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.

Inox: Hollow steel

Inox is the second largest  multiplex chain in India currently running 38 multiplexes in 25 cities. The chain has 144 screens and 40,000+ seats. Before delving deeper into the rationale of whether to invest/not invest, let us have a look at a typical day in an average Inox multiplex. 

 

 

It is easy to observe that due to three-way distribution of ticket collections, the net share of the multiplex is less than 30%. A heavy share of profits from multiplexes come from food (67% gross margins), and advertisements (90% gross margins). A multiplex takes about Rs 8-12cr to set up depending on the location (assuming that the place is leased, which is an industry trend now-a-days). The operating profit transforms into a RoCE of ~20% - apparently not too bad for a business with stable and predictable cash flows and good growth prospects.

Myth 1 - Stable and Predictable cash flows: Reality could not have been further from the myth. Entertainment tax is a key component in determining the profitability of the multiplex. A small rise in the entertainment tax will cut through a major chunk of the profits of the multiplexes. Most states have entertainment tax in the range of 50%-60%, with rebates during the first few years (5 in Maharashtra where first Inox started operations in 2003). The good profits during the first few years turn out to be a mirage as soon as the honeymoon period is over. To add to it, distributors and producers have lobbied to get a higher share of collections. Earlier, operators used to squeeze smaller film makers and average share of distributors was on the lower side. For Inox, occupancy levels have been on the higher side due to good locations of the initial multiplexes, but with expansion comes the scourge of low occupancies. At industry average occupancy of 35%, at a ticket price of 200, a multiplex is barely operating at breakeven. In tier-2 cities, low occupancies coupled with low ticket prices imply continual losses in the hopes of riches ahead. 

Myth 2 - Good Growth Prospects: The table below shows the composition of Indian cinema industry. Multiplexes command 4% of the share of the eyeballs, suggesting that there are enormous growth prospects. 

 

But before coming to any conclusions, let us have a look at another table, which finds average cinema visits per patron in the addressable segment. The average is not far behind US - 4.8, US's is amongst the highest cinema going populace in the world. 

 

For the purpose of finding average visits per patron, we have assumed that 40% of the people (a very high number, if you ask me, but let us keep it at that) residing in these cities visit multiplexes. So, in a country where per capita chicken consumption is 5% of the US average, multiplex operators want us to believe that per capita cinema visits will far surpass corresponding figures in US. 

With good reasons, I believe that majority of the addressable locations already have a multiplex, the newly opened ones are in fact, running in losses, with a very small likelihood of turning profitable in the next five years, unless the Government comes up with a radical overhaul of entertainment tax regime. Due a high cost structure, it is not feasible for multiplexes to move beyond Tier-1 and Tier-2 cities. The opportunity of growth through geographical roll-out gone,  the only way for multiplexes to increase revenues is through a rise in ticket prices or higher cinema visits per patron. Even here, prospects look bleak. The average cinema visits are on the higher side of the average in developed countries, while ticket prices are at the higher end of affordability level for most patrons - a trend symbolized by almost 15% reduction in food consumption per ticket in Inox as patrons look to bring down their average cost per cinema visit. A reduction in food consumption has been a double whammy for operators, due to the higher contribution to profits from food. That leaves the multiplexes with below average (may be 5-6%) growth prospects in the short to medium term. If they could have looked beyond their immediate greed, they would have cut down the ticket prices and offered food at reasonable prices to improve food sales as well as overall profits.

History of Inox: With the myths about multiplex industry forsaken, let us look at Inox specifically. The promoters of Gujarat Flurorochemical (a very good company with sound fundamentals) decided to make a foray into a sector with a mass appeal for investors. In 2002, promoters transformed a piece of land worth Rs 17cr into a company with a further investment of Rs 8cr. The Company launched its first multiplex in a year in Mumbai, and secured Rs 50cr debt in 2003 to start work on three other multiplexes. As the initial multiplexes slowly took off, the promoters put in an additional Rs 20cr as equity, which did not prove enough for growth (work on four more multiplexes started) and was supplemented by a Rs 40cr subordinated debt from Gujarat Fluorochemicals. In effect, promoters had put in Rs 68cr into the company (Rs 28cr equity, and Rs 40cr debt), leading to a 100-cr turnover Company by 2005-end with eight operational multiplexes (second only to PVR at the time), and Rs10cr+ profits. Armed with these statistics, Inox came out with an IPO in Feb 2006, valuing itself at Rs 576cr (pre-money). The company raised growth capital to the tune of Rs 144cr and the promoting company sold shares worth Rs 54cr (double of its equity investment in less than four years). GFC's shareholding in Inox came down to 72.5% as a result of the IPO. 

Inox used Rs 40cr from the proceeds to pay the promoting company back the unsecured debt over next three years. The Company bought an East Indian multiplex chain (1 operational multiplex, 1 about to be started, and 6 in pipeline) from Ambuja Group for Rs 48cr (instead of paying them in cash, Inox awarded them 5% equity worth almost that much at that time, bringing down GFC's shareholding to 69%). By 2009-end, the Company has 30 multiplexes with just Rs 224cr turnover and profits languishing at Rs 20cr. Stuck in a trap, Inox acquired a controlling stake in Fame Cinemas with a view to transform its operations (the stake, worth Rs 83cr was financed through an unsecured debt from GFC). Just about an year back, Fame's promoter was complaining about occupancies as low as 24% during the IPL season and the need to shut down a major chunk of his screens. Yet, at the time of acquisition the total number of screens was trumpeted. 

On a consolidated basis, Inox has 50 multiplexes (second only to Reliance Big Cinemas), with an expected turnover of Rs 452cr and PAT of Rs 22cr in FY11. At current market cap of Rs 286cr (about 30% of market cap in 2006 at listing), it is available at 13x FY11 earnings and at just under Rs 6cr per multiplex.The Company's profits have hardly moved up since FY06, as the expiry of tax rebate on the initial multiplexes cut out any new contributions from the other multiplexes. The average revenue per multiplex (ARPM) are just above Rs 9cr per multiplex (down from Rs 13cr+ ARPM at the time of IPO). In short, the Company's fundamentals have gone from poor to poorer. As if being in a bad sector was not enough, the Company is not even best in its category. PVR has surpassed it in terms of average revenue per multiplex by avoiding any needless acquisitions. The Company is better fundamentally than Reliance Big Cinemas (a heap of zero-yield junk bonds, as you would expect from an ADAG group company), and Fame Cinemas (the company which Inox seemed too eager to buy, and Fame promoters seemed too eager to sell). 

 

Transaction and Trade Multiples

IPO Frenzy of 2005-06: Investors who may have observed the IPOs by multiplex chains in 2005-06 period, may think that Inox is a very good pick. After all, a loss-making Shringar (erstwhile Fame Cinemas) commanded a valuation of Rs 41cr per multiplex. Taking cue, PVR valued itself at Rs 45cr per multiplex. Inox came with the IPO at an even better time, and its higher ARPM (Rs 13.6cr) allowed it to command a valuation of Rs 72cr per multiplex. Considering these figures, the current figure of Rs 6cr per multiplex on a consolidated basis seems very cheap. However, if we return back to our multiplex level analysis, it should be noted that Inox is operating at operating profits of just about Rs 1cr per multiplex, where it is in danger of going under with small fluctuation in occupancy levels or a rise in rentals. Hence, a value of Rs 6cr per multiplex after taking into account a debt of Rs 4cr per multiplex seems rather expensive.      

The Company has amassed Rs 100cr+ unsecured debt from the promoters, which they would want to get back soon (either directly or through loans extended to other group companies), so I expect a round of QIP or an FPO, once economy brightens up a bit. Needless to say, interests of the minority shareholders can be sacrificed at the altar of relentless expansion.        

Environment Management: I do agree that promoters have a good track record in environment management, but we have to keep in mind that Inox was just a value unlocking exercise from a parcel of land for GFC. As such, any promoter expertise is likely to benefit GFC more than Inox. To cite an instance, Inox has commissioned a wind power plant for captive consumption, but the real purpose is to test Wind Power potential, which once tested would likely end up as a separate company with substantial shareholding from GFC.   

There is only one recommendation coming out from all this analysis: stay as far as possible from this nervy steel.