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Sunday, February 27, 2011

Gross or Net Capital flows to use in economic analysis?

In the financial world, the issue of which figure to use(gross or net) is quite important in several contexts
  1. Revenue recognition:- Accounting rules have strict conditions for when to use gross/net values
  2. Regulatory restrictions:- The stock exchanges margin requirements(for derivatives trading) permit netting out only in certain defined situations
  3. Disclosures:- Where there are rights of setoff etc, the reporting institution(bank/FI) may want to netout the exposures and disclose only the net asset/liability on its balance sheet.
But it is in the area of investment policy and monetary management that this distinction is of most significance. Proponents of a gross approach(add inflows+outflows)  feel that(as mentioned in Dr Shyamala Gopinath's address to FEDAI in Feb-11 here)
  • Gross capital flows contribute immensely to diffusion of technology and international knowledge flows. This is also why gross trade flows(imports +exports)  are considered while comparing the extent of 'openness' of economies
  • It is gross flows that determine risk exposures and are therefore important for financial stability
  • Netting of cross-temporal flows does not capture the real impact of gross capital flows on exchange rate as well as asset price impacts.  
 While proponents of the net approach(take the difference of inflows/outflows) feel that the reserves change only to the extent of the net flows, so that value only should be taken.

Before the subprime crisis, the net approach was widely considered but now the gross approach is also considered to be more representative. Still, for currency analysis, the net approach may probably work better
Bottom Line:- Depending on the purpose you want to analyze capital flows more, select the appropriate indicator(gross/net)

Banking license & Centralized regulation-Light at the end of the tunnel for MFIs?

Fiscal 2010-11 was topsy turvy for the Microfinance Industry(MFI). The year began well with the successful IPO of India's largest MFI(SKS Micro Finance) but then collapsed mid-year with issues of corporate governance, usurious interest rates and unfair recovery practices. The Andhra Pradesh Government even passed  an ordinance which swung the regulatory pendulum apparently for borrowers(but as in the classic microeconomic case against regulation, actually for moneylenders!). The RBI then set up the Malegam panel which submitted its report in Jan-11. That report recommended a Central regulation for the industry but otherwise was not welcomed by it.

In that light, the Economic Survey 2010-11 brings some badly needed succor to the industry.
  1. Central Bill:- Chapter V(here, Pg 7) makes the case for a centralized law(the draft of which is under consideration). MFIs would prefer this to the vagaries of State regulation. 
  2. Benevolent approach:- The same Chapter V referenced above makes the economic rationale for not having an interest rate cap. It also elaborates on the overall interest of the borrowers. It could well have been written by the industry trade body!
  3. Banking License:- The Survey recommends considering NBFCs and MFIs for new banking licenses. However, they may only get the universal banking licenses in the first step, with the para banking activities(like credit cards etc) permit later.
  4. General Pro lender approach:- Chapter II(here, pg 17) clearly states that the laws should not permit spurious reneging on contracts. Though opined in the context of long term infrastructure financing, the principle does apply to MFI contracts as well.
Takeaway:- This may be a good time to load up on SKS(and banking stocks hit due to exposure to the MFI industry). Given that the regulatory pendulum is again shifting towards the MFIs, now may be the time the markets recognize this fact and remove the regulatory discount

Saturday, February 26, 2011

Buffet's recommended tax adjustment while comparing index and stock returns-is it justified?

The 2010 Berkshire Hathway Annual Report(like others before it) contains this caveat
The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax. If a corporation such as Berkshire were simply to have owned the S&P 500 and accrued the appropriate taxes, its results would have lagged the S&P 500 in years when that index showed a positive return, but would have exceeded the S&P 500 in years when the index showed a negative return. Over the years, the tax costs would have caused the aggregate lag to be substantial

This argument got me thinking that if the 'Oracle of Omaha' has suggested this adjustment, why aren't analysts following this by adjusting index returns for tax? Some careful thinking however revealed the fallacy in this argument namely that 
  1. Stock Index values are determined by the share prices of their constituents(which itself is determined by the post tax profits)
  2. Therefore, adjusting the index to obtain post tax returns would be double counting.
Buffet has a valid point that S&P index returns are pre tax for the investor. But then the same is true even for capital gains/dividends. So in this aspect, I feel the logic is flawed. 

Valuing companies whose business is based on OPM(Other People's money)

All entities use their owner's(equity holders) money initially. Some rely on heavy debt financing(for example infrastructure companies have D/E of around 4x). But for some(mainly banks, insurance companies), the whole business model revolves around using other people's money(depositors, policy holders) to whom they have a fiduciary responsibility(and not merely borrower-lender relationship). It is this class of companies which are the subject of discussion in this post.

Banks have historically created value for their shareholders. Barring the subprime blip(post which they were the first to post super profits), banking stocks have a secular trend of going up. For insurance companies, this is even more pronounced where the most legendary value investors alive today(USA's Warren Buffet and Canada's Prem Watsa) have made fortunes for themselves and their shareholders. Which begs the question, to what can we attribute the high valuations of those businesses.

Leverage is one argument. If the banks/insurance cos apply conservative standards of capital acceptance(tight underwriting norms, low deposit rates etc), they can safely leverage(sometimes called 'lazy banking') OPM to make outsized profits for their narrow equity base.

  1. So using a ROE metric would be flawed because though banks/insurance companies need to maintain an equity base for regulatory comfort/keeping their license, their actual profits are made from income on that OPM float(net interest income for banks, investment income for insurance companies). If that float is persistent in the form of loyal long term depositors or policyholders, one could theoretically do a proforma ROE calculation considering float as equity. But since the present disclosure standards do not permit this, we need to get other metrics. 
  2.  Where OPM outstrips equity,  ROA could be a good proxy for return on float. Banks with high ROA are given higher valuations(better P/BV; higher P/E). Insurers with higher investment income also get a premium abroad(no insurer is listed in India).
  3.  Using the old workhorse DCF may pose a difficulty because investors just do not have the information/expertise to value the returns generated by float(or indeed the possible MTM in the float itself). DCF may still be possible for banks but is difficult for insurers. 
  4. Barring these metrics, we can use hybrid metrics like P/BV, multiples of premium etc. But these would at best serve as triangulation measures and not for doing the primary calculations. 
One should remember that OPM dies to a trickle at the sniff of reputation risk. Bank runs start and policyholders get concerned. So which doing a valuation, it would be a good thing to embedd a discount to keep that crucial margin of safety for such events. 

Friday, February 25, 2011

Goldmine in the budget-Effective tax rates(industry wise) for Indian corporates 2009-10

The annual Union Budget is sometimes seen as a farce since many proposals go unimplemented(though that may change due to Outcome based budgeting and other controls). But some nuggets of information are invaluable.

For equity research analysts, investors, bankers and others interested in making/checking financial forecasts and projections, an important input is the effective tax rate. Unless an expert(CA/other tax professional) opines otherwise, the tax rate is mechanically assumed as the maximum statutory rate. Till 2006-07, this was the only option for 'naive' forecasting(without the benefit of expert opinions etc). But now, a much overlooked document hidden in the stack of Budget documents comes to your rescue.

The Statement of Revenue Foregone(available for Budget 2010-11 here) presents tax preferences(tax revenue foregone due to policy decisions of exemption, rebate, deduction etc) as a pro forma revenu expenditure in the Budget. The rationale is that these are subsidy payments to preferred taxpayers.
expenditures” and it is often argued that they should appear as expenditure items in the Budget.

The Appendix to this statement gives the effective tax rates for 74 industries spanning the manufacturing and service sectors. It gives the sample space(companies, total PBT, total PBT) along with effective PAT %. Most are in the bracket 20%-30%(versus the effective tax rate of 23% generally). Outliers are(those in bold are under scrutiny by the IT Dept)

  1. 5%-10%-Textiles
  2. 10%-15%-Diamond Cutting,Sugar,Film labs,Software,ITES, Property Developers
  3. 15%-20%-Cement, Drugs, Fertilizers/Chemicals/Paints, Petrochemicals, Consultants
  4. Above 31%-Commission agents, TV channels, motion picture producers,Cable TV producers, Banks, Security Agencies,Legal, Advt, Beauty Parlours
It would make an interesting project to analyze why the tax rates vary as per industry. 
Takeaway:- Given these rates, one can accurately make projections of tax rate without having to use advisors. 

Tuesday, February 22, 2011

Why is financial instruments accounting so controversial?

When the SEC and the G-20 commission reports on the role of accounting(!) in the global financial crisis(2008-?), it points to something serious.

The Netherlands financial regulator Hans Hoogervorst(in his speech here) had some interesting insights on this. He says that that it is hard to imagine a riskier business model than the current banking industry where sides of the balance sheet are volatility prone. Assets are cyclical while liability funding can dry up quickly. He further declaims the low capital margins(2% or less tangible common equity pre crisis) and implicit subsidies(sovereign guarantee, access to low cost funding via Central banks etc).

In this scenario, he states that prudential regulators are bound to strict confidentiality rules and prefer closed door solutions(like how Volcker solved the Latam crisis by cloaking the solvency issue of US banks). Whereas IFRS standard setters/auditors  prefer to seek for transparency.

So in my view, accounting for financial instruments is so controversial because:-
  1. Mark to Market(MTM) values are inherently pro-cyclical:-Though regulators do impose capital buffers(to allow for erosion of asset value; and Basel III proposes counter cyclical buffers), the fact remains that when asset values are high, everyone is happy(who ever complained of 'too high prices'?) but when accounting reflects the illiquid/fire sale prices, then people begin to grumble or lobby for suspending the reversal of those paper profits which they accounted for earlier
  2. MTM accounting hits banks when they are weak:- Post crisis, banks typically need more capital. MTM accounting increases the regulatory capital requirements and investor risk perception. 
  3. Domino effect/financial stability concerns make regulators act:- While booking losses may be technically correct/fair, regulators fear contigion spreading across the system and prefer to act to prevent this. In that case, the MTM accounting may get short shrift if it buys regulators more time
  4. Importance of regulatory framework:- In other industries, regulators do not have the all pervasive effect they have in banking where they can affect both assets and liabilities. So the regulatory objectives can prevail over those of IFRS

Tuesday, February 15, 2011

My expectations from Budget 2010-11(Infrastructure)

Infrastructure - Expectations from Budget 2011-12(this was the first article in the pre Budget series of Beta(IIM-A)
 By Anandh Sundar

Infrastructure sector (real estate, power and construction) heavily depends on governments for both supply and demand stimulus. While State Governments control the supply side factors ( Stamp duty, provision for infrastructure, registration, regulation of land, approvals), the Centre controls supply side (tax breaks for infra-bonds, refinancing, environmental clearances etc) as well as demand side factors(housing loan tax breaks, interest rates).
The sector is starved of funds. As the graph below depicts, infrastructure stocks have underperformed the broader market (since Budget 2010-11) while another interest rate sensitive sector (Banking) has done far better. While domestic investors shy away from equity issuances of these firms, other options are few.

infra 1.png
The multitude of controversies besieging the sector - LIC Housing Finance/other financial institutions ‘bribe for loans’ scam, environmental clearances delay and (now) arrest/questioning of some real estate executives on their telecom foray - has both the banks and foreign investors running scared. The graph below shows that infrastructure FDI has fallen off sharply in this fiscal.  Bank financing (for commercial real estate) became costlier from Sep-09 due to higher provision norms for those loans.

infra 2.png
I do not pretend that all these problems can be solved within the Budget framework. Given the present political turmoil, no radical measures are expected. But some incremental expectations are:
1.    Encourage corporate bond market: Given the $1trillion infrastructure spend in the 12th Plan, alternate financial instruments are necessary since one cannot compel banks/FDI investors to lend. Existing measures like avoiding withholding tax (on demat bonds) and encouraging retail participation (via Rs 20,000 additional rebate under 80CCF) have met with good response. I expect a hike in the limit under 80CCF, and launch of corpus for investing in these bonds (putting those forex reserves to some use.)
2.    Clarity on Vodafone ruling: Post the Vodafone ruling, investors have begun to review their positions or even take out ‘tax insurance’ for exit demands. This only increases the cost of capital of the impugned projects.  Given the nature of infrastructure (fixed to the ground), the likelihood of attracting Vodafone type tax demands is more. Given the gravity of this issue, I expect the Govt to clarify the law from prospective effect, being fair to existing investors.
3.    Use outcome based budgets to speed up project execution and payments: Given that outcome based budgets link physical progress to financial outlays (and mandate explanation for variances), it is hoped that NHAI type project delays do not recur. Given the spate of scams in 2010/11 (CWG, 3G, LIC Housing Finance), we expect that more rigorous controls will be introduced for project monitoring. This will ‘sort out the wheat from the chaff’ and positively impact efficient contractors, who presently reel under mounting Government receivables, pending projects for want of appropriate linkages etc
4.     Increase scope of ‘takeout financing’: The Indian Infrastructure Finance Company Ltd (IIFCL) will disburse INR 100BN in 2010-11. This refinancing of commercial bank debt (‘take out financing’) eases the burden of the banks who were recently cautioned by Dr C Rangarajan about their mounting exposure to the infrastructure sector. Any IIFCL specific measures (like increasing corpus, allowing issue of complex bonds) will help both IIFCL and the sector. Rather than opening the floodgates to corporate bond issuers, the Govt may decide to play safe with IIFCL specific measures.

Lessons from Jain Irrigation proposed NBFC foray-Information overload, unsustainable value addition

When Jain Irrigation informed the stock exchanges on 28th Jan,2011 of its plans to set up a NBFC to "integrate rural financing and sale of Company's products to the farmers", the response was muted. This item, hidden in a host of other resolutions, was missed out by the financial press/markets. But when the realization sank in, panic selling crashed the price from Rs 225/share to less than Rs 175 on Feb 3rd, 2011. After 'experts' on a popular financial site(www.moneycontrol.com) opined that this strategy was 'synergistic' with  the current one, order returned and the share price has bounced back to 200+. This episode has quite a few lessons for investors
  1. Learn from parallels across industries:-Educomp(India's premier education company) had an issue with mounting receivables from Government and other schools which had installed its 'Smart Class' infrastructure heavy solutions. These mounting debtors and capex heavy nature of business depressed the ROE/ROCE margins. Finally in 2009, Educomp decided to spinoff its receivables and infrastructure business to a SPV, which would pay Educomp upfront. What distinguishes this from Enron is that Educomp has negligible equity stake in that SPV and has persuaded banks/financial institutions to purchase the securitized debtors via the SPV route-without recourse. If we carefully notice, even Jain Irrigation had a problem of debtors, because the Govt would delay subsidy payments(Jain Irrigation's business model revolves around farmer's purchase being subsidized by Govt, which directly pays the manufacturer). So it now wants the farmer to take debt from its own NBFC(leaving the latter to bear the payment delay).
  2. Information Overload:- In a low promoter held stock(and fairly liquid one at that), you would expect such vital information to disseminate quickly. But it took 2 working days for the impact to sink through. If this is the scenario with a 1 page press release, I shudder the imagine the consequences when IFRS comes to India with its voluminous disclosures. Like how Enron did, companies may get away with blatantly confessing sins in their financial filings, with analysts being non the wiser. 
  3. Irrational response:- Then panic was unjustified because shareholders could have voted with their ballots instead of stampeding out of the stock-unlike a typical Indian company with 50%+ promoter holding, shareholder activism may actually work here.
  4. Unsustainable plans:- Strategy 101 classes harp on entering a venture if there is a strategic moat. In this case, there is little evidence to suggest that Jain Irrigation has a retail distribution strength. And then the stringent RBI licensing norms for NBFCs could come in their way, unless they tie up with a bank/financial player. Which begs the question-why have a NBFC instead of an alliance?
  5. Irrational valuation concerns:- A reason raised on some forums was that the company is entering a low margin NBFC business which detracts from the high margin 'Micro Irrigation Systems'. Fine- so use Sum of the Parts approach to value it-why punish the entire P/E ratio for that
I suspect this issue will fester longer and make the stock more volatile. Investors in this counter are advised to read up on this issue and take a long term view.

Sunday, February 13, 2011

Share subscription agreements with minimum assured return-debt or equity?

While reading the 2009-10 Annual Report of Escorts Ltd, I noticed(Pg 99) that in 2000, it had sold 49% stake in a subsidiary(Escorts Motors Ltd) to ICICI and had given an assurance to ICICI of a minimum return compounded annually for a period of four years.Since the subsidiary did not go for an IPO, Escorts had to buy back the stake. Now, this is not unique to Escorts. Peruse the DRHP filings with SEBI and you notice this demand for assured return in several cases

  1. Issuance of 0% Compulsorily Convertible Preference Shares/Debentures-with the conversion price reset downwards if certain financial targets are not met
  2. Share subscription agreements with PE funds for company/promoters to compulsorily buy back the stake with interest IF public issue not done
  3. Share subscription agreements with PE funds for company/promoters to optionally(PE fund has PUT option) buy back the stake with interest IF public issue not done
Now, case(1) will always be equity-extent of dilution is unclear. But in cases (2) & (3), the transaction is structured as convertible debt. In that case, is it fair to classify it as equity initially itself? 

Comment:- Making a proforma adjustment for such transactions is advisable. Unfortunately, unlike the SEC, SEBI does not require Indian companies to file share subscription agreements with the regulator. But with the advent of IFRS(needing such disclosures), investors should have sufficient information to make such adjustments. 

How Regulation impacts the Indian sugar industry

This series aims to explore how regulation significantly impacts industry prospects and what investors should know before taking positions on stocks in the industry. After all, in many of these industries, changes occur at sea change and before getting seduced by analyst reports, the investors should not lose track of reality. 

The first industry covered is sugar. An annual drama is enacted involving global scenario(Brazil rainfall, global demand), cane recovery rates(% of sugar obtained from crushing 1 quintal of cane-around 8%-12%), procurement price(Union Govt 'Fair and Remunerative Price' or State Govt 'State Advisory Price') and export/import policy. When there is an uptrend, investors are asked to buy stating stocking position etc but on downtrend still people point to low valuations(P/BV, dividend yield etc) to recommend 'buy'!!  Before analyzing the merits of these positions, we should realize that there is no free market at all in this industry.

  1. On the buy side, state Government decides at what price sugarcane will be produced and what will be the area from which sugarcane will be procured. However, these areas are often violated by both farmers and mills. 
  2. On the sell side, Central Government decides the quantity of sugar that each sugar mill will sell every month. 
  3. The situation is complicated by the requirement that industry must subsidize the sale of sugar in public Distribution system(PDS). 10% of production of every sugar mill is required to be offered for PDS at significantly below cost of production. 
  4. There is neither scope for smart buying nor scope for smart selling. Also, the commodity futures market has experienced suspensions in this commodity and is uncertain. 
  5. This being an 'essential commodity', exports are often capped. The high prices paid by the customer often end up as 'super normal profits' of retailers-not the mills or farmers. 
Given all this, sugar perhaps remains the only regulated industry in the Country whose fortunes can significantly fluctuate as per the regulatory policies. To be fair, mills are doing all they can to reduce dependence on these vagaries like
  1. Recycling their waste into energy(co-production), byproducts(industrial alcohol etc) or building materials production. Like how Jindal Steel had diversified into power and spun off the SPV, the next big trigger for sugar mills could be launch into power. While the cap on power trading margins(few paise) deters super profits like Rs 13-14/unit rate, profits can still be made here. Also, these projects could accrue carbon credits(doubtful now but still may be extended beyond 2011) 
  2. Improving their own production efficiencies and helping farmers improve yield

Saturday, February 12, 2011

How vertical forward integration delays revenue recognition at Coca Cola

When a company vertically integrates forward, the standard rationales given are more operating flexibility, entering the value chain, exclusivity in distribution, control etc. But one aspect is sometimes missed out- the impact on bottom line profitability due to revenue recognition timing.

Coca Cola follows a dual business model

  • It ships concentrate to independent bottlers who then manufacture and sell the drinks or
  • It manufactures and bottles in house.
In the 4Q'10 conference call( transcript here), while explaining the impact of Coca Cola acquiring its major bottler(Coca Cola Enterprises-CCE), it was mentioned that earlier, concentrate sales to CCE by Coca Cola could be accounted for upfront when shipped. But now that Coca Cola would own those manufacturing/distribution assets of CCE, it cannot recognize the revenue from concentrate sales till the final product is sold.

The estimated impact is delaying revenue recognition on concentrate sales by upto a quarter(for Coca Cola). Given our vertically integrated Indian conglomerates, it would be interesting to analyze the impact of this on them, given Indian fragmented transport/distribution chains

Friday, February 11, 2011

The limitations of 'adjusted'/'operating' profit

Open any company presentation or listen to any analyst conference call and invariably you notice a 'pro forma'number which represents the company's efforts to reflect for perceived weakness in accounting rules. This being a company produced figure, it will(naturally!) be favorable to the company itself. Unwary investors may be caught unawares if they blindly rely on those numbers.

This post takes issue with 'Adjusted EBITDA' commonly calculated as
Net Income+Tax+Depreciation/Amortization+non cash stock compensation expense+impairment etc. This is generally seen in the IT sector but is now making inroads elsewhere also.

Now, adjusted EBITDA is useful if it a
  • Used by management to evaluate their own performance, budget,plan and set bonuses. So disclosing this number gives third party an insight into the management control system of the company. 
  • Allows a period-period 'core earnings comparison'. 
But it has its own fallacies namely(as described in Linkedlin's prospectus here

although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future, and adjusted EBITDA does not reflect cash capital expenditure requirements for such replacements or for new capital expenditure requirements;


adjusted EBITDA does not reflect changes in, or cash requirements for, working capital needs;

adjusted EBITDA does not consider the potentially dilutive impact of equity-based compensation;

adjusted EBITDA does not reflect tax payments that may represent a reduction in cash available and

other companies, including companies in same industry, may calculate adjusted EBITDA differently, which reduces its usefulness as a comparative measure.

Given these limitations:-
·         Consider adjusted EBITDA alongside(and NOT in lieu of) other financial performance measures, including various cash flow metrics, net income (loss) and other accounting based results. 

Tuesday, February 8, 2011

How Xerox did financial structuring to manage its earnings

In an earlier post, I had written about how hedge accounting drives certain business transactions. But, this is not unique to only hedge accounting. Other areas of accounting also drive it-including the innocuous revenue recognition norms. To drive home the point that this(structuring transactions to manage earnings) prevailed way before hedge accounting/Repo 105, I detail the (in)famous Xerox accounting scandal as explained in the SEC lawsuit available here. There have been umpteen posts/books/articles written on other facets of the scandal but little on the Enron type securitization. So I thought to cover it here

Xerox committed many financial reporting sins while managing its earnings during 1997-2000. But the transaction detailed in paras 56-57(of the lawsuit) is most relevant here.

In 1999, Xerox Brazil changed its business model from its traditional sales-type lease model to one based on rental contracts. Because, under GAAP, the revenue from rental contracts cannot be recognized immediately, Xerox entered into PAS transactions(selling to investors the revenue streams from portfolios of its leases that otherwise would not have allowed for immediate revenue recognition) to allow such immediate revenue recognition

Essentially, Xerox securitized its rental revenues so that it could account for them upfront. While accounting rules(NOT principles but rules..) permitted this, these transactions had no business rationale other than earnings management.
Moral:- History repeats itself so our only recourse is to be vigilant,

Monday, February 7, 2011

The case for being sceptical in the finance world

  Pick up 'popular' analyst recommendations/research reports and you notice a 'story'. Communication experts prescribe stories as the way to impress others as mentioned in this book. While we enjoy stories in mass media(movies, books, TV, news), they are dangerous to use in investing.As Howard Marks puts it in his excellent letter to investors here,  
getting the most out of a book, play or movie usually requires “willing suspension of disbelief.”  We’re glad to overlook the occasional plot glitch, historical inaccuracy or physical impossibility because it increases our enjoyment. 

This is manifested in the 'confirmation bias' seen in investors where they
 selectively pick information that supports their hypothesis, or ignore information that goes against the hypothesis. Chartered Accountants(CAs) are trained(and if licensed in public practice, must) to adopt 'professional skepticism'. It does not mean being cynical or prejudiced against the client but means that one should keep an alert, inquisitive  and open mind for any inconsistencies/issues. This sort of training helps in investing because even the best executed frauds have some minor inconsistency which a well trained & receptive mind can capture. Whether you are an investment banker signing off an client due diligence, a trader deciding on increasing the limits of a client or a risk manager doubtful about data accuracy, that skeptical attitude can pay rich dividends.

Some readers may feel that this is merely 'intuition' learnt from the school of hard knocks. To them, I say that being systematic and following checklists(allowing for skepticism) hastens the process.

Moral:- If you do not want to get seduced by flowery stories, do keep a skeptical eye on the infirmation you get-including this post(!)

Sunday, February 6, 2011

Does the internet help or harm Indian value investors?

As any investor in Indian equities would know, reporting and disclose practices are not,err, 'top notch' in most Indian companies(barring the L&Ts, Infosys's and MNCs). Companies would not disclose much information barring the periodic annual report. But now thanks to IT revolution and SEBI regulations, investor can now view the following information.
  1. Viewing annual report in PDF-even if company does not host it on its own website. The Indian postal system is (and some companies's posting practices are) such that even registered shareholders may not get copies of their annual report-let alone any prospective investor who requests a copy. Thankfully, SEBI ordered the stock exchanges to host a copy of the electronically filed annual report(w.e.f FY 2009-10) on their websites. Now, the investor need not depend on the company's whims and fancies for getting the annual report
  2. For those companies which post the information(not mandatory so far)
    1. Conference Call Transcripts
    2. Presentations(quarterly results, 'About Us' etc)
    3. Quarterly results(this is also available on stock exchange websites)
    4. Business information like products etc.
  3.  For online clients of brokerage houses
    1. Research Reports
    2. Trading calls AND rationale behind them
    3. Access to analyst meet reports
  4. Blogs(both individual investors and famous names)
The flip side of all this is 
  1. Easier to 'pump and dump' stocks as the message board of any finance website would show
  2. Information overload for investors flooded with information
  3. Disadvantaging investors with slower/no internet connections
  4. Disadvantaging non net-savvy investors
  5. Rumours can now go faster
  6. Tendency to ignore prospectuses/mutual fund annual reports:- Since these are available online, the regulators allow the issuers to send the hard copies only to those investors who opt for them. As discussed by Richard Thaler in his book 'Nudge', the response rate under an opt in system would be low due to inertia. And investors who may have read something sent to them, may not want to read those many pages of electronic documents on screen. 
 For me personally, the advantages out weigh the disadvantages. But that is because I'm net savvy, have access to a fast net connection, do not go on rumours, reason for myself, and can reasonably cope with information overload(Ok I'm too modest to continue further!!).  For someone on the other side of the digital divide, the case may well be reverse.

Wednesday, February 2, 2011

Jawed Habib Saloons Rs 60Cr IPO_an analysis

A week ago, the famed hair stylist Mr Jawed Habib's company filed for an IPO. Investors following Peter Lynch's philosophy of 'investing in what you know' may feel that this is a lifestyle business and will grow as per the 'demographic dividend' hypothesis. But reading the prospectus is essential, and in this case throws up some nuggets.  The foll are the red flags I noticed in the prospectus
  1. Unusual franchisee business model without adequate controls:- Usually, a franchisee operates on a royalty cum profit share basis. But the salons(majority of the company's salons) pass on their entire collections to the company which in turn pays them the agreed share. Though this may have the same economic effect, scope for fraud/embezzlement is more. And by the company's own admission, there is no foolproof mechanism to verify and ascertain the accuracy of reporting. However, their proposed ERP solution, if implemented right, promises to mitigate this risk.
  2. Conflict of interest by promoters:- Group Companies( Habibs Hair & Beauty Studio
    Private Limited and Jawed Habib’s Hair Xpreso Private Limited) shall operate under the same or similar name with simillar objects and business activities. There is no 'non compete' agreement. 
  3. Heavy promoter dependence:- While the company has standardized their training
    methodology and the franchisee operation, they still depend on Jawed Habib(as the name shows). Succession issues could be a problem here.
  4. Unfathomable independent directors:- An auto OEM promoter(albeit with CA degree), a Padma Shri awarded political cartoonist and a Reliance Broadcasting COO-are the 3 independent directors. What value would they bring to the company, is difficult to fathom. And more importantly, will they be able to protect the shareholder's interest?
  5. A 22 yr old compliance officer:- I'm not demeaning merely because of age but the company engaged a 22yr old ACS as its compliance officer. Considering the rapid expansion plans, and the possible related compliance issues, this decision is hard to stomach.
  6. Neither Director, Finance nor Head, Accounts are CAs:-Despite the Satyam aftermath, a CA's guiding arm helps in a company's finance and accounts function. And this company has neither
  7. Heavy pay disparity between non promoter director and others:- The Director(Franchising and Operations)-a 32yr old former consultant from ISB gets Rs 48 Lakh CTC but other senior management even 40-50yr olds get Rs 5Lakh-7Lakh. This disparity does not reflect well on the company and may induce attrition..
On the positive side, these are some good aspects
  1. Own training academy for staff:- All the general hair-stylists and salon managers in  salons are mainly sourced from their academies.
  2. Media promotion agreements:- Though ethically questionable, they have 'private treaties' with Brand Equity Treaties Limited(Times of India affiliate), which results in (more than deserved?) publicity for the brand. BETL gets Rs 18 crore worth advertising in return for Rs 6 crore cash & Rs 12 crore worth of equity.
  3. Promoter routes his brand ambassadorship through the company(!):- In Dec-10, the Promoter in the capacity of Managing Director of the Company became Brand Ambassador of Panasonic’s hair drier products. This action reflects some generosity on his part. 
My take
 Given this company's lack of control systems and 'small company approach', be aware that you are basically investing in a one-man-show. Also, given that the promoter's average cost of acquisition is just 4.74 per Rs 10(face value) equity share, inducement to exit may be there Given the fragmented business model and risks with expansion, better avoid for the time being.