Mr Market has become extremely optimistic in the last couple of months. Stocks of most companies are going up - some with valid reason and some just riding the optimism. This is always a trying time for investors like ourselves who look to invest in undervalued companies for the long run. Both the price to value ratio and the margin of safety for companies are near "uninvestible" levels.
However, I remain optimistic that Mr. Market will throw up some opportunities our way and I continue to look out for them. Below is the current list of stocks that I am tracking and reading up on. I hope to publish more detailed analysis on a few of them once the timing and valuation are reasonable:
1. Suzlon Energy
2. TTK Prestige
3. Hawkins
4. Blue Dart
KM
Friday, November 12, 2010
Tuesday, July 20, 2010
Investing in Real Estate – Putting Your Money Where Your House Is!
I recently made a real estate investment – a 1,200 square feet (sf) 2 bedroom apartment in Koramangala (Bangalore). In my first blog, I had mentioned that real estate is an interesting investment opportunity especially in an inflationary environment. I had further pointed out that one has to be extremely careful while buying property in India given the fact that developers are not always dependable and are mostly out to screw the buyer.
I think the best way to invest in residential real estate is by purchasing completed or near completion properties in good established locations thus reducing construction, leasing and liquidity risk. It may entail paying a slightly higher amount per sf and a bulkier upfront amount (instead of a staggered construction-linked payment) but the benefits far outweigh the costs.
Before we go any further I would like to share some numbers from my investment: (click to enlarge)
The table above is a simple quarterly financial model I created to understand how much and under what circumstances I can make returns from this investment. The first box titled “COST OF PROPERTY” lays out all the costs I incurred in closing the deal including registration, stamp duty, brokerage and loan charges. As you can see, the total cost of this apartment came to about Rs. 59.6 lakhs or Rs. 4,946 per sf.
Similarly the rents table shows what rent I was able to get for the property. Currently the rent is Rs. 20,500 per month with a built-in bump of 5% per year. The Yield table show what rental yields I am making on my investment. For e.g for the 1st year I am making a 3.5% yield. This is the annual rent (minus maintenance and property taxes) divided by total cost (Rs. 59.6 lakhs). This goes up to 4.1% by year-4 because of the bumps.
The Sources and Uses table lays out how I have financed this purchase. I have taken a 40 lakh loan from Citibank at 8.5% (fixed for 3 years). I have assumed that I will sell this property after 4 years at Rs. 6,000 per sf – 20% more than what I paid for. Each one of you is the best judge of what this number should be for your own investment. I am pretty confident of this number for Koramangala.
There are also some savings in income tax, which is the benefit you get (in the form of higher monthly take home salary) from taking a home loan. (Refer to the last section for more). In my case the savings are about Rs. 4,500 per month. The EMI on my loan is Rs 34,700. So, the net gap I need to fund every month is Rs. 34,700 - Rs. 4,500 – Rs. 20,500 = Rs. 9,700. The table below lays out these calculations.
There is an interesting point to note here. The monthly interest on my loan is about Rs. 28,000. The total rent and savings in income tax is Rs. 25,000 (Rs. 20,500 + Rs. 4,500). That’s a gap of Rs. 3,000 per month. So of the Rs. 9,700 that I pay, around 30% is interest and the rest is principal repayment. Ideally, 100% of what I am paying from my pocket should have gone towards the loan with the tenant and the government funding the interest (and that’s my immediate plan) because otherwise it would mean that I am making my money work not for me but for the bank. Of course, this % totally depends on what % of the house you are funding with your own equity. In my case it was 33%. Had it been more this gap would have been lower.
Looking at it in this way the cash flows very closely resemble that of a Systematic Investment Plan (read my earlier blog). In a way this is nothing but an SIP on real estate. The only difference is that this SIP is on ONE asset with the price being fixed upfront. However, it is an asset that you fully understand and have thoroughly researched. I think the risks are a lot lower when you understand what you are getting into. According to me, this is one of the best ways to invest monthly on a real asset.
Coming back to the model, if I sell the property after 4 years for Rs. 6,000 psf (Rs. 72.3 lakhs) and repay the loan, I stand to make about 12% per annum and 1.5x my initial capital. This seems a reasonable rate of return for an asset that is comparatively less risky.
A sensitivity table on the right shows how the returns would vary if I were able to sell at higher or lower prices. For e.g. If I sell for Rs. 6,500 psf I make 17% and 1.8x my capital. At Rs. 7,000 psf I make 21.2% and 2.0x my capital and so on. I am confident that my returns here will be between 12.0 and 20.0%. Even if I am not able to sell at my price, the investment always gives me the option to hold it for a longer period of time and keep earning rental income. Perhaps, I may even want to stay there in the future. This flexibility is an added advantage of a residential real estate investment.
Now that we’re done with the numbers, I want to spend some time to understand why I think real estate is a good investment today.
The biggest drivers of my real estate investment were
1. Inflation
2. Capital Appreciation
3. Regular Income / Retirement Planning
4. Other Ancillary Benefits
Lets look at all these reasons one by one.
1. Inflation
Inflation scares me. Period.
Prices of food, petrol, travel etc are going up rapidly every year. It used to cost me Rs. 18 to travel from my house in Colaba to my office in Nariman Point in 2007. In 2008 it rose to Rs. 22. Today the same journey costs me Rs. 27. That’s a 50% increase in 3 years. On 16th July, Mint published an article on inflation which compared the cost of ordinary household groceries in 2000 and 2010. The results were the following:
The story is the same for all vegetables, grocery items, meat products etc. Newspapers give us a variety of reasons for this - bad monsoons, high government debt, rising nominal incomes, higher money supply, demand pull, supply push and so on and on. Whatever the reasons may be, as investors we cannot let external factors affect our investments and returns. We must do all we can to protect our investments.
My own opinion is that inflation is not going to go away any time soon, especially in a developing “growth” country like India. Our country has a large fiscal deficit that keeps growing every year due to oil and farm subsidies, infrastructure spending, rural development etc. The government borrows to fund this deficit every year. There are 4 primary ways to deal with this debt:
1. Default
2. Reduce expenditure
3. Print more money to pay off the debt
4. Borrow more
Of the 4 options, option 2 is the most difficult to execute. It’s political suicide. It makes the government instantly unpopular. Just look at the furore the recent oil price rise created in India or the protests on the streets of Greece when the prime minister announced budget cuts.
Option 1 junks your debt rating, currency and everything else you hold sacred and should be a last resort. Options 3 and 4 are the most likely ways to deal with this problem. However, with option 4 you are only postponing the problem. It’s like paying your debt with a credit card. It will end up becoming a much bigger problem later and you will again be faced with the remaining 3 choices.
Option 3 seems like the least harmful way to deal with this problem. Option 3 means more paper money in the system means more inflation means real assets will become more valuable. This is one of the main reasons why gold prices have shot through the roof in the last year. With European countries defaulting on their debt, investors are seeking the safer haven of real assets like gold.
Gold has already gone up 3x in the last 5 years and is at peak valuations right now. Maybe gold is still a very good investment. I frankly don’t know because gold prices have no fundamentals. I have always maintained that an SIP is the best way to invest in Gold.
I think right now the best REAL ASSET to invest in is property. It is affordable (you can easily get a loan), interest rates are low, it is fairly liquid and prices in most cities are below the 2008 peak levels.
My thesis for investing in real estate is that returns from real estate are closely linked to inflation. Rents go up every year almost in line with general price rise. When I started out in 2007 I used to pay Rs. 37,000 rent for my apartment in Colaba. The following year (which was the boom year), my landlord increased the rent to Rs. 49,000 (33% more). Last year (recession year) I renegotiated my rent down to 42,000 (down 14%).
My point is that rents move pretty closely with general economic conditions and is a good way to hedge against inflation. I think the basket of goods that a particular rent buys today will be more or less the same 10 years from now. Also, the cost of construction (steel, cement etc) will continue to go up and the cost of building the same house or apartment will always increase over time. This is why I like owning this asset class and this was one of the main motivations for purchasing the property.
2. Capital Appreciation
More often than not, this is the main driver for real estate investment in India. Historically property has been seen as a ‘safe investment’ that appreciates over time. This has held true in most cases. With increasing urbanization (more people moving to the cities), scarcity of land, improving infrastructure and rising incomes property prices have rapidly increased in almost every part of the country.
In Koramangala (Bangalore) itself prices have risen from Rs. 2,000 per sf in 2000 to 5,500 per sf today. I think, as long as the property is well located, the purchase prices is reasonable and the rental yield is healthy, this trend of rising home prices will continue for some more years.
3. Regular Income / Retirement
Retirement is something all of us think about. People plan their retirement by investing in insurance, provident funds, fixed deposits, post office schemes and equities but other than equities all these asset classes get their returns eaten away by inflation. I think good real estate is one of the best ways to invest in your retirement. There is no better way to get monthly inflation-adjusted “cash” returns month-on-month than rent. What’s more you can always enter into a reverse mortgage with a bank to get EMIs paid to you once you are retired.
A rented property today yields about 3.5-4.0% per annum, meaning total rent divided by total cost of apartment is around 4%. Like I pointed out earlier, the property I purchased is giving me a yield of 3.5%. However, this 3.5% grows by ~5% every year. In 10 years the property will probably yield around 3.5*(1.05)^10 = 5.7% and in 20 years around 9.3%. If you were to invest one crore in an apartment today (and pay off the debt in 20 years) the yield will be around Rs. 9,30,000 per year in 20 years, that’s Rs. 77,500 per month. Bear in mind that this does not factor capital appreciation.
4. Other Ancillary Benefits
Real estate investing has other ancillary benefits too. I can think of the following:
i) Tax benefits – If the property is “let out” (like mine is) the entire interest (minus the rent) can be set off against your taxable income reducing your tax. If the property is self-occupied you can set off up to Rs. 150,000 per year from your salary. So if you’re in the 30% tax bracket, you will save around Rs. 45,000 per year (Rs. 3,750 per month). The top right hand side of the model provides detailed calculation of how the tax benefit is calculated.
ii) Safety / Stability – Buying a house gives you that feeling of security. If nothing else, you can always stay in the house yourself with your family.
If you’re worried about inflation like I am and want to plan your retirement and have your own little cash flow stream other than your primary income, there is no better way than investing in good quality real estate.
KM
I think the best way to invest in residential real estate is by purchasing completed or near completion properties in good established locations thus reducing construction, leasing and liquidity risk. It may entail paying a slightly higher amount per sf and a bulkier upfront amount (instead of a staggered construction-linked payment) but the benefits far outweigh the costs.
Before we go any further I would like to share some numbers from my investment: (click to enlarge)
The table above is a simple quarterly financial model I created to understand how much and under what circumstances I can make returns from this investment. The first box titled “COST OF PROPERTY” lays out all the costs I incurred in closing the deal including registration, stamp duty, brokerage and loan charges. As you can see, the total cost of this apartment came to about Rs. 59.6 lakhs or Rs. 4,946 per sf.
Similarly the rents table shows what rent I was able to get for the property. Currently the rent is Rs. 20,500 per month with a built-in bump of 5% per year. The Yield table show what rental yields I am making on my investment. For e.g for the 1st year I am making a 3.5% yield. This is the annual rent (minus maintenance and property taxes) divided by total cost (Rs. 59.6 lakhs). This goes up to 4.1% by year-4 because of the bumps.
The Sources and Uses table lays out how I have financed this purchase. I have taken a 40 lakh loan from Citibank at 8.5% (fixed for 3 years). I have assumed that I will sell this property after 4 years at Rs. 6,000 per sf – 20% more than what I paid for. Each one of you is the best judge of what this number should be for your own investment. I am pretty confident of this number for Koramangala.
There are also some savings in income tax, which is the benefit you get (in the form of higher monthly take home salary) from taking a home loan. (Refer to the last section for more). In my case the savings are about Rs. 4,500 per month. The EMI on my loan is Rs 34,700. So, the net gap I need to fund every month is Rs. 34,700 - Rs. 4,500 – Rs. 20,500 = Rs. 9,700. The table below lays out these calculations.
There is an interesting point to note here. The monthly interest on my loan is about Rs. 28,000. The total rent and savings in income tax is Rs. 25,000 (Rs. 20,500 + Rs. 4,500). That’s a gap of Rs. 3,000 per month. So of the Rs. 9,700 that I pay, around 30% is interest and the rest is principal repayment. Ideally, 100% of what I am paying from my pocket should have gone towards the loan with the tenant and the government funding the interest (and that’s my immediate plan) because otherwise it would mean that I am making my money work not for me but for the bank. Of course, this % totally depends on what % of the house you are funding with your own equity. In my case it was 33%. Had it been more this gap would have been lower.
Looking at it in this way the cash flows very closely resemble that of a Systematic Investment Plan (read my earlier blog). In a way this is nothing but an SIP on real estate. The only difference is that this SIP is on ONE asset with the price being fixed upfront. However, it is an asset that you fully understand and have thoroughly researched. I think the risks are a lot lower when you understand what you are getting into. According to me, this is one of the best ways to invest monthly on a real asset.
Coming back to the model, if I sell the property after 4 years for Rs. 6,000 psf (Rs. 72.3 lakhs) and repay the loan, I stand to make about 12% per annum and 1.5x my initial capital. This seems a reasonable rate of return for an asset that is comparatively less risky.
A sensitivity table on the right shows how the returns would vary if I were able to sell at higher or lower prices. For e.g. If I sell for Rs. 6,500 psf I make 17% and 1.8x my capital. At Rs. 7,000 psf I make 21.2% and 2.0x my capital and so on. I am confident that my returns here will be between 12.0 and 20.0%. Even if I am not able to sell at my price, the investment always gives me the option to hold it for a longer period of time and keep earning rental income. Perhaps, I may even want to stay there in the future. This flexibility is an added advantage of a residential real estate investment.
Now that we’re done with the numbers, I want to spend some time to understand why I think real estate is a good investment today.
The biggest drivers of my real estate investment were
1. Inflation
2. Capital Appreciation
3. Regular Income / Retirement Planning
4. Other Ancillary Benefits
Lets look at all these reasons one by one.
1. Inflation
Inflation scares me. Period.
Prices of food, petrol, travel etc are going up rapidly every year. It used to cost me Rs. 18 to travel from my house in Colaba to my office in Nariman Point in 2007. In 2008 it rose to Rs. 22. Today the same journey costs me Rs. 27. That’s a 50% increase in 3 years. On 16th July, Mint published an article on inflation which compared the cost of ordinary household groceries in 2000 and 2010. The results were the following:
The story is the same for all vegetables, grocery items, meat products etc. Newspapers give us a variety of reasons for this - bad monsoons, high government debt, rising nominal incomes, higher money supply, demand pull, supply push and so on and on. Whatever the reasons may be, as investors we cannot let external factors affect our investments and returns. We must do all we can to protect our investments.
My own opinion is that inflation is not going to go away any time soon, especially in a developing “growth” country like India. Our country has a large fiscal deficit that keeps growing every year due to oil and farm subsidies, infrastructure spending, rural development etc. The government borrows to fund this deficit every year. There are 4 primary ways to deal with this debt:
1. Default
2. Reduce expenditure
3. Print more money to pay off the debt
4. Borrow more
Of the 4 options, option 2 is the most difficult to execute. It’s political suicide. It makes the government instantly unpopular. Just look at the furore the recent oil price rise created in India or the protests on the streets of Greece when the prime minister announced budget cuts.
Option 1 junks your debt rating, currency and everything else you hold sacred and should be a last resort. Options 3 and 4 are the most likely ways to deal with this problem. However, with option 4 you are only postponing the problem. It’s like paying your debt with a credit card. It will end up becoming a much bigger problem later and you will again be faced with the remaining 3 choices.
Option 3 seems like the least harmful way to deal with this problem. Option 3 means more paper money in the system means more inflation means real assets will become more valuable. This is one of the main reasons why gold prices have shot through the roof in the last year. With European countries defaulting on their debt, investors are seeking the safer haven of real assets like gold.
Gold has already gone up 3x in the last 5 years and is at peak valuations right now. Maybe gold is still a very good investment. I frankly don’t know because gold prices have no fundamentals. I have always maintained that an SIP is the best way to invest in Gold.
I think right now the best REAL ASSET to invest in is property. It is affordable (you can easily get a loan), interest rates are low, it is fairly liquid and prices in most cities are below the 2008 peak levels.
My thesis for investing in real estate is that returns from real estate are closely linked to inflation. Rents go up every year almost in line with general price rise. When I started out in 2007 I used to pay Rs. 37,000 rent for my apartment in Colaba. The following year (which was the boom year), my landlord increased the rent to Rs. 49,000 (33% more). Last year (recession year) I renegotiated my rent down to 42,000 (down 14%).
My point is that rents move pretty closely with general economic conditions and is a good way to hedge against inflation. I think the basket of goods that a particular rent buys today will be more or less the same 10 years from now. Also, the cost of construction (steel, cement etc) will continue to go up and the cost of building the same house or apartment will always increase over time. This is why I like owning this asset class and this was one of the main motivations for purchasing the property.
2. Capital Appreciation
More often than not, this is the main driver for real estate investment in India. Historically property has been seen as a ‘safe investment’ that appreciates over time. This has held true in most cases. With increasing urbanization (more people moving to the cities), scarcity of land, improving infrastructure and rising incomes property prices have rapidly increased in almost every part of the country.
In Koramangala (Bangalore) itself prices have risen from Rs. 2,000 per sf in 2000 to 5,500 per sf today. I think, as long as the property is well located, the purchase prices is reasonable and the rental yield is healthy, this trend of rising home prices will continue for some more years.
3. Regular Income / Retirement
Retirement is something all of us think about. People plan their retirement by investing in insurance, provident funds, fixed deposits, post office schemes and equities but other than equities all these asset classes get their returns eaten away by inflation. I think good real estate is one of the best ways to invest in your retirement. There is no better way to get monthly inflation-adjusted “cash” returns month-on-month than rent. What’s more you can always enter into a reverse mortgage with a bank to get EMIs paid to you once you are retired.
A rented property today yields about 3.5-4.0% per annum, meaning total rent divided by total cost of apartment is around 4%. Like I pointed out earlier, the property I purchased is giving me a yield of 3.5%. However, this 3.5% grows by ~5% every year. In 10 years the property will probably yield around 3.5*(1.05)^10 = 5.7% and in 20 years around 9.3%. If you were to invest one crore in an apartment today (and pay off the debt in 20 years) the yield will be around Rs. 9,30,000 per year in 20 years, that’s Rs. 77,500 per month. Bear in mind that this does not factor capital appreciation.
4. Other Ancillary Benefits
Real estate investing has other ancillary benefits too. I can think of the following:
i) Tax benefits – If the property is “let out” (like mine is) the entire interest (minus the rent) can be set off against your taxable income reducing your tax. If the property is self-occupied you can set off up to Rs. 150,000 per year from your salary. So if you’re in the 30% tax bracket, you will save around Rs. 45,000 per year (Rs. 3,750 per month). The top right hand side of the model provides detailed calculation of how the tax benefit is calculated.
ii) Safety / Stability – Buying a house gives you that feeling of security. If nothing else, you can always stay in the house yourself with your family.
If you’re worried about inflation like I am and want to plan your retirement and have your own little cash flow stream other than your primary income, there is no better way than investing in good quality real estate.
KM
Wednesday, June 23, 2010
Interesting WSJ Article: So That's Why Investors Can't Think for Themselves
Write to Jason Zweig at intelligentinvestor@wsj.com
From February through May, the Dow Jones Industrial Average gained more than 1000 points in an almost uninterrupted daily march upward. Then came the "flash crash" of May 6 and day after day of losses through May. Now, in mid-June, the market has been up six of the past seven days.
What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish, all changing direction together?
Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear.
In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn't just give investors a sense of "safety in numbers." It also gives them pleasure.
That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the "consensus view" on Wall Street.
In the experiment, researchers from University College London and Aarhus University in Denmark asked 28 people to submit a list of songs they wanted to buy online and then to decide which they would most like to own. Then the participants viewed the ratings of the same songs by two professional music experts. Meanwhile, a magnetic resonance imaging machine recorded the patterns of activity in their brains. Finally, as a way to measure the influence of the experts' views, the participants had the chance to change their minds about which songs they wanted the most.
The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum—a reward center wired with dopamine neurons that respond to pleasures like sugar and sex—fired intensely.
"If someone agrees with your choice, it's intrinsically rewarding in the same way food or money is rewarding," says one of the experimenters, Chris Frith of University College London.
Why might other people's estimates of what something is worth lead you to change your own? Their appraisal could make you unsure that yours is correct. You might become more popular once you agree with others, or joining the experts may make you feel like one yourself. "We are very social creatures," says Prof. Frith, "and we are desperately keen to be part of the group."
"When someone influences you, it happens very quickly, in under a second," says the lead researcher, Daniel Campbell-Meiklejohn of Aarhus University. "That mechanism can travel quite quickly through a population."
The experiment also showed that learning that the experts agree with one another—regardless of whether you agree with them—triggers activity in the insula, a brain region associated with pain and heightened body awareness. This suggests that the agreement of others may have a special ability to grab our mental attention. No wonder a consensus opinion is almost impossible for many investors to ignore.
Benjamin Graham, the founder of value investing, wrote that "the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities." Rather, he added, "the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion." Herding, Graham understood, is part of the human condition.
Thus, if you buy individual stocks, you should note which way the herd is moving—and go the other way. You should get interested in a stock when its price gets trampled flat by investors stampeding out of it. The list of new 52-week lows is a rough guide to what the voting machine has been trashing lately. Then run your own weighing machine, studying the company's financial statements, products and competitors to determine the value of its business—while ignoring the current price of its stock. And make a permanent record that thoroughly details your rationale for making the investment. That way, you set in stone exactly where you stood before the herd began trying to sweep you away.
http://online.wsj.com/article/SB10001424052748703438604575314932570154178.html?KEYWORDS=jason+zweig
From February through May, the Dow Jones Industrial Average gained more than 1000 points in an almost uninterrupted daily march upward. Then came the "flash crash" of May 6 and day after day of losses through May. Now, in mid-June, the market has been up six of the past seven days.
What accounts for these sudden moves? Why do investors so often seem to resemble a school of fish, all changing direction together?
Sometimes the most interesting answers to financial questions come from scientific labs. A study published last week in the journal Current Biology found that the value you place on something is likely to go up when other people tell you it is worth more than you thought, and down when others say it is worth less. More strikingly, if your evaluation agrees with what others tell you, then a part of your brain that specializes in processing rewards kicks into high gear.
In other words, investors often go along with the crowd because—at the most basic biological level—conformity feels good. Moving in herds doesn't just give investors a sense of "safety in numbers." It also gives them pleasure.
That may help explain why market sentiment can change so swiftly, why true contrarians are so hard to find and why investors care so much about the "consensus view" on Wall Street.
In the experiment, researchers from University College London and Aarhus University in Denmark asked 28 people to submit a list of songs they wanted to buy online and then to decide which they would most like to own. Then the participants viewed the ratings of the same songs by two professional music experts. Meanwhile, a magnetic resonance imaging machine recorded the patterns of activity in their brains. Finally, as a way to measure the influence of the experts' views, the participants had the chance to change their minds about which songs they wanted the most.
The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum—a reward center wired with dopamine neurons that respond to pleasures like sugar and sex—fired intensely.
"If someone agrees with your choice, it's intrinsically rewarding in the same way food or money is rewarding," says one of the experimenters, Chris Frith of University College London.
Why might other people's estimates of what something is worth lead you to change your own? Their appraisal could make you unsure that yours is correct. You might become more popular once you agree with others, or joining the experts may make you feel like one yourself. "We are very social creatures," says Prof. Frith, "and we are desperately keen to be part of the group."
"When someone influences you, it happens very quickly, in under a second," says the lead researcher, Daniel Campbell-Meiklejohn of Aarhus University. "That mechanism can travel quite quickly through a population."
The experiment also showed that learning that the experts agree with one another—regardless of whether you agree with them—triggers activity in the insula, a brain region associated with pain and heightened body awareness. This suggests that the agreement of others may have a special ability to grab our mental attention. No wonder a consensus opinion is almost impossible for many investors to ignore.
Benjamin Graham, the founder of value investing, wrote that "the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities." Rather, he added, "the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion." Herding, Graham understood, is part of the human condition.
Thus, if you buy individual stocks, you should note which way the herd is moving—and go the other way. You should get interested in a stock when its price gets trampled flat by investors stampeding out of it. The list of new 52-week lows is a rough guide to what the voting machine has been trashing lately. Then run your own weighing machine, studying the company's financial statements, products and competitors to determine the value of its business—while ignoring the current price of its stock. And make a permanent record that thoroughly details your rationale for making the investment. That way, you set in stone exactly where you stood before the herd began trying to sweep you away.
http://online.wsj.com/article/SB10001424052748703438604575314932570154178.html?KEYWORDS=jason+zweig
Monday, May 17, 2010
Update on Bharti and Mr. Market
Lately, the telecom industry and Bharti have frequently been in the news. Given my previous blog recommending Bharti as a long term investment I thought I would spend some time to analyse the impact of the recent TRAI recommendations on our investment.
Recent TRAI recommendations: TRAI has made a slew of recommendations last week on the telecom industry. Some of these are good for us and some are not. Mr. Market seems to have focused on one bad one with particular severity. TRAI has recommended that any player holding spectrum above 6.2 MHz would have to pay a one-time fee per MHz for the excess spectrum based on the current 3G prices. Bharti has spectrum >6.2MHz in 13 circles, the most amongst all players. If you remember, this was one of the competitive advantages we had said was in our favour giving us a “moat” from competitors. There is now a cost to protect this moat. As per current prices for each sector Bharti has to pay the following as per Thursday’s Mint:
a. Delhi – Rs. 945 cr
b. Mumbai – Rs 833 cr
c. Karnataka – Rs. 265 cr
d. Tamilnadu – Rs. 264 cr
e. AP – Rs. 211 cr
f. Bihar – Rs. 40 cr
g. Maharashtra – Rs. 235 cr
h. Kolkata – Rs. 73 cr
i. UP – Rs. 58 cr
j. MP – Rs. 54 cr
k. Rajasthan – Rs. 52 cr
l. Punjab – Rs. 32 cr
m. Orissa – Rs 15 cr
TOTAL – Rs. 3,078 cr
Lets take a re-look at the small model we had created earlier for analyzing the right price to buy Bharti:
At my recommended price of Rs. 275 the market cap was Rs. 104,413 cr. At the current price of Rs. 260 the market cap is 98,718 cr, a difference of 5,700 cr or 185% higher than the cost of excess spectrum. The future cash flows have not changed because this is a one-time fee that does not impact cash flows going forward. Thus, Mr. Market seems to be mispricing the impact of the bad news on the stock. If we were to buy the stock at the current price and assume the recommendations will be fully accepted and therefore pay the new fee we would still be better off (98,718 cr + 3,078 cr = 101,796cr which is < 104,413 cr). What I am trying to say is that its like buying the company at 101,796 cr compared to 104,413 cr.
The same Mint article also says that analysts at ICICI Securities estimate the impact to be Rs. 8.8 and Rs. 4.1 on the EPS for the next 2 years. As long term investors, this is precisely what we like about Mr. Market. He makes decisions with a short term horizon. We have analyzed the company’s long term strengths and are in it for the long haul and not for the next 2 years. Also, Mr Market has ignored other recommendations of TRAI which facilitate consolidation, give discounts on spectrum fees and cracks the whip on only “urban centric” players who have not helped (unlike Bharti) the rural Indian. Finally, this is just a recommendation and has not been accepted yet.
What makes me drool right now is the fact that Bharti is available at a 42 month low, that’s lower than what it was available at during the recession. I feel that Mr. Market has over reacted to the recommendations as he frequently does. Let me re-quote Ben Graham here from my earlier blog:
“It is customary to refer with great respect to the 'bloodless verdict of the market place', as though it represented invariably the composite judgment of countless shrewd, informed and calculating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information”
I plan to buy more at the current prices.
Recent TRAI recommendations: TRAI has made a slew of recommendations last week on the telecom industry. Some of these are good for us and some are not. Mr. Market seems to have focused on one bad one with particular severity. TRAI has recommended that any player holding spectrum above 6.2 MHz would have to pay a one-time fee per MHz for the excess spectrum based on the current 3G prices. Bharti has spectrum >6.2MHz in 13 circles, the most amongst all players. If you remember, this was one of the competitive advantages we had said was in our favour giving us a “moat” from competitors. There is now a cost to protect this moat. As per current prices for each sector Bharti has to pay the following as per Thursday’s Mint:
a. Delhi – Rs. 945 cr
b. Mumbai – Rs 833 cr
c. Karnataka – Rs. 265 cr
d. Tamilnadu – Rs. 264 cr
e. AP – Rs. 211 cr
f. Bihar – Rs. 40 cr
g. Maharashtra – Rs. 235 cr
h. Kolkata – Rs. 73 cr
i. UP – Rs. 58 cr
j. MP – Rs. 54 cr
k. Rajasthan – Rs. 52 cr
l. Punjab – Rs. 32 cr
m. Orissa – Rs 15 cr
TOTAL – Rs. 3,078 cr
Lets take a re-look at the small model we had created earlier for analyzing the right price to buy Bharti:
At my recommended price of Rs. 275 the market cap was Rs. 104,413 cr. At the current price of Rs. 260 the market cap is 98,718 cr, a difference of 5,700 cr or 185% higher than the cost of excess spectrum. The future cash flows have not changed because this is a one-time fee that does not impact cash flows going forward. Thus, Mr. Market seems to be mispricing the impact of the bad news on the stock. If we were to buy the stock at the current price and assume the recommendations will be fully accepted and therefore pay the new fee we would still be better off (98,718 cr + 3,078 cr = 101,796cr which is < 104,413 cr). What I am trying to say is that its like buying the company at 101,796 cr compared to 104,413 cr.
The same Mint article also says that analysts at ICICI Securities estimate the impact to be Rs. 8.8 and Rs. 4.1 on the EPS for the next 2 years. As long term investors, this is precisely what we like about Mr. Market. He makes decisions with a short term horizon. We have analyzed the company’s long term strengths and are in it for the long haul and not for the next 2 years. Also, Mr Market has ignored other recommendations of TRAI which facilitate consolidation, give discounts on spectrum fees and cracks the whip on only “urban centric” players who have not helped (unlike Bharti) the rural Indian. Finally, this is just a recommendation and has not been accepted yet.
What makes me drool right now is the fact that Bharti is available at a 42 month low, that’s lower than what it was available at during the recession. I feel that Mr. Market has over reacted to the recommendations as he frequently does. Let me re-quote Ben Graham here from my earlier blog:
“It is customary to refer with great respect to the 'bloodless verdict of the market place', as though it represented invariably the composite judgment of countless shrewd, informed and calculating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information”
I plan to buy more at the current prices.
Wednesday, March 10, 2010
Taking On Mr. Market!
Note:
I have bought 2,000 shares of Bharti Airtel on 2 Mar 2010 at Rs. 277 per share and plan to buy a significantly higher quantity if the stock is available at similar or lower prices. I think this stock has significant upside potential with low risk. My logic for this purchase is laid out below. (Its a bit long - but then i plan to commit a significant amount of my net worth in this company)
THE NUMBERS
TABLE 1 (click to enlarge - recommend opening in new window)
The table above captures the Revenues, EBITDA (operating cash flow), PAT and Market Capitalization of Bharti over the last 7 years. I have forecasted the 2009-10 numbers by simply doubling the half yearly revenue as of Sep’09 (which is in-line with its Q3 numbers). An analysis of this table reveals a lot about the telecom industry in general and Bharti in particular.
Bharti experienced tremendous growth in the last 7 years. Its revenues went from Rs. 50 billion ($1.1 bn) in 2003-04 to Rs. 396 billion ($8.7 bn) in 2009-10. That’s an 8x jump!
Similarly EBITDA and PAT went from Rs. 17 bn ($0.37 bn) and Rs. 5.8 bn ($0.13 bn) to Rs. 166 bn ($3.61 bn) and Rs. 97 bn ($2.11 bn) respectively in the same 7 year period. Again, that’s a 10x jump in EBITDA and a 16x jump in profits.
In the last 7 years Bharti generated about Rs. 597 bn ($13.0 bn) of cash from operations and Rs. 318 bn ($7.0 bn) in profits (see blue boxes). However, none of this cash reached the shareholder in the form of dividends. The main reason for this was that Bharti ploughed back all of the $13.0 bn to build infrastructure – towers, underground cables, generators, sub-stations etc. as it increased it’s reach to the smaller towns and villages of India. No other telecom company (barring probably BSNL) has spent so much on building ground-up telecom infrastructure – no wonder Bharti is the largest owner of telecom towers today.
So, how was the shareholder benefited by all this growth if no cash ever made it to his hands? In the first 4 years of the analysis, the market cap of Bharti went from Rs. 256 bn to Rs. 1,665 bn (See brown box) which means that if someone had bought Bharti on 1st April 2004, he would have made 6.5x his capital on 1st April 2008 – that’s a 550% return in 4 years! By not giving money to shareholders and reinvesting it in the business, the company and management actually made the shareholders much richer.
However, all this was the past. All good things come to an end and the same seems to be true for the Indian telecom industry. At ~500 mm users, most urban cities have crossed the 100% penetration limit. Most of the new growth is coming from rural India (as per Bharti’s latest annual report 60% of all new customers are from rural India) which does not spend as much as urban India. In the last 2 quarters, Revenues and EBITDA have been flat for Bharti – which means new customers are not adding enough to the revenues and old customers are spending lesser.
If lower growth were not enough, the industry is now plagued with competition. This is generally the case when the going is good and there’s money to be made. Till Jan 2008, there used to be only 3-4 players in every circle. In Jan 2008 the government issued new licenses and spectrum to 6 new players – Unitech-Telenor, Shyam-Sistema, S-Tel, Swan-Etisalat, Datacom and Loop Telecom. The government also issued new licenses to existing players like Idea, Tata and Spice in circles they were not present before. Today, there are 12 telecom operators in the country of which 10 have a pan-India license which means that potentially there could be 10 service providers to choose from in every city.
This is going to put tremendous pricing pressure on incumbents since new players will try and garner as many of the new subscribers as possible and try and convert subscribers from other service providers using lower prices. Tata Docomo, Uninor and MTS have already started the price war by coming out with a 30p per minute scheme and forcing others to follow suit. This will impact both revenues and profits of Bharti and other incumbents. All this has been telling on the company’s stock market performance. The chart below shows how Bharti has continuously under performed the market since Jan 2009. While the Sensex has gained 73% to 173 Bharti has lost 19% to 81.
In the short term, the merger with Zain Telecom has also spooked the market, and since announcement in early Feb the stock has tanked 15% from Rs. 320 to Rs. 275. Markets generally tend to react negatively to big cross border mergers as seen in the Tata – Corus, Tata – Jaguar deals. However, all these stocks are now back to their old prices.
Bharti currently trades near its all-time low of Rs. 280 per share with a market cap of Rs 1,100 bn. It’s P/E ratio is at ~11.0x as Mr. Market has come to the conclusion that growth in the stock is more or less over. This is a classic case of a big corporation being “currently out of favor” with the investment community. Ben Graham and Buffet have taught me that these situations present interesting long term investment opportunities and generally merit a thorough analysis of the company and its operations to see if the market is mispricing (as it frequently does) long term value in the current stock price. In the 1937 edition of Security Analysis, Ben Graham wrote:
“It is customary to refer with great respect to the 'bloodless verdict of the market place', as though it represented invariably the composite judgment of countless shrewd, informed and calculating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information”
In our analysis, we need to understand 3 things:
1. Are the long term economics of this industry intact?
2. Is Bharti positioned to take advantage of these economics and does it have the competitive advantages that make it better positioned as compared to its peers?
3. What is the right price to pay for the inherent long term value of Bharti?
QUESTION 1 – ARE THE LONG TERM ECONOMICS OF THIS INDUSTRY INTACT?
If the last few quarters are any indication, revenues and profits from mobile telephony have more or less plateaued. The growth story here is, for all practical purposes over. If we see the same table on top, the red circled CAGRs on the right (cumulative average growth rates) tell the story. In the last 6 years Bharti’s wireless revenues grew at a CAGR of 48%. In the last 3, 2 and 1 year the rates were 32%, 22% and 8% respectively. The only growth here can come from rural India which is going to be nowhere as exciting or sexy as that experienced by urban India in the last decade.
As investors, we can assume that mobile (or wireless) revenues are going to remain flat or show very little growth in the next 5-10 years. For Bharti, this is going to be a cash cow spitting out Rs. 100 bn ($2.2 bn) of cash EBITDA every year (since incremental capex on towers is going to be much lower). Bharti knows this as much as anybody else. It has to find newer un-penetrated markets to deploy this vast cash pile or it will remain a cash machine doling out huge dividends to its shareholders. Thus, the rush to enter new markets in Africa, Bangladesh and Sri Lanka.
The other indicator of future growth is the rush of foreign operators to enter India. As a Telenor or a Docomo or for that matter Etisalat, why would I want to enter a market that is saturated unless I saw value there? All these firms must have done their own research to see the potential for growth in India. However, my own experience of seeing foreign PE funds investing in India has made me fairly cynical about the quality and depth of their research. The other day I read an interview of the Sistema CEO saying there is a 700 million untapped subscriber base in India. I guess he was talking about India’s 1.2 bn population minus the 500 mn subscribers we currently have. Taking decisions on the basis of that number is a bit naïve as it assumes the whole of India’s population will start using cell phones in the future. Included in that are people below poverty line, children and senior citizens.
I think the real growth, if any should come from non-voice services because this is one area where there is still scope for growth. Around the world, telecom companies seem to derive almost 25% of their revenues from non-voice services like net browsing, data transfers, wimax etc (see the 2 graphs below by Motila Oswal and Deutsche Bank) whereas only 10% of revenues in India currently come from these services. Bharti’s non-voice revenues stand at 9%. With the upcoming auction of 3G and WiMax airwaves this segment is set to ride the next growth wave. Bharti stands to gain here more than others because of its captive subscriber base of 110 million users and lower incremental capex on infrastructure.
Source: Motilal Oswal Research (Jun 2009)
Source: Deutsche Bank Research (Feb 2009)
Passive infrastructure is the other area of growth for Bharti. Being an incumbent, it enjoys superior infrastructure which it can share with new players who cannot spend billions on infrastructure as it did. This leads to infrastructure sharing which will bolster the revenues of Bharti. Having spent huge capex over the last 10 years it can sit pretty as new incumbents lease tower space from it and pay rents.
I think these are the core areas of growth which can lead to higher revenues and profits in the next 5-10 year period.
This answers our first question. Though the next 5-10 years is not going to see the kind of growth the last decade witnessed, there is still some milk left in the udder. Maybe it’s going to be 10% or 15% and not the 41% of the last 7 years but its definitely there.
QUESTION 2: IS BHARTI POSITIONED TO TAKE ADVANTAGE OF THESE ECONOMICS AND DOES IT HAVE THE COMPETITIVE ADVANTAGES THAT MAKE IT BETTER POSITIONED AS COMPARED TO ITS PEERS?
In Buffet terminology this is the “moat” that keeps away potential competitors from coming in and destroying shareholder value by eroding margins and growth. This is the key to long term value investing as it helps protect investors like ourselves from nasty surprises in the future. I want to spend some time here because the next few points are going to help me sleep well when the market goes crazy (as it will) in the future.
Competitive Advantages / Barriers to Entry
1. SPECTRUM
Being the earliest entrants, Bharti, Vodafone and IDEA have been allotted spectrum in the 900 Mhz band. Among the three, Bharti has the highest (15 of the 23 circles) allocation in the 900 Mhz band followed by Vodafone (9 of the 23 circles) and Idea (9 of the 23 circles) while none of the new entrants – Tata Docomo, Unitech Telenor, Swan and BPL have 900 Mhz spectrum. All new entrants have been given spectrum in the 1,800 Mhz band.
A little read on the internet and broker reports tell us that the 1,800 Mhz band is commercially less viable as it requires double the number of towers for similar coverage. This is because network signals in the 1,800 Mhz have half the wavelength Vs 900 Mhz. Thus, incremental capex and opex is going to be double here for new entrants leading to massive capital expenditure and lower margins. This a double whammy for new players as it affects both the balance sheet as well as the income statement. Motilal Oswal estimates the impact of this to be 10-15% on the bottom line. Also, new entrants would have to price their product at a much lower price (what Tata Docomo, MTS and Uninor are doing now) in order to get higher subscribers. This will put even more pressure on their bottom lines till eventually they will have to increase rates or go out of business.
2. NETWORK
I think there are 4 aspects to this point as outlined below:
1. The Reach Aspect
As per their latest annual report Bharti Infratel (Bharti’s tower subsidiary) exclusively owns 27,548 towers in 11 circles and 35,066 towers in the remaining 12 circles through Indus Towers (where it has a 42% stake). Indus Towers is a JV between Bharti, Vodafone and Idea and owns towers in 16 circles (4 circles common with Infratel, 12 circles on exclusive basis). Therefore, together with Indus, Bharti owns towers in all 23 circles in India. This is the highest across all private telecom operators in India.
Bharti covers 5,060 census towns and 414,906 non census towns and villages in India covering 81% of the country’s population. Its national long distance infrastructure consists of 101,337 route kilometers of optical fibre while its international infrastructure includes ownership of the i2i submarine cable systems connecting Chennai to Singapore and joint ownership of transatlantic and transpacific routes. Any player, especially new (and on the 1,800 Mhz band) will find it extremely difficult and costly to replicate this network reach (up to 5 years or more as per industry analysts). Higher network coverage also means quality of service (roaming, network and data coverage) are far better for a customer using Airtel compared to a new entrant or an incumbent with lower reach.
2. The Value Aspect
In Feb 2008 KKR bought a 2% stake in Bharti Infratel for $250 mm implying a valuation of $12.5 billion for the whole company (see table below). However, Feb ’08 was the peak of the market and valuations were most probably stretched. Having said that, as late as Dec 2009 Citigroup sold its stake to JP Morgan at cost for $50 mm valuing Bharti Infratel at $10 billion. If we go ahead and buy Bharti shares we will automatically become owners of the tower company as well. Therefore, while analyzing Bharti, we will treat the Infratel arm separately by subtracting its “value” from the enterprise value of Bharti or by treating it as an ‘extra gift’ that we get with every one share of Bharti.
Table 2
3. The Cost Aspect
The setting up of a tower involves both passive (tower itself, repeaters, shelters, generators etc) and active infrastructure (electronic components on the tower such as antennas, feeder cables, nodes, radio access networks etc) spending. As per industry experts, the cost of setting up one tower is Rs. 30 lakhs. Clearly, new entrants will have to spend substantial amounts of capex on the construction of these towers. Amongst the incumbent private players, Bharti has spent the most on the setting up of these towers across the country. As we pointed out earlier, Bharti has spent close to Rs. 596 billion ($13 bn) in developing this infrastructure in the last 7 years alone.
4. The Revenue Aspect
As a new player it makes more sense to lease towers from incumbents than to spend on constructing them. This does 2 things – 1) makes new players dependent on incumbent players and 2) generates additional revenue for incumbent players. Also, new players still need to spend on active infrastructure to cater to their customers, so it’s not exactly ‘capex light’
For the year ended Mar 2009 Bharti’s revenues and EBITDA from passive infrastructure (tower business) were Rs. 42,489 mm (9% of total revenues) and Rs. 15,022 mm (9% of total EBITDA) respectively, a growth of more than 700% from Mar 2008. As new players enter the market, revenues from this segment are bound to go up even higher.
3. SCALE
At 141 billion minutes, Bharti was 5th in the world in the number of mobile minutes carried on its network for the Apr-Jun 2009 quarter (see table below) and almost double its nearest competitor in India - Vodafone. This is a significant achievement given the fact that compared to the other players; Bharti is a single country operator (Vodafone operates in 30 countries). Despite such high volumes, Bharti’s EBITDA margin from the mobile phone business in FY09 was 41%. This gives you some indication of the scale and cost structure that Bharti has built-up over the years. As per Macquarie, it is “likely the lowest cost producer of voice minutes in the world and this remains the biggest entry barrier for greenfield players”. This is a huge benefit for the investor as this provides a safety float around the company which makes it difficult for competitors to match its products and services at the same cost.
On 14 Dec, 2009 Economic Times ran an interview of Vodafone CEO Vittorio Colao. Let me quote verbatim a few lines from the interview that will give you an idea of Bharti’s scale advantage.
Q: In your last quarterly results, you have said that despite the price wars, Vodafone will be looking to leverage its brand and scale in India. How do you plan to do so? I believe your operating costs in India are much higher that that of your closest competitor Bharti Airtel.
A: …In terms of networks, we have been able to use our global scale to get the best deals from western and eastern equipment companies. Yes, Bharti has scale and they are ahead of us, but we are patient. Give us another 15 YEARS and we will catch up with them
Q. You must be joking about the 15-year period.
A: I am serious. In our sector, it takes time. I am not obsessed with being number 1, but we are happy to be among the top two leaders of the market here. Bharti is a very well run company. I admire them. But right now, they are well ahead of us
These words coming from its biggest competitor are manna for the investor’s ear!
Source: Macquarie Research (Oct 2009)
4. BRAND
Airtel was voted the 2nd most trusted brand in an economic times brand equity survey and 8th in the Top 50 most valuable brands in the world (by Brand Finance Plc). Over the years, Bharti has spent substantial amounts of money on marketing and advertising the ‘Airtel’ brand resulting in significant brand recall amongst consumers. In FY09 alone it spent $521 mm (Rs. 2,500 crore) on sales and marketing.
New players will find it extremely difficult to match the advertising budget of large scale players like Bharti and Vodafone who have already built up a significant brand presence throughout the country. Also, as an investor in Bharti it’s heartening to know that it is this brand that makes ordinary subscribers go to local kirana stores or airtel outlets month after month to recharge the currencies in their cell phones.
5. LEADERSHIP & MANAGEMENT
Sunil Bharti Mittal is the founder, owner, chairman and managing director of Bharti and owns close to 45% of the company. A short wikipedia search reveals that he’s a first generation entrepreneur who started his first venture as early as 1976 with a capital of Rs. 20,000 making crankshafts for bicycle manufacturers. After selling his bicycle parts business in 1980 he moved to Mumbai and stared a generator importing business and in 1984 started assembling mobile phones in India. He got his first big break in 1992 when the government was auctioning mobile phone licenses in Delhi. Understanding the potential of mobile connectivity, he bid and won 1 of the 4 auctioned licenses and has since built Bharti into the largest telecom operator in India with more than 110 million customers and $8 billion in revenues.
No doubt, Sunil Mittal has the vision and the entrepreneurial flair required for success but the best thing about him is that he has built-up and maintained a squeaky clean image of himself and his company. In the post Raju era, an investor needs to be doubly sure that the person at the helm of affairs is passionate and committed (financially and emotionally) to creating shareholder value. He is also conservative (Bharti has very little debt with most capex funded by internal accruals). All this has led institutional investors to own close to 27% of the company.
One of the best tangible ways to measure management performance is to see how effectively management reinvested earnings to create shareholder value. Buffet always says that “for every dollar retained by the corporation, at least one dollar of market value should be created for owners”. I did this exercise for Bharti for the last 7 years. The results are laid out in the table below:
Table 3
In the last 7 years Bharti retained Rs. 318 bn from shareholders and reinvested it into the business. At the end of 7 years, Bharti’s market value increased by Rs. 788 bn. That’s Rs. 2.5 of value for every Re. 1 invested in the business. The other option would have been to return everything to shareholders so that they can invest that money on their own. Clearly, in this case it would have been far more profitable for shareholders to invest it back in the company than to invest it on their own. This number gives you confidence in the management especially in light of the recent Zain merger. If Bharti can reinvest future earnings and create similar value, it could mean a windfall for equity shareholders in the future.
These 5 competitive advantages create a fairly secure moat around the company. As shareholders I think, we can rest assured that the company is far ahead of its competitors especially with regards to its first mover advantage in spectrum allocation, the depth and reach of its network, the scale of its operations, its brand and finally its strong management team. These attributes should keep the company ahead of the pack for a few years to come. (15 years as per its nearest competitor).
QUESTION 3: WHAT IS THE RIGHT PRICE TO PAY FOR THE INHERENT LONG TERM VALUE OF BHARTI?
Now that we know what the potential of the industry is and the inherent competitive advantages that Bharti enjoys, we need to answer the all important question – What is the right price to buy this value?
In the first table we saw how Bharti has performed in the last 7 years. Now let’s try and extrapolate this table 5 years forward and see, with the help of some basic assumptions, what we can expect:
We will make the following basic assumptions in our forecasts for the 5 year period:
1. The growth rate of profits, EBITDA and Revenue
2. The P/E ratio at which the company will trade 5 years from now
3. The value and timing of sale of the Tower business
Let’s start by assuming a 10% annual growth in profits over the next 5 years (see red circle). The 2009-10 profits is most likely going to be around Rs 97 bn. If we grow this by 10% every year it becomes 156 bn in 2014-15. Remember this number was 60%, 34%, 23% and 23.1% for the last 6, 3, 2 and 1 year respectively but of a much lower base. The 10% number may seem to be conservative given the fact that Bharti is going to earn incremental revenues from non voice services, Zain merger and tower revenues. There is also a strong likelihood that the industry will consolidate in the next 5-10 years with only the strong players remaining profitable.
However, we need to be mindful of the competition and risks involved. Here, it’s best to apply Ben Graham’s “Margin of Safety” approach which advocates that investors will never know everything about a given company. However much we try to analyse the risks, we will end up making errors on macroeconomic events, interest rates, regulatory changes etc. Like Buffet said "It is better to be approximately right than precisely wrong." We should err on the conservative side. 10% is not an unreasonable number given our discussion of future growth.
Our second assumption is that Bharti will trade at a P/E of 10.0x after 5 years. This seems reasonable given the fact that Bharti is likely to be a stable cash flow generating company after 5 years. A P/E of 10.0x implies little or no growth in the business going forward. I think this number too can surprise us only on the higher side.
Our third assumption is that the tower business trades at $9 bn, a 25% discount to peak valuation of $12 bn and a 10% discount to the most recent transaction, which was when Citigroup sold its Bharti Infratel stake to JP Morgan for an implied valuation of $10 bn in Dec 2009. We also assume that this is the same value at which this company trades after 5 years. Here again, we are being conservative. If the tower business is IPOed at a higher valuation this number could increase by 25 to 50%. However, our objective is to see if it makes sense to buy this company at the most punitive of assumptions. The tower valuation at $9 bn also implies that our going-in P/E is 7.17x (green circle) for the wireless business.
Armed with these 3 assumptions we can calculate the going-in price at which we make a reasonable return on our investment. Starting with Rs. 275, the model tells us that we can make a 12.4% IRR (78% return over 5 years) or 1.78x our investment in 5 years if these 3 assumptions turn out to be true. The stock price at the end of 5 years would be Rs. 481.9 (see green circle). A small sensitivity table below tells us what will happen at different growth scenarios:
If the growth in profits turns out to be 20% instead of 10%, we can make a 20.6% IRR (153% return over 5 years) per annum and 2.53x our initial investment (see the 20% column). For this to happen, the stock price after 5 years needs to be Rs. 685.
What I like about this sensitivity is that even if the company grows by only 5%, we will not lose money. We still end up with a 8.5% annual return. However, a closer scrutiny reveals that at 5% growth the retained earnings (Rs. 533 bn) will be much higher than the difference in market cap (Rs 491 bn) implying that Bharti will not be able to create even Re 1 of value for every Re 1 invested. We can, at the least, expect Mr Mittal to create value equal to reinvested earnings. Otherwise he is better off declaring all profits as dividends. From our earlier analysis (Table 3) we also know for a fact that in the last 7 years he reinvested Rs. 318 bn and returned 787 bn or 2.5x. Even our conservative 10% growth case assumes that he will only create Rs. 785 bn of value for Rs 617 bn of investment or 1.3x (see green circle).
Now, if we do the whole analysis at Rs. 250 per share going-in price instead of Rs. 275, our return becomes 14.6% going in (1.96x capital). See the table below for numbers at Rs. 250:
At 300 we make only a 10.4% IRR and 1.64x multiple. So obviously, the margin of safety reduces the higher up we go and increases lower the price. This leads me to conclude that between Rs 250 and 275, there is a chance of making significant returns with a high margin of safety.
The upside potential is high if non-voice revenues kick-in post 3G auctions, if Zain does reasonably well, if Mr Mittal is able to create greater value for every rupee reinvested in the business and if the tower business is “IPOed” at a higher valuation. If any / all of these add a 10-15% growth to the PAT the stock could trade at around Rs. 800 in 5 years.
Concluding Note
The urban Indian today is hopelessly addicted to his cell phone and is not going to stop using it any time soon. In fact he will probably use it even more, not just to talk but also to check mail, news, sports updates, transfer money, browse photos, follow social networking sites etc. As an investor in Bharti that would make me feel really good. Every time you talk to someone using Airtel the cash registers are ringing and I am likely to get 20% of it. So in a way investing in Bharti is no different from investing in a cigarette manufacturing company – it has consumers who are hooked to the product and who shell out cash at fixed intervals so that they can keep talking on their mobile phones. Every time you see someone talking on the phone there is a 25% chance that he/she is using Airtel, making the investor the ultimate beneficiary.
What’s even better is that it’s the market leader in the industry, it is led by Sunil Mittal who has a history of creating shareholder value and creating and managing a highly low cost and profitable business model. It has a brand that is recognized throughout the country and used by 25% of all cellular subscribers. Finally, it’s a company with high entry barriers and significant competitive advantages.
At the prices I mentioned above, especially in the Rs. 250-275 range, I am willing to bet 50% of my hard earned net worth in this one company. Right now the price may be around Rs. 290 but as investors we need to be patient and wait for the right price to pay. I would advise you to wait for the stock to come in investment range and add slowly to your position, as I will be doing. I think it’s only appropriate to end with a quote by Ben Graham:
“It requires strength of character in order to think and to act in opposite fashion from the crowd; and also patience to wait for opportunities which may be spaced years apart.”
KM
I have bought 2,000 shares of Bharti Airtel on 2 Mar 2010 at Rs. 277 per share and plan to buy a significantly higher quantity if the stock is available at similar or lower prices. I think this stock has significant upside potential with low risk. My logic for this purchase is laid out below. (Its a bit long - but then i plan to commit a significant amount of my net worth in this company)
THE NUMBERS
TABLE 1 (click to enlarge - recommend opening in new window)
The table above captures the Revenues, EBITDA (operating cash flow), PAT and Market Capitalization of Bharti over the last 7 years. I have forecasted the 2009-10 numbers by simply doubling the half yearly revenue as of Sep’09 (which is in-line with its Q3 numbers). An analysis of this table reveals a lot about the telecom industry in general and Bharti in particular.
Bharti experienced tremendous growth in the last 7 years. Its revenues went from Rs. 50 billion ($1.1 bn) in 2003-04 to Rs. 396 billion ($8.7 bn) in 2009-10. That’s an 8x jump!
Similarly EBITDA and PAT went from Rs. 17 bn ($0.37 bn) and Rs. 5.8 bn ($0.13 bn) to Rs. 166 bn ($3.61 bn) and Rs. 97 bn ($2.11 bn) respectively in the same 7 year period. Again, that’s a 10x jump in EBITDA and a 16x jump in profits.
In the last 7 years Bharti generated about Rs. 597 bn ($13.0 bn) of cash from operations and Rs. 318 bn ($7.0 bn) in profits (see blue boxes). However, none of this cash reached the shareholder in the form of dividends. The main reason for this was that Bharti ploughed back all of the $13.0 bn to build infrastructure – towers, underground cables, generators, sub-stations etc. as it increased it’s reach to the smaller towns and villages of India. No other telecom company (barring probably BSNL) has spent so much on building ground-up telecom infrastructure – no wonder Bharti is the largest owner of telecom towers today.
So, how was the shareholder benefited by all this growth if no cash ever made it to his hands? In the first 4 years of the analysis, the market cap of Bharti went from Rs. 256 bn to Rs. 1,665 bn (See brown box) which means that if someone had bought Bharti on 1st April 2004, he would have made 6.5x his capital on 1st April 2008 – that’s a 550% return in 4 years! By not giving money to shareholders and reinvesting it in the business, the company and management actually made the shareholders much richer.
However, all this was the past. All good things come to an end and the same seems to be true for the Indian telecom industry. At ~500 mm users, most urban cities have crossed the 100% penetration limit. Most of the new growth is coming from rural India (as per Bharti’s latest annual report 60% of all new customers are from rural India) which does not spend as much as urban India. In the last 2 quarters, Revenues and EBITDA have been flat for Bharti – which means new customers are not adding enough to the revenues and old customers are spending lesser.
If lower growth were not enough, the industry is now plagued with competition. This is generally the case when the going is good and there’s money to be made. Till Jan 2008, there used to be only 3-4 players in every circle. In Jan 2008 the government issued new licenses and spectrum to 6 new players – Unitech-Telenor, Shyam-Sistema, S-Tel, Swan-Etisalat, Datacom and Loop Telecom. The government also issued new licenses to existing players like Idea, Tata and Spice in circles they were not present before. Today, there are 12 telecom operators in the country of which 10 have a pan-India license which means that potentially there could be 10 service providers to choose from in every city.
This is going to put tremendous pricing pressure on incumbents since new players will try and garner as many of the new subscribers as possible and try and convert subscribers from other service providers using lower prices. Tata Docomo, Uninor and MTS have already started the price war by coming out with a 30p per minute scheme and forcing others to follow suit. This will impact both revenues and profits of Bharti and other incumbents. All this has been telling on the company’s stock market performance. The chart below shows how Bharti has continuously under performed the market since Jan 2009. While the Sensex has gained 73% to 173 Bharti has lost 19% to 81.
In the short term, the merger with Zain Telecom has also spooked the market, and since announcement in early Feb the stock has tanked 15% from Rs. 320 to Rs. 275. Markets generally tend to react negatively to big cross border mergers as seen in the Tata – Corus, Tata – Jaguar deals. However, all these stocks are now back to their old prices.
Bharti currently trades near its all-time low of Rs. 280 per share with a market cap of Rs 1,100 bn. It’s P/E ratio is at ~11.0x as Mr. Market has come to the conclusion that growth in the stock is more or less over. This is a classic case of a big corporation being “currently out of favor” with the investment community. Ben Graham and Buffet have taught me that these situations present interesting long term investment opportunities and generally merit a thorough analysis of the company and its operations to see if the market is mispricing (as it frequently does) long term value in the current stock price. In the 1937 edition of Security Analysis, Ben Graham wrote:
“It is customary to refer with great respect to the 'bloodless verdict of the market place', as though it represented invariably the composite judgment of countless shrewd, informed and calculating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information”
In our analysis, we need to understand 3 things:
1. Are the long term economics of this industry intact?
2. Is Bharti positioned to take advantage of these economics and does it have the competitive advantages that make it better positioned as compared to its peers?
3. What is the right price to pay for the inherent long term value of Bharti?
QUESTION 1 – ARE THE LONG TERM ECONOMICS OF THIS INDUSTRY INTACT?
If the last few quarters are any indication, revenues and profits from mobile telephony have more or less plateaued. The growth story here is, for all practical purposes over. If we see the same table on top, the red circled CAGRs on the right (cumulative average growth rates) tell the story. In the last 6 years Bharti’s wireless revenues grew at a CAGR of 48%. In the last 3, 2 and 1 year the rates were 32%, 22% and 8% respectively. The only growth here can come from rural India which is going to be nowhere as exciting or sexy as that experienced by urban India in the last decade.
As investors, we can assume that mobile (or wireless) revenues are going to remain flat or show very little growth in the next 5-10 years. For Bharti, this is going to be a cash cow spitting out Rs. 100 bn ($2.2 bn) of cash EBITDA every year (since incremental capex on towers is going to be much lower). Bharti knows this as much as anybody else. It has to find newer un-penetrated markets to deploy this vast cash pile or it will remain a cash machine doling out huge dividends to its shareholders. Thus, the rush to enter new markets in Africa, Bangladesh and Sri Lanka.
The other indicator of future growth is the rush of foreign operators to enter India. As a Telenor or a Docomo or for that matter Etisalat, why would I want to enter a market that is saturated unless I saw value there? All these firms must have done their own research to see the potential for growth in India. However, my own experience of seeing foreign PE funds investing in India has made me fairly cynical about the quality and depth of their research. The other day I read an interview of the Sistema CEO saying there is a 700 million untapped subscriber base in India. I guess he was talking about India’s 1.2 bn population minus the 500 mn subscribers we currently have. Taking decisions on the basis of that number is a bit naïve as it assumes the whole of India’s population will start using cell phones in the future. Included in that are people below poverty line, children and senior citizens.
I think the real growth, if any should come from non-voice services because this is one area where there is still scope for growth. Around the world, telecom companies seem to derive almost 25% of their revenues from non-voice services like net browsing, data transfers, wimax etc (see the 2 graphs below by Motila Oswal and Deutsche Bank) whereas only 10% of revenues in India currently come from these services. Bharti’s non-voice revenues stand at 9%. With the upcoming auction of 3G and WiMax airwaves this segment is set to ride the next growth wave. Bharti stands to gain here more than others because of its captive subscriber base of 110 million users and lower incremental capex on infrastructure.
Source: Motilal Oswal Research (Jun 2009)
Source: Deutsche Bank Research (Feb 2009)
Passive infrastructure is the other area of growth for Bharti. Being an incumbent, it enjoys superior infrastructure which it can share with new players who cannot spend billions on infrastructure as it did. This leads to infrastructure sharing which will bolster the revenues of Bharti. Having spent huge capex over the last 10 years it can sit pretty as new incumbents lease tower space from it and pay rents.
I think these are the core areas of growth which can lead to higher revenues and profits in the next 5-10 year period.
This answers our first question. Though the next 5-10 years is not going to see the kind of growth the last decade witnessed, there is still some milk left in the udder. Maybe it’s going to be 10% or 15% and not the 41% of the last 7 years but its definitely there.
QUESTION 2: IS BHARTI POSITIONED TO TAKE ADVANTAGE OF THESE ECONOMICS AND DOES IT HAVE THE COMPETITIVE ADVANTAGES THAT MAKE IT BETTER POSITIONED AS COMPARED TO ITS PEERS?
In Buffet terminology this is the “moat” that keeps away potential competitors from coming in and destroying shareholder value by eroding margins and growth. This is the key to long term value investing as it helps protect investors like ourselves from nasty surprises in the future. I want to spend some time here because the next few points are going to help me sleep well when the market goes crazy (as it will) in the future.
Competitive Advantages / Barriers to Entry
1. SPECTRUM
Being the earliest entrants, Bharti, Vodafone and IDEA have been allotted spectrum in the 900 Mhz band. Among the three, Bharti has the highest (15 of the 23 circles) allocation in the 900 Mhz band followed by Vodafone (9 of the 23 circles) and Idea (9 of the 23 circles) while none of the new entrants – Tata Docomo, Unitech Telenor, Swan and BPL have 900 Mhz spectrum. All new entrants have been given spectrum in the 1,800 Mhz band.
A little read on the internet and broker reports tell us that the 1,800 Mhz band is commercially less viable as it requires double the number of towers for similar coverage. This is because network signals in the 1,800 Mhz have half the wavelength Vs 900 Mhz. Thus, incremental capex and opex is going to be double here for new entrants leading to massive capital expenditure and lower margins. This a double whammy for new players as it affects both the balance sheet as well as the income statement. Motilal Oswal estimates the impact of this to be 10-15% on the bottom line. Also, new entrants would have to price their product at a much lower price (what Tata Docomo, MTS and Uninor are doing now) in order to get higher subscribers. This will put even more pressure on their bottom lines till eventually they will have to increase rates or go out of business.
2. NETWORK
I think there are 4 aspects to this point as outlined below:
1. The Reach Aspect
As per their latest annual report Bharti Infratel (Bharti’s tower subsidiary) exclusively owns 27,548 towers in 11 circles and 35,066 towers in the remaining 12 circles through Indus Towers (where it has a 42% stake). Indus Towers is a JV between Bharti, Vodafone and Idea and owns towers in 16 circles (4 circles common with Infratel, 12 circles on exclusive basis). Therefore, together with Indus, Bharti owns towers in all 23 circles in India. This is the highest across all private telecom operators in India.
Bharti covers 5,060 census towns and 414,906 non census towns and villages in India covering 81% of the country’s population. Its national long distance infrastructure consists of 101,337 route kilometers of optical fibre while its international infrastructure includes ownership of the i2i submarine cable systems connecting Chennai to Singapore and joint ownership of transatlantic and transpacific routes. Any player, especially new (and on the 1,800 Mhz band) will find it extremely difficult and costly to replicate this network reach (up to 5 years or more as per industry analysts). Higher network coverage also means quality of service (roaming, network and data coverage) are far better for a customer using Airtel compared to a new entrant or an incumbent with lower reach.
2. The Value Aspect
In Feb 2008 KKR bought a 2% stake in Bharti Infratel for $250 mm implying a valuation of $12.5 billion for the whole company (see table below). However, Feb ’08 was the peak of the market and valuations were most probably stretched. Having said that, as late as Dec 2009 Citigroup sold its stake to JP Morgan at cost for $50 mm valuing Bharti Infratel at $10 billion. If we go ahead and buy Bharti shares we will automatically become owners of the tower company as well. Therefore, while analyzing Bharti, we will treat the Infratel arm separately by subtracting its “value” from the enterprise value of Bharti or by treating it as an ‘extra gift’ that we get with every one share of Bharti.
Table 2
3. The Cost Aspect
The setting up of a tower involves both passive (tower itself, repeaters, shelters, generators etc) and active infrastructure (electronic components on the tower such as antennas, feeder cables, nodes, radio access networks etc) spending. As per industry experts, the cost of setting up one tower is Rs. 30 lakhs. Clearly, new entrants will have to spend substantial amounts of capex on the construction of these towers. Amongst the incumbent private players, Bharti has spent the most on the setting up of these towers across the country. As we pointed out earlier, Bharti has spent close to Rs. 596 billion ($13 bn) in developing this infrastructure in the last 7 years alone.
4. The Revenue Aspect
As a new player it makes more sense to lease towers from incumbents than to spend on constructing them. This does 2 things – 1) makes new players dependent on incumbent players and 2) generates additional revenue for incumbent players. Also, new players still need to spend on active infrastructure to cater to their customers, so it’s not exactly ‘capex light’
For the year ended Mar 2009 Bharti’s revenues and EBITDA from passive infrastructure (tower business) were Rs. 42,489 mm (9% of total revenues) and Rs. 15,022 mm (9% of total EBITDA) respectively, a growth of more than 700% from Mar 2008. As new players enter the market, revenues from this segment are bound to go up even higher.
3. SCALE
At 141 billion minutes, Bharti was 5th in the world in the number of mobile minutes carried on its network for the Apr-Jun 2009 quarter (see table below) and almost double its nearest competitor in India - Vodafone. This is a significant achievement given the fact that compared to the other players; Bharti is a single country operator (Vodafone operates in 30 countries). Despite such high volumes, Bharti’s EBITDA margin from the mobile phone business in FY09 was 41%. This gives you some indication of the scale and cost structure that Bharti has built-up over the years. As per Macquarie, it is “likely the lowest cost producer of voice minutes in the world and this remains the biggest entry barrier for greenfield players”. This is a huge benefit for the investor as this provides a safety float around the company which makes it difficult for competitors to match its products and services at the same cost.
On 14 Dec, 2009 Economic Times ran an interview of Vodafone CEO Vittorio Colao. Let me quote verbatim a few lines from the interview that will give you an idea of Bharti’s scale advantage.
Q: In your last quarterly results, you have said that despite the price wars, Vodafone will be looking to leverage its brand and scale in India. How do you plan to do so? I believe your operating costs in India are much higher that that of your closest competitor Bharti Airtel.
A: …In terms of networks, we have been able to use our global scale to get the best deals from western and eastern equipment companies. Yes, Bharti has scale and they are ahead of us, but we are patient. Give us another 15 YEARS and we will catch up with them
Q. You must be joking about the 15-year period.
A: I am serious. In our sector, it takes time. I am not obsessed with being number 1, but we are happy to be among the top two leaders of the market here. Bharti is a very well run company. I admire them. But right now, they are well ahead of us
These words coming from its biggest competitor are manna for the investor’s ear!
Source: Macquarie Research (Oct 2009)
4. BRAND
Airtel was voted the 2nd most trusted brand in an economic times brand equity survey and 8th in the Top 50 most valuable brands in the world (by Brand Finance Plc). Over the years, Bharti has spent substantial amounts of money on marketing and advertising the ‘Airtel’ brand resulting in significant brand recall amongst consumers. In FY09 alone it spent $521 mm (Rs. 2,500 crore) on sales and marketing.
New players will find it extremely difficult to match the advertising budget of large scale players like Bharti and Vodafone who have already built up a significant brand presence throughout the country. Also, as an investor in Bharti it’s heartening to know that it is this brand that makes ordinary subscribers go to local kirana stores or airtel outlets month after month to recharge the currencies in their cell phones.
5. LEADERSHIP & MANAGEMENT
Sunil Bharti Mittal is the founder, owner, chairman and managing director of Bharti and owns close to 45% of the company. A short wikipedia search reveals that he’s a first generation entrepreneur who started his first venture as early as 1976 with a capital of Rs. 20,000 making crankshafts for bicycle manufacturers. After selling his bicycle parts business in 1980 he moved to Mumbai and stared a generator importing business and in 1984 started assembling mobile phones in India. He got his first big break in 1992 when the government was auctioning mobile phone licenses in Delhi. Understanding the potential of mobile connectivity, he bid and won 1 of the 4 auctioned licenses and has since built Bharti into the largest telecom operator in India with more than 110 million customers and $8 billion in revenues.
No doubt, Sunil Mittal has the vision and the entrepreneurial flair required for success but the best thing about him is that he has built-up and maintained a squeaky clean image of himself and his company. In the post Raju era, an investor needs to be doubly sure that the person at the helm of affairs is passionate and committed (financially and emotionally) to creating shareholder value. He is also conservative (Bharti has very little debt with most capex funded by internal accruals). All this has led institutional investors to own close to 27% of the company.
One of the best tangible ways to measure management performance is to see how effectively management reinvested earnings to create shareholder value. Buffet always says that “for every dollar retained by the corporation, at least one dollar of market value should be created for owners”. I did this exercise for Bharti for the last 7 years. The results are laid out in the table below:
Table 3
In the last 7 years Bharti retained Rs. 318 bn from shareholders and reinvested it into the business. At the end of 7 years, Bharti’s market value increased by Rs. 788 bn. That’s Rs. 2.5 of value for every Re. 1 invested in the business. The other option would have been to return everything to shareholders so that they can invest that money on their own. Clearly, in this case it would have been far more profitable for shareholders to invest it back in the company than to invest it on their own. This number gives you confidence in the management especially in light of the recent Zain merger. If Bharti can reinvest future earnings and create similar value, it could mean a windfall for equity shareholders in the future.
These 5 competitive advantages create a fairly secure moat around the company. As shareholders I think, we can rest assured that the company is far ahead of its competitors especially with regards to its first mover advantage in spectrum allocation, the depth and reach of its network, the scale of its operations, its brand and finally its strong management team. These attributes should keep the company ahead of the pack for a few years to come. (15 years as per its nearest competitor).
QUESTION 3: WHAT IS THE RIGHT PRICE TO PAY FOR THE INHERENT LONG TERM VALUE OF BHARTI?
Now that we know what the potential of the industry is and the inherent competitive advantages that Bharti enjoys, we need to answer the all important question – What is the right price to buy this value?
In the first table we saw how Bharti has performed in the last 7 years. Now let’s try and extrapolate this table 5 years forward and see, with the help of some basic assumptions, what we can expect:
We will make the following basic assumptions in our forecasts for the 5 year period:
1. The growth rate of profits, EBITDA and Revenue
2. The P/E ratio at which the company will trade 5 years from now
3. The value and timing of sale of the Tower business
Let’s start by assuming a 10% annual growth in profits over the next 5 years (see red circle). The 2009-10 profits is most likely going to be around Rs 97 bn. If we grow this by 10% every year it becomes 156 bn in 2014-15. Remember this number was 60%, 34%, 23% and 23.1% for the last 6, 3, 2 and 1 year respectively but of a much lower base. The 10% number may seem to be conservative given the fact that Bharti is going to earn incremental revenues from non voice services, Zain merger and tower revenues. There is also a strong likelihood that the industry will consolidate in the next 5-10 years with only the strong players remaining profitable.
However, we need to be mindful of the competition and risks involved. Here, it’s best to apply Ben Graham’s “Margin of Safety” approach which advocates that investors will never know everything about a given company. However much we try to analyse the risks, we will end up making errors on macroeconomic events, interest rates, regulatory changes etc. Like Buffet said "It is better to be approximately right than precisely wrong." We should err on the conservative side. 10% is not an unreasonable number given our discussion of future growth.
Our second assumption is that Bharti will trade at a P/E of 10.0x after 5 years. This seems reasonable given the fact that Bharti is likely to be a stable cash flow generating company after 5 years. A P/E of 10.0x implies little or no growth in the business going forward. I think this number too can surprise us only on the higher side.
Our third assumption is that the tower business trades at $9 bn, a 25% discount to peak valuation of $12 bn and a 10% discount to the most recent transaction, which was when Citigroup sold its Bharti Infratel stake to JP Morgan for an implied valuation of $10 bn in Dec 2009. We also assume that this is the same value at which this company trades after 5 years. Here again, we are being conservative. If the tower business is IPOed at a higher valuation this number could increase by 25 to 50%. However, our objective is to see if it makes sense to buy this company at the most punitive of assumptions. The tower valuation at $9 bn also implies that our going-in P/E is 7.17x (green circle) for the wireless business.
Armed with these 3 assumptions we can calculate the going-in price at which we make a reasonable return on our investment. Starting with Rs. 275, the model tells us that we can make a 12.4% IRR (78% return over 5 years) or 1.78x our investment in 5 years if these 3 assumptions turn out to be true. The stock price at the end of 5 years would be Rs. 481.9 (see green circle). A small sensitivity table below tells us what will happen at different growth scenarios:
If the growth in profits turns out to be 20% instead of 10%, we can make a 20.6% IRR (153% return over 5 years) per annum and 2.53x our initial investment (see the 20% column). For this to happen, the stock price after 5 years needs to be Rs. 685.
What I like about this sensitivity is that even if the company grows by only 5%, we will not lose money. We still end up with a 8.5% annual return. However, a closer scrutiny reveals that at 5% growth the retained earnings (Rs. 533 bn) will be much higher than the difference in market cap (Rs 491 bn) implying that Bharti will not be able to create even Re 1 of value for every Re 1 invested. We can, at the least, expect Mr Mittal to create value equal to reinvested earnings. Otherwise he is better off declaring all profits as dividends. From our earlier analysis (Table 3) we also know for a fact that in the last 7 years he reinvested Rs. 318 bn and returned 787 bn or 2.5x. Even our conservative 10% growth case assumes that he will only create Rs. 785 bn of value for Rs 617 bn of investment or 1.3x (see green circle).
Now, if we do the whole analysis at Rs. 250 per share going-in price instead of Rs. 275, our return becomes 14.6% going in (1.96x capital). See the table below for numbers at Rs. 250:
At 300 we make only a 10.4% IRR and 1.64x multiple. So obviously, the margin of safety reduces the higher up we go and increases lower the price. This leads me to conclude that between Rs 250 and 275, there is a chance of making significant returns with a high margin of safety.
The upside potential is high if non-voice revenues kick-in post 3G auctions, if Zain does reasonably well, if Mr Mittal is able to create greater value for every rupee reinvested in the business and if the tower business is “IPOed” at a higher valuation. If any / all of these add a 10-15% growth to the PAT the stock could trade at around Rs. 800 in 5 years.
Concluding Note
The urban Indian today is hopelessly addicted to his cell phone and is not going to stop using it any time soon. In fact he will probably use it even more, not just to talk but also to check mail, news, sports updates, transfer money, browse photos, follow social networking sites etc. As an investor in Bharti that would make me feel really good. Every time you talk to someone using Airtel the cash registers are ringing and I am likely to get 20% of it. So in a way investing in Bharti is no different from investing in a cigarette manufacturing company – it has consumers who are hooked to the product and who shell out cash at fixed intervals so that they can keep talking on their mobile phones. Every time you see someone talking on the phone there is a 25% chance that he/she is using Airtel, making the investor the ultimate beneficiary.
What’s even better is that it’s the market leader in the industry, it is led by Sunil Mittal who has a history of creating shareholder value and creating and managing a highly low cost and profitable business model. It has a brand that is recognized throughout the country and used by 25% of all cellular subscribers. Finally, it’s a company with high entry barriers and significant competitive advantages.
At the prices I mentioned above, especially in the Rs. 250-275 range, I am willing to bet 50% of my hard earned net worth in this one company. Right now the price may be around Rs. 290 but as investors we need to be patient and wait for the right price to pay. I would advise you to wait for the stock to come in investment range and add slowly to your position, as I will be doing. I think it’s only appropriate to end with a quote by Ben Graham:
“It requires strength of character in order to think and to act in opposite fashion from the crowd; and also patience to wait for opportunities which may be spaced years apart.”
KM
Thursday, February 11, 2010
Riding the 'V'
In the last few weeks, there have been quite a few news articles on investing in company fixed deposits. Since my piece on Mahindra, some new companies have also hit the market with their deposits like Unitech and JP Associates. Here I would like to reiterate that as investors we need to be very careful of every issue and should deeply analyze the issuers / issue before we commit any of our hard earned capital.
In this blog, I am going to analyze, with the help of some data the pros and cons of an investment technique that has oft been written about and discussed in the investing world – Dollar Cost Averaging (also known as Systematic Investment Plan). At the end of the blog I would like to answer the question – Is dollar cost averaging helpful?
Simply put, dollar cost averaging means investing a fixed sum of money every period in a particular asset class. The benefits of doing this are the following:
1.It is simple and does not require you to be an expert on anything (stock market movement, GDP, interest rates, fiscal deficit, inflation etc)
2.It removes the emotional aspect of investing because it is mechanical and does not require you to think or react to anything
3.You end up saving a fixed amount every month which becomes a large sum later
4.It is a very passive and cheap way of investing
In order to verify the effectiveness of this technique I decided to look back at the Sensex for the last 10 years starting 1st Jan 2000. I took 10 years so that I would capture at least 1 full business cycle. What would have been the result if an investor had invested a fixed amount of Rs. 10,000 every month for the last 10 years starting 1-Jan-2000 into the Sensex? The results are below:
(click on table to enlarge)
The Table is divided into 3 parts – Part A, Part B and Part C. Part A lays out the performance of this Systematic Investment Plan (SIP), Part B lays out the performance of the Sensex and Part C compares the returns from the SIP and the Sensex.
Let’s look at Part A first. This part of the table shows the investment amount every year (Rs. 120,000 in this case), the number of units (or ‘shares’) of the Sensex that the Rs. 120,000 would have bought each year and its market value at the end of the year. For e.g. In the year 2000, the investor would have been able to purchase 26.2 shares of the Sensex whose value at the end of the year would have been Rs. 104,073 – a loss of 13.3%.
There is also a ‘cumulative’ column which shows the cumulative market value of the SIP at the end of every year. For e.g at the end of year 2 the cumulative market value of Rs 240,000 (Rs. 10,000 per month invested for 24 months) would have been Rs. 198,418 – a loss of 17.3% (the cumulative returns are in the purple boxes). As you can see the number of units bought varies considerably over the 10 years. In some years the 120,000 would have got the investor 37 shares of the Sensex (Year 2002) while in others it would have got him only 8 (Year 2007). This is an important aspect of dollar cost averaging.
Now lets look at Part B. Part B tells us what happened with the Sensex in those years. In the beginning of 2000 the Sensex was at 5,375 and closed the year at 3,972 – a fall of 26.1%. This table also has a cumulative column which shows us what the cumulative results would have been. For e.g At the end of year 2 (2001) Sensex had fallen by 39.3% from 5,375 to 3,262.
Part C simply tells us the difference between the SIP performance and the Sensex performance. In year 1 the SIP gave 12.8% more returns than the Sensex (-13.3% vs -26.1%). In year 2 that number was 22.0% and so on. At the end of 10 years, the SIP would have given a 199.6% return compared to 224.9% by the Sensex.
Now, if we plot the cumulative returns of the SIP with that of the Sensex year-on-year over the 10 years, we get the following graph:
This is a very interesting result because what it means is that this mindless investing technique would have beaten the benchmark index 8 out of the last 10 years! – A feat which 90% of highly paid highly educated highly cocky fund managers fail to accomplish.
Now, lets pause a while and analyze the numbers. The Rs. 12,00,000 invested in the SIP over 10 years would have grown to Rs. 35,95,109 or 2.99x the invested amount at the end of Year 10 (See Red Circles on the Table). Remember that this excludes dividends that you would have received over the 10 years. So, the actual returns will be higher than 200%. On the other hand, if you had invested in the Sensex on 1st Jan 2000 and sold on 31-Dec-2010 you would have ended up making 225% i.e. 25% more than the SIP.
However, to make that 225% return, the investor would have had to do a Rip Van Winkle for 10 years. For a normal person, it would have been emotionally torturing to see the Sensex go up and down day in and day out every day for 10 years. Imagine reading about it in the newspapers every day, watching it on television news channels and having dinner table conversations with your father /mother / uncle /aunt /brother / wife / friend.
Just think about how many things happened in the last 10 years economically, socially and politically that you would have thought would have been relevant. The government changed thrice from NDA to UPA to Congress, the markets went through the tech bubble and bust, outsourcing took off, inflation reached 12%, interest rates fell to 4%, real estate prices rocketed, Lehman collapsed, Saddam died, 9/11 happened, Iraq and Afghanistan got invaded, the price of oil reached ~$160 per barrel, Sensex reached 21,200 from 3,000 and crashed to 7,700, then there was Godhra, Kargil war, terror attacks on Parliament and Mumbai and so on and on. An investor would have had to be exceptionally stable to be able to live through those moments and still believe that his Rs. 100 would ultimately become Rs. 325. That’s a lot to ask from the common man.
On the other hand, all a brainless investor had to do was keep checking to see whether Rs. 10,000 was being debited from his account on the 1st of every month. She would know that whatever the situation may be she would be indifferent because she would be buying the asset at low as well as high prices. The investor would have bought at the bottom of the tech boom and at the height of the 2008 bubble but in the end would have been just 25% worse off than a non-existent Dravid of the investing world. At the same time she would have ended up saving a sizeable amount over the years.
Now let’s look at how we can execute this investment technique. In order to invest in the index every month, we will have to start an SIP on an index fund. Index funds buy stocks in the same weightages as in the index. Since it’s a passive investment technique, these funds have the lowest commissions in the mutual fund industry. There are only 2 things an investor needs to be careful about while choosing an index fund:
1. The Tracking Error or how closely the fund mirrors the benchmark index, and
2. The Fee or what % of the assets managed goes in administrative costs.
The 22-Jan Outlook Money magazine has a detailed list of index funds and their respective tracking errors and fees. I have listed the results below:
Before I end, lets look back at the advantages of an SIP again – 1: It is simple – all it requires is for you to give a standing instruction to your bank, 2: Its strips out the emotional aspect of investing as I have pointed out above, 3: It makes you save a fixed amount every month – Rs 10,000 per month becomes Rs. 12,00,000 at the end of 10 years and 4: Its cheap – the average cost of investing is only 1.3% per annum.
Starting 1st Mar, I will be investing a fixed sum every month in an index fund for hopefully a long period. Investing, after all is all about analysis and patience.
KM
Note:
I had briefly mentioned this in my first blog. If an investor wants to invest upfront and ensure safety of principal she could invest in the post office monthly income scheme and divert the monthly interest into an Index Fund SIP. Rs. 4,50,000 invested in post office MIS would yield a monthly income of Rs. 3,000 which could then be invested in an SIP.
Read the PDF of this entire blog by clicking here
In this blog, I am going to analyze, with the help of some data the pros and cons of an investment technique that has oft been written about and discussed in the investing world – Dollar Cost Averaging (also known as Systematic Investment Plan). At the end of the blog I would like to answer the question – Is dollar cost averaging helpful?
Simply put, dollar cost averaging means investing a fixed sum of money every period in a particular asset class. The benefits of doing this are the following:
1.It is simple and does not require you to be an expert on anything (stock market movement, GDP, interest rates, fiscal deficit, inflation etc)
2.It removes the emotional aspect of investing because it is mechanical and does not require you to think or react to anything
3.You end up saving a fixed amount every month which becomes a large sum later
4.It is a very passive and cheap way of investing
In order to verify the effectiveness of this technique I decided to look back at the Sensex for the last 10 years starting 1st Jan 2000. I took 10 years so that I would capture at least 1 full business cycle. What would have been the result if an investor had invested a fixed amount of Rs. 10,000 every month for the last 10 years starting 1-Jan-2000 into the Sensex? The results are below:
(click on table to enlarge)
The Table is divided into 3 parts – Part A, Part B and Part C. Part A lays out the performance of this Systematic Investment Plan (SIP), Part B lays out the performance of the Sensex and Part C compares the returns from the SIP and the Sensex.
Let’s look at Part A first. This part of the table shows the investment amount every year (Rs. 120,000 in this case), the number of units (or ‘shares’) of the Sensex that the Rs. 120,000 would have bought each year and its market value at the end of the year. For e.g. In the year 2000, the investor would have been able to purchase 26.2 shares of the Sensex whose value at the end of the year would have been Rs. 104,073 – a loss of 13.3%.
There is also a ‘cumulative’ column which shows the cumulative market value of the SIP at the end of every year. For e.g at the end of year 2 the cumulative market value of Rs 240,000 (Rs. 10,000 per month invested for 24 months) would have been Rs. 198,418 – a loss of 17.3% (the cumulative returns are in the purple boxes). As you can see the number of units bought varies considerably over the 10 years. In some years the 120,000 would have got the investor 37 shares of the Sensex (Year 2002) while in others it would have got him only 8 (Year 2007). This is an important aspect of dollar cost averaging.
Now lets look at Part B. Part B tells us what happened with the Sensex in those years. In the beginning of 2000 the Sensex was at 5,375 and closed the year at 3,972 – a fall of 26.1%. This table also has a cumulative column which shows us what the cumulative results would have been. For e.g At the end of year 2 (2001) Sensex had fallen by 39.3% from 5,375 to 3,262.
Part C simply tells us the difference between the SIP performance and the Sensex performance. In year 1 the SIP gave 12.8% more returns than the Sensex (-13.3% vs -26.1%). In year 2 that number was 22.0% and so on. At the end of 10 years, the SIP would have given a 199.6% return compared to 224.9% by the Sensex.
Now, if we plot the cumulative returns of the SIP with that of the Sensex year-on-year over the 10 years, we get the following graph:
This is a very interesting result because what it means is that this mindless investing technique would have beaten the benchmark index 8 out of the last 10 years! – A feat which 90% of highly paid highly educated highly cocky fund managers fail to accomplish.
Now, lets pause a while and analyze the numbers. The Rs. 12,00,000 invested in the SIP over 10 years would have grown to Rs. 35,95,109 or 2.99x the invested amount at the end of Year 10 (See Red Circles on the Table). Remember that this excludes dividends that you would have received over the 10 years. So, the actual returns will be higher than 200%. On the other hand, if you had invested in the Sensex on 1st Jan 2000 and sold on 31-Dec-2010 you would have ended up making 225% i.e. 25% more than the SIP.
However, to make that 225% return, the investor would have had to do a Rip Van Winkle for 10 years. For a normal person, it would have been emotionally torturing to see the Sensex go up and down day in and day out every day for 10 years. Imagine reading about it in the newspapers every day, watching it on television news channels and having dinner table conversations with your father /mother / uncle /aunt /brother / wife / friend.
Just think about how many things happened in the last 10 years economically, socially and politically that you would have thought would have been relevant. The government changed thrice from NDA to UPA to Congress, the markets went through the tech bubble and bust, outsourcing took off, inflation reached 12%, interest rates fell to 4%, real estate prices rocketed, Lehman collapsed, Saddam died, 9/11 happened, Iraq and Afghanistan got invaded, the price of oil reached ~$160 per barrel, Sensex reached 21,200 from 3,000 and crashed to 7,700, then there was Godhra, Kargil war, terror attacks on Parliament and Mumbai and so on and on. An investor would have had to be exceptionally stable to be able to live through those moments and still believe that his Rs. 100 would ultimately become Rs. 325. That’s a lot to ask from the common man.
On the other hand, all a brainless investor had to do was keep checking to see whether Rs. 10,000 was being debited from his account on the 1st of every month. She would know that whatever the situation may be she would be indifferent because she would be buying the asset at low as well as high prices. The investor would have bought at the bottom of the tech boom and at the height of the 2008 bubble but in the end would have been just 25% worse off than a non-existent Dravid of the investing world. At the same time she would have ended up saving a sizeable amount over the years.
Now let’s look at how we can execute this investment technique. In order to invest in the index every month, we will have to start an SIP on an index fund. Index funds buy stocks in the same weightages as in the index. Since it’s a passive investment technique, these funds have the lowest commissions in the mutual fund industry. There are only 2 things an investor needs to be careful about while choosing an index fund:
1. The Tracking Error or how closely the fund mirrors the benchmark index, and
2. The Fee or what % of the assets managed goes in administrative costs.
The 22-Jan Outlook Money magazine has a detailed list of index funds and their respective tracking errors and fees. I have listed the results below:
Before I end, lets look back at the advantages of an SIP again – 1: It is simple – all it requires is for you to give a standing instruction to your bank, 2: Its strips out the emotional aspect of investing as I have pointed out above, 3: It makes you save a fixed amount every month – Rs 10,000 per month becomes Rs. 12,00,000 at the end of 10 years and 4: Its cheap – the average cost of investing is only 1.3% per annum.
Starting 1st Mar, I will be investing a fixed sum every month in an index fund for hopefully a long period. Investing, after all is all about analysis and patience.
KM
Note:
I had briefly mentioned this in my first blog. If an investor wants to invest upfront and ensure safety of principal she could invest in the post office monthly income scheme and divert the monthly interest into an Index Fund SIP. Rs. 4,50,000 invested in post office MIS would yield a monthly income of Rs. 3,000 which could then be invested in an SIP.
Read the PDF of this entire blog by clicking here
Tuesday, January 12, 2010
Analysis of Mahindra Finance’s Fixed Deposit Scheme
I had mentioned in my previous blog that bank FDs should only be used as a means to park ‘transitory’ funds before deploying them in higher yielding securities. Since stock markets have continued their upward movement (Sensex is currently at 17,500) equities have become more and more expensive and risky. Interest rates on government securities have also gone up since my last blog. The 10 year bond is currently trading at 7.66%. I currently invest in a monthly SIP on Fidelity Flexi Gilt Fund, which invests in government securities (as recommended in my previous blog). I think the next 6 months will be a good time to buy government securities at such high interest rates.
Between all this, Mahindra Finance has launched an FD scheme that seems interesting. Since it also has a 1 year investment option, I thought I’ll take some time to analyze the issue. The key terms of the issue are mentioned below: (For the full terms and conditions click here)
Key Questions:
I think the key questions to ask as an investor in the FD are the following:
1. What does the company do?
2. Are the returns adequate?
3. Is my capital safe?
Let’s try and answer each of these questions
Question 1 – What does the company do?
Mahindra Finance is a non-banking finance company that provides loans to customers in rural and semi-urban areas to finance the purchase of utility and commercial vehicles like tractors, cars etc. They are placed between the organized banking sector and local money lenders in rural India. The company was originally started to provide finance for Mahindra utility vehicles but has today diversified into personal loans, construction equipment finance, rural housing finance etc. Its primary business remains financing utility and commercial vehicles in rural and semi urban India.
Question 2 - Are the returns adequate?
The asset class we are dealing with here is a fixed deposit. The natural comparable is the FD rates at banks. Below is the comparison between the Mahindra FD rates and the ones being offered at various banks. I have also included the rates offered by Post Office term deposit schemes.
Mahindra offers rates 125-150 bps higher than what banks are currently offering for a similar tenure product. I think 150 bps over bank rates is not too bad. However this return has to be seen in conjunction with the risk of investing in the FD, which leads us to question 3.
Note: I am not sure if one can buy 1 share of the company and ask for 0.25% more interest by qualifying as a ‘shareholder’ though the offer document seems to imply so. In that case the returns would be 150 bps to 175 bps higher.
Question 3 – Is my capital safe?
To answer this question, we need to look at where we stand in the company’s capital stack and whether the company is earning enough to be able to repay our principal and interest obligations.
As of Mar 09, there was Rs. 4,467 crores of senior secured debt ahead of us in the capital structure (the blue box is our position in the stack). This means that the company’s profits will first go to service these debt holders. A quick read through the notes to accounts reveals that this includes non-convertible debentures and bank loans which have a charge over the company’s fixed and current assets. However, we do have Rs. 3,260 crores of equity buffer below us. The current equity value implies that assets would have to fall by 38% (or in other words 38% of the loans would have to go ‘bad’) before our capital is affected. Even at its lowest point in Mar 2009 the equity value was Rs. 1,700 crores implying a 25% buffer. From a balance sheet point of view, our capital seems to be relatively safe.
Now let’s look at the company’s ability to pay interest and repay our capital.
Earnings
Last 10 years Analysis
Last 2 years Analysis Using Cumulative Deductions
Ideally, we would have liked to look at a longer term average in order to counter the effect of prosperous and average years in earnings, but we will have to be content with 2 years in this case. The company earned about ~2.2x of its interest obligations in the last 2 years (data for prior periods is not available) which means that even if earnings halve, the company will have enough to pay interest on its debt. For an NBFC, this number seems conservative since the variation in earnings will probably not be as high as say a commodity company. Also, the history of earnings shows a growing trend with no wild fluctuations.
The other way to look at this is that the company had Rs. 1,126 cr and Rs 983 cr left in FY 09 and FY 08 respectively to pay interest on debt after paying its operating expenses. This translates to a 22% and 20% yield respectively, meaning it could theoretically pay ~21% interest on debt.
Other Reasons to Feel Safe
Dividend History
It looks like the company has had a good history of paying dividends to it shareholders. Also, the dividends have been progressively higher over the years. Even in a bad year (FY09) the company managed to pay 55% to the equity holders (higher than the 45% in FY08 – a good year). Though not conclusive, this is a good sign for us because it means that the company has had enough cash flows in the past to service the lowest stack in the capital structure. It also means that we can monitor the health of the company in the future by looking at the company’s dividend policy. If it is lower or stops altogether we will hopefully receive a timely warning of impending trouble.
The Mahindra Name
The company is a subsidiary of Mahindra & Mahindra Ltd, a six decade old conglomerate with revenues in excess of $6.3 billion. The issue has the strong backing of a big business house which provides good confidence to any debt investor. In fact, for some, the backing of M&M itself would be enough to trust the company’s credentials. However, the past year has seen some of the biggest business houses like the Tatas dither in the wake of one of the worst economic downturns we have seen. Therefore, though it is comforting to know that the company has the backing of M&M, it should not be the only reason for investing in the issue.
Final Word
I think this is the best debt option available right now. I would recommend this issue to anyone looking to invest in debt.
Between all this, Mahindra Finance has launched an FD scheme that seems interesting. Since it also has a 1 year investment option, I thought I’ll take some time to analyze the issue. The key terms of the issue are mentioned below: (For the full terms and conditions click here)
Key Questions:
I think the key questions to ask as an investor in the FD are the following:
1. What does the company do?
2. Are the returns adequate?
3. Is my capital safe?
Let’s try and answer each of these questions
Question 1 – What does the company do?
Mahindra Finance is a non-banking finance company that provides loans to customers in rural and semi-urban areas to finance the purchase of utility and commercial vehicles like tractors, cars etc. They are placed between the organized banking sector and local money lenders in rural India. The company was originally started to provide finance for Mahindra utility vehicles but has today diversified into personal loans, construction equipment finance, rural housing finance etc. Its primary business remains financing utility and commercial vehicles in rural and semi urban India.
Question 2 - Are the returns adequate?
The asset class we are dealing with here is a fixed deposit. The natural comparable is the FD rates at banks. Below is the comparison between the Mahindra FD rates and the ones being offered at various banks. I have also included the rates offered by Post Office term deposit schemes.
Mahindra offers rates 125-150 bps higher than what banks are currently offering for a similar tenure product. I think 150 bps over bank rates is not too bad. However this return has to be seen in conjunction with the risk of investing in the FD, which leads us to question 3.
Note: I am not sure if one can buy 1 share of the company and ask for 0.25% more interest by qualifying as a ‘shareholder’ though the offer document seems to imply so. In that case the returns would be 150 bps to 175 bps higher.
Question 3 – Is my capital safe?
To answer this question, we need to look at where we stand in the company’s capital stack and whether the company is earning enough to be able to repay our principal and interest obligations.
As of Mar 09, there was Rs. 4,467 crores of senior secured debt ahead of us in the capital structure (the blue box is our position in the stack). This means that the company’s profits will first go to service these debt holders. A quick read through the notes to accounts reveals that this includes non-convertible debentures and bank loans which have a charge over the company’s fixed and current assets. However, we do have Rs. 3,260 crores of equity buffer below us. The current equity value implies that assets would have to fall by 38% (or in other words 38% of the loans would have to go ‘bad’) before our capital is affected. Even at its lowest point in Mar 2009 the equity value was Rs. 1,700 crores implying a 25% buffer. From a balance sheet point of view, our capital seems to be relatively safe.
Now let’s look at the company’s ability to pay interest and repay our capital.
Earnings
Last 10 years Analysis
Last 2 years Analysis Using Cumulative Deductions
Ideally, we would have liked to look at a longer term average in order to counter the effect of prosperous and average years in earnings, but we will have to be content with 2 years in this case. The company earned about ~2.2x of its interest obligations in the last 2 years (data for prior periods is not available) which means that even if earnings halve, the company will have enough to pay interest on its debt. For an NBFC, this number seems conservative since the variation in earnings will probably not be as high as say a commodity company. Also, the history of earnings shows a growing trend with no wild fluctuations.
The other way to look at this is that the company had Rs. 1,126 cr and Rs 983 cr left in FY 09 and FY 08 respectively to pay interest on debt after paying its operating expenses. This translates to a 22% and 20% yield respectively, meaning it could theoretically pay ~21% interest on debt.
Other Reasons to Feel Safe
Dividend History
It looks like the company has had a good history of paying dividends to it shareholders. Also, the dividends have been progressively higher over the years. Even in a bad year (FY09) the company managed to pay 55% to the equity holders (higher than the 45% in FY08 – a good year). Though not conclusive, this is a good sign for us because it means that the company has had enough cash flows in the past to service the lowest stack in the capital structure. It also means that we can monitor the health of the company in the future by looking at the company’s dividend policy. If it is lower or stops altogether we will hopefully receive a timely warning of impending trouble.
The Mahindra Name
The company is a subsidiary of Mahindra & Mahindra Ltd, a six decade old conglomerate with revenues in excess of $6.3 billion. The issue has the strong backing of a big business house which provides good confidence to any debt investor. In fact, for some, the backing of M&M itself would be enough to trust the company’s credentials. However, the past year has seen some of the biggest business houses like the Tatas dither in the wake of one of the worst economic downturns we have seen. Therefore, though it is comforting to know that the company has the backing of M&M, it should not be the only reason for investing in the issue.
Final Word
I think this is the best debt option available right now. I would recommend this issue to anyone looking to invest in debt.
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