Saturday, 18 October 2008

A Tale of Two Companies

The frequency of my posts have dropped drastically. I am at a loss to decide whether this is attributable to market conditions, or me not having anything significantly intelligent to say...I am tempted to vote for the latter.

After months of contemplating what to write, I settled for an exposition on something that I term "beautiful". Capital structure is something that does not get as much importance as it should by investors, analysts and management in general. What is the optimal capital structure? I wish someone knew the answer. In this post, I take a look at how the markets treat two companies that are similar in most respects except for their capital structures. I then take a look at a case of possible mis-pricing and how often, even 'good' companies never seem to get their due.

Capital Structure irrelevant? Hmm... I consider Chambal Fertilizers and GNFC (fertilizers again!) for this post.

Most finance experts and academics advocate having 'some' debt in a firm's capital structure. "You get a tax-deduction...debt is cheaper..." are some of the reasons cited. Not wrong in my opinion. What is the right mix? That's a question that doesn't really have one right answer. For the moment, even if we assume the company's management knows the 'right' mix, the broad market participants are mostly unaware of the 'right' mix. What do they do in such cases?

The example exemplifies the point beautifully.

Lets start with margins. Both companies generated about the same EBITDA margin for fiscal year ended Mar-08. However, GNFC topped at the net income margin level. It generated a good 3 percentage points more than Chambal.

Turning our attention to the capital side introduces a fresh perspective to these numbers. GNFC managed to generate 100% more profit for common shareholders, while employing 30% less capital and only 62% more equity compared to Chambal. Impressive? Very...in my opinion.

So what did the markets do? They rewarded GNFC's superior performance by ascribing a 50% less equity value, and 70% less enterprise valuation, compared to Chambal. In terms of multiples, Chambal is currently valued at ~4x more than GNFC on the EBITDA multiple and 3.5x more on the P/E multiple. What could possibly explain this wide discrepancy? Is it a sign of terrible mis-pricing or is there something else at play?

Traditionally, apart from the arguments put forward for assuming debt, common equity holders like debt as it bolsters Return on Equity. Taking on debt gives a firm leverage, which is a double edged sword. Take on too much and the management risks destroying enterprise value, take on too little and again there is a risk of firm value not being maximized. The optimal funding structure is, in my opinion, like a moving target. One cannot get it right all the time, but one can try and get as close as possible to the 'right' number.
When analyzing two companies within the same industry, the investor faces the tough prospect of forming an opinion on whether a company is over/under-priced compared to the other company.The statement seems innocuous, but is one of the most important factors for an investor to answer, in my opinion.

In the above case, assuming other things being more or less equal, it seems a bit intriguing to me that the markets are valuing GNFC only at 0.5x book value of equity and valuing Chambal at 1.5x book value of equity. Especially considering that GNFC scores on all other operational metrics. To some extent, the differences in capital structure could explain the difference in market values for the two firms. Firms with some debt in their capital structure get rewarded with a greater enterprise value, compared to an all-stock firm. The other explanation that comes close to rationalizing the huge discrepancy is that the markets are probably expecting far better growth rates in Chambal's case compared to GNFC. But in a lollipop business, most companies face similar growth prospects, give or take a couple points.

Maybe Chambal has a better history compared to GNFC?
Lessons from the past
A look at history reveals some very interesting insights into the two companies. The comparison is so striking that commentary is mostly unnecessary. GNFC's growth rate over 4 years on almost every operational metric is better than Chambal's. Notably, GNFC has managed to grow Net Income at 34% CAGR with only 12% CAGR on Total Capital employed. This compares very favorably with Chambal's performance (13% Net Income CAGR, 10% Total Capital CAGR).

GNFC has also managed to grow dividends at 3x Chambal's rate. Dividends are important, as shareholders typically put a premium to companies that not only pay dividends but also manage to grow them at a good rate.

Turning to averages, its clear that GNFC beats Chambal hands down on every metric. It uses debt sparingly compared to Chambal and has turned in better return ratios.

However, the market and enterprise values, and valuation paint a very different and interesting story! The market value of both companies have grown at about the same rate over the past 4 years. Turning finally to valuations, one can see that GNFC has historically traded at a discount to Chambal.
Over/Under/Rational-pricing? Why should a company that is larger in size (in terms of revenues), has demonstrated a history of better operating metrics, grown dividends at a much faster rate and is comparatively conservatively capitalized, trade at a big discount to its peer?

A look at 1H2009 results for both companies show that there has been a significant dip in operational performance. Since Mar-2008 Chambal's stock has corrected 20%, while GNFC's stock has fallen 58%. The latter had a production disruption for 3 weeks in July related to a plant shut-down, but how much will this materially impact results 5-year out? Not too much in my opinion. GNFC will most likely post a pretty bad 2Q2009 result, however, a long-term investor shouldn't be too bothered with a on quarter dip.

The stock action reveals something striking about the markets. Yet again it demonstrates the short-term thinking that determines the actions of market players. The markets conveniently forget the long history of superior performance and beat down the stock only on the back of short-term negative news. Rational?

While the past, admittedly, cannot be used to linearly extrapolate into the future, it does reveal some important clues about companies. If I were to take a 5-year view - and was forced to buy a fertilizer stock - I would choose GNFC. The likelihood of management continuing to do the good things it did over the last 5 years is far more in GNFC's case than in Chambal's.
Conclusion
So is GNFC under-priced or is Chambal over-priced? Tough call to make, on a standalone basis. However, in my opinion, it's far easier to form an opinion on GNFC than Chambal. A company with a demonstrated history of superior performance trading at 1.5x last year's EBITDA and 2x last year's earnings merits a close look, even if it isn't a screaming buy.

The comparison reveals the market's implicit appraisal of difference in capital structures of two firms in the same industry. The markets, on balance, prefer firms which have some debt to no debt. What is the ideal 'some' is an open question.

More importantly, the comparison reveals a beautiful insight into the way the markets think and act. Sadly, holding on to a 'strong' company for around 4 years, did not guarantee proportional outperformance over an inferior peer in GNFC's case. It is an interesting lesson. While in lots of cases, the long term is a good judge of true value, the markets don't seem to get it right in some cases. The long term investor in this case loses out.

This, however, does not undermine the importance of numbers in the investing decision. While numbers are important, it is far more important to try and think far ahead. Thinking five years or more makes the investing decision that much more easier than predicting two quarters ahead. Most times, the key to a good investing decision lies outside the cosy world of multiples...

Every day its in the nature of this business to force people to take decisions on imperfect and incomplete information. However, over time, some get better at it as they develop a 'feel' for the numbers.

At the end of the day, the guy who keeps his head when everyone around him are busy losing theirs, is the one who takes home the biggest prize...