I'll go through the checklist that I recently created, and try to eliminate the stock. Let's see how far can this business stand in my screening :-)
Checkpoint 1: Is the business OUTSIDE your circle of competence [Charlie Munger]? Can you talk about it right after you're waked up from sleep? Do you understand the business well? Is it simple enough for an idiot to run [Peter Lynch]? Assume you're no better than an idiot!
IL&FS Investment Managers Ltd. (IIML) is a private equity fund focused in infrastructure and real estate funds. While I don't understand either of real estate or infrastructure (related to real estate) development, I understand the role of a PE fund, and I'll explain below on how I believe this company can be a good side-car investment, apart from providing healthy dividend yield. In this context, I'll focus more on analyzing the management's ability to sustain and grow the returns, more than understanding how the business operates.
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
Checkpoint 2: What is your main reason to look at this company? Write this down and once we analyze the business, we'll come back to see if our analysis is biased by this presumption [Anchoring bias, Charlie Munger]. If your reason is mainly a recent, sharp decline in share prices, try to find why so many people are selling, and if they know more than what you (prospective buyer) knows, or in other words, are you taking undue risk by investing into something with many unknowns?
I'm interested in IIML due to the following:
- Healthy dividend payout (above 40%), translating into 7% yield for current share price.
- Fund managers have delivered very good performance in the past. This belief, if true, can turn this stock as a very good side-car investment, similar to PEL that I hold today.
Checkpoint 3: What kind of investment do you consider this business initially? Are you considering it as a long term story, or a medium term play (sorry, short term plays, i.e. for duration less than 3 months, are OUTSIDE the circle of value investors). Write down your initial thought in terms of [Peter Lynch] investment types - High Dividend Yielding, Stalwarts, Cyclical, Fast Grower, Turnaround story or an Asset Play?
I consider IIML as the following investment type:
- High dividend yielding
- Asset Play, where value of assets is very good, and a positive catalyst is needed to unlock the value
- Side-car investment due to proven capability of the fund managers, based on past performance of the funds.
Next checkpoint is the most important point for this investment, as we're banking on management's abilities to drive the value creation for shareholder (me).
The following key financial numbers will support the arguments below:
The following key financial numbers will support the arguments below:
Checkpoint 4: A good management is essential to keep a "good business" good, and hence, we must identify whether
a) Is management candid with shareholders? Have they done what they said in the past?
Looking at answers below on checkpoint 6, the management statements reflect that they're candid. They've acknowledged the challenges to business outlook and still tried to deliver the performance (we still want to validate their deep value investing belief, which we'll do towards the end, in checkpoint 7)
Yes, they do. As we see below in checkpoint 6, they've invested heavily during the downturn when the valuations became more favorable and this is the most rational thing to do for a long term investor.
We've not found any signs of a behavior from management which highlights doubts about their integrity, but we'll keep a tab on this aspect as we analyze MD&A and specifics of investments made in details.
Management of IIML has indeed demonstrated good capital allocation skills. Here's the reasons in support of this statement:
- Maintained 30% (or higher) PAT margin %age, for last 7 financial years. This demonstrate good exit (divestment) criteria for investments that the PE fund group holds.
- Consistent ROE higher than 40% except in FY2005-06, when last 7 years are considered.
- Consistent ROE higher than 40% except in FY2005-06, when last 7 years are considered.
- Grown dividend %age consistently in the past, as they've surplus cash, beyond good investment opportunities. IIML has passed on most of the cash as dividends to shareholders, as evident from more than 70% dividend payout ratio of PAT in many fiscals.
- Cash flow from operations has been positive, but erratic compared with net profits. Analysis of Cash Flow statements will be performed in detail when analyzing financial health.
- Business has avoided debt for all of the financial years. Only liabilities are the deferred employee benefit payments.
- Business has avoided debt for all of the financial years. Only liabilities are the deferred employee benefit payments.
- The business has only dealt with share split, bonus issue apart from dividend payouts, but not exercised buy back option. This means that management wants to reward shareholders for long term shareholding with consistent cash flow in form of dividends, and do not want them to "trade upon buyback", despite that management might have felt that share price is beaten down to make it undervalued and lucrative for buyback to reduce equity dilution.
According to Annual Report FY2011-12, the salary of director is Rs. 2.62 crores. The non-executing directors are paid between Rs 20 lacs and Rs 4 lacs. According to P&L statement, the total expense on salaries and allowance for FY2011-12 is Rs 23.2 crores. Understandably, for a PE fund, most of the expenses are employee salaries and benefits, as also evident from P&L statements. Notably, director's compensation is ~10% of total employee compensation, and about 6% of PAT for the year. This is certainly not small, however, we should note that it is P/E fund, and hence such values are also not unreasonably high. Considering that the "team" manages an AUM of $3.2 billion (as of FY2011-12), the salaries for the "team" is Rs 232 million, which is 0.15% of AUM, which indicates a very low "management fees" if this company is treated as a mutual fund.
The company also has policy of ESOPs and encourages to provide performance based bonuses. In this case, director's compensation of Rs 2.62 crores includes Rs 1 crore as performance related pay.
As of 31st Mar 2013, directors of the company (7) hold 5.59% of publicly listed shares of the company, apart from the fact that promotors of the company (IL&FS Ltd) hold ~51% of the total outstanding shares. This means that both promotors and directors of the company believe in the company.
Additionally, Parag Parekh's investment firm (PPFAS Pvt. Ltd.) also acquired a sizable number of shares in 2012 end, and as recent as May 3rd, 2013, IL&FS Ltd. purchased additional 500000 shares from the market at an average price of Rs 21.56
Looking back at 2006, both promotors and employees have increased their %age shareholding.
All this indicates strong confidence of promoters and management in the future prospects of the company.
Overall, we believe that IIML has got a good management team.
Checkpoint 5: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Since IIML is a private equity firm, they generate money as commission to asset sale. Their customers are their clients who provide them with funds, and as a policy, they get a fix management fees of about 2%, and a "carry" of about 20% of profits if they're able to generate returns higher than "hurdle rate" which is about 12%. In this sense, the fund managers either get this "fixed" income or they don't accept funds, and then there's no customer pressure, i.e, they won't 'sell' at reduced profit margins.
Since there're no suppliers (actually clients provide the money supply, and in that sense clients are both suppliers and customers), there's no upside pressure on costs.
The competition are other funds who may snatch the "deal", but a mindless competition will be when acquirers pay insane prices for purchasing assets, or sell assets at lower profits. Both of these acts will reduce returns on investments. This has been the environment during last couple of years when there's liquidity crunch in PE investing, and it's getting difficult to sell assets at good profits. This is like a push and a "near ideal" economy where no P/E player has any moat - if you sell at profits you'd like, you may not be able to sell enough, it's like reducing revenues to maintain profit margins. The good part about IIML is that they chose to maintain profit margins, which keeps their 'carry' and provide them source of income, however, if they can't sell assets 'in time while maintaining hurdle rate', they'll eventually lose money. In this respect, "passing time and slowing asset sales" is a killer for IIML, and this indicates 'weak moat'
There's no alternate product I can think of, which poses a threat of replacement to IIML.
Finally, IIML has been able to maintain profit margins in the past, but we need a thorough, careful analysis on why they were able to do this, because they possess some special 'skills' or it was out of sheer luck? We do not yet know this answer, we'll need deeper study of what they could sell at good margins, and what they've not been able to sell profitably, and the times in which their asset sales were grand successful. We'll analyze this in checkpoints 6 and 7 where we assess risks to the business.
In summary, we believe that the business doesn't have a very strong economic moat.
Checkpoint 6: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
As mentioned above, here's how IIML makes money:
1. They approach prospective clients who believe in IIML's capability to generate returns that're acceptable to clients.
2. The agreement is, that if there's loss on investment, it is client's. IIML gets a minimum of ~2% as fund management fees on the total "Asset under management (AUM)', and if they make profits on investments greater than "hurdle rate", which is about 8-12%, they get 20% of the profits.
3. This is a "win-win" model for IIML, i.e., if they generate good returns, they get to keep 20% of the returns. If they screw up, they possibly lose the clients.
4. To increase revenues, IIML needs to attract more clients and more money, and to be able to do this,, they should deliver performance, consistently, as we're talking about some serious money.
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
The company also has policy of ESOPs and encourages to provide performance based bonuses. In this case, director's compensation of Rs 2.62 crores includes Rs 1 crore as performance related pay.
As of 31st Mar 2013, directors of the company (7) hold 5.59% of publicly listed shares of the company, apart from the fact that promotors of the company (IL&FS Ltd) hold ~51% of the total outstanding shares. This means that both promotors and directors of the company believe in the company.
Additionally, Parag Parekh's investment firm (PPFAS Pvt. Ltd.) also acquired a sizable number of shares in 2012 end, and as recent as May 3rd, 2013, IL&FS Ltd. purchased additional 500000 shares from the market at an average price of Rs 21.56
Looking back at 2006, both promotors and employees have increased their %age shareholding.
All this indicates strong confidence of promoters and management in the future prospects of the company.
Overall, we believe that IIML has got a good management team.
Checkpoint 5: Does business possess a strong economic moat [Warren Buffet]? Check the following:
a) Do customers have a bargaining power that keeps an upper bound on prices and margin improvement is limited (cost cannot be lower than 0%)
b) Do suppliers have a bargaining power that keeps a lower bound on costs, such that margins are squeezed?
c) Risk of new entrants, who may play pricing wars and put pressure on pricing, i.e., does business have "earning power" like a brand value that allows it to maintain (or even increase) prices?
d) Is there an alternate product that poses a risk as a substitute to the product / service that business produces? Could it result in a permanent loss of revenue to the business?
e) Is the economic moat sustainable, or just due to luck?
Since IIML is a private equity firm, they generate money as commission to asset sale. Their customers are their clients who provide them with funds, and as a policy, they get a fix management fees of about 2%, and a "carry" of about 20% of profits if they're able to generate returns higher than "hurdle rate" which is about 12%. In this sense, the fund managers either get this "fixed" income or they don't accept funds, and then there's no customer pressure, i.e, they won't 'sell' at reduced profit margins.
Since there're no suppliers (actually clients provide the money supply, and in that sense clients are both suppliers and customers), there's no upside pressure on costs.
The competition are other funds who may snatch the "deal", but a mindless competition will be when acquirers pay insane prices for purchasing assets, or sell assets at lower profits. Both of these acts will reduce returns on investments. This has been the environment during last couple of years when there's liquidity crunch in PE investing, and it's getting difficult to sell assets at good profits. This is like a push and a "near ideal" economy where no P/E player has any moat - if you sell at profits you'd like, you may not be able to sell enough, it's like reducing revenues to maintain profit margins. The good part about IIML is that they chose to maintain profit margins, which keeps their 'carry' and provide them source of income, however, if they can't sell assets 'in time while maintaining hurdle rate', they'll eventually lose money. In this respect, "passing time and slowing asset sales" is a killer for IIML, and this indicates 'weak moat'
There's no alternate product I can think of, which poses a threat of replacement to IIML.
Finally, IIML has been able to maintain profit margins in the past, but we need a thorough, careful analysis on why they were able to do this, because they possess some special 'skills' or it was out of sheer luck? We do not yet know this answer, we'll need deeper study of what they could sell at good margins, and what they've not been able to sell profitably, and the times in which their asset sales were grand successful. We'll analyze this in checkpoints 6 and 7 where we assess risks to the business.
In summary, we believe that the business doesn't have a very strong economic moat.
Checkpoint 6: Since every business is essentially a system which takes in Cash and "is supposed to" generate more cash, such that the Return on Invested Capital (ROIC) is higher than Weighed Average Cost of Capital (WACC). Draw a "cash flow diagram" for the business explaining how it generates cash, and find out whether it has consistently been able to generate higher ROIC than WACC. Consider at least a period of last 5 years.
As mentioned above, here's how IIML makes money:
1. They approach prospective clients who believe in IIML's capability to generate returns that're acceptable to clients.
2. The agreement is, that if there's loss on investment, it is client's. IIML gets a minimum of ~2% as fund management fees on the total "Asset under management (AUM)', and if they make profits on investments greater than "hurdle rate", which is about 8-12%, they get 20% of the profits.
3. This is a "win-win" model for IIML, i.e., if they generate good returns, they get to keep 20% of the returns. If they screw up, they possibly lose the clients.
4. To increase revenues, IIML needs to attract more clients and more money, and to be able to do this,, they should deliver performance, consistently, as we're talking about some serious money.
The only investment in IIML is into their fund managers and 'human capital", and hence their's is a very asset-lite model. Looking at financials as above, we find that the business is able to generate a healthy 40%+ ROE. This is a good number considering that the company doesn't need any 'new capital' for operations and their operating cash is obtained out of their revenues (since if no revenues, no performance pay to managers).
Checkpoint 5: Before we go further, we need to make sure that the financial health of the business is good. Answer these sub-points to find this out:
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
a) Is company sacrificing operating margins to grow revenue (lack of sustainable moat)? We want a business which is able to grow profits at least as fast as sales (maintain / grow operating profit margin).
No, as we saw above, the business has maintained 30% PAT consistently, and while we need to read further (in checkoint 7) into "divestment policy", the financials show that IIML doesn't sacrifice profit margins to grow revenue.
b) Is operating cash flow poorer than profit (EBIT / EBITDA) on several occasions (consistently positive operating cash flow)?
We find that operating cash flow are erratic and do not match well with net profit. Looking at financial data table above, we see that CFO is always less than PAT, only in FY2008-09, FY2009-10 and FY2011-12, it matches well with PAT. Let us analyse why it is much lower in other years:
- In FY2010-11, there's an increase of over Rs 21 crores in trade receivables, which is about half the PAT. Additionally, the CFO reported for FY2010-11 in Annual Report for FY2011-12 is about Rs 11 crores lesser than reported in Annual Report for FY2010-11, which is because of difference in "change in current investments" and "interest income" between two reports. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2007-08, both trade receivables and payables increased by almost the same amount, causing a net "decrease in cash inflow" of Rs 3 crores, but about Rs 14.5 crores was spent in making new "current investments". The breakup in schedule 5 tells that most of it is "other debt"
- In FY2006-07, there's an increase of over Rs 21 crores in trade receivables, which is more than the PAT. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2005-06, major part of operating profit went into new advances and wasn't realized due to trade receivables. The breakup in schedule 5 tells that most of it is "other debt"
In summary, a significant part of operating profits being in form of "trade receivables" is the reason for smaller net operating cash inflow compared to net profits. Further, in all cases, most of increase in trade payable is recorded as 'other debt', and we need to find further details on what this consistent "other debt" is about?
- In FY2010-11, there's an increase of over Rs 21 crores in trade receivables, which is about half the PAT. Additionally, the CFO reported for FY2010-11 in Annual Report for FY2011-12 is about Rs 11 crores lesser than reported in Annual Report for FY2010-11, which is because of difference in "change in current investments" and "interest income" between two reports. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2007-08, both trade receivables and payables increased by almost the same amount, causing a net "decrease in cash inflow" of Rs 3 crores, but about Rs 14.5 crores was spent in making new "current investments". The breakup in schedule 5 tells that most of it is "other debt"
- In FY2006-07, there's an increase of over Rs 21 crores in trade receivables, which is more than the PAT. The breakup in schedule 5 tells that most of it is "other debt"
- In FY2005-06, major part of operating profit went into new advances and wasn't realized due to trade receivables. The breakup in schedule 5 tells that most of it is "other debt"
In summary, a significant part of operating profits being in form of "trade receivables" is the reason for smaller net operating cash inflow compared to net profits. Further, in all cases, most of increase in trade payable is recorded as 'other debt', and we need to find further details on what this consistent "other debt" is about?
c) How has working capital requirement changed over years? Is business generating cash faster than it needs (negative working capital)?
Yes, working capital is always less than net profits, and in a sense, this indicates that business 'can generate' cash faster than it consumes. This however flows out as dividend payments.
d) Is business generating good returns on capex, or it is burning precious cash in attempting to grow by capital spending (incremental return on capex)?
Since business model is asset-lite, there're no large incremental capex, and capital spend increases proportional to revenue increase.
e) Is the debt on balance sheet concerning? Is most of operating cash leaking away in interest payments? Is business able to retire debt and gradually reduce interest burden? How long do you think will it take for the business to bring down debt to advantageous levels? Is dividend being regularly paid despite debt on the books? If so, is "Financial Leverage Index" > 1, indicating that return on investments is greater than cost of debt, and hence the leverage created due to debt is advantageous to the business, and it is good to pay dividends using generated cash, while keeping the debt at advantageous level.
The business requires very small capital for its operation, and hence it doesn't require any debt, nor has it taken, and there's no significant advantage in increasing debt to benefit from financial leverage.
Overall, we can say that the financial health of the business is decent.
Checkpoint 6: Stocks generally become value picks when they possess a healthy business with an able management, but suffering from a transient problem which drives the stock prices southwards. Is the business suffering from any such condition, and if so, why do you think this is not a permanent change (inflection point)? If you believe it is indeed an inflection point for the business, why do you think business is capable of turning it into an advantage [Andrew Grove]?
The share prices of IIML have been falling since end of 2010 and have dropped down by as much as 60% in last 2.5 years. This is possibly because of the stagnated growth in income and hence the profits. This clearly reflects the fact that company has found it difficult to increase divestment process.
Let us analyze "Chairman's Statement" section across FY2005-06 till date to see if management anticipated this "slowdown", and what have they planned and delivered so far.
- FY2005-06 shows positiveness and optimism that Indian growth has been due to entrepreneurs who have extended their reach beyond India, and PE funds have significantly contributed to this effect.
We still need to see if they really follow what they say, but their voice echos strong value investing principles - deep understanding (circle of competence), management capability (a bad manager can easily destroy an excellent business), minimize risk (don't go where you may die) and timely exit (sell when others are greedy)
- FY2008-09 statement looks at financial upheaval in retrospection, and how company managed to grow the AUM as planned, and they mention that quality and valuation of deals has improved due to slowdown. But this must be read with care - the valuation multiples have come down, and hence divestment generates lesser profits than before, while investments have better margin of safety / better growth potential. Finally, management believes that India will maintain growth rates as a new stable government comes, and investment environment stabilize going forward, at least at a moderate pace. However, there's first indication of growth / profit slowdown as seen in the commentary. Note the fact that management is being candid about dependence of business outlook on macroeconomic environment.
- FY2009-10 statement talks about the eventful decade, where downturn of 2008-09 created challenges and opportunities for PE funds. Specifically, the following text is noteworthy, indicating innovative, prudent and strong value oriented approach of the fund
- FY2010-11 was a tough year across the world, with signs of EU zone cracks appearing, high interest rates in India, etc, and here's what the CEO of the company has to say about fund's performance - they're able to grow AUM (and hence the revenue from management fees which they call annuity). Looking at the financial data table above, they've grown AUM very fast before the downturn, and AUM growth has moderated substantially, so much so that AUM is stagnant at $3.2 billion since FY2010-11. This remains a big risk to the future outlook, that it'd be exceedingly difficult to continue to grow AUM at a reasonable pace.
- FY2011-12 statement from chairman again mentions the impact of downturn in second half of 2011, and how PE fund raising is severely impacted. They also show how the business has still managed to continue investments and divestment in this backdrop
In essence, we see that the business is indeed at an inflection point - the growth is slowing, the environment is becoming tough with high competition, and outlook is gloomy considering that the world economy may remain subdued for many more years to come (leave aside spurs of growth which are highly inconsistent). It is now upto the business leaders of IIML to capitalize this inflection point to their advantage. How can they do it, what are they planning to do about it? Let us try to find these answers while analyzing MD&A sections of recent annual reports and answering next checkpoint about catalysts.
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
The share prices of IIML have been falling since end of 2010 and have dropped down by as much as 60% in last 2.5 years. This is possibly because of the stagnated growth in income and hence the profits. This clearly reflects the fact that company has found it difficult to increase divestment process.
Let us analyze "Chairman's Statement" section across FY2005-06 till date to see if management anticipated this "slowdown", and what have they planned and delivered so far.
- FY2005-06 shows positiveness and optimism that Indian growth has been due to entrepreneurs who have extended their reach beyond India, and PE funds have significantly contributed to this effect.
Future strategic buyers find it reassuring to deal with a PE funded company, because they know that- FY2006-07 opens up with the following statement, boosting up optimism. They also indicate that capital availability is not a big problem now. However, quality human resources is highlighted as an emerging problem for sustaining long term growth of the company. Still no signs of concern about a potential slowdown or recession or difficulty in divestment.
governance and accounting will be up to standards. Institutional investors also attach significant value to PE
funded companies – this leads to a re-rating of the stock, thereby adding value to all stakeholders
The onward march continues. A trillion dollar economy, India’s future growth has been accepted as here to stay, rather than viewed as a passing phenomenon
In harnessing this growth, availability of capital is now largely being seen as an addressable issue. A positive investment climate ensures that an entrepreneur today has a variety of options for raising capital, as long as the matrix of past performance, reputation and project bankability measure up to the risk appetite of the investor- FY2007-08 statement mentions for the first time about the concerns of global turmoil and indicates that the smooth ride of past 4 years for India growth have seen first signs of problem, in terms of higher inflation, food crisis, depletion of investible funds globally. However, an important point in this statement is about "pro-active risk management" as a learning from the global problems. They indicate that IIML has developed such system of conservative yet productive risk management in their investments. Here's what they say:
We still need to see if they really follow what they say, but their voice echos strong value investing principles - deep understanding (circle of competence), management capability (a bad manager can easily destroy an excellent business), minimize risk (don't go where you may die) and timely exit (sell when others are greedy)
- FY2008-09 statement looks at financial upheaval in retrospection, and how company managed to grow the AUM as planned, and they mention that quality and valuation of deals has improved due to slowdown. But this must be read with care - the valuation multiples have come down, and hence divestment generates lesser profits than before, while investments have better margin of safety / better growth potential. Finally, management believes that India will maintain growth rates as a new stable government comes, and investment environment stabilize going forward, at least at a moderate pace. However, there's first indication of growth / profit slowdown as seen in the commentary. Note the fact that management is being candid about dependence of business outlook on macroeconomic environment.
- FY2009-10 statement talks about the eventful decade, where downturn of 2008-09 created challenges and opportunities for PE funds. Specifically, the following text is noteworthy, indicating innovative, prudent and strong value oriented approach of the fund
- FY2010-11 was a tough year across the world, with signs of EU zone cracks appearing, high interest rates in India, etc, and here's what the CEO of the company has to say about fund's performance - they're able to grow AUM (and hence the revenue from management fees which they call annuity). Looking at the financial data table above, they've grown AUM very fast before the downturn, and AUM growth has moderated substantially, so much so that AUM is stagnant at $3.2 billion since FY2010-11. This remains a big risk to the future outlook, that it'd be exceedingly difficult to continue to grow AUM at a reasonable pace.
- FY2011-12 statement from chairman again mentions the impact of downturn in second half of 2011, and how PE fund raising is severely impacted. They also show how the business has still managed to continue investments and divestment in this backdrop
In essence, we see that the business is indeed at an inflection point - the growth is slowing, the environment is becoming tough with high competition, and outlook is gloomy considering that the world economy may remain subdued for many more years to come (leave aside spurs of growth which are highly inconsistent). It is now upto the business leaders of IIML to capitalize this inflection point to their advantage. How can they do it, what are they planning to do about it? Let us try to find these answers while analyzing MD&A sections of recent annual reports and answering next checkpoint about catalysts.
Checkpoint 7: Are there any negative catalysts foreseeable, that may impact the business prospects going forward, like a long term industry slowdown, increasing competition, or a regulatory change? On the other hand, what are the positive catalysts that'll bridge the gap between price and value?
TBD
Risk Log: Based on analysis above, following are the risks to the future prospects of the business:
- Strong dependence of business performance on macroeconomic environment. If India doesn't grow like it did during 2004 - 2007, IIML may not be able to generate commendable returns as in the past.
- Since they're one of the largest PE funds in India, they might not have big scope to grow organically, mainly due to increased competition. (On the other hand, their large size may help them attract new capital if the PE investment environment regains the steam going forward)
- As performance is the key to maintain and grow AUM in this industry, inability to deliver good returns (timely divestment while maintaining profit margins) main negatively impact the future growth of both top-line and bottom-line for the business.
- IIML depends heavily on the performance of their fund managers, and if they can't deliver what they did in the past, the profits of the business can be severely hampered.
Stock Valuation
Even before we start 'calculations', based on risk log above, we must be conservative and assume:
- No growth, which means, we must assume constant 'free cash flow' going forward, and this constant can be taken as average FCF for last 3 years.
Quick valuation first. The business generates around Rs 400 million per year in cash flow from operations, and almost whole amount is free. Assuming no growth, a discount rate of 10% (risk free rate / base opportunity cost), we get a valuation of FCF, as of today at Rs 4 billion. The current market cap of the business is Rs. 437 crores, i.e., more than Rs. 4 billion. This means, there's no margin of safety in FCF valuations, contrary to the initial perception that the stock is probably available at very attractive valuations.
UPDATE as on 25th May 2013
I was 'away' for about a week, and I thought about IIML, and went through this "mirror test", to find any obvious reasons to drop the stock. I could not find strong reasons to either buy or ignore the stock - there're good deal of risks to the future growth / sustainability of AUM, and the past performance may not repeat. Incidentally, I also got to read about IIML's analysis here, and this adds to my belief that the risks of reduced profits from investments is quite high. On the other hand, if management can "maintain" the cash flow, there's a decent chance of 7% dividend yield from the stock. If things turn positive, it could be a black swan positive surprise and the stock can even generate capital appreciation.
In this context, there're large changes of negative catalysts over-weighing the possible positives, since the performance improvement for the business depends on macro-economic improvement, another boom in real estate (we didn't yet analyze, but a quick look at assets shows a large investment into real estate), and ability of management to generate returns as in the past - all of them happening will certainly be a positive black swan event. On the other hand, if any of these turns negative, it'll impact the business prospects, which will lead to reduced cash flow and dividend yield.
Hence, without further analysis of the stock, I tend to believe that the risk reward ratio is NOT favorable to hold this stock for long term. An annuity with 7% yield, but will a non-trivial downside risk, is not a Graham like pick, and definitely, the business moat doesn't warrant a strong conviction either. I'd therefore stay away from a long term relation with the stock. However, considering the potential for significant upside in the "best case scenario', this stock may be a potential addition to the "speculative" part of portfolio.
In summary of this "long post", this is certainly not a low risk, high dividend yielding stock as I originally started, but I'll keep IIML in the "sin stock watchlist" and add to the positions slowly, limiting a total exposure to less than 2% of the overall portfolio. Since I don't see the stock running away in near future, I'll wait for better opportunities before I start committing any serious money in the stock.
Risk Log: Based on analysis above, following are the risks to the future prospects of the business:
- Strong dependence of business performance on macroeconomic environment. If India doesn't grow like it did during 2004 - 2007, IIML may not be able to generate commendable returns as in the past.
- Since they're one of the largest PE funds in India, they might not have big scope to grow organically, mainly due to increased competition. (On the other hand, their large size may help them attract new capital if the PE investment environment regains the steam going forward)
- As performance is the key to maintain and grow AUM in this industry, inability to deliver good returns (timely divestment while maintaining profit margins) main negatively impact the future growth of both top-line and bottom-line for the business.
- IIML depends heavily on the performance of their fund managers, and if they can't deliver what they did in the past, the profits of the business can be severely hampered.
Stock Valuation
Even before we start 'calculations', based on risk log above, we must be conservative and assume:
- No growth, which means, we must assume constant 'free cash flow' going forward, and this constant can be taken as average FCF for last 3 years.
Quick valuation first. The business generates around Rs 400 million per year in cash flow from operations, and almost whole amount is free. Assuming no growth, a discount rate of 10% (risk free rate / base opportunity cost), we get a valuation of FCF, as of today at Rs 4 billion. The current market cap of the business is Rs. 437 crores, i.e., more than Rs. 4 billion. This means, there's no margin of safety in FCF valuations, contrary to the initial perception that the stock is probably available at very attractive valuations.
UPDATE as on 25th May 2013
I was 'away' for about a week, and I thought about IIML, and went through this "mirror test", to find any obvious reasons to drop the stock. I could not find strong reasons to either buy or ignore the stock - there're good deal of risks to the future growth / sustainability of AUM, and the past performance may not repeat. Incidentally, I also got to read about IIML's analysis here, and this adds to my belief that the risks of reduced profits from investments is quite high. On the other hand, if management can "maintain" the cash flow, there's a decent chance of 7% dividend yield from the stock. If things turn positive, it could be a black swan positive surprise and the stock can even generate capital appreciation.
In this context, there're large changes of negative catalysts over-weighing the possible positives, since the performance improvement for the business depends on macro-economic improvement, another boom in real estate (we didn't yet analyze, but a quick look at assets shows a large investment into real estate), and ability of management to generate returns as in the past - all of them happening will certainly be a positive black swan event. On the other hand, if any of these turns negative, it'll impact the business prospects, which will lead to reduced cash flow and dividend yield.
Hence, without further analysis of the stock, I tend to believe that the risk reward ratio is NOT favorable to hold this stock for long term. An annuity with 7% yield, but will a non-trivial downside risk, is not a Graham like pick, and definitely, the business moat doesn't warrant a strong conviction either. I'd therefore stay away from a long term relation with the stock. However, considering the potential for significant upside in the "best case scenario', this stock may be a potential addition to the "speculative" part of portfolio.
In summary of this "long post", this is certainly not a low risk, high dividend yielding stock as I originally started, but I'll keep IIML in the "sin stock watchlist" and add to the positions slowly, limiting a total exposure to less than 2% of the overall portfolio. Since I don't see the stock running away in near future, I'll wait for better opportunities before I start committing any serious money in the stock.
Awesome restraint from Temptation of speculation Sir. I admire you along with Safal Niveshak
ReplyDeleteThanks :)
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