Monday, February 27, 2012

Company auditors doubts its ability to stay in business? Read this before selling

Recently, there were going concern qualifications expressed by auditors, for airlines like Kingfisher/SpiceJet, and investors pressed the panic button. Going concern just means 'business as usual' and when the auditor feels that this is not tenable(without restructuring/bankruptcy), then they are dutybound to caution others of the same. But before investors panic, they should atleast understand the rationale behind this, as well as the conditions/limitations of this. It is contained in SA-570(Going Concern)[] which auditors need to follow. Some highlights of this standard relevant to investors are
  1. Financial Statements are prepared on cost basis , unless management either intends to liquidate
    the entity or to cease operations, or has no realistic alternative but to do so. Under the Companies Act 1956, directors are dutybound to certify in their 'Directors Responsibility Statement' that they have prepared the accounts on going concern basis! Hence, to accept any other basis is tantamount to violating the law unless they file for liquidation. However, auditors go by the economic substance and not the legal form, and while they cannot second guess management intent, they can certainly opine on the compulsions which will leave management with  no realistic alternative, but to cease operations/liquidate etc. 
  2. For helping the auditor arrive at the conclusion that going concern cost basis is justified, the management is expected to(as per para16, ibid) make its own assessment, and then the auditor is expected to evaluate the feasibility of those plans, reasonableness of assumptions, reliability of underlying data used in forecasts, consider additional facts in his knowledge. Also, auditor would look into whether company can realistically fill its unfilled orders, get committed funding/support.
  3. If there is a material uncertainty(like CDR negotiations on/major lawsuit pending), then the auditor is expected to highlight that uncertainty in adequate detail for investors to decide for themselves. But that itself does not mean an adverse comment.
  4. Some interesting red flags suggested for the auditor and which I feel investors are advised to consider are(I do not consider routine redflags like financial ratios etc)
    1. delay in approval of financial statements could be related to events or conditions relating
      to the going concern assessment
      . For example, GTL Ltd/GTL Infra delayed their financials.
    2. Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment. Since Indian companies do not usually reveal/tabulate their debt maturity schedule, getting this information will need some digging in. 
    3. Substantial operating losses or significant deterioration in the value of assets
      used to generate cash flows:-
      Since segment reporting is not adequate to get this data, investors must rely on the MD&A for this or else track the company metrics over time
    4. Inability to comply with the terms of loan agreements:-This would not be public data usually, but annually, the CARO 2003 order mandates auditors to mention such defaults..
    5. Change from credit to cash-on-delivery transactions with suppliers:-This would show in the reduction of the creditors days, which is an alarming signal as creditors would usually have a better sense of the business than even investors
    6. Inability to obtain financing for essential new product development or other
      essential investments
      :-Often, companies hit the equity market with FPO/rights issue for quite small amounts, which does indicate that other financiers are shunning them..
    7. Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that the entity is unlikely to be able to satisfy:- While tax disputes usually do not become that big, cases like the sugar mills SAP price dispute fall under this category
    8. Changes in law or regulation or government policy expected to adversely affect the entity:-The Andhra Pradesh ordinance(later on made into an Act) on microfinance which changed the fortunes of SKS Microfinance, is a classic example. 
  5. Do note however, that auditor would have access to the risk mitigation strategies of the company which are not usually in the public domain. So the auditor's not considering any major risk factor may mean that the company MIGHT have a robust mitigation plan in place 
  6. Also, remember the auditor is not passing his business judgement here. His role is just to check whether there is a significant dark cloud, and if so whether the financials explain it in sufficient depth. Remember, the risk-return tradeoff is not examined. Just ask those persons who purchased Satyam below Rs 10, and made 10x returns once it jumped back to normal.
So in short, before selling your shares/shorting the stock, do read the audit opinion/para in its entirety, and even for 2-3yrs before, and try evaluating against the above criteria and the audit standard, with what you already know. After all, barring black swans, no major problem rises overnight, so it would be interesting to know what prompted a sudden change in auditor assessment, or(like in case of airlines), the media just hyped something which was anyway there.

Corporate Debt Restructuring(CDR)-a primer on how it affects share prices

Kingfisher Airlines, GTL Limited, GTL Infrastructure, Vishal Retail(now renamed V2), Suzlon, India Cements, Jindal Steel-what is common to these disparate stocks? In the recent past, their share prices all shot up after there were rumours of their onerous debt being restructured under the CDR mechanism. Ordinarily, those unable to repay their debt when due are adjudged commercially bankrupt and can be forced into insolvency. But for companies with operating profits and significant intangible assets/reputation capital, such liquidation can destroy a large chunk of the company. Also, India's legal system is not too fast, and although SARFAESI and other acts do exist, they also take their own time.

Hence, lenders may prefer taking control of the company and sacrificing some interest/debt to ensure that they atleast get back something. Although common stock holders are last in line and would realistically earn zero in liquidation, CDR buys them time for the company to turnaround and for the common stock to carry some value. 'Time is money'-this adage is true for equity owners when CDR is enforced on the company. But investors should not impulsively react on the rumours of a CDR, but should note the following points and get extra information before they respond. This presentation by CA Rajesh Chaturvedi given at WIRC in Feb12 is very useful( and I suggest people read this carefully as well.
  1. Does it involve writeoff/deferment of interest or debt? These are equivalent in NPV terms, but often come with added riders like lookback options if company recovers etc. 
  2. Is debt converted into equity-if so at what price? Usually, SEBI ICDR norms mandate pricing of such conversion as if it was a preferential allotment(so last 6months/last 2 week pricing etc). Hence, it usually being at a premium to the market price by force, market should not interpret as lender's faith in the company, but rather that they had no choice to fix the equity price..
  3. Does the promoter infuse more funds besides sharing sacrifice? Especially in case of promoters with large personal wealth like say Vijay Mallaya, investors may want to see whether they walk the talk by infusing equity as well into the company, or whether they just want others to take a loss without themselves contributing. This is a powerful signal/information source for the market. 
  4. History of the firm with earlier CDR/restructuring:-While this data should have been seen earlier, investors who invest purely based on past 2-3yrs annual reports may have missed out on earlier near-death experiences. Hence, looking back into history with Google News would add that layer of judgement on whether past performance can back the future recovery. Firms like Suzlon/Kingfisher Airlines/Essar group companies with repeated distress may fail this test
  5. Are lenders holding=>75% willing to go for CDR? The balance sheet would usually indicate lender wise breakdown. If some lenders(especially foreign banks) have other exposure to CDS/equity/FCCBs, they may have conflicting interests which may delay CDR. 
  6. RBI Guidelines affect the potential upside of the shareholders due to following norms
    1. Unit should be viable within 7yrs/10yrs(in case of infra) quite obvious else not worth it..
    2. Promoter’s sacrifice and additional funds brought by them should be minimum of 15% of the banks’ sacrifice(but what if the debt equity ratio is more..)
    3. Personal Guarantee is offered by the promoter except when the unit is affected by the external factors pertaining to the economy and industry(isn't this always the case!!)
The above points will hopefully help investors evaluate the realism of the CDR proposals, and the chances of their upside. Usually, a CDR with only bank sacrifice/ without any added infusion by promoter, is not aligning the incentives of both parties. Also, do not go by rumours till the formal proposal is put up to the board. But ceteris paribus, CDR would cause the share prices to shoot up, but investors should still do their own fundamental analysis and downside analysis before investing

Identified that no-brainer investing strategy? Read this before you invest

Sometimes, a particular investing strategy seems just so obvious that we wonder why nobody around us gets it. It is easy to get seduced by the logic that we have XYZ credentials(read CFA/CA/MBA etc), have worked in ABC place(best equity/PE/hedge fund) and have spent so much time on the analysis(think of academics who spend months/years on a research, and the endowment bias makes them reluctant to abandon it without atleast publishing something!), and so we should know better than those multitudes of noise traders out there who have made the market inefficient. But remember that the market can remain irrational longer than you can remain solvent, also that your analysis itself may be flawed/misplaced. Below are some examples of seemingly no-brainer strategies, which need a deeper critical thinking before being acted on
  1. Growth Sector story: Every bubble-be it IT stocks, realty, telecom, education, consumer goods or microfinance-starts with the promise of an penetrated Mecca, which is accessible to the lucky investor who parks his money NOW. But, think whether the low hanging fruit has been already plucked by those PEs/VCs/angel investors who invested in the first movers. Are you investing in the lemons who are approaching you after being rejected earlier, and who will need to spend more to grab market share from incumbents, and run more risks. See this from the micro level, not assuming that those glossy consulting reports/graphs 'halo effect' will help your company as well.
  2. Fundamentally cheap(low price to earnings):- This is especially the case in cyclical stocks, or those stocks at the fag end of their growth cycle. So try placing the stock/industry within their respective business cycle and growth stage, before comparing the multiples with other stocks. PEG ration helps here for such an analysis. 
  3. Intermediary/Distribution model:- Here, the company does not run credit risk but usually runs a platform to facilitate transactions. Think But even there, you need to think critically-when will that information asymmetry go away? Already, price comparison websites(whcih are ad-supported) are threatening to disrupt the business models of travel and book retail sites. So do not assume that agency model is riskless and can grow for ever. 
  4. Low price to book:- Even for very low price to book multiples of say 0.1, it needs the most detailed balance sheet analysis to look for cash losses(which depress the ROE/balances), contingent liabilities, low asset quality, corporate governance risks like tunneling/related party transactions etc. 
  5. High dividend yield:-Besides the obvious risk(can this be sustained), you should also see the future plans/track record of the company. Stocks that yield more than bonds, do not stay that way for long-either someone takes them over or promoter looks for better business opportunities.
  6. 52 week lows:- While such stocks may get hyped up, look for the 3yr H/L and also all time lows. Also, remember to look for stock splits/bonus/rights issues which the price reporting service may have forgotten to adjust for. Else, you will end up being the sucker waiting for them to go up. And lows usually have a reason, so do not skip that analysis in the feeding frenzy to catch it at the lows.
These are just a few examples, of the need to always keep that critical thinking filter open. 

Sunday, February 26, 2012

GTL debt restructuring analysis-investors still at risk

When the GTL debt restructuring was announced, the GTL stocks had rose around 20%-40% in anticipation of a sweetheart deal and some opportunity for equity holders to salvage something. But the debt restructuring details contained in the postal ballots( and do not inspire much confidence for equity investors to accumulate their position. My reasons for stating this are given below.
  1. GTL Infra has outstanding FCCBs of $228MM, redeemable @40% premium in Nov,2012. Though the company is in talks with the holders to restructure those FCCBs, the outcome would merely mean significant dilution given that the conversion price is far above the existing market price. Of course, since the banks have agreed to convert 25% of their debt into equity, the FCCB holders may follow suit but I would not bet on it. 
  2. The banks have a conversion option on their debt in case GTL Infra/GTL Limited default on the repayment as per CDR LoA. This increases dilution risk, and it is not very clear whether SEBI will allow favourable pricing to the banks in future. This would lower the potential upside for the stockholders, as banks would prefer conversion later on. We need more clarity on this.
  3. Dilution is significant under the CDR. I applied the pricing as per the SEBI ICDR Regulations 2009, and my estimate came to Rs 11.8 for GTL Infra, and Rs 53 for GTL Ltd taking the stated record date. I assumed that the conversion price would be same for the next two tranches BUT since that is taken on trailing six months basis as per SEBI norms, it may be higher(thus reducing dilution later). But banks seem to have wanted maximum conversion upfront under the existing lower prices. Interestingly, even the market seems to have converged to that price, but the shares increase alone will be around 70%-100% for both companies, diluting existing shareholders.
  4. GTL/GTL Infra have, in anticipation of the CDR, reversed certain interest expense and charges, thus making credit analysis tougher and complicated
  5. As if the holding structure was not tough already, the GTL promoter got back his shares from ICICI in return for some debt returning to CNIL's books. This really complicates further analysis till a balance sheet is available, which would take till June at the bare minimum. If only proforma balance sheets were mandated by SEBI!
Hence, due to the complexity of the whole deal and the limited upside(read my earlier posts on GTL group companies where I felt it was fairly valued), investors can seek better opportunities.

Amrit Corp/Amrit Banaspati-still not deep value post Bunge edible oil buyout

As a former investor in Amrit Banaspati, I still track the edible oil sector occasionally, and remembered the Amrit Group with fondness due to the wealth they have created post the family demerger into three companies(Amrit Corp/Amrit Banaspati & ABC Paper-the last one is owned by a different branch of the family). The promoters of Amrit Corp and Amrit Banaspati did seem focused on their edible oil and dairy businesses respectively. Imagine my surprise then, when I read the announcement of Bunge(the same Bunge of the global agribusiness giant ABCD but I digress). In that, Bunge purchased the edible oil business as follows in two connected transactions, which closed in Feb12
  1. Edible Oil plant/brands from Amrit Corp for Rs 220 crores cash, and assuming the debt of Rs 40 crores and letting them keep Rs 25crores cash=>Rs 285 crores deal value in all. Structured as a slump sale under tax laws, leading to a profit of Rs 231 crores for tax purposes over book value
  2. Purchasing a brand from Amrit Banaspati for Rs 104 crores. Structured as a straight assignment
The share price did shoot up, but way below the implied deal values. I decided to understand why, and delved into the transaction details and post deal balance sheets, resulting in the table below for which I
  1. factored a tax rate of 20% for both transactions
  2. Did not assign a value to residual fixed assets/business assuming them to be loss leaders. That assumption seems fair since Bunge would have purchased the core of the business anyway.
  3. Did not do simultaneous equation for Amrit Corp's 23% stake in Amrit Banaspati, instead just took the value at mcap without holding company discount.

The above upside would come only
  1. IF the promoters can return the cash(unlikely since they own 70% and would prefer to take it out in other means rather than incur 19% dividend distribution tax) OR
  2. If they can grow the money at an ROE exceeding the opportunity cost of shareholders(WACC)
Both options seem unlikely, and for such a slim margin, buying into these companies does not seem worth it. Another classic example of a cash trap/value trap and holding company discount.