the tata group

The executive chairman of Tata Sons said recently, "we have moved away from fixing to focus on growth".  I have not dug deep into the context behind the statement. What I know is that just physical growth will not contribute to value. That has to be accompanied with consistent excess returns. Value creation to shareholders is the primary focus for managers of any business. Their duty is only towards their owners; everything else is incidental. But the chairman knows better than we do. 

The Tata group sells from salt to trucks, covering the entire gamut of consumption. There are 17 companies listed on the stock markets, and have a total market capitalization of Rs.10,401 b ($148 b). In addition to these companies, there are many private organizations - including not-for-profit - set up to serve the society. With more than 700,000 people, the group is probably the largest private employer in India. That is commendable. 

This post analyzes only the publicly traded entities within the group. These 17 companies have total revenues of Rs.6,496 b and total earnings of Rs.560 b (March 2018). That implies the group is priced at an earnings multiple of 18.55. Although price-sales multiple is not the best measure - enterprise value to sales is better - 1.60x seems quite interesting.

Yet when we look a little closely, we can note some peculiarities. Consider this: Just one company makes about 70% of the group's market value. With Rs.7,185 b market cap, TCS stands singular. It is a little hard to believe that the rest of the group - 16 publicly traded companies - are only 30% of value, and are collectively worth only Rs.3,216 b.

One of the most important measures of how well a company is managed is the return on capital, and TCS stands out with stellar performance. It also generates large amounts of free cash flows. Titan also has superior return on capital over the past decade. But then market's inconsistency in pricing equities is evident: TCS contributes (Rs.258 b) over 45% of the total earnings of the group and Titan (Rs.11 b) only 2%, and yet, TCS is priced 27x and Titan 81x earnings. This is not to say that only earnings matter for pricing stocks; what I mean to say is that Titan is richly priced as of now considering its growth prospects and return on capital.

Tata Motors revenues for 2018 were Rs.2,954 b (over 45% of total group revenues) and earnings were Rs.89 b (over 15%); similarly, Tata Steel too had significant revenues and earnings for 2018; but both are priced less than 6x their earnings. For Tata Steel it is understandable because it is in the cyclical business, and its average earnings over the decade have not been impressive, and we are never certain about timing of commodity cycle. For Tata Motors, the situation is different; having had some good times through Jaguar, Land Rover in the past few years, with slowdown in JLR business in its key markets, the business is faltering. A large amount of capital is required for its ambitious electric vehicles project, and it is not coming through easily. We are not sure if those revenues, earnings, and more importantly, free cash flows are going to be large enough to price its equity. At the moment, though, Tata Motors is worth just Rs.519 b. 

If return on capital is less than cost of capital over a long period of time, it is not possible to have free cash flows. No excess returns, no free cash flows. Tata Steel and Tata Power have failed in this test. Tata Communications is worth Rs.147 b, and its performance has not been impressive either. Tata Chemicals showing has been deteriorating over the past decade.

Tata Global Beverages and Tata Coffee, both, have not had decent growth. Their return on capital has not been good. Tata Global is priced at 24x earnings (Rs.119 b), and Tata Coffee at 14x earnings (Rs.15 b). They may well have potential going forward.

Voltas growth numbers haven't been good, but it is priced about 30 times earnings. We haven't got much to say about Indian Hotels which is priced rather rich and is worth Rs.165 b now. Trent has low return on capital and free cash flows over the past decade.

Tata Elxsi and Tata Metaliks are performing well, but aren't big enough to make meaningful contribution to the group; yet. Tata Sponge and Nelco are collectively priced only Rs.15 b, and aren't the best performers.

For 2018, TCS, Tata Motors, and Tata Steel contributed about 85% of the total group revenues and earnings. In July 2017, I noted what would happen if TCS falters and JLR slows down. Well a little over a year, and TCS is doing fine, but JLR is actually faltering.

Yes, the Chairman is right, the group needs growth. But growth requires capital for reinvestment, and more importantly, for growth to create value, it has to show excess returns. Superior return on capital and free cash flows.

Tata group, no doubt, is a significant contributor to the Indian economy and society. It intends well and means well. With the change in focus, we are confident that the group will emerge stronger than before. 

tata motors, and jaguar, land rover

The market value of Tata Motors equity was Rs.575.954 b as of yesterday. As I write this post, while markets are still open, it is down to Rs.472.066 b. That is an 18% fall. 

The company has two types of shares: 2,887.348 m ordinary common shares and 508.502 m differential voting rights shares. The DVR shareholders are entitled to one vote for every 10 such shares held and dividends of 5% more than that are entitled to the ordinary common. However in the absence of any dividends distributed to the ordinary, there will be no dividends for the DVR shareholders. 

In June 2008, Tata Motors completed its acquisition of Jaguar Land Rover business from Ford Motor Company at a net consideration of $2.3 b in an all-cash transaction. The acquisition was on a cash-free, debt-free basis, but, Ford contributed $600 m towards the pension plans. In November 2008, Tata Motors market cap was at a low of Rs.65 b (less than $1.5 b at the 2008 exchange rate). That itself should have made the consideration over the top. But the chairman had said it was a momentous time for all at Tata Motors. Another Tata company, Tata Steel, had just acquired Corus for $12 b (608 pence per share against the original offer of 455 pence) in 2007. So the group was in an acquisition binge.

But then in 2008, JLR was losing money. Surprisingly, Ford had failed to monetize JLR. The financial crisis and subsequent recession meant demand for luxury cars (Jaguar) and SUVs (Land Rover) was slowing down. Confidence in the credit market was the lowest. Borrowers struggled for credit, and lenders were worried about defaults. The combination was unusual because Tata Motors was in the mass segment and JLR in the premium segment, and the synergy seemed to be out of place. For the first financial year after acquisition (March 2009), Tata Motors posted a net loss of Rs.25 b. The company also ended up with debt of Rs.219 b. 

Raising cash was a priority for Tata Motors. The sale of 1.3% holding in Tata Steel to the parent, Tata Sons, for Rs.4.85 b and a rights issue of Rs.41 b was not much compared to the capital needed. A turnaround in JLR was what was required.

And what Ford could not do for years, Tata Motors did in two years. Earnings for 2011 were Rs.92 b; for 2012, Rs.135 b; and for 2013, Rs.98 b. The catch was that Tata Motors local business wasn't doing well. In fact, it posted huge losses in 2015 and 2017.

JLR was turned around all right. But there was a cost to it. A good business is one which earns a high rate of return on its capital employed, and does it consistently. In this respect, we don't think Tata Motors standalone has been doing well. Tata Motors consolidated earned about 15% on equity for 2018. But then that was largely due to contributions from JLR as we have seen. Both revenues and earnings from JLR have been disproportionately large compared to the consolidated numbers. Whether it will continue in future is a question.

Tata Motors has poured in billions of dollars in JLR since acquisition. Yesterday when it released its 3rd quarter results (December 2018), the markets had a surprise. The company said that the carrying value of its capitalized investments were brought down by 3.1 b euros ($3.5 b). When the assets are not expected to bring enough cash flows to justify their carrying values, they are brought down to the level equal to the present value of future cash flows, and such impairment is taken to the income statement. This is a non-cash adjustment that does not affect the statement of cash flows. Yet, the indication is the JLR business may not do as well in future. One of the primary reasons has been slow down in China which was its biggest market. Tata Motors reported Rs.269.61 b loss for the quarter. JLR reported a net loss of 3.1 euros implying no profits even before this one-time impairment loss. The standalone business reported a profit of Rs.6.18 b.

JLR has announced plans to come out with electric vehicles on all models. It will require a lot of capital for investment though. Tata Motors domestic business is doing better than before. Time will tell whether each business will be able to justify the capital invested. For that to happen they will have to show high return on capital and generate large free cash flows on a consistent basis. We hope that the group will be able to wither the past and come out on better terms.

there are rules for debt

Debt is an obligation; and obviously, it has costs. First and the biggest one is the default risk. Taken to extreme, it can lead to bankruptcy. This is real; and many a business has succumbed to its savage. It is true for the individuals too. History has told us about people who had to pay hefty price for taking on debt. Yeah, debt is merciless. Then there is loss of financial flexibility. Cash gets squeezed for the borrowers when they need it the most; ouch. There is always a conflict of interest between the owners of business (equity holders) and lenders of business. Again, this comes into play prominently when the business faces downturn. The marginal cost of debt zooms up before the borrower realizes it. 

All this trauma comes with just one advantage; that is, interest payments are tax deductible. If someone is looking to take debt for an asset otherwise not needed, this advantage quickly dissipates. I have seen too many businesses and people doing this as a matter of fact; and I am not even making it up. Just look at history.

I am not sure if this article is pointing to anything dramatic. Individuals have always got lured to the illusions of the kingdom of debt. But then there are certain rules for debt. Borrowers don't follow them at their own peril. 

First is that you should not borrow if you do not need to borrow. Cash is king; and you can be the emperor caressing it, figuratively. 

Second is that you should not borrow to buy a depreciating asset. I can understand the enthusiasm for car loans; but believe me, they will only make the lender richer. A little bit of common sense should tell us, it is much better to work towards making ourselves richer.

As a corollary, you can borrow to buy or produce an appreciating asset, such as business projects and home. While we know intuitively that the value of business and home equity will grow over the years, it is not always true. Put it differently, if the growth in business or home values (earnings rate) is lower than the interest rate on debt, it isn't a viable project. Don't borrow at 15% if you can earn only 10% on that cash. 

In short, if you don't have the capacity to service debt, don't borrow. Lenders can take control and throw you out. There have to be sufficient cash flows to make interest payments and principal repayments in order to qualify for loans. It is the job of both borrower and lender to assess this capacity. Otherwise, borrowers will be lurking, and lenders will be looking at bad assets.

Lack of financial flexibility due to unnecessary debt is actually a deterrent to one's wellbeing. I am not sure why people have to surrender their time to others until (or beyond) they reach retirement years. Time is the greatest wealth to which we cannot assign a value. There are costs to everything. If you want a Mercedes, you have to sell your time (work) towards making cash to pay for it. That is true whether you borrowed or not for it. There are no free lunches anywhere. 

Of course you can choose to forgo that Mercedes, and pick a much cheaper car; or, even choose not to buy a car. Then your working time will fall dramatically. At least that is how I see it. Financial independence is something that I value the most. Freedom to do things that I like are invaluable to me. I feel sorry for people who keep working for someone else all their life because it is self-inflicted. If only they had planned their lifestyle and finances, they could be having fun in life all the time. This is neither intimidating, nor difficult.

I measure success in terms of how much fun a person has in life, not in terms of how much money he or she has accumulated. It is easy to have fun with much lesser money than you can probably think. 

infosys, analysts and investors

Here's the low-down on the analysts take on the Infosys stock as of today.

You could lose money on the stock according to IDBI Capital, while you could gain as much as 22% as per Jefferies. 

Is there an investor who is betting on the stock for one year? The person should be a trader, rather than investor, for the investors bet on the probability that the business behind the stock is going to do well over a long period. 

My take is that if the earnings per share grow at 5% over the next 10 years, the stock is going to give a return of about 8% including dividends, and a little more than 5% excluding dividends. 

By doing the buyback, Infosys has already done the job of EPS increase for the next year. Post buyback, Infosys will have 2173 million shares outstanding down from 2285 million. Operating earnings remaining constant, the earnings per share will increase by a little over 5%. Any upside in earnings, will increase the per share growth rate.

It is fair to say that for Infosys the operating earnings are expected to grow, not fall, even if it is at a lower rate. If it performs buybacks on a regular basis over the period, yeah, with much lower amounts, 5% increase in per share earnings should not be too difficult, again probabilistically speaking. Any higher growth rate should only increase the rate of return over the period. How much can Infosys grow? That is the question everyone has, and everyone is guessing. During these uncertain times, the guesswork is murkier. 

So, do you want it? Or, is there any other business that you can look at giving you more than what Infosys can give? Tough times, isn't it?

infosys stock, why buy it if you don't believe in it

I have long back compared Infosys with TCS, and I said I was not going to buy into these stocks as there was too much to predict. 

Then I noted in Feb 2017 on how founding shareholders have the right to ask questions of the board on corporate governance matters. I also wondered how the remuneration committee, audit committee, and board could behave in the manner they did. In April 2017, I wondered how an investor in Infosys could make 35% return; and then I wondered whether it was probable. Then in June 2017, I noted how the managers were taking desperate measures what with their take on the risk factors filed in their 20 F.

In my view, the Infosys board and its managers have become a laughing stock. They first list the founding shareholders (they call them activist shareholders) as a risk factor impeding the company's growth. Later they tell the media that the founding shareholders are their well-wishers. And now they blame the founder for the mess that they themselves have created both for the business and its shareholders. 

Any shareholder has the right to ask questions about the way the company is run. When it is from a significant shareholder, there is much weight. And when it is from Mr. Murthy, the board is better off dealing with it as a top priority. 

None of Mr. Murthy's questions have been answered; and the board has the audacity to blame him for all the shit that has been going on. The CEO resigns, and takes on a role of executive vice-chairman. The board blames Mr. Murthy. Even while the shit is falling down, there is some comic sense. 

There are questions of the former CFO severance compensation; the former general counsel and chief compliance officer severance compensation; the Panaya deal; the (former) CEO compensation; and finally, because of all this, of the corporate governance itself. As a former CFO, Mr. Pai puts it, the board has failed in its duties. 

Well, there are many who have been talking good of both the board and managers and putting Mr. Murthy down in the process. They are entitled to their opinions. Yet, transparency is the key for any business organization if it has a long enduring story to tell. Otherwise, the story has to end either slowly or rather abruptly. This is the choice every business manager has to make.

Also, what do you expect from someone who does not even have skin in the game as they say? All shares owned are free; 44,886 free shares: not a penny, well almost, put in from pocket to buy shares of the business you believe in. The CEO also has (unvested) restricted stock units. So the number of free shares are much higher. But hey, they are free.

For those who defend by saying that those shares are a part of the compensation, here's the question: If cash was given instead of stocks, would the CEO have spent that cash and bought stocks? It is ridiculous to see the chairman of the board having virtually no stake in the business. Of course, Infosys is not an exception. Yet, I would have no faith in people who do not put where their mouth is. The logic is simple: if the business fails, they do not lose anything. In fact, they might even gain by hefty severance pay.

Infosys stock fell nearly 10% today after the CEO's resignation. The equity is available for Rs.2120 b now. The analysts are all over talking about how it is either a cheap or an uncertain stock depending upon whose opinions we hear. A 10% fall in a stock is not a big deal for an investor having faith in the business and its execution. So it should really not matter if there is conviction that the growth is visible and business model is sustainable. 

If due to the CEO's exit the execution is going to be an issue, then the investor will have to weigh in, and sell the stock when the price is more appropriate. There will be some opportunities in the near future for such action although a big blown price rise may not be there.

The shareholder-board-CEO saga is not new. It has been going on for sometime. So, the investor who is skeptical of the business execution should not have bought the stock at all, or having bought it, should have sold it when the stock price hit some higher levels, which the stock did in the recent past. Equity buying is not meant for short term gigs. Have the intention to participate in the long term performance, or don't just buy stocks. 

If the idea is to trade and speculate, short term is game. In fact, Infosys is just ripe for such action. I don't believe that the returns are going to be great by owning the Infosys stock. May be just about the market index; or slightly higher if lucky. I do like to trade in it though. Speculating with some insignificant cash is both fun and thrilling. The returns are also going to be insignificant. And on top of it, I get some comical scenes like the one going on right now. 

Of course, I noted in Feb 2017 that stock buybacks are good only when the company has excess cash and the stock price is lower than its intrinsic value. Is the stock price still cheap? 

tata group, concentrated, or faltering

Tata group includes several companies, listed and unlisted, making a variety of things, and of course, contributing to the economy and society. 

Employment is a massive contribution.

Yet, something is going awry for the group. Yeah, there was this Chairman spat. More importantly, though, it was always about the group companies. You incorporate the business so that the shareholders make money.  

Tata group has total market capitalization of Rs.8482 b. 

TCS (Rs.4726 b) and Tata Motors (Rs.1534 b) make up close to 74% of the market value of the group. Then you have Tata Steel (Rs.543 b) and Titan (Rs.473 b). These four companies are worth over 85% of the group. The concentration appears to be a little too much. When less modest, it means that other companies in the group are faltering.

Let's take revenues. The group had revenues of Rs.6662 b in 2016.

TCS had revenues of Rs.1086 b, Tata Motors had Rs.2755 b, and Tata Steel had Rs.1171 b in 2016. These three companies contributed over 75% of the group revenues. The story is similar with profits.  

Now Tata Motors MD has something to say. 

Tata Motors domestic business never did well, did it? All consolidated profits came from JLR. You can't bet on JLR and China all the time, can you? Remember that ever-loss-making Nano? 

With headwinds on the IT, and no investments in product development, cloud computing, and whatever the shit they call it these days, how can the Indian IT companies move ahead with their head held high? TCS, like others, has got to do something special and urgent.

Tata Steel's story isn't great either. Corus acquisition, large debt, dropping profits have been haunting the business.

Imagine a situation wherein TCS falters and JLR slows down. Tata Sons will then aptly be asked to show the money. Well, it has to start thinking about those lines, and actually be ready to show the money.

berkshire hathaway: return of cash

In July 2016, I noted that Berkshire Hathaway is a decent business that is not going to let its investors down, and yet it will also not be a market-beating investment. It is worth more than $400 b now, and sitting on a cash of over $85 b.

And it is its cash that is letting it down. Each quarter while the stash gets bigger, there aren't much avenues for its use. You cannot expect treasury returns on them forever; that would be an injustice to the shareholders. It's time now, probably, for Berkshire to consider the opportunity costs of its shareholders rather than its own. 

Berkshire has done very well in the past 5 years. 

As of May 2017, Berkshire stock has beaten both the Dow and S&P-500 by a decent margin. That's not the problem now though. As investors, we look at future rather than past. Quite naturally, we are interested in Berkshire's future returns.

Berkshire cannot sit on cash forever. Its operating businesses need far less cash for reinvestment than they throw out. Assuming that there are no further acquisitions, there seems to be an urgent need to return cash back to its shareholders. Even after allocating some cash for acquisitions, it is more rational to return cash than to keep in treasuries. 

The shareholders will have far better investment opportunities in the present environment than Berkshire for at least two reasons: Berkshire has grown too big such that its acquisition size has to be gigantic to make any meaningful return. Investment choices in marketable securities meeting both size and return criteria are rare; it would shake up the market prices. Opportunity costs of the individual shareholders are much higher. Therefore, cash in the hands of shareholders has much more value than in Berkshire's custody.  

Cash can be returned by way of either dividends or share buybacks. This is the single most important task in the hands of Berkshire; yet considering the towering brand of its two capital allocators, no one is brave enough to even talk about it. 

Let's allocate $10 b each to its two younger investment managers, Todd Combs and Ted Weschler. Let's keep $20 b in treasuries that is required for a good night's sleep for Buffett and Munger. That leaves Berkshire a one-time free cash of more than $45 b to give back to its shareholders. Each year, there will be free cash available to return based on an approved (significantly higher) payout ratio.

And return it must, in spite of its historical track record, and despite its iconic managers. We all have to appreciate that when facts change, we got to change our mind.

Who's going to show courage to inspire the bosses there?

infosys: what next

I noted in February about how an investor could make close to 35% on Infosys stock. All I did was pick management's target of $20 b revenues and 30% operating margins by 2020. Well, targets could not change in a month's time, could they? 

Infosys reported revenues of $10.2 b (Rs.684 b) and net income of $2.1 b (Rs.143 b) for 2017. Revenues grew 9.68% and net income 4.93% compared to last year. Management expects that revenues might grow 6.5-8.5% next year. 

To achieve the target, revenues will have to grow more than 25% annually in the next 3 years; is that possible? Of course, anything is possible. But before it becomes possible, it has to be probable, or even plausible. That's something we need to ask those who set the target. 

Yet, what seemed like a target now seems like a moonshot. If not in 3 years, when is it going to be, 5 years? Even for that to happen, revenues will have grow more than 14% annually. If revenues grow 8.5% next year as expected by management, they will have to grow close to 16% per annum in the next 4 years. Yeah, it ought to be an aspiration.

It's not wrong to aspire, though. If not 35% return, what can Infosys offer now? Let's start with keeping management's targets. Revenues of $20 and operating profits of $6 b. Assuming Infosys will continue to keep $6 b in cash earning 5% and a tax rate of 28%, its net income will be $4.5 b (Rs.317 b) whenever that happens. 

That's a net margin of more than 22%. Based on its current valuation of Rs.2,130 b, investors will be able to get an annual return of 30.80%, 43.90%, and 55% when it is priced at a PE of 15, 20, and 25 respectively in 2020. Those are returns for 3 years. If we move to a 5-year target, keeping the same pricing multiples, the expected returns will be 17.50%, 24.40%, and 30.10%. We are again back to what is plausible, probable, and possible. 

What if Infosys achieves its targets in 7 years? Then the returns would be 12.20%, 16.90%, and 20.70%. Note that these returns are not that bad. And topping these you have those juicy dividends targeted at 70% of free cash flows; they will be in excess of Rs.50 b each year. 

Even when these targets are achieved in 10 years, the expected returns based on those PE pricing will be 8.40%, 11.50%, and 14.10%. If an investor gets that 8.40% return at the lower multiple and receives a dividend yield of 2.50-3%, the aggregate returns will not look too bad. I have not included exchange rate changes in this model; investors can choose to incorporate that if they are able to. 

There is also the possibility of Infosys being priced at an earnings multiple of 10; who can rule that out? Finally, we have to ask whether this $10 b and 30% targets are achievable at all. Now, that's a question, which I will not be able to answer. 

buyback paradox at Infosys

Former CFOs of Infosys, who are also major shareholders, are seeking buyback from Infosys board in order to ensure proper use of its cash. They are right in questioning its capital allocation policies. 

That said, whether Infosys should initiate a buyback is a tricky matter. For a buyback to make sense, two conditions should be met. 

First, the firm should have excess cash. The business should be in a position to generate cash in excess of its reinvestment requirements. That happens when growth slows down, and it becomes a mature business. It looks like Infosys does have excess cash; it had Rs.345 b as of March 2016. This cash becomes free cash flow to equity investors if it cannot be used for working capital, capital expenditures, or acquisitions. The Infosys board should first assess whether it is the case; recall the CEO's grand plans for 2020. 

Second, the stock price should be lower than its intrinsic value. The value changes based upon the perception of the analyst though.

Price > Value: The former CFO considers that the stock price is expected to be lower, and consequently, generating lower returns to the shareholders; this is when the stock price is higher than its value. If the board agrees with this analysis, but carries out a buyback, which is usually at a premium to the market price, it would mean that cash is being used for a stock that had no growth prospects. This would bring down the value of Infosys as a business because of the purchase of an expensive stock. Any buyback of the stock would hurt the remaining shareholders, and therefore is not good for the firm. 

A better option for the CFO would be to sell the (expensive) stock at market price, and exit as a shareholder. Invest the proceeds in opportunities yielding higher returns. This will be good for the exiting shareholders, remaining shareholders, and the business itself.

Value > Price: If the board does not agree with the CFO's analysis, and considers that value of the stock is higher than its market price, the buyback makes sense. There is excess cash, and the stock price is cheap compared to its value. If the board carries out the buyback, the exiting shareholders (the CFO and company) would be worse off. This is because the stock having prospects of higher returns is exchanged for cash by the exiting shareholder. This would no doubt help the remaining shareholders; and that is the whole purpose behind a firm undertaking stock buybacks. 

A better option for the CFO then would be not to sell the cheaper stock back to the firm. Stay invested when the value is higher than price.

Whoever is right in assessing the value of the business will be the winner in this game. Heck, isn't this the case in any investment game?

Stock buybacks after all are dividend decisions. When there is excess cash, and assessing value of stock is difficult (if so the managers are not fit to run the business is another story), there is a much better option for the board. Payout higher cash dividends; even normal payouts accompanied by a onetime special dividend will be good.

Dividends are good!

troubled twins

To make money in stocks, usually, one has to stay focused on the story for a considerable period of time. The story is linked to the business behind the stock, not to the ticker price. So here it goes: in the short term, you do not know how the market prices will react; but in the long term, the prices are more aligned to the business performance. If the business does well, the stock prices go up. 

The risk in the business then depends upon the type of the business, the operating leverage, and the financial leverage. For instance, you take on too much debt, the business becomes that much vulnerable. 

Both Rcom and Rpower seem to have failed the investors big time. Unless one has played the game of high-and-low prices periodically, which is never easy, these businesses haven't given adequate returns to the investors.

Rcom is worth Rs.87 b now, from its peak of Rs.1742 b in 2008. 

Rpower is worth Rs.110 b now, from its peak of Rs.813 b in 2008.

Both businesses earn poor returns on capital employed. I wonder when they will be able to turnaround. 

bonus shares and value

Bonus shares are quite frequently used by the Indian companies for a variety of reasons. These stock dividends are popular among the investors. 

Recently, one of my friends was talking about how an MNC showered shares after shares as a bonus to the stockholders in the past three decades. Little does he know that those gifts did nothing to the value of his shares.

More recently, the shareholders of TCS were demanding bonus shares at their annual meeting. TCS is the most valuable listed company in India with a market-cap of Rs.5,130 b. 

Not many investors understand that value of a business depends upon its cash flows, growth and the risk in those cash flows. If an event does not affect these, it cannot affect the business value. 

Bonus shares represent issue of additional number of shares to the existing shareholders in a specified ratio by way of a transfer from retained earnings. In other words, it is a book adjustment from retained earnings to share capital. Forget doing anything else, it does not even change book equity. The market price, obviously, adjusts to reflect higher number of shares outstanding. 

If you hold 100 shares with a market price of 50, after an issue of 1:1 bonus, you will end up with 200 shares having a market price of 25. You are not going to be any richer with these additional shares. 

Some companies play games with market through stock dividends or stock splits, just to bring down the market price of a share such that it becomes cheaper (of course only in the minds of investors) to buy and sell. These tactics might temporarily change market price; but the intrinsic value of the business remains unaffected. 

TCS will be well served if it concentrates on its operations rather than distractions such as bonus shares. It could consider stock buybacks if market price is considered a bargain; but is it? It could also consider operating independent of other Tata-group companies. The inter-holdings within the group make an investor wonder about what is going to happen to the excess cash.

In the meantime, investors should try to understand the business behind the stock rather than the stock ticker itself. I am not sure when an Indian shareholder will actually understand the real story behind bonus shares. 

public sector banks into the abyss

Banking is a tough business; we know that. However, it is not such a bad business that a good manager cannot take advantage of its economics. Yet, a bad manager can surely keep the reputation intact while running a bank. Here's the proof.

The public sector banks in India have the reputation for being run poorly. The evidence is more prominent now. 

As of 10 February 2016, the market capitalization of the major public sector banks was as below:

The stock prices of these banks have reached the deep bottom; and it should take a while before they are restored to more reasonable levels.

State Bank of India is currently quoting at September 2007 prices. 

Punjab National Bank is at February 2005 prices. 

Bank of Baroda is at February 2010 prices.

IDBI bank is at October 2003 prices.



Canara bank is at December 2004 prices.



Syndicate bank is at February 2005 prices.



Such is the state of these banks that these pictures say much more than they are required to; and I haven't got anything to say now other than into the abyss.

shareholders or customers

Can someone run a business and become a billionaire snubbing investors? May be the title of the article is incongruous, or may be there is a real snub out there what with 5.80% return on equity.

Whatever that is, Mr. Kazuo Inamori must be a great guy with motives towards welfare of his employees. As per the story in the article, he was able to amass huge wealth focusing on making staff happy, let's call it creating employee value. He must have also created shareholder value in the process; he let Japan Airlines come out of bankruptcy. His lines: If you want eggs, take care of the hen; At times company management has to say no to shareholders' selfish requests. And the response from the shareholders was, we are shareholders and not selfish shareholders. Mr. Inamori apparently acknowledges that the companies do belong to the shareholders, however, he is quick to extend that hundreds or thousands of employees are also involved, and then he says, the hen has to be healthy. 

What I am not clear though is, who is the hen here. I would like to argue that if Mr. Inamori's businesses are any successful in increasing their long term returns, the hen would be shareholders, not employees. Mr. Inamori must have focused on creating shareholder value through the means of making his employees happy. Never mind if there has been some mix-up over who the hen is.

This brings us to think about the purpose of a firm. Although arguments on this topic are unresolved, the favorite choices remain: shareholder value, customer value and society value creation.

Here's my take. Any business, small or big, private or public, listed or unlisted, national or multinational, is started by the owners, with a combination of their own and borrowed capital, in order that they make money out of it. If this was not true, they would not be spending their time, resources and efforts. In an owner-managed business, the owner would both supply capital and operate the business. In a professionally managed business, the owners employ outside managers to operate the business as per their mandate; the managers would get paid for the services and final profits would accrue to the owners. The owners' goal here is not to make anybody but themselves happy, and happy they would be, if only they make money; otherwise they would do something else, not start a business. Of course, they would have to operate their business within legal boundaries set by the regulation and moral boundaries set by the society. If making money for themselves requires anything to be done, they would willingly do it. For instance, if happy employees would make more money for the firm, the owners would like to take good care of their employees; if it requires making customers happy, so be it.

What is important is to know the final objective of a business. The end is to generate cash flows, more the better, and there could be several means - making employees, customers and society happy. Therefore, creating long term value for shareholders is the only objective of a business. 

A business operates as a going concern, usually until perpetuity. It is clear therefore that the shareholders would look for long term profits and value creation rather than short term. It is true for a private business and also for a publicly listed business. For a listed firm, there are many distractions, the biggest one is the capital market. The market would like to grade the firm on a moment to moment basis, and at each quarter it is open to a harsh scrutiny. If managers and shareholders consider this as troublesome, they are not aligned with their thoughts. It really does not matter what happens in the short term, because there are always inefficiencies in that flawed process. What matters is the long term performance of the business. In the final analysis, stock prices follow earnings and cash flows. It is better for the business, managers and shareholders to focus on the long term than think about what would happen in the short term. 

In this respect, there is no need to reinvent the purpose of the firm as this report calls for. The article calls it the age of customer capitalism, as opposed to shareholder capitalism, and supplies a series of confused arguments. It gives example of four firms, Coca-Cola and GE as proponents of shareholder value, and Johnson & Johnson and Procter & Gamble as proponents of customer value. It argues that there is no sign that shareholders benefited more when their interests were put first and foremost.

My intention is not to disagree with the author personally, rather with everyone, who is from that school of thought. The article then goes on to say that to create shareholder value, you should instead aim to maximize customer satisfaction. Our response to that muddling is, who said no? Note that it starts the sentence with to create shareholder value, which means it implicitly accepts that the end is the creation of shareholder value, but fails to put it explicitly.

A CEO should do whatever it takes to ensure enhanced returns for the shareholders. If that takes making customers happy, the CEO should take it as a task.

Consider this: If happy customers do not translate into high return on the invested capital, why would shareholders continue to invest? It is called throwing good money after bad. Capital is not available free of cost. Let's take an example. Imagine that there is a business, which either due to being a monopoly or some other uniqueness has immense pricing power. Let's assume that because of this power, it is able to charge more than what its customers feel fair, and consequently it makes customers somewhat unhappy, and yet is able to make money. Would managers and shareholders think in these lines - this business is too good, makes a lot of money for us, but our customers are unhappy, we cannot see it, let's close the business or charge them less and earn less for ourselves - would they?

The article throws yet another argument: that the only sure way to increase shareholder value is to raise expectations about the future performance of the company. While it acknowledges that there is a behavioral aspect to this in the markets, it fails to bring forth the economic reasoning behind allocation of capital. The manager's role is to ensure that capital supplied by shareholders is suitably allocated to projects that earn more than their cost of capital. This is not an overnight's journey, but a long one. Those who are not tuned to this thinking, whether managers or shareholders, should rather stay away, and look somewhere else. 

I find the article's most flawed argument: Executives come to understand that shareholder value creation and destruction are cyclical, and more important, not under their control. How can we respond to this? If shareholder value creation is not in their hands, in whose hands are they? Why have shareholders picked these managers for? A CEO's job is to maximize the value of the firm, which requires obtaining a right mix of capital, allocating capital in the right projects, and paying out excess cash generated back to shareholders. These decisions are to be taken considering long term economic impact on the business and its value, not based on the dancing notes of speculators and traders. Short term gyrations are best to be ignored; when such alignment exists between executives and shareholders, shareholder value creation is warranted.

Value of a firm is the present value of its future cash flows. Managers can destroy value in several ways with short term tactics, which they often do - take projects that do not earn their cost of capital, pay too much for growth, take on excessive leverage - to manage quarterly earnings and increase immediate stock prices. This does not, however, change the objective of the business. 

Stock-based compensation is another aspect that is misunderstood. Stock options are given basically to align the thoughts of managers with that of shareholders. If managers are shareholder oriented and believe in long term economics of the business, they can buy stocks from open market themselves with their own cash. They need not rely on stock options for that. When we find top managers, who do not keep their stocks for long, it is safe to conclude that they are not shareholder oriented.

The article says that companies should seek to maximize customer satisfaction while ensuring that shareholders earn an acceptable risk-adjusted return on their equity. I would like to ask, what if companies are able to give an acceptable return on equity to shareholders despite making their customers slightly unhappy?

The article then promptly highlights Johnson & Johnson's credo, which according to it, gives shareholders last priority compared to the doctors, nurses, patients, customers, employees and communities. As I read the last sentence of the credo which states that when we operate according to these principles, the stockholders should realize a fair return, I find that again the primary goal appears to be shareholder value, if it was not, J&J would price its products at cost or below so that customers and society were happy. Whether CEO James Burke's recall of every Tylenol capsules across America, or more recent recall of Volkswagen vehicles across the world or recall of Maggi noodles across India, yes, it is about doing the right thing, but not for customers, it is for shareholders. If not, the long term brand image would be hit severely impacting long term profits; in such situations, it is better to take lower profits or even losses in the short term. This is again a shareholder oriented policy, not customer oriented.

The article mistakenly thinks that companies such as J&J and P&G are customer focused rather than shareholder focused, and therefore they are able to deliver impressive returns to shareholders. It is a flawed thinking. At the cost of repetition, I note that if maximizing shareholder returns requires customer satisfaction, the CEO should work towards it. However, it is a mistake to assume that customer satisfaction is the primary focus and shareholder profits are incidental.

A good CEO is one who understands shareholder value well enough, and runs the business accordingly. This involves taking investing, financing and dividend decisions in the best interests of shareholders. It is not about increasing stock prices in the short term, thus making way for managers and traders. It is about increasing long term economic value of the firm, which when done increases the stock price eventually. Investing in stocks, as opposed to playing in the derivatives, is not a zero-sum game. Here, the stockholders are rewarded for supplying capital to a well run business. This business, operating under free market environment, will be doomed in the long run if it continues with the policy of ill treating employees or charging excessively to its customers. The competition will ensure destruction of its image, business and eventually, value. The decisions taken here are business decisions which are shareholder oriented.

In conclusion, while creating shareholder value is the single objective of a business, creating employee, customer and society satisfaction is only a means to that end. If the primary goal is creating value to customers and society, the capital providers should look towards charity, not business profits. They are noble thoughts, but not ethos of business.  

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.

loans, dividends and dilutions at banks

Here's an interesting read regarding Indian banks. Indian public sector banks have been troubled by both bad management and government restrictions. Whereas, private sector banks are troubled by only bad management. Well, that can be a harsh statement. Let's read that to mean that when these banks are in trouble, we know whom to blame. 

Banking is not an easy business. A well run bank is one which lends prudently ensuring return of capital and adequate interest margin. If this is done on a consistent basis, banking can be a good investment. Unfortunately, we wouldn't know which bank is run prudently, until the tides go away. 

For banks, leverage is the way of doing business where debt-equity ratio is far too high. It seems natural because equity capital is not adequate to carryout lending operations. They have to borrow from depositors and bond-buyers in order for them to increase their asset size. As the asset size goes up, their operating income goes up. When net interest margins are good, return on assets increases, and because of outsized debt-equity, return on equity and earnings per share increase much higher. Therefore, managers aim to increase their loan book as much as possible. That is growth for them.

The story is good. But the problem is, not all banks are well run. If lending is not done prudently, the result is bad loans. However much they try to hide by either not disclosing or not disclosing fully, there will be the day of reckoning. The real bad news is when loans have to be written off. The effect is very harsh on equity; loan write offs can erode equity; in fact, because of low equity base, even a small portion of assets turning bad is enough to wipeout equity.

The second problem with banks, public sector banks in particular, is that they are considered as good dividend payers. We can argue that when equity is low, and bad loans are high, it may not be a good idea for banks to payout dividends. It is a simple idea: If there aren't any free cash flows, there are no dividends. Obviously, managers are aware of the fact that capital markets consider dividends as some sort of signals. When dividends are skipped or reduced, there is reaction to the stock price. Therefore, they continue with the mistake of paying out, or even increasing dividends.

The third problem which of course is a consequence of the first two is raising of equity capital through preferential buyers, or in case of public sector banks, through government capital infusion. Here's the irony: Chasing growth, managers raise more debt; bad loans reduce equity which is already low; and dividends are paid out when there are no free cash flows which bring equity even lower. The result is a very low equity capital base, and the need for capital infusion. The dilution in earnings per share is apparent. This is the-never-ending vicious cycle for banks.

The lessons: Managers should learn that higher coupons cannot make up for a bad loan. It is also obvious that the borrower should have demonstrated capacity to generate both adequate and consistent cash flows to cover both interest coupons and loan capital. For those that lack cash flows, equity financing is the only route. That is why, firms that are in start-up stage or even high-growth stage deserve only low-to-moderate debt-equity ratio. As firms become mature, their cash flows increase and become more predictable; and then they can take on higher debt.

The sooner managers and governments realize this, the better it is for the economy and the investors: If banks operate with a little prudence, and with an internally regulated maximum debt-equity ratio, there is no need to be worried about regulatory capital requirements of the Basel Committee. For banks, growth has to come with a cost; and that is higher reinvestment of cash back into equity in order to sustain the set debt-equity ratio. If there is no free cash, pass dividends.

Managers have never learnt lessons from the past, and the chances are they never will. All we can do as investors is be careful when investing in banks.

There is some consolation, though, in case of Indian banks; they have not indulged in destructive derivative instruments so far. 

castrol's capital constraints

Castrol is in the business of manufacturing and marketing of lubricants, and is mainly operating in the automotive and industrial sectors in India. Automotive segment contributes over 85% of revenues and earnings. Its manufacturing plants are located in Patalganga, Paharpur and Silvassa. Currently, Castrol's exports are negligible. Lubricants are made by blending base oil with additives. Its main raw material is base oil, which is largely imported, thus the company is exposed to foreign exchange risk.

Castrol sells several products under its brand:  

Engine oil for cars: Castrol Edge, Castrol Magnatec, Castrol GTX
Specifically for Tata and Maruti cars: Castrol GTD, Castrol Maruti Genuine oils
Automatic transmission fluid for cars, trucks and buses: Castrol ATF Dex II
Engine oil for motorcycles and scooters: Castrol Power1, Castrol Activ, Castrol Go
Engine for trucks and buses: Castrol Vecton, Castrol CRB, Castrol Tection, Castrol RX
Antifreeze and coolants for trucks and buses: Castrol coolant
Manual transmission fluids for trucks and buses: Castrol Manual
Castrol also makes engine oil, driveline fluid, and greases for off-road vehicles. 

As per the company's presentation, it is the largest lubricant player in India with the largest network of 380 distributors servicing over 105,000 retail dealers. Again as per the company's presentation, Castrol Activ, Castrol GTX, and Castrol CRB Plus are the largest selling engine oils in India.

Castrol India is owned by Castrol Limited (71%), which also has board representation. LIC owns 4.2%, and Aberdeen Global Indian Equity (Mauritius) Ltd owns 1.40% of shares in the company.

Its board comprises:

Three non-executive directors are nominated by the parent company, Castrol Limited, UK.

Management of Castrol comprises:

Remuneration to the management was Rs.41.40 m in 2014, approximately, 0.12% of revenues.

There were 494.56 m shares outstanding as of 31 March 2015.

The company pays approximately 2-2.50% of revenues as royalty to the parent company. In 2014, royalty amounted to Rs.730 m. In the last seven years, it has paid out Rs.4.76 b in royalties.

Castrol does not have any subsidiaries, and operates in India as a stand-alone entity.

In the last five years, revenues grew 7.91% annually, and in the last ten years, 9.98%.

Castrol had revenues of Rs.33.92 b in 2014, up by 6.69% over 2013. Previous two years growth has not been noteworthy (1.88% in 2013 and 4.66% in 2012) either.

Year-on-year, sales volumes have been falling. Clearly, the company is struggling to increase its revenues, although, there seems to be some pricing power. Castrol's products command about 20% premium over the competition on average. Price per litre has increased by 8.89% and 11.46% annually in the last five and ten years respectively outpacing revenue growth.

The aggressive pricing strategy by local as well as international competition, in an attempt to gain market share, and commoditization of products in the premium segments, has had an impact on the operating margins. Castrol has, however, demonstrated sustainable operating margins.

Return on capital is absurd with such little capital employed. Return on equity has been quite good, and should be much better in the coming years due to the capital reduction program.

There isn't much change in its earnings per share over the past five years, and this is without any dilution in shareholding.

Castrol is operating with a capital of only Rs.653.30 m compared to Rs.2,348.80 m in 2004, and the business has demonstrated that its current operations do not require much capital. Naturally, it has been generous in terms of dividends payout.

It looks like Castrol is facing severe competition in the market, is not able to increase its market share, sales volume, and revenues in any meaningful manner. Over the last seven years, it has not made any reinvestment in the business. Its savings from working capital and depreciation have more than compensated its whatever little capex program.

During 2014, Castrol returned half of its share capital, i.e. Rs.5 per share back to its shareholders under the capital reduction scheme amounting to Rs.2.47 b. Castrol had Rs.4.31 b of cash as of 31 December 2014.

Castrol does not need much capital is evident from its liberal dividends payout.

Castrol has been generating free cash flows to firm all through, which it has been returning back to its shareholders.

From 2004 to 2014, it generated free cash flows to firm of Rs.33.19 b, and paid out Rs.27.88 b as dividends.

Castrol and national oil companies have a market share of 55% (in terms of volumes), 20% is with other multinational companies, and 25% is with several local small competitors. These small players have been competing aggressively with lower prices and higher sales promotions to gain market share.

The management acknowledges that the industry has also witnessed a trend of some OEMs introducing lubricants under their own brand name, further impacting the competitive landscape.

As per the management: Lubricant volume consumption for the same rate of use decreases, while per unit cost and price realization increases. Therefore, other drivers remaining unchanged, the growth in demand for lubricants is expected to lag vehicle population growth rate in the foreseeable future.

Castrol spends significant amount on advertising; it has spent Rs.8.82 b in the last seven years. It is doing what is required in order to keep its brands strong.

Having heard the management, it is clear that Castrol is going to face challenges in increasing volume growth, and is dependent upon price increases to scale up revenues. It does not have any plan for increasing production capacities, and consequently, most of the free cash generated is promptly returned back to the shareholders. This is the correct thing to do for a manager if there aren't any investment opportunities, and there is no debt to repay.

Castrol has provided significant value to its long term shareholders. Its current market value of equity is Rs.211.94 b; its high was Rs.30.28 b in 2004. Annual return for the shareholders has been massive.

As it is the case, there are many stories for us to read, here are a few:
Castrol optimistic about lubricant market and growth;
India is a very big market for Shell;
Gulf Oil Lubricants India on a smooth drive;
Castrol's volumes are likely to grow 2-3% annually in the next few years;

Expansion of network to meet rural demand;

In the coming years, Castrol should grow at a very modest rate, yet generate a fair amount of free cash flows, unless it does or witnesses something dramatic.

Based on a perpetual growth model, i.e. assuming that Castrol will be able to grow its current free cash flows perpetually, the current market price would be justified depending upon the market's choice of a combination of the expected return and perpetual growth rate.

In other words, the market is assuming that if the expected return is 10%, the perpetual growth rate of free cash flows would have to be 7.74% to justify the market price of Rs.432.10. If the expected return increases to 18%, free cash flows would have to grow at 15.74% perpetually.

If you want to buy the stock today, you have to be comfortable with the perpetual rate for the free cash flows to grow. Gotcha!