Contrarian's Playbook

Performance Update - Winding down funds invested in US

2011-05-08T01:19:00.000-07:00

With my Indian managed accounts platform about to be launched, it will be increasingly hard to actively manage holdings in the US. As a result, holdings within the US have been significantly reduced and there is no near term desire of actively managing a US focused book of securities. As of the end of the first week of May, book was up 5.5% YTD and 46% since inception (July 2008). That compares with 3.7% and 12% for Dow Jones AllHedge Index over the same period (see Exhibits 1 and 2). Save for the big cash position while the book was being winded down, I could have expected to be up in double digits YTD. Except for Tata Motors [NYSE: TTM], every security in the book (remaining or liquidated YTD) had done at least as well as the market or better, with the long book up about twice as much as S&P 500 this year. Overall, hedge funds have lagged the bounce back in small caps to ensure that they fritter the entire 11 points advantage over Russell 2000 (and then some) from 2008.

For now, I don’t plan to publish any investment opinion on this blog.

Exhibit 1 - Cumulative Performance through May 2011

Exhibit 2 - Monthly Performance Summary

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

2Q10 Performance

2010-06-30T21:15:00.000-07:00

2Q10 was understandably brutal – We are set to face tough direct stimulus (tax credits and exemptions, extended unemployment benefits, incentives etc.) comparisons over the next 12 months, European situation remains uncertain, and US employment situation is significantly worse than most expected.

About half of equity holdings ended up in 2Q10, with VSNT being the only name underperforming the broader market. Overall, more than 90% of all holdings outpaced S&P 500 in 2Q, with net exposure remaining largely unchanged versus the previous quarter. Contravest finished 2Q10 up just under 2%, versus sharp double digit declines in S&P 500 and Russell 2000. Contravest is now up 7%+ YTD, comfortably ahead of the broader market and most peers. In under 2 years since inception, Contravest has outperformed S&P 500, Russell 2000, CS Tremont Allhedge* and Barclays Global Bond Aggregate by 50, 47, 33 and 28 pps respectively.

Note: CST AllHedge performance for 06/10 is not available yet.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

1Q10 Performance

2010-04-01T12:00:00.000-07:00

Contravest finished 1Q10 up 5.5%, 50 bps ahead of S&P 500. Including dividends, S&P 500’s performance was about in line with the portfolio. Net exposure increased during the quarter, with portfolio beta averaging around 0.55, ahead of the sub 0.40 average in 2009. Since inception in mid-2008, Contravest is up 30%, outperforming S&P 500, Russell 2000, CS Tremont AllHedge, and Barclays Global Bond Aggregate by 37, 35, 31, and 25 pps respectively.

Small cap stocks have rebounded so strongly that they have all but made up for the relative underperformance vs. hedge funds in 2008. Most hedge funds failed to safeguard their 2008 outperformance margin while equities resurged. Fund of funds continued to underperform, trailing S&P 500 by 4+ pps. One can’t help but wonder if poor due-diligence can turn out to be so costly that capital moves to fund of funds to further allocate to active managers – If you just take the number of hedge funds caught in fraud last year and imagine a hyperbolic seasoning curve to identify cumulative frauds, I’ll be surprised if materially more than 3% of all existing hedge fund managers will be caught in fraud over the next 5 years (Is that large enough to warrant investment in a vehicle that underperforms in almost anything other than a bearish market. Since 2002, the only point when fund of funds cumulative returns caught up with the broader market was at the end of 2008). Further, despite the “due-diligence”, it is well documented that FoFs were the biggest losers in the largest reported fraud. I am sure there are some FoF managers that add value but it is likely a small minority.

Exhibit - Cumulative performance through 03/31/10

Note: CST AllHedge performance for 03/10 is not available yet.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

The quest for cash-rich potential targets yields a catch

2010-02-19T10:24:00.000-08:00

With market providing ample opportunities, screening for M&A candidates wasn’t the most attractive strategy to pursue last year. Investors were looking for more than the “puny 30%-40%” acquisition premiums. Now, with massive output gaps across the world straining recovery prospects, 2010 will likely shape up as the year of consolidations, with strategic acquirers overwhelmingly taking the cake, in my view, at the expense of financial sponsors (and “puny 30%-40%” potential premiums appear much more attractive). It is as likely that consolidation focus will remain in the US and EU, where output gaps are the widest, ample liquidity is available (cash now accounts for about a fifth of S&P 500 assets), valuations most attractive, and credit markets relatively thawed.

Why financial sponsors will continue to sit on dry powder. Cash availability by itself doesn’t position financial sponsors (those focusing on non mid-market deals) strongly enough to put their capital to work. Lack of exit issues and higher equity contributions (“Tribune” transactions are passé) are among the key challenges to non-strategic buyouts.

CDO-backed deals (vs. those not backed by CDO structures) typically allowed LBOs to garner about 10% more contribution in transactions from banks, high yield bonds, and mezzanine debt. Such deals therefore had more wiggle room. Revolver drawdowns were frequently not required at outset, allowing sponsors more flexibility to re-raise. Loss of that appetite, coupled with requirement of higher equity cushions and already stretched existing investments, has effectively taken a lot of “free lunches” off the table. Financial sponsors are essentially being forced to increasingly restructure businesses without the luxury of wringing synergies through combining newly acquired businesses with over-burdened existing investments. Upside assumptions have been scaled back sharply. In anything other than very low-levered businesses, financial sponsors are much worse positioned against strategic buyers than they were in recent years – In 2009, strategic buyers accounted for almost 77% of middle-market deal activity vs. 69% in 2007. However, selective opportunities, particularly in the mid-market, will be actively pursued by financial sponsors. It is worth noting that a host of new players have recently entered the mid-market financing arena, with regional banks getting more active after CIT’s filing last year.

Here are a few businesses that may be in a position to get acquired without unduly stretching strategic buyers (see Exhibit 1). While there are quite a few ways to do this exercise, I am leaning towards businesses with strong cash positions in industries that have room to consolidate. Obviously, excess capacity can also turn out to be a significant distraction to consolidation if the industry happens to be over-fragmented – Why would you acquire capacity if you already have enough of it and new addition doesn’t benefit your pricing power ?. My current priority is to allocate an undisclosed % of capital to potential near-term targets. Some of these may not fit my usual idea of attractiveness but at this point I am comfortable with including potential targets that might otherwise not be on my radar, as long as their takeout proposition is compelling. Given the focus on “near-term” events, most of these positions will be liquidated if expected events take more than a year to occur, assuming nothing else changes. Since this strategy focuses on acquisition targets, the intention is to keep the focus limited to names with significant float and where trade isn’t crowded. I’ll summarize the following two situations – Forest Labs (NYSE: FRX; $29.48) and Versant Corp. (Nasdaq: VSNT; $15.12).

Exhibit 1 - Cash-rich potential targets

Sources: Company filings, Bloomberg
* QXM's shares o/s includes about 6 mil new shares (including restricted stock) issued post 3Q earnings, following exercise of some converts.
** includes short-term investments

FRX – trap of a kind. Usually, when I see too much pessimism, my eyes twinkle. That said, I am cognizant of the fact that in majority of cases valuations are reflective of something concerning. FRX is no different, except that it’s probably a bigger value trap than I normally see. At least there is something that makes it interesting. If cheap is all you ask for, blindfold yourself and start throwing darts on a board full of S&P 500 stocks. Odds are that you’ll hit something where current earnings power is significantly below what you saw a few years back. Some, such as FRX, are unlikely to regain that earnings power anytime soon.

I agree that FRX has a huge cash stash but the core business isn’t as cheap as it looks. The argument that shrinkage from patent expirations is “more than priced in” is bogus. For a business that will likely lose about 2/3rd of its existing sales between 2010E and 2015E, FRX is certainly not a valuation outlier (see Exhibit 2a and Exhibit 2b).
Exhibit 2a - Est. revenue loss from patent expirations

Exhibit 2b - Core PE vs. est. revenue loss

Source: Internal estimates, GPA, SEC filings, Bloomberg
Notes: Est. revenue loss was calculated as following - Price is expected to get cut in half, with unit share getting halved within 5 years of expirations; The statistically significant trend line in Exhibit 2b suggests one significant outlier – NVS; Core PE is adjusted for net cash position - Net cash is subtracted from market cap and after-tax interest income on this position is excluded from earnings.

Even if one builds in a 75% chance that each Phase III drug will launch at the expected time and ramps up to its expected goal even faster than expected (full achievement within 3 years vs. 5), their expected contribution in 2015E will still end up being no more than ½ of sales lost from Lexapro and Namenda going off-patent. Further, the whole idea revolving around cash being used to acquire new licenses, which in turn will offset revenue loss, isn’t very compelling either. Come to think of it, FRX’ current Phase III pipeline cost the company close to a billion dollars in just up-front payments (including $480 mil that the company paid for Cerexa, which came with Ceftaroline and two other early stage drugs, in 2006). Add in contingent payouts and you’ll come close to FRX’s current cash holdings. Also, the entire pipeline was acquired/licensed in Phase II or later, with launches expected 5-7 years after the deal. Even then, at its estimated prime, the current pipeline will likely not match Lexapro’s current contribution (Never mind Namenda). Effectively, FRX’ current cash is more of a “replacement” lever than a “growth” lever, if that. FRX in all likelihood will be a significantly smaller business by 2015E. For those that wish to look that far, it might be worthwhile looking at valuations on C2014E estimates, which suggest that FRX is the priciest drug name in town, not the cheapest. The fact that I estimate an incremental 30%+ loss in revenues in C2015E (from earlier patent expirations) doesn’t even need to be factored here. This is one of the biggest value traps I’ve seen in recent times.

VSNT – Potential mid-market buyout candidate. Object oriented technology can certainly not be categorized as a growth business. Given legacy issues with relational databases, ramp-up is very slow and sales cycles can easily extend beyond a year - A company like VSNT typically adds 1-2 clients a quarter, with billings starting way below that at existing clients. However, VSNT is truly a cash engine, averaging 30%+ FCF margins. Further, given the niche VSNT operates in, acquisition opportunities are few and far in between, further bloating an already bloated cash balance.

The next identifiable opportunity area for object databases is in MMOGs – VSNT’s object database has been used in developing a few MMOGs. Still, object databases haven’t been as successful as expected while competing with relational database usage within MMOGs. One shouldn’t get too excited about this opportunity yet.

While this is clearly a sitting takeover duck, the problem is integrating this business and its difficult to make a strong case about anyone truly interested in building a large ODBMS platform. The two leading vendors are Versant and Objectivity (privately held). Progress Software (Nasdaq: PRGS; $28.23) competes in this space through its Objectstore platform, which hasn’t been its focus area. Also, ObjectStore is likely no more than a mid-single digit contributor to PRGS’ sales, and PRGS is, in my view, more likely to entertain bids by a buyer than to expand its ODBMS capabilities by acquiring an Object Management business. I could be wrong on PRGS’ strategy, but it doesn’t hurt my eventual thesis here.

Interest from relational database vendors isn’t straightforward either – Incorporation of object oriented features in RDBMS, and high switching costs provide ample safety from direct competition and therefore put a dampener on traditional DB vendors aggressively pursuing ODBMS investments.

VSNT isn’t a type of business I’ll typically buy. There is, at best, an outside chance that a strategic buyer might step in. However, it’s significantly more attractive to a financial sponsor than to a strategic buyer. I’ll bet you that it isn’t every day that you find a business, where despite paying a 40% premium, contributing 60% in equity to the deal, and doing little to squeeze out material synergies, one ends up with IRR in the mid-20s (see Exhibit 3). With no street coverage, such candidates may be out of the radar for now but it’ll likely get attention if it stays here too long.

Exhibit 3 - Est. buyout summary for VSNT

Source: Internal estimates, Company filings, Bloomberg

On the radar – QXM, TSRA. I have certainly passed on QXM (too little float, deteriorating pricing power and limited transparency). TSRA remains on the radar but that trade is too crowded, for now.

Qiao Xing (NYSE QXM; $2.49) faces variety of challenges in its end market but market is effectively pricing the company where cash is being offered just to acquire it (underlying business comes for free). The typical problem with such situations is float, with deal largely dependent on a handful of holders and many of these guys often under-estimate the severity of challenges and won’t sell unless they absolutely have to. The biggest issue at QXM, just as with many other Chinese handset makers, is cut-throat price competition and continued pressure from “fakes”. “Fakes” (also known as Shanzhai) possibly account for more than a fifth of all phones assembled in China, and may be one out of every three sold in the domestic market. Given immense fragmentation, continued cuts by larger vendors, and struggling end demand, handset component providers have also been unwilling participants in the ongoing price competition for handsets in China, which will likely continue in the foreseeable future. But that aside, QXM’s performance has been abysmal – In the two years ending 3Q09, shipments dropped by almost two-thirds. Over the same period, Chinese domestic handsets market grew by more than 20%. Thanks to a new launch of VEVA phones in 2H08 (sounds disturbingly similar to VIVA, which is an HTC brand), QXM was able to temporarily stabilize its ASP. Then came VAVE (Shanzhai’s answer to VEVA) and QXM’s strategy got derailed again. Since 2H08, management had been stressing its strategy to focus on the “high-end” VEVA phones. With VEVA shipments coming under pressure recently, QXM was forced back into launching lower-priced versions. That however, didn’t help in stemming a continued drop in shipments, which sequentially declined 40% in 3Q09.

Attractive handset businesses sell into markets that protect them from illegal competition, and have the culture and know-how of constantly re-inventing themselves. QXM has neither. QXM’s only true attractiveness is from the viewpoint of someone acquiring facilities and using them to export shipments, effectively yielding the CECT brand redundant. Trying to compete in the domestic Chinese market is an exercise in futility – Market is unwilling to pay a premium for differentiated technology (assuming that wireless infrastructure can support it). Further, return on innovation is paltry as handsets are quickly dismantled and fakes quickly eat away at price and unit share. Regulatory intermediation is therefore required to make it attractive to sell into the domestic market. Whether bold decisions that will hurt a $5 bil+ industry will actually be taken is another debate.

This isn’t the first time that an Asian handset business is effectively being given away. Blow-ups such as BenQ’s acquisition of Siemens’ handsets business or TCL’s acquisition of Alcatel’s are prime examples of such situations. Further, two of the chief reasons behind devices’ acquisitions are technology and brand. It’s hard to argue that QXM fits either way. One way to think of QXM’s situation is as following – If price drag continues at current rate for another year, investors’ implied premium on offer* (assuming an acquirer coughs up 40% premium to buy QXM) can be eaten away within 2 years of owning this business, assuming no incremental deterioration in pricing after the first year of ownership. While QXM is certainly cheap (any upside comes for free), a potential acquirer will have its work cut out for it. Admittedly, this one can go either way. It looks cheaper than what it may look like after a year of ownership by a potential buyer. I am not comfortable in such symmetric situations.

*Cash that the market will pay the acquirer to acquire.

Disclosure – Author has a long position in VSNT.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Cumulative Performance [through Dec 2009]

2010-01-04T11:37:00.000-08:00

Contravest finished the year up 18%, in line with broader hedge fund indices, following a 5% gain in 2008. This came on the back of conservative portfolio construction and no use of leverage, with portfolio’s beta averaging under 0.4 in 2009. As at the end of December 2009, Contravest was up 23% since inception in 2H08. That compares with -12%, -13%, -3%, and +5% for S&P 500, Russell 2000, CST AllHedge, and Barclays Global Bond Aggregate respectively, over the same period.

Exhibit - Cumulative performance through 12/31/09

Note: CST AllHedge performance for 12/09 is not available

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

All that glitters.......

2009-12-22T16:55:00.000-08:00

Think of an event - Usain Boltesque inflation, gold reserves dry up before we leave this planet, dollar’s quick demise, central banks enter into a “happy ending” wedlock with the shining asset, and a concomitant denouncement of the most used method of transacting – paper. Throw in Sweden winning next year’s soccer world cup in the list (Who cares if it hasn’t qualified). With gold trading where it is, one better come up with some sort of a story, which is better than all of the above, and do so quickly.

The finite supply gobbledygook is useless when pricing gold over any realistic timeframe. The finite supply argument just doesn’t hold for a physically non-depreciable asset like gold. Gold’s actual usage (ex-investment) is down by almost a fifth since early 90s. The stock of available gold meanwhile has consistently grown over this period (see Exhibit 1a and 1b). Even assuming that non-investment usage decline stabilizes in the foreseen future, availability will likely continue to outstrip usage, independent of new discoveries or lack thereof. Rapidly dwindling supply just isn’t one of the factors that can support gold’s current price.

Exhibit 1a – Global per capita stock of gold

Exhibit 1b – Per-capita non-investment usage of gold vs. Per-capita stock

Source: Internal Analysis & Estimates; World Gold Council

The father of all decouplings in play. Over the last four decades, gold has comfortably outstripped inflation and currencies of dollar’s biggest trade partners. Over this period, gold is up more than a whopping 17x, well ahead of 5.1x and 1.5x increase in price levels and dollar’s chief trade currencies respectively (see Exhibit 2). Even M2 growth hasn’t kept pace with gold – M2 is up slightly over 10x since the early 70s, including a 5% increase over the last twelve months, comfortably underperforming gold.

Exhibit 2 – Gold vs. CPI and USD’s TWER

Source: WGC; Federal Reserve; BLS

It isn’t a “Chindia consumer” effect either. India and Greater China account for just under 40% of global gold demand, about where they were in the early 90s. For all the hype, India’s per-capita consumer gold consumption hasn’t kept pace with underlying economic growth. Realty and stocks are the new flavors. To put things in perspective, RBI’s recent purchase of 200 tonnes from IMF doesn’t even offset the loss of India’s consumer gold demand this decade.

So, what is gold discounting ?

Demise of the dollar ?. Besides death, few things in the world could be certain. The gradual decline in the dollar is as close as it gets. At some point it'll pass it's global reserve currency baton to another liquid currency, just as it acquired it at the turn of the 19th century from the sterling. The perennial rise in the US trade deficit only necessitates the global need to diversify into new currencies, which is exactly what central banks have been doing this decade. But it’s clearly more than priced in an asset that is up by more than 17x since early 70s, while currencies of US’ largest trading partners have appreciated barely 50% against the greenback over the same period.

…..or perhaps an unprecedented sovereign default ?. Both Greece and Ireland are ticking sovereign debt time bombs (see Exhibit 3). What is surprising however is the magnitude of the after effect that is apparently being priced into gold. It appears that the gold bugs might be working on the hypothesis that central banks will dump Euros in the event of a sovereign EU default and aggressively buy gold - Since most of gold stock is tied in jewelry and central banks hold just about half as much in gold as they do in Euros, Gold has no way to move but up. In my opinion, given underlying liquidity and re-investment challenges, dollar will likely be the prime beneficiary of any weakness in the Euro arising from a prominent EU default, neutralizing the impact from the advertised “rush” into gold, which will nonetheless occur to some extent.

Exhibit 3 – Euro-denominated sovereign debt within euro-transacting economies

Source: IMF; Fitch Ratings

……or maybe a new-found wedlock with central banks. The simplest argument in gold's favor is the growing chorus among certain big emerging market central banks to accelerate their ongoing diversification process. In that context, it's worth noting that emerging market central banks often rush into gold during sluggish growth periods before slowing their purchases down in recovery years. Further, while their aggressive buying may have previously supported strong appreciation in gold, their investment record is suspect, at best - Gold price virtually stagnated for more than a decade following 1988, which incidentally was the biggest year for gold purchases by central banks in almost three decades (see Exhibit 4).

Exhibit 4 – Net central bank gold purchases vs. gold price

Source: GFMS

At these giddying levels, one can’t be blamed for trying to factor in anything and everything to justify the price of gold. Potential payoff in an extreme case however, is unlikely to nearly compensate you for the price you are paying up front. By now, gold bugs are used to such profound levels of malarkey that I suspect that events can unfold in a way that can justify the asset's glittering price tag.

Appendix - Valuation snapshot for global gold miners

Source: Bloomberg; Company Reports

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Satyam Computer Services Ltd. (SAY) – Why it makes sense to load up against the crowd

2009-11-25T19:44:00.000-08:00

Successful turnarounds often lead to feeling of gratification well before their true potential gets widely appreciated. You can count Satyam Computers (NYSE: SAY; $4.65; INR 90.75) as one of them. Satyam was involved in a massive misrepresentation of financials earlier this year, and was subsequently bailed out by Tech Mahindra (INR 924.05).

From its January lows, Satyam had almost quadrupled vs. under 100% appreciation in BSE Sensex, before witnessing a 10%+ drop on Wednesday after CBI filed a fresh charge-sheet detailing how ex-promoters and certain key executives siphoned cash from the company. What is truly amazing is 1. How Mahindra Satyam’s stock still reacts to misdeeds of ex-promoters, and 2. Why such a grossly mismanaged entity be valued on current fundamentals ?. Promoters may clearly have siphoned funds off Satyam but it’s not as if Tech Mahindra’s decision to acquire Satyam was really contingent on it’s at the time cash position. Estimated cash on Satyam’s books was just about a tenth of Tech Mahindra's open offer.

Satyam’s financials are in the process of getting restated by KPMG, which is required to conclude the exercise by June 2010. This is one stock that is certainly not discounting a “dramatic” turnaround. If anything, as my argument goes, it may not be discounting a whole lot of potentially achievable things. Also note that potential valuation scenarios (outlined later in this post) attribute no value to cash in hand.

Satyam’s excess roster by itself must have been a 5%-9% drag on EBIT margins. Assuming that Satyam’s break-up of offshore/onsite revenues wasn’t too far off-track, I estimate that Satyam was carrying 5%-9% extra employees, to justify inflated revenues. That by itself may have been dragging down EBIT by about 400-700 bps, suggesting that EBIT could potentially move up in the high single digits by simply rationalizing headcount.

Lawsuit settlements may drain $100 mil+. I estimate that settlement of the 13 class action lawsuits (from ADS investors) and ongoing lawsuit with Upaid might end up costing the company northwards of $100 mil, with possibly $60 mil or more going towards settling the class action lawsuits (~3.5% of estimated investor losses, which is the average over the last 13 years, across class-action lawsuits). That said, the likely settlement with ADS investors is unlikely to take place soon. Under a third of class action lawsuits get settled within the first three years of filing, with close to 90% unsettled within the first two years. In all likelihood, ADS class action settlement wouldn't be a pre-FY11 event.

Misplaced gaiety or underappreciated turnaround ?. Satyam’s utilization rate was likely in the high 60s to low 70s in C3Q last year (as opposed to the reported figure of 76%). Based on Satyam’s onsite/off-shore break-up and recent unaudited indications of headcount, it appears that Satyam’s annual sales run-rate is now likely in the $1.1-$1.2 bil range. Ex-pricing (which Gurnani had recently suggested is in line with the industry), EBIT margin can potentially be a high single-digit figure, driven by headcount rationalization. But there is way more realistic room for improvement than just that, even for a standalone Satyam that may not yet have the luxury of eliminating cost redundancies with Tech-Mahindra. Across a range of operating expense lines, Satyam was materially ahead of industry averages, particularly in case of operating leases, receivable provisions, professional charges and marketing, which by themselves dragged true EBIT down by about 300 bps. Between head count reduction and overhead restructuring, Mahindra Satyam has every shot of being a 15%+ EBITDA platform. In fact, there are indications that some of the above may already have been partly achieved – For instance, the company had recently recalled more than a fifth of its benched employees while lifting its hiring freeze and has already gone on record saying that it is saving on lease rentals.

If Satyam does ramp up to low double digits EBIT over the next year, something I certainly don’t see as a stretch, then this stock effectively has no further incremental operational upside priced in it, be it through further cost control (and there is ample room for that), price negotiations or incremental contract signings (see Exhibit 1).

Exhibit 1 – Projected FTM Earnings and associated valuation scenarios

Note: Earnings are capitalized at a mid-teen multiple; Disclosed OBS liabilities (tenable or not) are brought back on balance sheet; All scenarios are independent of cash in hand and are built on low double-digits EBIT margin; Current utilization rate is assumed at 70%, below the C3Q09 industry average of 73%.

Sources: Internal estimates; Company filings

Disclosure – Author initiated a long position in SAY on the day of this post.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

With most post-Bhumibol scenarios not being particularly depressing, Thai equities are likely placing high odds on a prolonged armed civil conflict

2009-10-26T03:59:00.001-07:00

One Asian market that recently popped up again on my value screen is Thailand, which has trailed MSCI Emerging Markets by about 5% this year. However, Thailand was recently trading at valuations, which while fundamentally cheap, were about in line with Thailand’s historically depressed average. Then came the sell-off, driven by rumor around King Bhumibol’s health. Thailand is now trading at levels where political reform, if any, is essentially a free option in the hands of investors (and headline risk is at least partially priced in, post sell-off ). But, is the downside well understood ?– Will Thailand enter a prolonged phase of political instability, much worse than what it has been through over the last decade.

Among the markets I track, Thailand’s real equity yield of 6%+ is just behind Israel’s 6.5% and Czech Republic’s 7.3% (see Exhibit 2a). In fact, among the top 8 markets with highest real equity yields, only Chile’s 3.5% GDP growth est. for 2010 is higher than Thailand’s 3.3% consensus est. Thailand’s central bank is also well positioned to keep interest rates depressed for a while, as economic recovery picks momentum in what is arguably the most well employed economy in the region. Despite in-line 2010E GDP growth expectations and credit ratings, emerging markets collectively trade at about 1/4th the real equity yield in Thailand (see Exhibit 2b). The issue at hand is underlying political instability, which isn’t surprising for a country that has averaged a coup about once every four years. As of now, the attractiveness of an investment case for Thailand rests squarely on its political situation and there are more than a few reasons to believe that Thailand may not fully deserve its cheap valuation.

Exhibit 2a – Real Equity Yields

Exhibit 2b – Real Equity Yields vs. Credit Ratings

*Consensus credit rating score is provided by II; Real equity yields are calculated on 2009 earnings and headline consumer inflation.
Source: First Call, Economist, Institutional Investor

Historically, SET’s performance has been closely tied to Thailand’s political stability (see Exhibit 3a). In that context, not only is recent approval rating for Abhisit Vejjajiva comforting, but it is also equally comforting to see past performance of the ruling Democrat Party, whose average control duration, which is almost 4x the current time spent in power, has been twice the average control duration of all Thai governments over the past three decades.

While Thailand might look relatively attractive, that isn’t a particularly new observation. Despite what appear like cheap valuations, Thailand’s P/B is about in line with its 10-year historical depressed average (see Exhibit 3b).

Exhibit 3a – Duration (weeks) of govt. in power vs. SET performance (since 1988)

Exhibit 3b – Thailand’s historical Price/Book multiple

Exhibit 3c - Net monthly equity purchases by foreign institutional investors

Source: SET, MSCI, Misc. Sources

Is uncertainty overpriced ?. I estimate that had it not been for the political overhang, Thailand would have been trading at least 50%+ over its current multiple. There is uncertainty around Thailand’s political future, once King Bhumibol is no longer at the helm. That takes a “strongly perceived” stability factor out of the equation. That said, given Thailand’s political past, one could argue that the royal family hasn't been particularly successful in ensuring stability. What happens once King Bhumibol isn’t there is anyone’s guess. However, the range of possibilities isn’t too depressing, considering that a violent civil war is unlikely. Let’s pen down a range of scenarios, some likely and some less so:

Will Abhisit finish his term ?. On previous two occasions, Democrat Party finished more than 3/4th of it’s term. At this point, it is the party in power and is said to enjoy a good relationship with the royal family. As long as the privy council doesn’t go against future King Vajiralongkorn, Abhisit would fancy his chances of finishing his term.

Will PPP return ?. If Thaksin, the exiled ex-PM (now believed to be associated with PPP) or someone from PPP itself stages a comeback, it wouldn’t be a significantly worse option either. This is arguably the alternative that promises most significant change – Certain powerful members of PPP have previously stressed the need for reforming Thai monarchy. If that does happen, it may very likely be preceded by armed conflict, which is unlikely to sustain until there are clear divisions within the Thai army. While Thaksinomics might be nothing more than populist economics, many foreign investors cheered Thaksin’s last stint in power, which incidentally was also the longest uninterrupted rule (2001-2006) since the military rule from mid 70s to mid 80s. Between 2001 and 2006 (Thaksin’s period of rule), SET returned 100%+ over MSCI World.

Will Crown prince back a military coup ?. Despite Prince Vajiralongkorn’s military linkages, it doesn’t appear too likely that he’ll implicitly support a military coup. The royal family is well supported by Abhisit, and there isn’t an obvious motivation to compromise that relationship. Prince’s military relationships, which may not be particularly strong anymore, will likely be best used to ensure that a coup is not staged.

Will military stage a “precautionary” coup ?. Even if the military were to gain control and hold on for an indefinite period, will there really be much more than a headline impact ?. It’s worth noting that military rule by itself hasn’t hurt the Thai economy. Realize that Thailand has been hurt by constant changes, as opposed to military rules - SET went up almost 5x during the last prolonged military rule between 1976 and 1988.

Few can blame investors for only pricing downside in a market where a quasi-democratic system has failed to bring stability. Yet, a closer look at the range of options suggests that equities may be pricing high odds of an armed conflict, which may be co-incidental with PPP’s potential resurgence, and precede a “significant reform”. This effectively offers free optionality in the hands of investors, in case such a reform plays out. That being said, Thai equities of late have become short-term trading vehicles where foreign investors either rarely stick long enough (see Exhibit 3c above) or prefer to wait and watch. This is as speculative a trade as any and should only be traded for its optionality vs. its investment attractiveness.

Note - The range of scenarios outlined in this post are purely speculative, solely for the purpose of analyzing political risk, and do not constitute my opinion on the Thai royal family or various political outfits within Thailand.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Indian vacation musings

2009-09-27T05:18:00.000-07:00

For the first time in 4 years, I have had a truly enjoyable vacation, meeting family and friends in Delhi, Bombay and elsewhere. While I haven’t been able to consistently monitor market close, early evening opens are easier to monitor. That aside, I am having an awesome time. This is home !

I’ll get back to more thoughtful blogging in late October. Meanwhile, in a lame excuse to keep up with blogging, here are some weekend Indian musings.

Ex-necessities (not including food), purchasing power has improved but remains highly uncompetitive vs. the developed world. While growth in Indian domestic manufacturing (indigenous and assembling) has significantly improved the number of available consumption alternatives, the bang for buck remains significantly less. One can buy a BMW 3-Series in the US for as much as one would buy a Honda Accord in India (Buying on loan or leasing compounds the situation). A 330 ml soda can retails for about as much as it does in the US – All this in a country whose per-capita, even after adjusting for purchasing power, is about 1/13th of the US. That said, this pricing discrepancy in discretionary spends will gradually whittle away as volumes improve and aid absorption of significantly high fixed costs (Infrastructure bottlenecks ensure that typical cost structures are more fixed-cost saddled than what one sees in the US e.g. higher fixed power costs associated with captive generation, higher inventory levels due to longer lead-times etc.), infrastructure related challenges wind down, and import duties fall - Total duties (actual collection rates, which include CVD and additional special tariffs) on non-fuel imports still average in the low teens, about where they were 5 years back. Notional duties on about a tenth of products actually average more than 50%, steep by any measure.

Service quality is better or worse, depending on who delivers it. You step into a private hospital for a routine check-up, board just about any domestic flight or check into any half-decent hotel in India and you’ll appreciate what kind of shoddy service one gets in the US. I am being generous here in calling that “service”. The situation quickly changes when you compare anything that falls within state’s purview – Be it power supply interruptions, hap-hazard municipal cleaning routines in smaller cities or travel inspections by police on roads, which are nothing but facades for wringing money (I estimate that at least 80% of traffic violations are settled by money exchanging hands vs. actual citations being written), the sad situation of anything delivered by the state is apparently palpable. That said, quite a bit of what is generally provided by the state can, and is, often supplanted by private alternatives - In Gurgaon, for instance, many apartment buildings now come with electric supply back-ups, short-circuiting the underlying power-load bottlenecks.

Traffic citation……what citation ?. If you insist on a citation, traffic cops will list a laundry list of violations, forcing you to cough up cash and settle. However, quite a few of India’s underlying inefficiencies are curable – For instance, why not lower fines and put caps on citation’s value. Then share part of the receipts with cops responsible for writing citations and pocket the rest. Let’s examine the facts first – Cops are significantly underpaid in India (A police constable with 20 years under his belt takes home a salary, which is about half that of an Indian urban household ); Almost all violators who prefer getting a citation do so only if the payout is not much above what it will take to settle in cash; Violators don’t want to go through the red-tape of getting back their Driver License or Registration, one of which is usually retained by the cops when they write the citation. What regulators need to do is 1. Ensure that cops’ compensation doesn’t go down (Their settlement income needs to be substituted somehow); 2. Lower fines and institute caps on citations; 3. Incentivize cops to write citations; and 4. Do away with requirements such as retaining License/Registration at the time of writing a citation. Let’s say that currently out of every 100 violations, 80 get settled by INR 100 ($2) changing hands, with the other 20 violations getting an average citation of INR 250 ($5).That translates into INR 13,000 in cash receipts, with just under 2/3rd of that being pocketed by the cops. Realize that a major constraint to finding a solution here is ensuring that cops keep getting their INR 100 share per settlement. If one lowers the citation cap by 20% (INR 250 to INR 200) and shares half of citation’s value with cops, payout for cops remains unchanged. Even if one assumes that about 20% of violators somehow convince the cops to settle for INR 75 vs. writing an INR 200 citation (of which cops pocket INR 100), government receipts still go up 75% and even the cops see close to 10% increase. This is obviously over-simplified and I can think of plenty of challenges here. However, I can’t think of any that is insurmountable, especially given the potential of significantly improving cash flows. Such solutions are executable but amazingly these inefficiencies have lingered on for years. All this in a country, where non-tax revenues have been handily outpaced by tax revenue growth.

The case of parallel Indias – Chauffeurs and sahibs. Income growth across India has been wildly asymmetric. While real compensation growth for white-collar Indians has been significant, unorganized blue-collar workers have barely seen any material real growth. The massive rural-urban and cross-border migration patterns are driving this differential. That however doesn’t mean that bottom quartile households haven’t seen growth. Given income and savings potential differentials between rural and urban households, migration patterns tend to be significantly accretive. House maids and chauffeurs grind for hours each day, to earn enough to survive while their well to do patrons enjoy massively improved consumption choices and investments, whose returns by any measure are as sweet as the Indian sweets – I met someone in Delhi who had recently invested in a commercial property in Kolkata in Eastern India that yields after-tax returns of 12% (It’s actually pre-tax but I haven’t come across an Indian that discloses rental income on tax returns. However, I am sure some do).

Unless you plan to live in India, you are better advised not investing in the Indian residential realty market. Nowhere is the likelihood of bubbles more visible than in the Indian residential realty market; a market where yield chasers have driven down rental yields to low single digits, well below risk-free returns in India. Still, resident and non-resident Indians continue to flock to the realty market. The situation is particularly bubble-like in pockets such as satellite towns in the National Capital Region (Gurgaon and NOIDA), where the concentration of renters is well ahead of Indian averages – These towns have attracted quite a few realty investors, who have bought their second home in these markets. However, for any bubble to burst, demand-supply mismatch has to become sufficiently evident and will have to manifest through an incremental spike in vacancy rates [Note that there is no credible available information on residential vacancy rates. One way to look at the underlying issue is to analyze growth in a relevant industry that is expected to follow real-estate sales (with or without a lag) - Last week, I was having a chat with CFO of an Indian publicly listed appliances company and he mentioned how his industry continues to trail growth within real-estate. Note that Indian apartments come without appliances and even though appliances' sales are expected to follow real-estate sales, they are obviously getting outpaced, suggesting that quite a bit of sold apartments remain off-market and aren't being furnished]. It’s alarming to see that property prices have run up so much even as the market has been largely unable to keep up by raising asking rents, creating a situation where buying a second home as an investment property has become a highly unattractive proposition. Think twice before you act on what is now commonplace advice from your family and friends to buy an apartment in an upcoming building, which won’t be ready for another couple of years. You’ll be better off investing in Indian equities through some systematic investment plan.

Can India fail itself ?- A meaningless near-term question. Economic growth in India is more sustainable than most, given 1. High savings rates (I estimate that complete re-investment of India’s corporate earnings, and household consumption from income from invested savings, despite highly sub-optimal allocation, can contribute 100+ bps to underlying economic growth), 2. Lifestyle changes (selected savings monetization within the top quintile), 3. Massive rural -> urban migration pattern, which is generally consumption accretive (About two-thirds of Indians are rural residents, while rural India’s per-capita NDP, which is generally a good proxy for wage differentials, is about 1/3rd of urban India. The fact that investment in agriculture has trailed investment just about anywhere else has further compounded the situation. As a result, about 45 million rural residents are migrating towards urban India annually. Assuming such patterns are even $75/capita accretive to annual consumption, that alone contributes about 3% to GDP growth), and 4. Continued investment inflows, even as FDI inflow has dropped this year, in-line with the rest of the world.

India’s primary “derailment” risk stems from infrastructure related challenges. Nowhere does infrastructure fall short of minimal requirements than in power generation, driven by inadequate and inconsistent coal supply (the only space where state monopoly still exists). India is planning to increase its spending on infrastructure from the current 4%-5% of GDP to 9% of GDP by 2014E, with about a third of required investment coming from private sources. That translates into about $60 bil in incremental state investment, or more than 5% of GDP. If India’s recent fiscal progress is any indication, there is reason to suggest that the above target might be a little aggressive – Over the last 5 years, India’s consolidated fiscal deficit (centre + state) went down from 7.5% of GDP to under 5%, principally due to strong tax collections (more payees and simplified structure). Still, India will have to significantly improve on that performance if it is to achieve its infrastructure investment goal. That said, even with no help from FDI inflows, associated job creation and infrastructure related investment, India can still sustain a mid single-digit normalized growth (These aren't "normalized" times though) for the next several years (see Exhibit 1). India, at least among liquid markets, is what I call the “easiest growth” story, which unfortunately keeps poor fiscal discipline and inflexible economic policies away from limelight, at least for now.

Exhibit 1 – India’s normalized base-case growth est. (ex-FDI, new capital deployment and investment in infrastructure)

Source: Internal Analysis & Estimates; Misc. sources

Perma-bears and the broken clock syndrome. One can argue that the sorriest performers this year have been Emerging Markets’ dedicated hedge funds, which while returning a nonetheless impressive 20% return this year have underperformed MSCI Emerging markets by close to 40 pps. The situation is fascinating to observe – Those that have missed the boat are viewing current valuations as “relatively stretched”, ensuring that these investors will likely not keep pace with further upside but will be quick to point out that they came out unscathed in a potential sell-off, which will inevitably take place at some point. I have an opinion but I am not sure what’s coming next and rest assured that no one does, except for the ones that will be proven right in subsequent hindsight. What I do know is that India is by no measure a "relatively" expensive market, trading in the mid-teens (Liquid Sensex constituents trade much higher), and at a discount to MSCI World. With the exception of US aligned markets (ex-Japan) i.e. markets where earnings recovery is closely aligned to recovery in the US (Mexico, China, Chile, Taiwan etc.), most emerging markets are trading at a discount to MSCI World, and to India. With the exception of MENA and Baltics, most trade within 15% discount to India. Any b-school kid will tell you that 6% growth (India’s 2010E growth est.) is about 15% more expensive than 3% growth (Ex-China and India 2010E growth est. for emerging markets), everything else being the same. In fact, if anything, India’s situation is not particularly similar to emerging market peers – India, for instance, is a poorer country with very liquid markets and one that respects investment interests.

India may not be a relatively attractive pick anymore for some, given 65%+ returns YTD, within the broader emerging equity asset class (up 55%+ YTD) but to call it’s valuation “relatively stretched” is likely the work of those that have missed the boat, and that means most hedge funds. Even a chimp can keep on shorting and eventually be proven right, just like a broken clock. I am not saying that Sensex wouldn’t face a relative sell-off but to attribute such an event to “stretched” valuations is comical.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Cumulative Performance [thru Mid-Sept 2009]

2009-09-18T03:50:00.000-07:00

Note: CS-Tremont AllHedge performance for 1H of September 09 is not yet available.

Since inception in mid-08, Contravest has outperformed CS-Tremont AllHedge, Russell 2000, S&P 500 and Barclays Global Bond Aggregate by 29, 35, 36 and 16 pps respectively*. Contravest was up 4.5% (unlevered) in 2008 and remains up 16%+ in 2009 YTD*. Following a strong surge in equities in September, Contravest now trails the broader equity benchmarks for 2009 YTD*.

* as at the end of trading on 09/17/09. Comparison vs. CS-Tremont AllHedge is as at the end of August 2009.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

Looking for gas in the Industrials' tank

2009-08-20T12:00:00.000-07:00

I don’t understand what part of the puny 10% of $787 billion in stimulus spending plan outlay for infrastructure went unnoticed. The reason I say that is because I find it perplexing that Industrials, which is one of only three S&P 500 sectors (Energy and Materials are the other two) where EBITA recovery has consistently lagged the broader market in last 4 recessions, has already outperformed the S&P 500 by more than 2x it’s relative outperformance in the 4 quarters following the 1Q03 bottom, for absolutely unknown reasons.

What is causing a typical earnings laggard sector like Industrials, which comes with relatively rich valuation, and lower international exposure and leverage than the broader market, to outperform the market ?. Typically, reflation trades are based on the belief that assets whose current earnings power is most depressed should trade ahead of their historical relative valuations - One can note that any sector whose relative earnings power (current earnings contribution to the benchmark vs. in say 2006) is lower, now commands a higher relative valuation vs. it’s historical valuation vs. the benchmark (see Exhibit 1). While that trade may make sense for certain sectors, it has likely been overdone (at least since the March bottom for equities) in certain sectors such as Materials and Industrials, with Industrials a rather strange beneficiary. Industrial stocks now trade at close to 10% premium over the benchmark (vs. a historical high single-digit discount), even as their relative earnings contribution to the benchmark isn’t particularly depressed (current contribution to benchmark earnings is just about 4% shy of 2006A levels). Coupled with the fact that Industrials consistently lag the market in EBITA recoveries and provide relatively lower optionality for earnings upside (lower international exposure and leverage vs. the market), there is little to support the recent outperformance of Industrials.

Exhibit 1 – Analyzing how “reflation” trade has worked across sectors

* Relative implied pessimism is an absolute metric, which measures change in sector’s earnings contribution to benchmark vs. change in its relative value – The higher the better; ** EBITA is used as a metric to neutralize financial leverage effects while accounting for differentials in fixed-asset intensity; No sector has shown consistency in leading EBITA recoveries; Materials, Energy and Industrials have consistently lagged.

Source: S&P, Mckinsey & Co., Reuters, Internal Analysis & Estimates

I don’t see any credible evidence to support why 2010E estimates for Industrials could be viewed as relatively low vs. the broader market. In line with its consistent tendency to trail earnings recoveries, 2010 earnings growth expectations for Industrials are lower than every sector, except Telecom Services. To put things in context, in 2003 (the year of market bottom, which followed the earnings bottom at the end of 2001) Industrials posted a low single-digit earnings growth, well below the close to 20% earnings growth for S&P 500. In fact, it wasn't until 2005 that Industrials earnings began to outpace the broader market. For 2010E, estimates suggest high single-digit earnings growth for Industrials vs. 30%+ growth for S&P 500, which is largely driven by Financials, Energy, Materials and Consumer Discretionary.

Recent earnings performance hasn’t produced anything to support the relatively depressed estimates hypothesis – Just under half of S&P 500 companies beat earnings estimates by more than 5% in 2Q09, just ahead of Industrials’ 47% (see Exhibit 2). Further, only about a fourth of Industrials matched or exceeded revenue expectations, compared to 35% of S&P 500 companies.

Exhibit 2 – % of companies beating consensus earnings by >5% in 2Q09

Source: First Call

Note: Telecom Services’ performance may not be statistically significant. Only 9 companies comprise the sector in S&P 500, one-third of the second smallest representation, Materials.

This is purely a quant exercise to screen sectors for systemic protection (potential shorts). For the most part, this wasn’t meant to be a judgment on published estimates. It is rather an assessment of the first derivative – Are valuations appropriate, assuming that estimates, which are rarely right going into declines and off of recoveries, happen to be spot-on.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Cumulative Performance [thru mid-August 2009]

2009-08-17T15:50:00.001-07:00

Note: CS-Tremont AllHedge performance for 1H of August 09 is not yet available.

Since inception in mid-08, Contravest has outperformed CS-Tremont AllHedge, Russell 2000, S&P 500 and Barclays Global Bond Aggregate by 29, 43, 41 and 15 pps respectively*. Contravest was up 4.5% (unlevered) in 2008 and remains up and ahead of all benchmarks and most peers in 2009 YTD*.

* as at the end of trading on 08/17/09. Comparison vs. CS-Tremont AllHedge is as at the end of July 2009.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

House prices – Is this the inflection point ?

2009-08-01T00:57:00.000-07:00

Is it realistic to expect that Case-Shiller’s May report from earlier this week could indicate an end to house price declines ?. I was surprised that a high number of market participants viewed that as a sign of stabilization, despite an increasingly worsening inventory and a pull-back from first-time buyers.

Housing inventory is likely getting more distressed. The chatter around bulging “shadow inventory” isn’t one that could be out rightly jettisoned. Despite rising foreclosure activity (Almost 900K filings were reported in 2Q09 vs. under 750K in 4Q08), it’s worth noting that distressed sales have accounted for fewer home sales recently than at the beginning of the year (see Exhibit 1). It is likely that an increasingly smaller portion of distressed homes is showing up in the listing. Concomitantly, a relative lack of first-time buyers (whose focus has largely been on distressed transactions – see Exhibit 1) is lowering the concentration of distressed transactions in existing home sales figures. As a result, the “real” housing inventory has likely gotten more distressed than at the beginning of the year.

Exhibit 1 - Concentration of distressed sales and first-time buyers – Last 5 Months

Source: NAR

This isn’t a time to chase rental yields. Despite rental vacancy rates reaching all-time highs, asking rents have kept “relatively” steady even though rent growth is expected to remain flat this year (see Exhibit 2a). As a result, improved rental yield spreads are attracting repeat buyers in the market. On the other hand, participation from first-time buyers has suffered, following an initial spurt in response to the announced tax-credit. In June, first-time buyers accounted for under 30% of the transactions, down from 50% at the beginning of the year, 40% in June last year and a more normalized level of about 40%-45%. At this point, there is simply not enough interest from first-time buyers to fully support “move-up” of current owners.

Exhibit 2a – Rent Growth vs Rental Vacancy Rate

Exhibit 2b – Rental yield spread* vs Home Prices

Source: Census Bureau, Freddie Mac, S&P
* Rental yield spread is calculated as rental yield less tax-adjusted FRM interest

It’s hard to reconcile with the logic of chasing rental yields in the current environment – Rental yield spread over tax-adjusted FRM is barely above historical averages (see Exhibit 2b above) and even though that may begin to look attractive to some, there is enough evidence to suggest that asking rents could fall while mortgage rates are unlikely to - Rental vacancy rates are near all time highs, job losses continue, re-modeling costs are down and there is barely any (or prospect of any) wage inflation in the rental and leasing industry. That’s not all – If the MID cap comes down to 28%, rental yields could depress further.

To summarize, increased participation by first-time buyers is needed not only to absorb current REO inventory but also to support move-up of existing owners, which is the only way that housing sales mix will sustainably drive home prices higher. As things stand, any short-term stabilization will likely only signal a hiatus and not an inflection point.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

There is more to come for high yield

2009-07-16T23:54:00.000-07:00

In 2006, a host of issuers, whose credit ratings effectively barred them from accessing the unsecured debt markets, turned to bank loans, which at the time, were priced about 100-150 bps below bonds. Anyone with speculative rating and collateral to secure jumped in. Guess who is coming home to roost ?. To make matters worse, the implosion of CDOs, which bought into majority of leveraged loan issuance in the 2005-2007 period, has significantly depressed market appetite for loans.

If relative credit worsening (CCC and B, relative to BB) is in line with 2002, speculative grade default rate appears all set to reach close to 15% in 2H09. Despite that, high yield paper has rallied strongly this year, off of greatly depressed valuations. With US loans and bonds up close to 30% this year, and equities pricing in a meaningful recovery in earnings, it’s about time to take stock of the asset class, between constituents and vs. equities -

High yield paper will likely continue to outperform equities through 2009 – Equities are already priced for a significant earnings rebound in 2010E. Short of 30%+ earnings growth in 2010E, there is little else to support relative attractiveness of equities over high yield paper. That said, earnings rebounds are strongest in the early phases of recovery and there are more than a few pillars now to support that earnings could exhibit one of the strongest rebounds in history, if consumer deleveraging and unemployment stabilize. The issue if such stabilization could take place before 2010E is an entirely different question though (I’ll deal with this in a subsequent note). For now, let’s just say that despite the strong high-yield performance YTD, risk-adjusted upside potential for high yield paper (still) remains more attractive versus equities, albeit less so than at the beginning of 2009. The potential for any upside however, appears bleak for CCC and lower rated bonds and loans (see Exhibit 2a), both of which are likely to underperform equities in 2H09E.

Loans may offer better risk-adjusted yields, but across a range of 10%+ earnings recovery scenarios, bonds offer more upside potential. BB and B bonds are not only offering comparable expected all-in yields (after losses and amortized discount), but under almost any realistic earnings recovery scenario for 2010E, they also offer more upside potential vs. leveraged loans and equities. Overall, bonds appear more attractive, assuming earnings exhibit double digits growth in 2010E.

The 2013-2014 loan re-financing risk – Can the CDO void be filled ?. With many investors fearing a permanent impairment of CLO appetite, concern around loan refinancing has been growing. Following a light maturity schedule through 2012, more than $350 billion in leveraged loans come due in 2013 and 2014. Recent amendments are pushing out maturities, potentially turning the 2013-2014 refi concern into 2012-2014 refi concern. That said, majority of amendments this year appear to have focused on covenant relief vs. maturity extension. Despite the gloom, there are offsetting factors in play - I estimate that of the more than $350 billion due in 2013 and 2014, about a third could potentially face pre-emptive default or get rolled into bonds – Note that about 60% of high yield bond issuance this year went towards loan pay-downs. A range of other options exist – Banks can finally begin holding more of their originations, hedge funds and other investors might return, and profitability might improve from current levels, among other scenarios.

Loan amendments are pre-empting covenant violations. If average maximum debt/EBITDA covenant (of about 5x) of issuance between 2005-2007 were to be enforced, about half of loans originated over this period would be in violation before the end of this year (based on a 30% decline in EBITDA over 2008-2009 period). However, a spike in amendments is allowing issuers to preclude potential violations – The number of leveraged loan amendments year-to-date have already surpassed all amendments between 2006-2008 (see Exhibit 1a). To put things in perspective, the number of amendments this year alone account for about 40% of all issues included in the Barclays High Yield Loans Index. Even as these amendments have increased loan downgrades (see Exhibit 1b - Notice the spike in % of CCC rated loan issues since November last year), they have certainly provided issuers with some respite, assuming economic climate doesn’t worsen in 2010E.

Exhibit 1a - Leveraged Loan Amendments

Exhibit 1b - % of Issues rated CCC

Source: Fitch Ratings, Barclays Capital Fixed Income Indices

Improved high-yield pricing and tax relief have promoted loan-refinancing and exchanges. Relatively improved appetite for high-yield bonds, heightened need on the part of debtors to disentangle from restrictive covenants, and a steeper yield curve are attracting many issuers to replace existing loans with new notes. By some estimates, about 60% of high-yield bonds issued this year have been used to refinance bank debt - It is likely that the ongoing refi activity would have marginally depressed current bond default rates.

Relaxed debt repurchase accounting rules have also contributed to improved sentiment - Under the 2009 Recovery Act, tax on cancellation of debt income, arising from debt repurchases, may be deferred until 2014E, and original issue discount used in debt restructuring is now deemed deductible.

All-in yield for leveraged loans is likely to be better than high yield bonds, but bonds offer more upside across most recovery scenarios. 2009 YTD recovery rates (based on 30-day post-filing quotes) for loans have been in the mid 50s, well below the close to 70% recoveries noted during the 2001-02 period. Further, 1Q09 recovery ratings at Fitch also point to recovery estimates of below 60%. However, even at close to mid-teens default rate and about 50% recovery, I estimate that all-in yield (after amortized discount and losses) for leveraged loans will be about 3 pps ahead of high yield bonds (see Exhibit 2a). However, while loans offer better risk-adjusted upside in a muted earnings recovery scenario, across most other scenarios, high yield bonds appear to offer the most upside potential (see Exhibit 2b).

Exhibit 2a - Est. All-in yields*

Exhibit 2b - Est. Upside potential across earnings recovery scenarios**

Source: Barclays Fixed Income Indices, First Call, Internal Analysis & Estimates
* After expected losses and amortized discount
** Based on 2010E earnings recovery scenarios

High yield notes and loans have traditionally outperformed equities following downturns and are likely to do one better this time, following one of the worst years in 2008. High-yield bonds not only outperformed equities throughout the last downturn (2000 through 2004), but they also handily outperformed in 91, 92 and 93, following underperformance in 90. 2009E could very well end up outperforming 91’s high yield returns of close to 40%.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

ADDITIONAL DISCLOSURE: As of the date of this post, author had positions in high yield bonds and floating-rate debt.

Cumulative Performance [through mid-July 2009]

2009-07-16T17:05:00.000-07:00

Exhibit 1 - Cumulative Performance against benchmarks

Note: CS Tremont All-Hedge performance for 1H of July 09 is not available.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

Can India’s emerging low-cost vehicle segment come to the aid of lofty car ownership forecasts ?

2009-07-02T13:24:00.000-07:00

Many market participants actively buy the “India Shining” thesis and mindlessly paint it across consumption categories. Multiple domestic passenger car sales forecasts were predicting close to mid-teens growth over the next two decades. Most of these weren’t even factoring a concomitant drop in household savings, a mathematical improbability. Many of these forecasts were published even before the Nano concept was unveiled, which makes their credibility highly questionable. However, the emergence of the low priced car segment couldn’t have come at a better time for forecasters who were banking on an almost seven-fold increase in passenger car PARC between now and 2025E. That growth however comes with considerable risks, given embedded leverage (more on this later in the note) in auto demand - Note that while India’s growth slowed from about 9% to ~7% in 2008-09, new car sales collapsed and reported a flat year in 2008-09, following on +12% growth in 2007-08.

The following are the likely reasons for rosy car ownership forecasts -

1. Expectation that income growth will drive affordability, which it will.

2. India’s per-capita car ownership is very low (see Exhibit 1b) and is bound to increase. Note how high gasoline prices (relative to per-capita income) and low penetration of paved roads explain low ownership (see Exhibit 1a).

3. Expectation that consumer savings can be monetized, since India’s savings rate is too high, relative to other emerging markets, and higher than where major car-ownership “take-offs” occurred. Also, dependency ratio is expected to continue to decline.

Exhibit 1a – Car ownership vs paved roads and gasoline cost

Exhibit 1b - Car ownership vs. per-capita GDP

Source: World Bank, Nationmaster, IMF
Note – Per-capita gasoline cost is based on annual consumption of 300 gallons; Bubble sizes indicate cars/1000 people

In my view, while the above are all relevant reasons, they are 1. Influenced by past performance, which benefited from a significant increase in auto loan penetration, 2. Fail to take into account economic affordability (vs. levered affordability) outside the top quintile of households, and 3. Fail to recognize that Indian household net-worth, disposable incomes and inadequate government social support warrant the need for high household savings.

Even Nano is out of “economic reach” for about 80% of Indian households. Chief constraints to increasing car ownership in India include inadequate road infrastructure, sky-high fuel prices (absolute and relative to per-capita income), and low net-worth level, considering already low disposable incomes (see Exhibit 1a and 1b). Unless households are willing to either considerably cut or completely do away with their current run-rate savings rate (I don’t see that happening – See the exhibit set titled Net-Worth to Personal Disposable Income – a cross-market comparison), a vast majority of Indian households remain priced out of even the low priced car segment. Before Nano came to market, the on-road cost of base versions of some of the cheapest models on offer (Maruti Suzuki Alto, Chevrolet Spark, Hyundai Santro etc.) was northwards of $5,000, effectively pricing out a material number of Indian households, even within the top decile, let alone the top quintile. By my estimate, the 90th percentile Indian household falls just short of world average Net-Worth/PDI ratio – In an economy with a very low level of absolute disposable income and inadequate social security net, the bottom 90% is simply not in a position to significantly compromise their monthly savings by indulging in big-ticket discretionary spends such as car purchases. Consider this – India spends significantly less on social expenditure than even many poor neighboring South Asian economies. Both Bangladesh and Nepal, for instance, spend considerably more on social expenditure than India does. Further, any material drop in savings within the top quintile of households will significantly reduce India’s overall household savings rate, given that the top quintile accounts for almost half of Indian household savings.

In my opinion, absent the low-cost car segment, car ownership will largely remain confined to a subset of the top household quintile in the near-term (The 80th percentile household will likely not be able to afford an ex-Nano base version until 2016E, assuming they are comfortable with seeing their savings rate getting slashed by at least a third). With it, car ownership can spread across the top two quintiles by 2025E (see Exhibit 2). Nano may not be your car but you cannot seriously buy into the estimates that project seven-fold increase in passenger car PARC in India between now and 2025E (@12% average unit growth) without considerable penetration of the low priced passenger car segment.

Exhibit 2 – Plotting passenger car PARC against affordability

Source: Indicus, National Registrations Data, Internal Estimates & Analysis

Shoving capital down consumer throats. Not only is a vast majority of India’s car sales financed, but it is also done at particularly high LTV, considerably above global averages (Before credit crisis forced more stringent underwriting, average LTV of 90% or more on auto loans was pretty common, which has since come down to closer to 80%; EMI to Income of 50% is still viewed as “comfortable”). With onerous seizure and recovery policies, auto loan growth now desperately needs a breather.

While capital availability grew comfortably ahead of affordability over the last decade, that trend will almost certainly not last much longer (given already high % of financed cars), suggesting that the dominant driver of car ownership, going forward, will have to be real per-capita income growth, which is unlikely to sustain average growth of more than 5%-7%.

Be cautious on contribution from replacement cycle. While credible statistics on Indian vehicle scrappage don’t exist, it’s fair to assume that Indian passenger car scrappage rate is likely to be a very low single digit figure (There is a laundry list of reasons) - The average age of existing Indian car fleet is likely in the neighborhood of about 5 years, or about 50% of US, and average odometer reading for a 5-year old car in India will be no more than 40% of the reading on a same age car in the US. Given significantly lower use and affordable service and aftermarket component costs, scrappage rate is likely to be significantly less than the mid-single digit rate in the US.

Most Asian car ownership “take-offs” began at significantly higher per capita income levels than where India stands. Car ownership “take-offs” in Japan (1960s), South Korea (1980s), Taiwan (1970s) and China (present) occurred when per-capita incomes (in 2000 constant prices) in these markets were 125%-290% ahead of where India is today (see Exhibit 3). Also, in each case, gas prices were far more manageable relative to household income than they are in India now. That said, Indian car ownership take-off is benefiting from globalization like no one (barring China), did. More importantly, India’s savings rate is well ahead of where take-offs occurred in the above cases, providing some room for it to go down, which has to occur to support 12%+ CAGR from here on, unless India reports unprecedented real income and employment growth, or over-generous financing miraculously gets sustained for a decade. In sharp contrast, Japan, South Korea, and Taiwan, reported a sharp increase in savings rates during take-off periods, even as car ownership spread rapidly.

Exhibit 3 – Asian car-ownership “take-off” decades – Beginning GDP per-capita vs. per-capita sales growth

Source: GM, CSO, Internal Estimates & Analysis

(In)sanity Check - Segregating the top quartile as a separate economic group. If top 25% of Indian households were to be addressed as a separate fictional economy, Indian gasoline pump prices remain unchanged through 2025E, and passenger car sales were to average 11% growth over this period, I estimate that such an economy would have car ownership of about 250 cars for every 1000 people in 2025E. This is based on a fairly aggressive assumption that real per-capita income growth for the top 25% of households will average close to 8% through 2025E. The resulting quadrants (car ownership against retail gasoline prices and per-capita GDP (2008 constant prices)) are shown in Exhibit 4. The results indicate that even 11% average growth expectations appear aggressive, at least when compared with the peers on that plot – While our fictional entity will have a per-capita GDP (in 2008 constant prices) about 15% below peer average, it’s resulting car ownership would be 15% ahead of peers, second only to Malaysia on that exhibit, a country whose per-capita GDP is 16% ahead of our fictional entity and retail gasoline prices more than 40% below Indian pump prices. Comparison using diesel-prices wouldn’t yield anything that is materially different. Any way one looks at it, the mid-teens CAGR that some forecasts suggest is likely based on past performance, assumes aggressive acceleration in wage growth, and largely ignores an almost certain and profound impact on household savings, given high car ownership costs.

Exhibit 4 – Addressable top 25% of households – Est. car ownership vs. GDP per capita and gasoline prices

Source: Misc, Internal Analysis & Estimates
Note – Bubble sizes indicate cars/1000 people; Disposable Income multiplier was used to calculate GDP for top 25% households.

Can India repeat its 12% CAGR performance of the last decade, which was fuelled by generous loan underwriting ? – I wouldn’t hold my breath, but a sustained strong growth of new low-priced passenger vehicle segment will almost certainly be required to emulate past performance. In addition, an unlikely scenario of significant monetization of household savings will need to play out. The median Indian household in the top quintile makes just enough to save about a fourth of his disposable income after purchasing a model such as Alto, Spark or Santro. Those in the bottom fourth of the top quintile will see their savings rate dip into mid-high teens if they were to purchase any of the above mentioned models (Such households typically have less than 4 years of their disposable income as savings, which is a low denominator to begin with, and close to half of savings are tied up in physical assets). On the other hand, purchasing Nano’s air-conditioned variants is much more affordable for households at the bottom of the top quintile, with savings rate dipping into mid-20s post-purchase. In either case, it is critical to appreciate the fact that impact of car ownership costs on household savings across a vast majority of Indian households in the top 2 quintiles is too striking to ignore. Given where Indian household net-worth stands, such a change can only take place gradually and places economic limitations to car ownership . More importantly, if 12%+ market growth is to materialize, I estimate that the low-priced car segment (which only includes Nano at this point), will account for at least a fifth of the increase in Indian car PARC between now and 2025E.

DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

ADDITIONAL DISCLOSURE: As of the date of this post, author owned depository receipts of Tata Motors (NYSE:TTM)