Is Bharti Infratel a buying opportunity after recent 20% correction due to Vodafone-Idea merger

I was reading Damodaran’s excellent book ‘Narratives and Numbers’ in which he advises poets(those who love stories and narratives) and quants(those who love numbers), to unite the approaches during a valuation exercise. Perchance, I got a chance today when the largest listed telecom tower operator of India (Bharti Infratel) corrected  corrected 20% in 2 sessions, as the market tried to absorb the risk of tenancies loss due to the proposed merger between 2 leading telecom players Idea and Vodafone India. This poses an interesting valuation exercise because

·         85% of Bharti Infratel’s tenancies are from the Big 3 operators-Bharti Airtel, Idea and Vodafone, and therefore any consolidation would give those customers pricing power

·         However, Bharti Infratel also owns 42% in an affiliate towerCo Indus, which is jointly owned by it along with Idea & Vodafone.

·         Indus &  Bharti Infratel have geographically delineated areas of operations, and non compete agreements in place which deter entry

·         ~50% of Bharti Infratel’s valuation is from its minority holding in Indus

·         Average lease period of Infratel sites are ~5.5years implying that operators cannot exit the sites without considerable penalty.

·         A new player Reliance Jio has been doing a ‘test launch’ for a long time-it is speculated that the proposed merger talks were sparked off by this impending commercial launch of Reliance Jio.

Two possible scenarios appear evident to me which the market is pricing in, for a valuation range of 246-296, ASSUMING THAT THE MERGER TALKS FRUCTIFY, AND THAT THE MERGER IS APPROVED, both of which are very optimistic assumptions presently. But let us try and put some numbers to it.

In the first scenario, going by published estimates of consolidation impact, Infratel will lose 4000 colocations and Indus will lose 14000(which is around 5% of present operations). I have further layered on a 5% price drop assumption, for an overall 10% revenue decline. While EBITDA remains constant on the lowered price, the valuation multiple of EV/EBITDA compresses to 10x, giving a value/share of 246. Here, EV approximates market cap as cash and net debt are margina.

In the 2^nd scenario, we consider that the towerCos honour the existing contracts for 5 years with the 2.5% escalation, after which 10% of sites are exited(hence the dip after 2022). The lack of pricing power therefore ensures merely a 6% revenue growth, versus a cost of capital of 13.1%, to arrive at an overall value/share of 263. This scenario is what I would consider optimistic.

Scenario 3 would be where the proposed merger is approved, with safeguards to remove undue market concentration. If this accrues to the benefit of Infratel(eg a scenario where shareholding in IndusTowers is reduced below 50% etc), then the share price should move back to present levels of 350. This might also happen if due to Reliance Jio entry by the time of transaction closure, Vodafone-Idea do not have bargaining power vis-à-vis Infratel.

Scenario 4 is if the rumoured merger talks fail due to Idea valuation avoiding swap ratio etc. In this case, the bull case for Infratel will return. This scenario is possible given that negotiations are still underway and that swap ratio is not yet concluded. In that case, the share price could touch 400-500

At an overall level therefore, considering all 4 scenarios, a rational valuation could be

With the CMP at 294, there does not seem much upside at present levels. While such an exercise is difficult, it is often in the zone of darkness that rewards are maximum

Beware of companies in low tax sectors-these may bite you

While reading about failure patterns of listed Indian companies, some themes caught my eye. One of them is that certain sectors had a high share of corporate mishaps. Whether it is the plantation investments Ponzi schemes of the 1990s, real estate boom of the early 2000s, some things never change. The below post tries to analyze and explain why

1. Agriculture-Tax free income hence cannot correlate tax payments to reported income. Also, there is usually indirect tax exemption as well, so possibility to raise 'accommodation bills without any other offsetting check/VAT chain'. Forensic audits ordered/pending for Kaveri Seeds and Camson Biotech, and the near insolvency of India's largest rose grower Karuturi networks, illustrate the point, that accounting issues in these sectors do exist. Other examples like Transgene Biotech also exist. 
2. Education-Like how Chinese shell companies were incorporated abroad (with local operating partnerships) to circumvent Chinese FDI restrictions, Indian companies resorted to agreements with trusts etc to make money from the traditionally non profit education sector. This did not end well for Educomp and Everonn, both of whom are facing distress..
3. Scrap Sales-This sector again operates on cash, hence for companies whose raw material/finished product uses scrap/recyling, there is a risk of siphoning out. While companies like Ganesha Ecosphere have thankfully not reported frauds so far, this risk exists.
4. Real Estate-Nearly all the players experience high leverage and low profits despite ever mounting prices. It seems promoters become rich(eg DLF) with outside interests(eg land) disguised via land ownerships/shell companies, while shareholders face negative returns
5. Jewellery-This industry is notorious for trust based/cash transactions. There were pan India strikes when PAN was introduced for high value transactions, and when excise was proposed-even at a much higher exemption threshold. Examples of frauds in this sector include Winsome Diamonds, while financial distressed firms include Gitanjali Gems

Bottomline-Triangulation of data is always useful and being subject to direct/indirect taxes(and the resultant audits/returns/investigation) helps outside investors to detect red flags, or exit somewhat in time. Of course, as I outlined in an earlier post, this exit may be premature http://specialsituationsindia.blogspot.in/2016/04/should-you-buy-on-dips-after-news-of.html but one is informed atleast

Beyond 'sin stocks'-companies whose business models depend on general bad health

While we all know about the classic 'sin stocks'(gambling, alcohol, tobacco, arms), not many would have thought of other stocks as benefiting from human vices/distress. However, if we look at what drives certain business models, we remove the blinkers and realize that certain stocks thrive on tragedy and on general economic distress.

1. Healthcare/Hospitals-Correcting lifestyle diseases caused due to pollution. This especially applies to speciality clinics
2. Pharma-Lifestyle diseases
3. Snacks-Ready to eat/unhealthy-yet this appeals to obese people and 'salt sugar fat' unholy trinity helps to ensure this. 
4. DG Set/Inverters-These are energy inefficient but as per Economic Survey estimate, quite prevalent due to poor grid power
5. Real Estate in city centres: These survive due to long commutes and poor public transit-hence people prefer to stay in cities rather than in suburbs like what happens abroad
6. Security Systems: Depend on penetration of crime. Zicom and Quickheal are examples of this
7. Mobile broadband: Depend to a large extent on underpenetration of wired broadband. Otherwise, the natural choice for homes and offices is wifi/fixed line
8. DTH: Depends on the cable operator not being present or not competing efficiently. However, this suffers from the tax arbitrage enjoyed by the (till now) unorganized LCO(Cable operator)
9. Gyms/Fitness: Lifestyle diseases and obesity lead people to these options rather than the (simpler) morning walk.
10. Skin cleansing: Companies like Kaya Clinics cite the increasing pollution and social pressure as reasons for people to take their treatments

I am not passing any judgement on these companies/sectors but am pointing out the scope of immense disruption here, if things change for the better.

Should you buy on dips after news of search and seizure/ income tax raid?

As a chartered accountant (one of my dual hats, the other being MBA), I look for places to apply the learnings in practical life especially investing. One of these includes the impact of regulatory/tax/accounting matters on the pricing of stocks.

Recently, I read an article(http://www.business-standard.com/article/pti-stories/ashoka-buildcon-shares-recovers-4-pc-116040700846_1.html)  on the stock price crash and recovery of a Mumbai based infrastructure company Ashoka Buildcon(https://www.screener.in/company/ASHOKA/consolidated/) . The company is linked to a jailed politician and there was a 'search and seizure' operation by the Indian Income tax authorities. Due to the seriousness of this(more on this below), Clause 36 of the listing agreement mandated the company to disclose this price sensitive information to avoid a false market in the shares, and therefore it revealed it to the exchange through a press release.

Under the Indian income tax law(http://legalsutra.com/1388/search-and-seizure-under-the-income-tax-act/), the provision to inspect the company's premises and take copies of documents is subject to administrative safeguards which need to stand the subsequent quasi judicial/judicial scrutiny. The relavant extract from the legalsutra article is below
The existence of reasonable belief is a condition precedent for a valid search and the section does not permit indiscriminate search and seizure. The belief must be honest and based on cogent material and not on anonymous calls and letters.[17]Materials which may be only remotely or distantly relevant, may not be sufficient to satisfy the test of relevance. ‘Reason to believe’ means that the officer has faith or accepts a fact to exist. It was laid down in the case of ITO v. Seth Lakshman Mewal Das[18] that belief must be genuine and not a mere pretense and has to be held in good faith and not a reason to suspect.

Presuming that the search is not to harass someone with political inclinations contrary to the ruling dispensation (unfortunately, the Indian tax authorities are not totally independent of the central government hence this is possible), the very fact of a search indicates something is fishy. However, the long judicial process of the courts means there could be 3-4 years before trial, and hence an investing chance in the interim.
 
My first impulse was to buy on dips reasoning that the charges of bribery, corruption and tax evasion are on par for the murky infra sector, and that the share price would revert to the mean once the market realizes the transitory nature of this news. This reasoning was generalized and not fundamental based, so I thought let me crunch some numbers to validate this hypothesis.

Hypothesis: Stocks recover to their earlier price within a reasonable time of the news(say 1yr), after an initial correction
Test: Compare the undisturbed price(Day-1) to Day 0(day of news), Day+7 and CMP as at Apr 8,2016.
Limitations: Does not factor in earnings impact or comparison versus sector and general nifty
Results:

Irrespective of the limitations, it is clear that buying on dips is NOT an open and shut case. In fact, income tax raids may be the unveiling of accounting fraud, or pave the way for out of court settlement and/or strained relationships with the tax authorities and delays in assessment closure.

In my view, only the possible situations would make it 'safe' to enter on dips, and as they can be assessed only with a detailed study of company and tax laws, this is not for the lay person.

• Notes to financial statements have clearly disclosed all pending tax litigation and the company's stand seems plausible/defensible  including reference to reputed external counsel
• The situation seems politically driven (eg-Ashoka Buildcon)
• The company has sufficient liquidity to make interim pre-appeal deposits to appeal tax orders
• Past record of such search and seizure incidents without consequential impact

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
http://www.bseindia.com/xml-data/corpfiling/AttachHis/Aanjaneya_Lifecare_Ltd_280613.pdf

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.
   
   
   

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.