Buy
A case of Ignored Liabilities
Published: 20 Sep 12
There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again with tata steel.
I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J
I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.
The story behind tata steel
Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.
Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.
The Corus acquisition
Tata steel acquired Corus in 2007. Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company.
Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.
Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.
I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).
Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.
So what interested me ?
As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.
The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years
The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.
So what scares me?
As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .
I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.
Look at the above number and ponder on it for a minute.
Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.
I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.
The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.
As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.
In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.
The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot get away from such liabilities at all (short of bankruptcy)
Where’s the risk
The assets under the pension plan cover the liabilities for now. However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.
I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders
So why is no one talking about it?
I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J
If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this –
Controlling my testosterone
As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.
In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and weak European operations . All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !
Finding Great Stocks – Emerging Markets?
Published: 19 Jul 12
During the last decade we saw a huge demand for infrastructure development in the emerging markets.
This was especially true for those countries making up the BRICS: Brazil, Russia, India, China and South Africa.
The Commodities Boom
Had you invested in commodities, or those companies producing building materials like copper, you would have fared better than the S&P 500 Index during the same period of time.
And what about precious metals?
With rapid growth in the emerging markets came a rapid increase in inflation, which typically entered into double digit territory. In order for the governments of these growing economies to put a curb on inflation, their respective central banks acquired large positions in gold as a hedge against inflation.
It is no wonder that we saw precious metals show a dramatic price increase during the past decade.
So what does this current decade hold in store for us as far as investment possibilities?
The Emerging Market Consumer
This second decade will see the rise of the emerging market consumer.
A rising international middle class will want the same goods and services that we in North America take for granted.
If this is so, then we can tap into these wants and needs by allocating a portion of our investment capital in those industries that will be providing those much desired products and services.
The new middle class is aspiring to have an improved diet, better health care, access to major appliances and the use of new phone and computer technologies.
A question to ask yourself is: What businesses should do well if there is an increase in the global demand of a particular company’s products or services?
Over the past couple of years we have seen a phenomenal demand for products associated with the mobile internet.
Take Apple for example. The company has seen a huge growth in its iPhone and iPad products, propelling the company to be both the market leader in its sector as well as best of breed in its industry.
What are some of the other industries that should see incredible growth during this decade?
Industries to Watch
With an emerging global middle class we can expect to see above average growth in the following:
- baby foods and formulas
- pre-packaged meals
- fast food and specialty restaurants
- health care products – supplements and drugs
- mobile internet – phones and pads
- household appliances – kitchen and laundry
- brand-name clothing manufacturers
These are just a handful of the industries that should see better than average performance internationally over the next decade. Now you can start drilling down, finding great stocks that are market leaders poised to take advantage of an expanding global middle class.
Should you prefer investing only in American companies, look for those businesses that have at least 30% of their net profits coming from outside of the U.S.
Also, invest in those companies that you know and understand. You are better served by picking out a handful of those best-of-breed businesses with strong fundamentals rather than a country specific ETF or mutual fund.
In a nutshell, over the next decade you may be well-served by investing in those international companies that allow people the opportunity to increase their standard of living.
One stock, three viewpoints
Published: 03 Feb 12
Confirmation bias is the tendency to look for confirming evidence to support an idea. As an investor, one of the risks is that once you like or fall in love with an idea, it is easy to ignore all the negatives and risks associated with the company. In order to avoid this trap, I typically compare notes with my friends and fellow investors Ninad Kunder and Neera.
We are all value investors who share the same philosophy and similar thought process. You would assume that if we look at an idea, we would come up with similar conclusions and more or less agree with each other thus re-enforcing the confirmation bias.
The reality is much different. I have routinely found that we look at the same facts and arrive at very different conclusions. I consider this difference of opinion as a good thing as it helps me in avoiding confirmation bias when I bounce my idea with other investors.
Let’s look at a live example. In the last 2-3 months I have been analyzing one such company – NESCO. Both ninad and Neeraj have been looking at the same company independently and have arrived at their own conclusions. I am posting my analysis of nesco below. We have decided to do a joint post to highlight the difference in our conclusions inspite of looking at the same company at the same time.
Moral of the story : Share you analysis with other smart investors who share your philosophy but are not your clones 
About
NESCO is a real estate and capital goods company. The company has a parcel of land in Mumbai on which it has developed an exhibition centre (BEC- Bombay exhibition centre) and an IT park. In addition the company has a capital goods business – Indabrator group which has plants in Gujarat.
The company was originally a capital good company, but started incurring losses in the late 90s. The company res-structured its operations and moved the plants to Gujarat. In addition the company has a large piece of land in goregaon, Mumbai where it has developed one of the largest convention centres in India and is now developing an IT park on the same land
Financials
The revenue of the company increased from 16 crs in 2001 to around 145 Crs in 2011. This revenue growth although good, does not highlight the change in the quality of the revenue.
The company had a net margin of around 3% in 2001 and was equal parts a capital goods and Services Company (convention centre). Since then the capital good segment has more or less stagnated and the service segment has expanded with expansion in the convention centre and addition of buildings in the IT Park. The company earned a net margin of 48% in 2011.
The profits of the company, especially from the services business is entirely free cash and has been used to pay off debt. The company now has almost 200 Crs cash which is around 20% of the company’s market cap. The ROE of the company is now 35% and if one excludes the surplus cash, it is in excess of 100%.
The company is able to earn such high margins as the services business (convention centre and IT Park) involve upfront investment and very low operating expenses. In addition the company’s business is now working capital negative due to minimal inventory (only in capital goods business) and low accounts receivables (due to customer advances for the services business).
Positives
The financial positives are listed in the previous section. The company is able to earn such high margins and high ROE due to the competitive advantage of the business. The company has been able to develop one of the largest convention centres in Mumbai which is not easy to develop considering the cost of land. In addition the company is developing additional buildings in the IT Park with the surplus cash (without incurring any debt).
The company thus enjoys a form of local monopoly (large piece of land at negligible cost on the books) and has used this advantage to develop an increasing stream of income. The company plans to re-invest the surplus cash into new buildings in the IT Park (building IV) which are high IRR projects.
The company has also re-structured its capital good business in the last 5-6 years and although this business is not generating attractive returns, it is not a big drain on the company.
Risks
The company has a large number of advantages and a steady cash flow. The business risk comes from a slowdown in the economy, which could impact the utilization of the convention centre and lower tenancy in the IT parks.
I personally feel the above risks are low and would be temporary in nature (will not impact the long term cash flow of the company).
The bigger risk is the re-investment risk. The company has developed 30-40% of the land and will continue developing the rest using the cash flow from the existing properties. In a period of 4-5 years, the company will be done with the development and could be generating 150-200 Crs of free cash flow with no clear avenues for re-investment in the business. At that point of time, the risk is that the management may re-invest the cash in all kinds of poor businesses.
Management quality checklist
Management compensation: The management compensation is around 3% of net profits which seems reasonable.
Capital allocation record: The management has allocated capital intelligently for the last 10 years and may do so for the next 3-4 years. It remains to be seen what will happen after that.
Shareholder communication: Management provides the mandated disclosure through its annual reports and details of the business are available on the website. The communication is adequate, though not extensive.
Accounting practice: The company has followed a bit of aggressive accounting in the past . During the period of 2000-2005, the company was re-structuring the capital goods business and also had accumulated losses. The company capitalized the VRS expenses and other costs and wrote them off till 2006 as it became profitable. The company has however followed conservative accounting since then.
Conflict of interest: None as yet
Performance track record: Above average in the last 10 years. The company has re-structured the capital goods business and expanded the real estate business which is a very high IRR business.
Valuation
The company is currently valued at around 800 Crs and has around 200 Crs on it balance sheet (which is likely to be used partly for IT Park IV). Net of cash the company sells for around 600 crs which is around 7-8 times the expected earnings for 2012. This valuation is low for a company which has an ROE in excess of 100% and can grow at 20%+ for the next 4-5 years with small amounts of added capital.
The above valuation appears low from a cash flow standpoint and the company can be conservatively be valued at 1600-1700 crs (twice the current market cap).
Another view point can be based on the assets of the company. The company has around 70 acres which itself can be valued at a minimum of 2000 crs (if not more). This does not include the value of the BEC business or the IT Park, which enhance the value of the land bank.
Conclusion
The company possess close to a local monopoly due to a large piece of land in a prime location. The management has re-structured its capital goods business and shifted focus to the real estate (exhibition and IT Park) business which has high profitability. The company is developing new projects (at high IRR) which should increase its profitability in the near future. In view the above the company appears to be undervalued as of writing this note.
