Come hell or highwater

Come hell or highwater, private equity goes about its business.

During the first half of 2008 while public markets choked by a grisly hug, PE funds did 207 deals worth $10.4 billion , as against 178 transactions worth $6.69 billion last year same period. Average deal size increased to $59 million compared to $41 million during 2007 same period.

Standard Chartered topped the charts with its $830 million investment in property fund of DLF Ltd, followed by Providence equity’s $640 m in idea cellular. Others include Symphony Capital's $450 m investment in DLF Assets, L N Mittal and Farallon Capital's $399 million in Indiabulls Real Estate and investment firm J P Morgan's 300 million dollar investment in Tower Vision India.

I like the way they go about business as usual. Oil prices are slowly receding and Y.V.Reddy is bent on reining in inflation. That’s the way it should be. Growth is not the purview of Central Bankers, that’s for M/o.Finance to handle by accelerating pace of reforms. Now that the Left is out of the ruling coalition, Govt. has a lot of bandwidth to flex its muscles. Rate hikes hit back with a lag, so it’s important for us to brace up before we are blown all over the place. Pretend as usual and go about life, investment and all.

Things will fall in place. Or where they fall is exactly their place.
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Not bad being a contrarian

So RBI unveils credit policy and sends chill down the nation’s spine revising GDP growth expectation to 7.9% as against 8.1% earlier.

Repo rate up by 50 bps is now at a record 9%. CRR is up by 25 bps and it is at 9% too.

On the back of high oil and fertiliser subsidies, farm debt waiver and the implementation of the Sixth Pay Commission recommendations, how bad can things get? Let me mangle definition of optimism, true contrarian style - wait till things get so bad that the only way for them is to get better.

I should know. The stock markets have given a thumbs down by falling around 4%. The two sugar stocks I bet on have moved up by 7% and 8% today. My portfolio inched up by 2.6% too.

Not bad, huh!

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They just don't `get it'

It’s results season again. I glanced at the results of ICICI Bank and HCC.

For ICICI, the net profit for the quarter fell by 6.07% (Rs.728 crore) in relation to Q1-07-08 (Rs.775.08 crore). Nothing unusual, given the sluggish business sentiment tempered by high interest rates. But something else rankles. The bank’s non-tax provisions and contingencies (for bad debts / bond trading losses) rose nearly 43.5 per cent to Rs 792.49 crore during April-June this year, compared with Rs 552.27 crore during the corresponding period last year. The increase in interest rates and adverse market conditions hit the bank’s trading portfolio and treasury income by Rs 594 crore. This is for a bank that is quick to grab an opportunity, having an agile management that is high on financial savvy and in using sophisticated risk management systems. CFO Chanda Kochar can play down the worries on the lines that the provision levels are `nearly’ the same as in earlier quarters, but they are mistakes in a row just yet. An indication that they are clearly losing sight of the market risks.

For HCC, revenues grew 22% to Rs.895 crores (Rs.731 crores for Q1-07-08 quarter) but PAT slipped to Rs.31 crores as against Rs.34 crores. What stands out is a provision of Rs 50.6 crores on account of foreign exchange losses on foreign currency loans including FCCB. This is bad choice of debt since prudence demands raising Foreign currency loans only if you have foreign currency income to hedge its exchange risk. But construction companies merrily used FCCB route to bet on rising values of land banks and a seemingly ever appreciating rupee (so that they will end up repaying less as Rupee gets stronger). But the trends reversed, the tide ebbed and they realized they were swimming naked.

Where did they let up? Were they not forewarned of the risks by smart managers that signed up for such financial arrangements? The numerous credit crises from the past (remember the great depression, the asian meltdown) has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects. Several Indian companies took on unsustainable debts, pushed around by I-bankers and other “debt merchants” who made a quick buck by disregarding risks. While this happened, our central bankers though a little unnerved by the swelling forex reserves, were still marveling at the creativity of capitalism. When the bust came, most borrowers / bond traders aiming to make quick bucks on currency / bond appreciation were left catching the hot end of the rod.

So I begin to distrust the individuals in charge as also our macro economists. Neither `get’ the true picture of the flip side of risks they assumed. The I-bankers that peddled these instruments never really understood it themselves to explain it to the borrowing clients. Now I see the same pattern in the manner in which both RBI and Finance Ministry handle the oil price shock and resulting inflation in commodity prices. Finance minister can hide behind his oft-quoted statement `it is imported inflation’ only for so long. He may have to soon come up with a plausible defense. Clearly, arresting inflation and maintaining price stability is an important task of the central bank as is ensuring financial stability. But this dimension is completely absent from the macroeconomic models now in use. In addition, since financial stability these days also depends on avoiding deep recessions, stabilizing the business cycle should also be of the concern of the central bank.

But that is at a macro level and CFOs can’t rely on that to shield their individual risks. ICICI treasury has clearly goofed up by ignoring cyclical nature of bond yields. Their bet on junk bonds went haywire. HCC and other construction majors played fast and loose with FCCB for long gestation projects where eventual profits (as and when they come) might have already been eroded by the exchange risks they suffer here and now. Stock prices have also fallen so badly that the lenders would not want to exercise the loan conversion (into equity) option attached to these bonds. They are reeling the under grave liquidity crisis in their home markets and could do well with a cash pay back.

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So here are the lessons. Never miss the wood for the trees. Look at the indicators. Stock markets don’t beat down stocks without reason; and you can’t blame it all on bad sentiment alone. So Ms.Kochar and Mr.Ajit Gulabchand, it's time to roll up your sleeves and begin to see risks from a mile. That’s when you can claim you're really `getting it’.

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Edelweiss' right pick for its ARC - Sibi Antony of IDBI

Edelweiss Alternate Asset Advisors (EAAA), an arm of Edelweiss Capital is looking at launching a $200-million distressed asset fund under Sibi Antony (Ex-IDBI). I’ve met Sibi often at IDBI (Merchant Banking Division) during my earlier stint in corporate service and have found him to be an extremely capable manager. He has been instrumental in recovering a large portion of IDBI NPAs and in managing their SASF (Stresses Assets Stabilization Fund) ; hence must have a ready database of owners of stressed assets as well. I am sure he has several aces up his sleeves to turn them around (or to hive them off).

In the coming weeks, I will be closely watching him take on some of the biggest hurdles in ARC business I’ve outlined viz. –

a) Banks' reluctance to minimum 20% haircuts while transferring stressed assets to ARC;
b) Non rationalization of stamp duty incidence while transferring dud assets;
c) Govt. stand on triggering of takeover code when debt is swapped into equity in terminally ill companies;

Still the distressed asset market size is about $35 billion and the nine odd ARCs in India have of late been a bit passive since the stock market and realty markets are going thro a lull phase. May be if the conditions (high crude price, rise in Bank NPAs, inflation and liquidity squeeze) persist, Sibi will be looking at a much larger market size where his stated strategy of focusing on corporate / SME assets with accent on single assets than portfolios should payoff. But then much depends on bringing around lenders to accept ARC terms and getting the borrowers to accept the strategic and financial bitter pill offered by undertakers like Sibi. Sibi will have a great support from Rashesh Shah and his team of I-Bankers in finding premium buyers to these stressed assets anyway - and much less bureaucracy to deal with unlike with his previous employer IDBI.

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"Good luck, Sibi... " [Now some sales pitch.] "Call me if you have some [not so] bad apples to get rid of, fast "

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For better realty transparency

Shobhana Subramanian of Business Standard contrasts the real estate market rules in India / China leaning on CRISIL and CLSA reports. She finds Indian laws on real estate developers way too lenient. I found the piece pretty insightful. Excerpts –

- In China, mortgage payments have to be utilized for a specific project; Indian builders divert customer advances for other purposes as well (say, acquisition of new land).

- In China, developers must develop the land acquired within a certain time frame, failing which the appreciation in the value of the land is taxed. Back home there's really no hurry to start any construction, the land can simply lie vacant and can even be resold at premium.

- Chinese developers hold relatively small land banks; some estimates put it to be sufficient for development over a 4- to 10-year period, depending on growth targets; in India developers are estimated to be holding on to land banks for anywhere between 8 and 15 years (of course, various Indian regulatory approvals can take years - goes the argument)

- The difference in the amount of debt that Indian and Chinese players have on their books is striking. The average gearing for listed Chinese developers, CLSA reckons, is 50-60 per cent with only a couple of them at 100 per cent. For companies back home, the average would be closer to 100 per cent with a couple of firms indulging themselves beyond that.

- In India, sales and profits of realty firms and recognised well before the entire project is completed. That just won't do in China; revenues there flow into the books only after the project has been completed and the property handed over to the buyers.

Here is another case for toning down regulations. Or even Housing Finance Companies (HFC) can also help if they choose to finance buyers in projects only when they are ready for occupancy and possession. Much better if they insist the HFC be made a (confirming) party to the transaction so that even the end-use of funds is validated.

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Smartest buyback

Here. ICICI Venture biting another bitter pill. It invested $22.5 million for a 43% stake in Dr.Reddy’s Labs (DRL) research outfit Perlecan Pharma in November 2005 and is getting back $9 million for divesting it back to DRL. Joining it in drinking that Karma Kool-Aid is Citi Venture that is in a brual *sell-all* mode giving in to CEO Vikram Pandit's earnest efforts aimed at resuscitating Citigroup by selling all things that it can find a buyer for.

I think of Dr.Anji Reddy. He must be allowing himself a rare chuckle (*rare* because the $754 million Betapharm acquisition is bleeding now). He had invested $7.5 million in Perlecan for a 14% stake. Now he has 100% stake for just $25.5 m – ain't that smart?

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PE back in Realty form – at an entity level now

Gone are the days when PE players were interested only at a project to project level in their Realty exposures. Now the valuations are beaten down, they seem to be fairly interested in buying stakes in Realty companies instead of specific projects. Clearly their risk perception has come down. Another clue to me is what I see in the rising instances of creeping acquisition. Promoter holding in various companies has been going up sharply. Puravankara Projects and Akruti City have 89.96% promoter holding. If DLF was to go ahead with its entire buyback, it could have one of the highest promoter holding of 89.3%. I get to hear the “buyback” word more now.

Last week I’ve been talking to one of my friends working for a large Realty PE fund. I was surprised when he asked me if I have any interesting proposals from Realty companies. So far his tribe never entertained a hint if it spanned beyond a specific project. I gulped the drink in front of me and ordered another!

Today I read about the resurgence of PE interest in the papers. Now you know why I still call him a friend. He broke it to me two days before!

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Art of going naked

Now some reverse sweep.

A few months of living with an appreciating rupee it seems had robbed our exporters of their art of making profits from currency fluctuation. Now the Rupee has been depreciating since June, our IT vendors have been steadily making – yeah, you guessed it – losses.

Here is the score card. HCL Tech – $65-75 million; TCS - $12 million; Mindtree - $3 million; Biocon - $ 7 million.

These are violent times in the currency markets and no one can accurately predict the direction of a currency. In the best of times, sometimes it pays to go naked. I had figured it out more than a month back, well almost!

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Lay the decoy, draw the blinds, go goose hunting

The wild see-saws in the market has leveled many a prophets of boom and doom. Where have they all gone? Now all of them seem to have gone into hibernation. The clients have deserted them. While some muster the energy to come and talk about clients asking them “is it time to get in?” Yeah, they ask. But get in they won’t in a hurry.

I see companies losing money by the ton with Rupee reversing its run up. Despite upward revision in retail fuel prices, govt subsidies and oil bonds, the Oil marketing companies are busy making new losses. Politics is another big spectacle with everyday new numbers of supporters and turncoats for the impending trust vote.

Enough uncertainty, huh? The waters are troubled and murky. Good time to go fishing? Or should we settle for some goose hunting?

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Say No to DLF buyback at Rs.600/-

So, why is everybody questioning DLF buyback?

As per filings before NSE, the company will spend close to Rs.11 billion ($255 million) to buyback 22 million equity shares at price not exceeding Rs.600 per equity share. Giving in to the babble around the expediency of this bold decision, I ran a check on the DLF data.

The company had revenues of Rs.60.58 billion and an EBITDA of 31.18 billion for FY 2007-08. So the EBITDA margins are in the range of 51.47%. The company has an interest outgo of Rs.4.48 billion during the period. DLF is an industry leader, let’s assume its cost of funds at an average of 14%. That means it has a debt of about Rs.32 billion in its books (Rs.4.48 billion x 100/14). Now if you imagine 14% funds getting deployed in a 51.47% margin earning business, it is a no-brainer to decide in favor of its retention in the business.

Why is then DLF bent on spending Rs.11 billion to buyback just 1.18% of its equity? Bravado? Why don't they retain that cash and plow it back in business?

I think it has to do with the high promoter holdings in the company. First off, in a buyback, even as the company forks out funds to buy its stock back, it is the promoter who gains in individual wealth since his % stake goes up. The SEBI formula - six months’ average of daily highs and lows or the last two weeks’ average, whichever is higher – comes as a blessing in disguise now that DLF prices have declined by over 50% of their all time high. So if the stock price is not kept propped up, the founder K.P.Singh’s family holdings of about 88% will have to be eventually valued lower. Being a high beta stock, DLF price will revive faster when markets improve and the founders know it only too well. That’s when the promoters stand to gain if they choose to dilute their stake and cash out.

So it pays to think like a promoter. I see a clear 50% upside from current valuations in about six months when the current turbulence fueled by oil price surge and political tempest settle down and the realty sector looks back up. What say you?

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Oh really?

Cheap valuations augur well for M&A – Business Standard.

Oh, really? Ask who is willing to sell at these valuations. My database has at least a 100 companies that could do well with some capital infusion right now. I have also identified moneybags that could be either strategic industry leaders or private equity financiers. But sellers are lazybones. They still think their stock should be valued at pre-january 08 valuations and it’s just the overall down sentiment that drove down their stock prices.

You can do nothing but wait for them to get real. In the process, the buyers that I had earlier at much higher valuations have now revised their buy price. Who is suffering? Starved of liquidity, their businesses languish eroding their value further. It’s getting harder to find buyers as each day goes by.

When I read such headlines, I search for its author to see if that’s someone I know. If it is, I’d certainly like her to check out a few I-bankers and private equity managers and present their honest views as well.

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Now it's Amar Singh - ADAG dance

With the Left gone, Politics in India has become a lot easier to grasp. It is no longer Congress+Left Vs. BJP+Allies. It is now split between the Reliance family factions - Mukesh Ambani camp Vs.Anil Ambani camp. Here is my earliest prediction. Look at how Amar Singh, SP general secretary rips Finance Minister P. Chidambaram and Petroleum and Natural Gas Minister Murli Deora at a media briefing Saturday.

"I am not asking for my pound of flesh. We are against anti-people policies. Deora's behaviour is disgusting. He should come clean on whether he is a corporate honcho [for Mukesh Ambani's RIL] or a minister".

Regarding Chidambaram, Singh said: "Under his stewardship, price rise and inflation have happened."

Politics never baffle me. In fact they help me balance my portfolio by just looking at the daily news headlines. If Murli Deora is in the limelight, go buy Mukesh Ambani’s RIL, RPL stock. Of late Samajwadi Party and Amar Singh steal the show. It’s time to trade loyalties. Remember how Sahara group was let off by RBI recently? Go long on ADAG group – Reliance Capital, Reliance Infrastructure, R-Com, RNRL, Reliance Power, Adlabs.

What about the Indo-US nuclear deal? That has never been the central issue except for the Left. Nobody ever had a clue whether it is good or bad for the country. The comrades led by Prakash Karat just opposed all things American as if the Left is run by the Chinese – financially if not ideologically. Ideology is in severe short supply amongst the communists now. Want proof? See where China parks its surplus - rushing to hold stake in Blackstone Private Equity, the capitalist moniker.

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The Airline experience

The progression (if not evolution) of successful industrialists sometimes baffles me. Doesn’t success yield some experience? I see airline after airline collapsing all over the world. Oil prices and operating costs are soaring, demand slows down, flights get cut. Few of them have even gone bankrupt. Still enterprises that make money from successful businesses head straight towards the airstrip. Vijay Mallya made money from his liquor and other businesses set up Kingfisher airline that is bleeding. Subroto Roy (Sahara, now sold out), Dr.B.K.Modi (Modiluft, sold out), East West, NEPC, Damania (closed down / soldout) are all examples. Mallya found LCCs as the culprits and bought out Air Deccan (now eyeing Spicejet) to consolidate his business. May be he'll get to own 40% market share. But to what purpose when the pie itself is shrinking? The high passenger load factor that allure investors is because of LCC fares. If they are gone, passengers too will be. Remember they used to take the trains before. They will, in future. [The upright seating airlines offer has already forced many to reconsider their mode of travel, now they drive up fares and cut flights too - last nail?] That leaves the managements to put up with soaring fuel costs, expensive pilots and maintenance crew. Here is Naresh Goel’s Jet Airways endorsement. I am sure fellow industrialists would be watching this spectacle.

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Or did they? At least some of them who are up close, like GMR infrastructure – that builds large Airports are expected to know better. Apparently they see something that we obviously don’t. Perhaps they are right. But I am certainly curious. Who can bet on this business? What are the odds of success?

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Here's Warren Buffett on Airline industry -

"I made the comment that if a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money.

But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in.

You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success.

I have an 800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: "My name is Warren and I'm an aeroholic." And then they talk me down."

Prove me wrong. I'd be obliged.

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Stock buybacks - value capture or management swagger?

Why do buyback announcements fail to boost stock prices?
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Typically if a company has generated surplus cash from its operations and is of the opinion that the cash cannot be profitably redeployed in the business in the near term, it may choose to distribute such cash amongst its investors by way of dividends. Further, if the company has built up a war chest anticipating large capital expenditure and because of adverse market conditions it decides against expansions, then its management may decide in favor of using the cash to mop up equity from stockholders desirous of cashing out. It also sends out signals that in the opinion of the management, the intrinsic value of the business is not adequately reflected in its stock price.

When a company buys back its shares and cancels it, the residual stake held by existing holders goes up. Each residual share gets a larger claim to the earnings pie (the numerator) since the number of shares (denominator) has gone down. As a result there will be fewer claimants to its equity and distributable profits (numerator) in future. Lower investor base brings down annual servicing costs. So even at a time when business prospects are not so buoyant, the surplus resources are not allowed to clog the arteries of business since overcapitalization is more dangerous than under capitalization. The business runs with optimal capital – and no excess flab.

But recently we’ve been noticing consistent decline in stock prices of companies that announce the buyback. Is it that investors don’t read the signals? Or is it that they read it only too well?

Notice the times. Liquidity is hard to come by and managements would do well to keep money in the bank than apply it towards stock buyback. If they need it later, how sure are they of raising it? If sure, at what cost? That is why investors see buyback announcements made by companies as management swagger, not backed by seriousness of purpose with an intention to capture value. Not the least when interest rates are going up and raising debt is way too expensive. Especially if it comes from companies that are already reeling under huge interest burden such as Reliance Infrastructure or DLF Limited that face a double or triple whammy - with large unfunded capex plans, bruised by economic headwinds and wading through a tardy business cycle.

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