Category Archives: India

WEEKLY COMMENTARY 2/13/17- 2/19/17

WEEKLY COMMENTARY               2/13/17- 2/19/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

PC Jeweller report Q3 FY17 results over the past week. Demonetization impacted the quarter’s results with the company estimating sales were affected for three to four weeks. Post-demonetization, sales started improving in December and returned to normal in January. Gross margin were stable but the decline is sales resulted in a decline in profitability. Year on year sales declined by 3.4%, the number of showrooms grew from 58 in FQ3 2016 to 68 FQ3 2017, or 17%, and total square feet increased by 8% year on year from 346,855 square feet to 374,481 square feet. Year on year, the company’s operating profit declined 13.7%. Assuming during the four weeks that demonetization affected sales there was a 50% decreased in sales, no impact from demonetization would have lead to an increase in sales by roughly 16% year on year.

 

It is tough to tell how good or bad the quarter was due to demonetization. The company continues to increase its showroom footprint and sales barely declined despite demonetization. The company estimates 75% of the jewelry industry is unorganized dampening competitive pressures.

 

PC Jeweller is one of the most profitable and fastest growing companies in the Indian jewelry industry illustrating the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the company’s strengths, it trades on an EV/NOPAT of 14 times and an EV/IC of 2.6 times. We will maintain our current position size.

 

In the past week, Grendene reported Q4 2016 and full year results. For the full year 2016, net sales declined by 7.2% with domestic sales falling by 1.6% and export sales falling by 16.3%.

 

Overall volume declined by 9.3% with domestic volume declining by 8.0% and export volumes falling by 13.0%.

 

ASP increased by 4.1% with domestic ASP increasing by 7.2% and export ASP falling by 3.2%. Gross profit fell by 6.7% as cost of goods sold declined by 7.6%.

 

Operating profit declined by in 7.5%. The company’s capital intensity did not change over the year with working capital at 47.9% of sales, fixed capital at 18.9% of sales, and invested capital at 66.8% of sales.

 

Grendene’s key value drivers are illustrated above. In 2016, gross margin reached a peak level of 48.7%. Selling expenses remain near its historical average relative to sales at 24.0%. General and administrative is at its peak at 4.8% of sales. EBIT margin remained at its historical peak of 20.0%. Working capital remains slightly elevated relative to historical averages. Fixed capital as a percentage is at its highest level over the past eleven years.

 

Grendene continues to struggle with economic weakness in Brazil and in export markets. The company operational efficiency allows the company to maintain its profitability during a period of declining revenue. In 2015, the company reiterated its growth targets of revenue growth of 8-12% and net income growth of 12-15%. The company continues to believe these targets are achievable but acknowledge risks of not achieving these results are increasing due to economic weakness in Brazil and in exports markets.

 

Given the new data, we update Grendene’s earnings valuation range. Grendene illustrated its ability to maintain profitability despite a period of declining revenues and increasing competitive pressures making earnings valuation the most appropriate valuation methodology.

 

Looking at Grendene’s earnings valuation, the company reaches our target return of 15% per year under the most optimistic scenarios. We would assume perpetuity growth only under scenarios when the company operates in an industry with barriers to entry and pricing power. Within the domestic market, there are clear barriers to entry with the company and its main competitor Alpargatas having economies of scale as they occupy over 50% of the market with large fixed costs in the form of distribution and advertising. Grendene also has unique capabilities in manufacturing plastic products as it modifies its own machines and can formulate plastics that are unavailable to other footwear producers. These barriers to entry do not transfer outside of Brazil. The company is a low cost producer with only China producing exports at a lower price.

 

The question is whether the barriers to entry within Brazil translate to pricing power. The barriers to entry within the segment means very few other players could sell products at the Grendene’s and Alpargatas’ price range meaning the company’s probably do have some pricing power in Brazil. Over the past ten years, the company average selling price increased by 3.8% per annum with the domestic selling price increasing by 2.6% and export selling pricing increasing by 3.9% in USD terms so there is a strong argument for potential pricing power. We assume 2.5% pricing power in our base case scenario. The company sales have grown at 6.8% over the past ten years with growth stagnating at 4.9% over the past five years. Assuming an inability to growth operating profit above sales growth a 5% growth rate seems appropriate for our five-year forecast period. Despite the company’s ability to maintain profitability during the recent industry weakness using peak margins seems aggressive therefore average margins are more appropriate. Our base case scenario is 5% forecast period growth, 2.5% terminal growth and average operating margins leading an upside to the 2021 fair value of 60% or 9.9% annualized return. Overall, the average return over the next five years under the earnings valuation is 59% or 9.7%.

 

 

INTERESTING LINKS

 

 

How much is growth worth? (Musing on Markets)

 

Professor Damodaran breakdowns how to value growth, the key drivers of growth, and the importance of ROIC in determing whether growth is valuable or not. (link)

 

 

Narrative and Numbers: How a number cruncher learned to tell stories! (Musing on Markets)

 

Another post by Professor Damodaran explaining how narratives can be worked into your valuation to provide a better picture of how the market is valuing a company. (link) Professor Damodaran recently published a book Narrative and Numbers, which I have not read but is next on my list.

 

 

Diversification..again.. (Oddball Stocks)

 

Nate Tobik of Oddball Stocks shares his thoughts on diversification. (link) Our current thoughts on diversification and position sizing can be viewed here. (link) We have a similar thought process on the limits of one’s knowledge as an outside investor with valuation being the biggest tool to offset the limits of our knowledge.

 

 

Humility and knowledge (Oddball Stocks)

 

Related to his post on diversification, Mr. Tobik discusses how investors sometimes make the mistake of believing they know too much. (link)  We touched on a similar topic in our diversification post linked above.

 

 

Graham & Doddsville (Columbia Business School)

 

Columbia Business School put out another edition of Graham & Doddsville, which always makes for interesting reading. (link)

 

 

Buffett’s Three Categories of Returns on Capital (Base Hit Investing)

 

Base Hit Investing’s John Huber talks about how Buffett categorizes business by their return on capital and capital requirements. (link)

 

 

What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (Wall Street Journal)

 

The Wall Street Journal profiles the Steve Edmundson, the investment chief for the Nevada Public Employees’ Retirement. (link)

 

 

Howard Marks’ Letters Sorted by Topic (Anil Kumar Tulsiram)

 

Anil Kumar Tulsiram complied all Howard Marks’ letters by topic. He has compiled other documents in the past and can be followed on Twitter @Anil_Tulsiram. (link)

 

WEEKLY COMMENTARY 1/30/17-2/5/17

WEEKLY COMMENTARY               1/30/17-2/5/17

 

 

CURRENT POSITIONS

 

 

 

COMPANY NEWS

 

There was no company news over the past two weeks.

 

 

INTERESTING LINKS

 

 

Expectations Investing: Reading Stock Prices for Better Returns (Michael Mauboussin)

 

A 2006 report by Michael Mauboussin when he was at Legg Mason discussing what he calls Expectations Investing. The report also discusses the link between ROIC and PE. (link) Mr. Mauboussin discusses how investors often only look at a company’s fundamental when investors should be assessing company fundamentals then comparing them to market expectations. He argues that any returns will be driven by a change in the markets expectations. Given there are many types of value investing (quality, deep value), value investing itself is the act of ensuring the market’s expectations are well below the probable path of a company’s fundamentals.

 

In the article, Mr. Mauboussin discusses the theoretical link between ROIC and PE. We studied the relationship between ROIC and EV/EBIT and EV/IC. Growth is eliminated from our study, as it is the most difficult value driver to forecast. We feel EV/EBIT is a more appropriate measure of earnings than PE as it eliminates all non-operating items and it takes into account the whole capital structure something that ROIC takes into account. We studied a number of different Emerging Market companies in a number of different industries from 2011 to 2015. We used a company’s estimated ROIC for the year (operating profit/ (net working capital + PP&E)) and the company’s valuation at the end of the year. As illustrated below, our study found no correlation between ROIC and EV/EBIT, with the adjusted R squared at 0.01, and a strong correlation between ROIC and EV/IC, with an adjusted R squared of 0.65

 

The scatter plots graphs below visualize the correlation between ROIC and the two EV valuation multiples.

 

As you may have noticed, EV/IC is not really mentioned in our reports as we use more in-depth valuation methods. We use EV/IC vs. ROIC as a shortcut when screening companies to determine whether there may be sufficient margin of safety to spend addition time analyzing the company. Using a 10% discount rate and no growth, you can easily determine the appropriate EV/IC given a company’s ROIC by multiplying the company’s ROIC by 10.

 

 

Thirty Years Reflections on the Ten Attributes of Great Investors (Michael Mauboussin)

 

A more recent report by Michael Mauboussin discussing the ten attributes of great investors. (link)

 

 

Ten Attributes of Great Fundamental Investors

 

The top ten attributes discussed in the paper are:

 

  1. Be numerate (and understand accounting)
  2. Understand value (the present value of free cash flow)
  3. Properly assess strategy (or how a business makes money)
  4. Compare effectively (expectations versus fundamentals)
  5. Think probabilistically (there are few sure things)
  6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected)
  7. Beware of behavioral biases (minimizing constraints to good thinking)
  8. Know the difference between information and influence
  9. Position sizing (maximizing the payoff from edge)
  10. Read (and keep an open mind)

 

 

7 Deadly Sins of Investing…..!!! (Tortoise Wisdom)

 

Given the previous link discussed the 10 attributes of great fundamental investors, it seems appropriate to include a link discussing what not to do in investing. Tortoise Wisdom discusses the seven deadly sins of investing. (link)

 

The seven deadly sins of investing are:

 

  1. Following the herd
  2. Overconfidence
  3. Trading too much
  4. Envy
  5. Keeping Unrealistic Expectations
  6. Uncontrolled Emotions
  7. Focusing on outcome, Not on Process

 

 

The truth about pricing power (and chocolate) (Intelligent Investor)
Graham Witcomb of the Intelligent Investor provides insight into pricing power. (link)

 

 

Video Library (Hedge Fund Conversations)

 

Hedge Fund Conversations created a library of videos of hedge fund investors. It may be a useful resource. (link)

 

 

Video Library (Ben Graham Centre for Value Investing)

 

While on the topic of video libraries, The Ben Graham Centre for Value Investing at Ivey Business School has a tremendous video library of presentation given to its students by practitioners. (link)

 

 

Understanding the Role of Emerging Markets in Your Portfolio (Fortune Financial)

 

Fortune Financial discusses Emerging Markets and their role in a complete portfolio. (link)

 

 

 A Profitable Industry You’ve Likely Never Considered (Fortune Financial)

 

Fortune Financial write an article discussing Mexican airports as a potential investment. (link)

 

 

How YouTube could capitalize on its rivals’ mistakes, and conquer the future of TV (Business Insider)

 

Business Insider discusses Youtube’s potential to take ad spend from television. (link)

 

 

Rolex is suddenly battling one of the biggest threats in history (Business Insider)

 

Business Insider examines the threats to Rolex and the watch industry. (link)

 

 

Conversation with Irish Hotel Mogul Pat McCann (Independent)

 

The Independent talks with Pat McCann on the hotel industry. (link)

 

 

Curing the Addiction to Growth (Harvard Business Review)

 

Harvard Business Review discusses retailers and strategies for when growth. Interestingly, they find the key metric in determining the winners and losers is ROIC as management teams that follow ROIC do not try to grow just to grow. Their focus is only growing when it creates value. The researchers focus on two other key metrics revenue per store and estimated revenue added per new store. (link)

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

WEEKLY COMMENTARY DECEMBER 5 2016 – DECEMBER 12 2016

 

 

 

 

COMPANY NEWS

 

There was no news related to portfolio companies this week.

 

We are decreasing our Credit Analysis and Research (CARE) position to 0%. We initiated the position at 2.0% as categorizing CARE as a high quality company that was slightly overvalued. Since initiation, the share price increased by 44% making the company overvalued with significant growth needed to generate any return.

 

We are also decreasing our Anta Sports position to 0% as we initiated the company as a high quality company that met all the criteria for investment with the exception of price as we felt it was slightly overvalued. The share price appreciated by 25% since our initiation and the company is now overvalued rather than slightly overvalued.

 

 

INTERESTING LINKS

 

At Deloitte, the problems with audit quality and professionalism start at the top (Marketwatch)

 

Deloitte is facing regulatory backlash over faulty audits and misleading investigators. It is not the first time and will not be the last. (link) There have been many examples of Chinese companies listed in Hong Kong IPO’d with a big 4 auditor that turned out to be frauds.

 

The Magic in the Warehouse (Fortune)

 

An interesting article discussing Costco, its business model, and its culture (link)

 

How to Build Great Teams (Society for Human Resource Management)

 

A great discussion on how to build great teams through communication and fit (link)

 

Why is Customer Acquisition Cost (CAC) like a Belly Button? (25iq)

 

Tren Griffin illustrates the importance of knowing the CAC in your business. (link)

 

Huawei’s Hard-Charging Workplace Culture Drives Growth, Demands Sacrifice (Wall Street Journal)

 

The Wall Street Journal writes about the culture of Huawei. (link)

 

Q3 2016 Report (IP Capital Partners)

 

IP Capital Partners’ Q3 2016 Report contains a good investment case for Amazon. (link)

 

 

 

INTOUCH HOLDINGS PRE-RESEARCH REPORT

 

EXECUTIVE SUMMARY

 

Intouch Holdings is an investment holding company with Advanced Info Services (AIS) account for over 95% of its intrinsic value. AIS is the leading mobile operator in Thailand with roughly a 50% market share. The industry has barriers to entry in the form of economies of scale and brand.  The large fixed costs come in the form of investment in spectrum and infrastructure and to a lesser extent marketing and distribution. Given AIS size and the presence of economies of scale, it has a significant advantage over its peers. Regulation also limits the competition to Thai companies.

 

Thailand recently held 3G and 4G spectrum auctions. The increased cost of spectrum decreases returns on investment in the industry as capital efficiency is much weaker leading to lower intrinsic values. The market is pricing in current earnings weakness due to a strong intensity of rivalry but valuations must fall further to account for the lower capital efficiency. In our estimate, AIS would be a buy below THB70 before becoming a buying opportunity translating to a buy price of Intouch below THB30 per share.

 

 

FACTOR RATING

 

 

 

COMPANY DESCTRIPTION

 

Intouch Holdings is a telecommunications holding company in Thailand, with investments in public and private companies. The company was founded as Shinawatra Computer Service and Investment by Thaksin Shinawatra in 1983. In 2006, when Shinawatra became the Prime Minister of Thailand, he sold his family’s stake in then Shin Corporation to Temasek Holdings. Shin Corporation rebranded itself to Intouch in 2011, including its new stock symbol, but did not officially change its registered name until March 2014.

 

The company’s main assets are publicly listed. Intouch has a 40.45% stake in Advanced Info Service PLC (AIS), a 41.14% stake in Thaicom PLC, and a 42.07% share in CS Loxinfo through a 99% owned Thaicom subsidiary.

 

The vast majority of the company’s net profit and value is derived from its investment in AIS.

 

AIS is the leading mobile operator in Thailand with 39.4 million subscribers nationwide or approximately 46% of the subscriber market share. In Q2 2016, 85.2% of subscribers were pre-paid.

 

To service its subscribers, AIS has 40MHz of its own spectrum (the regulatory limit is 45MHz), and up to 30MHz of spectrum rented from TOT. The company’s own spectrum was acquired at a total cost of THB319.4 billion (USD7.8 billion) and the rented spectrum has up to an annual cost of THB3.9 billion with a potential cost of THB39 billion over the life of the lease. To support its spectrum, AIS has 32,000 3G base stations covering 89% of the population and 15,500 4G base stations covering 55% of the population. AIS’s 4G goal is to cover 80% of the population by the end of 2016. AIS mobile operations account for over than 99% of AIS revenues.

 

Thaicom provides satellite transponder leasing in both the domestic and international markets under a concession from the Ministry of Information and Communications Technology, which expires in 2021, and the Telecommunications Service License Type III granted by the NBTC, which expires in 2032. THAICOM currently operates four satellites: one broadband satellite, Thaicom 4 (IPSTAR), and three conventional satellites, Thaicom 5, 6 & 7. Another satellite (Thaicom 8) is under construction and is expected to be launched in the first half of 2016.

 

Other businesses includes a JV with Hyundai Home Shopping creating a home shopping network in Thailand, and InVent, a venture capital arm launched in 2012, with the main purpose of supporting and promoting high-potential start-up companies in Telecom, Media, IT, Digital Content and other related businesses.

 

Intouch Holdings is 41.62% owned by Temasek. On August 18, 2016, Singapore Telecommunications entered into a conditional share purchase with Temasek to purchase 21% of Intouch Holdings at a price of Bt60.83 per share. The agreement should conclude in December 2016.

 

 

INDUSTRY ANALYSIS

 

Barriers to Entry

 

There are three major mobile operators: AIS, Total Access Communications (DTAC), and True Corporation (True). In Q2 2016, AIS had a 49.9% market share, DTAC had 25.5% of the market, and True had 24.6% of the market. Two other players CAT and TOT mainly lease their mobile networks to other players and have minimal market share.

 

There is strong evidence that barriers to entry exist among mobile operators. The industry only has three players. If there were no barriers to entry, there would be many more competitors as entrants are free to enter the industry.  Additionally, there is market share stability.

 

Market share stability points to captive customers that have difficulty changing between suppliers or do not want switch suppliers making it difficult for new entrants to compete. AIS tends to be the biggest beneficiary of the barriers to entry in the industry as it consistent generates the highest average revenue per user (ARPU), and the highest profitability.

 

AIS outperforms on all key value metrics including ARPU, gross margin, operating margin, invested capital turnover, and ROIC.

 

Additionally, AIS consistently generates excess profits well above its competitors, accounting for 89% of the industry’s excess profits since 2011.

 

The evidence points to barriers to entry within the industry with AIS being the main beneficiary. Given AIS’s market share advantage, economies of scale seems to be the primary source of its advantage as there are significant fixed costs with the largest being investment in spectrum and building a network with smaller fixed costs being marketing to build a brand. Investment in spectrum and network build are made prior to acquiring customers and the more customers these fixed costs are spread across the greater the profitability. The existence of economies of scale can be tested by observing profitability across different markets and seeing whether size explains profitability. The chart below illustrates the relationship between market share and ROIC among the three largest players in Thailand, China, and Indonesia in 2015 and over the last five years. China, and Indonesia were selected because they are the largest markets in Emerging Asia and oligopolistic.

 

There seems to be a relationship between market share and profitability with an adjusted R squared of 0.60. In addition to having the highest ROIC, in all three countries, the market share leader has the highest ARPU, operating margin, and invested capital turnover.

 

Additional evidence of the presence of economies of scale is the percentage of excess profits going to the market share leader in Thailand, China, and Indonesia. The market share leader in all three markets took an extraordinary amount of excess profits in 2015 and over the past five years averaging 122% of all excess profits.

 

Given the relationship between ARPU, gross margin and size, size appears to drive pricing power and brand as AIS can spread the fixed costs of building a network over allowing it to spend more on network coverage, speed, and network quality thus customers are more willing to pay to use a better network.

 

ARPUs are converging with True gaining on DTAC and AIS, but AIS was able to increase its ARPU relative to DTAC.

 

Gross margins are diverging with AIS expanding its gross margin by 5.7 percentage points while DTAC’s and True’s gross margins contracted by a minimum 4.1 percentage points.

 

As illustrated below, AIS has much better throughput than peers on 4G.

 

The company also has better 3G coverage.

 

The evidence points to size is a crucial competitive variable and barrier to entry among mobile operators.

 

The other barrier to entry is regulatory. In the latest 4G spectrum auction, only companies that are majority owned by a Thai could participate. Telecom companies outside of Thailand have the capital and desire to enter the market but the inability to find a suitable local partner to meet the spectrum auction requirements of being a local firm.

 

There was a threat of a new entrant when Jasmine International won a spectrum auction in December 2015. Fortunately for the industry, Jasmine was unable to raise the necessary capital illustrating the difficulty in entering the industry.

 

 

Other Four Forces

 

The industry is in a period of intense rivalry as competitors invested heavily in upfront fixed costs of acquiring spectrum and building out 3G and 4G networks. In a quest to generate as much profit as possible on their upfront investment, competitors are marketing aggressively through handset subsidies and marketing expenses to gain subscribers on their networks. Since 2010, AIS invested THB43.205 billion in spectrum, DTAC invested THB13.615 billion, and True invested THB48.602 billion.

 

In October 2012, Thailand auctioned 3G spectrum with AIS, DTAC and True all winning 15MHz of 2100MHz spectrum. AIS paid THB14.63 billion for its spectrum, while DTAC and True both paid THB13.50 billion for their spectrum. Thailand then auctioned 1800MHz spectrum in November 2015 with AIS and True winning 15MHz of spectrum. AIS paid THB41.00 billion while True paid THB39.80 billion. In December 2015, Thailand auctioned 20MHz of 900MHz spectrum. Initially, True and a new entrant Jasmine International won the spectrum. True paid THB76.30bn for its 10MHz allocation but Jasmine was unable to pay for the spectrum it won so the spectrum was re-auctioned in July 2016 with AIS winning the spectrum auction by bidding THB75.70 billion. Cumulatively, DTAC has paid for its entire spectrum. AIS paid THB43.205 billion of its THB131.33 billion spectrum obligations so the company has THB88.125 of spectrum payments that still need to be made. True paid THB48.602 of its THB129.60 billion spectrum obligations meaning the company has roughly THB81.00 billion in spectrum payments to be made. DTAC’s has 45MHz (3x15MHz) of spectrum with a license expiring in September 2018. This spectrum will be auctioned in July 2018 with a reserve price of THB3 billion per MHz or THB45 billion per 15MHz block of spectrum.

 

The investment in spectrum is followed by the need to build out an infrastructure to allow the company to sell the spectrum to customers. The more capex spent building infrastructure creates greater supply as well as a greater desire to get a return on the upfront investment in spectrum and infrastructure leading to more aggressive marketing campaign to acquire customers.

 

AIS has guided capex of THB40 billion in 2016 to build out its 3G and 4G networks with half going to 4G. The company had already spent THB14bn in 2015 on 4G network spend bringing the total capex to THB54 billion to build a 4G network will cover 80% of the country. According to the Bangkok Post, AIS will spend a total of THB60 billion to build out is 4G network. True estimates it will cost THB56 billion to provide 4G LTE to 97% of the country.

 

The chart above shows capex since 2010 with Q1 2016, Q2 2016, and Q3 2016 capex annualized. Combined capex increased from THB 14 billion in 2010 to roughly THB100 billion on an annualized basis in Q1 2016, Q2 2016, and Q3 2016. The increase in capex should continue for at least the next year as competitors continue to build out their 4G networks.

 

To recoup the investment in spectrum and infrastructure build, Thai telcos are aggressively marketing. Handset gross margins are a good indicator of the current level of marketing aggressiveness. Recently, AIS has been heavily subsidizing handsets to migrate from 2G to 3G as it license for its 2G spectrum expired near the end of 2015, while DTAC is subsidizing handsets to slow market share losses as it has gotten a reputation for having a low quality network due to underinvestment. All competitors are subsidizing handsets to acquire 4G customers as companies roll out their 4G network. Companies are also subsidizing smart phones for postpaid subscribers as postpaid subscribers use much more data and voice leading to an ARPU over 3 times the ARPU of prepaid subscribers. AIS’s guidance is for continued subsidies and negative handset gross margins in 2016. The industry handset gross margin declined from 5.1% in Q1 2013 to -18.9% in Q3 2016, making Q3 2016 handset gross margin the lowest since 2013.

 

In addition to handset subsidies, competitors are aggressively on pricing and marketing. Marketing expenses among all players are on an increasing trend as illustrated by the chart below, Q1, Q2, & Q3 2016 marketing expenses are annualized. In 2010, industry marketing expenses totaled THB9.5 billion. In Q3 2016, annualized marketing expenses reached THB55.2 billion.

 

Despite lower regulatory costs, higher marketing expenses led AIS to guide for a 2016 EBITDA margin of 37%-38% in 2016 down from 45.6% in 2015. The regulatory costs for 2G were the highest in the world at 20-30% of revenue. The 3G and 4G regulatory costs are much more lenient with up to 5.25% of revenue going to regulatory costs. DTAC also expects its EBITDA margin to decrease to 27%-30% in 2016 from 31.8% in 2015. Industry regulatory costs decreased from 26.5% of industry sales in Q1 2013 to 8.8% of industry sales in Q2 2016.

 

Further fueling the rivalry is TRUE’s market share gains (+9.1%) since Q1 2013 at the expense of DTAC (-5.2%) and AIS (-3.8%). Given the importance of economies of scale, it makes sense for firms to increase the rivalry to maintain market share.

 

True’s also recent recently raised capital. In December 2013, True spun off its infrastructure assets through an IPO raising THB58.1 billion or USD1.8 billion. The infrastructure fund allows investors to benefit from the revenues generated by telecom towers, a core fibre-optic network and related transmission equipment, and a broadband access system located in provincial areas of Thailand. In January 2015, True sold 350 towers and 8,000km of fiber to its infrastructure fund for THB14 billion or USD424 million. In September 2014, China Mobile purchased 18% of True for THB28.6 billion or USD880 million in a private share placement. Despite the fund raising, True’s net debt to ttm operating profit is still at 6.05 as the company has generated cumulative free cash flows of THB-113.81 billion since the beginning of 2011. The continuous fund raising fueled by negative cash flows points to the competitive advantage held by AIS.

 

As illustrated above from 2010 to the end of 2015, True’s operating cash before any investments just covered investment in working capital and investment in spectrum. With external capital needed for almost all of the company’s investment in network. AIS’s generated the highest operating cash flow before any investment and free cash flow. DTAC generated a strong operating cash flow before any investments but spent significantly less than its peers on its network and spectrum. If DTAC spent a similar amount on spectrum and network build its free cash flow as AIS and True, its free cash flow would have been slightly negative. The lack of investment in its network and spectrum has hurt DTAC brand leading to market share losses to True.

 

Weak economic growth in Thailand and continued decline in voice revenues also add to the intensity of the rivalry in the industry.

 

 

Threat of Substitutes

 

The threat of substitutes for voice revenue is high as users are shifting away from voice to text, messaging apps or cheap voice services like Whatsapp or Skype leading to a continual decline in voice revenues.

 

The decline in voice revenue is a trend among more mature mobile markets as illustrated by the chart/table above.

 

The threat of substitutes for data revenue is low as mobile phones are a necessity and the trend continues to shift towards an increasing reliance on mobile phones for many aspects of daily life. The shift away from voice revenue is to substitutes that generate data revenue for mobile operators.

 

The overall threat of substitution to mobile operators’ products is low as the mobile phone is now such an important part of everyday life.

 

 

Bargaining Power of Suppliers

 

The bargaining power of suppliers is low. The main supplier are handset providers and SIM card producers as AIS creates its own infrastructure. SIM card manufacturers make a commodity product and the industry is much more fragmented than the mobile operator industry. The handset industry is also more fragmented than the mobile operator industry giving operators bargaining power when discussing handset purchases. The only supplier with any bargaining power is probably Apple given the brand associated with its product.

 

 

Bargaining Power of Customers

 

Customers have some bargaining power as they can freely switch providers particularly when so many subscribers are pre-paid meaning there are no contracts and there is number portability. Additionally, the information of all operators offering are readily available allowing customers to easily compare competitors increasing the bargaining power of customers. The ease of comparing competitors’ offerings along with the increasing cost of mobile services makes customers very focused on pricing.

 

Mobile operators compete on network quality as much as price. The difference in network quality creates a cost of switching from a good network to a bad network. Hindering bargaining power is the presence of only three mobile operators creating a significant amount of concentration at the mobile operator level while customers lack concentration. Overall, customers seem to have a fair bit of bargaining power due to number portability and the ease of comparing competitors’ offerings.

 

 

Industry Growth

 

In Thailand, mobile penetration reached 126% in 2015 meaning there is relatively little growth potential from an increase in subscribers. Since Q1 2013, subscribers grew at a CAGR of 1.9%. At the end of Q3 2016, smartphone penetration reached 70% while 4G handsets penetration reached 19% meaning future growth will not come from subscriber growth or even increased smartphone penetration but from increase in 4G penetration, which comes with increased data usage. In Q3 2016, AIS data subscribers accounted for 57% of total subscribers averaging 2,960 MB of data used per month up from 34% and 240 MB in Q1 2013 representing 17% CAGR in data subscribers and a 95% CAGR in data usage. Over the same period, the estimated price per MB has declined from THB0.2046 in Q1 2013 to THB0.0201 in Q3 2016.

 

The growth of data usage now makes non-voice revenue a larger portion of revenues than voice revenue with non-voice accounting for 56.5% of service revenue in Q3 2016 up from 27.3% in Q1 2013. Since the Q1 2013, non-voice revenue grew at a CAGR of 23.0% compared to voice revenue declining at 11.7% per year.

 

 

MANAGEMENT

 

All director and executives of Intouch Holdings have very small share ownership and therefore are hired hands rather than owner operators. Neither Intouch’s management nor AIS’s management do not extract too much value with the remuneration of directors and executives only 0.18% of operating income at Intouch Holdings and 0.25% of operating income at AIS.

 

 

Capital Allocation

 

Despite Intouch’s goal of achieving 25% of value from non-AIS businesses, AIS currently accounts for over 95% of Intouch’s market value therefore the focus will primarily be on AIS’s capital allocation decision.

 

To determine the strength of capital allocation decisions, we will attempt to determine a return on investment. The majority of AIS’s business is 3G but the company is building out its 4G network. For conservatism, we assume no change in the current competitive environment and no growth in AIS business to get a perpetuity cash flow figure. AIS spent THB131.33 billion on 3G and 4G spectrum. Additionally, the high end of the company’s 3G network build is THB90 billion. The company also estimates 4G network build will cost THB60 billion. The total investment in spectrum and network build THB281.33 billion.

 

Assuming a 15 year useful life on the investment, no change in subscribers, no growth in ARPU, an operating margin of 25%, a tax rate of 25%, and no salvage value; the overall investment in 3G and 4G generates a return on investment of 14.3%. It is not the returns that the company is used to generating, as the investment cost in 4G spectrum was expensive, but it still creates value for the company. The investment is a necessity for the company to stay competitive.

 

Looking at the assumptions, AIS currently has 39.8734 million subscribers so there is no change to the number of subscribers in the market or to market share. Depreciation is assumed to have a 15 year useful life, in-line with the license period leading to an annual depreciation expense of THB18.755 billion. Depreciation is 16.3% of sales well above the average rate of 12.5% over the past five years. ARPU is expected to remain stable at THB240 per month as the increased data usage is offset by cheap data prices. AIS’s ARPU has averaged THB240 per month since Q1 2013 with no particular trend. The 25% tax rate equals the company’s historical tax rate. The operating margin of 25% is well below historical rates. It is assumed that competition continues into perpetuity with negative handset margins and elevated marketing expenses with lower regulatory expenses from 3G and 4G networks as Q3 2016 saw operating margin at 24.3% with gross margin at 44.0%, selling expense at 10.3% of revenue, administrative expenses at 9.3% of sales, and depreciation and amortization at 16.9% of revenue. The table below illustrates the sensitivity of the investment in 3G & 4G to various assumptions.

 

Other than mobile, AIS is investing in fixed broadband with a goal of full coverage of Bangkok by end of 2016 and having significant market share in three years. The investment is insignificant relative to the investment in mobile.

 

Both Intouch and AIS are very shareholder friendly with an 100% dividend payout policy.

 

Other than the investment in AIS, Intouch also has smaller investments in Thaicom and a number of private equity investments related to media and telecommunications. The company’s stated goal is for non-AIS investments to reach 25% of the value of the portfolio. Many of the private equity investments are for to aid AIS of strategy of providing more content and digital applications. Intouch’s largest investment outside of AIS and Thaicom is a home shopping network in Thailand called High Shopping Co. Ltd. It is 51% owned by Intouch and 49% owned by Hyundai Home Shopping and has total capital THB500 million. The TV home shopping market in Thailand is expected to double in market value to 20 billion baht by 2020. Intouch forecasts it share of the market will reach THB4.5 billion in 2020, or of 20% of the TV home shopping market in Thailand.

 

 

VALUATION

 

Currently, AIS is overvalued as the market has yet to factor in decreased capital efficiency from the size of the recent investment.  The total investment will reach 282 billion while estimated revenues are less than half of that. In order to get the market’s current valuation for AIS, assuming an alleviation of competitive pressures leading to average historical margins and no growth, invested capital turnover needs to remain near historical levels. Even with these assumptions, there is 10% downside.  Assuming no growth, a persistence of competitive pressures along with a decline in invested capital turnover to 1.1 times, half of the historical average of 2.2 times, AIS intrinsic value is closer to THB70.00.

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

 

Company News

 position-summary-table

PC Jeweller

PC Jeweller’s share price fell by 15.1% during the week bringing the total decline to 31.7% this month as the Indian government demonetized INR500 and INR1,000 notes in an attempt to fight “black money”. On the back of the regulation, the market is speculated that gems and jewelry companies would be one of the most impacted industries as gold and jewelry is thought to be a favorite “black money” asset. The Indian jewelry industry participants speculate a potential import ban on gold is also coming.

 

After the fall in share price, PC Jeweller is now offers a 9.1% NOPAT yield causing us to increase our position to 4.0%. While the company is in an industry with no barriers to entry evident by the thousands of competitors, PC Jeweller and Titan are far more operationally efficient than competitors creating excess profits through strong management. Our initial theory on PC Jeweller’s and Titan’s excess profits was associated with weaker competition from the unorganized sector, but the continued outperformance of PC Jeweller and Titan while listed peers continue to struggle points to operational advantage over organized peers.

indian-jewelry-value-driver-comps

 

The table shows the key value drivers within the industry as well as the financial health of peers. From 2012 to 2016, PC Jeweller has the third highest gross margin with the highest operating margin. Gross margin points directly to the customers’ willingness to pay while the difference between gross margin and operating margin point to the efficiency of management in running operations. In addition to the highest operating margin, PC Jeweller also has the fastest growth in the industry. PC Jeweller has the second highest ROIC leading to the second highest value creation in the form of excess profits. PC Jeweller and Titan are the only competitors that generated any significant excess profits over the period examined. The ability to continually generate excess profits in a period of raw material constraints and weak demand points to the strength of the management teams at PC Jeweller and Titan and an ability for sustained excess profits.

 

To get to an annualized return of 15%, PC Jeweller would have to fight margin pressures through stable operating margin and capital efficiency, while growing at 10% during the forecast period fading to a 0% growth rate in perpetuity. These assumptions do not seem too aggressive given, management ability to continue to create value despite points to sustained excess profits. New store openings and franchising should provide the 10% growth with the fade to 0% growth in year ten potentially being conservative. Our big concern with the above assumptions is competitive pressures lead to ROIC contraction rather than growth. If we change our profitability assumption to marginal excess profits from superior management (ROIC = 15%, Economic Spread = 2.5%), the five year would be 10%. This profitability assumption seems much more conservative and gives us sufficient comfort that if profitability declines there is still ample upside. It seems the risk reward is balanced sufficiently to increase our position size in PC Jeweller to 4.0%. We will be increasing our position size at a price below INR375.

 

Zensar Technologies

On November 17, 2016, Zensar Technologies reported FQ2 2017 results. Revenue grew by 2.7% and operating profit declined by 9.3%. FQ2 2017 was the third straight quarter where operating profit declined as the lack of growth on the top combined with continued growth in employee benefit expense leading to margin compression. The margin compression comes with an increasing average deal size and an increasing number of customers above 1 million, Zensar are unable to grow its top line as rapidly as its employee benefit expense leading to margin contraction. The weak top line growth may be temporary as the company’s backlog is strong at USD700 million up from USD500 million in the last quarter. Zensar is now offering a NOPAT yield of 6.5% despite being a business with no competitive advantage. With very aggressive assumption of a 12.5% discount rate, stable margins and capital efficiency, 10% forecast period growth, and 5% growth into perpetuity, Zensar offers 85% upside over the next five years. Growth in perpetuity is usually only assumed for companies with sustainable competitive advantages, which seems not to be the case for Zensar. Assuming a perpetuity growth rate of 0% decreases the potential upside over the next five years to 47%. Changing the growth assumptions to a 5% growth rate over the next five years, and a 0% terminal growth rate, there is only 19% upside over the next five years. Given the lack of upside, and lack of competitive advantages, we will be selling our Zensar position at prices above INR900.

 

Other Links

 

Why Moats are Essential for Profitability (Restaurant Edition) (25iq)

A fantastic essay at 25iq discussing the importance of moats. It also discusses the amount of research needed to understand the economics of a business. (link)

 

A Narrative Narrative (Polemic’s Pains)

A good blog post discussing how the current narrative on many topics is nothing more than speculation and subject to rapid change (link)

 

Expected Return (Research Affiliates)

Research Affiliates maintains expected real returns of different asset classes including Emerging Market Equities. (link) Given our view that the discount rate is an opportunity cost it may be more appropriate to view expected returns as the discount rate rather than historical returns. The appropriate discount rate for Emerging Markets would be 7.3% expect real return. Adding an additional 2.5% for expected inflation gets to roughly 10% discount rate. Adding an additional 2.5% as a margin of error gets us to 12.5%, our current discount rate. The idea that the discount rate should be tied to expected returns needs to be flushed out, but it seems interesting.

 

Predicting the Long Term is Easier than Predicting the Short Term (Intrinsic Investing)

An interesting article discussing how it is easier to predict the long term than the short term due and why this is one of the reason investing for the long term investing outperforms short term investing. (link)

 

Value Stocks vs. Value Traps (Old School Value)

Old School Value wrote an interesting article by discussing the characteristics of Value Stock and Value Traps. (link)

 

Chris Mayers on 100-Baggers (MicroCapClub)

Chris Mayers wrote 100-Baggers, an update on Thomas Phelps 1972 book 100 to 1 in the Stock Market. In this video, he discusses the key characteristic of 100-Baggers. (link) Below are the summary points.

 

  • Start small
  • Hold for a long time
  • Prefer a low multiple
  • High returns on capital
  • Owner operators

 

Fake News (Stratechery)

A good article by Stratechery on the subject of “fake” news, Facebook’s role in the delivering the news, and the dangers of who decides what news is deemed fake. (link) The discussion of fake news is interesting with the potential to leading us down a scary path. We must not forget the masses still receive their news from a small number of news outlets creating gatekeepers who deem some information to be newsworthy and other information less newsworthy. The existing gatekeepers already create narratives and form opinions among the population.

 

How the Brain Decides Without You (Nautilus)

It may not matter what the facts are, as the brain seems to decide how the world appears based on your existing views. (link) The best way to ensure, you are not missing anything due to pre-existing biases is to seek out the other side of the argument and understand it as well as you understand your side of the argument.

 

How Headlines Change the Way We Think (New Yorker)

Tied to the previous two articles, is an older article from the New Yorker discussing how headlines change the way we think about a story (link)

WEEKLY COMMENTARY NOV 7 2016 – NOV 14 2016

WEEKLY COMMENTARY NOV 7 2016 – NOV 14 2016

 

COMPANY NEWS

 

PC Jeweller declined by 14% over the last three days of the week as the Indian Government decided to ban all INR500 and INR1,000 notes to fight black money. Roughly, 80% of the industry sales are in cash. In the short term, there will be an impact. In the longer term, it may increase the attractiveness of gold and jewelry as a store of value as credibility of the government and its potential actions decrease. It may also help consolidate the market in the organized sector. PC Jeweller offers a 7.8% NOPAT yield. We are maintaining the current position size of 2.0% for now with any further price declines probably prompting a position size increase.

 

Turk Tuborg reported Q3 2016 results with revenue increasing 39% while net profit increased by 55%. It remains extremely profitable with a Q3 2016 annualized ROIC of 151%. Turk Tuborg continues to gain share on Anadolu Efes with Anadolu Efes Turkish beer revenue increasing by 2.5% in Q3 2016. Over the past 12 months, Turk Tuborg gained 7 percentage points of market share (34% to 41%). These two players have accounted for over 99% of the industry for many years. It also is much more profitable generating 1.14 times the EBITDA of Anadolu’s Turkish beer operations on 70% of the sales. Turk Tuborg net profit was six times Anadolu’s Turkish beer operations net profit due to the financial leverage employed by Anadolu. The combined market share, a two-way distribution system (bottles and kegs account for over half the market), and the economies of scale within the industry alleviate concerns of entry from new players. Competitive rivalry is also weak despite Turk Tuborg’s share gains due to Anadolu Efes financial leverage (6.1 times EBIT in 2015), currently a big concern of the company. Anadolu is also a much bigger entity with operations all over Eastern Europe diverting their attention while Turk Tuborg is focused solely on the Turkish market. The big risk to the investment case is the increased centralized control within Turkey may decrease secularism in the country leading to prohibition. The Turkish government taxes the Turkey’s beer market heavily making it a steady stream of revenue for the government, which it may not want to lose through prohibition. Turk Tuborg now trades at an EV/ttm EBIT of 7.8 times with a net cash position almost two times ttm EBIT. We will maintain our 4.4% position potentially increasing if there are any significant share price declines.

 

 

COMPANY IN FOCUS

 

Veto Switchgears and Cables

 

Executive Summary

Veto operates in a commodity business with low barriers to entry yet only offers a NOPAT yield of 6.1%. The commodity nature of the business means growth does not add value and therefore does not generate any additional return, therefore the current expected return is 6.1% well below the required return for a commodity business.

 

Company Description

 

Veto Switchgears and Cable manufactures wires & cables, electrical accessories, industrial cables, fans, CFL lamps, pumps, modular switches, LED lights, immersion heater, MCB and distribution boards.

Veto has a distribution network of 2,500 dealers across the country with a majority of revenues coming from Rajasthan with growth opportunities in the rest of India and the Middle East. Given it growth potential, the company purchased 10,312.99 square meters in SEZ Jaipur to increase manufacturing capacity. The company’s targets reaching more than Rs.1,000 crores in sales by FY2021. The company’s current capacity and capacity utilization is illustrated below.

capacity-and-capacity-utilization

The company’s main raw materials are copper, PVC resin, and aluminum.

raw-materials

 

The company listed on the public stock exchange in 2012. The promoters own 58.19% of the company down from 71.76% at the end of December 2015.

 

Industry

The company describes the industry as fragmented with low barriers to entry therefore the only way to generate excess returns is through operating efficiency. Given the difficulties maintaining a competitive advantage, it will be difficult sustaining excess profits and therefore the company should trade at reproduction value.

 

A volatile ROIC averaging 15.8% over the past five years seems to confirm the lack of competitive advantage but the company’s capacity utilization is low providing an opportunity for the company to double its ROIC. An inconsistent gross margin is evidence of a lack of pricing power.

 

Management

Management has not overly levered the company with current net debt to 5-year average operating income of 1.95 times.

 

Management remuneration is reasonable at 2.0% of operating income in FY16 and FY15.

 

Related party transactions are relatively insignificant at 2% of sales.

 

Given the lack of barriers to entry, the company’s number one strategic focus should be operational efficiency.

 

Valuation

Assuming an 12.5% discount rate, cyclically adjusted operating margin, and cyclically adjusted capital efficiency, for the company to generate over a 10% annualized return, the company needs to grow by 20% over the next five years fading to 5% terminal growth rate in year 10. Given the lack of barriers to entry in the industry, any growth should not generate any value therefore is irrelevant making the market’s current assumptions very aggressive.

 

Veto currently offers a NOPAT yield of 6.1%. As mentioned the commodity nature of the business means growth does not add value and therefore does not generate any additional return, therefore the current expected return is 6.1% well below the required return for a commodity business.

 

Risk

Continued growth in the market alleviates competitive pressures allowing the company to main elevated returns.

 

The company fills capacity and is able to double its ROIC through much better capital efficiency.

 

Key Areas of Research Focus

  1. Operating costs relative to peers

 

 

INVESTMENT THOUGHT

 

Whether an industry has a barrier to entry or not is a key question in our investment process. In an industry with barriers to entry, competition cannot freely enter limiting the potential supply in the market allowing excess profits to be sustained. The sustainability and predictability of earnings or cash flows means an earnings or cash flow based valuation is a more appropriate valuation methodology. If barriers to entry do not exist in the industry, competition will freely enter the market leading to a reversion of profitability to the cost of capital. In times of elevated profitability, supply will increase until profitability reverts to the cost of capital. In an industry with no barriers to entry, the appropriate valuation methodology is reproduction value or the value of a new competitor to reproduce the assets of the company.

 

In a scenario of no barriers to entry, we also take into account barriers to exit. An industry with no entry barriers and no exit barriers, profitability will revert to the cost of capital as new supply enters and exits the industry. The speed of the reversion of profitability will depend on the time to add new supply, the time to eliminate supply from the market, and the growth in demand in the market. If exit barriers exist, it will be harder for supply to exit the market slowing or even halting the reversion to the mean of profitability during periods of underperformance when supply should be exiting the market. A state where industry returns persist below the cost of capital occurs and is rectified when demand growth catches up to the supply in the industry or supply exits the market.

 

In an industry with barriers to entry, growth is an important assumption in determining the value of a company. Assuming 25% ROIC and a 12.5% discount rate, every $1 invested creates $2 in value illustrating the importance of growth. In an industry with no barriers to entry, ROIC will eventually revert to the cost of capital meaning $1 invested will create no additional value making growth an irrelevant assumption.

 

The crucial strategic questions in industries with barriers to entry are what is the barrier to entry, and then is the barrier to entry strengthening or weakening. The crucial strategic questions in an industry without barriers to entry are do exit barriers exist, is supply increasing or decreasing, how long does it take to bring on supply or shut down supply,  and is the company at the low end of the cost curve as operational efficiency provides an opportunity for potential excess profits.

 

Not understanding the importance of barriers to entry leads investors to make mistakes. The thought that all growth generates value and is therefore relevant being the biggest mistake. Another mistake investors often make is assuming an industry in its early stages with strong profitability means barriers to entry exist. Often in the early stages of an industry’s life cycle, companies are able to generate excess profits as demand is growing at such a rapid pace that supply cannot keep up. The supply demand imbalance allows producers to be price takers. In most industries, the excess profits from the early stages of the industry eventually dissipate as demand growth slows and supply catches up eliminating the tightness in the market causing profitability reverts towards the cost of capital as pricing power of suppliers is eliminated. Only a small number of industries will be able to limit the supply allowing for sustained excess profits. The short-term thinking in the industry is the main culprit for the errors listed above. If an investor has focus on whether next quarter’s earnings will beat expectations, barriers to entry and industry life cycle is irrelevant, as these events may not occur for quarters or years.

 

Whether barriers to entry exist or not is an important question in our investment process determining the type of industry analysis and the valuation method used.

 

 

INTERESTING LINKS

 

CVS Warns of Prescriptions Shift, Shares Tumble on Profit Warning (Wall Street Journal)

An interesting article discussing the differences in business models of CVS and Walgreens. It is a reminder that strategy involves choosing not only what to do, but what not to do. (link)

 

Why Warren Buffed Does Not Believe in EBITDA (S&C Messina Capital Management)

While market participants regularly use EBITDA as a proxy for cash flow, we find it to be a very flawed metric therefore we use it only we there is no other option. The linked article by S&C Messina Capital Management discusses the main reasons for our suspicion of the EBITDA metric. (link)

 

Joel Greenblatt on Wealthtrack (Hurricane Capital)

Hurricane Capital took notes on Joel Greenblatt’s recent visit to Wealthtrack. Mr. Greenblatt is always insightful and a very articulate value investor. He discusses many of the key tenets of value investing. (link) You can watch the full interview here on YouTube.

 

Reader’s Questions (CSInvesting)

CSInvesting answered some readers’ questions on reproduction value and EPV with some very interesting insights. (link) CSInvesting has a lot of useful resources so it is worth the time to have a look around the website. Reproduction value and EPV are valuation techniques made famous by Bruce Greenwald. His book Value Investing: From Graham to Buffett and Beyond is one of the best value investing books ever written. Professor Greenwald also wrote Competition Demystified another invaluable resource on thinking about the competitive environment. Professor Greenwald teaches a value-investing course at Columbia Business School. A playlist of his course can be found here on YouTube. It is well worth the time to watch multiple times.

Don’t Confuse Cheap With Value (Broyhill Asset Management)

Broyhill Asset Management put together an interesting presentation on valuation multiples and what a multiple actually represents. (link)

 

Interesting Tweet Comparing Nike and Under Armour (Connor Leonard)

Apparel much more prone to trends and higher margins but a weaker competitive position as performance footwear is much more complex requiring more R&D. Additionally, performance footwear is crucial to the activity it is bought for therefore much more loyalty. Apparel is much more fashion oriented so significantly less loyalty. These views conform to our views mentioned in our Peak Sport Products and Anta Sports reports. (link)

 

Common Mistakes Made When Investing in Quality Companies (Lawrence A. Cunningham)

Mr. Cunningham was the co-author of Quality Investing: Owning the Best Companies for the Long Term. A wonderful book that is a must read for all investors thinking about investing in quality businesses. As stated in the title, the article discusses the common mistakes made when investing in quality companies. (link)

Weekly Commentary 10/31/2016-11/6/2016

Weekly Commentary 10/31/2016-11/6/2016

We are starting a weekly commentary to provide more consistent updates.  It will contain the news from the companies we cover, random investment thoughts, and the top articles of the week.  Let us know what you think.

 

Company News

 

On November 2, 2016, Zensar Technologies announced the acquisition of Foolproof. Foolproof is one of Europe’s leading experience design agencies, headquartered in London with other offices in Norwich and Singapore. The company helps global brands design better digital products and services for customers based on a deep understanding of consumer behavior, their clients’ business and new technology. It has many Global500 firms amongst its clients. LTM revenue = GBP8.5 million with a mid-single digit GBP million EBITDA with expectations for continued growth rate of 10-15% post acquisition. Zensar’s digital revenue now is 30% of total revenue.

 

From a strategic standpoint, the Foolproof acquisition makes sense. Foolproof adds knowledge in a fast growing industry strengthening Zensar’s digital services business. It strengthens Zensar’s client list adding relationship with a number of Global 500 allowing Zensar to cross-sell other services. It is also a smaller bolt on acquisition making it easier to integrate into existing operations. Unfortunately, the lack of price disclosure eliminates the ability to evaluate the transaction fully.

 

We will maintain Zensar’s current 3.5% position in our model portfolio. The company is trading at roughly 6% NOPAT yield with expected growth between 5-15% over the next five years. It continues to generate strong profitability and its executing on its strategy to increase revenue from digital services. It continues to win larger and larger contracts allowing for greater profitability. Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and/or some switching costs. Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers. The Indian IT services sector is based on low cost labor or price competition. There is no sustainably differentiation on knowledge as employees hold the knowledge of the organization and employees can take this knowledge to another company.

 

Why are we maintaining Zensar Technologies 3.5% position size while decreasing PC Jeweller’s position size to 2.0%? Zensar and PC Jeweller’s both offer a NOPAT yield of roughly 6.0% and both offer growth between 5-15% over the next five years. Zensar’s business seems slightly better to us. Both industry have significant competition, but Zensar’s industry generates much higher average returns on invested capital than PC Jeweller’s, due to the asset light nature of the business. The jewelry business is very working capital intensive. Additionally, Zensar has a long history of steady growth while PC Jeweller has grown rapidly; it is in a much more cyclical industry.

 

On November 3, 2016, Miko International announced the resignation of Mr. Zhu Wenxin, an Independent Director at the company with Mr. Chan Wai Wong replacing him. The resignation is the latest in a series of director resignations. Below is a list of previous resignations.

  • On June 30, 2016, Gu Jishi resigned as Executive Director being replaced by Ms. Ding Lizhen, a member of the founder’s family.
  • On March 14, 2016, Mr. Wong Heng Choon resigned as Independent Director less than a month after being appointed.
  • On February 19, 2016, Mr. Leung Wai Yip resigned as Independent Director.
  • On September 8, 2016, Mr. Ng Cheuk Him resigned as Chief Financial Officer.

 

All the resignations follow the resignation of KPMG on April 21, 2016 and appointment of HLB Hodgson Impey Cheng Limited, an auditor of last resort for many Chinese frauds. The signs of fraud are piling up.

 

On November 4, 2016, Miko announced it signed a Memorandum of Understanding to set up a Joint Venture in the factoring business, an industry far removed from the current operations, which does not make much sense. We are already in the process of selling our position in Miko International.

 

On November 4, 2016, Credit Analysis and Research (CARE) reported first half results. Revenues grew 9% and operating profit grew 20%. The company also grew its client base by 8.5% from June 2016. It also signed a Memorandum of Understanding to start a credit rating agency in Nepal. The company also designated the first “SMART CITY” credit rating. Overall, the earnings report does nothing to move the needle either way. CARE is trading on a NOPAT yield of 3.0% but it is the most profitable company in an oligopolistic industry with significant barriers to entry and a very long runway for growth requiring no capital to grow. We entered with a 2.0% position in hopes that we could increase our position size at a cheaper price. We will maintain the current position given the barriers to entry in the industry, the runway for growth, and the lack of capital required to grow.

 

 

Random Thoughts

 

A recent FT Alphaville article discussed Sanford Berstein’s shift away from valuing companies by discounting cash flows. Bernstein argued in a zero rate world the risk free rate and the over weighted average cost of capital (WACC) is so low the importance of distant cash flows in the intrinsic value is much higher. Given an inability of analysts to forecast cash flows in the distant future, this increasing importance of the terminal value places a significant weight on highly uncertain cash flows. The following exhibits from the FT article illustrate the importance of the terminal value in Berstein’s estimation. Bernstein uses a discounted cash flow model with a five-year forecast period followed by a fade to a terminal value in year 10. Bernstein’s first charts assume a 10% growth rate for the next five years followed by a fade to a terminal growth rate of 3.5% in year 10. The second chart assumes a 5% growth rate for the five-year forecast period followed by a fade to a similar terminal growth rate.

importance-of-terminal-value-ft

 

Under the scenarios mentioned, Bernstein estimates the terminal value accounts for 55% at a 10% WACC increasing to 99% for a 3.6% WACC. WACC or discount rate is one of the many factors determining the importance of terminal value in a discounted cash flow valuation. We believe Bernstein, like many other market participants, is overlooking many other crucial factors in determining the importance of terminal value. We will discuss our view on the discount rate as well as other factors overlooked by Bernstein. We will also discuss another valuation method to overcome the shortfall of increased importance of terminal values in the discounted cash flow valuation. Whenever we value companies at Reperio, we use a similar discounted cash flow model with a five-year forecast period fading to terminal assumptions in year 10.

 

In the article, Bernstein’s main concern was lower interest rates lead to a lower discount rate leading to a lower WACC. Given the value of a corporation is driven by cash flows well into the future, the main assumption in lowering a company’s WACC is interest rates will remain low for a very long period of time. The chart below is the yield on a US 1 year treasury rate since 1953 illustrating the current rate of interest is the lowest on record.

1-yr-treasury-rate

We are bottom up investors but to assume market participants will accept 64 basis points forever in compensation for lending the US government money for one year seems aggressive, particularly, when one-year interest rates were over 1600 basis points in the early 1980s.  .

 

The treasury rate is a key input into the Capital Asset Pricing Model (CAPM) used by Bernstein and many other investors in determining a company’s WACC or discount rate. CAPM like many models in economics and finance is built with assumptions completely detached from reality. The biggest flaw in the CAPM is price equals risk. When calculating the cost of equity to determine the cost of equity, beta is multiplied by the equity risk premium. Beta is the volatility in a stock relative to a stocks benchmark meaning if a company’s share price is more volatile than its benchmark, it is assumed to be a more risky investment and therefore have a higher cost of capital. Putting aside the potential errors in measure a stock beta, a volatile stock does not equate to risk for the investor. This logic would lead you to believe a private business with the exact same characteristics of a public company listed on a stock exchange is a much safer investment, as there is not daily price volatility associated with being listed. At Reperio Capital, we view permanent loss of capital as the true risk of any investment. Permanent loss of capital comes from three risks: business risk, financial risk, and valuation risk. Business risk is the permanent loss of capital due to a permanent impairment of cash flows from competition or mismanagement. Valuation risk comes from overpaying for a security. Financial risk is when a company is has significant financial leverage that may lead to bankruptcy.

 

Another significant problem with CAPM is measuring a stock’s beta. The measurement of beta lends to significant estimation errors. Using Zensar Technologies as an example, if you calculate the company’s beta on a weekly basis since its listed in July 2002, its beta is relative to the SENSEX is -1.19. If you change the time period used in calculating beta to the last 10 years, Zenar’s beta changes to 0.77 illustrating the potential issues calculating beta.

 

Instead of calculating the weighted average cost of capital, we have used a constant discount rate as we assume there is an opportunity cost associated with making any investment. We are increasing our discount rate to 12.5% discount rate (from 10%) for all companies, roughly the average annualized return generated by the MSCI Emerging Market Index since inception and slightly more than the S&P 500 average annualized return is 9.5% since inception. If we can generate 12.5% annual return elsewhere then cash flows from any potential investment should discounted at that particular rate regardless of what the cost of capital is for each individual company. A constant discount rate also eliminates some of the subjectivity in valuation.

 

Other than lower interest rates and faulty measures of risk, Bernstein’s assumptions seem very optimistic. The FT article only mentioned growth and discount rate assumptions meaning the other important value drivers of operating margin and capital efficiency must have remained constant assuming no competitive pressures over the life of the company. The vast majority of companies succumb to competitive pressures leading to a fall in profitability and/or capital efficiency eliminating any excess returns. If excess returns are eliminated, growth does not add value making it an irrelevant discounted cash flow assumption. A small number of companies can hold off competitive pressures making profitability and capital efficiency irrelevant assumptions. The FT has a great free equity screener. In its universe, there are 13,799 stocks with a market capitalization above USD100 million and a 5-year average return on investment. Of the 13,799 stocks, only 2,001 stocks or 14.5% of the universe averaged a 15% return on investment over the past five years, which a very, very crude approximation of a company with a competitive advantage illustrating the difficulty in fending off competitive pressures and maintaining excess returns. Given the vast majority of companies face competitive pressures the assumption of constant operating margin and capital efficiency and any growth in terminal cash flows is very optimistic. An example is PC Jeweller, the company is operating efficiently generating excess returns but jewelry retailing is a fiercely competitive industry with thousands of competitors with little ability to sustain differentiation. We assume a 10% growth over the first five-year forecast period with growth fading to 0% in year 10 and competition eliminating excess profits.

1-scenario-terminal-value-total-value

 

As illustrated, at a 5% discount rate, the cash flows in the terminal value account for 51.0% total value. At a 15% discount rate, cash flows in the terminal value account for 31.6%. At a 5.0% WACC, Bernstein estimated 91% of a firm’ value is in the terminal value, while our estimate is much lower at 51.0% as we are more conservative on our assumptions for the vast majority of companies. The failure to account for competition makes terminal value a much larger percentage of total value.

 

Changing our initial assumptions to view PC Jeweller as competitive advantaged with sustainable margins and capital efficiency but with no growth in the terminal value, at a 5% discount rate, the cash flows in the terminal value account for 73.6% total firm value. At a 15% discount rate cash flows in the terminal value account for 39.1% of the total firm value still well below Bernstein’s estimates.

3-scenario-terminal-value-total-value

 

Being competitively advantaged and adding terminal value growth of 3.5% similar to Bernstein’s calculations further increases the importance of the terminal value assumptions. Again, growth in the terminal value is aggressive, as the vast majority of companies do not generate excess returns. Assuming a competitive advantage and 3.5% terminal growth, at a 5% discount rate the importance of cash flows in the terminal value increases to 90.5% of total firm value, while at a 15% discount rate 46.1% of the of the total firm value is derived from the cash flows in the terminal value.

 

The assumption of permanent low interest rates, no competitive pressures, and perpetual growth are all flaws in Bernstein’s assumptions that increase the importance of terminal value in a discounted cash flow valuation and probably are over aggressive. Like Bernstein, many investors make the same mistakes in their discount cash flow assumptions, which leads to the question why? The biggest reason is institutional constraints and the focus on asset gathering rather than performance making the vast majority of investors short term oriented and trying to outperform every quarter and every year. This short-term orientation leads to focus on next quarter’s earnings and whether a company will beat earnings estimates rather than focusing on a company’s competitive environment, management, financial health and valuation. The charts below from Andrew Haldane’s Patience and Finance illustrate the short-term orientation of market participants with the average holding period of a stock on the many different stock exchanges decreasing.

nyse-lse-holding-period

other-exchange-holding-periods

 

In the US, the average holding period of equities dropped from 7 years in 1940 to 7 months in 2007. In the UK, the average holding period of equities dropped from 5 years in the mid-1960s to 7.5 months in 2007. Looking at stock exchanges around the world the average holding period of equities has dropped to under 1 year on all exchanges with the exception of the Toronto Stock Exchange and Euronext. It seems evident that equity investors have a shorter and shorter investment horizon leading to focusing on the next few quarters making the discounted cash flow a useless tool for many investors. For long-term investors, a discounted cash flow with conservative assumptions it is still very useful. Another use for a discounted cash flow is to reverse engineer the market’s expectations of key value drivers, which eliminates the need for forecasting and makes judgment of the assumptions of key value drivers, the main determinant of the margin of safety associated with an investment.

 

If the use of a discounted cash flow still concerns you, a residual income model provides the same valuation while eliminating the importance of cash flow forecasts in the distant future. At Reperio Capital Research, we also use a residual income model with a five-year forecast period followed by a fade to the terminal value in year 10, with the current invested capital as the book value and return on invested capital and the discount rate as other key inputs. Residual income = (ROIC – discount rate) * invested capital. The residual income stream is then discounted back and added to the beginning of the year’s invested capital. The theory is every company has an asset base to generated returns. The asset base comes with an opportunity cost as the money invested in the asset base can be allocated elsewhere. If the company cannot generate its discount rate, it is destroying value and the company will be valued at less than its asset base. If the company generates excess profit, it will be valued above its asset base. Revisiting PC Jeweller using a residual income valuation and the same three scenarios illustrated above, we can see the residual income valuation method relies less on the discounted cash flows from the terminal. Under a scenario of no competitive advantage, no excess returns are generated in the terminal value assumptions therefore; the terminal value adds no value. Under the scenario of a competitive advantage but no growth, at a 5% discount rate, the terminal value accounted for 57.1% of the total firm value while a 15% discount rate 14.6% of the total firm value is derived from the terminal value. Finally, under the scenario of competitive advantage and terminal value growth, at a 5% discount rate, the terminal value accounts 83.4% of the terminal value and 21.0% of the total value at a 15% discount rate.

residual-income-terminal-value

 

The residual income method does a much better job at decreasing the reliance on terminal value calculations, but provides the same valuation outcome.

 

Discounting cash flows to value companies is still a valuable for any investor with a long-term orientation. Unfortunately, a model is only as good as its inputs. In a world with increasing short term thinking, garbage in will lead to garbage out.

 

 

Other Interesting Links

 

Jim Chanos’ and Kyle Bass’ views on China (link)

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

  • They talk about a potentially interesting idea within the Emerging Market Small Cap space: ABS CBN in the Philippines.
  • They also discuss other ideas First Pacific Holdings in Hong Kong and Rallye SA in France. Both are based on management track records.

 

Apple Should Buy Netflix (link)

A very interesting post at Stratechery discussing the media value chain.

 

Competitive Advantage of Owner Operators (link)

Base Hit Investing goes into detail into the advantages of owner operators.

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

Value Investing using Enterprise Multiples — Is the Premium Due to Risk and/or Mispricing? (link)

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products, PC Jeweller, and Honworld Position Sizes 10/30/2016

Peak Sport Products completed its privatization at HKD2.60 per share on Monday October 24, 2016, therefore we no longer have a position in Peak Sport.

 

We are decreasing our position in PC Jeweller to 2.0%. The company is now valued at 12.9 times EV/EBIT and 3.7 times EV/IC. The company and Titan are clearly the two most operationally efficient competitors within the India jewelry industry, but we must remember, the organized sector is very small portion of the total market and there are no barriers to entry in the jewelry retail industry. As the organized sector increases its share of the market, competitive pressures will be more intense. The lack of barriers to entry means PC Jeweller and other participants can do very little to shield themselves from competitive pressures.

 

To reach an annualized return of 15%, sales growth of 5% into perpetuity, stable operating margins, and stable capital efficiency must be assumed. Stated another way, PC Jeweller must have pricing power and defend against competitive pressures in an industry with no barriers to entry and over 500,000 participants, which seems high unlikely. Our conservative base case scenario assumes 10% growth over the next five years before fading to 0% growth in the terminal year and no margin deterioration leading to annualized return of 8.6% over the next five years.

 

We are decreasing the limit on our current sell price of Honworld to HKD4.00 per share. Our position size decrease to 2.0% is a risk measure because during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to an increase in prepayments, which is extremely concerning. Capital allocation to inventory is a big concern as the company has sufficient inventory to last for years and the overinvestment is hurting profitability. The lack of free cash flow, the increase in soft asset account, and it being a Chinese company leads us to be concerned over the factual nature of financial statements. Our initial position size in Honworld, Miko International and Universal Health were far too aggressive. We were blinded to the risks of our aggressive position sizing due to the strong performance at PC Jeweller and Zensar Technologies and more importantly, our assumption that financial statements were accurate representations of the operating performance of theses Chinese small caps. The inability to trust the financial statements of Chinese companies should probably eliminate any future investments, as there never really can be high conviction. For these reasons, the position size in Chinese companies are typically going to be no larger than deep value stocks, if any positions are taken.

PC Jeweller Position Size August 8, 2016

PC Jeweller Position Size August 8, 2016

We have decreased our position size in PC Jeweller from 6.3% at the closing of 7/29/2016 to 3.9% at the closing of 8/8/2016. We sold 390,509 shares at an average price of INR415.28 at an average USDINR FX rate of 66.76.  The average cost of our PC Jeweller position was INR118.20 at an average exchange rate of 59.49.

PC Jeweller Position Size July 31, 2016

PC Jeweller Position Size July 31, 2016

We are decreasing our position size in PC Jeweller to 4.0% from 6.3%. The company continues to perform very well operationally, management is very innovative and entrepreneurial, and the company has a long run way for growth but the expected return under the aggressive base case has fallen to 14.9% per year while a more conservative base case is 9.73% annualized return over the next five years. The company’s competitive position seems to be strong as it was able to maintain strong profitability during the recent industry downturn while all competitors except Titan had an extremely tough time staying profitable and it maintains very strong return on invested capital, but retailing is a very tough business to build a sustainable competitive advantage. Additionally, PC Jeweller’s position size was not altered to reflect our new position sizing philosophy.

 

The company has raised over INR60 billion in capital to finance future growth. On May 24, 2016, DVI Fund Mauritius received 4,269,984 Compulsory Convertible Debentures with a face value of INR1,000. The convertible bonds are convertible into shares at a conversion price of INR380 within 18 months.

 

Fidelity received 257.373 million Compulsory Convertible Preferred Shares. The conversion price is INR382.54 per share. Fidelity has 12 months from July 22, 2016 to convert the preferred shares. Until conversion, the preferred shares are paid 13% dividend yield. Assuming full conversion of preferred shares, Fidelity will hold 3.62% of the shares outstanding.

 

Assuming full conversion from DVI Fund and Fidelity, total dilution would be roughly 11 million new shares equal to 6.14% dilution for existing shareholders leading to total shares outstanding of roughly 190 million shares.

 

We are only selling if the company’s share price is above INR400 per share.

 

Credit Analysis and Research June 20, 2016

Credit Research and Analysis                          June  20, 2016

Ticker: CARE:IN

Closing Price (6/20/2016): INR993.50

1 Year Avg. Daily Vol. (USD): 530,269

Estimated Annualized Return: 8-9%

Credit Analysis and Research June 20 2016 RCR

 

INVESTMENT THESIS

 

Credit Analysis and Research is the second largest Indian credit rating agency in an oligopolistic market.  The three largest players in the credit rating industry have a significant brand advantage over smaller players and potential new entrants as credibility is crucial for ratings, a third party assessment to be valuable. The company is extremely profitable with personnel expense as a percentage of sales half of its peers and operating margins twice its peers in an industry with little to no capital requirements. Using conservative estimates, the company currently offers a base case expected return of 8.0-9.0% with potential downside of 28.0% over the next five years under the bear case and potential upside of 100% or more over the next five years under the bull case.  We will take a 2.0% position as the company is very high quality with a competitive advantage but is slightly undervalued to fairly valued.

 

 

KEY STATISTICS

CARE Key Statistics June 20 2016

 

 

FACTOR RATINGS

CARE Factor Ratings June 20 2016

 

 

COMPANY DESCRIPTION

 

Credit Analysis and Research (CARE) incorporated in April 1993 as a credit rating information and advisory services company. It is promoted by the Industrial Development Bank of India (IDBI), other financial institutions, public/private sector banks, and private finance companies. It offers a wide range of products and services in the field of credit information and equity research including credit rating, IPO grading, SME rating, and REIT ratings. The company’s ratings are recognized by the Government of India, the Reserve Bank of India, and the Stock Exchange Board of India. In FY2016 (March 2015-March 2016), ratings services account for 94.8% of CARE’s revenue.  Rating assignments generates two types of revenue: rating revenue and surveillance revenue.  Rating revenue is generated at the time of the rating and surveillance revenue is generated as CARE continues to monitor the company over the life of the financial product being rated. Ratings revenue is dependent on the amount of credit outstanding and the company’s share of the credit rated.

CARE Volume of Debt Rated June 20 2016

 

Over the past five years, 60.9% of debt rated was bank facilities, 32.7% long term debt, and the remainder was short term and medium term debt.   Bank facilities are bank loans that are rated to determine the risk weights under the Reserve Bank of India’s (RBI’s) Guidelines for Implementation of the New Capital Adequacy Framework under Basel II framework. CARE rates all types of fund-based and non-fund based facilities including cash credit, working capital demand loans, Letters of Credit, bank guarantees, bill discounting, project loans, and loans for general corporate purposes. Credit rating for bank loans is not mandatory under Basel II, but the higher rating on the loan ratings the lower the risk weight and the less capital required for the loan.  If a loan it not rated, it retains a capital risk weight of 100%.

CARE Bank Loan Rating Capital Savings June 20 2016

 

The table above illustrates the capital savings by having bank loans rated under Basel II for an INR1,000 million bank loan. It assumes a 9% capital requirement under Basel I. Under Basel I, a INR1,000 million loan would require INR90 million in capital.  Under Basel II, if the same INR1,000 million loan was AAA rated only INR18 million in capital leading to a capital savings of INR72 million. Some of CARE’s larger bank loan ratings customers have significant volume allowing them to negotiate a rating fee cap making the bank loan segment much more price sensitive than other parts of the rating market.

CARE Credit Penentration June 20 2016

 

As illustrated above, India’s population is under banked relative to Asian peers leading to growth potential in the bank lending market.

 

Roughly 39.0% of CARE’s revenue comes from the non-bank loan ratings. These ratings include most kinds of short, medium and long term debt instruments, such as commercial paper, bonds, debentures, preference shares and structured debt instruments, and deposit obligations, such as inter-corporate deposits, fixed deposits and certificates of deposits.  Other rating products include IPO grading, mutual fund ratings, and corporate governance ratings.

CARE Bond Market Penentration June 20 2016

 

As illustrated above, India’s corporate and government bond markets are still underdeveloped relative to Asian peers.  It is not a given that bank lending and bond markets will develop to the potential of other markets due to idiosyncratic reasons, but there seems to be a relationship between GDP per capita and development of both bank lending markets and bond markets, as illustrated by the charts below.

CARE Domestic Credit vs GDP per capita June 20 2016

 

CARE Bond Market vs GDP per capita June 20 2016

 

Other than increased penetration of existing products other avenues for growth for CARE include increased market share, new products, and new geographical markets.  New products for CARE include SME rating, the MSE rating, Edu-grade, Equi-grade, Real Estate Star Ratings, Green ratings, and valuation of market linked debentures.  The company can also move into adjacent product market like research and advisory services.   CARE intends to move into new geographical markets and has a 75.1% interest in a ratings business in Maldives.

 

CARE does not have any shareholders classified as promoters. The company’s largest shareholders on March 31, 2016 are listed below.

CARE Shareholder Structure June 20 2016

 

IDBI Bank, Canara Bank, and IDBI Bank have all sold down their stake progressively and now own roughly 25% of the company.

 

 

INDUSTRY

 

CRISIL, the first India credit rating agency, was established in 1987.  ICRA was the second rating agency opening in 1991. CARE was the third rating agency established in 1993. ONICRA was also established in 1993. India Ratings and Research Private Limited followed in 1996. Brickworks Ratings India Private Limited (Brickworks) and SME Rating Agency of India Limited (SMERA) began their ratings businesses in 2008.

 

In 1992, credit rating became mandatory for the issuance of debt instruments with maturity/convertibility of 18 months and above. Subsequently, the RBI guidelines made rating mandatory for issuance of commercial paper. RBI also made rating of public deposit schemes mandatory for Non Banking Financial Corporations. Since then credit ratings have continually increased the number and value of instruments that have been rated.

 

In 2003, SEBI along with stock exchanges made ratings mandatory for debt instruments placed under private placements with a maturity of one year or more, which are proposed to be listed. Also in 2003, the RBI issued prudential guidelines on the management of the non-statutory liquidity ratio (SLR) investment portfolio of all scheduled commercial banks except regional rural banks and local area banks. These guidelines require such institutions to make investments only in rated non-SLR securities.

 

Similarly, non-government provident funds, superannuation funds, gratuity funds can invest in bonds issued by public financial institutions, public sector companies/banks and private sector companies only when they are rated by at least two different credit rating agencies. Further, such provident funds, superannuation funds, gratuity funds can invest in shares of only those companies whose debt is rated investment grade by at least two credit rating agencies on the date of such investments. Investment by mutual funds and insurance companies in unrated paper/non-investment grade paper is also restricted.

 

Barriers to Entry

 

The industry structure points to barriers to entry.  There are only seven competitors with the three largest competitors, CRISIL, CARE, and ICRA, dominating the market, accounting for an estimated 90% of the market.  The market share among the top three players since FY2006 is illustrated below.

CARE Top 3 maket share June 20 2016

 

CARE has steadily increased its market share to 29.5% in FY2016 from 20.1% in FY2006, at the expense of ICRA. Further illustrating the oligopoly is CARE’s share among the Business Standard’s top 1000 companies (45% share), the Economic Times top 500 companies (54% share), and the Financial Express’ top 500 companies (52% share).

 

The oligopolistic industry structure of ratings agencies in the United States points to strong barriers to entry in the industry. Although the credit rating industry is more mature in the US and idiosyncratic factors exist in each market, companies in both markets have similar business models and competitive advantages allowing the US market to be a potential roadmap for the Indian credit rating industry.

 

CARE is very profitable. Since FY2011, the company’s NOPAT margin averaged 45.3%, although the company’s margin is on a declining trend. The company requires no capital with an average invested capital of negative INR123 million.  The negative invested capital is driven by average working capital of negative INR632 million and INR509 million in fixed capital. The negative working capital and negative invested capital points to a barrier to entry and very strong bargaining power.

CARE Profitability June 20 2016

 

The rating agencies seem to lack pricing power pointing to no barriers to entry.  The largest bank loan ratings customers have been able to put pressure on pricing but in the rest of the market the rating agencies say they have pricing power.  The lack of pricing power among the large bank loan ratings customers is probably down to economic weakness rather than sustaining bargaining power as there is significant benefit for the customer from using rating agencies, often more than one is used, in the form of capital savings. Typically, cash gross margin is used to identify pricing power, but in the knowledge industry the key input is employees so employee expense/revenue is the key proxy for cost of goods sold.

CARE Employee Expense June 20 2016

 

CARE’s employee expense to revenue increased from 17.7% in FY2011 to 27.1% in FY2016 illustrating a lack of pricing power. Revenue per employee increased from INR3.6 million in FY2012 to INR4.9 million in FY2016 while personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016.

 

Brickworks and SMERA started in 2008. While these entrants point to the possibility of new entrants, it will take years for these new entrants to gain the reputation of the larger rating agencies.  ONICRA entered the market in 1993 and Indian Ratings and Research was established in 1996. Despite both companies entering the market over 20 years ago, both have nowhere near the scale of the three larger firms.  The ability to enter but not scale illustrates the low minimum efficient scale or lack of economies of scale and the importance of a brand.

 

Ratings agencies require a brand as a rating is nothing more than assessment of a complex instrument or product by an independent third party, therefore trust must be placed in the third party and its assessment.  If the third party lacks credibility the assessment is useless. Credibility is built up over many years and very difficult to replicate.

 

Economies of scale also exist in marketing, administration, legal, compliance, and software development costs. Economies of scale are nowhere near as important to as brand advantage as illustrated by the number of smaller players in the market.

 

Other Four Forces

 

The rivalry between competitors exists but is not a significant drag on profitability. Competition among the three largest rating agencies has increased recently due to weakness in the credit markets, lower government subsidies for Micro, Small, and Medium size enterprises (MSMEs), and weaker infrastructure spend leading to weaker margins over the past few years. Competitive rivalry is decreased as ratings account for a smaller portion of revenue at CRISIL and ICRA.  In FY2016, rating revenue accounted for 31.5% of CRISIL’s revenue and 57.9% of ICRA’s revenue.  Many times debt instruments are rated by multiple rating agencies further decreasing rivalry.

 

The credit rating agencies main supplier is employees. Employees are non-unionized and fragmented. As illustrated above under pricing power, personnel expense per employee increased from INR856,255 in FY2012 to INR1,336,628 in FY2016 or 11.8% per annum, while revenue has not been able to keep pace with the increases in personnel expense.  The steady increase in personnel expense illustrates the bargaining power of employees. Given the fragmented nature, the steadily increasing personnel expense seems to be due to a shortage of qualified talent in the labor market.  Since 2011, CRISIL’s personnel expense per employee increased from INR1,100,699  to INR1,863,188 or 14.1% per annum, while ICRA’s personnel expense per employee decreased from INR3,962,465 in FY2012 to INR3,436,615 in FY2016 representing a 4.6% decline.   CRISIL’s personnel expense per employee inflation confirms the trend at CARE, while ICRA’s personnel expense per employee is much higher so the decline does not necessarily counter the trend seen at CARE and ICRA.

 

The credit rating customers include financial institutions, corporations, municipalities, and others. Banks are CARE’s largest customers accounting for 60.9% of debt rated.  A bank loan facility are not required to be rated by regulation, but under Basel II, if the loan facility is not rated it receives a risk weighting of 100%. As illustrated below the higher the rating on the bank facility the lower the risk weighting and the less capital required for the facility. This creates a strong incentive for banks to have loan facilities rated decreasing their bargaining power.

CARE Bank Loan Rating Capital Savings June 20 2016

 

Given the volume of instruments rated, banks are an important source of revenue for CARE. Banks are much more price sensitive than other customers and have been able to negotiate a fee cap illustrating their bargaining power.  The volume of bank loan facility points to a much more sophisticated customer as banks have dealt with the process more often than non-banks. Other customers are less price sensitive given their fragmentation relative to the ratings agencies and the benefits associated with having debt rated.

 

The threat of substitutes is low. Banks can choose to not use ratings or use an internal ratings based system but the risk weight for an unrated loan is 100% so there are benefits in the form of capital savings.  Corporations and other customers of rating agencies can decide not to have their debt rated but a debt rating increases transparency on the instrument and/or company leading to a decreased cost of debt and a better image of the firm.  Additionally, as more and more investors use rating agencies, the value of having your debt rated goes up and the penalty of not having your debt rated also increases.

 

 

MANAGEMENT

 

Operational Performance

 

Operationally, management has performed very well.  It is increased its market share among the top three rating agencies by almost 10% over the past ten years.

CARE Top 3 maket share June 20 2016

 

The company is also the best performing credit rating agency in terms of operating profit per employee.

CARE vs Peers Per Employee stats June 20 2016

 

ICRA generates the highest revenue per employee, while CARE has the lowest personnel expense per employee and the highest operating profit per employee leading to the highest operating margin. As mentioned earlier, the company is extremely profitable with very low investment requirements.

 

Capital Allocation

 

Management has done a good job on focusing on the ratings business.  CRISIL and ICRA have allocated capital to research, advisory, and consultancy businesses.  These businesses currently generate strong returns but have much lower barriers to entry making the businesses much more prone to competition. Both CRISILs and ICRA’s and rating businesses have negative capital employed while research, advisory, consultancy and other businesses require capital.  CRISIL’s research business generates very strong pre-tax returns on capital employed averaging 98.3% over the past four years.  ICRA’s non-rating business pre-tax returns on capital employed averaged 17.9% over the past three years. CRISIL has done a good job of generating strong profitability on its non-rating business while ICRA is barely generating its cost of capital illustrating the potential pitfalls of allocating capital from a business with strong entry barriers to a business is much weaker entry barriers.

 

The only other capital allocation decision made by management is whether to hold cash or payout cash.  Since its IPO in Dec 2012 (FY2013), CARE has paid out 87.4% of after tax net income in the form of cash dividends. The company has a net cash position equal to 3.29 times FY2016 net income. Given the negative invested capital in the business, no additional capital is needed to grow therefore management could pay out more cash in the form of dividends.

CARE Return on Financial Assets June 20 2016

 

Paying dividends make even more sense when CARE’s cumulative return on net cash since FY2012 is 1.1% lower than what can be received on a 1 year fixed term deposit (7.4% return on net cash vs. 8.5% return on 1 year fixed term deposit) over the same period illustrating the weak investing returns generated by the company.

 

Given the low investment requirements, the company did not need to IPO but it was owned by a number of financial institutions that wanted to gain liquidity on their investment.

 

Corporate Governance

 

There are no related party transactions other than management remuneration.   Management’s salary averaged 2.4% of operating income over the last four years, below CRISIL’s management salaries average of 2.6% of operating income, over the same period, and well below ICRA’s outrageous average of 11.5% of operating income.

 

There are no other corporate governance issues. The board has two members of the CARE management team and the other five members are either independent or represent outside shareholders.

 

Managers at CARE are compensated primarily with a salary with their shareholding and performance related pay being less than a third of pay in FY2015.

 

 

 VALUATION

 

Given the asset light nature of CARE’s business model and negative invested capital, any asset based approach to valuation does not make sense.  The brand advantage in the industry makes earnings based valuation the most appropriate valuation. We use a blended average valuation of DCF/Residual Income/Earnings Power Valuation and an IRR approach.

 

Under the blended valuation, we use different scenarios to determine potential upsides and downsides.  The key value driver assumptions changed are sales growth and operating margin, while, the discount rate, the effective tax rate, working capital turnover and fixed capital turnover remain the same at the figures in the table below.

CARE Key Stagnant assumptions June 20 2016

 

Sales growth and operating margin are changed to determine upside under different scenarios.  The scenarios and assumptions for both value drivers are listed below.

CARE Key Variable assumptions June 20 2016

 

The estimated intrinsic value per share under each scenario and upside from June 17, 2016 closing price is listed below.

CARE Scenario Valuations June 20 2016

 

The average FY2017 earnings valuation per share is INR1,035.80 representing 4% upside and the average FY2021 earnings valuation per share is INR1,378.91 representing 39% upside.

 

The bear case valuation assumes 0% perpetuity growth and trough margins leading to the FY2017 intrinsic value per share of INR616.26 or 38% downside and a FY2021 intrinsic value per share of INR722.82 or 27% downside to the FY2021 downside.  The bear case assumes a no further development of credit markets and a slight decrease in margins from competition.

 

The base case valuation assumes 5% growth into perpetuity with current margins leading to a FY2017 intrinsic value per share of INR1,107.35 or 11% upside and 45% upside to the estimated FY2021 intrinsic value per share of INR1,436.62. The base case is conservative on the growth side as it assumes growth slows down but banking and credit markets continue to develop, while margins compress due to the bargaining power of employees is also conservative given margin weakness has followed economic weakness.

 

The bull case valuation of average growth, average margins, and 5% terminal growth leads to 40% upside to the FY2017 intrinsic value per share of INR1,393.43 and 97% upside to the FY2021 intrinsic value per share of INR1,955.08.

 

Using a conservative IRR valuation, the current FCF yield is roughly 4.0% with estimated growth of 5.0% leading to an estimated annual return is 9.0%, which is almost equivalent to the estimated annualized return from the base case under the blended valuation.  The 9.0% is a conservative estimate given where in the life cycle, banking and credit markets are in India.  Additionally, the last few years saw margin compression due to economic weakness and slowing growth in the credit rating industry as growth returns margins should expand.

 

CARE seems to be slightly undervalued to fairly valued.

 

 

RISKS

 

The biggest risk to CARE’s business is reputational.  After the 2008 financial crisis, the ratings agencies in the United States had their credibility questioned from apparent conflicts of interest due to poor analysis and ratings that did not properly reflect the risks of instruments being rated.  During the U.S. housing boom, the ratings agencies inflated mortgage bonds ratings to generate fees allowing rating sensitive investors to purchase the securities for their portfolios. The bonds later plummeted in value.  S&P was frozen out of rating mortgage bonds after admitting a flaw in their CMBS models.

 

Many investors are restricted to purchasing higher rated debt instruments in the domestic bond market that are rated by multiple rating agencies. If investors are no longer required to purchase rated bonds or if the ratings from multiple rating agencies are no longer required there is a risk of loss of revenue.

 

Accessing the overseas debt market by Indian borrowers is regulated including restrictions on raising debt in overseas markets. If accessing overseas debt markets was permitted, many borrowers could search for lower borrowing costs leading to decreased reliance on Indian debt markets and lower rating revenue for ratings agencies.

 

There is a risk that banks will use an internal rating based approach for credit risk. In a circular dated July 7, 2009, RBI advised banks they may request approval for the using of an internal rating based approach to use their own internal estimates to determine capital requirements for a given credit exposure. Bank loan facilities accounted for 60.9% of CARE’s revenue in FY2016.

 

Despite strong brand advantages that will take new entrants years to replicate. There is always risk of increased competition with rating agencies like Brickworks and SMERA recently entering the market with operations starting in 2008. Given the low fixed costs in the industry leading to a low minimum efficient scale, smaller players ONICRA and India Ratings and Research have survived over 20 years with minimal market share.

 

After the Amtek Auto default to JP Morgan some investors are calling for strong regulation of and increased accountability for ratings agencies as the rating agencies were late to change their ratings on Amtek Auto.

 

CARE is managed by external agents rather than owner operators.  If the board is unable to keep management’s incentives aligned with shareholders, management may make decisions in their interest over the interest of shareholders.

 

CARE investment thesis and price paid is based on the development of banking and credit markets.  If banking and credit markets do not develop, there may be permanent loss of capital.

 

CARE is more expensive than our typical investment opportunities, but with little or no investment requirements and underdeveloped credit markets, any growth is essentially free. If investors are unwilling to pay the current multiples for Indian equities in the future, there may be a permanent loss of capital.  To combat this risk, we are taking a small starting position.