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! 

Time to buy Videocon now at present valuations.

Videocon is perceived largely as a consumer goods company. But often, it has been in the news for its GDR issues, new new petroleum/natural gas findings of its JVs etc. Given the company’s low price to book of 0.6, possible natural resources upside, and very good technology and its grabbing market share in the digital TV market; I just had to analyze this as a potential multibagger given the possible upsides. But finding data was so difficult that I had to often remind myself of the old warning ‘If you gaze into the abyss long enough, the abyss becomes part of you’ i.e the psychological danger of getting attached/anchored to something where analysis/research has taken a lot of time. That said, lets plunge into the company itself.

The latest annual report for year ended Dec-11 can be downloaded from the BSE website (http://www.bseindia.com/bseplus/AnnualReport/511389/5113891211.PDF) while the Luxemburg May-12 GDR prospectus can be obtained from this link after free registration-tellingly neither this nor the annual report are uploaded on the company website but that is an indictment of the IR team actually ( https://www.bourse.lu/application?&_flowId=SignEmetDocumentsFlow&numEmet=228665#SignEmetDocsInstr_showMoreDetails). The data I use is sourced from these hard to find documents, and summarized below

Hence, even stripping out the capital invested in other businesses(telecom, energy, power), the question is given the strong underlying performance of the consumer appliances division, is the market penalizing Videocon too much by assigning an equity valuation of just Rs 5355odd crores?  But then, remember the huge debt of around Rs 27000 crores(consolidated FY11 figure). Lets go business by business

1.    Consumer Electronics:- This is the mainstay of the company. Unfortunately we do not have segment profit figures to value the company. Still, even taking a profit of standalone figures to value the company of Rs 3600crores,  that needs just a P/E ratio of 9x to achieve the combined valuation, which does not seem such a challenge. Even the standalone EBITDA is around Rs 2200crores, which would entail EV/EBITDA multiple of 15x(seems much steeper challenge here).

2.     Crude Oil:-  On the energy assets of the company(details available in the annual report and press release), I’m not an energy buff, so really do not know how to value them.  I welcome comments from energy investors on this front on what multiples to assign proven reserves! Presently, the Ravva Oil & Gas Field is currently the only source of revenue in our Oil & Gas Business, so valuing this is a challenge. Still, given the May-12 board announcement of a possible spinoff to unlock value, we can get clarity about what the management has done with the funds and how the assets are  working! This segment contributed around 500crores to the company’s bottomline, as evident from standalone P&L(before interest expense). Still, given the capital commitments in the next year, spinoff would improve cash flows

3.    Telecom-Post the license cancellation, the temptation would be to assign zero value to this business, given that the mobility business is not very strong. However, a silver lining exists in telecom. As per Dish TV’s investor relations presentation(http://www.dishtv.in/Library/Images/DishTV-Investor-Presentation-Apr'12.pdf), Videocon had 12% of the market share for digital TV. While we do not know the active base/ARPU for this business, anecdotal evidence praises both the quality and the distribution efficacy of the business. With 29% market share, Dish TV had a enterprise value of around Rs 9400 crores(equity 7200crores, debt 1200crores). Given that metric, and assuming the superior technology/subscriber adds of Videocon DTH allows the same multiples(a very big assumption but then we do not have comparable metrics for DTH), the DTH business itself should be valued around Rs 4000 crores, much more than the negative book value assigned to it as a part of telecom. Of course, as I blogged earlier, DTH is a loss leader but investors assign it a valuation for some weird reason. Even Edelweiss praises the DTH operations in this research report (http://www.edelweiss.in/IEReport/common/content/reports/current/sector_&_company/media/2011/11/15/15112011142151/Videocon_d2h_-_visit_note-Nov-11-EDEL.pdf)  

4.    Power-With land acquisitions, coal linkages and PPAs pending for the project, it is a Herculean task to value the two power projects which Videocon has entered into. Still, book value is fair.

What works against the company is the qualitative factors like

1.    this nugget on pg6 of GDR prospectus In the past, we have made loans and advances to, and given guarantees for, and have received loans and advances from and benefited from guarantees given by certain Promoter Group entities. Some of these loans and advances are undocumented and may therefore be more difficult to enforce than if they were documented

2.     Also, we do not know much about the contract manufacturing operations revenue(presumably sale of components which makes up 11% of revenue). As described in the risk factor, We rely on the income generated by manufacturing and sales under licensed international brand names for a significant proportion of our income. If the marketability of the licensed brand names diminishes, this could have an adverse effect on our sales and results of operations. We also manufacture finished goods on an OEM basis and components for third parties. We also produce products under the brands “Electrolux”, “Philips” and “Kenstar”, which are marketed by the members of the Promoter Group. One would need more clarity on this, before giving the generous 9x P/E multiple!

3.    Promoter owns the brand, and perpetual license terminates if control changes. Also, the promoter holding is 60%+, which does not permit easy change of control(not that India business families sell out that often)

Upside triggers for the stock seems

1.    Sale of DTH business-if rumours like this one come true(http://www.dealcurry.com/2012076-Videocon-To-Exit-DTH-Biz.htm)

2.    Spinoff of oil and gas assets-no more expensive capex. Also, it may reduce the complexity discount/conglomerate discount attached to the stock. 

3.    Resolution of telecom 2G auction issues and possible compensation

With all 3 looking possible, this is certainly a good speculative bet. INVEST

The bar is too high to invest in Bartronics-avoid now

With a price to book of just 0.13, you would think that Bartronics would warrant a 'eyes wide shut' investing approach. It can make 80MM smart cards per annum(but it just made 20MM of them in FY11 leading in a capacity utilization of just 20%), and given the financial inclusion/debitc card/UID boom, you would think that a company making Rs 100Cr+ profits is a screaming buy on a market cap of just 85 crores! Yet, reading the past 3 annual reports and the latest earnings release on the company website, threw up the following factors that would warrant a relook. Earlier, I'd commented in my other blog on the governance issues in the FY10 report(http://financeandcapitalmarkets.blogspot.in/2011/01/bartronics-next-satyam.html)

1. Suspect audit quality:-Till FY09, the audit partner of Deloitte, Haskins & Sells(Hyderabad) did not have any issues with the audit. But when the audit partner changed for FY11(and maybe the Satyam scam resulted in more rigorous audits), he qualified the audit reporting casting aspersions on the competency of the(then) sole individual auditors, fixed asset verification etc. Bartronics then had to engage another professional internal audit firm, improve their controls etc and it worked as they got a clean chit for that in FY11. But what is worrying is their retaining the same internal auditor albeit jointly(loyalty should only go too far) and that it took the Big4 auditor a change of partner to clamp down on this. 
2. Aggressive accounting for sales(and therefore debtors):- This is best described in the company's terms Sundry Debtors include trade receivables aggregating to Rs. 84,193.09 lakhs as at March 31, 2012. On account of the economic slowdown and consequent recessionary conditions in the global market there have been delays in recovery of such amounts.
   Given the fact that the amounts are recoverable from customers with whom the Company has a long standing relationship, the Management is confident of realising the amounts due and no provisions are required on these accounts at this stage,notwithstanding the "disclaimer" by the Auditors in their report for the period ended March 31, 2012. Consequently,Management believes that the recognition of revenue and the corresponding foreign exchange translation gain(loss) to the extent of Rs. 29,891.93Iakhs and Rs. 9,757.33 lakhs respectively for the twelve months ended March 31, 2012, including Rs.9,797.27 lakhs and Rs. (3,125.80)lakhs respectively for the quarter ended March 31, 2012, is appropriate, as there is no uncertainty regarding recovery of the corresponding outstanding amount. This issue had cropped up in the FY2010-11 audit report as well, albeit confined to debtors only. This year, it has gone to include revenue as well. And to put figures in perspectives, the translation gain on those doubtful debtors is nearly equal to the net profit of FY12! So without this gain, the company's profits would have been wiped out, to say nothing about the profit on the over due sales! One would ordinarily trust management to know its customers best, except that this management has had tussles with its auditors before on tax provisioning under MAT, revenue recognition on software transactions etc. So on this, it is better to adjust the accounts as per audit qualifications in which case they look much less impressive. 
3. Tussle with Municipal Corporation of Delhi:-As described in the Mar12 press release, Bartronics has spent Rs 218 crores(capital advances, security deposits, capital work in progress) on the 2000 sites contract awarded by MCD, which has not allocated further sites despite just 15% of the contract being fulfiled. While Bartronics and MCD are locked in arbitration, any upside from this will only help the valuation. But given the lack of disclosure from the company on this issue, I'm not very optimistic on the outcome. This may adversely impact the chances of getting contracts from other governments/PSUs till the issue is resolved.
4. Extending the accounting year to Sep30:-This has resulted in a 18month accounting year for no possible reason! what I suspect is that to avoid the 'going concern' qualification in audit report(most recently suffered by SpiceJet and Kingfisher), Bartronics has delayed its accounting year in the hope of manna falling from heaven to save the accounts!  
5. Low ownership stake that too mostly pledged:-With a 23%odd ownership of which 58% is pledged, Bartronics management does not have skin in the game except the portion of debt for which it has personally guaranteed.

Is their 80MM smart card plant worth Rs 722 crores?:-The present enterprise value of the firm is Rs 85crores(equity)+Rs 637crores debt(i.e Rs 587crores as reported for FY11+Rs 50crores MTM change on the $50MM FCCB due for redemption in FY13). Thankfully, the current liabilities & provisions are more than met by the non doubtful sundry debtors/other current assets(nearly net zero assets otherwise). As I'm not an expert in this field, I invite readers to give their views on this one, considering the possibility of capacity utilization etc. Assuming that this is not the case, the only other upside sources are the MCD arbitration case going in their favour OR the Rs 400odd crore sundry debtors suddenly paying up their share despite the worsening global economic recession.

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. 

Eon Electric-trading at 1/4th of its free cash on balance sheet

When an Edelweiss stock screener popped up this stock as one with low P/BV, low P/E, 52 week low etc; it triggered my attention to look beyond the screen, and delve into the annual report. And I was not disappointed. The company had sold its fusegear business to a French Co for around 530 crores, and therefore was sitting on cash worth around Rs 280 crores(w/o considering other investments, net current assets, negligible debt). And unlike the typical Indian holding companies, the promoter does not have other listed group companies to sink that cash in. So why is the market valuing the stock at just Rs 68 crore?
From my analysis, some reasons are

• Cash burn:-Since they divested their crown jewel, they are making quarterly losses of around Rs 6 crore. That is not too surprising
• Poor use of surplus cash:-The surplus cash is invested in FMPs/debt plans. Even at a conservative 7% short term rate, their quarterly income should be around Rs 5 crores. But they show other income of just 2.2 crores or so, leaving a gap to be explained
• No promoter buyback from open market:-Despite the huge valuation gap, the promoter has not tried to increase its stake from the open market. This is surprising. Also, the company announced a buyback in Oct-11, only to abruptly withdraw it at the month end
• Poor/investor unfriendly disclosures:-They do not update their website with the quarterly results. There are no conference calls or investor relations presentations. Shareholders would be eager to know the management's intent to use surplus funds, but the company is mum
• Low institutional holding:-A FII even sold off its major stake last month. Of course, they tend to follow the herd mentality, so it is not so much of an issue 

However, some positives are

• Management recent preferential allotment at Rs 70:-While this was a fait accompli since the conversion price was below the market price prevailing then, it would still give the management incentive to boost the share price
• Promoter holding just 45%:-This does not confer a stranglehold, and leaves room for some investor activism
• Postal ballot for diversifying business:-The management has announced its intention to change the line of business, and invest the cash there. This should improve the valuation/

My take:-One does not often get to buy a Rs 100 note for just Rs 25. Such opportunities are  rare to come buy, and should be grabbed, in view of the positives outlined above. I know this does not fit the criteria outlined in the earlier post, but this was just too juicy to pass over.
Credits:-Thanks to my IIMA classmate and friend Gaurav Singhal(http://gauravsinghal.wordpress.com) for helping build the argument,and discussions on this topic