Pattern recognition as an investing framework
In life & in investing, few successful patterns repeat itself. We just have to make an effort to recognize & validate it. One such investing pattern is – Emergence of New Sub-Sectors.
When a new sub-sector emerges from a matured sector, it typically tends to grow at a higher rate than the matured sector.
For example:
- The API sub-sector emerges out of the Pharma sector
- Housing finance companies emerging from NBFCs
- NBFCs from banking
- AI emerging from IT
- EV from Automobiles
- ESDM from Electronics etc
You got the gist, right! It often begins with a mature company demerging its new business segment, leading to the formation of new companies that focus solely on this emerging area. We are interested in these growth themes and aim to participate in their growth.
Stocks like Kaynes in the ESDM sector (which is a sub-sector of the Electronics sector) is what we’re talking about.
What is Kaynes?
They design and manufacture electronic parts. Their product portfolio includes Cluster PCBA, Engine Control Panel, Endoscopy Cart, X-ray Machine, LED Headlamp, etc. They serve industries like Automotive, Industrials, Railways, Medical, Aerospace, IoT, etc. I think you get the gist of what they do—they manufacture parts of electronic devices that we use in our daily lives.
Kaynes was founded by Ramesh Kunhikannan in 1988 with its HQ in Mysore. His wife, Savitha Ramesh, joined the company in 1996 and now serves as the Chairperson. Promoters currently own 57.8% of the company.
The company’s recent notable accomplishments include supplying electronic systems to power Chandrayaan-3. They have eight manufacturing plants and two service centres.
Global ESDM – A Trillion-Dollar Industry
There is a large ESDM industry out there—globally around $1 trillion, with India at only about $25 billion.
*Source: Kaynes Investors Presentation Q3FY24
You see that innermost circle (or oval) labeled as the Indian ESDM Market, which is expected to grow by 34% to reach around $110 billion from the current $25 billion in the next five years or so. That’s it, that’s the story. And that’s why we like this ESDM industry.
You may ask, but why is such growth expected? After all, we’re talking about an entire industry growing at roughly 35%, not a particular company. What’s driving this?
Answer: Government incentives.
If India imports more than it exports, it impacts our current account deficit (CAD). The government doesn’t want the CAD to get out of hand, so it keeps an eye on what we’re importing the most—crude oil (~29%), gold (~10.8%), and electronics (~9.7%). We can’t do much about oil and gold, so they focused on the third item: electronics.
They started incentivizing companies to design and manufacture domestically. They have provided import substitutions and a PLI & DLI grant of Rs 76,000 crore for the ESDM sector. Good enough to get the ball rolling.
Value vs. Volume: Picking the niche
Just like contract manufacturers in other sectors (pharma, manufacturing, etc.), EMS players have also created their niche in individual segments. They either play the game of high volume, low margin (HVLM) or choose the side of low volume, high margin (LVHM).
HVLM focuses on producing a few types of products in large quantities, maximizing efficiency and capacity utilization, which is commonly seen in consumer electronics and IT hardware. On the other hand, LVHM emphasizes quality and customization for specific needs, ensuring stability and premium pricing in industries like automotive, medical devices, and aerospace.
Kaynes leading the growth & profitability
Among the listed peers in ESDM space, Kaynes has delivered the strongest growth (3Y revenue CAGR at 45% and PAT CAGR at 112%) with the industry leading margins at 14%.
You may ask, how come Kaynes manages to clock much higher margin than its peers? The answer is in its product mix. Kaynes segmental break-up looks like Automotive (38% of revenue), Industrials (27%), Railways (14%), IoT (12%), Medicals (6%), Aerospace (2%). More than 60% of their overall revenues comes from LVHM product portfolio.
The margins may further increase, as Kaynes is looking to increase their LVHM portfolio and venturing into Semiconductor segment.
OSAT segment: Key growth driver
As a natural progression for a ESDM player, Kaynes is also looking to enter OSAT (Outsourced Semiconductor Assembly & Test) sector. They are looking to set up an OSAT facility with a planned capex of 5000 Cr. Initially it was planned to set up in Telangana. However, due to some delay in the approvals, it has moved to Sanand, Gujarat. The same place where CG Power (7000 Cr) & Micron Technology (20,000 Cr) is setting up their OSAT facilities.
The company had raised 1400 Cr via QIP in Dec 2023 to fund the new OSAT facility and other planned expansions in Mysore & Manesar plants.
Let’s talk about high PE
Did I just opened a pandora box?
Nevertheless, go to screener and search for Kaynes. You will be disheartend to see the PE (TTM) at 115 times. I am not saying this is high PE or low PE. And hell no – this is not BAAP (Buy at any price) as well. I am far against it. Let me explain.
Any company in its high growth stage commands a high PE. And here we are talking about the industry growing at 30%+, not just individual stocks
We had seen this in multiple cases (Either, Page, Bajaj Finance, DMart etc). As long as the growth sustains, the market will continue to give them the premium. Emphasis is on two words – growth sustains. If the growth comes down, the market starts to derate the PE eventually, that’s the rule of the nature. So, if we expect this growth rate to sustain over the next 3-5 years, we may still have a decent compounder in our hands.
As of now, the company is trading at a one year forward PE of around 80 times. If we can zoom out a little bit more, and if they get this OSAT and PCB manufacturing right, we are looking at an estimated revenue of 4000 Cr and PAT of around 400 Cr by FY28E. At this stage there is very little room for error for both the company & for the investors as well.
Q4 Results Update:
- They have cash of 1540 Cr on the books. The order book is at 4115 Cr, and the average order value is 0.92 Cr. The management expects margins to improve in FY25 as the product mix will focus on high-margin products like Industrials, Medicals, etc.
- The company has received new orders in railways for the Kavach segment. They expect to generate cash flows of 200-250 Cr in FY25. EVs, smart meters, and power electronics can be major drivers for its Industrial and EV segments.
- OSAT is in the final stages of approval (expected after elections). It is expected to contribute to revenues in the next three years. The management has guided for 60% revenue growth in FY25 with a margin expansion of 100 bps. The working capital has decreased from 99 to 83 days in FY24 and is further expected to decrease to 72 days.
To summarize:
- ESDM is the sub-sector currently in its high-growth phase, with the industry itself expected to grow at 30%+ CAGR over the next couple of years.
- Kaynes is into the Low Volume – High Margin product segment, having better growth, margin profile, and a net debt-free balance sheet.
- OSAT will be their next focus area. With a capex of 5000 Cr (mostly funded by internal accruals), the OSAT facility is coming up in Gujarat. They are awaiting final approval.
- They did a QIP of 1400 Cr to fund the OSAT and PC Board expansion in Mysore and Manesar plants.
- Priced to perfection. No room for error at current valuations.
For those who would like to watch, here is the video summary:
Subscribe to the Focused smallcase for access to the full portfolio
Disclosure: Kaynes is part of our Capitalmind Premium Portfolios. This article is for information only and should not be considered a buy or sell recommendation for any stocks.
