Investing strategies for high promoter pledged highly leveraged companies

The case of Arshiya International excellently covered by Punit Jain of Value Notes (http://www.valuenotes.com/Investment-Analysis/Arshiya-International-A-Collapsing-Star/180224/15530028.00/C)  showcases the perils of investing in innovative companies with great businesses, but which somehow are cash deficient and therefore highly leveraged. Arshiya was a pioneer in logistics parks, was even picked by Kotak as a possible multibagger for 2013, yet was hit by the vicious cycle of panic selling of pledged promoter holding. Other companies like Tulip Telecom, GTL Infrastructure/GTL Limited, Suzlon had faced the same cycle as below

1. Company has very good growth/business, becomes the darling of Dalal Street with high valuations
2. In quest to expand, burns cash flow and results in persistently negative free cash flow. However, analyst myopia on just profits ensures that EV/EBITDA type multiples inflate the valuation, without any downward risk adjustment for leverage.
3. Funding gap(negative FCF means that funding gap should be met through fresh financing) usually through debt, since 'pecking order' theory(tax arbitrage, control issues) and reluctance of promoters to give up stake in growing companies, rules out safer path of equity
4. Lenders may request promoters to pledge their shares in the company/and or give guarantee. At the high prevailing share prices, a lesser % of pledge may be required.
5. The bubble bursts through poor market sentiment/poor economic performance. Flight to safety happens with investors going to 'safe' stocks like FMCG/Pharma that actually generate free cash flow. Market Valuations of the leveraged companies dip
6. The Mark to Market(MTM) valuations of pledged collaterals begin to touch levels exceeding the haircut/margin of safety. Lenders ask for 'top-up' in collateral
7. Company tries to refinance the loans-approach suppliers/vendors/NBFCs etc in most cases it is just deferring the problem. Sometimes it works(like RCOM got loans from Chinese banks), or else rights issue opted for(like how Dish TV did in 2009)
8. Promoters try negotiating lower top-up, till then market gets rumours/bear cartel attacks the shares and stock starts hitting lower circuits. Lenders decide to cut their losses and sell the shares at a loss
9. Promoters sue the lenders for breach of trust/selling the family silver and matter goes to courts. Company lands up in CDR(Corporate Debt restructuring)
10. CDR compensates the promoters/lenders by issuing shares almost at par! Everyone is happy except the minority shareholders  who do not get chance to rights issue(since preferential allotment done)

Business Today suggests(http://businesstoday.intoday.in/story/invest-companies-fccbs-due-redemption-caution-returns/1/21869.html) looking at the re-financing ability of the company-reputed companies and/or asset rich companies may still get secured financing and exit CDR/pledge status. Also, robustness of business model matters in case companies exit. Some pointers before investing for speculative gains in these shares

1. Evaluate refinancing options-this may stop the cycle at Step 7 instead of going the whole way
2. Compare with industry parameters, if EV/EBITDA or P/B multiples are dramatically lower, a white knight/takeover offer may arise as happened with Everonn.
3. Be willing to remain for a long time, but then you may get a Wockhardt! 

Short Selling tips from Bronte Capital investor letters

Bronte Capital first came to my attention through an RSS feed, when it was reported that they had correctly drawn attention to accounting redflags in Autonomy Plc financials, much before its acquirer HP wrote off nearly 2/3rd of the acquisition price as impairment charges. Intrigued, I thought it worth a deeper look. And then I stumbled upon this goldmine of interesting comments/info(http://brontecapital.com/Letters.html). I urge you to read them in their entirety-monthly letters going back nearly 3years-but for those starved of time-not of interest else you won't be reading this(!), I post verbatim the bits I found interesting with my comments in italics

1. For most of the last 8 years there has been a large liquid bid for most small-cap stocks from private equity.  Private equity has several advantages over us – in particular they can borrow money non-recourse at 6 percent and they can do extensive due diligence. The latter amounts to legalized insider trading. This may explain why in developed markets, penny stocks are more traded by retail investors than these midcaps
2. we expect almost every stock we are short to go to zero or thereabouts –that is the end-game for scams and stock promotes. However we are completely unaware of and unable to predict the path to zero. Some of our shorts will go up 400 percent on their way to zero – and we will necessarily lose money on them even if we are eventually right. We will lose money because we are forced to buy them to avoid potentially threatening losses if they go up further. Essentially, markets can remain irrational longer than you can remin solvent, hence the need to be able to hold your bets yet cut your losses.
3. There is a reason we keep possible fraud shorts small. Fraudulent companies are not reporting results that are linked to reality. They are making them up. If a fraudulent oil company tells you they have 10 million barrels (when they have nothing much) there is nothing that stops them telling you they have 1 billion barrels. The stock could go up massively. When companies take the path of offence, then it is quite difficult to prove otherwise except in case of ghost assets etc.
4. The fraud-shorting business is complicated. We think that (by far) the hardest part of it is risk management. It is easy to identify frauds but it is very hard to work out what breaks them. We have often been short a fraud and had it double, even triple on its way to zero.We have lots of tricks to limiting losses (put options, shorting the debt rather than the equity , small position size) but these tricks often limit our gains too and we need to get better at working out when to press on a fraud (increasing our position as the stock goes down) and when to keep out of the way.  Market Timing is always an issue, more so here if you have put options that expire within time limit
5. Alas we think the amount of fraud out there is so high, and the standards required of regulators so demanding, that the job of head of a regulatory agency is nigh impossible. And that suits us – and so we celebrate our relatively good returns as we celebrate (unavoidable) regulatory failure.  It is not always a regulatory breakdown, as standard of proof may differ
6. Some people might wonder why they are paying us hedge-fund fees (as opposed to index fund fees) to invest in large cap stocks on which we can add little value.  We offer a modest defense:
   (a) We do have some selective small-cap stocks which are likely to give us enough returns to pay the
   fees and then some. For a variety of reasons these are not attractive to PE funds. (b) We still short small caps. The extraordinary crowding into some of these names gives us good opportunities to short. (c) You will be here for the swing. When we no longer find nonsense frauds and promotes amongst $300-500 million companies with ease, we will turn around and go long small caps. At the moment it is so easy to sell nonsense that you know the small caps are nuts. One day we will be a small cap –fund. That day however is not today. This should console the fund managers of PIPE(Private Investment in Public Equities) who get a good sum!
7. We are not averse to takeover arbitrage - but it has to be in an industry and with businesses we understand.  Both are utilities and are within our field of expertise.    We are also -and very unusually - doing two reverse arbitrages.  (The jargon is that we are going “Chinese the spread”).  What this is, is betting that the a takeover deal does not close - an unusual position.   If we are wrong on these we will lose say 1.8 percent.  If we are right we might make 4-8 percent. In India, since the hostile takeover/debt financing/bidding battles are less common, this strategy would be difficult here.
8. We will have to be doubly-clever to detect fraud on which we can earn “lottery-ticket” type returns.
   As explained last month we are very fond of positions where our losses are capped at (say) 2 percent
   of the portfolio but which have the possibility of delivering 10-20 percent months. Winning lottery
   tickets however are very hard to find but have been responsible for a fair part of our returns.This is similar to purchasing out of the money calls/puts in anticipation of a regulatory/legal event.
9. With small and medium capitalisation stocks we see nonsense everywhere.  We see companies with venal management and limited prospects but enormous amounts of stock  promotion.  We see bulge bracket Wall Street brokers getting involved in the IPO of companies we consider to be criminal enterprises.  By contrast, with large caps we see real businesses with considerable cash flow (free cash flow measured in the billions and sometimes tens of billions) but with some business challenges.  And they are invariably being priced on a “glass half empty” basis. This is true even of many Indian companies which attract less retail investor interest under the faulty assumption that they are anyways fair valued/over valued. But in reality, they may be cheaper than their smaller peers, where an excessive premium for growth is paid.  
10. Our clients know things we do not.  If you are an insurance broker and you see a company reluctant
    to pay claims then please tell us.  If you see a supplier discounting insanely or alternatively raising prices please tell us.  We are in the new ideas game – and one of the advantages in being a long way
    from Wall Street is that we have quite different ideas from the New York/Connecticut consensus. 
    Crowded trades are dangerous trades and very few of our positions are crowded. One of the disadvantages is we get less idea flow across our desk A pretty interesting processs on how they get short selling ideas-from seeing a business model that is broken rather than looking at pure financial metrics.
11. The midsized banks however are a mess.  They have neither the personal skills of the better microbanks or the management depth of the larger banks.  Fundamentally they have no competitive
    advantage and hence have no long-term reason to exist.  This does not mean that equity holders are
    doomed – but even if the banks survive, the best exit will be to sell to a large bank that will use the
    cheap deposits to make better-selected loans.This is an interesting take on why size or personal connect matters in banking. When yyou have neither of these, you are in trouble 
12. To make money in technology you need to do two things.  Firstly you need to change the world
    (which First Solar clearly did) and secondly you need to keep the competition out.  Alas very few
    businesses manage the second trick. http://www.brontecapital.com/peformance/2010/Client%20Letter%20201003.pdf Excellent explanation of why they shorted FirstSolar, along with the underlying philosophy. Interestingly, the jury is still out on this one, as the furious debates on Seeking Alpha would show. Is it fair that Palm is facing bankruptcy?  Or that Garmin is being displaced?  We don't think so –but then capitalism is not necessarily moral or fair – but it does produce goods and services quite  well.  We don't invest on the basis of fair – we invest to make you good returns. 

Rio Tinto's $3bn Mozambique coal impairment-implications for India

Last week, RioTinto(the global miner) announceda $2.8bn writeoff of its Mozambique coal mines. Since companies like Jindal Steel, Tata Steel and Mercator Lines have coal mining operations in Mozambique, I thought of analyzing this situation if it holds any insight for investors. For some background, note that by acquiring Riversdale’s operations in Mozambique, Anglo-Australian RioTinto took control of 22 exploration licenses in Tete, including 65% of the Benga mining project (Tata Steel from India holds the other 35%) and the 100% of Zambezia project. Benga mine was under prelimnary production while Zambezia was under exploration. Under RioTinto's original plan Coal would have to be moved from its mines then loaded on to a train so it could travel 600km to the Zambezi River where it would be taken to the coastline 
http://www.riotinto.com/documents/110605_Andrew_Woodley_Riversdale_Mozambique_Coal_Conference_slides.pdf

But Rio could not win the approvals to ship the coal down the Zambezi. To compound its challenges, coal prices have stayed weak and Rio appeared to overestimate the amount of coal it could access in Mozambique. As per the Reuters article below, 65% of the Mozambique coal holding company is now valued by RioTinto at $600MM, thereby giving a total enterprise value of $1bn. Even giving a 50%(very conservative considering it was the higher potential mine) valuation to Benga, that gives it an EV of $500MM. 

http://www.reuters.com/article/2013/01/20/australia-rio-mozambique-idUSL4N0AP0I820130120

Given that Tata Steel paid a bargain basement price of $88MM for its 35% stake, it need not fear any impairment even using the same assumptions
Even for Mercator Lines which I wrote about earlier below, the Kotak Report in below PDF of 23Aug2012, assigns a value of around Rs 12 to the coal mining operations+coal trading operations. By coincidence, the market values the company at the estimated NAV of the ships only, without giving value to the volatile coal business, or the troubled mining business.
http://financeandcapitalmarkets.blogspot.in/2011/09/why-mercator-lines-is-buy-thanks-to.html
http://www.business-standard.com/content/research_pdf/mercator_230812.pdf
 
Lesson:- Companies like RioTinto have global experience of navigating these issues. The fact that they failed to do so in Mozambique, should be a cautionary note to the other Indian companies who rushed to do business in Africa-for example Karuturi which faced flash floods wiping out its first year crop in Oct-12 http://financeandcapitalmarkets.blogspot.in/2011/12/karuturi-global-africa-agriculture.html And before according premiums to the relaxed regulatory regime in those countries(like for African farmland/mining concessions), do accord the regulatory risk and enhanced NGO scrutiny.
 

From Rs 120 to Rs 4.5 in 3years-the riches to rags tale of Raj Oil

In Sep-09, one of the IPOs which slipped through the cracks was Raj Oil Mills(better known for its brands like Cocoraj). The IPO was oversubscribed and hence issued shares at the higher end of the band Rs 100-120. Since then, things have only gone downhill for the company(but not its promoters, that is how India Inc works-companies go under but their promoters don’t). The stock caught my eye during a routine stock screen thanks to it having low price to book, and being in the edible oil space which has seen acquisitions by foreign players(like Bunge acquiring Amrit Banaspati). Interestingly, when I analyzed it today, the share hit the upper circuit AND the lower circuit on the same day! It opened at Rs 5(previous day close), jumped to Rs 5.2, and then fell within minutes to Rs 4.5. The delay in executing my order saved me in this case. After some due diligence, I realized that there are some corporate governance and operational issues with the companies, but that its promoters and some mysterious GDR subscribers think it worth double the current share price(or even 1.5x the price it was when they took the decision). That, coupled with the absence of any financial jugglery redflags, low promoter holding making it vulnerable to a takeover etc, makes this a BUY. Further analysis and statistics are below.

•  The annual report of FY12 was uploaded on the website somewhat late and does not inform the reader much, however gives a reassurance about the financial issues http://www.rajoilmillsltd.com/pdf/ROMLAnnualReport201112.pdf
• As per the annual report, the company had defaulted on its debt and some statutory dues, and was in talks with Edelweiss Assets Reconstruction Co. Ltd.(EARC) for restructuring of its debts from Banks and Financial Institutions to correct its working capital position and to reschedule its debts in line with projected potential earning
•  However, recapitalization is on track, with the fact that in Jul-12, the company allotted 700,000 Global Depository Shares representing 35,000,000 Equity Shares of the Company of the face value of Rs.10 each at a price of US$11.084 per GDS aggregating US$7,758,800. Also, in Sep-12, the AGM approved preferential allotment of 2crores warrants, at issue price Rs 12. Promoters must pay 25% of that upfront i.e Rs 3, and must decide on exercise within the next 18months. So upfront, the company has raised Rs 48crores(42 crores from GDR and Rs 6 crores upfront from warrants). This should take care of atleast the immediate debt maturity, albeit diluting shareholders a lot
•  A red flag is the resignation of the statutory auditors M/s. Agarwal, Desai & Shah, Chartered Accountants, Mumbai, who have cited pre - occupation in other matters and hence not offered themselves for reappointment. Another equally obscure firm has been appointed, which does not bide well for shareholders.  
•  Something to ponder is the identity of the GDR holders who decided to purchase stake at premium in such company. Let us hope it is not a case of roundtripping as investigated by SEBI earlier. 
• 
  

       In the past 2-3years, the promoter holding was diluted due to banks invoking pledges, sales of stake in between etc. But with the preferential allotment of 2 crore shares @ Rs 12, they are back on track, to asset some control and hold premium in case of merger(is this the reason for the hasty allotment)?   

Skumars-capex spending amidst declining cash flows reason for low valuations?

A friend pointed out the low valuation multiples of Skumar(low in terms of price to book, P/E etc). A cursory scan convinced me of the apparent veracity of this case, and hence I decided to probe more in depth, starting with the latest annual report FY2011-12 http://www.sknl.co.in/pdf/SKNL_AR-12_Web.pdf

I noted from the financials that though the company has quite a bit of debt, it turned around the operating cash flow situation in FY12 with efficient working capital utilization. However, as the savings went into capex, the net cash position and leverage did not improve.
 

The company trades at P/BV of 0.19 and dividend yield of 5.5%, but this despite being profitable. As the profits do not reflect in FCF/OCF, maybe that is why investors are shying away from this stock. Otherwise, a textile company with 45+ global brands and global presence(as evident from the above map) should not be undervalued. There are some negative qualitative factors though, which are material, which I reproduce from the annual report. 

• Aggressive accounting by the company. As mentioned in the auditor's report, they capitalized Rs 85 crores brand spending, which is debatable under accounting norms

•  Financial Management could be better-this is a company which defaulted for some time on bank dues, which still spending on capex!

• Suddenly started commission to non -executive directors in FY12-Rs 90 lakhs!

However, promoters exercised warrants at Rs 64.33 when the prevailing market price was hardly 50% of that. This shows some confidence, as they would have forfeited only 25% of the exercise price, and yet been in a profit. Maybe they expected it to appreciate, but still that was a good reason.

CONCLUSION:- It is not very clear as to WHY the company is spending on capex again. The investor relations PPTs/concall transcripts on website are outdated. So without clarity on whether the capex is being well spent, entering this company is risky given the qualitative factors. Upside trigger could be the Reid & Taylor IPO finally happening as planned.