Getting Squeezed

There are some companies who are dependent on just a single company for a bulk of their revenues. I had invested in one such company some time ago but did not realize this concentration risk. I had bought the company as the market was not factoring in the increased capacity that the company would have. When I look back I realize that capacity addition cannot be the sole reason for buying, as the margins that the company makes on that incremental capacity might be very different. The company I had bought was Hitech Plastics, the company derives 80% of its revenues by selling plastic containers to Asian paints. Now if Asian paints wants to protect its margins in an rising input cost scenario, the first place they will cut their margins is where they have the highest bargaining power and that will be guys who are solely dependent on them and hitech fell in that category.

Next consider the case of a company called Shah Foods which is basically a bakery company, the company does contract manufacturing for Britannia biscuits. The company is 100% dependent on Britannia for its revenues and the company in its annual report acknowledges the fact that they have been trying to diversify its revenue base, and the demand from Britannia is highly erratic and irregular. Their financial performance speaks of the same.

Next the most recent example which actually prompted me to write this article, Mphasis derives 80% of its revenues from HP and yesterday in the results reported by the company there was a mention of the company giving price cuts to its parent company. Now people are questioning the corporate governance issues, but is it not a matter of lack of pricing power and bargaining power rather than corporate governance? It simply shows the solutions being provided by the company to HP are not differentiated and there are other competitors who are willing to provide the same service at a lower cost. Had the company’s product being in-substitutable, the price cut would not have happened as the possibility of switching from one service provider to another involves a lot of costs and effort and time.

Had the company not taken a price cut, HP might have moved to some other solutions provider, the revenues would have taken a further beating and hence the profits. There are numerous companies that take a price cut to push their products, but the fact here is accentuated by the fact that the cut is taken for a customer from where 80% of revenues come, this leaves the company vulnerable to further price cuts since it bulged once, it might bulge once again.

After my learning’s from Hitech I have decided not to invest in companies which are hugely driven by one customer and even if I would invest it would be at a huge huge discount to the multiple that other firms are trading at in the same space.

Mr. Porter said it long ago, look at the bargaining power with buyer and suppliers.

Compounding Machine

Value investing has the same definition but everyone chooses different stocks. The field is huge. But i like the concept of "Compounding Machine" brought about the manager of Akre Focus Fund

1. have durable pricing power
2. have real prospects for growth
3. are not natural targets of regulation
4. require only modest amounts of capital to operate efficiently
5. are run by people of the highest integrity
6. duplicate what happens at the company level at the per share level
7. have an opportunity to reinvest all the excess profits at above average returns

This model of great businesses, great managers, and great reinvestment

opportunities has the potential to create a great “compounding machine”.

Hyderabadi Biryani - Tasted really Bad

Hyderabad Investing sucks!! That is how my experience has been investing in companies based out of Hyderabad. The companies are among the worst in terms of communication of information to shareholders. I guess as Dilios say’s in the movie 300 “We did what we were trained to do, what we were bred to do, what we were born to do”.
The Hyderabadi Companies can replicate the above line with a small word at the end which says ‘-SCAMS’.
The premise comes from two companies that I ended up investing and from other examples that we all are aware of, Ramalinga Raju. Below I will write about the two companies

1. Premier explosives:A company based out of Hyderabad, whose website seems to have been updated ages ago. None of the phone numbers given on the website leads to the company. Even if you try calling the agents, most of the numbers are out of service and one number luckily got a response, a guy picked up the phone, but alas, he did not have the head quarter number.
   
   The problem with the company is the company has been maintaining its gross margin over the past quarters, which is a good sign as the raw material price rises have been passed on to the end consumer which is 90% times coal India. The worry is the employee expenses which have been travelling at the speed of light. On exactly the same quarterly sales as last quarter, the Q3FY11 results show that employee expenses have increased by 28%. In Q2 and Q1 the Y-o-Y increase was 19% and 25%. I fail to understand what has the company been doing without increasing the sales which is leading to such dramatic jumps in employee cost. I had asked the same questions to the management in the HOPE that would reply, but as it turns out that my hopes are based on FALSE EXPECTATIONS. I Have not received any reply from the company till date.


2. Nagarjuna Agrichem The name speaks of its Hyderabad origins, but I somehow got invested in the company due to two good years of growth the company witnessed where it made EPS of 40 rupees each year. But alas!! I was caught at the wrong part of the cycle. Anyways that is my mistake. The company had a plant shutdown for the DECEMBER quarter for 2 months and there was no investor communication!! Can you beat that!! I guess No!! Tata chemicals even if they close the plant for 15 days, they send out a notice to the exchanges. Well that’s the difference!!

I face a dilemma whether to book losses on these stocks or not. For the second one I will wait till the next year. On the first one, if the management replies to the emails that I have sent them after Q3FY11, fine, otherwise that would be my first BOOKED LOSS.

One more thing I was reminded of after the recent market correction is

“Markets go up the stairs, but come down the elevator” – warren buffett

Time for Capsules

I had seen the capsule brothers long time ago, nearly 6 months ago as i remember, but at that time i found better opportunities and hence decided against putting the money in these companies. I call these companies as brothers because both have exactly the same capacity, but one is a case of pathetic capital allocation while the other is a case of good capital allocation. Both the companies have a total capacity to manufacture 3.5Bn capsules a year, i guess this should be the critical mass required to set up a manufacturing unit as it is really difficult to find exact capacity among competitors. I will present a small comparison of the two brothers below.

1. The companies have starkingly different RoE, Medi-caps has an effective RoE of 6-7% while Natural capsules has an RoE of 18%. Thats a huge difference!! And as it turns out, the difference is partly about operational efficiency but majority cane be attributed to capital allocation. Medi-caps has Rs.44cr of its assets invested in mutual funds out of a total asset base of Rs.57cr and the best part is the market value of these investments is only Rs.27cr but the company refuses to mark it to market as it believes the fall is temporary in nature and hence is carrying it at cost price. Which essentially means the company is never going to give this money back to the shareholders and is going to put the free cash it generates in more such stupid mindless capital allocation activities.
2. The EBITDA margins of the companies have a difference of nearly 6ppt. Natural capsules reports an EBITDA of 27% while medi-caps has that number at 23%. A further look at the number reveals that both the companies in 2010, earned a gross margin of 4443 and 4487 per lac of capsules sold respectively. So no major difference here, the difference stems from the fact that the employees in medi-caps are paid much more higher than those in natural capsules. For every lac capsules sold, medi-caps pays Rs. 897 while natural capsules pays only Rs.567.
3. Similar is the case with power and fuel expenses, natural caps uses only Rs.537/Lac capsules while medi-caps uses Rs.639/Lac Capsules.
4. On an asset turnover comparison, both the companies generate 1.2 times the gross fixed assets, but the story changes at the net fixed asset level where in Medi-caps due to its 70% depreciated assets is able to show a higher net fixed asset turnover as compared to natural capsules. On the working capital front, Natural capsules scores a strong upper hand than medicaps, the company has been able to bring down its net working capital cycle to a negative region while for medi-caps it stands at nearly 40 days.
5. The best is the fact that Medicaps has shown a 6% CAGR over Fy08-10 in revenues and (-12%) CAGR over the same period in profits while Natural capsules has shown a revenue and a profit CAGR of 20% over the same time period.
6. One more sweetener to the entire thing is the fact that Natural capsules is planning to double its capacity over this financial year to 7.35Bn capsules while medi-caps still decides to put its money in mutual funds.
7. Both the companies are almost debt free with natural capsules having a leverage of 1.2 while medi-caps being completely debt free.

I believe in comparison to medicaps, natural capsules is a far far better company and is still cheap despite its recent run-up today of nearly 17-18%.

AlphaGeo

This one is the most wierd result, that I have seen till now, I have seen profits doubling, quadrupling, margins expanding, revenues falling but revenues falling to zero is truly amazing, how can a company not have any revenues in a quarter i.e. 90 days. Well the company i am talking about Alphageo, just reported some crazy numbers, they reported zero sales and hence a total loss of -5.4cr. The company is into collection of seismic data for exploration and drilling purposes. The comapny during January 11, 2008 was quoting at a price of 901 and PE multiple of 50!!! and P/B of 12!! and as it stands today the company is at a PE of ~11. I really would want to see how the market reacts to the zero revenue. As of today the price was up 2% and the stock was quoting at 202.

IPO Gradings and Market Performance

Mr. Buffett had once said, a company might be a brilliant company, but a bad investment which I believe is very true. The fundamentals of the company might be pretty strong, the company might generate a loads of cahs, have high returns on invested capital, low debt on books and a leader in its field of operations. But that does not make it a good investment. The above criterias just satisfies one of the three things that Graham had mentioned, i.e. thorough analysis. The other two criteria, namely the adequate returns and safety of principal are both guaranteed by the valuations at which the stock is being offered.

And the IPO gradings only take care of the first criteria, they leave out the other two parameters on valuations. That is the sole reason why there cannot be a correlation between the investment performance and the company performance. The very act of coming out with an IPO is akin to a bride getting ready for the marriage, she would obviously dress herself in the best possible way after all she is the bride. Similar is the case with the owners who come out with an IPO, they would want the best value for their shares, would dress the IPO nicely, will promote with all the rigor. The valuations of IPOs are generally on the higher end.

For example consider the company Aster silicates, whose price went from somewhere to nowhere. It came out with an IPO price band of Rs.112-118, went on to reach a high of Rs.255 and presently trades at around Rs.48/share. At the offer price band and post issue equity, the company had and PE of 37.7-39.7. The company is a commodity space with no entry barriers, and neither did the company had high Returns to justify such a high PE. The valuation grading commented nothing on this, and it is not supposed to comment. The valuation part is something what the brokerages had to take care of and most of them did it correctly.

I would have been more surprised had the results of the study thrown some correlation, because then SEBI would have come out and said, IPOs with high gradings have performed well. This would have given further leeway to companies to come out with higher valuations as the subscribers to the issue would obviously have something at the back of their mind which would jingle like "High grading=high fundamentals=Good stock performance".

If sebi is so interested in correlations, would it not make more sense to do a correlation between IPO gradings, brokerage recommendations and the stock performance as it would capture the true definition of investment.

For the article that prompted this post refer the link below

Sebi study finds IPO grading futile
http://www.business-standard.com/india/news/sebi-study-finds-ipo-grading-futile/412080/

Seasons Or Quarters

Today morning I received a forward from one my colleague, I could not help locate the similarities between the images in the mail and the quarterly results of the companies.

One Picture taken at different seasons!!
Lessons on Life




You cannot judge a tree, or a person, by only one season,
and the essence of who they are and the pleasure, joy and love that come
from that life can only be measured at the end, when all the seasons are up.

If you give up when it's winter, you will miss the promise of your spring,
the beauty of your summer, and fulfillment of your fall
Moral
Don't let the pain of one season destroy the joy of all the rest.
Don't judge life by one difficult season

I reproduce the last paragraph of the forward with certain modifications

You cannot judge a company, its management, by only one quarter,
and the essence of who they are and the returns, dividends and wonder that come
from that company can only be measured at the end, when all the quarters are up.

If you give up when its Q1, you will miss the promise of Q2,
the beauty of Q3, and the fulfillment in Q4.
Moral
Don't let the pain of one quarter, destroy the joy of all the rest.
Don't Judge company by one difficult quarter

I guess nothing summarizes value investment better than the above description of nature, buy when the market sees a fall and winter in the results to reap the benefits in summer and spring.