deccan chronicle: in search of cash

Deccan Chronicle's results for the 18-month period ended 30-Sept-2012 are out.

The company has changed its financial year from 31-March to 30-September. The annual report is still not out. So we have many missing links as of now.

The company has suffered loss for the period. Sales are down. Costs are high. We don't have information regarding other expenses of Rs.345 crores. Operating losses are about Rs.389 crores. Finance costs are Rs.734 crores.

The whole company is available today at about Rs.100 crores. Of course, if you buyout, you will also get to pay (a financial liability) about Rs.3,903 crores. That's how it is: obligation.

In search of cash
Depreciation for the period is Rs.81 crores. Capex for the period is Rs.3,025 crores (most of which is spent for brand building as per the information provided). We don't know yet to whom these amounts are paid and what brand is being built for the business.

There has been significant savings of about Rs.420 crores from working capital and some long-term assets/liabilities. To put in another way, basically, the operations are down.

Joining these dots we get about Rs.109 crores of cash from operations. See, the cash is out there.

Restructuring of operations and recasting of financial statements
Apparently, there has been restructuring of operations (we don't know what this means yet; as of now as we understand, the operations are down) and recasting of financial statements (we don't know what this means either; recast lets one have new or some different arrangement; recast of financial statements is an interesting idea, though).

Net loans received after all this is about Rs.3,189 crores. This cash is in. But, needs to be repaid with interest sometime in the future. However, it is known currently that this future is not knowable.

There has been buyback of own equity during May-August-2011 amounting to about Rs.228 crores.

If we join the dots again, we get net financing (loans net of interest and buyback) cash inflow of about Rs.2,228 crores.

The reconciliation of cash
So we have operating cash of Rs.109 crores; financing cash of Rs.2,228 crores; and capex of Rs.3,025 crores. That brings net cash loss for the period to about Rs.688 crores. This deficit is financed by, aha! opening cash of Rs.704 crores. What remains as of Sept-2012 is a cash of Rs.16 crores for the company to continue its operations. What a challenge!

More losses to come
The cash loss of Rs.688 crores does not include accrued interest on loans. This means that interest charges have not been fully provided by the company for the period.

Non-performing asset
In the mean time, some (why not all is a question) of the lenders have classified the financing provided to the company as non-performing asset.

Due to the invoking of pledged shares, the promoter shareholding has gone down from 73.83% to 38.4% as of Sept-2012.

IPL franchise granted by BCCI has been revoked. The company claims that it is a contingent asset.

The dive
The performance of the stock has been miserable:

In the past 5 years, the stock is down by about 97%, while Sensex gained about 15%.

This brings down the promoters, the minority shareholders and the lenders. Now we need to find someone to blame: the choices are a) promoters; b) lenders; c) rating agencies; d) analysts; e) all shareholders; f) all of them. Take your pick.

Cash as of now
We need to know what happened to that Rs.16 crores cash that was there as of Sept-2012. If the company has continued to operate, surely, that cash has gone. Ouch!

ril: cost of diversion

Reliance Industries is the company of the country. It has a solid track record of projects execution and returns to its shareholders. It generates loads of cash each quarter.

Let's have a look at what it does with its cash.

Current core operations
The company currently operates in 3 prominent segments: Petrochemicals, Refining and Oil & gas.

The petrochemicals segment includes production and marketing operations of petrochemical products namely, High and Low density Polyethylene, Polypropylene, Polyvinyl Chloride, Poly Butadiene Rubber, Polyester Yarn, Polyester Fibre, Purified Terephthalic Acid, Paraxylene, Ethylene Glycol, Olefins, Aromatics, Linear Alkyl Benzene, Butadiene, Acrylonitrile, Caustic Soda and Polyethylene Terephthalate.

The refining segment includes production and marketing operations of the petroleum products. 

The oil and gas segment includes exploration, development and production of crude oil and natural gas.

These operations are good as these are related businesses. There is synergy in these combinations. These businesses are profitable as we can see from below (consolidated as of 31 March 2012).

Future operations
Then there is another segment which includes - Textiles, Retail, SEZ development and Telecom / Broadband; and more: hotel and TV broadcasting businesses; and more: financial services(?).

The returns
A rough estimate of return on assets employed shows that energy related businesses have provided decent returns to the shareholders. Whereas, other businesses have not.

Bad business
As of March 2012, an amount of Rs. 31,000 crores was invested in these unrelated businesses (as much as about 11% of total capital employed in the company) but gave the shareholders zilch. They are yet to take off.

Excess cash
A large portion of that unallocated amount of Rs. 94,000 crores is actually cash, an excess cash. This cash can be used for repayment of debt, paying dividends or buying back stock. Alternatively, the cash can be used for reinvestment in and expansion of the current related energy businesses.

The company has chosen to keep the cash available for future investments. A small amount has been used for buying back stock.

Bad investments
While a good portion of this cash is planned to be invested in the energy businesses (See this for instance), the worrying factor is that a large portion is planned for investment in unrelated (bad) businesses as well. For instance, a whopping $9 billion (more than Rs. 45,000 crores) in telecom. There is significant investment in retail too. If these investments generate below-average returns over the next decade (no surprises if they do), the opportunity cost to the shareholders, including the controlling shareholders, would be massive. For instance, at 15% returns, Rs. 1,000 crores would earn about Rs. 3,000 crores in 10 years. Try translating this on the investment of the size that the company has envisaged in bad businesses. The difference when compared to the actual returns earned on these investments is the opportunity cost for the shareholders.

Profit margins in retail are very bad; unless you can turn over inventories at a very high rate, you are sure to earn worse-to-bad returns. Let's not talk about telecom / broadband business which is a technology-driven business.

Taking a leaf out of Exxon Mobil
Why can't the company which has a good operating business already stick to its roots? Taking a leaf out of Exxon Mobil would not be bad. Exxon has 3 segments: Upstream, Downstream and Chemicals, all in energy business. Return on capital employed is 26% (Upstream), 19% (Downstream) and 22% (Chemicals). Average for the company is 24%. On about $171 b capital, the return is about $41 b as of December 2011. Current market value of Exxon: about $410 b.

In contrast, Reliance Industries market value is just over $50 b.

Potential in energy business
There is immense potential for the company to grow within its current operating business, viz. energy. India needs energy; the world needs energy. Would it not be good for a Rs. 5,000-plus crore a quarter cash-generating company to get into profitable operations (based on price-value propositions) rather than getting into growth just for the sake of growth?

Imagine the amount of competition in retail and telecom; it's a little optimistic to think that the company, even with its muscle power, will be able to pierce into the competition and make its mark, meaning earn above-average profits.

There is no point providing capital to a business if it is not able to earn more than its cost of capital. That is corporate finance and maximization of shareholder value.

It would have been better for the company to pay heed to the fact that obvious prospects for physical growth in a business do not necessarily translate into obvious profits for investors.

The current year results reflect the following (stand alone numbers 9-month ended 31-Dec-2012):

These stand alone numbers are not strictly comparable to the consolidated numbers mentioned above. Nevertheless, it appears that return on capital is getting affected.

There is no mention of total capital employed so far in retail and telecom operations.

We hope that these businesses yield above-average profits in the years to come. Hope that is. We sincerely hope that this company goes a long way further in the global arena.

voilà! interest rates

One of the main factors that affect prices of any asset held for investment is the interest rate. The more it changes, the more it affects the prices and thus, the investment performance.

So, we have the scapegoat, blame it on the rates.

For bonds it is quicker: It is quite clear that when interest rates go up, bond values fall and vice versa.

For equities it is gradual but sure: For equities, it is the same since the current alternative options (bonds) appear to be more attractive. The opportunity cost of investing in equities goes up, and consequently, their intrinsic value goes down. Cost of borrowing goes up when interest rate goes up. Equities will appear to be overvalued if their prices don't fall to a level that is reasonable. To adjust to a more rational market values, it will take more time for equities than for bonds.

Inflation also is affected by the level of interest rates. So, watch out for that long-term, risk-free government bond rate.

Here's the historical information of the long-term rates in India and US.

Low interest rates during the period 2002-2005 made immense sense to invest in equities rather than bonds. For the last 2 years we have been in the 8%-regime, which is also the mean rate over the long period. One reason it has been holding on to that level is the level of inflation. It hardly makes sense to invest in a risk-free rate lower than inflation. We can argue that when inflation is tamed down, interest rates are more likely to go down. I cannot make a prediction on that.

US is experiencing one of the lowest interest rate periods in its 100-year history. While the economy did extremely well since low rates of 1940s, it is a challenge for it now to replicate its past performance simply because of its sheer size. Now if it can clock a growth rate that is 1.5-2 times its long-term rate it will be a stupendous performance. If you believe in corporate America to increase its profits and cash flows in the next decade and more, this is the best time to invest there. I cannot predict the future rates here as well.

So much for the interest rates and their magical powers.

aig: a strange suit

The company goes bankrupt, seeks help. The savior comes in and offers help in return for a majority ownership; eventually the company survives. The previous owners, now, are furious and suing the savior, and may be the company as well. Strange as it may feel, such is the gratitude.

AIG's share price fell from $70 to $1.25 in Sept-2008, a loss of 98% value. It reported loss of over $13 billion from Jan-2008 to June-2008.

However, since the US government's bailout there has been a steady recovery of the company's market value:

Jan. 7, 2013	58.57B
Sept. 30, 2012	53.45B
June 30, 2012	57.57B
March 31, 2012	58.48B
Dec. 31, 2011	44.06B
Sept. 30, 2011	41.66B
June 30, 2011	55.61B
March 31, 2011	63.14B
Dec. 31, 2010	8.081B
Sept. 30, 2010	5.284B
June 30, 2010	4.652B
March 31, 2010	4.607B
Dec. 31, 2009	4.036B
Sept. 30, 2009	5.936B
June 30, 2009	3.122B
March 31, 2009	2.691B
Dec. 31, 2008	4.223B
Sept. 30, 2008	8.954B
June 30, 2008	70.47B
March 31, 2008	109.09B

From a low of $2.69 b the value has recouped to $58.57 b.

It would be difficult to imagine what would have happened if there was no help from the government. Only based on an analysis of no-help valuation to post-help valuation it will be possible to award justice.

One way to calculate the value of benefit to the shareholders (other than government) would be: The difference between $2.69 b accruing in full and that portion from $58.5 b accruing to them. That is, how much their shares were worth before bailout and now.

It is easy to assume that under bankruptcy the sale of assets would have been at distressed values. Alternative argument from the claimants should be demonstrable. Otherwise the case is void ab initio.

return on investment

Return on investment

There are no set rules to arrive at the required rate of return on an investment. We are excluding mathematical models of corporate finance here.

While we have discussed this in the past, it is interesting to see it in the right perspective.

How have you done

Consider that you are investing in an equity asset with Rs.100, and at the end of the year its value goes to Rs.115. Well done, you have earned 15% on your investment.

But before you give a pat on your back, you need to take note of the inflation, treasury bond rate and the broader market.

Only when the inflation is < 15% you have done fine. That is, you have exceeded your purchasing power. This is the first step in measuring your performance.

Next, you check out the treasury bond rate. If your return has exceeded this rate, you have done well. This is your second measure.

Finally, you come to compare your performance with the market itself. If, say, Sensex or Nifty performance for the year is < 15% you have done well.

You should not compare each rate in isolation; it would be misleading.

For instance, if your performance is 4%, market index is 1%, but the inflation is 8%, you have failed in the fundamental principle of investing, i.e. to increase the purchasing power by postponing current consumption.

When you earned 10%, market earned 9%, treasury did 8%, but inflation was 10%, you are left where you were. The monster of inflation has done you - you are left with nothing at the end of the period.

Similarly, if you are able to beat inflation and market, but treasury rates are better than yours over long term, it would still not make sense in investing in equity.

The rules for the expected return and performance

Therefore, the simple rules for the expected rate of return (you can call it discount rate) should be:

1) First, to beat the inflation - you have increased your purchasing power. Give yourself an A;

2) Then, to beat the treasury rates - you have done better (assuming treasury exceeds inflation). Give yourself a AA;

3) Finally, to beat the broader equity index (not sectoral index) - you have done very well. Give yourself a AAA.

Add some stars to your rating depending on the number of points by which you have exceeded the comparable rate.

If the market has under-performed the treasury or inflation, you still got a AAA.

The discount rate

Let's say, once you have estimated the inflation (don't have to break your head for this; historical rates and future economic prospects should be able to guide you), the treasury rates (same analysis), and the market return (same analysis), you simply have to add a few (you choose) points to arrive at your expected return on investment.

Note that if your estimates of inflation, interest rates or the market return are a bit different from the actual in the long term, it's not a big deal since your discount rate is meant to be an estimate not a precise rate.

Well, your discount rates are in front of you. You don't need CAPM or any other model to estimate your cost of capital. 

aviation fuel and risk

If you are in a bad business, you generally can't help it, or help yourself. Well, if you are in airline business, we wonder who can help you.

There are too many variables which are likely to outsmart this business and its owners. For one, it requires a large amount of capital expenditure just to be where it is. Then are operating costs which are beyond management's control.

Take for example, fuel costs of airlines. If there is no fuel, the fleet can't fly. Common sense. If they don't fly, there is no revenue; no cash to settle obligations. The circle is generally vicious. Aviation fuel is the single most important component of operating costs of an airline business. And Alas, you cannot manage it. The fuel costs are beyond the control of management. The prices fluctuate at random. The steeper they go, the higher the airlines suffer.

Take a look at the historical oil prices:

And the aviation fuel prices in the past year:

 Now, have a look at the airlines' income statements:

At current prices, fuel costs are about 50% of revenue generated. That means, to achieve an operating profit, all other costs will have to be below 50% of revenue. There are employee costs, lease costs, aircraft maintenance costs, airport costs, depreciation, and many other costs. To bring them down to make way for operating profit is a challenge. High interest costs (as the business requires huge capital investment usually there is high debt) can turn operating profit, if any, into much lower net profit or even loss.That's why airline business is such a pathetic business. Too much cash inside, too little or no cash outside.

Getting back to fuel costs, is there anything management can do to tackle it? Some do; they manage their fuel costs. What are the options available? You cannot fiddle with the volume of fuel. Then it's the price we are talking about.

1) Some airlines do nothing about their fuel costs. It is a good choice if you see falling prices. If oil prices keep rising, you can see the pictures above.

2) Some enter into forward contracts for oil. The price of purchase is locked in for the agreed period. It is a good strategy if you see increasing prices. But if the prices fall, airlines take the hit.

3) Instead of forward contracts, some airlines buy call options for oil. The airlines can choose to exercise the option (if prices go up) or buy market (if prices go down). This is a good choice if you don't know what is going to happen to the prices. The cost of the call is the premium paid. The prices have to be good enough to give you a better total cost including the premium.

4) The airlines have another choice, selling put options for oil. Letting someone else have the option to sell, that is. Airlines get the premium upfront. If the prices fall, the buyer (of the put) will exercise the option to sell at the agreed higher price to the airline. If the prices go up, the buyer will not exercise the option; but the airline will have to purchase fuel at higher prices from market. Its total cost is net of premium received. This is the least preferred strategy.

We can see that in one way or the other, the airline is exposed to the fuel price risk.

Let us once again conclude that airline business is such a lousy business to be in. Look elsewhere in the pond, or in another pond, shall we?