bayer-monsanto

Bayer has agreed to acquire Monsanto at $128 per share valuing its equity at $57 b in an all-cash transaction. To finance the deal Bayer intends to raise both debt and equity. If the $19 b mandatory convertible bonds are the only debt to be raised, it appears like the entire acquisition being financed by equity. Then by implication it is not an all-cash deal, but an all-equity acquisition. For that to happen, Bayer must consider that its stock is overpriced. That is the first explanation that Bayer needs to give to its shareholders, although the major equity increase is through a rights issue.

Bayer must also consider that value of Monsanto's operating business is higher than $66 b. But is it? 

Monsanto is a mature business. Its revenues have not moved much in the past three years. And it has been generating steady cash flows. How much its revenues could grow in the next 5-10 years? Perhaps they would grow at a modest rate which would also be its perpetual growth rate; Monsanto is not a high-growth business. As of May 2016, Monsanto had $10.56 b of debt and $1.37 b in cash. 

If we consider operating margin of 25% and return on capital of 20% as sustainable for a foreseeable period, we can make value of Monsanto's business a function of perpetual growth rate and expected rate of return. 

For the analysis, I have not adjusted research and development expenses that Monsanto charges to its income statement. It would be much better if that is accounted for as an asset and amortized. 

The perpetual growth rate should be sustainable and reflect its mature business profile. Expected rate of return, which becomes the cost of capital, should be based upon the opportunity costs available at the time of acquisition. Of course, it should reflect the riskiness of cash flows; but how risky these cash flows are is a matter of perception. Rather than relying on CAPM, to supply a cost of capital, I would rather use a rate that I see is suitable for the acquisition. After all, if Bayer has opportunities to invest in a business that has an expectation of 10% rate of return, why should it invest in a business that can give 7%? As of now, the 10-year treasury has a yield of 1.69%. Obviously, Bayer would like to beat it, but by how much? 

If revenues grow at 3%, Monsanto will generate free cash flows of $2,134 m. Value of the business now depends upon the expected rate of return on cash flows. 

It looks like at 7% rate of return, Bayer is expecting value increase from control and synergies of 22.39%. This is to say that Bayer expects to increase growth rate in revenues, increase operating margins and increase return on capital after the acquisition is complete. How feasible is that? I am not too sure of growth rate, but if Bayer achieves an operating margin of 30% on a sustainable basis, it appears to have nailed the deal at 7% rate of return.

If the expected rate of return is higher, obviously Bayer has a tough job ahead.

To justify the acquisition price without benefits from control and synergies, Monsanto needs to grow at a much higher rate on a perpetual basis. 

At 3.73% growth rate, Bayer should expect a rate of return of 7% on the acquisition. Any higher expectation would put Monsanto under immense pressure to grow. It looks like a rate of return of 10% is not feasible.

If Monsanto grows at a much lower growth rate of 2% (operating margin of 25%), Bayer will have a lot explain to its shareholders. 

That is even when Bayer manages to increase operating margin to 30%. 

Such is life even for the corporates. It is both uncertain and filled with probabilities. By the way, Monsanto is still trading at a 20% discount to the acquisition price. Investors, who have faith in this acquisition and Bayer, still have the opportunity.

questions to buffett, 3 and another

I have always wanted to ask Warren Buffett a few questions, which have been in my mind for quite sometime. I have 3 questions for him, and another as a bonus question.

why back out of own path
Buffett was quite cool when he said what he said in 1955 as a 25 year old.

I was blown away when I first read the Forbes article. Here's someone, barely 25, talking about retirement in 1955. He did not mean to retire, retire like everybody past 60 does. He was talking about teaching and reading, and yet, confident of becoming rich managing his own cash. That's not retirement, but financial independence as we see it now. He did not want to be part of the rat race. He neither had plans of a partnership, nor taking up a job. For me, it was a profound statement because personally I could very much relate to it.

So then why did he choose to form the partnership?

Why did he himself offer to form the partnership when he thought he was going to be quite happy (and also rich) doing what he wanted to do, i.e. be on his own not being accountable to someone else?

why manage other people's money
Buffett is arguably the best investor the world has ever seen. I don't think there can ever be another of his kind. His ability to pick stocks is not matched by anyone considering consistency and duration.

If he had not formed the partnership, and opted to manage his own capital instead as he wanted to anyway in the first place, he would as well have achieved superior results. Perhaps, over the long period, the rate of return might have been higher because of the lower base. When he closed his partnership in 1969, its assets were $100 m, and Berkshire today has billions of dollars to manage. Both at their respective times are large numbers to invest.

Buffett's actual performance on Berkshire market price is 20.9% over 51-year period (2015), and 30% over 25-year period (1989).

If Buffett had listened to his heart in 1955 and chosen to manage only his capital of $127,000, its value would have been $11.2 b by 2015 considering 20.9% return. If we consider 25%, the capital would have grown to $82.8 b. No wonder compound interest works like magic; I dare not think of 30%. He is worth $67.6 b as of now. But that hardly matters, does it? He would be worth $1 b at 16.1%; a piece of cake for him.

Beyond a certain point, all dollars are directed righteously to charity. His frugal lifestyle hardly requires much cash; most ordinary people could have a similar lifestyle, but alas, they don't; that's a behavioral pattern, which I reserve for another day's discussion.

My point is whether he would be worth $11 b, $82 b, or $67 b is irrelevant. The question is why did he choose to manage other people's money? I don't consider taking cash from others and being obligated to the responsibility of keeping them informed of all times in terms of targets, key information, explanation for gaps, positive or negative, between actual and targeted, is a good idea. Definitely not for someone who is as smart as Buffett is. Perhaps, he wanted to get rich a bit quicker collecting performance fees, did he?

why close partnership and then start allover
In his 9 October 1967 letter to his partners, Buffett first mentioned about change of investment environment and personal factor. He noted that he did not want to form habits that ceased to make sense. Change of heart, so to speak.

He said he also wanted to do things which were non-economical, rather than only chasing the biggest point gains in his economic activities. He said he preferred, but did not say he would, to own controlled businesses that let him be with people he liked and have a life personally enjoyable.

Finally, he informed his partners in his 29 May 1969 letter of his decision to quit.

Much the quantitative guy that he was at the time, under the patronage of his mentor, Ben Graham, Buffett noted that good investment opportunities were lacking. Stock prices were very high; value did not seem to make sense.

He formally informed them that he wanted to retire. He did not mention what he meant by retire, though.

He mentioned quite frankly that he did not understand the investment environment, and did not hope to get lucky with other people's money.

Yet, he did not have a plan for the future; but he did mention that his priorities at 60 would be different from those at 20. I thought his remarks in 1955, 18 years prior, were more clear.

He was worth $25 m at that time, and could have chosen the path he had seen in 1955. If he had, his capital would have been worth $65 b in 2015 at 18.6%; $15 b at 15%. So he would be easily worth between $15 b and $65 b today had he chosen the path of a 25 year old.

So again, why did Buffett, despite all his aspirations to detach himself from economic only activities, continued to engage and immerse himself in only business and investment? Perhaps, he thought advance premiums from insurance operations were sort of free capital (when managed well like he did) compared to his partners' capital which had a cost, did he?

why coke

My final question, and I cannot resist this. Why coke?

the tap dance
Buffett could have done this or that. In the final analysis it really does not matter. In fact, from my personal point of view, and I am sure from world's point of view, it was good that he did what he actually did. If not, we would not have got the Warren Buffett; we would have missed his philosophies, his thoughts, and his wit; and that would be a big loss for mankind.

It gets better from his point of view because he really seems to enjoy what he has been doing for years. No wonder he tap dances to work.

Yet, if only he could answer my questions.

tata coffee: not much to take out

Tata Coffee's market value increased from Rs.5,074 m (high) in 2006 to Rs.23,533 m in 2016. It was as low as Rs.3,117 m in 2006. One would have earned 16.58% or 22.4% depending upon when one bought it, and if one had bought it. Not bad. 

Nevertheless, in 2016 the investor would have made 3.23% based upon the high price and 29.11% based upon the low price in 2011. The disparity is because of the double whammy presented by the market itself: a high PE of 27.67 and a low PE of 9.04 for the stock in 2011. 

In the last five years, revenues increased by 6.28%, yet earnings per share increased by 10.18% helped by other income and exceptional items. The average operating margin has been approximately 14%.

The return on capital has remained low, and was 9.1% in 2016. The company's annual average spend on reinvestment was Rs.278 m in the last five years. 

The alarming part though is that Tata Coffee's incremental return on capital has deteriorated. 

For any business to be successful, the key is to have the ability to generate a very high rate of return on its incremental capital. Unfortunately for Tata Coffee, the historical return on capital is already low, and its incremental return on capital is worse. 

With 19 coffee estates measuring 18,273 acres, instant coffee capacity of 8,400 MT; 7 tea estates measuring 6067 acres; and pepper vines, I need to estimate the growth rate, which if I use what I reckon is reasonable takes the value of Tata Coffee to a very low number. It's a struggle to find the growth rate.

The company has identified volatility in the international coffee prices, currency rate movements, high, price-sensitive competition, and dependency on nature as key risks involved in the business.

It has Rs.11,344 m of goodwill on the balance sheet; its subsidiary, Consolidated Coffee Inc. earned Rs.804 m of which, Rs.402 m was attributable to Tata Coffee. Consolidated Coffee owns Eight O' Clock Coffee Company.

The good news is that there has not been any dilution to equity. However, Tata Coffee should strive to have the ability to take sufficient cash out compared to what it has put in its operations. Can the company pull it off?

sovereign gold bonds, not colored

I have already displayed my dislike for gold for investment purposes; I don't like it for decoration either; wasteful altogether.  It is like when there is demand, supply shouldn't stop. To say that Indians are fascinated with the yellow metal is an understatement, what with 1000 tons of annual consumption. In a country where foreign exchange is precious, the dollar spend on gold never ceases. There isn't any appreciation for the lost opportunity; and the cost is massive.

After the government came out with the sovereign gold bonds, has the equation changed for gold buyers? The short answer is: No for those who love decoration; and may be for others. 

Before we go further, here's the brief.

• Bonds held in demat form and traded on the exchanges.
• There will be no physical gold.
• Time to maturity is 8 years.
• Interest is paid semi-annually on the investment at 2.75% pa, which is taxable.
• Redemption proceeds are calculated based upon units held at the prevailing market price.
• Capital gain on maturity is not taxable; before maturity is taxable.
• Minimum investment is 1 gram and maximum is 500 grams.
• Units held are protected; however, there is no protection against capital loss due to price fall.

At least there is no physical trace of gold; and with no foreign exchange involved makes it interesting. The government is not going to deliver gold upon maturity; all that is involved is, cash in and cash out. There isn't any yellow to be seen; and this might make the majority of Indians go gaga. Never mind, the few remaining will have reasons to think more rationally. 

These bonds are sort of derivative instruments, whose price would change based upon the price of the underlying, i.e. the gold. How likely are these prices to go up? If history is any indication, there might be a little scope to make these bonds good enough. From 1969-2012, the prices increased by 9.25% annually; from 1992-2012, 7.77%; from 1997-2012, 10.15%; from 2002-2012, 17.91%; from 2007-2012, 17.85%; and from 1969-2005, the prices increased by 7.57%; however, from 1980-2012, it was -(0.55)%. What is our fallback time period?

Now that the new tranche of September 2016 is coming up, the investor's prime concern should be where the prices would be in September 2024; and then marginal tax rate of the investor; all the rest can be safely ignored. The gold price for the September 2016 investment is fixed at Rs.3,150 per gram.

In the last 7 years, gold prices have increased annually at 10.65%. If this is any indicator, the bonds are going to be fabulous. Alas, that may not be the case; that is called the risk in the game.

Whether these bonds are any good for investment purposes depends upon the expectations of the investor. 

Let's start with the base rates. If the alternative is to keep the cash in bank deposits, the opportunity cost is about 7.25%; the long term government bonds trade at 7.12% today. This is the pretax rate of return. Since capital gains on the bonds are tax free, we need after-tax rates. For someone who is at 20% tax, the after-tax rate of return is 5.70%. 

So how much the gold prices will have to increase for the bond investor to match the government bond rates?

For someone who is in 0% tax rate, it is going to be 4.78%. That is to say, the gold prices will have to increase from Rs.3,150 to Rs.4,238 per gram by September 2024. 

For the 20% tax rate investor, the gold prices will have to increase by 3.78% annually until September 2024 to match the government bond rate of return.

Since I believe that investment in gold is based upon the greater fool theory, gold prices can be anywhere in September 2024. For each, the hunch is unique; yet, the hunch it is. 

For the 30% tax rate investor: If the price remains at Rs.3,150 in 2024, the rate of return will fall to 1.92%. To make it a little more interesting, to get 0% return (i.e. just the capital is protected) over the 8-year period, the gold prices will have to fall by 2.07% to Rs.2,665 per gram.

The gold bond investor would obviously expect more than the government bond rates. What if the investor expects 10% after-tax return?

Well, the investor at 25% tax rate would have to see the gold price increase by 8.46% annually over the 8-year period to get 10% after-tax return on cash flows. I come back to the hunch.