Thursday, 29 December 2011

Dear SEBI. Can We Short Please?

The catalyst that turns fantasies into realities came in the form of this SEBI order for OneLife Capital Advisors (covered here). 

SEBI (Indian market watchdog) barred this company, several others and the merchant bankers to these initial public issues from accessing the securities markets. SEBI accused them of diverting IPO proceeds, performing shoddy due diligence and aiding promoters to prop up prices post-listing.

Unsurprisingly, in the beginning of the end scene, OCAP IN is down 15% as of this writing. A pummelling, rightly deserved. The end would be interesting. HaLin rued their inability to initiate Shorts on such cases, in the previous post.  

The Shorts are common whipping lads when markets and companies come under fire. The chorus against Shorts is inversely related to (1) market levels/stock prices, and (2) the acceleration of the fall from grace. Shorts are blamed for disrupting markets, for acting on misplaced rumours, for cornering poor and genteel companies looking to create employment in a socially responsible manner, and for generally being Evil. 

Few derive satisfaction from seeing others go bust and the Shorts aren't St. Good Guys at all times. But in certain instances, measured corrective forces in markets (provisions for single-stock shorts, for example) are a necessary counter-weight to the (sometimes questionable) actions of companies and issuers. A Long-only market character leads to a one-sided world, loaded in favour of companies. Frauds, historical and prospective, find a fertile setting to grow unabated in such an environment. 

Shorts impose a certain discipline on company managements, inducing them to contemplate the ill-effects of their actions, if exposed. Since the effect would directly be experienced by insiders through a drop in value of ESOPs/insider holdings, the Short-brigade bring some semblance of sanity to markets (its another matter that the Shorts themselves go insane occasionally!).  

The purging exercise brought about by the Shorts is a case of Darwinian survival of the fittest in business. By shorting dodgy companies into extinction, Shorts ensure that capital eventually finds its way to places where it is most welcome. (Social fallouts of capital re-allocation, a touchy subject, is left for another day)

The SEBI has a fine balancing act. If it raises minimum qualifying criteria, there's a risk of keeping public markets off-limits for fledgling companies reliant on capital for growth. This would impel them to seek capital from private sources, which come with their associated pros and cons. Relaxing qualifying criteria would attract shady companies. It is a tough problem which is, like so many things in life, without a black or white framework for a solution.

It is in such situations that Shorts serve a useful purpose. 

Is the SEBI listening?    

Wednesday, 21 December 2011

Over-priced Anomalies In Bear Markets

One of the alluring things about investing is the prospect of rare sightings of anomalies. In a torrid market, typically, the universe of value Longs tends to expand relative to bull times. The opposite - an anomalous over-pricing in certain pockets - is rarer.

One such example is OneLife Capital Advisors Ltd (Bloomberg: OCAP IN; "OCAL" or "Company"), a recently listed Indian company engaged in providing financial intermediary services, an aspiring equity broking franchise and portfolio management services company. 

'Aspiring' is the operative word, as OCAL was incorporated in 2007 and commenced business in September 2009. As the Company admitted, there is little to look at in their limited operating history. Nevertheless, market participants enthusiastically bought into the Company's prospective story. Overall IPO was subscribed 1.53x, with retail participation at 2.5x allotted portion and Institutional interest at 1.02x.  

Investment Banking franchise dynamics
People are an investment banking franchise's key source of competitive advantage. Superior deal sourcing, well-entrenched network of corporate relationships and deal history help differentiate one player from another in this competitive industry. Moat can also be derived by specialising in niche pockets (e.g., debt restructuring/resolution, mezzanine financing). A generalist investment banking franchise with limited history of operations, promoter pedigree and key employees (there were 11 employees as of the IPO filing) competes from a rather weak position. OCAL has all the ingredients of this eclectic combination.

Broking franchise dynamics
Broking is a fiercely competitive business, bearing a natural correlation with the capital markets. Except for instances where a broker serves an underpopulated segment in the market, pricing power is low and players compete fiercely in a race to the bottom of the price pyramid. Other means of building a moat is timely and best execution, low slippages, pre-trade investment research, post-trade execution services and attractive terms on margin funding. 

Revenues are primarily a function of volumes. As a result, waning volumes in a weak/sideways moving market has a negative impact on business. Well-entrenched incumbents tend to buy growth or rely on ancillary activities to drive revenues. A new, small-sized entrant would run into a gladiatorial arena full of competitors. OCAL is in such a position.

Portfolio Management Services dynamics   
This is a typical hedge fund structure, with respect to fees, that is. Performance-wise, there isn't much to be said about this group as a whole, in both absolute or relative terms. 

Revenues can form a good annuity stream (upfront yearly management fee) with optionality driven by Carry (a cut of profits). Recurring revenues are contingent on assets under management, which encourages management to embark on asset-gathering exhibitions to support revenue growth, sometimes to the detriment of investment performance.  
Differentiation is largely a function of investment performance than fee structures. Long history of superior performance under (hopefully) the same investment manager lends much credibility and strong competitive positioning. OCAL neither has the track record nor the personnel to guide this operation. A majority of its recent IPO proceeds (~35%) was earmarked for this venture, which hitherto contributed nothing to its topline. Attracting the right talent for this venture would not only prove difficult, given its history, it would also entail a large capital outlay; which will likely keep expenses on a rapid growth trajectory relative to revenues. It is difficult to envision OCAL achieving sustainable profitability, let alone cash flow, in the medium-term, given the scheme of affairs.

With this background, it is insightful to glance at a quick comparison, contrasting OCAL with a competitor, Brescon Corporate Advisors Ltd (Bloomberg: BFS IN). BFS IN is an investment banking franchise specialising in debt syndication, restructuring and resolution services. It is also involved in real estate and private equity financing.

OCAP IN has doubled since listing in mid-October.

An all-in bet on a perfect future
My interactions with the lead manager to the issue were illuminating. OCAL's current investment banking mandates = $95 mm (have to rely on the weight of words of the management). The revenue stream is a fraction of this value and payments are received based on achievement of milestones.

Working with a rather liberal 50% p.a. growth rate in mandates over the next 3 years and a 5% fee arrangement (typical, 1%-2%), the mandates would translate into revenues of ~$15 mm, which would accrue to OCAL over a period.  

Moving on to Portfolio Management Services. $2.5 mm is the initial funding received from IPO proceeds. Let's assume Management manages to grow assets under management (alliteration unintended) to $200 mm over the next few years and can charge 3% of AUM as fixed-management fee (typical, 1.5-2.5%). This would translate into revenues of $6 mm. 

Equity broking is a function of volumes. The largest company, Religare Enterprises managed volumes of $800 mm / day in 2010-11. Assuming OCAL manages 10% of this and using an average brokerage rate, this business would add ~$10 mm to OCAL's revenues. One of the ways of running a low-cost brokerage operation is to focus solely on execution, without adding ancillaries such as research (which add to costs). It was unclear, from my interactions, whether OCAL intended to take this route. 

Summing the three revenue streams up, one arrives at around $30 mm (cumulative, over a 3-year period). The largest integrated financial intermediaries currently trade at a Market value / revenue of ~2x, which is the multiple OCAL is discounting based on its prevailing market value. We haven't even touched upon profitability...

Parting thoughts
For a company with minuscule revenue, limited history and anything-but-upbeat business prospects, the stock enjoys good short-term momentum trading interests (daily traded value = $8 mm)The run enjoyed by companies like OCAL is a characteristic generally commonplace in bull markets. 

Market participants are expecting a stupendous show from OCAP IN over the next few years. With a drop in trading volumes and slowing investment banking mandates, the environment has been tough for players like BFS IN and indeed, for many players in the financial intermediation services industry. A situation that is likely to persist over the near-term. Another possibility behind the strong stock performance 2 months post-listing could be a take-over attempt by a larger rival, which appears remote.

These are the sort of occasions when one misses the ability to initiate a short.

Disclosure: No position

Disclaimer: This is not meant to be an invitation to indulge in speculative activity. Please consult your adviser, and more importantly, your judgement, before making investment decisions.   


Friday, 16 December 2011

The Bungee Jumping Indian Rupee

Of the many interesting events occupying market participants' attention in India in recent times, few have been more riveting than the rapid slide of the INR, which has depreciated > 20% against the US$, since the end of July 2011. 

The pace of depreciation appears to have caught policy makers and market participants by surprise. Hedge funds focused on India, who did a reasonably good job of arresting capital erosion until July, saw their returns plunging into the red, thanks largely to the INR's free fall. An economy on the fringes of diverging negatively from historical growth rates and a political climate dominated by corruption issues and policy flip-flopping aren't doing much to assuage negative sentiment either. 

If one traces India's macroeconomic developments over the past few years, the INR's fall-off-the-cliff show would be seen as a delayed reaction to realities. What is surprising is the lateness of the reaction, not the event itself.

In simple terms, if country A purchased more than what they sold to country B, A would stare at a trade deficit and B would enjoy a surplus. If this process continued over time, A's cumulative deficit would grow, mirrored by B's cumulative surpluses. A would have to continually rely on external capital to continue with the status quo. B, with its accumulated capital over the years, might agree to lend to A, so both continue to trade happily...

A's persistent borrowing to finance the deficit would lead to increasing indebtedness. Beyond a point, its financial health might begin to cause B some concern who, worried about repayment, might curtail lending. At this point, much-needed capital dries up and as confidence in A's financial well-being erodes progressively, investors would begin pulling out capital, leading to depreciation in A's home currency. 

To prevent continued depreciation and lend support to its currency, A could (1) utilise foreign currency reserves and/or (2) borrow. (2) is not a good option in situations similar to those in the above paragraphs (would lead to further erosion of investor confidence). Many countries through history have resorted to (1), and then (2); before complete erosion in confidence led to obliteration.   

Worsening Trade Balance...
Working off this (highly) simplified example, we turn to India's Trade situation. 

Source: RBI

The flat INR helped buoy imports, which grew 25% p.a., over the past 7 years. Exports, during the same period, grew 21% p.a. The progressive deterioration in trade balance necessitates a counter-weight through inflows of capital. Unlike its Asian peers, India does not enjoy surpluses on its current account, thereby exposing it to the vagaries of capital flows.

...funded by Capital inflows, so far

Source: RBI

Source: RBI

In the past, India has been somewhat heavily reliant on foreign portfolio flows, followed by credit, to fund the current account deficit. In 2008-09 when net portfolio investment was negative and credit dried up following the credit crunch, India had to dip into its foreign currency reserves to make good the shortfall. Part of the hypothesis behind the INR's prospective weakness is centred around this possibility. 

For the first 6 months of the current fiscal, net capital inflows were $40 billion, with FDI contributing over 50%, followed by External Commercial Borrowings (ECB). The more volatile foreign portfolio investment has been negligible this year, largely a reflection of the global macro environment, flight-to-safety and eventually, flight-to-cash.

The influx of longer-term FDI capital is a welcome development. In this backdrop, the recent backlash on FDI in multi-brand retail comes at an inopportune moment. Superimposed on a political environment characterised by credibility deficit triggered by corruption issues and frequent policy flip-flops, tapping the ECB route for funding seems the path of least action, going forward.     

INR History: An artificially high level?

India snapshot (source: RBI)

The growth in M3 - a money supply measure - over the long-run has been an important carrier of information on inflation (evidence from around the world: hereherehere)Over time, inflation chips away at the purchasing power of currency. Given the divergence in India's true inflation and those in developed market economies, the INR should have trended down over the years. While it wiggled up and down, the INR stayed flat over Dec-03 - Jun-11, even as money supply and credit expanded strongly.

Viewed in this context, a combination of foreign portfolio capital flight due to jittery global markets and persistently high inflation, have finally managed to trigger a long-overdue correction in the INR. 

External Debt situation
India's current total external debt = $316 billion. $68.5 billion of this amount is short-term, making up 43% of residual maturity (historical levels). Foreign currency reserves cover ~8 months of imports. Assuming that the maturing short-term debt is fully rolled over and the trade deficit at the end of fiscal '11-12 = $150 billion, India's incremental capital requirement through Mar-12 is likely to range between $20-30 billion. With external debt at < 20% of GDP and debt service coverage ratio at 4.5x, solvency is not a central issue. Refinancing could largely be contingent on the EU situation. Any deterioration on that front could put some pressure on debt roll-overs, by way of availability of refinance and/or cost. In the worst scenario, India's foreign reserves should be able to cover the maturing short-term debt comfortably. 

What could support the INR?
Broad factors:

  • Interest rate hikes
  • Foreign capital inflows 
  • EU debt resolution
  • RBI intervention

The strong pace of economic growth over the years has stoked inflationary pressures, which is persistently above the RBI's comfort zone. Prioritising inflation combating over growth, the RBI embarked on a rate-tightening regime over 2010-11. This interest-rate stance has been one of the factors supporting the INR, so far. As the world dipped into recession and interest rates headed towards the zero bound, investors hungry for yield found succour in high-interest rate markets such as India. 

Economic growth and investment activity are exhibiting signs of slow down, while industry and consumer expectation surveys paint a gloomy picture. The continuing issues in the EU is likely to persist into 2012. In this backdrop, rate hikes by RBI, going forward, appear low probability. If anything, should economic growth slow down, a reversal of RBI's interest-rate stance is highly likely, which would reduce the INR's allure. -1.

Given the negative real interest rates and political gridlocks repeatedly scuttling policy initiatives, the prospect of foreign portfolio investors returning to India with gusto appears grim. ECB seems the most likely route to be tapped, weakening INR notwithstanding. -2.

The evolving EU situation could have interesting repercussions for the INR. In the best case, a complete resolution that infuses a sense of bonhomie among investors could see capital flows into India, which would be positive for the INR. This, it must be admitted, is very low probability. The only other plausible options seem; (1) band-aiding of the EU continues, which would be neutral to the INR, due to investor risk aversion, or, (2) The extreme scenario: A Euro breakdown. This would mean curtains for the INR. -3

Enter RBI?
There's a growing chorus of voices urging intervention from the RBI to stem depreciation. The RBI's few attempts so far hasn't had the intended effect on market participants. Unlike its Asian peers, which may recycle trade surpluses to support their currencies, India's deficit situation reduces its room for manoeuvre. The RBI has voiced its intention of resorting to Open Market Operations and tapping other levers should push come to shove (jigging the Cash Reserve Ratio/Statutory Liquidity Reserve). 

Parting comments
A turn in RBI's hard interest-rate stance seems likely, going forward. Continued reliance on foreign currency borrowings appears to be the most likely outcome. In the best case (low probability), the INR is likely to wiggle sideways, while progressively introducing hurdles in the form of domestic and global macro issues (higher probability) quickly weakens the case for a long INR.    

Wednesday, 23 November 2011

Kiss From A Rose: Scenting Karuturi Global

US$1 million = रु.5 Crore
Country: India
Home currency: INR

This post focuses on Karuturi Global ("the Company"), the world's largest producer of cut roses and an aspiring agriculture company with a presence across India, Kenya and Ethiopia.

Before getting acquainted with the Company, it is worthwhile to get introduced, briefly, to the business of rose production. 

The Business: A thorny process to a rosy end
The birth of a rose involves the following:
  • Land and Equipment: The major fixed-cost components. The quantity of roses produced is a function of yield, which tends to vary depending on a slew of factors
  • Planting
  • Harvesting and Picking: It takes about a year for full production, from the time of planting. Picking is a critical activity that influences rose quality and prices. Trained personnel are a critical requirement here
  • Packing and Transport: Once the roses are picked, off they go into a bucket of bacteria-enhanced water for preservation. From here on, they enter the safe confines of a Cold Storage Unit. Stems aggregate into bunches, then boxed and ultimately get transported to end user markets across the globe 

Growing roses is a complex operation. For the pain that goes into the production and the pleasure they grant to consumers, roses are reasonably resistant to recessions. The arenas where they are commonly found; weddings, funerals, home/office adornment, image building, expressions of love et al are typically unaffected by the mood swings of recessions. 

Pricing is a function of rose variety; which ranges from small stems (Sweethearts, how apt!), medium stems (Intermediates) and large stems (Hybrid Teas) 

Over the past couple decades, trade volumes of cut flowers have grown in the high teens. Pricing, however, has largely remained tepid. Roses enjoy relatively stable long-term demand, generate good margins and above-average returns on invested capital. Europe is the largest consumer market, accounting for over 50% of global cut-flower consumption. Other major markets include USA, UK, Russia and Japan. 

Pegged at over $40 bn (source: US Department of Commerce), the global cut-flower business has been a steady grower.

Rose Production: Economics
A farmer owning 1 hectare of land and contemplating growing roses might look at the following picture.

For illustrative purposes only

Key levers that influence operational performance are yield, pricing and costsHistorically, it has proved difficult to exercise the Pricing lever consistently. Yield tends to vary and is dependent on a variety of factors such as geographic location, water/irrigation facilities, soil dynamics.

A hold over costs and benefits of size become a critical factor in developing a strong moat. As the world's largest producer of cut roses, Karuturi enjoys admirable competitive positioning. Roses are a fragmented market and competition, of any reasonable size to pose a threat to the Company, is low.  On the costs front, Africa compares favourably with Europe, where high costs of production are driving producers to convert their floriculture bases to holiday villas. Another critical aspect is proximity to end user markets. Africa's proximity to Europe and India's to Japan bestows distinct advantages on the Company in catering to two of the largest markets in a cost-effective manner.

Roses reach end consumers through various channels. Primarily, the auction markets in Netherlands witness frenetic activity and account for ~40% of roses moving in Europe. Roses are also sold to bulk distributors, retail chains and bouquet makers.   

Company History
An insight into the company's evolutionary history makes interesting reading.

Karuturi entered the floriculture business as Karuturi Floritech in 1994 in India, with an annual cut-roses production capacity of 7 mm near the city of Bangalore.

Late 90s and early 2000s: Changed its name to in 1999. In 2001, it obtained an internet service provider license and rechristened itself as Karuturi Networks. Operational performance was anything but boast-worthy with the company swinging from profits to losses and vice versa. Though revenues grew at a compounded rate in excess of 90%, after-tax profits flip-flopped between Red and Black. Free cash generation was lacklustre.

Grew as a floriculture company focused on rose production. Roses were produced in India and exported to Europe, Japan and Russia. Revenue grew from 
रु.10 Cr in 2002 to रु.45 Cr in 2006. Net income swung from losses to रु.15 Cr, achieved on a capital base of रु.45 Cr funded with negligible debt. Operational performance was noteworthy during this phase, with strong growth being achieved with improving profitability and returns on capital (>40% ROIC). Revenues CAGR was 60% while EBITDA CAGR outran revenues, growing close to 100%. Capital base grew at 75%, as incremental capital was invested profitably. Enterprise value reflected this improvement, growing >40x over this period. Cash burn progressively increased, concomitantly. The Company was morphing into a growth machine. 

2007-present: It enhanced its footprint in rose production with the acquisition of Sher Agencies, a Dutch rose producer (500 - 550 mm roses production) with operations in Kenya in Oct-2007. Purchase price was around $70 mm and Karuturi paid about 6-7x profits for the acquisition, which has turned out well. Through acquisition and expansion, the Company is now the world's largest cut-rose producer.

It has since embarked on a flower-to-food transformation. Karuturi is evolving into a global company with a growing presence in Africa (Ethiopia, Kenya). About 600 million rose stems are produced and sold each year across Kenya, Ethiopia and India (small contributor), which find their way into Europe and other export markets. In addition to floriculture, it aims to evolve into an agriculture company over time. The latter business is focused on producing food crops; maize, wheat, rice, sugar, palm oil and soybean. In due course, agriculture is expected to be the mainstay business. Corn and rice produced currently are bought by South Sudan.  

Revenue CAGR over this period was 60%, EBITDA grew at ~50%. Unlike the previous stage, growth has been achieved on a capital base that has expanded faster, at 70%. 

Revenues in the most recent year were रु.640 Cr, EBITDA of रु.240 Cr, net income रु.155 Cr, achieved on a capital base of रु.1,900 Cr with debt at रु.560 Cr. Over this period, enterprise value grew to रु.2,300 Cr. Stock price currently is lower than in 2007 but market cap has grown 2.5x, as this period was accompanied by significant equity dilution.

The expansionary third phase has witnessed massive capital outlays (about
रु.1,500 Cr) as the company acquired land in Africa. The next 3-5 years should see operations expanding to Tanzania with investment outlays of $500 mm. 

In 2006 (when I first invested in the Company), I was attracted to its high ROIC, lean balance sheet, attractive dividend yield (5%), inexpensive valuation (2x trailing earnings) and growth profile. 

An unknown company back in 2006, its sheer pace of expansion 
over the next two years attracted investors like Soros Fund Management, IL&FS Investment Managers and a slew of others, who rode with the stock on its journey from mid-single digits through the early 40s. It also smartly sold convertible bonds (foreign currency convertible bonds, as they are called in India) in two tranches totalling $75 mm at the height of the bull market. c.$39 mm is currently outstanding.

It isn’t surprising that investors (foreign investors hold 35%) adore this company. The agriculture premise strikes a chord, especially as Karuturi is essentially an India-domiciled company with operations heavily weighted to Africa, the next expected growth frontier.

Over time I have been pruning exposure, though. This is largely attributable to strong share price movement post purchase (8-10x rise), historical (and prospective) equity dilution, compressing ROIC and management.

Promoter holding is a little over 18%. There are numerous instances of Indian promoters with relatively minor stakes in their listed Indian entity routing cash to fund overseas projects. Painful experience investing in Indian convertible bonds has impelled me to view such instances with a healthy dose of suspicion. As a mitigating factor, the promoter recently made a preferential warrant issue at रु.21.6/share (5x current share price) which, if fully converted, would take his stake to over 20%. 

African Sojourn
The recent trend of Indian promoters venturing into Africa has been greeted with approval but question marks remain. Overseas companies have been cutting deals with local governments to lease land at throw-away rates. Karuturi has signed a 50-year renewable lease on 100,000 hectares in Ethiopia where its rentals are $1.2 / hectare / year. The Company claims that it managed to cut competitive (extremely) deals as it enjoyed first-mover advantage. Subject to the Ethiopian government’s satisfaction on Karuturi’s execution record in developing the first 100,000 hectares, it would have rights to develop an additional 200,000 hectares. 

A recent deal by a US company in South Sudan was annulled after a pressure-group activist exposed the one-sided deal. Karuturi has so far remained unscathed but given the low payment rate, the limelight could fall on it in the future. Further, the contract allows the lessor to amend rents at its discretion and includes an exit clause, allowing the lessor to terminate the contact post a 6 months written notice. Even though the Company is in dialogue with World Bank to insure against political risk in Africa, this remains one of the key risks to the business.

Thoughts on Convertible Bond: Debty Matters
Some thoughts on the unappreciated piece in the capital structure is in order.

Companies in India carry convertible bonds at book value on the balance sheet. When stock prices fall so much as to make the convertible bond's conversion option practically worthless, the convertible needs to be perceived as debt. When redemption comes calling, the book values morph into redemption values (which, in some cases, are far higher than stated balance sheet numbers). Several companies in India (and many unfortunate investors) have had a gut-wrenching experience with this phenomenon in the aftermath of 2008.   

The Company issued the following FCCBs in 2007:

  1. Feb-2007: $25 mm, 0%, 5-year maturity. Current outstanding = $0 - 3 mm  (FCCB I)
  2. Oct-2007: $50 mm, 0%, 5-year maturity. Current outstanding = $39 mm  (FCCB II)

Total debt outstanding, Sep-2011 = $120 mm, with FCCB making up $39 mm. 
Split isn't available; as FCCB I is a small amount, it is best to assume all outstanding as FCCB II.

Redemption falls due in Oct-2012. Conversion price on FCCB II is nearly 5x current share price. Thus, conversion into equity is a remote likelihood. In this scenario, focus shifts on ability to repay the convertible bond, either through internal cash flow or refinancing.

Including the YTM (Yield to Maturity) of 7% p.a on the FCCB II, total amount payable at maturity = रु.270 Cr. Credit situation, next year, should be comfortable with Total debt / EBITDA ~3x and Debt / Equity = 0.5. 

EBITDA may be ~रु.250 Cr and operating cash flow रु.150 - 180 Cr, next year. Total credit limits available with the Company = $200 mm, leaving undrawn credit lines at $80 mm, or ~रु.400 Cr. A combination of cash flow and refinancing should be able to fully cover  FCCB redemption. 

At current indicated bid/asks, the convertible could fetch a YTM between 32% - 40% for a holding period less than a year. Considering the above repayment scenario and Karuturi's equation with foreign investors in the past, full repayment may be reasonably expected, in the event of non-conversion. Given the weak prevailing sentiment towards equities, an investment in the convertible bond instead of common equity affords a more favourable risk-reward (but is limited to only certain classes of investors).  

 ...that is to say, ability to pay should not pose a problem. Willingness, however, may be another matter altogether.

Thoughts on Valuation
Current share price = रु.4/share, Common equity @ market = रु.340 Cr, Enterprise Value = रु.810 Cr, P/E (last year earnings) = 2x

A useful way of thinking about Karuturi's value is to think through individual business. 

Floriculture: Using an after-tax profit / stem of c.4 cents (above illustration) and rose production at 500 mm stems (2011 production = 600 mm), profits = $20 mm. Rolling 3-year average multiple over the past 8 years = 7x. Using a 4x multiple, market value of the equity = $80 mm, or रु.400 Cr for the stable floriculture business. 

Agriculture: This business is in nascent stages currently. Beginning with maize and paddy, production of palm oil and sugar is expected over a 3 year time-frame. This year 12,000 hectares of maize and paddy were planted but a flood decimated the entire crop. Hopefully, this will be a non-recurring event. It competes with the likes of Bunge and Cargill in this business, as a result, competitive positioning is weak compared to its strong positioning in the floriculture business. 

A hectare yields between 1.5 - 5 tonne of crop. Using 2.5 tonne / hectare, 5% after-tax margin and  25,000 hectares under crops over the next 3 years (Company is eyeing 100,000 hectares), this business could generate after-tax profits in the region of रु.15 - 20 Cr, on a conservative basis. At 4x earnings (global agriculture companies trade between 8-10x), this business would be worth रु.60 - 80 Cr 

Floriculture + Agriculture = रु.400 Cr + रु.60 - 80 Cr = c.रु.460 - 500 Cr, a broad range of value for Karuturi's equity on a conservative basis.

Considering that floriculture capacity is slated to grow 30% over the next couple years (probably sooner) and relaxing some of the assumptions for the agriculture business, intrinsic value has the potential to be far higher than indicated above. 

Dwelling on the two primary drivers of business, the stable floriculture business is likely to continue ticking at a reasonable rate, while the agriculture business will drive optionality over the intermediate-to-long term. 

Headwinds to the business are:
  • Africa pressure group activists. Most do not seem to share my concerns but this is something worth watching closely
  • Sustained cash burn, leading to equity dilution/increasing indebtedness. This is likely to offset the positive effects of revenue growth
  • Exchange rate movement. With exports making up a significant chunk of business, a hardening of the INR would affect the Company negatively. The probability of this, however, is low. The high inflation environment compared to the developed nations and a slew of other macro-related issues is likely to keep the INR weak  

Extend the investment horizon longer to 5 years and above, strong sustained revenue growth is needed (c.20% CAGR) to support stock price. Allowing for compression in margins and pencilling in expected capital outlays, cash burn rate is likely to be high and the Company would be hard-pressed to generate free cash flow. In this setting, as debt burden mounts progressively, further rounds of equity dilution may be warranted (a recently planned GDR issue was shelved due to adverse market conditions). A convertible security offering might enter the picture (speak purely from experience, no mention from the Company).  

Concluding remarks
Growth in the pie (business value) looks highly likely, but if there are more claimants on the pie, value of each pie (share price) could languish. Equity holders would be loath to bear the weight of prospective equity dilution (shares outstanding have grown 14x in the past 6 years). A convertible instrument - preferential warrants/preferred shares/convertible bond - seems the best mode of financing prospective growth.  

In sum, market participant interest (and other interests) in the Company could lead to wild swings in prices. For those who admire momentum, relying on an eager soul to whisk one's stake off one's hands at a higher price in the near-term is likely to be a profitable affair. For those who perceive those pieces of paper as a stake in a business, the rosy road could be strewn with thorns. 

Position disclosure: Long common equity.

Disclaimer: This is not a recommendation or a solicitation of interest in the Company. History is rich with examples of losses triggered from speculative activity in financial markets. Please consult your advisor, and more importantly, your judgement, before investing.  

Sunday, 25 September 2011

Schizophrenic Markets

An abrupt market drop causes a rally in gloom-n-doom hypotheses. More than a few that landed in my inbox recently focused on the relationship between corporate profits and GDP. The core theme was this: corporate profits as a percentage of GDP exhibit a mean-reverting characteristic. Whenever they overshoot too far from the mean, they fall back; and this isn’t good for long-term equity returns. Current levels are close to historical highs, so equity bears invoke the above to build a bear case. Historical references cite the peaks hit in 1965/66 and 2006 as strong evidence for weak subsequent equity performance.

History provides some insights. The following exhibit uses after-tax corporate profits from NIPA and uses the Dow Jones Industrial Average as a barometer of equity performance. The DJIA was chosen as a longish history of prices was readily available. For comparative purposes, a similar exhibit for the S&P 500 is appended later. 

Only 2 out of the previous 9 occasions have been dreadful for long-term equities. The 1965/66 peak (the so-called Kennedy-Johnson peak) was followed by a long period of negative equity market returns. Something had changed on this particular occasion compared to previous instances. The 2006 peak seems to be (so far) tracing the 1965 pattern. Indeed, in terms of performance, the latest instance is unprecedented.  

The S&P 500 shows a similar pattern, except that the 1965 peak exhibited some divergence with the DJIA’s performance over the 2 and 3 year time frames. The 1997 peak preceded a decent show by equities over the typical time frames that a majority of market participants inhabit (1-3 years). 

Given the above, the equity-bears’ argument for selling equities on the premise of historically high corporate profits/GDP necessitates a closer look.

One went about searching for the missing pieces that could complete this jigsaw puzzle somewhat, and zeroed in on some metrics that to have a bearing on equity performance. Metrics included Robert Shiller’s cyclically-adjusted P/E ratio (CAPE; real S&P 500 price divided by last 10-year average real earnings), 10-year US Treasury yield, AAA corporate bond yields and inflation (CPI).

Ceteris paribus, a high starting CAPE accompanying peaks might be posited to set the stage for weak subsequent returns. High valuations and high profits relative to GDP would imply that most of the positives were already priced in by market participants; and slip-ups on profitability would be perceived unkindly.

A closer look at history
In investing, very often, the path taken to arrive at a signpost has a strong influence on future course of events. The exhibit below presents a 10 year picture; 5 years prior to the peak year and 5 years subsequent to the peak year.

Cut to 1965: At the cusp of 1965, the market came off a period of low inflation and general prosperity in the 50s and 60s. Optimism buoyed by President Kennedy’s election in the early 60s, and followed by President Johnson’s Great Society program, stoked a rally in equities. And then the Vietnam War escalated, degenerating into a deadlock, ultimately entering the history books as a costly indulgence. Johnson’s Great Society dream would remain a dream and inflation worries increased as a result of the war, puncturing investor confidence. Proving market participants’ right, inflation inched up through the 60s and 70s. 10-year Treasury yields inched up through the same period.

It appears that a high starting P/E + corporate profits / GDP peak + high inflation + rising bond yields in the post-peak period set the stage for weak equity performance.

Some caution is warranted, however, before forming a provisional conjecture. Post-1941 performance dents this hypothesis. The World War II peak was followed by a rise in inflation. Through 1941, average P/E was reasonably high and inflation was low, similar to 1965. Ensuing equity performance was strong, however. High valuation + peak + high inflation had not succeeded in keeping equity returns in check. The outcome is interesting considering that average inflation was higher post-1941 v/s post-1965.  

The post-1974 performance was similar in behaviour to post-1941. Things get more intriguing here as average inflation was high both before and after the peak year and bond yields were well on their way to multi-decade highs. Yet, equities did okay.

By 1997 investor optimism was running high again and the CAPE was at elevated levels relative to history. Inflation was low and bond yields had been trending down over the past 15 years. This peak, however, was followed by a tepid show for equities over the medium/long-term.

Cut to 2006. CAPE was high, inflation and bond yields were reasonable. But ensuing equities performance has given no cheer whatsoever (so far anyway).

In a nutshell, equities do not bear a consistent static relationship with inflation or bond yields at all times. Valuation levels, however, are a different matter. But writing equities off because corporate profits / GDP are at peak is a little simplistic, in my opinion. Another important factor that these periods share is investor sentiment. Psychology plays a pivotal role in determining future outcomes and is, unfortunately, the least considered variable. The character of investor sentiment changed post-1965 due to a multitude of factors (Vietnam War inflation, Cold War etc.), resulting in bearishness, and was probably a contributory influence in keeping returns down. The vicissitudes of the human mind has trumped cold reality repeatedly through history.

Could this time be different?
A summary of the present: Corporate profits / GDP are presently at elevated levels relative to history, inflation is reasonably high considering the recessionary backdrop and bond yields are at historically low levels with little room to fall further. Are equities doomed, or does this represent an attractive entry point? Considering the above exposition one is reluctant to proffer a conjecture.

At 20x, the S&P CAPE is high relative to the past and broad interest rates are expected to stay low over the foreseeable future. Given the repeatedly unsuccessful attempts at band-aiding the global economy, few believe the present downturn to saunter into history books anytime soon. The difference between buying and selling the broad index is essentially a bet on the future pattern of investor sentiment. If the latter does not turn up, a purchase now is likely to face an unsatisfactory outcome. In relative terms, however, Germany seems to offer better value. The current CAPE of ~12x is close to 30-year lows. Throw in reasonably attractive dividend yields (~4.5%), and the DAX looks like a better basket to be long in. There is, however, the real risk of low valuations morphing into value traps and the high dividend yields potentially signalling lower dividends in the future...well...

S&P 500: High CAPE + historically low bond yields + medium inflation + poor sentiment + mixed history = Trance  
DAX: Low CAPE + attractive dividend yield + King Kong of the EUR + poor sentiment = (lesser) Trance

It seems a better proposition to dwell on individual businesses rather than participating in a broad index. High dividend yield equities combined with low dividend payout ratios in industries that are relatively recession-resistant is a theme that the mind is drawn to.

Sometimes, history accentuates an investor’s Uncertainty Quotient. It’s a bittersweet feeling.

Schizophrenic markets do not help either.