10 questions for Opto Circuits ManagementWe are very impressed with what Opto Circuits has achieved so far. Opto makes a sweeping entry into the final shortlist that our in-depth process for hand-picked stock-picks throws up. There were a few questions that came up during our detailed analysis on Opto Circuits, its prospects, and risks as we see it. (of course that was based on published sources and without the benefit of a meeting/interview with Management). We put forward these questions to Opto's Management with a request for a meeting/visit to Opto.We had a very productive session with Mr. P. Bhaskar CFO(02 Feb 2009)- this certainly helped us appreciate Opto Circuits and its prospects, better. We engaged much deeper on our factory visit and 2nd round of discussions (25 Mar 2009) spending nearly 4 hours at Opto in discussions, looking at flagship products, and going around the factory. Mr. Vinod Ramnani, the MD spent more than an hour openly sharing his thoughts and answering questions on everything that we wanted to probe and understand better. What are the longer term plans? "We are ambitious. We have been growing at a fast clip. The Invasive and Non-Invasive market, where we operate in, is ~$12 billion. We are not even anywhere near close to any percentage points here! So in 5 years, we will be a $billion plus business. That is the Target. We believe we can continue to grow at the fast clip that we have till now, constantly moving up with higher value-accretive business models." Follow-up question: That is an ambitious Target allright. In order to reach there, you will have a Roadmap and will need to cross some significant milestones. Could you share some of that with us, please? "Yes, we will need to execute our plans and cross a few significant milestones. Opto is now reasonably known in the Medical Devices space. We have engagements with the largest OEMs to the biggest players in this market. There is constant interest from some of this biggies in taking advantage of Opto Circuits capabilities. If China is the first choice for outsourced manufacturing, India is certainly the next. There are huge opportunities, and we have big plans. Some of the bigger players are in regular touch with us for taking things forward. Infact, we want to invite the biggest players to come and get their entire line manufactured here. Another significant milestone is in executing our plans on continuous forward integration. Some of these can only be shared as developments take place. Wait for them!" 2. Opto Circuits has obvious strengths in low-cost manufacturing base –which it has been gradually augmenting with acquisitions like Altron, and the SEZ plans. With EuroCor and especially Criticare it is also gaining a foothold in the patents-led medical electronics product segments. Where is Opto Circuits key focus? Or do these dovetail somewhere? "Well obviously both are equally important growth areas for Opto and offer huge potential. So the focus remains twin-pronged one could say. In the short term, the SEZ plans are primarily aimed at tax efficiency. You see by FY10 we are on course to record Rs.300 cr in profits, implying a tax outgo of around 90 Crs. So it makes sense to invest Rs. 100-150 Crs in the SEZ plans and augment manufacturing capabilities." In the longer term, these are critical to achieving our ambitious targets, as we discussed before. This could be very big if some of our plans take off. Unfortunately the economic environment coupled with policy uncertainities have hampered decisive action, for now." 3. Opto Circuits competes against huge companies with finances and resources far greater than it itself can assemble. Nihon Koden (10x), Boston Scientific (90x), Medtronics (150x) bigger in annual revenue sizes. On the other hand Opto enjoys margins/returns almost twice and in some cases several times itscompetitors. Why wouldn’t one of these competitors go after acquiring Opto Circuits? "Opto Circuits promoter shareholding was 30.50% as of Dec 31 2008. As you are aware, on January 12th 2009 another 5,40,000 warrants were converted to an equal no. of shares and alloted to Mr.Vinod Ramnani, CMD and Promoter - Director, OCI at Rs.360 per share -adjusting for the two intervening bonuses in Oct 2007 & Nov 2008 -at ~Rs.140 a share. Besides other promoters have also been consistently buying from the market. The Promoters are completely committed. They are aware that Opto Circuits is at an inflexion point - the last two acquisitions - EuroCor and Criticare have catapulted Opto Circuits into the next league -if they can successfully execute their plans for the next 2-3 years, there's huge growth potential -waiting to be tapped. The original 4 promoters are at the helm of the company and surely, not looking to sell out! They are all the time looking at increasing their equity, as you would have no doubt noticed from some recent transactions too. Opto Circuits is listed in India. The takeover code doesn't make it easy for acquirers. The Promoters plus friends & family have roughly 45% shares. An acquirer will have to afford acquiring 51% from the open market!" Follow-up question: Mr. Ramnani, would you clarify why you chose to convert 5.4 lakh warrants at such a high premium. Our estimates show you could have picked up at Rs. 70 from the market "Unlike how many people think, this was a no-brainer for me. From a principled standpoint, I wanted to honour the commitment. Had the market boomed at the time of warrant conversion, I stood to gain significantly. Why should it be different in the reverse case. The money would accrue to the company if I convert, but would go away to some 3rd party if I bought from the open market. But be assured it made perfect sense from a financial standpoint as well. Purchasing such huge numbers from the market couldn't be done at prices you mentioned. The whole transaction would have taken prices to significantly higher levels. And don't forget the 10% paid on allotment would have been forfeited. So do you think you would do otherwise for some small gain of Rs. 20-30??" 4. AMDL(60% owned) and MediAid (wholly-owned) are subsidiaries of Opto. Each contributes ~10-12% of overall revenues. But they operate on very thin margins ~2-4% as compared to Opto’s ~27-29%. Why would an efficient management make lots of money in one company and no money in another? Are they purely reseller organizations? Please explain the sales process, direct/indirect sales, and the accounting process. Sorry about forgetting this. We wanted to take this up with the Marketing Head, but ended up spending so much time on the rest, that it slipped us. I will probably take in an emailed reply, soon! 5. Opto Circuit’s Debtor days are very high at ~220 days (Opto standalone). This is significantly above the industry norms. Nihon Koden’s (108), Boston Scientific (66), Medtronics (89) debtor days. Even accounting for 30 days shipping too, this is a big disadvantage. Debtor-days have shown a deteriorating trend over the years (92, 141,131, 194,172,185 days –consolidated FY03 to FY08) What are the reasons? What are management plans on this? "Opto Circuits products, though penetrating some markets rapidly, are still some way off from acquiring significant marketshare. Sales are driven primarily through distributors -MediAid in the US, AMDL in India, and distribution network of subsidiaries like EuroCor and Criticare, besides independent distributors. Terms usually get set as per norms set in individual markets. for ex. in India leading hospitals like Wockhardt and Apollo demand 120-150 days. In the US it is around 90-120 days. Shipping accounts for another 30 days for the non-invasive segment. The bigger players with dominant marketshare are able to get significantly better terms. Opto is slowly increasing its market share; things should get better as market penetration rises. Efforts are on to bring down the debtor days from around 180 days to about 170 days. However in the immediate future, next 2 years or so, there is unlikely to be any significant improvements due to above cited factors. Having said that, Opto's products are needed for critical care; there's a certain dependency on these products. Besides as far as sensors are concerned -these are primarily the disposable patient-charged products. There is very minimal risk of defaults as customers are typically very big OEMs and leading hospitals. There hasn't been any significant bad debt ever, except for the one odd instance of some 16 lakhs in the balance sheet." Follow-up question: Understood, but this does not explain why the trend has consistently deteriorated every year? "You see in the earlier years, Opto's revenues comprised mostly of OEM sales. The business model and payment cycles were naturally different. But as we introduced Opto branded (MediAid) products in the market and had to deal with distributors ourselves, the business models and payment cycles had to be extended. As you would know, Medical Devices market is heavily dependent on the strength of your distribution network. In any market that you want to enter, you need to enagage with atleast #1 to say the #5 distributor. And to push products in categories overwhelmingly dominated by the big players, the distributors want/need extended terms. That's the reality. As Bhaskar has mentioned before, we don't see this picture changing much -it will stay in the 170-180 days range- in the medium term. However this has not been an overriding concern for us. We factor this in in our working capital costs, and our high-margins business model ensures we can absorb these. Having said that, with a product like DIOR, where we are the only product with CE approval, things may well be different!" 6. Purchase/Sale of goods from Subsidiaries -28 Cr/31 Cr (2008). 27Cr/67 Cr (2007). Sundry debtors 33Cr (2008), 52 Cr (2007). Please explain the basic nature of relationships with subsidiaries and the terms of payments. "Opto operates in 2 significantly different product segements -Non-Invasive and Invasive products. The distribution sales force, skills and efforts needed are significantly different. All our subsidiaries AMDL, Eurocor, Criticare utilise their own network of distributors, except for MediAid's distribution network which is company owned. There is some rationalisation sought to be leveraged from merging MediAid and Criticare distribution networks." 7. Operating Cash flow FY06 marginal and FY07 negative. FY08 ~39 Cr. Minus the blip in FY07, Free Cash flow/Sales has been in the range of 4-6%. Free cash flow at 6% of Sales – is this sustainable in the next few years? What are the committed/planned capex layouts for next few years. Criticare & EuroCor will see increasing commitments? "Opto Circuits has been managing accruals judiciously. We have managed capex requirements mostly out of internal accruals so far. Even for the recent Criticare acquisition of the $68 mn requirement, we utilised $52 mn debt, with the rest coming from internal accruals. The blip in operational cash flow in FY07 was in parts on account of the additional dividend outflow. As your report too mentions Opto Circuits has an exemplary record of rewarding shareholders through bonuses and increased dividends. How many companies in India can boast of a 46% dividend payout record? Investors should be happy! It does appear that we should be able to manage free cash flow at existing levels in the near future." Follow-up question: What are the planned capex for EuroCor and Criticare in FY09 and FY10? "Yes there are significant investements we are making in both these subsidiaries. The investments are in Capex as well as for the approvals process, conducting workshops, trials and promotions with doctors. Yes, Free Cash Flow will be impacted. However for a business of our size, that is growing at the rate that we are, we need to invest heavily in business expansion, else we will suddenly find ourselves wiped out! Every growing business needs to re-invest aggresively in the business - all that they have and more. You would have seen that we have been judicious with our resources. In the current economic environment, we will continue to be judicious in the way we allocate our capital and resources." 8. Criticare has a substantial patents portfolio (approved and pending) and EuroCor too has some patents. The invasive stents business, for example, is particularly mired in litigation. Boston Scientific had legal settlement charges of $75 Mn (CY04), $780 Mn (CY05) and $365 Mn in CY07.. Similarly Medtronics Inc. incurred legal settlement charges of $654 Mn (FY05), $40 Mn (FY07), and $366 Mn (FY08). Will Opto Circuits need to provision significant amounts - patent infringement protection /claims of infringement risks -as it engages and competes with the bigger players? "Yes, we are aware of this and are proceeding with due caution. We are filing for patents as needed. The DIOR product -where we are the only one with the CE approval -is the latest product for which we have filed a patent. Provisioning for patent infringements/claims (which needs to be done) is not what is so worrying to us. We have to be very careful that we are able to take care of these significant risks while effectively operating and competing in the market." 9. There is huge foreign exchange related exposure. Imports (ranging between 40-50% of Sales) provides some natural hedge. EOU sops end in 2010. Is the natural hedge sufficient? What’s the progress on the Mysore and Hassan SEZs? When will it be operational and what are the plans? "First on the Forex hedging issue. As you know, hedging is a double-edged weapon. A judicious amount is necessary, but too aggressive a position can be disastrous, as many companies have found out this year with the rupee depreciating severely. We have some amount of natural hedge because of our heavy imports (40-50 percent of sales). We are happy with that at the moment. But we do seize opportunities when we can. You see the Criticare debt we had taken from SBI at Rupee terms at ~Rs. 38 a dollar. We are looking to cap repayments at current levels ~Rs. 52 or less, a dollar. Now as for progress on the SEZs, all is dependent on the government policy. The land is already acquired form KIADB and available. We are waiting for the clarity/announcement in extension/termination of the EOU exemptions -which is expected soon, probably by June. In the event of termination of the exemptions, we have some transitional plans, for example, using rented space out of the Vizag SEZ in the transition phase. We are exploring other options too." 10. Finally, when will Opto Circuits abolish Dividend cheques by post, and start using the ECS facility??? "This is an aberration, I can assure you. We are certainly going to revert back to the ECS facility."
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