that fascination for gold

Indians buy a lot of gold is actually an understatement. They not only do it in truck loads, but also take immense pride in it. I am yet to find a reasonable answer to why would they buy 1000 tons annually spending $35 b. In Rupee terms, at a price of Rs.26,987 per 10 grams, the cost is Rs.2,698.70 b. That's the Indian enigma. 

For them, the opportunity cost of cash, stuck in this bad investment, is hard to contemplate. Yet, this cost appears to be much lower today because the prices have fallen in the last 5 years. 

The stream of cash flows, both in magnitude and consistency, they could have received in return from the investment made in any other (cash-flow generating) asset would have been impressive. It would have made them richer, and continued to do so. 

I have already mentioned how bad gold is as an investment earlier, and need not repeat it again. Nevertheless, it does not stop me from musing about it. 

value or growth

There is never a single approach to make money; this is granted. Each should embrace one that suits the temperament. Yet, there is only one way we can make money: buy low and sell high. Of course, we can sell first and buy later; however, the essence is the same. 

In investing, two types of approaches are well talked about. One is value investing, and the other is growth investing. Each camp is eager to take on the other. And boy, aren't those value investors too proud of their pedigree? 

I am going to keep a detailed post for some other time. At the moment, let's just highlight what the world thinks of these two approaches. Value investing is construed to be picking securities at low prices such as low price-earnings, low price-book values, high dividend yields. The key for value investors is bargain prices; they like to call it statistical bargains. Whereas growth investing is taken to be investing in stocks that have higher than normal growth rates. The key for growth investors is the growth rate, not price. 

I am not in either camp. It is better to be an investor than a value or growth investor. If investing is all about buying securities that are priced lower than value, that's all we need to think about. 

If what is given away is higher than what is received, it is not a business-like transaction. There are other places where such actions are applauded. That person will be well served if charity work is taken up; even here one can feel what is given away is lower than what is received; the pleasure of giving is beyond any pricing. 

In business and investing, profits are made by buying low and selling high. The focus therefore should be on the present value of cash flows and price paid. Four things are of importance here: There should be mispricing, which should be identified and then taken advantage of, and finally, the markets should correct that mispricing. 

In investing, the predominant factor is the mispricing of securities, not the type of securities or the period of holding. For an exceptional business, the longer the holding period, the higher the returns. For a low quality business, it is preferable to close out the transaction as soon as mispricing is eliminated by the market. When low risk arbitrage opportunities are available, the transaction period can be much shorter. 

All investing is value investing, for what is investing without value? Similarly, it isn't investing, if price paid for growth is higher than value of growth. It is a mistake to separate the two. And we know that if it is not an investment, it is actually a speculation. Heck!

m and a lessons

Firms can grow in two ways: By reinvesting their earnings back into the business. By using their excess cash or issuing stock to acquire other firms. Both represent reinvestment without which there is no growth.

Usually, firms start with organic growth. It is only when growth in their core business dries up, they look for other ways to grow. There is nothing wrong with the strategy, except that very few firms are good at identifying right targets at right prices. 

When managers stop getting projects that earn excess returns, it is wise is to accept the reality that the firm has matured and behave like one. Here, cash flows are more predictable, debt is more affordable, and dividends and stock buybacks are more value accruing for owners. Investing, financing and dividend decisions are less complicated. For a good business, continuing as a going concern, albeit at lower growth, works best. For a bad business, well, slow decline or liquidation is the preferred route.

There is a problem, though. It is not common for managers to exhibit common sense. As if to prove that common sense is so uncommon, they refuse to accept the reality. This leads them to do one of the two things.

They continue to believe that their business is always capable of earning returns that are acceptable. Attributing below par earnings to a temporary setback, they continue to pour cash into the business. Nothing is worse than dissipating cash, which rightfully belongs to the owners. This will only lead to the eventual value destruction of the business and consequently, poor returns for the stockholders.

If they realize that pouring cash back into the business is not a wise idea, they continue to believe that there are other ways to grow. They trust their hubris more than their capital allocation skills. The result is acquisitions. Most of the mergers and acquisitions around the world start with this framework. Firms need to grow; the bigger they grow, the faster they grow, the higher they are valued. It really doesn't matter whether just physical growth is good enough for the business and its owners. 

The rationale is the standard M & A lingo: Control and Synergy. Firms can be run better and the combined firm is always more valuable than sum total of the individual firms. In addition, operating, financial and tax synergies are quantified. Lo and behold, the firm with no growth becomes bigger and superior. There is more fun when stocks are issued instead of cash. Magically, growth is created without even using cash. 

What is lost somewhere is the fact that all growth does not add up. They are not created equal. There is a cost to the capital used. Again, it goes down to the basics. A business that lacks durable economic advantages is not worth buying, except as a bargain. A business that is unrelated to the core business of the acquirer is difficult to operate since there is lack of experience. In all acquisitions, the key question to ask is whether value of the business is far more than the price paid. Unfortunately, many acquisitions fail in all three counts: an unrelated business that is lacking durable excess returns acquired at an exorbitant price. Often, managers do not hesitate to use high leverage in buyouts. Even corporate cultures hinder otherwise workable mergers.

One justification offered in buying an unrelated business is diversification. A better idea is to let investors use their own cash in dealing with that issue. Owners give cash to the managers to invest in core business. Managers should rather stick to that instruction.

In fact, acquiring a business is no different from investing in stocks. All that matters is a good business bought at a reasonable price. 

What managers learn from history is that they don't learn from history. There is always more action in a vibrant market. While there are many acquisitions that have made sense, many more have not. Cisco did phenomenally well by inorganic growth in the past. HP did not.

The latest one playing the game is Anheuser-Busch InBev and SAB Miller. When price is at a 50% premium to the market value, and when we aren't even sure whether market value is lower than its intrinsic value, we realize the blame is on some one.

It is not that acquisitions are bad, it is only when asking price is way higher than the present value of cash flows that is available in return.

When price is high, no action should be the action. Like someone rightly said, all trouble starts when people are unable to sit quietly at a place.

indigo ipo

InterGlobe Aviation Limited is seeking to raise capital and accordingly, is filing its IPO in October 2015. There will be a fresh issue totaling Rs.12.722 b and an offer for sale of 26.112 m shares from the selling shareholders. Currently, there are 343.716 m shares issued and outstanding.

The promoters

The board

Managers

The objective of the issue
The objective of the fresh issue is explicit, while that of the offer for sale is implicit.

The story

InterGlobe Aviation operates IndiGo, India’s largest passenger airline, with a 37.4% market share of domestic passenger volume. IndiGo operates on a low-cost carrier (LCC) business model and focuses primarily on the domestic Indian air travel market. It primarily aims to maintain its cost advantage and a high frequency of flights - low fares, on-time flights and a hassle-free experience to passengers. IndiGo started operations in August 2006 with a single aircraft, and currently has a fleet of 97 aircraft all of which are Airbus A320. 

IndiGo claims that its market share has increased to 33.9% in terms of passenger volume. It has the largest market share in terms of top 10  metro-to-metro, metro-to-non-metro and non-metro-to-non-metro routes. Its maintenance costs are the lowest among Indian airlines. Its fuel costs are also among the lowest. IndiGo is the only airline that has been consistently profitable over the past seven years. Its order book currently is the largest with 430 aircraft. Average age of its current fleet is only 3.7 years. IndiGo's EBITDAR margins are the highest at 19.8%.

Extract from the prospectus:

One reason for IndiGo to remain profitable is that it uses only one type of aircraft (Airbus A320) with a single type of airframe and engine, which reduces its operating, maintenance and crew training costs; it also facilitates fuel efficiency.

IndiGo is strictly a no-frills product airline: It offers a single class of economy service, which allows for the maximum seating capacity of 180 seats. Unlike most full-service carriers, it does not offer a frequent flyer program, free lounges or include food and beverages in its ticket price for non-corporate passengers.  

Revenues increased from Rs.38 b in 2011 to Rs.139 b in 2015.

So far, it's been consistently profitable:

As of 30 June 2015, IndiGo had long term debt of Rs.35 b mainly aircraft related, and cash of Rs.22 b. There wasn't any short term debt. However, it remains to be seen how non-cancellable operating leases have been dealt with in the books. Any such commitment is a form of debt. 

The airline has been generating free cash flows:

Just that those dividend payouts appear to be special and intentionally managed.

Who are going to make money

There are others who too get to make money

What can go wrong

While the majority is gung-ho about this IPO party, it is worth knowing the risks highlighted in its Red Herring Prospectus. 

There are several legal cases pending against the company amounting to at least Rs.9,642 m. Of course, the final outcome depends upon the probability of ruling. The present value of the probable amounts will affect its value. 

The prospectus rightly notes that airline business is a low margin and high operating leverage business. Especially, aircraft lease and acquisition costs and engineering and maintenance costs cannot be postponed. The industry is laden with intense price competition. 

Aircraft fuel costs represent the single most significant cost item for an airline accounting for almost half of its total operating costs. Fuel costs vary in terms of fluctuations both in the international oil prices and in the US dollars exchange rates. For an airline, the ability to pass on increases in fuel costs to the customers is limited. Whether is worthwhile to hedge oil prices risks is open to debate.

IndiGo has plans to expand its current routes and also to other tier II and III cities in India, and later to look for expansion of routes in South East Asia, South Asia and the Middle East. How far it will be able to replicate its LCC model is the moot question. 

It has agreed to purchase a total of 430 Airbus aircraft under its 2011 and 2015 purchase agreements. This right is generally assigned to a third party lessor, and the company takes delivery of the aircraft under a sale-and-lease-back agreement. If the business faces adverse conditions or if the lessor defaults, the financing of aircraft would be in trouble. This will have the biggest impact on its ability to continue as a going concern. 

Extract from the prospectus:

The company is making some interesting statements about transactions with its related parties. Check out the risk factors # 4 in the prospectus. It is almost hinting that these transactions were not on an arm's length basis and might have adverse effect on its cash flows. 

The aircraft leasing and financing arrangements have restrictive covenants, breach of which might adversely affect its survival.

The company has acknowledged that there are lapses in its internal controls, and the auditors have qualified on the delay in dealing with certain statutory dues. This also speaks about the quality of management.

IndiGo has also acknowledged that it is seeking an implied valuation for its equity in excess of the international LCCs such as Air Asia, Cebu Pacific, Ryanair, Southwest Airlines, Spirit Airlines and Wizz Air. Higher issue price will adversely impact the return on investment for the IPO subscribers.

The company has been subjected to an ongoing investigation regarding competition and cartelization. 

The managers have intentionally turned book value of equity to negative by paying out special dividends to the existing shareholders. This speaks about the intention of both managers and selling shareholders.

While revenues are mostly earned in Rupees, a significant portion of costs including leasing and financing, engineering and maintenance and aircraft fuel are incurred in US dollars. There is a clear mismatch between the cash flows, which is rather difficult to fix unless the company uses derivatives to hedge its foreign currency exposure.

There is a likely dilution in equity due to 1,111,819 shares granted through employee stock options at an exercise price of Rs.10 per option. In addition, 578,746 options are proposed to be granted at an exercise price of Rs.10 per option, and 2,528,928 options are proposed to be granted at an exercise price per option equal to the issue price.

We can get to know more of the risks (there are 68 in number) highlighted in the prospectus. Check them out. 

IPOs are diced against investors

In addition to these, there are some obvious risks for investors in any IPO. Here are a few sellers who know more about the business selling shares to a large number of buyers who know much less (or mostly nothing at all) about the business, and these sellers have the option to choose the time to sell the shares to buyers having no such option and at a price implicitly chosen buy the sellers. 

What do we expect? Unless the sellers are dumb, they would choose a rising market and price the shares so that the collections are the highest. IPO is indeed a very good mechanism for promoters to get rich quickly. The dice is rolled against the investors; so it is always the buyers beware. There is no point in blaming the sellers. It is never a fair game. 

The kind of profits that are going to be made by the promoters can be noted from this:

The basis for issue price

For sellers, the determination of issue price is easy for obvious reasons, nevertheless it is noted in the prospectus in a manner that is to be noted. However, it will do well for investors to know that due to fresh issue of shares and through employee stock options, there will be dilution in both earnings per share and return on equity in the coming years.

It looks like IndiGo is better managed compared to any other airlines in India.

Extract from the prospectus:

I don't really like EBITDA as it is dangerous to assume that capex requirements are offset by depreciation and amortization.

Here's EBITDAR for airlines extracted from the prospectus:

No wonder then that IndiGo is seeking higher valuation compared to its peers. 

To be or not to be 

That is the question. I am not considering this IPO for two reasons: Airline is inherently a bad business. I am as biased as one can be towards an IPO, that is any IPO. I like to play the game my way.

You have your prerogative too. You can ask whether IndiGo is worth Rs.32 b.

when capital was free

The team was evaluating an acquisition for a large holding company. It was full of qualified professionals, CFAs, MBAs, lawyers, engineers and analysts; and certain areas such as market research were outsourced. In addition, there were top bankers as investment advisors, and two of the big four accounting firms carrying out financial and tax due diligence. In effect, you could not have asked for a better qualified analyst team.

The holding company (let's call it a private business, although it wasn't) was the investment vehicle for its owners. The capital, all equity, was supplied by the owners. The company was never short of capital as the managers asked and owners gave. The quarterly reporting was filled with colored graphs, charts and presentations, but devoid of any meaningful analysis and action. Nevertheless, it did not matter because such were the owners; may be it was in spite of the owners. Equity was treated virtually free of cost. No wonder then that performance of historical investments, spread across the globe, was not adequate considering the opportunity costs. None cared; whatever was earned on the costless capital was more than adequate. 

The target company was in the commodities business and was exposed to cyclical overtones. The historical performance was very good, and it was majority-owned by private investors. 

The sellers were more pronounced on two matters: Their asking price was fixed and not available for any negotiations. Furthermore, certain key information that mattered was not to be disclosed until the deal was signed. The double whammy was also conspicuous in its absence in the buyers' den. It wasn't laughable; remember, all capital was free. 

As I was discussing with an analyst in the team about how the valuation of the target was going to be done, his reply was obviously based on the discounted cash flows. When I asked what if the value came very different from the seller's price, the reply was that the team did not care about the seller's price and would ensure that their bid would prevail, and the buyers would be able to get a high return on capital. All I did was smile softly from outside and laugh loudly from inside.

The analysts and investment advisors took cash flows and growth rates, obviously supplied by the sellers, that were not only aggressive but also questionable. They were plotted on a complex model and presto, the value was exactly equal to the asking price. Wasn't that magical? Of course, there were meetings with the sellers, and lots of it, to discuss, question, demand and negotiate. Yet, the result was more predictable than any other.

In that paradox, the buyers spent a lot of time, resources and money, and then botched in the name of thorough analysis. They compromised the first principles of investment all through. It appeared that they did not understand the business, for they would not have accepted unrealistic cash flows. They went carelessly and desperately after the business that did not have any durable competitive advantages. It was prone to economic cycles. They did not have a clue about the intention of the incumbent managers, although, it was agreed that they would continue office after the take over on terms that were not in the best interests of the buyers. Finally, the price that was paid was quite incompatible with the value of the business.

What the owners got in the end was a commodity, cyclical business that had no competitive advantages, with debt disproportionate to the size of equity, and price that was outsized.

The epilogue was that cash flows did not meet the projections and goodwill was fully written off. So what, for the owners, this was only one more addition to the existing deteriorated investment portfolio of the holding company. After all, the managers and owners were consistent in their behavior, except that this particular acquisition was a bit heavy on their pocket book.