The Subprime Credit Cycle

The Subprime Credit Cycle

In an interview last year with ValueWalk, I mentioned a description of the subprime auto credit cycle which I will repeat here. The cycle can be broken down into 4 sequential phases. Because this is a repeating cycle, we can begin at any point on it:

High Profitability: With tight access to capital and few competitors, lenders are able to negotiate favorable terms with borrowers. Return on assets is high, financial leverage is lower, and lenders are able to get high net yields and high profitability.

Expanding leverage: Due to the wonderful reports that are coming out of the lenders in the sector, new entrants begin to enter the market. Capital markets are willing to lend more money at more favorable terms. Increased competition causes ROA to fall as borrowers have more options to choose from. Lenders begin to lever up their capital structure in order to boost ROE.

Low profitability: Intense competition forces lenders into a choice of surrendering market share or decreasing lending standards. Loans are given at lower rates. Leverage is increased even more to maintain ROE. Fraud and mismanagement increase throughout the sector.

Decreasing leverage: Decreased standards from the prior phase will cause defaults to dramatically increase. Loan yields fall below profitable levels. The deteriorating loan performance of the industry causes capital markets to tighten. This deterioration will often happen at the same time as an overall economic recession which causes capital markets to be tight across the economy in general. Lenders are forced to exit the subprime auto market as they find their business unprofitable and/or access to capital markets absent. Some lenders go into bankruptcy. The tightening clears away all lenders with poor underwriting or too much leverage.

Monopoly

Characteristics of a Monopoly Business

1. They are either regualated monopolies or there are unregulated monopolies but if it is an unregualted monopoly it would be bad for the regulators to know about it. Therefore, most unregulated monopolies would try to show the market as very big or would encapsulate multiple fields in order to show their market share as very low. The financial characteristics of true monoplies include

1. Increase in per unit EBITDA

2. Increase in gross margin per unit or gross margin %

3. Negative working capital cycle

4. Either the market is niche with very little scope for larger players entering the market, thus protecting the existing market size

5. Healthy return on capital employed with no need for dilution

6. Boring business with no large people coming in. 

These are all a reflection of the following

1. Economies of sclae

2. Brand Power

3. Network effect

4. License/Patent

https://hurricanecapital.wordpress.com/2016/08/02/peter-thiel-on-characteristics-of-monopoly/

Technology Improvement either improve the technology 10x than the existing technology or invent someting completely new. 

Problems in Hydro power sector

- Issues with Hydro power plants

a)Technical issues - Geological surprises, topography, hydrology and accessibiliyt of the project site. 

- Enabling Infrastructures: hydro in remote site with no evacuation infrastructure, creating excess evacuation infrastrcuture keeping future projects in mind  especially where right of way is an issue. Furthermore PLF, is low thus significant capacity is underutilised, all this results in high transmission cost. 

- creation of associated infra like road bridges which lead to addtional costs. 

- Lack of infra like school, hospitals at difficutl to access site leads to non transfer of skilled manpower in the area. 

- water is a state subject with varying policeis like upfront premium, royalty power, and land acquistion policy of the state

- R&R issues (Tehri dam was started 25 years after R&R was started)

- Delay in clearnaces moef, letter certicicates and clearances from various agencies

- dispute in another state with respect to inter state agreements and disputes on water sharing. the sutlj beas dispute between PUnjab and Haryana and the Mullaperiyar dam conflit between kerala and Tamil Nadu. Conflict of division and utilisation patterns of the Brahmaputra also emerging.  No objection Certificate is required from each down-stream State for getting sanction even for run-of-the-river scheme which is time consuming job

- Improper planning, due to development of new projects on the same reiver, by increasing or reducing levels of silt in the water. 

- Low return on equity for developers  as long gestation. unpredictable cash flows as construction time period is uncertain

- High upfront investment to address greater complexity in design, engineering, environrment and social impact mitigation 

- Due to poor law & order and militancy condition in various parts of the country, heavy security arrangement has to be provided by the State for which cost is being borne by the project. As the law and order is the responsibility of the State, the cost of security may be borne by the State/Centre.

Jim Rogers on Indian Agricultural

India should have been among the world's greatest agriculture nations—you have the soil, the people, the weather, but it is astonishing that you have not become one—it is because Indian politicians, in their wisdom, have made it illegal for farmers to own more than five hectares of land.

Not Heard Too often

Swaraj Engines Ltd has informed BSE that the Board of Directors of the Company at its meeting held on April 29, 2014, inter alia, has recommended an equity dividend of 150% (Rs. 15.00 per share) for the financial year ended March 31, 2014. Following its Investor friendly approach and keeping in view of Company's surplus cash position, the Board, over and above the said normal dividend, has continued with a special dividend payment of 200% (Rs. 20.00 per share) for FY14 as well, taking the total dividend to 350% (Rs. 35.00 per share) for the FY 2013-14.

Despite a SELL, Stock is unmoved

Most of the times, it is hard to find stocks with most of the analysts at sell and still the stock being nearly 50%-80% higher than the analysts price. When something of that shows up, it is really interesting to know what is supporting the price. In this case,the company in point being BHEL. As per my understanding BHEL is undergoing a "DHOOM" problem

 

1. Debtors Collection

2. High Operational Leverage

2. Order Cancellation possibility on slow moving orders

3. Order Inflows

4. Market sluggisheness

 

This in my opinion should have ideally lead to at-least a EV/EBITDA multiple compression and hence lower market prices. That however, does not appear to be the case.  So is there something that has been missed.

 

Though I don't disagree with BHEL contention that it is not something they are facing at an individual level, it is an economy wide phenomenon. The government has started initiating steps, but the real effect of these steps coming to action is some time away. 

 

I believe, the past order book levels are difficult to reach as during FY10-12 the order inflows comprised of huge private sector orders. Such interest has wanned considerably given the issues of fuel, land, clearances and distribution companies health being faced by such developers. I believe INR300bn-INR350bn would be a decent run rate to assume for order inflows. Moreover, even if the central government were to be strong, I still don’t see order inflows increasing to FY10-12 levels simply because the current PLF of power plants is low at 65%. So if the coal were to be actually available, it would first be used up to increase PLFs of existing plants. So, the real incentive for setting up new power plants has come down. 

 

In addition, the recent CERC guidelines for 2014-19 leave a meager 10-11% IRR over the life of the project for the thermal developer due to which NTPC may decide to go slow on projects. However, being a government enterprise they might not be able to do so. But if the project were to take longer than accepted, the IRR may drop to 9% at which point NTPC would be better putting its money in a FD without setting up any power project. Most of the SERCs follow CERC guidelines, hence even if the activity from the state generating utilities were to slow down, my expectation of INR300-350bn order inflow could be under threat. 

 

I believe at the order inflow run-rate expected the revenues would be closer to 300-350bn for the company. Given high operating leverage for BHEL, which is acting negatively on a muted revenue base, the margins may not increase more than 10-11%. The margins earlier when revenues were INR300-350bn were in the range of 18-20%,m so cant they get back to those margins again.

 

I don’t think that is possible over the medium term. BHEL completed a capacity expansion to 20GW from 15GW earlier, hired new people and has high fixed overheads. So, BHEL was ideally not prepared for a downturn but an upturn which has not happened and is not expected in the medium term. 

 

On Revenues of INR350bn, EBITDA would be 35bn, 10bn as annual capex. Assuming a 5% growth rate in sales and cash conversion cycle of 200 days. WACC of 11% for the company, the value should be nearly 300bn. 

 

However, if BHEL were to make margins of 13% in the long range and an overall cash conversion cycle of 200 days with rest all assumptions remaining constant. The value would be closer to INR500bn, the current valuation.  

 

 

Can BHEL really make 13% EBITDA margins over the long term. In my opinion after 4-5 years may be if they cut the over-head slack and employee slack. But not with INR350bn as revenue run-rate. So even if BHEL were to rationalise say employee costs over the next 3-4 years, the EBITDA could be more closer to 11-12% at which i believe the valuation would be INR355-420bn. 

 

So it all depends on the margin profile the management is able to show. 

 

In addition to my fixed cost theory of why margins cannot increase, there are other evidences which point to non-increase of margins. 

 

1. The order book is comprised of orders booked during FY11-13 which were taken at extremely competitive prices as competition was fierce. This could lower gross margins, though management says they have been able to de-package and indigenise components, To what level is it sustainable is questionable. But i still believe there is some merit because the current order book comprises of large 660-800MW orders. In such sets the surface area increases by square while volume by cube hence the raw material required for larger sets automatically decreases. Thus BHEL gross margins could still be protected but to what extent is the question. 

 

2. Management has been looking at areas other than Power like Railways, Solar PV for propelling growth indicating the growth is most likely to be slow in the power segment. The transformers space is a low margin segment and has large competition. So BHEL cannot compensate the lost margins from shift to this segment. Secondly against supply of BTG to generators, transformers are supplied to state discoms which are worse off financially. Hence the overall returns on the business might not be great. 

 

3. Also Railways is not such a good at payments, at-least this is what my experience with talking to some of the smaller players who supply to Railways suggest. But can BHEL alter that, may be. But I am not aware about the margins from such segment. Most likely they cannot be as lucrative as those in BTG space earlier as this space also has decent competition. 

 

I believe the analytical community is correct in its appraisal of BHEL. The valuations cannot be justified fundamentally until BHEL is able to rationalize costs. Should i short the stock. Possibly yes, but will I short it? No. Why? Because like BHEL I don't want to be leveraged. Though in my case it would be financially and not operationally.

This beats the previous one of 600pt fall