Investment Update

In May, we had noted that we may make additional investments based on our recommendations if Sensex touches 15,000-16,000 levels. Sensex has meandered between 16,000 - 17,000 for some time now, but more importantly our highly recommended scrips including Venky's and Confidence's came down by more than 40-50% making them very attractive.

Accordingly, we decided to allocate a further Rs 12lacs for Confidence Petroleum (@ Rs 9 per share) and Rs 8lacs for Venky's India (@ Rs 400 per share). We still keep Rs 10lacs cash to benefit from any unprecedented fall in Sensex.

Dhanuka Agritech and Amar Remedies have posted smart gains despite fall in Sensex and hence our net investment in six companies (Rs 24lacs) still sits pretty at Rs 52lacs (a fall of just Rs 4lacs or 7% since early June as against Sensex's fall of 18%).  Amar Remedies is at a level where we can consider partial withdrawal if it goes up by 10-15%.

In view of a nightmarish situation in Infrastructure segment as well as changing equation in post-Anna Hazare era, we downgrade our outlook on Om Metals from Bullish to Average and hence are refraining from upping our investment. Yet, we feel substantial value remains locked-in in the stock.

IT: Industry Analysis

While we do not normally recommend banking and IT stocks, due to their close correlation with global variables, which sometimes render them aloof to India growth story, it is this very nature which can present frequent opportunities in times of tumult.

With a short term perspective, as distinct from our routine investment perspective, we analyze IT stocks to identify the potential investment opportunities that can fructify under certain triggers.

IT Companies have a fairly simple business model. They staff their employees on lucrative client assignments. The average sales per employee (a key valuation driver) is determined by the utilization rate and average billing rate. The utilization rate of larger IT firms hover around 70%-75%. Smaller firms tend to focus on better utilization, which at times means need-based hiring and premature firing resulting in higher staffing costs, which more than undo the better utilization.

 

On the cost side, IT firms pay their employees salaries and incur an overhead per employees (in terms of office rent, support services and others). 

Employees salaries will typically be about 50% of the sales or 60-65% of the total cost. IT Companies' net margins range from 10%-25%.

The table above shows major listed IT companies arranged in order of decreasing number of employees. Since an employee is the smallest possible business unit in an IT services company, we have considered their valuation on a per employees basis. TCS and Infosys command better valuation (Rs 1.25cr+ per employee) primarily due to better margins earned, largely on account of their ability to attract better talent at similar salary levels to their competitors. Cognizant is better placed than Wipro largely due to the higher growth trajectory of the company (Note: Wipro also has a debt of Rs7lacs per employee). HCL seems cheaper in comparison, but its higher debt of Rs 10lacs per employee and lower margins (largely due to higher overheads) put it at par.

The next two companies in line present unique challenges. iGate has acquired Patni, and Tech Mahindra acquired Satyam (on which there is still lack of clarity about the financials). Any value judgment on these stocks has to be a based on a thorougher due diligence that is beyond the scope of our analysis. Polaris (with focus on BFSI vertical) and KPIT Cummins (specialized in Manufacturing domain) have been the darlings of FIIs lately, however there low sales per employee figure, coupled with lower than industry average margins, put them at a none too attractive pedestal. Polaris is a better value stock, but has a highly uncertain growth trajectory.  

Glodyne Technoserve caters mostly to domestic clients in IT infrastructure management, that explains its low sales per employee. But it has been able to maintain good margins along with higher growth (expected due to its domestic focus). But with a debt of Rs 6lacs per employee, Glodyne at firm valuation of Rs 26lacs per employees is not exactly cheap considering its size. Yet we sense a strong opportunity in case of a 30%+ fall in stock price due to a Sensex crash.  

Persistent Systems is a product development outsourcing firm having low sales per employee along with an un-scalable model (difficult to repatriate employees across projects seamlessly). Mindtree is suffering from a mid-life crisis, even its founder deserted it after seeing the writing on the wall. 

Vakrangee operates on top of a distinct business model, it implements eGovernance solutions and primarily trades software packages (hence higher sales per employees). Their largest cost component is not the salaries (less than 10% of sales), but cost of traded software packages. The space offers good growth potential but the profitability of the model is uncertain and hence a call on Vakrangee is fraught with uncertainty. 

Zensar provides a good opportunity to own a pie of an IT services stock at a good value. It may have an uncertain growth trajectory in the face of relentless pursuit of additional accounts from IT biggies, yet its valuation is attractive.  

Zylog Systems and Take Solutions are product development firms focusing on telecom (Zylog) and life sciences and supply chain management respectively. Product Development firms spend lesser amount on salaries (roughly 40% of sales) despite higher salaries on an average due to better sales realization per employee. Despite better margins and historical growth, Zylog is available at half the value of Take. Even accounting for Rs14 lacs per employee debt in Zylog, it is still available at a discount to Take's price. A 20-25% fall in stock price can provide a very good entry point for an investment in Zylog.

Our Indicative Portfolio

Eighteen months ago in Nov 2010 (with Sensex just below 16,000), we built a virtual portfolio of 17 promising companies (prima facie) available cheap. The quantum of investment in each company (ranging from Rs 2-8lacs) was such that the exposures to sectors were mostly uniform with inclination towards sectors that we felt had the potential for better performance.   

After analysis of these companies, we found that six companies are fundamentally sounder than the rest. These six companies that we currently hold along with their returns in the last 18 months are given below in the table. The average returns on the investment in these companies are 135%.

Of the Rs 50lacs investment, Rs24lacs was in the six companies outlined above, and Rs 26lacs in the other 11 companies, which included unloved sectors. Our other 11 investments returned 16%, almost mirroring Sensex (though with higher risk, as the companies were smaller than an average sensex company). The results confirmed our belief in Environment Management based identification of value stocks. The value stocks with poor Environment Management could just mirror Sensex in good times.     

Accounting for dilution of our holdings in the 11 companies, we hold Rs30lacs as cash and Rs 56lacs as equity investments. We plan to rejig the portfolio slightly (selling a portion of lower rated equities and buying some higher rated equities) based on our relative ratings of the six portfolio companies. We believe Sensex is slightly above par at present and will make further investments at 15,000-16,000 level.

Our relative recommendations are as follows:

Highly Bullish: Confidence Petroleum
Bullish: Venky's India
Bullish with close Watch: Om Metals Infraprojects, Dhanuka Agritech
Average: Dr. Agarwal's, Amar Remedies (Partial withdrawal can be considered, if Sensex touches 20,000-21,000 level or stock rises 50%-100%)

We have also identified Excel Industries as a promising prospect, on which we shall carry further analysis before making public our recommendation. We shall make public any portfolio rejig exercise, that we may undertake.  

Dr. Agarwal's Eye Hospital

Dr. Agarwal's started off as a one-off hospital in Chennai and is now a chain of 35 specialty eye clinics - 24 owned clinics and 11 partnerships.

During the last fiscal, Dr. Agarwal's had Rs88cr turnover (65% medical services, 25% optical sales, 10% pharmacy sales). The PAT figure was a measly Rs 50lacs. However, it is expected to close FY11 with sales of Rs100cr and PAT of ~Rs4cr.

Between 2006-2010, Dr. Agarwal's started on a debt-fueled expansion program that resulted in a 50% growth in sales and a cut in net margins to almost 0%. Doctor's salaries are 26% of medical services fees collected, while operating overheads are at 45%. Rents, and other administrative overheads at 22% of sales imply an under-utilization of facilities - quite understandable as a large chunk of clinics have come online in last four years.

Dr. Agarwal's has halted its expansion program a bit with just two more clinics coming online in YTD.With better facilities utilization, administrative overheads can come down to 10% of sales, while doctor's salaries can be brought down to 20%, even with better remuneration. An industry standard operating overhead of 35% can allow Dr. Agarwal to target 35% margins in medical services division (from current 5-10%). Opticals (50% of sales is job-work including wages) and Pharmacy are high operating margin activities. 

We expect Dr. Agarwal's to achieve Rs130cr in turnover in FY12 with a PAT of Rs10-15cr, that leads to a valuation of 3x-4x the current market cap. Over a three-four year horizon, Dr. Agarwal's can expect to achieve a PAT figure of Rs25-30cr. However, for the profitability to materialize, Dr. Agarwal's would need to sacrifice their pursuit of growth, which may not be likely.

Competition: Lotus Eye Care came with an IPO in June 2008. At the time of IPO, Lotus had four operating clinics with average sales per clinics (ARPC) to the tune of Rs2.5cr and a net profit of Rs2cr. Lotus valued itself at Rs41cr (pre-money) and sought to raise Rs39cr for a 48% stake dilution. Despite falling below issue price at listing, its market cap was in excess of Rs70cr. It was effectively valued at Rs10cr per clinics and 20x earnings. At present with 7 operational clinics, Lotus is valued at Rs24cr, (almost 70% down from its market cap at listing) at a per clinic valuation of Rs3.5cr (negligible debt). Ignoring Dr. Agarwal's partnership clinics, at current valuation, Dr. Agarwal's is valued at Rs1.73cr per clinic, but it also has a debt of Rs1.33cr per clinic. Dr. Agarwal's ARPC at  Rs4.1cr is 65% more than Lotus's ARPC of Rs 2.5cr. Fundamentally speaking, Dr. Agarwal's is a better stock, but Lotus is a better value pick considering that it is available at 0.4x book (probably prompted India Deep Value Fund to take a 1%+ stake in Lotus).

Both the stocks can have a tumultous future ahead, and we will see either an erosion in growth or in profitability. Lotus can't sacrifice on either front, as growth was the premise on which IPO funds were raised, while any erosion in profitability will put it in a hole from which it may be difficult to climb back. In that respect, Dr. Agarwal's is in a better position as it can choose to consolidate and improve its profitability and yet at Rs100cr+ sales, it will have a sizable presence in its market.  The total debt of Rs32cr is manageable, current capital structure is tax efficient for shareholders.

Lakshmi Vilas Bank: Largely Unbankable

Lakshmi Vilas Bank (LVB) is a Karur (Tamil Nadu) based old private sector bank, having 275 branches (188 ATM's) and 16lac customers. The Bank has an asset base of Rs12,000cr (Dec 31, 2010 estimate) and a loan book of ~Rs7,000cr growing at 20%. With a bank capital of just below Rs800cr, LVB's equity multiplier stands above 15.  

Deposits Classification: From total deposits of Rs10,000cr, LVB only has Rs2,000cr of the money in current account and savings account (CASA ratio of 20%, up from 18% in FY10). This results in a high cost of financing the deposits (roughly 7.5%).  In fact, a cursory glance at LVB's press releases paint a gloomy picture. More often than not, it is announcing a hike in FD rates, hence relying on term deposits to boost its ability to lend. 

Operational Performance: The Bank has recently announced an increase in NIM to as much as 3.75%. In the past, LVB's NIM has hovered in early 2%'s. It increased to 2.75% in FY10, and now the Company has announced a further 1% jump. The high increase has come despite no significant improvement in CASA. This poses a serious question on the kind of loans LVB is extending (as its average lending rates are 12%+). Despite good NIMs in the last two years (FY10 and FY11), company's net profits have remained below par, due to higher provisioning for non-performing loans. Its RoA is lowly 0.4%, with an RoE of none too impressive 7%.  

Asset Quality: The Company's Gross NPA's as on Mar 31, 2010 were at an astoundingly high level of 5.12% (in absolute terms, Rs325cr). Due to higher provisioning for NPA's in FY10, the net NPA's may have come down to 2%, but Gross NPA's remain at very high levels (4%+). In absolute terms, NPL's have hardly come down (still at Rs 300cr+). LVB has reported a massive rise in NIM in Dec '10 quarter, raising doubts about the quality of newly extended loans as well. Relatively speaking, amongst high profile banks, LVB's Gross NPL ratio is just below ICICI (6.52%). 

LVB is one of the smallest banks, and can count its next door neighbor Karuvr Vysya Bank, and Dhanlaxmi Bank for company. Karur has got Rakesh Jjunjhunwala's interest and a large GMR group shareholding, while Dhanlaxmi has got Nandan Nilekeni (no slouch himself, he owns 1.1%) to boot.  Fundamentally also, LVB trails both its counterparts. It is no match, neither in fundamentals, nor in size, to the smallest public sector bank - Dena Bank. It can claim to better only Yes Bank in terms of CASA, but Yes scores heavily on accounts of growth (50%+), asset quality, and operational efficiency (RoA - 2%). 

LVB is available at 1.4x book, but it is not exactly setting its book on fire by returning 7% on equity. In the past, it has had too many rights issue (you would expect that from a low RoE, average growth company), leading to dilution of stake of existing shareholders.  Asset Quality remains a concern. The per bank valuation comes at Rs 4cr per branch, lower than the Rs 7cr per branch ICICI paid for Bank of Rajasthan, and ICICI's branch setup costs (Rs 7cr).  But its branches lag ICICI's and BoR's in terms of quality and amount of business undertaken. Management plans to open 100 more branches in FY12. There is a potential for average returns, but nothing beyond that in 3-4 years.

Talking of banking sector in general, Yes's growth impresses us, but it has failed to improve its CASA ratio despite repeated tries, anyway Yes is available at inflated valuations. HDFC's fundamentals are praiseworthy but a P/B of 5x is enough to scare, even in loveliest of times. Dena Bank provides best value for money, but with a PSU tag as a liability. Banking sector moves in sync with Sensex, which we believe is at above par level. Hence, we recommend investors should stay away from banking sector as there are no great value-creating opportunities. 

Our View on Real Estate

Mails have been pouring in, asking for our stand on real estate, particularly in view of Om’s analysis. I will take this chance to elucidate on what we believe. 

We think India is a poor country and contrary to what many people believe, it is slated to be so for the next few investible periods. Necessities are going to come at a premium and luxuries shall be available at a discount. We shall continue to see queues for subsidized LPG Cylnders, and home delivery of tickets for watching a blockbuster in a multiplex (so bad, they cannot bring the multiplex to our doorstep).

Indian Societal Structure

“A country of 1.2billion people must have a substantial number of customers for whatever you can throw at them at whatever price”

Let us take a different approach – a bottoms-up income based approach to judge the market size of customers for residential real estate at prices touching Rs 50,000 a square yard for freehold, and Rs 4,000 a sq ft for leasehold. 

A few MNC’s, investment banks, and management consulting firms pay handsome salaries to premier college graduates. If we analyze the college enrollment data of last three decades, we can expect about 200,000 employees, who get salaries exceeding Rs 30lacs per annum. 

An enquiry with Income Tax office confirms this facet. Even if you adjust for fringe benefits and exemptions, it shall not be disputable to say that “less than 200,000 employees earn more than Rs 5m annually.”

Who else are rich in India – businessmen of course? The number of companies earning more than 10cr annually can be pegged at 50,000 (estimates based on RoC filings). Taking two promoting families a company on an average, we can safely say that 100,000 businessmen match or exceed the income levels we discussed previously. 

The last part of the riddle is the politicians – 800 MPs, and 5,000 MLAs. Assuming each MP has 10 cronies and every MLA has 5 cronies (cronies can include bureaucrats) and no one overlaps with the classes already discussed above (a liberal assumption if you ask us), we are talking about 33,000 ultra-rich politically inclineds (PIs, including politicians and their cronies). Now for every MP seat, there are two other strong candidates, who are financially and croni-cally as capable as the winner, ditto for MLAs. So, we have 66,000 other ultra-rich PIs, putting the total at 100,000 for PIs.

We are still left with the performing class (actors, singers, cricketers), who can be numbered on fingertips. Assuming 100 different classes of performers, and 100 performers per class, we still get only about 10,000 performers. 

Adding all the four classes, we have a figure of 410,000 who are economically capable of guzzling real estate at the above discussed prices. Is there enough real estate to satiate the demand of these 4.1lac richests. There seems to be almost as much in Gurgaon itself – leave alone other regions. Based on a sample size of 100 in this class, we concluded that about 30% i.e. 123,000 are themselves active directly in real estate through self/proxies. Indians always find resources for the talk of the times due to their entrepreneurial gene (more on this later).
 
The Growth Myth

India is a large economy (size almost $4 trillion if you take into account black money) growing at 8%. But the incremental income is failing to materialize for a majority. 95% major new companies and IPOs have been offshoots of the existing promoter family network. In politics, entry is difficult without having an in and so is survival. That leaves the service class as the only place, where you can carve out a way up (in economic terms, high mobility). The salaries in the lower and higher echelons have been more or less stable, just about meeting inflation, leaving only a few even in this category to benefit from the growth. No wonder, India is seeing the highest growth in the number of billionaires. Yes, India is growing, but so is inequality (as measured by Gini’s coefficient). In this sense, India seems to be taking direction of Thailand: growing inequality, rampant corruption, high growth and high inflation. 

Who else is in India?

There are 180lac government/public sector employees in India, of whom about 5% i.e. 9lacs are Group A /B officers. 84lacs are employed by the private organized sector.  Then there are small-time shop-owners businessmen to the tune of 100lacs. A Group A government/public sector officer earns Rs 50,000 per month during the mid stages of his life. He can afford to buy a home for Rs 30lacs without any other support. Well paid private sector employees (mostly in metros) can afford to buy a home for Rs 50lacs. The purchasing power of shop-owners and their kin fall in that range as well. Sadly, prices in metros as well as non-metros are completely misaligned to the reality of purchasing power.

Historically, a high number of purchases have been fueled by home equity – in short, the exorbitant price that the seller gets for his owned real estate enables him to buy something else at an equally exorbitant price. That has set loose a dangerous trend, which when reversing, will have a cascading impact across the segments.

The Supply Side

Not so long ago, investors were jumping up and up over Unitech. 10,000 acres of real estate must be worth at least a Rs 10,000cr and a credible company like Unitech should be able to realize sales of up to Rs 100,000cr from this land, if not more. But the reality has dawned. The real estate companies, all over India, put together, are developing 30,000 acres of land in the next two years. Assuming an average size of 2,000 sq ft for a home, the figure leads to a supply side estimate of 1.15m homes. India has 70m urban households, of which just about 14m are in a position of even contemplating a house buy. The ratio of tenants to house-owners in India is a measly 2%. So, we are left with an end user demand for just 23,000 homes, that too, at much lower price estimates than are prevalent. How long can a majority of supply be sustained by investor demand in the wake of falling prices in real terms (a key thing, as companies never emphasize the inflation aspect)? 

How about a bit of rhetoric?

Indians are highly entrepreneurial; unlike the Americans or Europeans (my statement may call for censure from the face-book smitten populace). But I am not talking about pieces of art created by idle minds. I am talking about carving out a way to survive within highly limited means. 

A company will learn more from a product launch here in a month than they will in a year in US. People define their own use of a product; a washing machine is used for making Lassi, a shampoo for seamless washing of buffaloes. In USA, the customers are too brainwashed by continued exposure to scientific marketing and systematic neuro-programming to develop even simple alternative uses which seem almost akin to common sense.  

Where else can you see development of a submersible pump for air coolers for $3 or jugaad at its best “a convertible sports jeep” for $3,000, that looks much like the resource guzzling hummer at its worst. Sample this – a million students graduate every year, hardly 10% gets placed in the organized sector (Americans and Europeans will laugh at this statistic, even in today’s recessionary times), yet year-after-year 80% of the unemployed graduates find an honorable way to survive. Surely this cannot be by accident. 

PIEG (Poor India with Entrepreneurial Gene) Hypothesis: The entrepreneurial gene in a widely poor populace provides an important insight into crowd behavior in India. Many investors made crores during the last two decades in Real Estate that explains fascination with real estate during last few years, those smitten by it were rich and poor alike – rich due to its tax-efficient nature, poor due to the riches it offered. But Indians are quick learners. The last few years in Real Estate have been fairly static, with minimal returns. With good infrastructure and substantial competition, enough supply shall be online to ensure negative real returns on real estate in the decade ahead. It will perhaps take an ordinary Indian a couple of years to figure things out, but figure he will out, before the mayhem. The exit may happen in stages, but the phenomenal returns on a preferred asset park of yore are gone forever. 

When that happens, there will not be any left to splurge on buying homes at $100,000+ price points. Those who can are already neck deep in the home market. Those who cannot, will rather find ways to survive, then waste their limited means on a sumptuous living experience. If there is a market, it is likely to be for $15,000-$30,000 homes in Tier-II cities, and for $40,000-$80,000 price points in Tier-I cities, nothing beyond that. 

There will still be opportunities due to standardization in cost of real estate; prices can rise in places which were hitherto left untouched – like Bihar and MP. Yet, I scarcely see an organized player extracting any benefit out of it.

With that, I sum up our fear of Real Estate fascination.