Forget Leaving Something on the Table...These Promoters Are Taking the Table Too! - Views on News from Equitymaster

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The Equitymaster Research Digest

Forget Leaving Something on the Table...These Promoters Are Taking the Table Too!
May 11, 2016

  • PMFL's (hilarious) issue extension
  • The scary dairy industry
  • The stability of large caps
  • It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).

- Warren Buffett

A high profile IPO hit the market last week - Parag Milk Foods Limited (PMFL), the makers of milk and dairy products sold under the GO and Gowardhan brands. Given their recent aggressive marketing efforts, we were excited when news of this IPO broke out. One colleague had been following PMFL and waiting for its IPO for a long time.

That the investor community shared his excitement was evident at PMFL's IPO meet a few weeks ago at the majestic Taj Mahal Palace Colaba. The room was overflowing with analysts - with no seats empty. The aisles were filled with people who ended up standing throughout the meet.

But all that excitement just went pop (at least for us) when the financials were discussed. Especially considering the valuations the company was asking for.

Well...not the company entirely: 60% of the issue size goes to exiting investors, including some high profile private-equity funds and individuals from the promoter family. In short, these funds do not go to the company.

The issue was to close last Friday. But, while it was oversubscribed 1.32x overall, turns out the institutional portion (75% of the issue size) was subscribed only 55%. So, the company extended the issue and offered a discount - a mind boggling 2% - to the lower price band.

Even more hilarious was the reason the management gave for the extension:

  • The Issue closure date has been extended by three working days to accommodate pending demand from certain international and domestic investors against the backdrop of volatile stock markets in the week of May 2-6, 2016.

We're not kidding.

The Scary Dairy Industry...

Going through the offer document and learning more about the dairy industry has reinforced the idea that superficial decisions in investing are a bad idea.

No doubt, the marketing efforts of PMFL have been laudable. They have made a name for themselves. The problem is they operate in a very tough industry; with the largest of players having sub-par numbers.

The opportunities in the Indian dairy space are massive - given the organised market's share is small. But the quality of earnings - and the medium-term expectations for them - is not encouraging at all, especially for a company with strong and well-known brands.

The nature of the industry makes (and will continue to make) it difficult for the players to really prosper. The lack of pricing power, the very high competition, and the working capital requirements are just a few of the unfavourable dynamics.

A few important lines from Equitymaster's PFML IPO analysis:

  • On gauging the numbers of its peers - Hatsun Agro Products and Prabhat Dairy - industry dynamics don't seem great in the first place. The industry is working capital intensive, and the debt-to-equity ratios of these companies are on the higher side.
  • A DuPont analysis of the three players gives a good insight into this:
DuPont Analysis of the Leading Dairy Industry Players
PMFL FY11 FY12 FY13 FY14 FY15 Avg.
PAT% - 2.1 2.2 1.5 1.8 1.9
Asset T/O - 1.5 1.3 1.3 1.6 1.4
Leverage - 10.4 8.5 8.5 7.5 8.7
RoE - 32.6 25.6 16.4 21.1 23.9
Hatsun Agro
PAT% 1.4 1.7 2.1 3.3 1.3 1.9
Asset T/O 2.9 3.0 3.5 3.3 3.1 3.1
Leverage 6.5 5.3 5.3 5.0 4.7 5.4
RoE 25.6 26.5 37.7 52.9 19.5 32.4
Prabhat Dairy
PAT% 2.3 2.0 2.2 2.4 2.1 2.2
Asset T/O 1.9 1.0 1.2 1.3 1.3 1.3
Leverage 6.9 4.2 3.1 2.5 2.5 3.8
RoE 30.0 8.4 8.2 7.8 6.7 12.2

Source: ACE Equity; offer document

  • While the RoEs may seem attractive, they are being spruced up by debt. Hatsun has averaged a D/E ratio of about 3x in the past five years. Prabhat, on the other hand, has had a D/E ratio of about 1.4x. And PMFL's D/E was 5.8x in the past four years ending FY15.
  • Thus, it makes sense to compare the RoCE. The four-year average was 11%, 18.2%, and 9.8% for PMFL, Hatsun and Prabha respectively. Hatsun generated higher returns because of higher asset turnover, as its working capital requirements were lower.
  • In short, the major concern for us is PMFL's low pre-tax RoCE.

The dairy industry is just one of many sectors that have weak economics. My colleagues have written a series of articles about these sectors, including:

A Universe of Stocks to Consider

Moving on from stocks with unfavourable economics, let's check out some companies that are able to curb volatility by virtue of their size and dominant market positions.

But first, some facts...

Ten years ago, Rs 100 invested each in the BSE 200, BSE Mid Cap and BSE Small Cap indices would be worth 215, 185, and 143 respectively today. Yes, large caps have outperformed...

How can we explain this? Well, valuations definitely played a big role. But I believe the real differentiating factor (particularly over longer periods) is the stability of larger companies. The stability of margins. The stability of earnings quality.

Let's take up earnings quality for instance and gauge the return on capital employed (RoCE), which nullifies the effect of debt on books. The chart below shows the average RoCE of small, mid, and large-cap companies in the decade gone by...a period that covers a complete business cycle.

Large Caps: The Outperforming Lot

In the table, 'L' stands for the latest available data, 'L-1' for one year prior to the latest year, 'L-2' for two years prior to the latest year...and so on.

As you can see, larger companies have been more resilient than their smaller peers. This was true during good and bad times both. The index representing large caps - the BSE 200 - averaged annual RoCEs of 23% in the past decade. Mid-cap companies averaged 19% and small caps 17%.

Apart from the average figures, consistency (measured as the deviation from the long-term mean) is important too I believe. And here too, large caps ranked first, mid caps second, and small caps third.

If anything, this justifies the view that large caps are stable and relatively safer businesses (but not necessarily safer investments, as that depends on the price you pay). Investors desiring to invest down the market cap hierarchy would do well to acknowledge the risk-reward payoffs and manage them accordingly.

StockSelect, our large-cap stock recommendation service aims to do specifically that - recommend safe and profitable investment ideas from the large-cap space. The StockSelect team is working on a report on blue chips in the Sensex and beyond that have high earnings growth possibilities. Expect more on this in the next 30 days.

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