yes bank, market, and rating

Yes Bank is taking its toll; rather its investors are. It is becoming too much, or it's not? In September, the RBI said, weak compliance, weak governance, and wrong asset classification. The CEO had to step down without extension of tenure. 

It was enough for the stock to plunge. On 28 September, the stock was staring at Rs.165 per share. Things seemed to be better in October and November as the stock was trading at around Rs.200, not moving much. October's high was Rs.248.90; and low was Rs.180.70. November's high was Rs.227.90. But then...

Some of the board members resigned later in November. The stock closed below Rs.200 for the first time in the month on 16 November. Here's the snapshot of the skin in the game that the board exhibits (as of March 2018).

Not all directors own shares in the bank, and those who own have insignificant number of shares.  This is not new to only Yes Bank; most of the companies in India have board members and even executive officers who do not own meaningful number of shares. I find that surprising, but want to keep the story for another day.

Whereas look at the volume of shares owned by the CEO and the CFO. I wouldn't conclude that they will act against the interest of their fellow shareholders. I don't know the inside story; but the RBI's remarks regarding corporate governance are serious, and should be taken seriously. There is time to repair the damage caused, and that should be the new CEO's top priority.

On 26 November, it was reported that the CEO, who is also one of the promoters, had raised money from two mutual funds through his associate firms by keeping his stake in Yes Bank as some sort of a guarantee. It was interpreted by the market as shares pledged, but not reported. This perception was bad enough for the stock, and it closed the day at Rs.187.90.

On 27 November, Moody's downgraded Yes Bank's ratings citing corporate governance and growth concerns. The stock had to react; Rs.182.65. On 28 November, Rs.162.10. And today, 29 November, it quoted as low as Rs.146.75, but closed at Rs.160.45. The trading volume was 292 m shares. I don't have any respect for the rating agencies, but the truth is that it becomes difficult for the downgraded business to raise cash on favorable terms; the cost of borrowing goes up. 

The two promoters must have felt it too. Let's do some math. Rana Kapoor, including Yes Capital and Morgan Credits, owns 245.875 m (10.65%) shares in the bank, and Madhu Kapur, including Mags Finvest, owns 213.987 m shares (9.27%). 

Based on the 20 August 2018 price of Rs.404, the market value of Rana Kapoor's shares was Rs.99.333 b ($1.419 b); and Madhu Kapur's was Rs.86.450 b ($1.235 b). As of 29 November, the respective market values are Rs.39.450 b ($563.580 m) and Rs.34.334 b ($490.489 m). It is still a lot of wealth. But, when the stock price falls 60% from its high, the value of shares goes down with it. Yet, it is important to remember that these are only paper losses until they are realized through transaction. 

Is the reaction from market an overreaction of some sort? While time will tell us about it, I guess, there are a lot of people out there on the media and social media giving enlightened opinions about how a badly managed business is a bad investment. Well, when the stock was going up, these naysayers were probably talking about some other stock. Never mind, it is the business of people to talk about other people. 

Every business has a price. A good business has a price, and a bad one has another. I am not too sure at the moment whether Yes Bank is a bad business. Yet, at the price it is quoting now, probably there is some value to be claimed by patient investors. Didn't I say something like that in early October too?

kotak bank stake conundrum

Kotak Bank has been a well run bank among the private banks of India. With gross npa of 1.94% and net npa of 0.73%, its track record has been extraordinary. The net margins are over 4%; business is growing. And the market is willing to pay the price for its equity. At current prices, it doesn't come cheap in excess of 4 times September 2018 adjusted book value. 

Yet I reckon, if it grows at 15% in the next 3 years and market allots a pb of 3.50, the investor will have about 8.50% annualized return. Is that enough, is a question for the investor as of now. 

However, with the RBI asking the promoters to reduce their stake from 30% (current) to 20% by December which we see likely not happening by the time, there are chances that the stock prices might get lower. Time will tell whether they will become attractive enough to meet the investor's opportunity costs.

This article presents options available to the promoters well; however, I don't think this will leave investors on edge. Investing isn't a short term game; so they should relax and take it easy. If they believe in the capabilities of the promoter manager, they should be fine.

At the moment though, the promoters have the following options to keep the regulator happy, unless the RBI accepts the current status of Rs.5 b perpetual non-cumulative preferred shares.

The promoters have the option of selling 191 m shares or issuing 477 m fresh shares in order to meet the RBI's directive. I am assuming that fresh issue will have to take place at discounted prices. With the first option, the promoters will have challenge of dealing with some Rs.224 b cash; they will not only have to pay taxes on it, but also will have to check out the alternative investment opportunities. If fresh shares are issued, the bank will get about Rs.530 b in cash which can be useful in meeting its growth targets. But then, Kotak bank has a Tier 1 capital ratio of 17.04%; so it already has enough cash for its growth requirements. 

It is an uneasy conundrum for the promoters for sure. To keep able promoters' stake high enough is a good idea so that investors benefit from aligned objectives. Whether 30% or 20% is a good stake, will have to be dealt with independently. Yet, the RBI cannot have a separative guideline for one bank and another for other banks. 

Kotak bank stock had a high price of Rs.1,417 in July 2018. I find that even at current prices which are much lower, it is not cheap. But then investing is a waiting game, isn't it?

yes bank's september

Never mind what happened to the Indian markets today. The nifty-50 fell 2.39% to end at 10599.25. Yeah it fell yesterday too. Let's keep the index story for another day. On 6 September, Yes bank traded at a high of Rs.347.80. On 20 August, at a high of Rs.404 per share. Things were looking alright for the bank until 21 September. The day before was a market holiday. On 19 September, the stock closed at Rs.319.20.

On the same evening, the bank reported that the RBI had rejected its request to extend the CEO's tenure by three years. The next trading day on 21 September, the stock tanked 29%, and closed at Rs.226.50 per share, equivalent of a loss of Rs.213 b in market value. Can one person be so important for a publicly traded, large banking business, or was it just the market's whims? The quantity traded on that day was over 293 m on the NSE, compared to the average of less than 30 m during the previous seven trading days.

As per this report of that fateful day, the bank was cited three reasons for the RBI's deadline for the CEO's tenure until 31 January 2019: Weak compliance culture; Weak governance; and Wrong asset qualification. The allegations seemed too brutal, and the bank made a new low of Rs.197.25 on 25 September when the board was to meet for the future course of action. 

However, 28 September was more special when the stock quoted at Rs.165 at some moment, but closed the day at Rs.183.65 per share. The market capitalization of the bank stood at Rs.423 b, some 54% down from its August's high. Too much, too soon? Is the market crazy, or is there more to this?

As of June quarter, Yes bank had impressive performance to show: Gross npa 1.31%; Net npa 0.59%. Net npa, security receipts and standard restructured assets totaled 1.52%. Yet, herein lies the catch. If these numbers are good, at the current price of Rs.215 per share, the stock is trading at 2.15x its adjusted book, a reasonable price having potential to yield better returns in the next 2 to 3 years. 

If the asset quality is worse than it is reported, it becomes a little complicated. The value becomes a function of how the book looks like. For instance, if the net asset quality is worse off to say, 3%, the current price becomes 2.50 times its adjusted book. If 5%, the price will be 3.19 times the adjusted book. Naturally, the returns will be impacted. That is why the management trust factor is so important when it comes to valuing banks.

The bank's capital raising plans have been held up because of the story that has unfolded. At the moment, therefore, the capital ratio is not the best which means the bank's near term growth will be somewhat subdued. After new capital, the bank should be able to move on to the growth path. Its return on assets (1.35%) and return on equity (16.40%) are pretty decent. There is a reason to believe that this should continue. 

On 1 October though the bank released its unaudited details for the latest quarter, and noted that its gross npa were stable compared to the previous quarter. 

In the meantime, there is no dearth of recommendations:

Time will tell whether Rs.215 is a good buy, or a great buy, or something else. It looks like there is an opportunity here for the investors if they are willing to show some patience after picking it. 

pnb equity

Punjab National Bank stock is trading at Rs.97 per share. In January 2018, it had a high of Rs.194.  Oh yeah, it was priced Rs.231.45 on 26 October 2017. What happened? Well, this happened, and was explained here. $1,771.69 m is about Rs.115 b; that's the amount the bank is likely to be liable to the counter parties in case of full default. And later an additional Rs.13 b fraud was detected. 

So how much PNB's liability in this fraud is depends upon how much is the default going to be. SBI is already confident that PNB will make good all of its dues. PNB is in a slippery lane as of now. Until how much can be recovered from borrowers is known, all numbers are estimated in speculation. And the market says, so be it, if the price has to fall in speculation.

PNB equity was priced by the market at Rs.560 b in October 2017. It was Rs.392 b on 13 February 2018 just before the fraud detection, and has fallen 40% (Rs.156 b) since then. That raises question to the rational investors as to whether the stock is a buy now. After all, 40% fall is unprecedented, or is it?

Before the analysis, we have to begin with an understanding of the banking business. Core banking is after all raising equity and debt, the operating capital, at a lower rate in order to lend it to the borrowers at a higher rate. The difference in interest rates is the margin, and the difference in the amount of interest earned on lending and that incurred on borrowing is the operating profit earned by the equity shareholders. Ignoring the nuances of the banking regulation, it is a simple business at its core. 

A bank's borrowings include customer deposits and its bond raising. Debt for banks is actually the main feed for their lending business. Because banks are heavily leveraged, it is imperative that they exercise extreme caution on their operations. Otherwise, its shareholders will have to pick up the tin cups. Here's is how enormous its impact can be.

Suppose that a bank's equity is $10 and its debt is $90, and suppose that $100 is fully lent to the borrowers. Now, if only 1% of total loans turn non-performing, $1 of bad debt erodes 10% the bank's equity. Bad debts of 5% clears 50% of equity. Now we get the point how leverage plays on the bank's balance sheet. Nevertheless, banking is a business where debt is like oxygen; you need it to function. That said, extreme caution is imperative for banks.

Lending business is actually an investment operation. Investment in pure debt instruments requires both skill and caution. What is the point in lending for the sake of increasing the size of advances when its recoverability is in question? Be it businesses or individuals, there have to be sufficient free cash flows, both in size and consistency, available to service their debt; if not, they do not deserve debt. Banks will have to grasp this before lending.

Our definition of non-performing asset is one that bank is unable to recover. Let's see what the RBI guidelines say about NPA. 

Generally, the guidelines say that banks will have to classify assets as non-performing if principal or interest remains overdue for more than 90 days. That means, if a bank takes a view on a loan and before it becomes 90 days overdue concludes that it is not recoverable, it need not classify it as non-performing. That's the leeway banks take anyway which is legit, though not correct. However, after it becomes 90 days past overdue, the bank will have to classify it as an NPA. Do banks do that all the time? That's the question which remains a question. When a loan becomes NPA, bank's assets and income reduce due to provisioning and loss of income. That's bad for the banks, and they don't want to look bad. And that's why they take recourses to not to classify as NPA; and this ain't legit. 

Have a look at the RBI guidelines for provisioning.

The guidelines say that banks will have to provide 100% if the loan remains overdue for more than 3 years. While the call has to be taken by the individual banks as to whether a loan has become bad or remained doubtful, what is clear is that not providing for an unrecoverable debt does not make it recoverable over the period. One day the true picture will emerge. The credibility of a bank is built upon how it deals with its bad assets. The quality of a bank is built upon the levels of its non-performing assets; the lower the levels, the higher the quality, and of course, the safer its equity.

Coming back to PNB, as of December 2017, it had total equity (standalone, as we don't have consolidated numbers) of Rs.489,970 m; and shares outstanding of 2,425.587 m. That gives us a book value of Rs.202 per share. At the current market price of Rs.97, it appears to be a steal for an investor. But not so soon. As we have learned before, we need to know how good is this book value of Rs.202. 

As of December 2017, PNB had gross NPA of Rs.575,190 m (12.11%), and net NPA of Rs.340,760 m (7.55%). Its reported provision coverage ratio was 60.78%; whereas, our calculation suggests that just over 40% of gross NPA were provided for. The bank had stressed assets of Rs.671,290 m. There is an overlap between the gross NPA and stressed assets, and the stressed assets outside of NPA are estimated to be Rs.96,100 m. These are only estimates, still. 

The math then comes to this: Net NPA of Rs.340 b, fresh NPA of Rs.128 b, both of which call for higher provisioning if not 100%. Then the stressed assets of Rs.96 b. PNB is planning to go ahead with its Rs.55 b equity raising through issue of 334.9 m shares to the government at Rs.163.38 per share. After this, the total number of shares outstanding will be 2,760.487 m, and the new book value will be Rs.197 per share. 

Against its total equity of Rs.545 b, PNB is staring at NPA of Rs.468 b, and stressed assets of Rs.96 b. How much of PNB's equity is good depends upon how much of its loan assets will turn 100% bad. 

If all of its NPA turn bad, the bank will have to frantically look for fresh equity; or else...well, there won't be any equity left. That will not be good for a going concern operation.

If we estimate a loss 50% on NPA and none on stressed assets, the book value per share reduces to Rs.112. 

Loss of 50% on the existing NPA and 75% loss on the fraud assets will lower the book value to Rs.101 per share. 

A 75% loss of its NPA and none of stressed assets, and the book value will be Rs.70 per share.

We will have to take a pick based on our judgment. 

In fact, 75% loss on NPA and 25% on stressed will bring the book value to Rs.62 per share. What it means is, if the market wants it, it can bring the stock price to any level it wishes.

As of December 2017, PNB had return on assets of 0.12%, and return on equity of 2.03%. Its reported Tier 1 capital ratio stands at 9.15%; but the moment further provisioning is made, it will fall, and the bank will be much starved of equity capital.

It will be interesting to see if the government will buy the stock at Rs.163.38 per share as scheduled. The movie is unfolding for the public sector banks, surely.

infosys board immature

On 18 August, the Infosys board released a statement squarely blaming Mr. Murthy for the CEO's resignation, and it went a little further than that.

The board goes again:

It said Mr. Murthy has repeatedly made inappropriate demands:

It concluded by stating that the board has no intention of asking Mr. Murthy to play a formal role in the governance of the organization. What a remark.

While I read the statement I found it a bit funny, and my take on the whole drama was that it was funny. Post appointment of Mr. Nilekani as the new chairman, there was a big shuffle in the board, which was great, although there was a need for a little more. Two former CFOs of the company were apt when they said what they said. 

Then came some more funny moments with the board. On 25 August, the board made a statement again:

I read it again for the sake of clarity; I said, no, it can't be that comical; heck, it was. First, blame the guy, then say it was not the intention to blame. People around are not idiots. The height of immaturity was apparent in the 18 August statement. And  now, I don't know what to say. The better thing would have been either to retract the previous statement, or if that was not possible, at least keep mum. The board has been reshuffled already; all that is needed is to repair the damage and look to the future. 

Investors don't want the shit like, it wasn't our intention to...They are more mature. Yeah, there have been more articles on how the founders have to get off. Basically, they just don't get the point Mr. Murthy is making. You do have some rotten apples in the box, which you cannot help.

The board is in the right hands now; and we do hope that Infosys gets out of the mess.

infosys: desperate or demoralized managers

The more I decide to let Infosys be, the more it gets attention. These are spooky times for the managers; and they are not making it any easier for the company either. Desperate times, desperate measures; humans will be humans, don't they?

I don't have to elaborate much, other than quoting them in their latest 20 F filing:

Any sensible manager would have kept that thought in mind, if there was any, rather than in print. This is anyway noted well in both these articles. We don't know whether the squabble was worth it; we don't even know whether it is a squabble or a hammer on the nail. Instead of dealing with real risks haunting the business, the managers proceeded to demonstrate their comical side, which wasn't required in the present situation.

There is a way to end this game, I guess. Something that is subtly suggested in one of the articles above. Both the founders and managers can exercise their choices; it's a free market anyway. The manager's actions will be reflected in the way the business is run, and the stock prices follow it eventually. 

If any shareholder has an issue with it, the first step is to connect with other shareholders who too are on the same page. Then this group can confront the board and management to replace the incumbents. There's really no point in expressing their views in the news media anymore. Enough has been said what looks like in vain. 

There are views that the founder shareholders have no right to comment on how the business is being run. This is in fact both ludicrous and egregious. They should be reminded that the founders have not ceased to be the shareholders; and shareholders are owners of the business. 

If war is not what shareholders want, they have an exit route available. Sell those shares, and look for a better business. It is a tough one for the founders, but probably should serve them well in the long run. 

Now it is for the managers to show that they are neither desperate, nor demoralized. And let the markets decide in due course as to who the winner is. 

infosys: shareholder value

Infosys is currently in news. This time it is up against its founding shareholders. They are questioning corporate governance at the company. 

After October 2014, when the founding shareholders left the company voluntarily, its affairs were handed over to the outsiders. The shareholders showed faith in the new professionals in running the company in a diligent, transparent and professional manner. The expectation was also that the new board and management will increase the shareholder value over time. 

As noted by them, after their departure, the founding shareholders did not interfere in either strategy or direction. 

There was no question of interference from any of the founding shareholders. Then there was this sloppy headline at the economic times:

However, when you click open the headline, this is what you get to read:

However, the headline coolly puts words in Pai's mouth to blame Murthy for the fiasco. It is evident from the article itself that Pai never said anything of that sort. We wonder why not do some clean reporting. In fact, Pai has backed founders in raising corporate governance issues at Infosys. 

Making significant severance payments to departing employees was not called for in the best interests of the company and its shareholders. This was the first crack. Furthermore, remuneration of the CEO not commensurate with the value being created was also questioned; the second. The remuneration committee is primarily responsible for it. 

With responsibility, there comes defense, which is human nature. Yet, not disclosing such a serious matter (excessive severance pay) in the annual financial statements was a serious breach of corporate governance. How could the audit committee overlook such an important matter?

Of course, the board is collectively responsible for this mess. 

And of course, it is a joke to bring in a legal firm to deal with the founders. 

The founding shareholders own over 12% of the business. It is only fair that their queries are addressed in a manner that is transparent and professional. The fact that their opinions are out in the open reflects how they are being treated by the board. 

I am surprised that Oppenheimer Funds, which owns 2.40% of Infosys, is not in line with the other large shareholders. What the founding shareholders have said, and what response Oppenheimer has given is another joke. The fund needs to know the difference between corporate governance and business strategy and plan. They are two different things, although one would expect the managers to have strategy that is not in fight with corporate governance. 

Of course, Infosys is the business of its shareholders. So what it is publicly listed? A 12% shareholder is a significant shareholder, not an apathetic animal in captivity.

Let's come to the management performance. Vishal Sikka took over in June 2014.

Infosys has done reasonably well in the past five years. Both operating profits and earnings have increased on a per share basis. Yet, the market value has not moved much from 2011 high.

Pai is not off-mark when he said:

It looks like the past performance was not satisfactory for the market. Clearly, market expectations are low with respect to its future performance; growth rates have reduced, and both automation and global, especially the US, trends are expected to drive down growth rates further.

Nevertheless, Sikka has grand plans for the business.

For 2016, the revenues were $9.46 b (Rs.624 b), and operating margin was 25.39%. If these targets are achieved, operating profits would be $6 b in 2020; in rupee terms, the value will depend upon the expected exchange rate. At Rs.70, the operating profits would be Rs.420 b as against Rs.158 b in 2016. Infosys was priced at a high of 17.80x EBIT and a low of 13.44x in 2016. If we take the lower value of 13x, Infosys could be priced at Rs.5460 b in 2020, which is only 3 years away. For the investor at the current price of Rs.2224 b, the annual rate of return would be close to 35%; phenomenal, assuming no dilution in equity. Any one interested?

As for the intrinsic value, I am not brave enough to do it as there are too many variables related to the future, which I am not capable of dealing with.

morality of business

I have always maintained that one should carry out in a way that is within the legal boundaries set by the regulation and the moral boundaries set by the society. It applies to both personal life in terms of behavior and professional life. While it is easy to know the legal boundaries, checking out morality is not so easy. What is moral to one, might as well appear to be immoral to another. So, where do we stand here?

Is advocating Coke consumption immoral or is it tobacco that is bad? What about fried, packaged and canned food? What about environmentally unfriendly business? I can give more, but the line is blur. Yet, people always like to talk, or preach is the right word. Do as what I say, not as what I do, seems to be the cliche. 

I have not been a fan of Coke, and although I have said in the past that I won't buy Coca-Cola stock, I might buy it if the price is right, but not tobacco. When you attach big names to stories, they become more interesting; and that's what is happening at the moment. Wall Street likes to make it interesting. Someone says buying Valeant stock is immoral and some other says buying Coke stock is immoral. I liked the thud of that counter attack. 

I don't think any of these accusations are new stuff though. When it is never easy to draw the line of morality, opinions become personal not pervasive. If image-bashing is what attracts attention, people think so be it, and more. Now, is that moral? 

I don't think Warren Buffett has crossed any legal boundaries; I also find him to be very honest and ethical. His advice on investment management is the best one can take. No one has ever let out secrets of investment as openly as he has, and it is all free of cost. Probably, that's why they are not taken sincerely by people. Perhaps he should have priced his advice appropriately for its value to appear. As a matter of fact, I thoroughly enjoy his mocking Wall Street and the academia. Why not, when they fail to understand the difference between price and value, responsibility towards owners and are obsessed with personal gain? Yet, it does not mean that he is free of faults. He is a businessman and an investor. When he deals with other people's cash, he has the responsibility to maximize their (and his) returns. His actions are always within law, and what he considers to be within morality is up to him.

The accusations have been: He does not advocate use of derivatives, yet, he uses himself. He is an activist investor and uses his connections for profit. He advocates higher taxes, but pays the lowest tax rate. There are more. 

If he knows what he is doing, and his doing profits him, why not use derivatives? He is a businessman looking for profitable projects for his shareholders. His advice has been to avoid doing what you don't understand especially when it involves cash. Derivatives can be so complex that most don't understand the game, yet, play it, whereas, he is smart and plays it to his advantage; is that wrong? 

Activism and connections is a severe charge because it amounts to insider trading, which is illegal. Well, it is not proven as such. So people should be careful about what they talk. This one is ridiculous. If he found opportunities during the financial crisis when irresponsible firms were in trouble, why not profit from their folly? Did these reporters want him to look around and just feel sorry? It does not happen in business. 

He would be a bad businessman if he does not use prevailing tax laws to his advantage. He is in charge of shareholders' money where he has a fiduciary duty to make its best use. Did these characters want him to pay tax at say, 40% when as per rules it was only say, 20%? That math is crazy.

He is human too, and has his own shortcomings. Some may not find him to be the most adorable person due to stories regarding his family relationships. I too might have liked to advice him on a thing or two. We are all entitled to our opinions.

I would like to look at his positive side: He has taught people how they can lead a fulfilling life with lots of fun, and also make money by being honest, ethical and law abiding. Isn't that wonderful? 

His personal story may have been interesting for his biographer and others who enjoyed it, but I don't attach too much importance to it. I admire his simplicity, wit and wisdom. The guy is giving away almost all of his wealth. 

Charlie Munger can be the smartest guy we can find, and he is entitled to his views on morality of Valeant's business model. And so is Bill Ackman on Coke.

It is those storytellers who tend to attract attention with their so-called insights. They probably fail to look at the purpose of a business and decisions that maximize its value. To generate cash flows and growth, managers have to take good projects, finance them well and deal with excess cash appropriately. For personal charity, there is another platform.

blame it on accountants for poor investments

However much we want to blame the accountants for what they do and how they do it, there is one thing we cannot do, that is, take their advice for investing decisions. 

A firm would do well if it takes good projects over a long period of time which earn returns higher than its cost of capital. Easier said, but in practice we don't find too many firms enjoying excess returns over a sustainable period. Value creation is a rare virtue.

Value destruction is easy; take bad projects on a periodic basis, and then blame someone else; how about bad weather? Nevertheless, the last thing the managers could do is blame accounting advice for their poor investing decisions. Is it their ignorance or ego issue, or just for the heck of it? 

The recent news is about MF Global going bankrupt due to its poor judgment on sale of certain sovereign (mostly bad European) debt instruments, only to repurchase them back (repurchase agreements). The result was higher liquidity, and yes, a lot of commitments; we call it debt, but for which the accountants might have another name and treatment; the definition of debt to the accountants is probably different; it appears that they cannot recognize contractual commitments having debt characteristics. 

MF Global was formed in 2007 just before the financial crisis in 2008, and was trapped in a series of bad investments; it was forced to bankruptcy in 2011. 

Now it is blaming PwC for its poor judgments. Kidding it or playing the scapegoat?

If the managers try to play the short term games and dress-up quarterly results just to satisfy the rating agencies, analysts and investors, it is only a matter of time for the reality to catch up.

accounting gambit

Investor requirements

An investor's job is to analyze whether a stock is worth buying at its current trading price; the investor is naturally an analyst first. The task on hand is estimating the intrinsic value of the business behind the stock and making informed decisions.  

The pursuit is estimating the earning power of the business on a sustainable basis. This requires at least some knowledge about the business, the industry where it operates, and of course the macro environment. In acquiring such knowledge, the analyst has to check whether the business enjoys any particular competitive advantages, and how sustainable these special advantages are. Tough entry barriers, favorable regulation, great brand name, superior technology, economies of scale make the businesses earn superior (excess) returns over a sustainable period. 

The analyst has to estimate the extent and timing of free cash flows a business can generate during the initial, high-growth and stable-growth periods. This leads to estimating revenues and operating margins, and reinvestment needs, i.e. capital spending and working capital requirements to generate those revenues. The book capital then should include both the existing capital and reinvestment to be made in future. This capital is usually funded by equity and debt in proportions envisaged by the managers. 

The analyst will also have to assess the risk associated with these cash flows before a valuation can be carried out. 

Suppliers of information

However, none of this is possible in the absence of the financial statements of the business, both historical and current. This brings us to discuss the role of accounting in business valuation. 

The fact that financial statements are more a product of accounting is not for debate. Financial statements are prepared using a framework which is the GAAP as directed by FASB for the companies incorporated in the US, or the IFRS as directed by IASB for most of the other companies. There are exceptions (as of now) such as India where financial statements are prepared using the GAAP as directed by the ICAI. 

In the past the accounting standards setting bodies such as FASB and IASB focused on the historical costs as the basis for preparation of the financial statements. This presented the financial statements as the cash was spent or received with adjustments made for the accruals accounting. 

Particularly the last decade has drastically changed the way financial statements are prepared. The basis for preparation has moved towards fair value accounting rather than the historical cost. The rationale primarily has been that historical costs told nothing much about the indicative value of the company, but fair value accounting makes an attempt to supply much useful information required by the investors in assessing the value of the company. 

The financial statements in their current form, however, still lag behind the information that is required by the investors. Check this out:

Acquired assets include property, plant and equipment, goodwill and other intangible assets. PPE are presented based on the historical costs usually, or based on revalued amounts when managers consider that book value appears too low, or based on fair values when these assets form part of a business acquisition. For an investor, each of these could pose challenges both when assessing the current book value of capital employed and when comparing with other firms. All PPE are presented net of depreciation, but the method adopted to calculate depreciation can be different. 

Goodwill is presented as a product of business acquisition which remains on the balance sheet until someone wakes up and says it is impaired when its value is brought down. Intangible assets such as brand names, customer relations and copyrights arising out of business acquisition accounting are more dicey. If these were not presented in the balance sheet the acquisition costs would be allocated to goodwill. We can see that these intangibles are presented as acquired assets to lower the goodwill value on the balance sheet. A firm on a stand-alone basis cannot bring its brands or customer relations on to its balance sheet, then why when it acquires a business that is allowed - is it purchase-price allocation, or window dressing?

Investments in associates are presented based on equity method of accounting; all other financial investments are usually carried at fair value. All derivative instruments are presented at fair value. Estimation of fair value, however, is left to the accountants. Quoted marked prices are considered as fair values; and when there are no quoted market prices the preference is to call the book value as fair value.

All these games make the job of calculating book value of capital difficult which otherwise is a very easy task.

Details of acquisitions are also not supplied keeping investors in mind. If acquisition is made in cash, there is a chance that it shows up in the statement of cash flows, and we can get some more information from the footnotes. If the acquisition is made in stock, the financial statements hardly supply more details regarding this. 

Debt is categorized in the balance sheet as short-term and long-term. However, further information on debt is presented as the managers feel about it; some present well, some don't. The cost, maturity profile and special covenants for each debt instrument is not presented in a way that is useful for an analyst. Operating lease commitments are considered as operating costs even when these are long-term and non-cancellable. 

Costs related to research, advertising and staff training are charged to the income statement in the year when incurred. For an analyst these could be in the nature of investment for future depending upon the nature of the business. 

Information related to stock options, and other derivative financial instruments is usually not presented in a manner an analyst would have liked. The same is true regarding pension and health care obligations. 

All these factors pose serious challenges to the analyst when making estimates for reinvestment, growth, and return on capital. 

The least the managers, accountants and auditors can do to help analysts is to present in a more transparent manner. Asking for too much?

ongc is not a fair game

Exploration business

Brent crude is now at about $108 per barrel. In fact, it has remained higher than this level for much of the period. Oil exploration companies are treading good fortune, one might say. 

Despite that, 2013 annual report of ONGC says that its net realization on crude oil was $47.85, and it was $54.72 in 2012. For the first-half of 2014 it has been $42.56. This is not new, it has always been like that for ONGC. What is going on here? 

For any exploration business two biggest risks are explorable oil and oil price. The former depends upon several factors including technology and cost. As for the latter, the higher it goes the better it is. However, for ONGC it is not. Funny though, it is in a weird situation. 

The regulation

ONGC is forced to sell oil at discount to oil marketing companies, its customers. The discount is pretty large as we can already see. 

This is how it works: The government controls retail selling prices of high speed diesel, superior kerosene oil and liquefied petroleum gas. The reason appears to be simple; non-subsidized votes from the general public in exchange for subsidized petroleum products. Consequently, IOC, BPCL and HPCL sell for too low and incur losses (call it under-recoveries). The story gets interesting from now on. As mandated by the government more than 90% of these losses are to be borne by the government itself (about 55%), and upstream companies (ONGC, OIL and GAIL - about 35%). And more than 80% of the upstream share is charged to ONGC. The government does not reimburse in cash, it issues oil bonds to the oil marketing companies instead. ONGC and other upstream give discounts to them. 

Value destructive

Some thinking and analysis would tell us that this policy has had enormous impact on the business and shareholder value. The cornerstone of corporate finance has gone bonkers. In the last ten years, total subsidy borne by ONGC is about Rs.2,163 b; it's massive. That's the amount of revenue lost by the company. The bottom-line impact on ONGC is lower than this because it has to be pay VAT and statutory levies to the government. In 2013 the firm lost Rs.421 b and in 2012 it lost Rs.378 b on net basis; that is, cash loss after paying taxes. The minority public (including institutions) have lost about 30.77% (their stake) of this cash on account of poor regulation. 

Lack of substance

I just don't understand why the math had to be like this; it is ridiculous. If the public has to be supplied with cheaper products, why not just reimburse directly to the marketing companies? Just collect taxes, levies and dividends from the upstream, and give it to the marketing. Or better yet, stop this nonsense and go for market-driven policies where everyone gets what he or she deserves. Create employment, private partnership and growth, and make people work to afford goods and services, however expensive they might be in the market. If they cannot afford it, people should learn to live without it; a fair game.

The hapless minority

This is how I see it. The average return on equity (also return on capital) earned by the firm has been more than 26% over the last decade. If the subsidy cash was reinvested by ONGC in the business and earned say 25%, the current value of that cumulative reinvestment would have been staggering Rs.2,635 b; compare this to the current market value of equity of Rs.2,400 b. The government has destroyed the firm's equity value by about 50%. In other words, the minority would have been richer by 100% if only those policies were not adopted. Alas, it was not to be. 

The following shows how the minority has been taken on a ride by the majority shareholder (at March 2013).

This shows value lost by the firm at different levels of opportunity costs. Even the no-brainer 8% rate would have increased market value by Rs.1,534 b.

In fact, the government too could have done far better without regulation. Its share of value including all levies would be much higher. But then, politics is not business and finance.

The deregulation...the value creator

In 2013 both return on equity and capital reduced to less than 20% for the first time in the decade. No wonder the chairman is worried. The production levels (both oil and gas) have not moved much for a long time; fields have become old and mature.

For the firm to create value in future a few things have to take place: Increase reserves acreage; improve technology to reduce cost of production; hope for steady oil prices; and above all, pray for deregulation. The production targets require sustained reinvestment which would be impacted if the current policy continues.

We are informed that in June 2010 petrol prices were deregulated (I don't see it explicitly though) and diesel is on its way to be deregulated. All this is to bring down subsidies and fiscal deficit; the current hot topic.

When or whether it will happen is left only to guesswork. What we learn is that we don't learn. That should not stop us from guessing.

socialist democracy

The outsiders' view
He is usually low on the US and Europe, and high on Asia and commodities; that is his view. I don't track Jim Rogers. I am not particularly interested in commodities as such, because for me they are subject to pricing mechanics, not value mechanics; and that is my view.

Nevertheless, I found his recent comments about India quite interesting. Some of his thoughts:

Well, these are his thoughts and views. How much of these are really true, it is for anyone to ponder.

The fish school
The government has been from the school of giving the fish, rather than teaching to fish thought. Free food, subsidized food, subsidized products, in exchange for non-subsidized votes, probably. Wouldn't job creation be better? Wouldn't partnering with the private be better if the state cannot do it alone? Tough questions I guess, but, is India really catching up with the world, is it behaving right? Imagine a state owned listed company looting its minority public shareholders in the name of general public subsidy.

An option to delay...for how long...
I do see opportunities for improvement, if only some questions are addressed properly. We need to first check what India has shown in the past several years in terms of employment, per capita income, and real growth; how easy it is to do business, both for domestic and foreign firms; what kind of infrastructure is in place; how flexible or stringent are the rules regarding capital, currency and profits to move. These are to be assessed on a relative basis, both what it was before and what it is now, and also how it compares with other economies. If other economies are better placed it is easy to tell that business, money and growth will flow there.

The advantage India has is that it is difficult for the world to ignore it; it is tough to shrug off a billion-plus people, the potential for demand is immense; consequently, there is colossal opportunity for doing business. It is up to India now to capitalize on this, or fall behind.

At this stage, though, it is tough to tell whether India is a democracy, or a socialist; or a socialist democracy, I don't even know what it means.

Right now for investors it is like an option to delay worth a very low value. India needs do everything to increase that option value.

costly reporting; a corporate governance matter

This story tells us how fortune can be lost in a short time. While it is easy to criticize, for fortune to be lost, first fortune has to be made. And, it is no mean feat.

Having said that, to keep that fortune and let it grow, is the toughest thing to do. Not everyone is successful at that. 

The markets had created expectations beyond reality; and who was responsible for this? When operational and financial disclosures are made by managers, it is vital that they are important, accurate, relevant and timely. They should know that whatever they say (and not say) has direct impact on market and its expectations. 

The firm is now defaulting on its debt payments. The consequence is near bankruptcy. That is the cost of debt: default risk, which is direct and measurable; and bankruptcy risk, which is indirect and probable, but is very costly. This is basic corporate finance. 

Coming back to transparent disclosures and oil and gas in particular, if managers are not honest and realistic about their reserves, reality will catch up sooner than later. This is what happened with the firm.

jp morgan and its whales

JP Morgan is currently in talks with the department of justice regarding a settlement payout of about $11 b in fine on its mortgage backed securities transactions in the past. 

It is also in the news regarding its London Whale fiasco. The losses due to aggressive bets on credit default swaps trades were estimated at $5.4 b, which later were reported to be much higher; in addition, now fines have been levied to the tune of $920 m for violating securities laws as key information regarding the trades were withheld from the board. 

Too much of losses and too much of payouts; it is troubling times for JPM for sure. 

Many of the investment banks have been under the radar, but not punished adequately, for their reckless behavior: aggressive (proprietary) trading, rogue trading, insider trading, speculative trading. Top executives who are the real culprits keep doing the stuff they are used to. The documentary film, inside job, shows how the financial system collapsed and how top managers got away.

Back to JPM which earned about $23 b during the last four quarters. If that $11 b materializes, about 50% of its earnings will be dusted. But then it had some $593 b of cash as of 30 June 2013, which will be of some use now, albeit at the cost of its shareholders. 

It would surely like to pay up and forget. What we can say, grow up?

ongc punished for being good

The good news

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

The bad news

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

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

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

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

The reporting

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

Unusual risk in the business

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

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

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

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