Tuesday, July 2, 2013

Aanjaneya Lifecare FCCB conversion price reset-backdoor M&A?

With USA, UK, Japan, Chinese and other equity markets in a turmoil, it is unsurprising to see Indian markets in even more turmoil, with external volatility magnifying its inherent volatility. To avoid missing some interesting snippets among all the financial news 'noise', I read corporate announcements on a weekly basis. During one such read, I found that Aanjaneya Lifecare has proposed to reset the conversion price of its 5.44% USD40Mn bonds due 2018, from Rs 260 per share to Rs 55 per share(!). This works out to hardly a 10% premium over the existing share price of Rs 49.5. With a present market cap of Rs 68.81 Crores, the company's present capital structure is 13.9Mn shares. If the conversion option is fully exercised at Rs 55 per share and fixed exchange rate of 54.29, there would be an additional issue of 40Mn shares, or nearly 3x the existing share capital! The postal ballot notice can be read below

While trying to figure out the reason, I read the  Offering Circular FCCB which envisages the only adjustment contemplated to the conversion price was as per Clause 5.3 of the FCCB which stated that The Conversion Price of the Bonds will be reset downwards only if, on the Reset  Dates, the average of the Volume Weighted Average Price (VWAP) of 21 consecutive  Trading Days on BSE prior to and including any of the Reset Dates is lower than the  Conversion Price prevailing on that Reset Date. Maybe this was to safeguard against price manipulation on that date. However, even this came with the caveat that The Conversion Price will not be reset  below 90% of the Conversion Price prevailing on the relevant Reset Date. However, such Conversion Price will not be  reset below the floor price which is in turn defined as The minimum conversion price of  a convertible bond as calculated under the provisions of Press Note dated 21 November 2008 issued by Ministry of Finance,  Govt. of India

The promoter holding has steadily dipped from 60% to 40%, so maybe this was a way to use friendly FCCB bondholders to acquire control at bargain basement prices. After all, the company trades at P/BV of hardly 0.2 and with net debt of hardly 300 odd crores{Gross debt Liabilities around Rs 735 Crores less Cash Rs 212 Crores minus 50%*443 Crores of inventory+receivables=>approx 300Crs http://www.bseindia.com/xml-data/corpfiling/AttachHis/Aanjaneya_Lifecare_Ltd1_300513_Rst.pdf}, control could be got at Rs 600crs or so, for which you get a 500MTPA quinine plant at Mahad, a plant at AP and brand. Plus the management has won quality awards including one for its annual report. The name change to 'Dr Datson's Labs' seems reflective of management's R&D focus.  The auditors and merchant bankers are lesser known brands, nothing against that but does nothing to enhance investor confidence in price discovery of FCCB/fairness of FCCB allotment process.

The questions I have are
  1. Even if share price dropped to hardly 20% of earlier highs, is that a reason to say that price discovery done hardly 3 months ago, was improper? Does management not expect the stock price to recover to its old highs, even in 5years from now i.e 2018? Or did a bull cartel drive down the share price to force the company to reset conversion price, and hence acquire control? After all, unlike direct share purchase, FCCB holders identity is not disclosed.The auditors and merchant bankers are lesser known brands, nothing against that but does nothing to enhance investor confidence in price discovery of FCCB/fairness of FCCB allotment process.
  2. Institutional shareholders hold a majority voting stake with Religare Finvest 13.43%, Apex Drugs 9.44% and some brokerage firms 10.7%. Their collective vote of 33% odd percent will be crucial, given the management's vote at just 41%. Shareholding Mar13 Will institutional shareholders abstain/back management as always, or go ahead considering this is allotment at the existing market price only(almost)? This is an interesting question since if they decide to be activist, there can be plenty of trouble.
  3. In such cases where potential equity shares are 3x of existing capital, should repricing be
    allowed in the first place, without an open offer to the remaining shareholders? Will the SEBI ruling in case of IFCI apply where open offer is exempted http://www.moneycontrol.com/news/market-news/sebis-exemptionifcis-open-offer-what-is-it-about_763393.html

    Even if the share looks cheap, management does not think so, nor does the street otherwise an equity white knight should have come by now. Anyways, this is worthy of a case study in itself, and if successful/unchallenged, may write a new takeover strategy.

Saturday, February 2, 2013

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! 

Wednesday, January 23, 2013

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. 

Monday, January 21, 2013

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 
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. 

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.
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.