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Guest Post: The Royalty Mess at Kaveri Seeds, by Ravi Duggirala

This is a guest post by Ravi Duggirala. Ravi Duggirala is a budding value investor and an ardent admirer of Warren Buffet, Charlie Munger and Prof Sanjay Bakshi. (Full Bio Below)

In 2002, Mahyco Monsanto Biotech (India) Pvt. Ltd (MMB) a 50:50 Joint venture between Mahyco (Maharashtra Hybrid Seed Company) and Monsanto introduced BT cotton technology in India. BT cotton seeds have higher resistance to bollworm, a pest that has often killed the cotton crop in India. In 2007, Monsanto has developed, the Boll Guard II which is protected under an Indian patent. The company sub-licences the same to seed manufacturers in India like Kaveri Seeds, Ajeet Seeds Limited, Nuziveedu Seeds and 46 other companies.

Price Controls

The BT cotton seeds have been subject to various price controls over the past 10 year and the recent one being a reduction in the maximum selling price (MSP) by the Maharashtra govt. In June 2015, the govt. of Maharashtra had issued a G.O fixing the MSP of BT II cotton at ₹830 per packet, a straight 100 cut from its current MSP. This G.O was challenged by the Seed Industries Association of Maharashtra, in the Bombay High court and the court has upheld the decision of the govt.

Limit

On the other hand, the governments of Telangana and Andhra Pradesh have capped the seed prices at ₹930 per packet for the past few years. Recently they have also mentioned the procurement fees (money that has to be paid to the farmer who produces the seed) and the trait fee/royalty (amount to be paid to MMB, the technology provider).

Costs

Wait! The seed companies have paid around ₹185 per packet as the royalty for BT II seeds for the past 5 years which is much higher than the trait value fixed by each of the three state governments. Why did they do that?

On this point, it’s interesting to hear what the management of Kaveri Seeds has said in the conference call- “The royalties were fixed in 2010 level and we never opposed to the technology provider or to the government and always we were requesting to increase the prices. But the parliament clearly mentioned this time that these are the prices which the government has fixed for this year and we (seed firms) will not able to increase the prices on the backdrop of last year’s draught and we cannot pass it on to the farmer. So they said clearly “we are not going to increase the prices this year”. They have clearly guided the seed companies “this is the royalty portion what you need to pay, if you pay excess that is up to the seed companies and them but as a government this is what it is.”

  • So the Indian seed firms haven’t worried about the trait value all these years in the anticipation of a price hike! But now with a very low possibility of raising prices in the near future coupled with bad monsoon and lower acreage, the major seed firms have decided to stop paying the trait value to Monsanto.
  • An arbitration petition was filed by MMBL against the seed companies with the allegations of breach of contracts resulting in payment dues of ₹400 Cr. MMBL also claims that most of the season’s sale happened before the government order.
  • In response to this, the seed companies have filed a counter affidavit, stating that they have paid more than ₹1300 Cr to MMBL since the year 2010, which is in excess of trait value stipulated by the government and they want that money back!

Let’s look at the possible outcomes-

Outcomes

Outcome#1: Govt. controls neither the MSP nor trait value

It’s a win-win situation for both Monsanto and the seed companies. Monsanto as per its bilateral contracts with the seed companies can fix a trait value and the licensee firms can sell the seeds at a price which gives them decent profits after paying the royalty to Monsanto. This is an extreme
outcome and the possibility of it happening appears to be remote as such a free pricing mechanism would raise fear of MMBL abusing its dominant position in the market.

Outcome#2: Govt controls the MSP but does not interfere in fixing the ‘trait value’

This is an interesting scenario. The probability of this outcome is strengthened by the fact that governments cannot legitimately regulate the technology fees set in private contracts. The govt can consider various factor including ‘trait value’ in determining the MSP, but it as such cannot fix the trait value.

The recently issued GO by the Telangana govt reducing the royalty payment to ₹50 from ₹90 has already been stayed by the high court of Andhra Pradesh.

Outcome#3: Govt regulates both MSP and Trait Value

Did something like this happen in the past?

Yes. In 2006, the Monopolies and Restrictive Trade Practices Commission (MRTPC) directed MMBL to fix a trait value on a reasonable level which is on par with the royalty charged by the company in USA and China. MMBL later challenged the MRTPC order in the Supreme Court which was later turned down by the Supreme Court. The AP govt had also issued a directive, mandating seed companies not to sell BT cotton seeds above ₹750 per packet. MMBL had to reduce it trait value to the current levels of 160-180 from the highs of 900-1200.

If this would be the outcome, seed companies like Kaveri will get some relief in the form of lower trait values and Monsanto would lose out massively on its future royalty income.

But what about the past royalty payments received by MMBL since 2011? The seed companies are demanding a refund of the higher royalty payments to the tune of ₹1300 Cr. This appears to be a low probability but high impact event. Kaveri Seeds has made royalty payments of around ₹423 Cr since 2010-11. Assuming even a 50% return of the royalty paid over these year, Kaveri would get a onetime gain of more than ₹200Cr.

Provisioning for Royalty Payments

Kaveri has cut down its royalty payments by ₹64 Cr in Q1FY16. This is the amount which it should have ideally paid to MMBL ideally assuming a royalty of ₹185 per packet. The company hasn’t provisioned for this amount, and assuming a hit of 64Cr on the bottom line, the numbers for Q1 FY16 look as given below:

  •  Adjusted net profit of ₹147 cr vs. a reported ₹221 cr
  • Adjusted EBITDA margin of 24% vs. 34% as reported
  • Adjusted PAT margin of around 22% vs. 33%

The company is currently trading at 12 times the trailing earnings. Considering the adjusted earnings (after deducting 64Cr), the company is trading at 16 times earnings.

Bottom line: In spite of reasonable valuations, it’s better to wait for some clarity on the royalty issue.

Disclosure: No position in the stock

Author: Ravi Duggirala is a budding value investor and an ardent admirer of Warren Buffet, Charlie Munger and Prof Sanjay Bakshi.

Photo

 

 He loves reading annual reports and attending AGMs whenever possible. 

  • punit says:

    Very good analysis….

  • Paddy says:

    Great Article Ravi and Deepak!.
    There is more element of uncertainty and risk for investors. Look at the Balance sheet for Kaveri, its receivables have gone up more than 500%. Looks like the seed firms are resorting to aggressive credit sales in a low growth scenario. A significant portion of the receivables are >90 days.

  • Tarang mehta says:

    Kaveri has accounts receivables to sales ratios of 14% that increased from around 7% last year. The management was very vocal about receivables and credit sales in their last con call.
    They are very conscious of that and have therefore not participated selling in credit markets this year. The analysis is true but either this doesnot impact kaveris business in the long run. Kaveri has the cash balance to make the addtional payment if needed.
    I have also prepared a note on long term prospects of kaveri incase any one is interested can view it https://oneupondalalstreet.wordpress.com/2015/10/28/kaveri-seeds-2/

  • Saurav Jalan says:

    Very good analysis Ravi. Keep it Up. The thing which is important to notice is whether the management communicated to the shareholders regarding royalty liability of INR 64 crs(in case they lose the case against Monsanto) while declaring FY16 Q1 results or in subsequent concall. If they did, then it shows candour and humility on the part of the management but if they didn’t then we have to be cautious in taking a call on management’s integrity in future.

    • Ravi says:

      Saurav, they did mention that if they lose the case they would have to pay ₹64 Cr as the royalty for the current year, which now stands around ₹66 Cr as per the latest concall.