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

Fwd: Nice thoughts on working capital management and interest alignmnet

---------- Forwarded message ----------
From: Vivek Jain <vivekjain.iitr@gmail.com>
Date: Mon, Jun 10, 2013 at 12:18 PM
Subject: Nice thoughts on working capital management and interest alignmnet
To: Vivek Jain <vivekjain.iitr@gmail.com>

http://businesstoday.intoday.in/story/best-cfo-india-ambarish-raghuvanshi-info-edge/1/195637.html

Humorous Letter

After four and a half intense and wonderful years as CEO of Groupon, I've decided that I'd like to spend more time with my family. Just kidding – I was fired today. If you're wondering why… you haven't been paying attention. From controversial metrics in our S1 to our material weakness to two quarters of missing our own expectations and a stock price that's hovering around one quarter of our listing price, the events of the last year and a half speak for themselves. As CEO, I am accountable.

You are doing amazing things at Groupon, and you deserve the outside world to give you a second chance. I'm getting in the way of that. A fresh CEO earns you that chance. The board is aligned behind the strategy we've shared over the last few months, and I've never seen you working together more effectively as a global company – it's time to give Groupon a relief valve from the public noise.

For those who are concerned about me, please don't be – I love Groupon, and I'm terribly proud of what we've created. I'm OK with having failed at this part of the journey. If Groupon was Battletoads, it would be like I made it all the way to the Terra Tubes without dying on my first ever play through. I am so lucky to have had the opportunity to take the company this far with all of you. I'll now take some time to decompress (FYI I'm looking for a good fat camp to lose my Groupon 40, if anyone has a suggestion), and then maybe I'll figure out how to channel this experience into something productive.

If there's one piece of wisdom that this simple pilgrim would like to impart upon you: have the courage to start with the customer. My biggest regrets are the moments that I let a lack of data override my intuition on what's best for our customers. This leadership change gives you some breathing room to break bad habits and deliver sustainable customer happiness – don't waste the opportunity!

I will miss you terribly.

Love,

Andrew

Insider Buying

Those "in the know" are voting with their wallets

Cheaper than Cash

Typically negative EV companies are associated with pre-bankruptcy cases, usually involving large cash burn, in other words, where the cash may or may not be tomorrow, and which may or may not be able to satisfy all claims should the company file today, especially if it has some off balance sheet liabilities.

But what if we there were businesses with negative Enterprise value and still running a profitable business though profitability might have only fallen because of certain low margin contracts or unexpected increase in commodity prices. I believe there are some stocks trading with this profile. 

Havells

http://www.thehindubusinessline.com/features/weekend-life/the-shocking-rise-of-havells/article4171177.ece

Fun in Raising Prices???

Q. Being a government company and the biggest in the sector, are you in a better position to get coal compared to other power companies.
We always get much less than what we require. But our supply has grown. Our requirement for the current year is 160 MT. The CIL Chairman has assured us that NTPC will get 10% more coal over last year's supply. Fuel Supply Agreements (FSAs) are in place for meeting this coal requirement. We have no dispute with Coal India on the issue of FSAs. But the fact remains that India is producing around half a billion tonne of coal every year and we need to double our production. What is the fun in increasing profitability by raising prices? Productivity must be increased if business is to be done.

Arup Roy Choudhury, Chairman and Managing Director (CMD) of the country's largest electricity producer NTPC

If you have bargaining power, it is definitely a lot of fun to raise prices. The productivity enhancements can be the kickers. Growth has to come from both volume and pricing power.

CIBIL Report - what it contains

In your credit report, here are a few areas lenders focus on.

Payment History: This appears in the Account(s) section of your CIBIL credit report.

There are two parts to this information: the Days Past Due (DPD), and the month and year of payment. The DPD indicates how many days the payment is late that month. Obviously, anything other than "000" is considered negative.

Up to 36 months of this payment history (with the most recent month displayed first) is provided in this section.

Current Balances: Also appearing in the Account(s) section of your credit report, the current balances on various loans indicate the depth of your debt. The sum of your current balances helps determine your strength to take on additional debt in relation to your current income.

Naturally, lower the current balance, better the chance of your loan getting approved.

New credit facilities: If a loan provider observes that you have recently been sanctioned a number of new credit facilities, it would mean that your monthly outflow in terms of loan repayments is likely to have increased. Hence, it may be viewed negatively.

Number of new enquiries: If you have applied for a number of loans in the recent past, the chances of your loan getting approved are likely to suffer. Simply because such credit behaviour indicates that you are 'credit hungry' and are in urgent need of money.

By understanding how banks think, you can not only complete a lending application that will showcase your strengths better but you can also pre-qualify for loans by lenders based on their lending criteria.

This will reduce the number of attempts you make to qualify. Fewer attempts at the doors of various lenders for getting loans reduce the short-term damage to your credit prospects.

Ensuring that your 'reputation collateral' is reflected accurately will provide you with access to credit faster and on better terms.

Why FDs rated hgiher than NCDs

http://www.thehindubusinessline.com/features/investment-world/money-wise/article3901228.ece

If you are investing in a debt instrument, you need to check not just the interest rate but the credit rating too. But did you know that fixed deposits (FDs) and non-convertible debentures (NCDs) issued by the same company may have a different risk rating? Rating agencies may give a higher rating to an FD scheme from a company, despite its NCD being rated a notch lower or vice-versa.

But, why is it so? Well, industry and company specific risks hold good for all investors, irrespective of the instrument. That said, there are few factors that could lead to the differing ratings.

Time factor

The first one is tenure. Given that all businesses can go through cycles, risks for the same company may vary across time. If a rating agency thinks a business has higher uncertainties over the medium or long term, ratings for longer term instruments may be different from short term ones.

For instance, if the medium term outlook for a company looks promising, then rating agencies may consider a higher rating for FDs. However, assuming that uncertainties loom large for the company over the longer time frame, rating agencies may take a cautious stance while assessing long-term instruments such as NCDs and bonds.

Two, there can also be differences between credit ratings on instruments with the same tenure. The underlying security is one factor here. Instruments backed by collateral may have a better rating, when compared to unsecured ones. This is because the risk of default is hedged to the extent of the underlying security.

security

But mere collateral may not suffice. Quality of the security also matters. For instance, fixed deposit issues by NBFCs are backed by investment in government securities to the extent of 15 per cent of the receipts. In contrast, NCDs are usually secured by the company's receivables. Though secured, you may still run the risk of bad debt with receivables. Hence, rating agencies may give higher weight to the fixed deposit scheme by an NBFC than its NCD.

Instances of such divergent ratings across instruments are common with NBFCs. Sundaram Finance is a classic example. The company's FD has been rated as FAAA by Crisil, a leading rating agency, while its NCD has been rated one notch lower at AA+ (plus). Other NBFCs with a similar trend include Mahindra & Mahindra financial services (MMFS) and Shriram City Union Finance (Shriram).

MMFS's FD has been rated as FAAA by Crisil, while its NCD has been rated at a lower grade AA+ (plus). In the case of Shriram, its FD carries a FAA rating, higher than its NCD rating of AA – (minus).

According to Crisil, FD issues are rated better as they attract higher retail participation. Being retail in nature, the ticket size of the issue may be relatively small, unlike NCDs. This may cushion the issuing company from the refinancing pressure, at the time of maturity. Simply put, all the investors are unlikely to pull out at the same time.

This is in contrast to NCDs, which as a category are largely aimed at institutional investors.

In Crisil's view, a fair amount of fixed deposits get renewed and this strengthens the case for a better rating. However, given the medium-term rating scale for these instruments, it makes sense for you to look at the NCD rating for the issuing company too. This can throw light on the long-term concerns that the rating agency has for the company you invested in.

Luminous - Lack of management bandwidth leading to lower margin - A real risk

The revision in outlook underlines the Luminous group's lower-than-expected profitability estimated in 2011-12 (refers to financial year, April 1 to March 31) because of writing of an extraordinary expense of Rs.650 million as a one-time adjustment done in the books of account. In 2011-12, the group has incurred an estimated net loss of around Rs.283 million as against CRISIL's expectation of a healthy profitability. The Luminous group's operating margin in 2011-12 is also estimated at weaker-than-expected levels; the group's operating profitability is estimated at around 5.8 per cent in 2011-12, lower than the operating margin of around 9.4 per cent in 2010-11. This is because of the decline in the Luminous group's market share in the first half of 2011-12 because of limited management bandwidth available in the first quarter of 2011-12 as the acquisition by Schneider Electric South East Asia (HQ) Pte Ltd (Schneider) was underway, and also because of the relatively cooler summer season leading to a fall in the overall demand.

More power woes

Hyderabad April 30: 

The Rs 1,500-crore ferro alloy industry in Andhra Pradesh, which accounts for 30 per cent of the country's total production, has slashed production by almost 40 per cent, impacting steel makers in this region.

This comes in the wake of a hike in power tariff by the State Government and prolonged power cuts in the last few days.

The AP Electricity Regulatory Commission has effected a nearly 50 per cent hike in tariff, increasing it from Rs 2.65 a unit to Rs. 3.65 for the ferro alloys sector with effect from April 1.

The ferro alloy producers will be meeting in Hyderabad on May 9 to decide on whether to appeal before the appellate authority of the commission. In the meantime, the production cut will continue, industry sources said.

There are 30-odd companies in the State producing 2.5 lakh tonnes of ferro alloys, a bulk of which are located in Visakhapatnam and Vizianagaram districts.

The 50 per cent hike in power tariff has increased production cost by Rs 4,000 a tonne for ferro chrome and ferro manganese and Rs 9,000 for ferro silicon.

Production of ferro alloys, a vital input for the steel industry, is power-intensive, with energy constituting between 40 per cent and 70 per cent of the production cost. Power consumption is about 4,000 kwh per tonne for ferro chrome and silico manganese and 9,000 kwh for ferro silicon.

"We could have taken a 20-25 per cent hike, but this increase makes the industry unviable, as we have to compete with suppliers from other States that enjoy cheaper power," Mr R.K. Saraf, CMD of Facor Alloys Ltd, and President of AP Ferro Alloys Producers Association, told Business Line.

This development could discourage the proposed investments of Rs 5,000 crore by this sector in Andhra Pradesh, involving a new capacity of 2.5 lakh tonnes.

Production cost is also high as 95 per cent of their raw materials has to be sourced from outside the State. "For one tonne of ferro chrome, we need 2.5 tonnes of chrome ore. Transportation cost of the raw material alone is Rs 5,000 a tonne," Mr Saraf pointed out.

Impact of Power Cuts

Hindu Business Line Hyderabad, May 6: 

Restile Ceramics Ltd, a manufacturer of ceramic tiles, has announced closure of its factory due to inadequate power supply.

In a statement to the stock exchanges, the company mentioned that it was forced to take this extreme step due to erratic and inadequate supply of power.

While the company has made representations for better power supply, there has been no exemption from power cuts.

In the BSE statement , Restile said: "Central Power Distribution Company of A.P. Ltd has imposed compulsory power holiday for two to three days in a week. This is in addition to three hours of power cut on daily basis for the rest of the week days."

The company representations to the Distribution Company to exempt it from compulsory power holiday citing the ceramics industry's need for continuous power, have not been successful.

Due to the precarious power supply situation, the distribution company was not in a position to exempt the company from power cuts.

Under the circumstances, the company management stated that it had no other option but to declare a layoff with effect from April 12.

Consequent to this layoff, the company stated that the workers were not allowing dispatches of existing stocks available in the company. Due to these developments, the company has temporarily declared lock out with effect from April 23.

The plant, with a capacity of 12,000 tonnes a year, is located in Medak district .

vrishi@thehindu.co.in

Nice Thoughts

"The danger of Board management, against which
one has to be on one's guard, is lest one should succeed in persuading the Board
rather against its better judgement in the first instance, and then have to suffer the
penalty of their faint-heartedness at a later date, just when the virtues of continuity
of mind are most required if one is to be successful in the long run"

Credit cycling means
in practice selling market leaders on a falling market and buying them on a rising
one and, allowing for expenses and loss of interest, it needs phenomenal skill to
make much out of it

As time goes on, I get more and
more convinced that the right method in investment is to put fairly large sums into
enterprises which one thinks one knows something about and in the management
of which one thoroughly believes

Keynes also thought in a novel way about equity valuation. For example, he
estimated the value of Austin Motor shares in terms not only of earnings yield but
also of market capitalisation per car produced and estimated that Austin traded at a
67% discount to General Motors in October 1933

"Buying is forward-looking and selling is backwardlooking.
We tend to consider what a new stock will do for the portfolio and what a
current holding has done. This makes buying a more hopeful activity, focusing on
the future and what good might come from owning a stock, whereas selling can be
full of regret as we ponder the poor choice we made or that we held on too long"

when buying, investors consider the past
only inasmuch as they believe it is informative about the future, but when it comes
to selling their focus is heavily on the past and many investors, seeking to minimize
regret, sell winners too early and hold on to their losers

Tea - Economics

http://www.thehindubusinessline.com/companies/article3317925.ece