the electric current from the copper wire and then sent it to the transmission wire in the electricity grid. This is where we are. Now this is not the end of the story.

Now, the electric current travelling on the grid is travelling with a lot of pressure. The electronic devices we use at home can’t take that much pressure. So what happens next. At the end of the first transmission wire is another transformer. This again acts as a toll booth. It reduces the pressure with which electrons will travel further. So this second transformer reduces the pressure of electric current and then passes on the electric current to another wire which comes into our home. This is the essence of how electricity works. Of course there are more complications to this. For example there might be multiple transformers and transmission lines before electricity reaches your home. But our point here is made. That humanity discovered it can transfer energy from burning coal over long distances. But this in itself was not enough. And then came the motor. A motor was basically a machine which spins when it receives electricity. And anything connected to it will also spin. So for example the fan you have in your home. It has a motor in it. So does the washing machine. So we figured out how to use motors in our homes when plugged into the electricity supply. There are also other devices which dont have a motor and still use electricity. For example a TV or a kettle. These also use electricity for something or the other. For example a kettle or a lightbulb would apply electricity to generate heat. A TV would use electricity to power its systems so that any data received by the TV using its antennae can be processed and displayed.

So this in a simplistic way is how electricity is generated and transferred. Now the generation till now was mostly using coal. Obviously the byproduct of producing electricity this way is a lot of air pollution. But this wasn’t really much of a problem till now. The earth did not have so many people and also we were not using electricity for so many things. So even if there was some air pollution we were ok with it. But then as the world started becoming more equal, people started demanding the same quality of life everywhere. Indians also wanted computers and microwave ovens as much as Americans. So we are now in a situation where demand for electricity is going up. And we are figuring out even more ways we can use electricity. For example my electric car has ensured that my electricity usage has gone up by 20%. At the same time doing logistics for coal and electricity is becoming cumbersome due to land becoming more expensive everywhere. You need to move coal physically from where it is mined to the power plant. And the power plants are spread all across the country. And we are dedicating more and more railway lines or trucks to transfer coal. And then the technology to somehow offset the air pollution from coal is too expensive. And therefore right now humanity is trying to figure out if we can replace coal with something else. Coal has some great properties. It is cheap to mine. It is cheap to transport. We have a lot of expertise in how to use it end to end. A lot of our coal requirement is fulfilled from Indian mines, some of it is imported. Coal works in all weather conditions. And most importantly we know that if we burn a particular quantity of coal at a particular temperature then we will be able to comvert a fixed quantity of water into steam. And then we can predict the rate at which electricity will be produced by the coal we have. This makes the job of the transformer pretty easy. Remember the transformer collects electricity from power plant and then pushes that electricity to a wire so that it can be transported miles away. The pressure at which this electricity will come to the transformer is predictable when it comes to coal. But this changes when we switch coal with renewables.

Sun and wind are currently our two primary sources of renewables. And both don’t give any guarantees about the rate at which they will be available. In fact their intensity changes every second. Sometimes wind will blow for 40 km per hour and then at 10 km per hour the next minute and then at 80 km per hour the next minute. Similarly when the sun is shining brightly you are producing a lot of electricity. But then a stupid cloud comes between the solar panel and the sun. And suddenly your electricity generation from the solar panel falls drastically. So now the transformer is confused. Why is the power source behaving so erratically? And that is what our company Shilchar Technologies does. They manufacture transformers which can work with both renewable energy as well as fossil fuel energy.

They have been building transformers for more than 15 years. But it was only in 2015 or so when they got into building transformers which can work with renewable energy. Renewable energy itself has picked up pace in India since then. If the world has to meet its emission targets by 2050, then we have no other option but to reduce our dependence on coal. This needs a lot of work across many fronts. We need to keep getting better at capturing energy from solar and wind. We need to keep getting better at the batteries which can store that energy. Right now the batteries are very expensive. This works out when you want to buy a car. Since a car does not use battery very intensively. Like the battery in the car knows the maximum and minimum power which can be drawn from the battery by the car at any time. But if I were to similarly first store all the energy produced by solar and wind and then release that energy to the grid as per my requirement, then the cost of that energy would become very high to me. The battery I would to store all that energy is extremely expensive today per unit of electricity. One possible solution to this in the future is green hydrogen. Basically what we are now trying for is to figure out if we can use solar power to split water into hydrogen and oxygen and then store the hydrogen thus produced in big cylinders. Then later when we need to put electricity on the grid, we can burn this hydrogen and then generate electricity. To produce green hydrogen today we need to pass water through a sieve. These sieves are known as electrolysers. The price per kg of hydrogen thus produced is expensive today. May be around 6 USD per kg. We are trying to make this cost <1$ per kg in a few years. Even if that does happen, we would still need to do massive changes to the grid. Essentially we need to increase the length of the grid and also upgrade the current grid to accommodate green sources of power. Let us see how.

We need to increase the number of transmission lines. This is because electricity will now be generated in many places. Wherever you have sunlight or wind or green hydrogen storage, you will generate electricity. And similarly you will continue to have demand for electricity everywhere in the country. So on the one hand you have supply coming and therefore more transmission lines are needed to connect that supply to the overall grid. On the other hand, demand is also going up so you need to put more transmission lines. For example think of a new SEZ which the government of Odisha may be building in a remote part of the state which is also close to the shore. So this explains why we would continue to add more transmission lines. And that automatically means more transformers.

The other reason is that even the current transmission lines will require upgrade. Suppose you have a transmission line running from Mumbai to Thane. Now let’s assume that 20 years back per capita consumption in Thane for electricity was x. During these 20 years the population of Thane has gone up and so has the number of use cases involving electricity. So the transmission line which was laid 20 years back, would it continue to be fit for purpose 20 years from now. Even though it may not be near the end of its life. But you simply need a power line which has more capacity now because suddenly the demand has jumped. And you have limited supply of land. So it makes sense to just upgrade the current transmission line by replacing it with a transmission line of 50x capacity or something like that. And again new kinds of transmission lines will require new types of transformers.

Even the technology used within transformers is changing. Now you have sensors which sit on the transformer that can monitor in real time about gas or oil discharge, overheating in the transformer, etc. As part of monitoring of infrastructure there are two things you need to do. One is you need to do detection. You need sensors to let you know that something is not right. For example the quantity of transformer oil is lower than recommended. But now in the next few years in addition to detection, we will also start having diagnosis. So software (may be AI) will monitor all transformers of a network as well as all sensors on each transformer to come up with a diagnosis on what exactly is going wrong. What is the underlying reason for the transformer oil being lower than it should be. Is the transformer asking for more oil because the moisture in the air around the transformer much higher as compared to last year? Right now transformers are not very smart. I think they will get there.

This industry favours incumbents. People buy transformers with the expectation that if they maintain the transformer well, then the same transformer would run well for decades. And when you are purchasing something for decades you definitely want to buy from an experienced operator. You dont want to take a punt on a startup. So this is in favour of our company. This industry also requires lots of labour and expertise. Transformers have a core and wires are manually wrapped around that core. So there are broadly two types of transformers. There are power transformers and distribution transformers. A power transformer has a lot of capacity as it takes power directly from the power generator. A distribution transformer is cheaper, smaller and has lower capacity and is used to draw electricity from the main transmission line and pass on that electricity to your home. I am still studying whether our company specialises in power or distribution transformers. The manufacturing of distribution transformers is more automated as you have standards in place. The manufacturing of power transformers is more customised as you need to take into consideration the nuance of different types of power generators. Is it renewable or fossil, etc?

As with many other things transformers right now are in heavy demand all over the world. This is an industry which has a globe spanning supply chain. For example there is a certain type of core which is needed inside a transformer called CGRO core. India’s demand for this core is 3,00,000 tonnes annually. But we only manufacture 50,000 out of it. And that too has started recently. We need to buy the remaining from the rest of the world. Similarly there may be certain other metals like copper which are import dependent today. Post covid the supply chains of the world are in flux. As a result the lead time for transformers has changed from 70-80 days to 1 year or so. If Shilchar can use this time to massively increase its production capacity as well as its sale capacity, then I think this company can 5x revenues and earnings in three years. But I also understand why the promoters may be sceptical. Transformers are expensive. And all expensive things become difficult to buy when interest rates remain high. Will the world sort of slow down its deployment of renewable energy because the upfront investment is a lot more as compared to traditional energy? Will that mean that demand for renewable energy transformers not see the kind of pick up expected. What would happen to all the capex that the company would have put up in the interim especially for renewable energy transformers? The promoters have a taste for running a high ROCE business. They would hate to get into a capex and then hope that capacity utilisation comes about. That is why you don’t see big ticket announcements from the promoters. They are expanding but taking baby steps by using their own accruals to do so instead of debt.

Let me study the company a bit more and update this thread.

Thursday, 7 March 2024 at 5:42:59 PM

So I have been spending a lot of time reading annual reports of Shilchar. These seem to be the only source of learning about the company. They don’t do any mass market marketing at all. And communication with shareholders is bare minimum. So I started reading the annual reports hoping that the organisation would at least detail out the progress of the business in the annual report. However even the annual report remains sparse. I mean you would not find them violating any regulatory guideline. The annual report would have the director’s report and cash flow statement and management discussion and analysis, etc. But not much colour is provided within that. For example significant portions of the management discussion and analysis would be exactly same year on year.

But anyways. We study what we have. So this company starts with a father who sowed the seed of the Shilchar Group. His name is Jitendra Shah. He had a son called Alay. There is another son Ashesh. But he stopped being a part of the business in 2015. So Alay actually studied electrical engineering and then joined his father’s business. Alay is about 64 today. He has been involved with the current company for more than 30 years. And Alay is the whole and soul of the business today. Along with his immediate family he has more than 70% of the business. At least till 2018. Now the business makes transformers. They have a plant in Vadodara and they have kept expanding that plant as and when needed. Around 2015 things were not going so great. Alay used to draw a salary of about 50 lakhs from the business. Revenue growth was tepid. Competition from the Chinese and Korean in the domestic market was very tough. Also, BJP government was still finding its feet. Power sector as a whole was ambling along. There was not a lot of bank funding also available. The whole NPA mess had not been sorted. In this situation Alay and team were also just going with the flow. They were still doing exports. Around 40% of the revenue was coming from exports. Actually let’s take a pause and talk about exports.

Manufacturing a transformer with higher capacity is a laborious job. Why is that? So how a transformer works is that it has a core inside it. This core is made up of some metal. Usually it is a special type of steel called electrical steel. Now there are wires which are manually wrapped around this core. You can’t have machines doing the wrapping. Each higher capacity transformer requires customisation as per the need of the client. For some reason this is not a very standardised industry. I mean why is that? For example the electronic appliances we use at home are the end users of electricity. And all our electronic appliances follow some standards. For example we know that which electronica appliance will go in the regular socket and which one would require a power socket. But the transformers throughout the electricity supply chain vary. Kolkata electricity board may require a transformer with 400 KV capacity whereas in Delhi you may need 600 KV or in New York you might need 800 KV. Now therefore world over manufacturing transformers is something which requires human intervention. So automatically India gains in this because we have skilled labour which costs much less than the same skilled labour in the US.

So Alay realised this early and therefore he has experience of exporting transformers for many years (even before the theme of China + 1 gained ground). And it seems that being export ready is not very easy. I heard a panel discussion on the Industry forum Trafotech. Everyone was crying about how the customers in foreign markets are extremely demanding. They would refuse to take delivery if there is even a small inconsequential welding issue in the transformer. And Indian manufacturers are known to cut corners. And therefore the typical attitude would be to make sure that all the components are great, but dont worry if the presentation and craftsmanship around it is not 100%. I think it also has to do with our lack of branding sensitivity. Somehow in our culture branding and marketing are considered unnecessary skills. We believe that our product quality should speak for itself. But how will the client appreciate what is inside the transformer body if the external body of a brand new transformer shows some bits of rusting due to a bad paint job. And Indian manufacturers are not even being forced to change their ways. They are finding so much business from the cost conscious Indian clientele, that most of the domestic industry is ignoring the global opportunity. Shilchar has been doing exports for a long time. And they continue to focus on the export market along with the domestic market instead of doing a cop out and stating that there is only so much that they can do.

So the company finally started doing well 2016 onwards. The raw material prices were stable and revenue was increasing due to power capex finally starting to revive in the country. Specifically the Paris accord was signed in 2015 which committed the world to net zero in a few decades. India was also a signatory and the BJP government started really pushing renewable energy. Actually India faces two problems. One is that we have a growing population and therefore our power demand continues to go up. Also, that population is trying to find more ways to use electricity in everyday life. Second problem is that we do not have a lot of natural gas. We only have a lot of coal. And producing electricity using coal is polluting. So what can a government do. What is it that India has an abundance of which can be used to solve our growing hunger for electricity. And that is where the sun comes in. We are blessed with sun cover as a country because of our tropical geography. And that is what the government really started to push post Paris 2015. Now as mentioned in my previous blog renewable energy requires different kinds of transformers as compared to non-renewable energy. And that is what this company understood well. They figured out how to make transformers which are suitable to the renewable power generation industry. And that is when they started discovering their niche. And that niche just kept on getting bigger after 2015. India started putting up more and more renewable energy and the world also did the same. And then the company just started expanding its production capacity. In fact in 2017, when the company still had not realised a lot of profit from the renewable industry, the company took a bet and put up fresh 3X capacity. Imagine running a company for 20 years (company got listed in 1995) and then suddenly taking a call to increase your capacity 4 times. And that too in a single year. Today the company is reaping benefits of that. In fact they have just announced fresh capacity expansion since they are again at almost 100% capacity utilisation within 5 years of their last capacity expansion.

I still have a lot of questions about the company. The biggest one is whether they make most of their revenue from power transformers or distribution transformers. As I understand it, every power generation plant of a decent size would need power transformers to take its power to the grid. And usually power transformers have their capacity measures in MVA. But on Valuepickr someone had summarised the recent notes from a meeting the company had with investors. In that they mentioned that most of the sales for the company come from selling transformers with a capacity of 66 KV or less. But only distribution transformers are measured in KV. So either the company is not selling power transformers to the renewable industry. Or the renewable industry does not require very heavy capacity power transformers and they only need low capacity distribution transformers? But then how do such low capacity transformers help the renewable industry to put power on the grid which needs a much higher voltage? I am trying to understand this. Let us see.

Company does not have a big problem of bad debts. They do have to wait many days for payments to come in. But usually they get all the money they are owed. Only in one year did I find that they wrote off trade receivables of 5 crores or something. The employee costs of the company are in check. The median salary was around 2.4 lakhs in 2018. The total employee strength was 105 people. Wages were around 4% of revenue. Major cost item is obviously the raw material of copper or aluminium or steel. This is a risk to the company. In cycles where the prices of these commodities goes up the company should see some pressure on their margins. Let me write back more after I read the remaining annual reports of the company.

Monday, 11 March 2024 at 1:20:25 PM

So I have now read a few more annual reports all the way up to 2023. One thing is clear to me. The management is extremely conservative. They take on debt only for capex and then as soon as they generate any cash flow, they pay off that debt. So what has suddenly changed for the company is that they have started receiving a lot of foreign orders. In FY2023 about 50% of the revenue was from foreign orders. This led to massive improvement in profitability. And the primary reason for the same is the difference in gross margin. So if you take out the cost of raw materials then any domestic orders give the company a gross margin of 15-20%. On the other hand export orders give them a gross margin of 50%. Without any great increase in cost. So the overall volume that the company is doing has not increased by a lot. I figured this out by looking at the units of power consumed. The same is declared in the notes to the financial statements. It is a good proxy to figure out whether revenue is increasing due to increase in price or increase in volume. But the power units consumed have only gone up by 15% or so. Whereas revenue went up by 50%. Now there are a few obvious questions.

First is how much capacity does the company already have and how much of it is currently utilised and how much more capacity can the company build quickly. So the company currently has 4000 MVA annual capacity and they are scaling this up to 7500 MVA by July 2024. They are at about 100% capacity utilisation right now and with the rate at which they are growing (50% annually in revenues), I am expecting them to quickly consume their 7500 MVA capacity too. So the good thing is that the land which they already have allows them to scale up to 30,000 MVA which is 4x their capacity in July 2024. So the company does not have any immediate problem in scaling up their producing capacity to meet the demand in the market.

Next is what is driving this increased demand. My opinion is that the usage of captive renewable capacity by industries is growing massively now. I say this because Shilchar does not work with any government clients. They mostly work with private clients. But the private sector in India is a minority player when it comes to transmission of power or when it comes to the discom business. So what is the private sector going to use their transformers for? Also, the company’s transformers are of small capacity (remember majority are 66KV or less). And yet their business is growing at 50% y-o-y. How? My sense is that private sector companies have realised that captive renewable power generation is now much more reliable as compared to lets say 10 years earlier. The equipment, the technology is all now mature enough to give entrepreneurs the confidence that they can start using renewable power generation within their own industrial complex to power their machinery. One more reason could be compliance with green energy standards being set by the EU. So a few years back EU started making claims that how they are reducing the amount of carbon emissions within their own geographies. For example the amount of carbon that Germany was emitting in the year 2000 per unit of GDP was far greater than the same number in 2020. So what happened? How did EU actually reduce carbon emission and at the same time continued to increase their GDP? And the answer is that a lot of the physical things which were produced in the EU started getting produced in Asia. Think about car headlights. If I am assembling a car in the EU today and I want to buy headlights for that car, will I decide to produce the headlights myself or will I ask someone else to produce them. And where am I likely to find a supplier for headlights who offers it to me for cheap but at the same time does not compromise on quality. And the answer has been Asia. And therefore Asia started doing a lot more carbon emission and therefore on paper you saw that how fast carbon emission intensity has come down in the EU. So climate activists started reminding the EU that climate change will not stop just because the EU has physically shifted its emissions to some other country. And therefore they started pushing the EU to somehow convince their asian suppliers to reduce carbon emissions as well. Now how could the EU do this? After all they have very limited control over their Asian suppliers. Also, green technologies were not really efficient. So it did not make sense for Asian suppliers to move on to inefficient green power. But that is not the case anymore. Green power is very efficient and reliable today especially when using it captively. And that is what Indian industry is now doing. There is a company called RACL Geartech. They produce car parts in Noida. They mostly export to EU. Recently they have announced that they have built captive revenwable energy generation to power their own factory. The EU is now also sort of using tariffs to force asian suppliers to start using green technology. And RACL Geartech is a testament to that. They realised that they will become uncompetitive due to tariff barriers in the EU if they do not start using green power. This may also be a malign way for EU to enforce its technology domination. I do not completely know the facts yet. I am still exploring this angle. Is the EU pushing for green power because the patented technology to produce green power is owned by the EU? Even if that is the case, for now it makes sense for suppliers to shift to green power. And I suspect that is what is pushing industries to figure out their own sources of green power and not completely depend on the grid for green power.

And I think this is the niche that Shilchar is trying to exploit. They built small and medium power transformers which need to collect the electric current being created by many solar panels and then step up the voltage so that the electric current can be used to power the machinery of a factory. Each factory is different and each factory using different machinery and therefore the voltage at which electricity if required is different. Also, each factory has different physical space. Therefore the number of windmills that can be put or the number of solar panels that can be put is different in each factory. And therefore the transformer to step up this electricity has to be different each time. And this is the reason that demand for customised transformers is going through the roof right now. Shilchar has been specialising in transformers for the solar and wind energy for about 10 years now. And now finally the demand is coming in for their competence. Also they have a strong balance sheet which can fund their working capital requirement as revenues continues to grow up fast. This is an industry where you have to give credit. And therefore as a manufacturer you are constrained when revenue is growing fast but you dont have the ability to borrow from banks to fund your working capital requirement. That is not the problem with Shilchar. They are debt free today and have a lot of plant and machinery and land against which they can borrow. And they can also borrow against their receivables. They have not resorted to bill discounting till now. That would impact the margins. But why do they need to? They have easy access to financing.

Another thing working in our company’s favour is that they have a track record. They can point potential customers and ask them to check out renewable energy transformers that were installed 10 years back at a client site and are still working fine. You need a track record in this business. People find it extremely tiring to change their power generation mechanism repeatedly. And therefore they won’t mind paying more for a reputed supplier and that is what Shilchar is.

The business is run by the promoter Alay today. He is nearing 60. His elder son is 34 and has been working at the company for more than 8 years. For now the family seems do be doing a decent job of running the company. They have started taking out more money from the company though. I dont mind this. But I do want some understanding of how are they going to structure it. For example till now Alay was taking a fixed remuneration from the company. Suddenly as profitability went up, he has started taking 3% of profits too in addition to his fixed remuneration. Also the company has started buying expensive cars of about 2 crores or so. So I dont know when again will the promoter increase his own compensation or that of his family and what exactly is the framework that he is going to follow for this. Also there is a private company ‘Nile Transformers’ which has the son as a director. This company is also in the business of manufacturing and selling transfomers. So I want more clarity regarding this company. What is the requirement of this company in addition to the listed company which is owned by the family? Shilchar sold transformers of about 1.3 crores to this private company. But I dont know what were the margins in that transaction. This is not a major red flag. But I am hoping that the company will clarify the nature of this relationship.

This company will continue to do well as long as they maintain their focus on building customised transformers. The west suddenly wants to replace China for all its imports. Indian manufacturers who respect product excellence and honesty should continue to get a lot of business from this company. I will keep monitoring the progress here.