it's all about the long term

This company was incorporated in 1994 and came out with an IPO in May 1997. As per the company itself it serves consumers, sellers, enterprises and content creators. The business is seasonal with the largest contribution (take a third) to revenue taking place during the last quarter ending December each year.

 

But the interesting part is the journey which has been amazing. To see why, just have a look at this:

 

 

In the 13 years which ended on 31 Dec 2011 the revenues increased at an annual rate of 40%. Operating losses were turned into profits of $862 million pretax. Even with very low margins the return on capital is mind-boggling. Return on equity is pretty decent considering the current times.

 

Virtually entire capital funded by debt and equity is sitting in cash. It seems like this business is actually funded by suppliers (trade payables) and customers (advances). Isn't this amazing? If you are a business owner and are able to squeeze both customers (less or no credit) and suppliers (more credit) on a long term basis, you probably have immense competitive advantages and entry barriers. In 2011 the company had about $788 million of unredeemed gift certificates (advances) which if not redeemed will go to revenue.

 

It operates in a highly competitive environment but has done well. Just in case you are wondering which company could this be, here it is. And the reward to the shareholders:

 

 

 

Not bad for (an online) retailer business.

 

As Jeff Bezos said in his 1997 letter to shareholders, it's all about the long term. The business was first started to take advantage of the then ruling that online retailers did not have to collect sales taxes in states where they lacked a physical presence. 

 

The question is: Could anyone have thought in 1998 that this loss-making business would one day sell at about $120 billion? Well, not many.

oracle of redwood city

Oracle Corporation is the world's largest provider of enterprise software and a leading provider of computer hardware products and services as per its filing with the SEC. The company is organized into three businesses - software (new licences, and licence updates and product support), hardware systems (products and support) and services (consulting, managed cloud services and education services). A large portion of revenue (about 70%) is contributed by software, followed by hardware (17%) and services (13%). In short, this is a hi-tech company.

Being a technology company, it is subject to several risks, primary being technological obsolescence and competition. The 10-K filed by the company lists a number of risk factors. These are sort of caveats on company being unsuccessful.

Given the background how has the company performed?

In March 2008 it had a market cap of $100 b and now it is selling at $150 b; about 8% annual return over 5-year period is not bad, especially under difficult economic conditions.

May 2012

That's the story from the market. But how has the business performed? Revenue for the year ended 31 May 2012 was $37 b which has grown 13% annually over 4-year period and 16%+ over 3-year period. Not bad at all considering the state of the global economic conditions.

Key aspect of this growth, however, has been acquisitions. The company realized that only software services from its original portfolio was not enough; therefore it has been acquiring other companies; recent acquirees include: Taleo Corporation ($2 b); RightNow Technologies ($1.5 b) and Art Technology Group ($1 b).  Standout acquisitions include Sun Microsystems ($7.3 b) in 2010 and BEA Systems ($8.6 b) in 2008. Total goodwill on acquisition stands at $25 b as of May 2012. The economic value of this goodwill remains to be tested over the next few years, though. If the acquired businesses do not generate adequate cash flows the goodwill will turn out to be just water.

The company has about $14 b of operating income and about $10 b of net income, both of which have grown over 15% over the last four years. Debt ratio has been respectable at about 29% on average. Almost half of total assets is cash ($ 30b). With operating assets of $30 b, after-tax return on capital (over 30% average) and return on equity (25% average) have been extraordinary. Average free cash flows to equity have been more than $5 b over the past 3-4 years.

This sounds one heck of a business. Can this continue? Recent quarters also have not been bad (analysts are not happy though since software segment has not been good enough).

Hardware...at this time?

Why did the company buy Sun Microsystems which is into hardware business? It is $7 b and the world is not so much gaga over hardware these days. Remember all growth is not value.

Use of cash

The company has also been using its cash for stock buy-backs, a signal from management that its stock is under-priced. It bought back $5 b worth of stock in 2012; and $5 b again in the last 2 quarters ended Nov 2012. The question is: is the stock cheap? Say the truth.

Valuation

At $150 billion the company is selling at about 11 times pretax operating income and about 15 times 2012 earnings. Trailing-12-month multiple is also similar. It appears on a reasonable valuation level if you see it from the historical standpoint. This means if you buy the stock today and expect the company to replicate its past performance in the next 5-10 years, you should be able to get about 10-20% annual returns. That's cool!

But wait.

What if the company does not do as well in the future? What if its growth slows down? What if it does not find good acquisitions? What if it overpays for future acquisitions? What if its past acquisitions fail to generate adequate cash flows? What if it fails to catch up with changes in the latest technology? What if the margins come down (they are hard to maintain in the long run)? The average annual capex (before netting off depreciation and amortization) has been $4.5 b. Similar amount is spent for research development activities as well. The company will have to spend similar or more in the future and these reinvestments will have to translate into growth - which will have to translate into cash flows which will have to translate into increase in value of the business - which will translate into higher stock price. Bingo! you have created value for the business.

Estimating technology business cash flows....is that possible?
I am not tech savvy; I don't even understand what Oracle does in the first place. That new boy in town...Cloud Computing...the name itself is scary....That didn't stop me; when I tried more realistic assumptions of free cash flows, growth (period) rate, terminal growth rate and discount rate (representing cost of capital or cost of equity as the case may be), I found the current price of stock at $31 to be expensive.

Who knows what's in store? Hardware days are gone; expensive software is being undone; cloud computing has arrived. Revenue pressures; margin pressures ahead.

But then you may have different set of assumptions. Management may have different assumptions.

How deep is ......let's explore! 

ongc punished for being good

The good news

ONGC has struck oil and gas in three places; but is it any good for the shareholders? Sounds weird, but the company is being punished for doing well over the past years. 

The bad news

The largest shareholder in the company is taking a ride at the cost of minority shareholders; reminds me of those classic conflicts in corporate finance. 

As per the company's 2010-11 annual report, although the average crude oil price was $85.09 per barrel (22% higher than previous year), due to subsidy burden borne (82% share), the net realization was at $53.77 per barrel. This is about 37% marked down. The subsidy burden was Rs.248.92 billion. 

I am not able to read the 2011-12 annual report as the pdf version is pathetic. However, as per the financial results presentation, the subsidy borne by ONGC is Rs.444.66 billion (more than $8 billion).

For the nine-month period ended 31 Dec 2012 the burden is Rs.371.08 billion. As per the presentation the total subsidy shared by ONGC from 1 April 2003 to 31 Dec 2012 is about Rs.2,040.23 billion (about $40 billion).

The reporting

The company's revenue is shown net of these subsidies in the financial statements. Nowhere in the income statement it is disclosed clearly. It would be more appropriate for the investors to see the income statement as follows for instance:

Unusual risk in the business

In addition to the oil price risk and exploration risks inherent in the business, the company has an unusual risk of subsidy sharing. If oil marketing companies are in pain, the medication costs are footed by the upstream companies. This is ridiculous. Why can't the two be kept separate? If the government wants to subsidize, why should it charge the minority shareholders of the upstream? 

The key beneficiaries of high oil prices are usually the upstream companies. In fact, they thrive when prices go up and suffer when prices are down. This is a key incentive for them to be in the business.

However, for the upstream companies in India, the story is shockingly different. High crude price is like a double-edged sword for the company; One, the input costs of business go up; Two, the subsidy demand from the controlling shareholder is higher which makes the net realization lower, much lower. The incentive to be in the exploration business is snatched away. Heck!

The game of subsidizing the crucial petroleum products is a farce, anyway. Let's wait for the 2012-13 annual report; I hope that it is at least readable.

manappuram's gold

The news is Manappuram Finance stock is down 30% in two days. Analysts are saying there are problems due to change in regulations and competition. On 19 March there was an announcement from the company that due correction of gold prices profit may fall. There was also resignation from a director.

Only time a lender will have to bank on the collateral is when he has not lent properly, i.e. he has violated the first principles of lending. The key to good lending is to ensure that the borrower has the ability to generate cash flows to repay debt. Collateral is just incidental; sort of a back-up. However, gold loans (or is it all loans?) in India don't appear to follow this rule.

Manappuram is a lender against gold collateral; the promoter-holding is 31.55% and the institutional holding is close to 40%. I am sure these institutions must be tracking this business. The company is worth about Rs.2,000 crores. 

 

As of 31 March 2012 it had debt of Rs.9,300 crores. The loans advanced were about Rs.10,000 crores as of that date. The challenge is recovery of these advances; it is a continuous challenge. Proper risk management holds the key: who you lend; how you lend; how safe are the assets; mechanism of recovery.

The price of gold as of 31 March 2012 was $1,660 t.oz; now it is $1,612 t.oz. During the period the price looked like this:

The highest point was close to $1,800 t.oz and the lowest was below $1,550 t.oz. The swing has been about 14% downward.

Gold holdings of the company as per 2011-12 annual report was 65.57 tonnes (about 2.1 million t.oz) translating to about $3.5 billion (Rs.18,000 crores).

The company is in the business of leverage; debt is high. Nine-month period ended 31 Dec 12 results show that earnings before finance costs were Rs.1,408 crores and finance costs were Rs.891 crores. Clearly there isn't much room to accommodate volatility in lending rates. If gross interest charged to the borrowers goes down it will be a difficult situation for the company.

It appears that average lending rate was about 24% while average borrowing rate was about 14%. The margin of 10% isn't very bad provided that the loans are good, gold prices remain stable and lending rates don't change.

This one is a tough business.

restrictive bank deposits.... uniquely unsafe

Fallacy of a decent investment

Imagine you have a deposit with a local bank which you had placed after careful analysis. You had concluded that there weren't much risks associated with the deposit although it might not be as safe as a government bond. It made a good deal earning decent, almost guaranteed, interest payments for you. In addition, some part of the deposit was fully guaranteed by the federal insurance. Not a great investment you thought but considering your personal finance, risk profile and behaviour, you thought it was alright. 

Bang! You woke up on a nice morning and found that the bank has suddenly decided to levy some sort of a charge on your deposit. You were not asked for permission; neither was there any choice. Now, you are one disgruntled investor.

Solving a troubled nation...the action

This is what has actually happened in Cyprus. Cyprus is currently in trouble due to its debt and could face bankruptcy if the bailout it is seeking does not come. It could also go out of the eurozone. The country's debt-to-GDP ratio is likely to go to 140% if that Euro 10 billion bailout is not there. In short, Cyprus needs money rather badly right now. However, a precondition to this bailout is: collecting about Euro 5.8 billion from the depositors. Cyprus is left with little choice.

The drama is just beginning to unfold. 

The breach of trust

This brings down to the fundamental principle of the investor rights: If a business goes under first payments are made to the senior security holders and last payments, if any, would go to equity investors. However, Cyprus banks are violating this basic principle. Losses are borne largely by the depositors, not much by the bond holders; and common stockholders....we don't know. But is this a fair game?

Cyprus has bank deposits aggregating to about $65 billion; which means about $4.4 billion (at 6.75%) to $6.4 billion (at 9.9%) will be collected from the depositors' money. These depositors include all kinds of savers: individuals, retired, institutions and corporations, both local and foreign. 

Greece, Ireland, Portugal and Spain, all of them have sought bailouts of some kind in the recent past. However, nothing of the Cyprus kind was seen before. There are probably political reasons around collecting money from the depositors. 

The reaction

Surely, if the charge is levied the repercussions would be noticeable: Investors would lose faith in bank deposits in any country, but particularly in the eurozone. The flight of capital would take off to somewhere outside of the eurozone. Banks would collect less in deposits, which means they will have to go to bond and stock markets for raising capital. Bank deposits would demand extra premium (to compensate for default and restrictions risk). The cost of capital for banks would go up significantly. 

Trouble when it walked in

Euro will still be troubled: Common  currency, common central bank and common monetary policy; countries giving up their right to print currency; surrender of the countries' sovereign powers - all of this would lose credibility, not because of Cyprus factor alone but due to collective troubles of the eurozone. 

The eurozone and Euro can be summed up by quoting Taylor Swift: I knew you were trouble when you walked in. The basic crime of Euro is having been born.

social service companies

We all know that the primary objective of any business is to make money for the owners. In corporate finance it is called maximization of shareholders' wealth. There is inherent expectation of increasing the firm value so that both debt holders and equity holders see their wealth grow.

This is the standard rule. Can this rule be broken? Sure; but then you have to come up with another objective which should satisfy stakeholders, say, capital providers, capital markets, employees, customers, suppliers, government and society. It is not easy, unless you are a not-for-profit company. I mean your primary objective is not to make money for the owners but to meet some social objective. An example: utility provision. Money-making becomes a secondary objective in this case. Typically, the government or the trusts carry out this kind of venture.

What if we can pick some publicly listed firms, whose primary objective is in sync with corporate finance, but in reality meets the objective of a not-for-profit firm, instead? Sounds weird; but it is actually true. Take a look at the following (incomplete) list:

These are the top loss-making companies in 2012 as presented in ET 500. (Click on PAT to get the list. LL means loss in both the years). These are what I call social service companies. Ignoring some who are exceptions and might turnaround, and those who fail to pay their dues all the time (social burdens), we can argue that these companies do at least some service to the economy, primary being providing employment. If it were not the case, why do they continue as going concerns? Optimism in capitalism is alright; but the shareholders should be wealthier if they shut down loss-making ventures and put their money in some other venture which would give them a decent risk-adjusted return.

The list is only illustrative; there are probably much more of this type listed on the exchange.

The sarcasm is rather a reminder of basic principle of corporate finance: if you can't make it, don't venture it. 

ril: lure of technology

Reliance Industries has intentions to change the game in the telecom sector. Investments lined up to the tune of $10 billion; sounds good, does it?

All this is being done apparently for two reasons: one is emotional and the other is growth. We have no response to the emotional aspect other than that this investment is coming from total shareholders' money (i.e. from the company itself), not from a selected few. As for the growth, the question is whether it will add value to the firm. Some growth does; and some doesn't. There are plenty of examples of bad growth.

Take for example: Bharti Airtel has been the undisputed leader of telecom market in India beating every other player; but only until recently. Now the story is quite different, if this has to be accepted. The return on capital has dropped significantly, by about 35%; no different for return on equity. This is probably thanks to its appetite for growth outside India. In the process it borrowed too much. The African safari has not yielded adequately. The market-cap has stayed at about Rs.120,000 crores for the last three years. We can argue that if the company continues to earn this kind of return on capital in the coming years, its value will fall significantly. The reason is simple: its cost of capital is way higher than the return made. Where is the logic in making more in a losing proposition? In fact, if the company has large capex plans and there is no improvement in return on capital, its value will fall sooner than anticipated. Can it improve its position? It is possible because investments in new markets, especially in this kind of business, take time to fructify. But not sure.

Coming back to Reliance, the question is will it earn adequate returns on the invested capital? Telecom is asset-heavy, technology-driven business; consequently, it is a high-risk business.

But then Mukesh Ambani is a master performer. He might prove everyone wrong. Time will tell, I guess.

gmr infra: selling core assets, a bad idea

A business could see cash shortages due to various reasons; one is leverage: it may have operating profits but not much cash at its disposal due to debt.

GMR infrastructure recorded a loss of about Rs.490 crores for the nine-month period ended 31 December 2012 compared to Rs.237 crores loss in 2011. Operating earnings were Rs.940 crores on revenues of Rs.7,400 crores.

The damage was naturally done by the finance costs of about Rs.1,500 crores, 25% higher than last year.

So it is a case of a business facing challenges of high leverage: About Rs.43,000 crores debt; Rs.5,300 crores cash; and equity (31 March 2012) of about Rs.7,500 crores. Naturally, we cannot calculate a meaningful return on equity. Approximate return on capital including preferred stock (assuming it is still there in the books) is less than 3%. Note that we don't have the latest balance sheet and statement of cash flows. Not sufficient interest coverage; not sufficient cash from operations. If the company has to go for a credit rating, you know what it should expect.

Return on investment so far: none for equity holders; not much for debt holders.

You may not have enough cash from operations; but that does not mean you keep funding your long-term projects with debt. But it is amazing to see how businesses all over practice this, and how lenders, for lack of a better word, keep fooling themselves.

The reality will have to catch up. This is how it goes: The obligation to pay off debt. But there is no cash! Can't borrow more. Let's sell assets. But there aren't any non-operating (i.e. excess) assets. Need to sell something that could be bought by someone. Let's sell some of our core operating assets. But isn't that a crazy idea? Why in the first place that was funded? Let's not get into any of that argument. We need to reduce debt. GMR has found itself in a cage along with its shareholders and lenders.

GMR is selling its Singapore asset and making a profit of Rs.1,350 crores. Cool! But is it? I don't know who has got the better deal here, GMR or FMP Power, the buyer. If the project is indeed profitable it is a bad idea to sell; if it is not, it is a bad idea to buy. That we will get to see sooner than later.

GMR will receive about Rs.2,600 crores from sale. Is that enough? What about the rest of the debt? Now the entire company is selling at about Rs.7,500 crores, significantly low compared to its 2009 value.

The puzzle is who is taking who for a ride: The management and board; the controlling shareholder; or the lender? It is a puzzle for sure.

ntpc: a poor state of affairs

Here's a company which talked too much in the past. A sample from 2007-08 annual report: "The company's performance in the stock market has been steady and robust amid the fluctuations and shareholder wealth has increased over three times in a period of nearly three and a half years since its IPO in October 2004. Our investor base has crossed the number of 1 million shareholders, indicating that your confidence in our company is continuously rising." ...."We plan to become 50,000 MW plus by 2012 and 75,000 MW plus by 2017. ..." This is from the chairman and managing director. That sounded good at that time. Market value of the company was about Rs.162,000 crores and had a lot of promise.

After that the story changes track and becomes a new story, (un)worthy of attention. Five years and the stock is not moving up:

Any other alternative investment would have been better for the shareholder. Even that fixed deposit with banks.

Well, there must be some reason for that. After all, the investors are not (that) stupid. This is what happened in the previous 4 years ended 31 March 2012 (stand-alone basis):

• Capacity increased from 29,000 MW to 37,000 MW;
• Revenue increased with a compounded annual growth rate of 12.7%; but operating profit by only 4.9% and net profit by only 5.6%;
• EPS increased from Rs.8.99 to Rs.11.19;
• Return on capital decreased from 15% to 12%; 
• Return on equity decreased from 14% to 13%;
• Stock price decreased from Rs.196 to Rs.163.

The stock price on 1 March 2013 was Rs.150. Net result of the management and board actions was a loss of about Rs.38,000 crores in market value over the period. There are some dividends paid out during the period. 

With all the odds, the broader market has increased by about 21% whereas NTPC is down by about 24%.

There have been so many issues that are required to be resolved including fuel sourcing, credibility of state utilities, land acquisition and environmental clearances. Above all there is the need for superior financial performance.

In 2012 annual report, the chairman and managing director says " ..... In the 12th Plan period the company plans to add 14038 MW of installed capacity to maintain its leadership position in the sector. Work on the projects of the 12th Plan period is progressing satisfactorily. The clearances and approvals are in place. Fuel for these projects has also been tied up including that from the captive mines, the first of which is expected to yield coal from next year. Tying up finances for the projects has never been an issue given the excellent rating that the company enjoys...."

So far the performance in the current year has been better; but I need the final analysis. Let's wait until the annual report is out.