Mercator-little understood but debt default risk impacting valuations

Earlier, I blogged about Mercator(http://financeandcapitalmarkets.blogspot.in/2011/09/why-mercator-lines-is-buy-thanks-to.html) when it was Rs 25. Now the share price has slid to Rs 21 and the latest annual report FY12 has been released hence I felt its time to come up with an update(http://www.mercator.in/investors/AnnualReport/Annual%20Report%202011-12.pdf). The company has a jazzy annual report which has won several awards, so I reproduce graphics from it when helpful. For example, as the FY12 revenue mix shows, the company's main revenue comes from coal trading/mining from its Indonesian operations. Hence, should the market value it as a shipping company or a coal mining company? There is sufficient information in the annual report for sure, but not being a shipping investor, I do not try that.




Instead, what I focus on is the Rs 3400 crores odd debt. The company has had negligible operating cash for the past 3years, and has cash reserves of just Rs 280crores or so. No wonder then, that it was planning an IPO of its coal assets to raise funds. But given the precarious cash position, one wonders whether debt default risk(which seems the only valuation impacting factor) will catch up with the company before then.As the valuations on P/BV are at a record 5yr low, it may make sense to still enter pending debt recap issue.

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

SKS Microfinance-time to buy at book value?

The riches-rags story of SKS Microfinance has been fascinating-be it the borrower 'suicides' induced microfinance bill in Andra Pradesh that reduced the share to less than 7% of its IPO price, the management tussle between the founder and the professional CEO which eventually led to both of them being ousted, and so on. Mutiple case studies could be written on this subject, but I restrict my case here to whether SKS Microfinance is a good asset play. Market perception is that since the bulk of its loan portfolio is in andhra pradesh and therefore irrecoverable, one should wait till the legal clarity is there.

 Earlier, I did get egg on my face by purchasing it at Rs 142(http://specialsituationsindia.blogspot.in/2011/11/why-i-purchased-sks-microfinance-at-rs.html), seeing it dip to less than Rs 100, and then frantically selling it when it touched Rs 147. Given the governance paralysis here, many of the upside triggers I'd noticed then now seem a distant dream. However, when I read the most recent earnings release and investor presentation(http://www.sksindia.com/downloads/SKS%20Results%20March%2012.pdf and http://www.sksindia.com/downloads/Q4-FY12%20Earnings%20Update.pdf), there finally seems an end to the nightmarish exposure of SKS to Andhra Pradesh. As explained in the earnings update, SKS has written off nearly 1100+crores of its exposure to Andhra Pradesh(thus the bloodbath losses and negative EPS/erosion in book value which has now touched merely Rs 60). However, at market capitalization of Rs 467crores and debt of Rs 1021 crores(adjusting for cash of Rs 690crs), one can get the company at an enterprise value of just Rs 788crores(i.e 7880 million INR). For this, one gets the following assets

1. Non Andhra Pradesh Loan portfolio of Rs 529crores(deducting Rs 236crores residual Andhra Pradesh exposure from the Rs 765crores advances on books)
2. Deferred tax assets of Rs 460crores(even say 50% of that is in form of carried forward losses which can be written off for tax purposes, that still gives Rs 230 crores).
3. and the biggest prize of them all-The Rs 1129 crores of loans to AP borrowers written off in the books, which could become recoverable if the Central Microfinance Bill 2012 becomes law. Of course, this needs recapitalization, political willpower to enact the law, executive support to restore order in the districts, and above all, the borrower's willingness to repay. I feel that loans being overdue for nearly 1.5yrs now, nothing short of a Ponzi scheme(borrowers being extended new loans to induce them to repay existing loans) will obtain repayment, whatever the law may saw. The lack of a rural credit bureau aggravates things further.

Hence, aggregating the assets in (1) and (2), there is very little margin of safety remaining for the investing, and this is certainly not the deep value cigar puffs which Grahan or Buffet would have purchased. Hence, despite the rule of law, I am not optimistic about the microfinance bill giving a Rs 1129 crore windfall gain to SKS and other microfinance companies.

Recomendation- Still, the market is irrational, and does overreact to such announcements. So what I would suggest is to accumulate at book value, and then sell ASAP when the share price zooms on the passage of the MFI Bill 2012, thus exiting the counter

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.

HCL Infosystems stock analysis-AVOID despite low price to book

By conventional ratio analysis metrics, HCL Infosystems(belonging to Ajai Choudhary, not related to HCL Technologies owned by Shiv Nadar) seems cheap with price to book of just 0.52, low price to earning(based on FY11 consolidated EPS) and so on. Also, the company does have a good cash pile with near zero not debt. However, things are cheap for a reason, and in case of HCL Infosystems, the  lesson is to dig deeper however attractive the stock may seem. My reasons for passing on this stock are

1. Declining performance over the past 5yrs:-Though the stock does give dividends(very high div yield of 16% and payout ratio c.f 50%), its revenue has stagnated for the past 5yrs & profits falling.
2. Only a well timed QIP+preferential allotment to promoters of 51million shares @ Rs 152, helped the company raise Rs 780crores(of which 50% remains unspent). THAT is the secret of the cash surplus(not operating cash flows which have been negative for the past 3 years at -42,-42,-64 crores respectively for FY11, FY10, FY09 and just slightly positive at Rs 64crores for FY08. Agreed that they may be in a capital intensive business but still this does not make sense. I do not suspect the company of financial jugglerly despite the alarming sign of persistently negative operating cash flows, but it does not inspire confidence in their financial management. 
3. EPS of Just Rs 2 for 9month period July11-Mar12=>even if they have an excellent quarter to close FY12 at EPS of Rs 3, that gives P/E ratio of around 14x, which is quite high for a negative/zero growth company. The 'ASPIRE' transformational strategy has neither fixed the topline nor the bottom line.though they have received IDC awards for being the top ranked systems vendor, that does not reflect in their market share/profits.
4. Business profile is also quite unusual for listed IT companies as it is into IT manufacturing(laptops, desktops and tablets) and systems integration for the domestic market(it has negligible export earnings). The domestic focus should have given it first mover advantage but some how that has not happened. And since it imports components for manufacturing, that exposes it to FX risk, and the depreciating rupee exposed it to sizeable losses in FY12. Hence, do not make the mistake of comparing it to domestic BPOs/other foreign BFSI focusses ITES Cos.

While they have  have well qualified staff(CEO is gold medalist from IIT Delhi), as Buffet puts it, when a good management confronts a bad business, it is the reputation of the business that stays intact.