hindustan unilever goes like private

The recent past

Hindustan Unilever has gone through some tough times during the recent past. Take a look: It saw its market value stagnate during the period from 2002 to as recent as 2011. Stock price in 2002 was near Rs.290 and until recently in 2011 it was still about that range. Patience is virtue, is it?

Today, the stock is trading nearly at Rs.600. All that increase has been in the past 2 years. While Nifty increased by about 3%, HUL doubled. 

The glorious past
Prior to 2002 HUL was actually a star performer.

That Rupee stayed the same for the next decade, though. Constant pressure from the competition and raw material prices brought EBIT down from 17-18% (2002) to 12% (2011). 

The change in market cap:

The present

Now the market capitalization stands at Rs.126,000 crores with robust performance in 2012-13. The current P/E is 34 and dividend yield is about 3%. 

The open offer on 30 April 2013

Unilever has announced a voluntary open offer to buy 48.7 crores shares in HUL at a price of Rs.600 per share. The stock price jumped by 17% that day from Rs.498 to Rs.584. Not bad for a day-trader.

The signalling effect

Promoter purchases are always considered as some signal to the market about how they feel about the current price compared to the future potential of the business. As the insider managers know more about the business than the market, any announcement or action from them should tell some story. Here, the promoter is trying to purchase voluntarily a significant stake (22%) in the firm. Everything else remaining intact, the market should consider that the price of Rs.600 is cheap compared to its intrinsic value. Is it really?

The promoters' insight, a delayed action

If that were so, why did the promoters (Unilever) wait until the HUL stock price doubled? They could have easily bought the stake for half the price two years ago. May be they did not have the insider's insight. Of course, Unilever is using its own cash (i.e. its shareholders' cash) not HUL's cash for it is not a stock buy-back from HUL. 

If the price is not fair then Unilever's manager is cheating its shareholders. Unilever is paying about Rs.29,220 crores for the purchase. The excess cash, if that was, could have been returned back to the shareholders as special dividends or if its own stock price was cheap, it could have done the stock buy-back itself. 

Obviously, Unilever knows that its future growth lies in the emerging markets. Currently, they account for 57% of its revenue. Sure, India could make a meaningful contribution to its growth, both in terms of revenue and earnings. This is a special business earning very high return on capital.

But the price paid has to be reasonable compared to the cash flows. This part is a bit difficult to figure out since the promoters waited for too long to do this. Now, they are telling us that at 34 P/E this company is worth it. 

Who is going to sell?

I don't think the additional stake will make any difference to its control because Unilever already owns 52.48% in HUL. The additional 22.52% will take it to 75%, the maximum limit. 

What does it mean to the HUL shareholders? The current shareholding is: Promoters 52%, Institutions 30% and Others 18%. The promoters would own 75% if the offer becomes successful. Who is going to sell? About 6.43% is currently with LIC, Oppenheimer fund and Virtus Fund. Assuming that not all shareholders in the others category would sell, a large part of that 22.52% has to come from the institutions. To make it more difficult the run up on the price means that the offer may not be accepted or the offer price has to be increased. 

The easy decision is rejection

Unilever has refused to increase the offer price. This means even if the offer price was fair the shareholders should reject since the current stock price is pretty close to the offer price. Those who believe the promoters can stay on and participate in the Indian FMCG growth story, and those who don't can sell directly in the market. You don't need additional paper work or anything to do with Unilever for now. 

Special dividends to the promoters

There is a new arrangement for royalty payments to the promoters too. It will increase from 1.4% of revenue to 3.15% before 2018. It is quite significant as a percentage of earnings. At the current revenue of Rs.27,000 crores the royalty cost is Rs.378 crores. Is this some kind of special dividend to some special shareholders? This will have impact on the future EPS.

Going like private

If the offer is successful, HUL will act more like a private business in a way than a publicly traded business. For one, the stock would have very little free float; about 54 crores shares will be available for trading. With 75% stock remaining with the promoters and some more with those who really don't want to trade the stock, the trading volume should come down significantly. It is not necessarily a bad thing as long as the business does well. However, this is something that the shareholders should know. The institutions who want to trade will continue to set the stock prices but they will own much less stock than before.

Buying from the market
The hunch is that since the voluntary offer is not likely to be accepted, Unilever will try to buy the stock from the open market as and when the prices are suitable.

the dancing dow and its long-term history

The Dow Jones Industrial Average is probably the oldest stock market index with more than 100 years of history behind it. The history is here:

In 1900 the Dow was just below 70 and now in April 2013 it is 14700. The table shows some facts:

It is evident that the Dow survived the uncertain world: The great depression of 1929, two world wars, the 1973 oil crisis, the cold war, the black Monday of October 1987 (22% fall on a single day), the dot-com bubble, the 2008 financial crisis, and the current economic recession.

Despite all odds, the Dow has marched on. Its 80-year return is about 6% annualized. However, the last 6-year period return since April 2007 is about 1.5%. Probably, its worst 20-year return is for the period from Jan-1965 (889 points) to Jan-1981 (822 points). Talk of long-term investing. Index buyers would have faced some terrible times there. 

The real American growth story began after 1981. Look at the graph. This must have created many a millionaire. 

So what causes the rise or the fall of the index besides the human (rather bad) behavior? Simple to answer but difficult to predict. It is the cash flows (earning power) of the firms. These cash flows are a factor of their growth rate and the riskiness. If growth rate goes up and interest rate goes down, it is good; vice versa is very bad.

The riskiness of cash flows is affected by the prevailing interest rates. As interest rates change practically the value of all assets with cash flows change. 

Have a look at the interest rate history in the US.

Interest rates touched 20% during 1980-82 period. The two decades that ended in 1982 experienced one of the highest interest rate periods in the history. Just as of now, it is facing one of the lowest rates  in the history.  What do you expect the index to do during these high interest times? It promptly fell in the absence of any meaningful growth in cash flows probably. 

What's in store now? The current global recession, the European crisis, the Euro mess, the Japanese regression, and the unstable BRIC markets - where do we go? 

The US may not be the best market in isolation; but if you consider what's happening around the globe, it is still probably the most enduring markets to consider.

At least in the American context, picking the right stocks could help; if not, low interest rates should help the Dow rise from here (take the next decade) until we see significant increase in the rates, of course, subject to a reasonable growth rate in the cash flows of the firms. 

Passive investing should offer some help for those who are wary of stock picking. 

jet airways dealbook

Jet Airways recently announced a deal with Abu Dhabi's Etihad Airlines based on which Etihad will buy 24% stake in Jet. It will also make additional investments in order to get some slots at Heathrow and frequent flier program.

Jet will issue 27,263,372 equity shares to Etihad at a price of Rs.754.74 totalling Rs.2,057 crores. That should make Jet worth about Rs.8,600 crores. Is it really worth that much? If you were in November 2010, you would have said that it could be. But we are in 2013 not 2010. 

Immediately after the issue, the promoter holding should come down from 80% to about 60%; LIC, Platinum Asia Fund and Birla Sun Life Frontline Equity Fund (other major shareholders) together would own about 4%, down from 5.23%. So effectively it will be Naresh Goyal and James Hogan show going forward.

With over Rs.10,000 crores debt, Jet has its challenges already. The latest announced results for December 2012 quarter have shown a profit of Rs.85 crores from Rs.4,200 crores revenue. This was the best quarter compared to the several previous quarters (which showed losses). Even for December 2012, operating margin of 7%, net margin of 2% and Rs.250 crores of finance costs are more telling. 

The future plans appear to be grand with expansion of capacity, taking advantage of Etihad management skills and possible exposure to more international markets. However, what remains a fact is that Jet is operating in a business that is inherently more risky than many other. High capital needs, uncertain revenues and uncontrollable fuel costs are a few of the business risks.

Jet commenced operations in 1993 and currently it is India's second largest airline in terms of market share and passengers carried. It has about 122 fleet in service and about 40 more fleet in order. Just have a look at its latest annual balance sheet (March 2012) and see its retained earnings, which are the cumulative earnings less any dividends paid to date. It appears that dividends have not been paid since 2007. I don't see much of earnings there.

Even if Rs.2,000 crores realized from share issue are used to reduce debt, the remaining debt would still be in excess of Rs.8,000 crores. Well, that is far in excess of the current market value of Rs.5,500 crores.

This current market value is a result of that sharp run up that has taken place in anticipation of too many good things happening to Jet after the deal. 

The stock price has almost doubled in the past 6 months; that is about Rs.2,500 crores increase in market value. Really, the public exuberance has no limits. Rather is that Etihad's?

I like to travel Jet anytime compared to the other airlines. That I am sure, no buts here.

movie making: a high risk business of creativity

Creativity.....it is a business

Movie making as it appears is a pursuit of creative satisfaction and also fun. In addition, you get to make a lot of money. But is it really so?

 

I consider movie making as no different from being in any other business. You need to get your investing and financing decisions alright before you can think of any dividends. Here, the producer has  two very complicated numbers to estimate: One, costs of the movie. Two, net collections from the movie. Heck, more often than not you can't get these right, not even approximately right.

Movie failures could be pretty bad for the business. Check this out for the sample.

 

Then why is it that so many movies are being made all over? India, for instance, releases far too many movies compared to any other country; and why not, when about 1.25 billion people are constantly looking for some entertainment in life? It is another matter that the number of flops outnumber the number of hits. If this report has to be believed, the failure rate in India is as high as 95%. Also, hits and flops are being used very loosely. For instance, if the movie collections cross a certain threshold, say, Rs.50, 75 or 100 crores, it is considered a hit. In reality, however, it could be a super-flop movie for the producer. And it shows up: even for hollywood; just have a look at the net cash flows. 

 

The odds of the business....unpredictable cash flows

In general, the odds of making money is a movie business are stacked against the producer. Here is why. The costs of a movie include: 1) The actors' fees, the director's fees, other technicians' fees, and other costs of making the movie; 2) Printing costs; 3) Marketing and publicity costs; 4) Finance costs; and 5) Taxes. A significant part of these costs are not under the producer's control such as lead actors and director fees. Publicity costs which are imperative considering the shelf life of a move these days could run large. Finance costs could be large depending on how the capital is funded. Taxes are taken away by the government in various ways at different stages, not necessarily all from the producer though.

Reducing costs is not easy. Consider the choice of not-so-popular actors and director (lower costs) and higher chance of lower earnings or popular actors and director (higher costs). Talk about the odds.

 

Even when the costs are diligently managed, there is the next element in cash flows which are completely out of control, viz. the collections. The producer wouldn't know how much the ticket sales and other collections from sale of music rights, satellite rights, etc. are going to be until they are actually collected. If people like the movie, the collections are going to be higher; if not, they are going to be lower. On a majority of occasions this has nothing to do with the script, the story, the lead actors, or the director of the movie. The critics can give their opinions (which are more often biased anyway), but they do not matter. What matters is the opinion of the people (as much irrational as it may be) who watch the movie paying for the ticket. Eventually, that is what decides the producer's earnings. From these collections, there are other payments that are to be made such as distribution costs, exhibition costs, and entertainment taxes.

 

So what is under the control of the producer? Well, it may be only the idea. He might have this bright idea of making a movie which he might think might make money for him. However, net cash flows not ideas are important. If an idea, however bright, is not liked by the public it could spell disaster.

 

Overall, movie making is a risky business unless cash flows are carefully estimated and there is fair amount of luck. I wonder how financing is done in this proposition. It has to be the prospect of high returns.

 

There is one silver lining though in this whole process. There are some things that are stacked in favour from the start. Let's consider the Indian market: A growing population (more movie watchers), high inflation (increasing ticket prices) and that craze. Consider this: If only about 25 million people pay Rs.75 per ticket on average for a movie the gross collections would be close to Rs. 200 crores. And we are making a big deal about Rs.100 crores.

 

The only problem is that this business is very unpredictable and requires a lot of luck. Another way to generate cash, if possible, is to insure the movie against failure. That is a gamble for the insurer.

In the final analysis, if one ever wants to value a movie, one has to be sure to use the cost of capital associated with the riskiness of those cash flows. And boy, how risky!

It's a gamble

The statistics for relatively good years for India: for 2012 and for 2011 - not sure of accuracy as financial information is not published. And so far so bad for 2013.  All time disasters and toppers for hollywood.

coke's increasing brand power; it is irrational consumers and investors

The soda and sugar

Consider this: You take some soda water, mix it with some sugar, ok, lots of sugar and some flavor, and offer it to your friend. Then offer to him a branded cola, say, a coke. Now, ask him two questions: were the two any different and which one tasted better. Chances are that he will say, yes to the first question (wrong answer) and coke to the second one (not an honest answer). If you want correct answers from him, give him these two drinks blindfolded.

 

Irrational excitement...the brand power

He would be more than happy to pay a dollar for that small can of coke than say, a quarter for the unbranded. Ask him why and he will say that he likes coke because it is the most widely consumed soft drink in the world; everybody drinks it and likes it. Cut this... he drinks it because every other drinks it knowing fully well that it has nothing special to offer. That is what I call the power of the brand. 

There is no point in talking about how powerful coke's brand is; everyone knows it. But I wonder why it should be the way it has been. Here's an unhealthy drink: soda is bad, sugar is very bad, flavor is no good, and the combination is one of the most powerful brands in the world. How ironic; how irrational.

 

The sugary soda business

I am not a fan of any carbonated drinks, leave alone coke. All I want to know is from the perspective of an investor in coca-cola as a company. Is it any good to be an investor in this company? With hindsight, the answer is simple: growing brand power, reduced prices, higher earnings. The coke has been a runaway winner over a very long period of time. Here is the proof:

However, the stock performance during the last decade has not been great. Take a look (2000-2013):

S&P-500 has barely moved, coke up about 75% and pepsi has doubled. Is this good enough for a long term investor in a consumer business, that too in one of the most powerful brands? 10-year treasury bond has yielded annual compounded rate of 5.31% during 2002-2012. Coke has lagged this and pepsi has managed, just barely. If you consider the stock performance from 2000-2011, the result is even worse: 3.67% pa for coke, 5.07% pa for pepsi. What has caused this?

 

Financial performance of coke for the last 5 years:

 

The market value has increased from $118 b in mid-2008 to $189 b now. Diluted earnings have increased at a pretty decent rate of about 12% pa. We know that markets always over or under react to situations. Ignoring their short term frenzy, we are pretty cool on long term story of a good business. Coke has passed this test over a very long period. Should it have?

 

Good or bad business

As my personal strategy has been not to get into a business which causes injuries to health in general, I would never invest in coke or pepsi, or any tobacco company for instance. That's my game. It's not been the opinion of the investors at large for the past several decades. Hence, these companies have performed enormously well.

 

There have been several concerns regarding health caused by carbonated drinks which have been to the courts and come out of the courts, not causing much of a damage to the financial health of these businesses. But will this continue? While more people are becoming coke consumers, there are several who are talking about health and freshness. There are too many alternatives to these soft drinks available now in the market: canned juices (is it any good?), fresh juices, etc.

 

Will any sense prevail?

Is it a matter of when, rather than will, people start to abandon carbonated water? I don't know about you, but I personally think so. It's amazing, it's so stupid, that people are crazy about a product which has nothing but soda and sugar to offer, and they create a brand out of it. It's not even the kick as in alcohol or a cigarette. You have to give it to coke for this, for managing to let people get cheated happily and willingly.

 

There isn't one rational reason why these businesses should make money: no product differentiation other than the brand. These businesses should have had failure written everywhere just like fast food businesses such as McDonalds and KFC. But hey, my opinion doesn't matter one bit.

 

It will take some time (or long) for good sense (the rational one) to prevail upon the people of the world and those marginal investors who set prices for the stocks. Until then, happy soda and sugar.

 

penney for pennies

When you try to value a business, you invariably consider the business as a going concern and apply your inputs. It could be a dcf valuation or a comparable valuation. Rarely will you use inputs considering the business as a dead firm. But what happens if your anticipated earnings turn out to be far lower than its current total assets? The classic term for this is that the business is currently worth more dead than alive. 

Well, that may be the case for JC Penny for currently it may be selling for less than its assets. If this report has to be believed the firm's assets, mainly real estate, could be worth about $5-10 billion where as the equity is selling at $3.27 billion. With the total liabilities of $6.6 billion including debt of $3 billion, the stock market may be discounting the business in its liquidation form; but not too sure.

Nevertheless, key beneficiaries will not be the stockholders since most of the cash realized will go to the lenders and other creditors; the residual, if any, will be for the stockholders. Is it worth it? Ask the lenders and stockholders, you may likely get different answers; you see, agency issues do creep in. 

What is the cause of all this? Continuing operating and net losses; the business suffered operating loss of $745 m and net loss of $552 m in the latest quarter; cash flows were somewhat better mainly because of reduction in inventories. For the full year ended 1 Feb 2013, it had operating loss of $1.3 b and net loss of $980 m on revenues of $13 b. Revenues have been falling; there are large lease commitments too.

Here is the latest attempt to raise cash; but will it succeed? Retailing is a tough business unless you turn those lower margins into higher return on capital. It is proving to be more difficult even for this 100-plus year old firm. 

faulty lending takes you back to history

Lending is investing

Banking is a good business if carried out properly; but can turn into a bad business if key principles of investing, primarily lending, are not followed.

When you lend, whether by buying bonds of a firm, or by giving loan to the firm, these key principles remain the same. In investing the primary expectation is safety of capital and secondary expectation, albeit an important one, is profit. Remember someone put it aptly, return of capital is more important than return on capital.

When you breach the rules of the game you end up with a bad investment. When banks do it, it is called non-performing assets. When a loan turns bad you lose all those so-called benefits of debt. You neither get the promised principal nor periodic interest payments, nor you have any control over the firm or its assets. It really does not matter whether the assets are pledged as security against loans.

That a lender has rights to the property and equipment pledged against the loans is good on paper; writing covenants is of little help; in reality is very difficult to realize those assets. It is not a new story, but just ask the banks, they are fresh in (bad) memory these days.

For the firm, debt is considered good because it can increase its return on equity and earnings per share, and also give tax benefits. But then debt has to be good, i.e. the firm should be able to service both principal and coupon payments. Otherwise those ratios can go for a toss. When they do, it is nightmare for the lenders.

Debt investing should begin with an analysis of debt capacity of the firm; in other words, the firm should be able to generate sufficient cash flows in both good times and bad times. If there is no earning capacity during a weaker economy, chances are that both interest and principal payments will be affected. Instead of analyzing earning capacity if the investor relies on the brand of the firm or the promoter, or pledged assets of the firm, he is heading for disaster. This is exactly what happened to the sub-prime loans in the US and also to our local banks sitting on NPAs. If banks rely on appreciating value of the pledged assets alone, it is not good banking, not good lending, not good investing.

Banks seem to be always in a hurry to increase their asset base, but fail to understand that it is the quality of assets that is important not the size. If they have to write-off most or all of their NPAs, they wouldn't be doing any justice to the depositors and shareholders.

Some instances of NPAs: Kingfisher Airlines, GMR infra, Deccan Chronicle, Manappuram Finance, Suzlon, RCom, the list goes on. It is amazing that the lenders were prepared to, and continued to, lend to these firms only on two counts, i.e. to increase their asset base, and assumed that assets pledged will back them during bad times.   

Buying stocks of a lender

May be the shareholders themselves are not following the principles of investing when they buy stocks of banks. Banking is a highly leveraged operation that is subject to regulation. But a few bad transactions can wipe out a bank's equity. It makes sense to keep away from such banks. A thorough analysis of the banks' book is a must before investing in their stock - because bad lending by banks will lead to bad investing by stockholders. This analysis is not an easy task; more often, you will know the bad book after it goes bad.

Look around the globe
What is happening around the world currently is primarily because of bad lending. Any lessons learnt? You must be joking, never heard this......what we learn from history is that we do not learn from history.