d-mart and markets

Radhakishan Damani, the promoter of D-Mart supermarkets, lived up to his reputation and market expectations as his company, Avenue Supermarts Limited listed on the stock exchanges at unprecedented premium valuations.

The bid opened on 8 March, and closed on 10 March; the stock got listed, and started trading on the exchanges on 21 March 2017. 

Avenue Supermarts in engaged in the business of organized retail, and operates supermarkets under the brand D-Mart. Prior to the public issue, the company had 561.542 m shares outstanding, of which over 90% was held by the promoters.

The company issued 62.541 m new shares at a price of Rs.299 per share based on which the promoters valued the entire equity in the company at Rs.186 b.

The promoters know the business better than others is a fair assumption. Consequently, they must have assessed the business fundamentals, industry, and macro structures before arriving at the issue price. The company earned Rs.3,187 m for the previous year, and Rs.3,874 m for the nine months ended December 2016. When we extrapolate, the net earnings for 2017 would be Rs.5,165 m. Therefore, the issue price is 58 times current earnings and 36 times expected earnings; not quite modest.

The stock closed at Rs.641.60 on 21 March 2017 valuing its total equity at Rs.400 b. The return expectations don't change unless there are changes on intrinsic basis: cash flows, growth, and risk. Yet, the value of the company's equity increased by Rs.213 b in a day. 

Of course, it made the promoters, who are already rich, richer. Besides that it showed us a glimpse into the market psyche. 

Avenue Supermarts is one of the most profitable retail chains in India. It is organized into 3 divisions: Foods (50%), Non-foods FMCG (20%), and General Merchandise and Apparels (30%); most of its revenues comes from Maharashtra.

It has three wholly owned subsidiaries, and one associate.

Currently, it operates from 117 stores across the West and South.

Based on its track record and growth plans, the company will require cash to fund its future expansions.

Avenue Supermarts had revenues of Rs.87 b for the nine months (December 2016) and Rs.85 b for 2016; net earnings were Rs.3.87 b and Rs.3.18 b respectively. Net margin increased to 4.47% in 2017 compared to 3.71% (2016).

The annual growth during the past four years was 40% (revenues) and 51% (earnings). 

The book value of equity capital in December 2016 was Rs.19.054 b, which will increase to Rs.37.754 b post public issue. Consequently, the return on equity of 21% (2016) will fall down to 14% (projected for 2017). The company cannot double its profits overnight by doubling capital. Also, much of the proceeds is being used to pay down debt; only Rs.7.5 b is being used in operations; while equity capital has doubled, cash used in operations has not. 

In order to achieve past growth rate of 40%, the company will have to reinvest 160-250% of its earnings considering its return on equity. It has already been reinvesting in excess of its earnings in the past.

There aren't any free cash flows at the moment; and I don't see any dividends soon either, if the company wants to maintain its growth momentum.

As of December 2016, Avenue Supermarts had cash of Rs.661 m, and debt of Rs.14 b.

Proceeds from the issue will be used for repaying a significant part of debt.

The company had financial expenses of Rs.907 m for the nine months (December 2016), which might seem likely to decrease in the coming years. However, as we noted, the company needs reinvestment far in excess of profits in order to sustain its growth rate. Where would it come from? I see two options: reduce growth rate expectations, or borrow again. By retiring its high cost old debt, the company may have plans to borrow again at current lower rates. Anyway, I would not count on significant increase in profits due to reduction in interest costs. In fact, its free cash flows might remain negative for much long and much worse compared to the past due to higher reinvestment.

The company might earn Rs.5.16 b (extrapolated) for equity in 2017. At its closing value on 21 March of Rs.400 b, the markets are pricing Avenue Supermarts at 77 times its projected earnings. I will keep the intrinsic valuation for another day. The question now is: is the market correct in its pricing mechanism? Where does Avenue Supermarts stand in the expectations game?

So what has happened post public issue? First what has not happened: Avenue Supermarts' revenues and profits have not increased; its cash flows, growth, and risk parameters have not changed significantly. There could be some changes in costs due to accessibility of public markets and in expectations due to public market investors. The company's corporate governance will be monitored more closely.

Avenue Supermarts is now worth top 6 retailers together. The next best in terms of market-cap are Pantaloons at Rs.117 b and Future Retail at Rs.116 b.

Some individuals and entities have gotten richer. The lead managers got richer by Rs.94 m. Certain management personnel are collectively worth Rs.1 b now.

The promoters, owning 82% of equity, are worth Rs.329 b now.

Since their cost of acquisition was negligible, the return on investment is exceptional.

Do they deserve this? Of course, they do. This is how free markets reward capitalists. 

Rs.10 M, not too difficult in India for the average

While making $m in the US is not that difficult, making some money in India isn't that much of a hassle either. 

It's just the question of the attitude. If you have it, you can make it. If you are like the most, well, you end up like the most. We are not talking about those who already have plenty to take care of in their later years. The lower and the middle class are the ones who are most affected, and therefore, need to make arrangements for themselves. Someone said aptly, parents aren't emergency funds, and children aren't pension funds. You got to keep your individualism. 

In the absence of any social security system in India, it becomes all the more imperative that a person shows some wisdom in dealing with the finance. It is strange that bonded labor for life in employment is preferred to making slight changes to the behavior. Well done consumerism.

Let's deal with the finances of an average person in an average employment; yeah, it comes with an average salary.

In January 2000, Nifty was at 1592.20, with a PE lurking at 25.91; dangerous tread for a rational stock picker. By now, it appears that it isn't so for a rational equity buyer. If the index was bought as of January 2000 and held through December 2016, the annual returns would be 10%; not bad. If the investor had bought the index on a monthly basis instead, the annual returns would be over 12%. It would be slightly more, if we include dividends. 

So how can an average employee in India enrich oneself? Let's pick someone earning a salary of Rs.25,000 per month, with a spouse matching that sum. Not too unusual in these times; in fact, quite modest. Left to themselves, they would be swayed by the waves of consumerism, and would be bonded for life. Throwing caution to the winds comes natural to them. If only we could tame them, and teach them to behave, it would be a different life. Alas, we can't.

If the average couple can spend one salary for living costs, and invest the other salary, the value of their financial assets would be over Rs.16 m. Assuming they started at age 25, they would be quite fine compared to their own lifestyle by the time they are 42. At 6% average inflation, the present value of their assets is more than Rs.6 m. If the couple increased their investment by about 7.40% annually reaching Rs.84,000 per month in the last year, the value of their assets would be approximately Rs.27 m, and the present value of which would be Rs.10 m. Even when the growth in investment is matched to the inflation rate, the assets would be worth some decent money in today's terms.

Yeah, Rs.10 m is the number that is illusive to the lower middle class in India. Yet we found out that it is very much achievable. With that much of cash, the couple who worked only for about 17 years, can move on with their life. Chase their passion. One way that can be possible is to move to a place where housing and living costs are much cheaper. Life then is only fun. They can even continue to work, but on their own terms; choose the location, employer, work hours. The lower middle class too has the power to make life more purposeful.

Imagine what people who are better than the lower middle class could do. We see them everywhere earning decent salaries; yet, they are in the rat race, not able cope. When in fact they can be financially independent within 15 years of their work time, they choose not to. Getting pleasure out of self-torture?

If the couple, who are better off than the one discussed earlier, are able to invest Rs.600,000 annually, they would have more than Rs.12.50 m in today's value; this is made possible in 15 years, if the annual increase in investment is 5%. We are talking about someone earning Rs.50,000 per month, which is matched by the spouse. Such salaries galore in these times. Their investment in the 15th year would Rs.1.25 m. The formula is the same: save one salary, and invest the other.

I hear a lot of excuses. Instead of focusing on what they can do, they spend time on things that are not in their control such as the government, employer, and the workplace. They have no problems in spending on the status car, large TV, expensive cell phone, fancy gadget, and regular fine dining. Cash for investment purposes, heck, life is too short and momentous to dwell on uncertainties such as the long term; for them it is preferred gratification.

It is a simple trade off: A maximum of 15 years of deferred gratification, or work under someone else for life. Guess, what they pick. Like I said earlier, human behavior has reasons that reason cannot understand.

who's the winner in valeant

Bill Ackman's Pershing Square Capital Management held 18.1 m shares in Valeant as of December 2016, which represented 5.28% of Valeant, and was valued at $263 m. 

In fact, Pershing Square also held some call options to purchase 9.1 m shares. The total exposure to Valeant was about 3% of its $11 b assets under management. While Ackman had been defensively bullish on the investment, he has now exited the position entirely. 

The average price of investment was $196 per share, and the average sale price was $11 per share, a loss of over 94%. Such are the rules of the investment game; no mercy; no sorry; no thank you. The markets are never accommodating; they are as ruthless as one can be. 

Yet, Valeant was a business with some terrible economics. 

The market value of its equity today is $3.82 b, whereas its debt is $30 b. Almost of all its operating assets are owned by debt holders. With problems around, the economic value of $16 b goodwill becomes questionable too. Under the circumstances, Ackman was probably correct in exiting from this business. 

The equity was worth $88 b in July 2015 when the share price was $257.

Based upon the sale of 18.1 m shares and options equivalent of 9.1 m shares, Pershing Square must have incurred a huge loss on its investment. The loss, which could be anywhere between $3 b to $5 b, could have been avoided, but only with the power of hindsight. 

NY Times estimates the loss to be $4 b.

Bloomberg estimates the loss to be more than $2.8 b.

Whatever is the quantum of loss, it is quite significant to the assets managed by Pershing Square. Ackman also admitted this in his annual letter of January 2016:

We cannot tell if greed, arrogance, or anchor bias was the reason for continuing to hold the stock despite negative vibes about the business. It could even be a rational theory that went terribly wrong; a mistake that Pershing Square and its shareholders need to forget, and move on.

Still, there is no dearth of long positions in Valeant as of now. Significant institutional investors include John Paulson (Paulson and Co) and Jeffrey Ubben (ValueAct Capital).

There is yet another battle to be won; again between Bill Ackman and Carl Icahn. This time on Herbalife. 

Who's going to win?

how far apple can take you

Apple is worth $744 b now; just 34.41% away from becoming a $ trillion company. Next in line are Google at $588 b; Microsoft at $502 b; Berkshire Hathaway at $447 b; Amazon at $408 b; and Facebook at $400 b. Since Apple is already 27% ahead of Google in the run, we can assume that it could the first company to hit the $ trillion. Much credit goes to Buffett and Munger for not falling behind the technology companies in today's times.

The discussion is on Apple; so let me stick to that. The question is whether Apple would make sense for an investor at its current price.

The business
For the year ended September 2016, Apple had revenues of $215 b, on which it earned $45 b for its shareholders.

Over 60% of its revenues come from one product, iPhone.

Units are in thousands:

The key for this business is growth. Can its revenues, operating profits, and free cash flows grow at a meaningful rate in future? The law of large numbers is impending, although it enjoyed extraordinary growth in the past decade. Where can it possibly sell more?

Of course, the return for the investor is directly based upon its growth rate. iPhones are not going to be changed every year, although certain geeks engage in doing just that. iPhones, iPads, and Mac are not cheap. Growth in China and India is some possibility; yet, there is enough competition in the emerging markets. Fighting the price war is not going to be easy. Average price of iPhone is $645, iPad $452, and Mac $1,235. A large base and high price are a serious impediment to the growth story.

In the current interest rate scene, 10-year treasury is yielding 2.48%, and 30-year treasury, 3.07%. For an investor then the choices are: pick treasury at these rates, or look for something that is higher than that. I am not checking real properties, or high-yield bonds; that is a separate business. So let's stick to equities in the public market. And I am not going to calculate the cost of equity to precision with the academic formula.

I reckon, any rate that is higher than 3% should be sufficient, unless the investor is predicting higher interest rates. Even then how much higher? We can add an equity risk premium of say, 5 points to get to an expected rate of return of 8%.

Apple is a weird business. It is currently earning ridiculous amount of cash on virtually insignificant capital. It had $237 b of cash from $128 b equity and $87 b debt. That amounts to a negative operating capital employed. Yeah, it is a weird business.

The intrinsic value
In order to estimate intrinsic value of Apple, obviously, we cannot assume that such weirdness should continue. We have to assume that Apple will have to reinvest in order for it go grow. So there are assumptions regarding the revenue growth rates in the next decade, and beyond that, there is a cap on the growth rate until perpetuity. How much the revenues would be say, in a decade, $325 b? Tim Cook has a story, and so do you and I.

Apple has shown remarkable improvement in operating margins from 12.70% in 2006 to 27.84% in 2016, all thanks to the brand iPhone. Net margins gained from 10.30% in 2006 to 21.19% in 2016. Again, return on equity increased from 19.92% to 38.28%. For the reasons mentioned earlier, it is not meaningful to calculate return of capital. However, we cannot expect these margins and returns to improve any further or even remain unchanged in future. Apple has become truly large to sustain further improvements is a reasonable assumption. How far down will these be in a decade is anybody's guess. Are 20% operating margin and 15% return on capital until perpetuity defendable? Time, not Tim, should tell us.

As a consequence of higher reinvestment rate, lower growth rate, lower margins, and lower return on capital assumptions, Apple's free cash flows to firm should also be lower in the coming decade. How about $37-40 b for the stable business growth?

Based upon its intrinsic value calculated considering a myriad assumptions, Apple might even be successful in giving the investor a 7.50% return at its current price. However, following it has its pitfalls.

Perpetual cash flows
We can even assume that Apple has already matured, and can value it on a perpetuity basis. At $40 b of free cash flows growing moderately forever, I see that the rate of return to the investor based on its current price is about 7%.

The pricing effect
Pricing is relatively easier. Apple had an EPS of $8.31 in 2016, which grew 16% (in 5 years) and 38% (in 10 years) annually; exceptional. From now on, though, there would be bumps on the road; but how high to obstruct growth? At 5% annual growth, its EPS in 2026 should be $13.50. Apple has been trading at an average high PE of about 15, and a low PE of say, 10 in the last five years. If we mark its high of 15, its estimated price will be $202.50 in 2026. That is a return of 3.78%.

Then there dividends. If we assume that Apple will fall short of innovation and moves to return much of its cash back to the shareholders, and further assume that $200 b of cash, net of repatriation taxes, will be used up in the next ten years, the dividend per share should be $5.40 at year 10 without any equity dilution. The aggregate investment return (price appreciation and dividends) will then be just about 6%.

If we assume that Apple realizes its size and acknowledges that it can no longer innovate, and further assume that, consequently, it chooses to distribute all cash back to the shareholders, at $435 b of cash return during the decade, the aggregate investment return will be about 8.60%. At this rate, the dividend per share should be $10.40 at year 10 without any equity dilution.

This assumption also has its perils; the market might mark its PE down to lower levels; and Apple may not be able to generate another $200 b cash in the next ten years. Just imagine a return of $435 b of cash in dividends! That would be a voodoo. That would even be the end of story.

Buybacks
Apple could expedite share buybacks. $200 b can be used up to buyback 1.3 m shares from its shareholders. Sure, it would trigger market pricing if done at one go. Nevertheless, that should leave approximately 4 m shares outstanding. This should have an immediate effect of increasing EPS to $11. If this grows at 5% annually, EPS in 2026 would be $17.91. The estimated price at 15 PE will be $268 in 2026. That is a return of 6.72%. With increased dividends, the annual return could be in the region of 9%; much better.

All this assumes that Apple will be able to retain its existing earning power. Yet, is 9% a cap on Apple's returns for the investor?

The benefactor
Warren Buffett has been piling up on the Apple stock. That should say all is well for its business. Is that so? Buffett has also been piling up on the airlines stock. Yeah, that is the same person who said, if a capitalist had been present at Kitty Hawk in the early 1900s, he should have shot down Orville Wright. Yeah, the same airlines that grow rapidly, require significant capital to grow, and earn little or no money.  Yet, Berkshire's purchases have been like there is no other time. This time there is no 800 number to dial either.

Never mind, Buffett bought 61 m shares of Apple for $6.75 b as of December 2016; that is about $110 per share.

Subsequently, he also bought more shares of Apple, because he liked it.

These 133 million shares might have cost him at least $15 b, which makes the average price per share at about $113.

Well, these are worth over $18 b now; so he has already earned book profits of $3.5 b. The Buffett factor is also imminent in the market.

So what is it that he saw in Apple now that he did not see before? From a technology-hater to the 2.50% owner of a technology company, sure, there must be something. One could be the law of large numbers staring at him.

But here's the bizarre reason that he chose to give; some enlightenment I suppose.

Of course, the product is sticky; otherwise it would not have enjoyed the growth rate that it reported. It has been there since 2007, when iPhone was first launched. Granted, 2007 was too early to feel the stickiness; but, last five years would have told something.

Even Microsoft's windows and office have been sticky products since a long time. What stopped him from buying its stock, conflicts of interest due to friendship?

The enterprising Apple
What else Apple could do to please its shareholders? With $200 b cash and growing, it can create an investment portfolio with some high-quality stocks. It can acquire certain high-growth companies. There is no other business, presently, in the world that matches cash generating capacity that Apple has. That cash has to be employed such that its shareholders get a meaningful rate of return. Tesla is selling at $40 b; What about some of Google and Facebook? A diversified portfolio of high-growth technology, and high-quality stable business stocks, and some of the index itself will not be a bad idea. Then Apple will have two divisions, iPhones, etc. and company, and investments business. Tim Cook will have to look for a worthy capital allocator.

The trillion
If the $ trillion is what matters, here's what it takes Apple to reach it.

While irrationality knows no bounds, Apple is a 7.50% return stock. That's not bad considering the alternative opportunities available at this time. But, even the broader markets are capable of delivering that return, give or take some points. That leaves us to choose between a low-cost S&P-500 index fund and say, Apple. A comfortable, low stress market return, or an exciting Apple return.

That is the question.