JP Morgan Bullish on Educomp

JP Morgan got bullish on Educomp and set a price target of Rs 1,000. I decided to put together "The Quant Report" for Educomp. I am in the process of adding a further 55 reports and Educomp was one of them so I took the opportunity to add Educomp today; you can access the report here.

I do like Educomp. Its earnings have grown at a rapid pace. At the same time its investment in growth has accelerated and this can be expected to drive continued and rapid earnings growth; clearly operating risk (management ability to drive growth) is not questionable. And while the dividends are a pittance, the returns since 2004 have run at over 74% annualized; thus the management's ability to create shareholder value is very visible. But in my view the company is not a great long term opportunity. Here is why:

1. Its financial risk is high, too high. Its debt to debt plus equity ratio is at over 62% which is unhealthy. The company did raise 1.62 million new shares at Rs 606.69 each to repair its balance sheet and this will have reduced the ratio considerably, but the balance sheet remains weak. Future dilution to repair a poor capital structure rather is likely. New capital raised to drive growth is fine, but when funds are used to repair a bad balance sheet, the impact will be dilutive – growth in earnings per share will fall even while earnings at company level will continue to grow.
   
2. The future growth potential is evident from investments in growth which have risen at an annualized rate of 95% since 2004. However, investment in growth is funded largely through debt. For every Rs 1 in operating cash flow, Rs 2 is borrowed and Rs 3 invested in growth. I would feel happier with Rs 0.50 borrowed, Rs 1.5 raised in new equity; the resulting Rs 2 can be added to operating cash flow of Rs 1 and invested in growth.
   
3. The valuation risk is very high. A five year growth target of 40% annualized is possibly achievable; I say this with a great deal of skepticism because such a growth rate is rarely long term, especially with the overhang of dilutive fund raising in future economic cycles. Once risk aversion has abated, the dilutive threat as a result of a terrible capital structure is likely to be ignored until the next recession. If I accept a 40% long term growth rate (which I personally do not) the multiple to pay for an investor wanting a 4% growth risk premium (i.e. required investor return is 44%) willing to purchase at intrinsic value is 35X. This gives a target price of Rs 910. Since the stock is already trading at Rs 781, the discount to intrinsic value is not sufficient to attract my long term interest.
   

If you look at The Quant Report, the Moderated and Mod 2 values should be disregarded because it is clear that the future growth rates are well over the more modest growth assumptions used on the report. Similarly, Graham, bear and fair values do not remain relevant because the risk of a reversion to long term median levels of earnings and slow rates of growth used on the report are very unlikely for young growth stocks. In bear markets, such stocks carry very significant downside risks; but since "The Quant Report" avoids analyst bias through the use of macro broad growth expectations in the model, identifying bear and fair values is not possible. My own view, is that a 40% growth rate with a 4% growth risk premium gives the share a fair value of near Rs 500 and downside to a bear value of Rs 400; these are the levels I feel sure the stock will trade to during the bottom of the next economic cycle.

For targets during normal market conditions, the Historic X based valuations on "The Quant Report" do remain relevant. For 2010 I expect historic multiple based valuations of Rs 810 to Rs 860. However as earnings confidence rise, upside to Rs 1,250 by very late in 2010 is possible.

Personally, I would compromise on lower return for lower risk and avoid this stock at present levels. If however, it is hit by adverse sentiment and trades down to Rs 500 levels, I would become interested.

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US Macro View

GDP

GDP at market prices in current prices reported on 1 July 2009 came in at $14,305.1 million. This compared with $ 14,546.7 million for the same quarter during 2008. The annual decrease is 1.7%. Comparing average CPI levels during the quarter for 2009 versus the same quarter in 2008, I observe a price decline of 0.2%. Thus there is no growth in economic activity in nominal terms or in real terms. Using 2008 as the base period, economic activity contracted 1.5% in real terms.

During the immediately prior quarter, GDP at market prices in current prices was $ 14,151.2 million; thus the most recent quarter shows a 1.1% improvement compared with the immediately prior quarter. Average CPI levels fell 0.6% comparing the most recent quarter with the immediately prior quarter. This economic activity improved 1.7% in real terms using the prior quarter as the base period.

In my view, it is clear that US has seen a significant contraction in economic activity. It is also clear that a recovery is occurring. Inflation, remains a very distant threat, but it must be pointed out CPI has inched upwards in each of the past five months. Elimination of deflation as a threat and a gradual return to health appears to be on the cards. Longer term, in my view rising commodity prices together with the massive creation of fiat money will bring inflationary pressures into the economy; I remain of the view that this threat will arise earlier than most expect – perhaps as early as mid 2010.

Interest Rates

Interest rates have remained at the low 0.12% level. The 10 year note has inched up to 3.39% by October. The yield curve remains very steep, rising rapidly from a two year maturity at 0.95% to 3.39% on the 10 year note. In my view, the yield curve should now start flattening as interest rates at the short end of the yield curve rise faster than those at the long end. The spread between the GS10 and the Aaa/Baa corporate bonds have narrowed but remain well ahead of historic spreads; this is indicative of continuing risk aversion. But it must be noted that the spread between Corporate Aaa and Corporate Baa bonds is now in line with historic norms; this is indicative of falling risk aversion. In fact risk capital is first chasing super normal returns from corporate debt markets and equities (including riskier classes such as emerging markets, cyclical stocks and mid/small caps). In my view, the next step will be further narrowing in the spread between GS10 and corporate bonds as the recovery takes hold. Personally, I would not like to be in corporate bonds once the recovery takes hold and the first indication of rate rises is priced by markets. It might not be as bad as I expect, because chances are that confidence in an enduring recovery will be week and this will lend support to treasuries.

Observe that real interest rates are presently high. The 10 year is trading at a money rate of near 3.39%. Twelve month inflation based on CPI is running at negative 1.3%. Thus the real interest rate is 4.7% (Real Rate = (1+Money Rate %)/(1+ Expected Inflation Rate%) - 1. Historic real interest rates in US have run at 1.9% positive. Thus the fed should really be under no pressure to raise interest rates until inflation and inflation expectations rise. The spread between the 10 year TIPS and GS 10 indicates an inflation expectation of 2.06%. Using 2% as a long term inflation expectation, the real interest rate with the 10 year at 3.39% is 1.363%; this is low compared with the long term real interest rates. In my view, once actual inflation rises to 2%, the fed will begin raising rates to challenge higher inflation expectations; the GS10 by that time can be expected to rise to 3.9% to 4%.

Over the upcoming economic cycle, I expect to see higher real interest rates followed by rising money rates as long term inflation expectations start rising. I would not be surprised to see the money rate increase to 5.5% as inflation expectation of 3.5% rear its ugly head. I do expect forward inflation to be higher than the historic inflation rates of 2.5%; creation of fiat currency, a weakening $ and rising commodity prices will likely offset deflationary pressures from deleveraging to give a long term inflation rate of near 3.5%. As a result, I expect the long term yield associated with the GS10 to rise to 5.5% over several years. However, I expect this dance to be vigorous and volatile; there are likely to be further periods of deflation as deleveraging re-asserts during periods of low or regressive growth.

With an expectation of rising interest rates as the back drop, I would support investment in large caps which have better access to cheaper foreign debt compared with small and mid caps. In addition, rising interest rates can add much volatility to earnings; in these circumstances, it would make sense to avoid over-leveraged companies and target those with stronger balance sheets. During periods of rising interest rates and accelerating activity, I expect to see considerable dilution in over leveraged entities forced to return to responsible capital structures in the face of rising cost of debt. Corporate bond spreads are likely to shrink below historic norms as risk aversion disappears, but given that spreads are near historic norms, the shrinkage is unlikely to offset the higher cost of debt expected to arise in the upcoming year. The risk trade is over; large returns from investing in over-leveraged entities are past – the threat of dilution is no longer priced.

Do keep in mind that equities as an asset class can be expected to outperform bonds as interest rates rise. The force of history is compelling and as we revert to median levels of economic activity measured in real terms, equities are the class most likely to outperform. While valuations are no longer dirt cheap, The Quant Report is still indicating significant return potential for long term investors. However, it is equally clear that better prices will be available in the future. Yet, on a cycle basis there are returns to capture. The current markets are great for portfolio allocators; as markets rise, rebalance to raise liquidity levels in preparation for the next buying opportunity.

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India Macro Outlook

GDP

GDP at market prices in current prices during the first quarter of fiscal 2010 came in at Rs 13,269.57 billion. This compared with Rs 12,354.27 billion for the same quarter during fiscal 2009. The annual increase is 7.4%. Comparing average CPI levels during Q1 2010 versus Q1 2009, I observe a price rise of 8.8%. Thus growth in economic activity while apparent in nominal terms; did not really exist in real terms. Using Q1 2009 as the base period, economic activity contracted 1.4% in real terms.

During the immediately prior quarter (Q4 FY 2009), GDP at market prices in current prices was 13,930.96 billion; a 4.98% decline compared with Q1 2010. Here nominal growth rates contracted quarter on quarter. Average CPI levels rose 0.3% comparing Q1 2010 versus Q2 2010. This economic activity declined 5.18% in real terms using the prior quarter as the base period.

In my view, it is clear that India has seen a significant contraction in economic activity. While the recession is viewed as an earnings recession in nominal terms, it is clear that real economic activity is running at a pace below where it was in the prior year.

Q2 2010 GDP estimates are expected on 30 November 2009. I am expecting quarter on quarter inflation to come in at 2.9%. Year on year inflation comparing CPI during Q2 2009 to Q2 2010 is expected to come in at 11%. I expect Q2 GDP at market prices in current prices to come in at Rs 13,866.7 billion; 4.5% over the prior quarter and 8.25% over the same quarter last year. Real economic activity compared with the same quarter last year is expected to be down 2.75% (using the same quarter last year as the base period), but compared to the immediately prior quarter (using the immediately prior quarter as the base period), it is expected to have improved 1.6%.

The Q3 GDP estimates can be expected to be stronger quarter on quarter because of seasonable factors, however, the year on year numbers face downside risks as a consequence of monsoon risk; late December we will know how bad or good the monsoon really was.

Interest Rates

Interest rates have remained at the low 3.25% level. However, an expectation of near future rate increases is getting firmly priced by the markets. During November the 10 year note has inched up to 7.28%. The yield curve remains fairly steep, rising rapidly from a one year maturity at 4.5% to a 3 year maturity at 6.5% and continuing to rise to 7.5% on the 9 year and then dipping to 7.28% on the 10 year note. In my view, the yield curve should now start flattening as interest rates at the short end of the yield curve rise faster than those at the long end. The spread on corporate bonds have narrowed towards historic norms. Liquidity is ample and risk aversion is contracting. As the recovery takes hold credit expansion can be expected.

What is interesting to note is that the 10 year note is now trading at over 7%. In the prior economic cycle, the 10 year note crossed 7% only in June 2006 by which time growth was robust. In June 2006, the RBI rate was at 5.5%. This indicates to me that the upcoming economic cycle will come with higher interest rates as the RBI battles to contain long term inflation levels at or near 6%.

Observe that real interest rates are presently very low. The 10 year is trading at a money rate of near 7.3%. Inflation based on CPI is running at 11.72%. Thus the real interest rate is 3.6% negative (Real Rate = (1+Money Rate%)/(1+ Expected Inflation Rate%) - 1. Historic real interest rates in India have run at 1.7% positive. For real interest rates to revert to historic levels, with 11.72% inflation, nominal interest rates would need to rise to 13.15%. I do believe that using 11.72% inflation as a long term expectation is not rational; high interest rates will tend to reduce inflation expectations. Using a 6% long term inflation expectation would mean nominal rates near 7.8%. All in all, I believe the long term interest rates will be within this range. However, as the RBI does battle with inflation during calendar 2010, we could see a rapid escalation in interest rates at both the short and long end of the yield curve. The pace of increase could be measured or accelerated depending on the rate of acceleration in economic growth.

With an expectation of rising interest rates as the back drop, I would support investment in large caps which have better access to cheaper foreign debt compared with small and mid caps. In addition, rising interest rates can add much volatility to earnings; in these circumstances, it would make sense to avoid over-leveraged companies and target those with stronger balance sheets. During periods of rising interest rates and accelerating activity, I expect to see considerable dilution in over leveraged entities forced to return to responsible capital structures in the face of rising cost of debt. Corporate bond spreads are likely to shrink below historic norms as risk aversion disappears, but given that spreads are near historic norms, the shrinkage is unlikely to offset the higher cost of debt expected to arise in the upcoming year. The risk trade is over; large returns from investing in over-leveraged entities are past – the threat of dilution is no longer priced.

Do keep in mind that equities as an asset class can be expected to outperform bonds as interest rates rise. The force of history is compelling and as we revert to median levels of economic activity measured in real terms, equities are the class most likely to outperform. While valuations are no longer dirt cheap, The Quant Report is still indicating significant return potential for long term investors.

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Sensex Earnings Upgrade

The second quarter earnings for all Sensex companies are in. On an as reported stand-alone basis, total earnings have come in at Rs 928.44; adjusting it to include only that part of earnings attributed to the free float gives a number of 543.53.

Calculating earnings per share on a normalized EPS basis (excluding prior period, non recurring and exceptional items) gives first half earnings of Rs 885.59; adjusting it to include only that part of earnings attributed to the free floating shares, gives normalized earnings per share of Rs 514.77.

The above numbers are stand alone. Fairly significant damage to normalized earnings can be expected from consolidated results from various Sensex entities. Several entities have reported quarterly consolidated reports; these include ACC, Airtel, DLF, Grasim, ICICI Bank, Infosys, Reliance Communication, SBI, Sterlite, Sun Pharma & TCS. For these companies, the consolidated results add Rs 45 to stand alone normalized earnings per share.

The companies which have not reported consolidated earnings include:

1. BHEL, HDFC, HDFC Bank, Hero Honda, Hindustan Unilever, ITC, M&M, Maruti, ONGC, NTPC, RIL, Reliance Infrastructure and Wipro have not reported quarterly consolidated financials; for these companies, I do not see downside to stand alone results versus consolidated results. In total the downside to stand alone results which can be expected on consolidation on a float adjusted basis is Rs 4.77.

2. Hindalco, Jaiprakash Associates and L&T have also not reported quarterly consolidated numbers; for these entities I do expect reduced consolidated earnings versus stand alone results. In my estimation, the consolidated results will reduce Sensex earnings on a float adjusted basis by Rs 30 for all three companies in total.

3. Tata Power, Tata Motors and Tata Steel are yet to report second quarter consolidated numbers. For these entities I estimate a reduction in Sensex float adjusted earnings of Rs 35 for the first half year.

Stand alone normalized EPS adjusted only for earnings attributed to the free float were Rs 514.77. From this amount we need to reduce earnings by Rs 69.77 for the adverse impact expected from consolidation for companies which have not reported consolidated results. The revised number for first half earnings is Rs 445. To this we need to add Rs 45 for the float adjusted normalized EPS which arose from the difference between standalone and consolidated numbers reported by several Sensex entities. Thus the expected first half consolidated normalized earnings on a float adjusted basis are Rs 490.

For the second half of the year, I expect an improvement. My estimate for Fiscal 2010 earnings for Sensex has now been increased to Rs 1,009 (Macro View) with downside to Rs 930 (Company Specific View). For fiscal year 2011, estimates have been revised to Rs 1,130 (Macro View) with downside to Rs 1,105 (Company Specific View).

Following the earnings upgrade, I expect the Sensex to trade within a range of 14,830 to 17,820. These numbers are based on median and 75th percentile historic PE's applied to the Rs 930 revised estimate.

 With support from liquidity and sentiment, I would not be surprised to see a break out to the 19,354 to 20,941 range. These numbers are based on the median and 75th percentile historic PE 6 (Annual Average Price divided by 6 year median EPS) applied to an Rs 712, 6 year median EPS.

The updated Quant Report can be accessed here.

Disclosure:  Indirect long positions in all entities listed in this post with additional over-weights on Reliance Industries, Hindalco, Tata Steel and Bharti Airtel.

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Sterlite’s a Buy on Valuation

Sterlite (SLT) is trading at a very reasonable value; no doubt higher than the bad bear values, but with sufficient upside potential for both long term investors and speculators. Please access "The Quant Report" here (or link straight through to the Sterlite file) for data based on which below commentary is based.

Operating Risk

SLT has low levels of operating risk. Between 31 March 2000 (fiscal 2000) and 31 March 2009, the company has delivered annualized earnings growth of 20.55%; the dividend has grown an abysmal annualized rate of 0.23%. Including estimates for the year ended 31 March 2010, the annualized growth rates are 12.6% and 0.21% for earnings and dividends respectively. The six year median earnings levels between the year ended 31 March 2005 and 2009 has grown at 42.91% annualized and growth in six year median earnings at the end of 31 March 2010 is expected to clock in at 35.22%. SLT is cyclical and strongly influenced by the economic cycle - the annual rate of earnings growth (year on year) was huge during fiscals 2003 (235.88%), 2004 (65.8%), 2006 (96.3%) and 2007 (246.9%); during fiscals 2008/09/10, growth has been negative at 18.9%, 26.8% and 39% respectively. This is a high degree of volatility even for a cyclical stock; high volatility creates the perception of high risk. And this can have a significant impact on valuations in that it sets up beautiful entry points for long term investors and equally appealing trading gains over shorter time horizons.

Its cyclical nature will create good entry opportunities and good exit opportunities as it dances to the song of the economic cycle. Normally the Materials sector will tend to outperform off bear market bottoms, about 6 to 12 months before a typical recession end. After the recession ends, Materials will normally out-perform for another 12 months or so before returning to a market-perform cyclical phase. We are presently headed for a period when Materials can be expected to out-perform. For SLT, this could mean a period of significant speculative (short term) gains over the coming 12 months. SLT trades at a very modest premium to 2010 projected fair value. However, buy and hold investors need to be aware that bear values lie far below fair value as a result of the great historic volatility in earnings.

Future Growth Potential

All told, I believe SLT has put in a solid long term performance. As regards the future, I believe SLT in can return to 12% year on year growth with little to no risk. Growth could be higher given that the payout from significant investments during fiscal 2008, have yet to fall through to the bottom line. SLT is seeking to acquire Asarco LLC, which is a potential growth trigger. However, this deal has been so volatile that I would not count on it happening; as it happens, I believe SLT is reasonably valued even ignoring growth from Asarco. Sterlite has raised capital twice during the few months, including once only a few weeks ago. These monies are not to repair a damaged balance sheet but to grow earnings through significant investment in copper. Copper as we know, leads out of recessions, and SLT's strong presence in India gives it a brilliant market in which to grow. In India the infrastructure sector is going through a huge period of growth; in my view, infrastructure in India is very fully valued, but material providers are still fairly valued.

Creation & Return of shareholder value

What is great is that a long term investor, who purchased shares at annual average prices during fiscal 2000 and diligently re-invested dividends in shares, would have made an annualized return of about 16.9%. This compares with Sensex which has returned 14.41% over the same period. And I do expect SLT to outperform the Sensex for the next 12 months.

The growth in earnings and core long term earnings potential has been reasonable for SLT. Dividend growth has been delivered at disappointing rates but when you consider the scale of long term investments undertaken and the prudent balance sheet, it is understandable. Payout ratio has run at median levels of 8% to 9%; this level of payout is fully acceptable when you consider the need for investment in future growth. All in all SLT has done a satisfactory job in value creation and return.

Financial Risk

Growth requires investment and investment needs cash. A company's capital structure indicates how the cash is raised. What part of it is equity, what part of it is debt and what part of it is hybrid (debt with characteristics of equity or vice versa).

The Modigliani-Miller theorem says that the value of a levered company is equal to the value of an un-levered company plus the marginal rate of tax multiplied by the market value of debt. Simply put, if a company borrows money as part of its capital structure, it will be worth more than if it finances its capital structure 100% equity. The rational is simple, when you borrow, you pay interest; this is tax deductible. The dividend on equity is not. Thus the market value of a levered company must be higher. In numbers it works like this; if you buy an asset for 100 and expect it to generate 10 (14.29 pre-tax) in post tax cash flow in perpetuity, and the cost of equity is 8%, the future value of cash flows is 125; this is your market value. This assumes a tax rate of 30%.

Now if you have a tax rate of 30% and you borrow 30 at 10% and use 70 from equity costing 8% the picture changes. You now have post tax cash flow in perpetuity of 7.9 (14.29 pre-tax cash flow, minus 3 in interest charges and minus 3.39 in tax). At an 8% cost of equity, this is worth 98.75. And the debt is worth 30 (3 in perpetual interest cash flow with a 10% cost of debt); so the total worth is 128.75 compared with 125 previously. For the equity holder, in an un-levered company 100 is worth 125 (Market Value to Book Value of 1.25); in a levered company 70 is worth 98.75 (Market Value to Book Value of 1.41). So you can see that leverage is an important tool to create shareholder value.

The problem with the words of wisdom of Messrs Modigliani & Miller is that their wisdom is often not understood or misused. In the real world, debt holders want their money back; your operating cash flows need to be sufficient to pay back both the interest and principal. You can replace debt by borrowing as you pay down debt, but the cost of debt changes as the economy transitions through its cycle. In addition, during times when the yield curve is inverted and risk aversion is at high levels, access to debt might be very constrained. At the same time, earnings and operating cash are volatile over the course of an economic cycle. This acceptance of volatility is one reason why equity investors demand a higher return expectation compared with debt providers; volatility implies risk and risk demands a return premium. Debt is a two edged sword. Using debt enhances shareholder value, but using too much debt can cause future dilutive events which will destroy shareholder value.

In July 2009, SLT raised $335 million through ADR's. As I mentioned previously, this capital raising is unlikely to be dilutive because it will drive earnings growth from expansion of SLT's copper portfolio. During October raised a further $500 million. The threat of dilution caused the market to worry. In a sense, SLT could have raised non dilutive debt without damaging is balance sheet. But why should they; the convertibles (debt to convert to ADR's) are issued at a 40% premium to the market price on the date of issue; the coupon is low at 4% and you can be sure that the growth coming from investment of funds will ensure there is no dilution. I believe a prudent balance sheet makes sense at present, especially considering the capital which might be required to acquire Asarco if the deal comes to fruition.

At the end of fiscal 2009, SLT had a strong un-leveraged balance sheet; net of cash and cash equivalents at end of fiscal 2009 the company was very lightly leveraged with a debt to debt plus equity ratio of just over 5%. In my view, there is potential to add leverage and acquire growth. In the unlikely event that M&A activity is not on SLT's mind, adding leverage to a 20% of debt plus equity level is fairly safe even in the present climate; it can enhance shareholder value. The funds raised could be returned via dividends, buybacks or a combination of the two.

Economic Risk

In my view, the economy has recently entered an early phase of expansion. While the expansion might be less robust than bull predict and the next contraction may be harsher than the bears expect remains to be seen. What I do see is an expansion commencing, and one that is good for at least six months. The signs for reversal will be watched for, but personally, I expect signs of trouble to emerge no earlier than 2012; of course I could be wrong.

SLT is considered a large cap in India which is its principal market of trade; this adds a touch of defense. SLT is a cyclical stock; the earnings volatility adds a level of risk. This brings me to valuation risk; which is modest for long term buy and hold investors but possibly very low for speculators. I refer a modest valuation risk for the long term investor, but do keep in mind that huge earnings volatility has caused SLT to trade well below fair value on several occasions. I do believe that going ahead earnings volatility will normalize to a level more consistent with the sector; the past few years have had massive growth and investment and abnormally high standard deviations on earnings is an outcome one must expect.

Financial risk is low as a result of a strong balance sheet. But keep a watchful eye on news flows and M&A activity; the strength of a balance sheet can quickly change and since Indian companies do not include balance sheets in their quarterly reporting, investors do not always have good visibility on leverage until the year end.

This brings me to valuation risk.

Valuation Risk

SLT trades at near Rs 800 per share. In my view, 2010 fair value of the share is near Rs 750. Let's be clear, my fair value calculation is based on an adjusted version of Gordon's Dividend Growth Model. I use 6 year median EPS as a base long term earnings. I use a notional payout ratio of 40% as reflecting the notional dividend; if the actual payout is lower, it's not a problem because the lower payout will drive future growth higher than growth rates assumed in my calculation. The future notional dividend flows together with growth in notional dividends at a rate equaling the forward nominal GDP growth expectations (12% for India), are discounted back to today at rates equaling a slight premium the long term return (16% for India) on the main market of trade. This discounted value is fair value; fair value is a level where markets rarely trade; but when they do, it is time for long term investors to consider buying.

The share price is well below forward fair value expectation (Rs 1,344) projected out to 2014. So I can call SLT a buy on valuation for long term investors.

Persons who trade can take speculative positions for the upside potential left in this economic cycle. In my view, over the course of economic cycle, the stock has a potential price target of Rs 1,600 with potential to rise to 2,150. Over 12 months, the gain potential is in my view to Rs 1,200 levels; keep in mind that Materials can be expected to out-perform during the coming phase of the economic cycle.

In US SLT is trading at $16.93 which is close to the Rs 800 in India.

Disclosure: Long indirect positions in SLT, with intent to add small speculative positions at Rs 800 or below.

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Drill Baby Drill

I liked Transocean's earnings release. 

You may want to visit Transocean's website here and download the power point presentations at the end of q2 09 and q3 09 to see the information based on which my comments are made.

Guidance indicates strengthening confidence in day rates.  At the end of last quarter, q4 09 high spec average day rates were estimated at $408k/day; the November release shows expectations creeping up to $419k/day. 

Looking out q1 2010 and q2 2010 show day rate expectations rising from $426k and $431k respectively at the end of last quarter to $423k and $433k this quarter - this is roughly flat quarter on quarter.  What is encouraging, is the q3 2010 rate expectation coming in at $458k/day; this is 6% over rates expected in q2 2010.

For mid water the news is not so positive.  Last quarter expectations for q4 09, q1 2010 and q2 2010 were $343k/$346k/$342k.  The current quarter comes in at $343k/$335k/$336k; which is indicative of softness in the mid-water market.  Rates introduced for q3 2010 are $348k which is indicative of stability in day rates.

For jack ups the news is not so positive.  Last quarter expectations for q4 09, q1 2010 and q2 2010 were $161k/$163k/$156k.  The current quarter comes in at $155/$161/$153; which is indicative of continuing softness in the jack up market.  Rates introduced for q3 2010 are $147k which is indicative of continuing deterioration.

Strength in deepwater and stability in mid-water will more than offset any weakness in the jack up market.

Out of service rig months expected during 2010 at the end of the prior quarter were 25/33/20/12.  In the November release, out of service rig months is down to 16/25/15/8.  This is a considerable decline in out of service expectation.  Two observations; with utilization rising as is evident from the reduction in out of service months; it is very clear that RIG's day rate expectations are conservative; even modest.  Rising utilization normally causes fairly dramatic increase in day rates in a tight market.  The second is that lower time out of service is indicative of rising revenue - the back log may start rising again on a 1 year horizon.

The cost trend shows an escalation for q3 2009; from $1,277 in q2 09 to $1,396 in q3 09.  But looking into the cost component shows that rig operating costs are declining (from a peak of $922 in q4 08 to $737 this quarter).  Out of service costs and drilling support/other direct costs have caused the increase.  Going ahead, the out of service costs can be expected to decline as time out of service declines.  Drilling support costs are small relative to rig operating expenses; and frankly easier to contain.  No doubt rig operating cost will face inflation as demand picks up; but when it does, there should be no margin dilution because there will be a more than proportionate increase in day rates.

Contract backlog is down from $33.7 billion last quarter to $32.2 billion.  With softness in the market this must be expected ahead of new contracts.  In my view, there is evidence in management expectations to indicate backlog will start building sometime in 2010; this is a big positive.

Cash flow backlogs excess over debt has risen from $4.4 billion at the end of last quarter to $4.8 billion at the end of this quarter.  The cash conversion for q3 09 has obviously been ahead of expectation; this is a big positive.

By end of 2010, the backlog will have generated an excess of $1.9 billion over debt maturities.  In my view, a special dividend or buyback activity is very likely.

All in all it has been a very pleasing first glance at RIG's results.    It trades at a very small premium to my fair value calculation.  My review of results indicates that firm catalysts for growth in share value are now well in place.  From an economic cycle perspective, the energy sector can be expected to outperform in 2010.

I would rate rig a buy at current levels.

Disclosure:  (1) Long RIG (2) Ex Employee

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Wipro – Add Speculative Positions for the Current Phase of the Economic Cycle

Wipro (WIT) is a good company. For some reason it has never quite caught investor interest in the way that Infosys has. Azim Premji is a formidable leader; he has a great track record and is well respected in India. On quality of stewardship WIT is INFY's equal; on valuation it is ahead - but lets be clear, INFY is the clear leader in management. Access The Quant Report here for data based on which below commentary is based.

Operating Risk

WIT has low levels of operating risk. Between 31 March 2000 (fiscal 2000) and 31 March 2009, the company has delivered annualized earnings growth of 31.7%; the dividend has grown an annualized rate of 62.7%. Including estimates for the year ended 31 March 2010, the annualized growth rates are 29.6% and 61.4% for earnings and dividends respectively. The six year median earnings levels between the year ended 31 March 2005 and 2009 has grown at 28.7% annualized and growth in six year median earnings at the end of 31 March 2010 is expected to clock in at 27.6%. WIT is cyclical and strongly influenced by the economic cycle - the annual rate of earnings growth (year on year) was huge during fiscals 2005 (57.9%) and 2007 (38.5%); during fiscals 2006/08/09/10, growth has been subdued at 23.7%, 12.3%, 19.4% and 12.8% respectively. Its cyclical nature will create good entry opportunities and good exit opportunities as it dances to the song of the economic cycle. Normally the IT sector will tend to outperform off bear market bottoms about 6 to 12 months before a typical recession end. After the recession ends, IT will normally under-perform for 18 months or so before returning to an outperform phase. We are presently headed for a period when IT can be expected to under-perform. Within the IT sector; IT consulting services and communication (networking equipment) services can be expected to perform well ahead of the broad IT sector. For WIT, this could mean a period of holding a core position bought earlier in the cycle and should the stock under-perform, slowly adding speculative (short term) positions to benefit from further out-performance later in the economic cycle.

Future Growth Potential

All told, I believe Wipro has put in a solid long term performance; do note that the slowest year on year growth was 12.3%. As regards the future, I believe WIT in can return to 20% year on year growth, however, in the aftermath of the crisis, a stronger Rs, increased competition resulting in margin pressure and slower demand growth might lead to slower growth. In my view 12% as a long term rate over the next several years is achievable with little to no risk.

Growth does not just happen; it takes effort and hard work – and the cost of this effort can be seen in historic financials. WIT has increased operating cash flow at rates of 24.7% between fiscal 2000 and 2009. During the same period investing cash flows have grown at 33.9%; and yes estimated free cash flow too has grown at about 15.7%. In my view, the payout from investment in growth will show in forward years.

Creation & Return of shareholder value

The growth in earnings and core long term earnings potential has been phenomenal for WIT. Dividend growth has been delivered at exceptionally high rates. Payout ratio has run at median levels of 18% to 20%; this level of payout is fully acceptable when you consider the need for investment in future growth. All in all WIT has done a great job in value creation and return.

What is disappointing is that a long term investor, who purchased shares at annual average prices during fiscal 2000 and diligently re-invested dividends in shares, would have made an annualized return of just 5.6%. Sadly, this is more a cause of bubble valuations early in the decade than any deeply distressed valuation today. This is a perfect example of why I tend to avoid Rs/$ cost average investing strategies; my strategy is and always will be to buy value; even deep value.

Financial Risk

Growth requires investment and investment needs cash. A company's capital structure indicates how the cash is raised. What part of it is equity, what part of it is debt and what part of it is hybrid (debt with characteristics of equity or vice versa).

The Modigliani-Miller theorem says that the value of a levered company is equal to the value of an unlevered company plus the marginal rate of tax multiplied by the market value of debt. Simply put, if a company borrows money as part of its capital structure, it will be worth more than if it finances its capital structure 100% equity. The rational is simple, when you borrow, you pay interest; this is tax deductible. The dividend on equity is not. Thus the market value of a levered company must be higher. In numbers it works like this; if you buy an asset for 100 and expect it to generate 10 (14.29 pre-tax) in post tax cash flow in perpetuity, and the cost of equity is 8%, the future value of cash flows is 125; this is your market value. This assumes a tax rate of 30%.

Now if you have a tax rate of 30% and you borrow 30 at 10% and use 70 from equity costing 8% the picture changes. You now have post tax cash flow in perpetuity of 7.9 (14.29 pre tax cash flow, minus 3 in interest charges and minus 3.39 in tax). At an 8% cost of equity, this is worth 98.75. And the debt is worth 30 (3 in perpetual interest cash flow with a 10% cost of debt); so the total worth is 128.75 compared with 125 previously. For the equity holder, in an unlevered company 100 is worth 125 (Market Value to Book Value of 1.25); in a levered company 70 is worth 98.75 (Market Value to Book Value of 1.41). So you can see that leverage is an important tool to create shareholder value.

The problem with the words of wisdom of Messrs Modigliani & Miller is that their wisdom is often not understood or misused. In the real world, debt holders want their money back; your operating cash flows need to be sufficient to pay back both the interest and principal. You can replace debt by borrowing as you pay down debt, but the cost of debt changes as the economy transitions through its cycle. In addition, during times when the yield curve is inverted and risk aversion is at high levels, access to debt might be very constrained. At the same time, earnings and operating cash are volatile over the course of an economic cycle. This acceptance of volatility is one reason why equity investors demand a higher return expectation compared with debt providers; volatility implies risk and risk demands a return premium. Debt is a two edged sword. Using debt enhances shareholder value, but using too much debt can cause future dilutive events which will destroy shareholder value.

WIT has a strong unleveraged balance sheet; net of cash and cash equivalents at end of fiscal 2009 the company was unleveraged. In my view, there is potential to add leverage and acquire growth. In the unlikely event that M&A activity is not on WIT's mind, adding leverage to a 20% of debt plus equity level is fairly safe even in the present climate; it can enhance shareholder value. The funds raised could be returned via dividends, buybacks or a combination of the two.

Economic Risk

In my view, the economy has recently entered an early phase of expansion. While the expansion might be less robust than bull predict and the next contraction may be harsher than the bears expect remains to be seen. What I do see is an expansion commencing, and one that is good for at least six months. The signs for reversal will be watched for, but personally, I expect signs of trouble to emerge no earlier than 2012; of course I could be wrong.

WIT is considered a large cap in India which is its principal market of trade; this adds a touch of defense. WIT is a cyclical stock; the earnings volatility adds a level of risk. This brings me to valuation risk; which is high for long term buy and hold investors but possibly low for speculators. Financial risk is low as a result of a strong balance sheet. But keep a watchful eye on news flows and M&A activity; the strength of a balance sheet can quickly change and since Indian companies do not include balance sheets in their quarterly reporting, investors do not always have good visibility on leverage until the year end.

This brings me to valuation risk.

Valuation Risk

Wipro trades at near Rs 600 per share. In my view, fair value of the share is near Rs 300. Let's be clear, my fair value calculation is based on an adjusted version of Gordon's Dividend Growth Model. I use 6 year median EPS as a base long term earnings. I use a notional payout ratio of 40% as reflecting the notional dividend; if the actual payout is lower, it's not a problem because the lower payout will drive future growth higher than growth rates assumed in my calculation. The future notional dividend flows together with growth in notional dividends at a rate equaling the forward nominal GDP growth expectations (12% for India), are discounted back to today at rates equaling a slight premium the long term return (16% for India) on the main market of trade. This discounted value is fair value; fair value is a level where markets rarely trade; but when they do, it is time for long term investors to consider buying.

The share price is marginally above forward fair value expectation (Rs 500) projected out to 2014. So I cannot call WIT a buy on valuation for long term investors.

However, persons who trade can take speculative positions for the upside potential left in this economic cycle. In my view, over the course of economic cycle, the stock has a potential price target of Rs 1,500. Over 12 months, the gain potential is in my view to Rs 900 levels; keep in mind that while IT can be expected to under-perform, IT services can benefit coming out of the crisis. In addition WIT's recent quarterly report was both strong on performance and outlook.

In US WIT is trading at $17.36 in US and Rs 595 in India. With the Rs at near 47 to $1; the ADR trades at a big premium to India. The premium is abnormal even when considering other Indian ADR's listed in US. I have little conviction in this premium as I believe it would have disappeared in a blink by arbitrageurs; yet WIT has maintained a high premium for several years.

Disclosure: Long indirect positions in WIT, with intend to add small speculative positions at Rs 560.

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Buy ICICI Bank, HDFC Bank; or Not

I looked at IBN and HDB today; both are interesting, unfortunately I came up with a simple hold view. The numbers discussed below are based on data contained in "The Quant Report"; you can access the quant report here.

Operating risk

History tells the tale of management competence; and management competence is a key indicator of operational risk. No one can predict growth accurately; using very long term nominal GDP growth rates results in disciplined and conservative buy targets. History is important; for instance no one can tell you the future but history tells the tale of how a company exploited the growth opportunity when it arose; or indeed; historic data tells the story of how individual companies responded to survive crisis situations.

Both IBN and HDB have had changes in senior management during 2009. In my opinion, the teams post change, is just as strong as previously. As far as earnings growth is concerned, IBN drove earnings growth at over 20% annualized during the fiscal years 2000 to 2009; the annualized growth is expected to remain at over 20% at the end of fiscal year 2010. HDB on the other hand grew at near 16% annualized during fiscal 2000 to 2009, with annualized growth expected to accelerate to 18% by the end of fiscal 2010. Over the period, IBN has outperformed HBD. However consider this; between fiscal 2005 and fiscal 2009, IBN's 6 year median EPS has grown at an annualized rate of 15.3% compared with HDB's annualized growth rate of 20.2%. IBN significantly outperformed on growth until fiscal 2004; but since 2005 HDB has pulled ahead.

Over the long term, the management of both groups demonstrated the ability to grow at a pace higher than nominal GDP. I would assess the operating risk to future growth as low, assuming a growth target of 12% annualized.

Future Growth Potential

Future growth potential combined with purchasing at reasonable valuation often provides a very powerful gain potential combination. The problem with the future is that it is unpredictable; or is it? Mark Twain is believed to have said "History does not repeat itself, It rhymes". While historic performance does not necessarily assure future performance, it is certainly indicative. All of the criteria of the operating risk section thus help in forming an expectation level for the future. But eventually, The Quant Report believes integrates conservative methodologies in looking at future potential. Using a standard growth rate eliminates analyst bias; and this is important. The future growth estimates used in the Quant Report are set at a rate at which nominal GDP has grown and can be expected to grow in the foreseeable future. In India, I believe the nominal GDP growth can clock in at a long term rate of 12%.

Over the next few years, demand for credit can be expected to rise. Both banks have done a reasonably good job in expanding the deposit base. Both banks have expanded the number of branches and have enormous potential in expanding the number of branches further.

I believe IBN has the better balance sheet to drive near future growth. In addition, HDB's rapid expansion in retail is viewed as carrying incremental risk.

Creation and return of shareholder value

Shareholders of both companies have made just over 28% annualized on a dividend reinvested basis between fiscal year 2000 and present. HDB has delivered dividend growth of near 14% annualized while IBN has grown at an annualized rate of 27% during the period from fiscal 2000 to fiscal 2009. Median payout ratios have been at 35% and 43% for IBN and HDB respectively. Ignoring share count, HDB is expected to have grown at over 20% between fiscal 2000 and fiscal 2010 while IBN is expected to have grown 43%. Share count at IBN has increased at an annualized rate of 18.92% compared with 1.79% at HDB. At IBN, the June 2007 ADR issue and public issue were certainly timely; they served to strengthen IBN balance sheet ahead of a period of severe stress. The growth trigger expected from this capital raising has in my view been forfeited in favor of a better balance sheet; in my view this is the better end result.

Financial Risk

I believe that IBN has the stronger balance sheet and this shall be an advantage as they can increase risk to drive growth as the expansion takes hold.

Economic Risk

The financial crisis which occurred will not leave us behind for a while yet. In my view, financial risks will remain elevated for at least another 4 to 5 years. However, at the present time, an economic expansion is taking hold in India. While the yield curve can be expected to flatten, the rising demand for credit will drive earnings growth forward.

Valuation Risk

Both IBN and HDB trade at a significant premium to fair value. IBN trades at a valuation which offers a better return on my forward cycle price target; however the total return potential is not great. At this point, there is long term upside benefit; but buying at premiums to fair value creates long term downside too; I would neither a buyer nor a seller be! I would look to add small speculative short term positions (12 month horizon) at Rs 1,450 ($100) for HDB and Rs 625 ($28) for IBN. Long term positions in Reliance Infrastructure Limited and Grasim provide better cycle return potential; I will post on these two companies in the coming days.

Disclosure: Indirect long positions in HDB & IBN.

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M&M Reports a Stellar Quarter

Operating Risk

M&M had a stellar quarter. It was a super Diwali for the group. The Quant Report shows that normalized EPS growth between fiscal 2000 and 2010 is at 19.6% annualized. During the same period annualized dividend growth was 15.2%. Annual average prices have risen at about 14.8% annualized. The 6 year median EPS has grown at 45% annualized; this as a consequence of acceleration in the rate of growth during 2004, 2005 and 2006. The dividend has provided a 10 year median yield of 2.65%. The payout ratio of 22% is indicative of a reasonable return of shareholder value policy. Median PE ratios (Annual Average Price divided by normalized EPS) remained at median levels of 8. PE 6, a measure of value in the context of an economic cycle, ran at median levels of 22; the PE 6 is the Annual Average Price divided by 6 year median EPS. All in all growth has been well over GDP plus inflation during the decade; growth has also been superior to Sensex earnings growth. Yet the stock has underperformed the Sensex on relative valuation. In my view, there is considerable scope for PE expansion, but for that to take hold, the management must return to a responsible capital structure. Once that is achieved, lower earnings volatility and better earnings/earnings growth visibility will lead to better valuation. Based on the decade performance of the management, I view the operating risk as low; but for reasons explained later in this note, financial risk is high.

Economic Risk

Economic risks are uncontrollable. They come with the cycle. At this point in time, it is my view that we are transitioning from the early stage to the mid stage of a cyclical upturn. Thus near term economic risks are low. Longer term economic risk is somewhat higher; the kind of crisis we have been through will carry a lasting impact.

Since most of M&M's business is in long life assets, there is exposure to earnings volatility from the replacement cycle. This means that growth will tend to come in spurts. M&M's passenger vehicle (cars/SUV's) business is driven by consumer demand; discretionary spending by consumers is subject strongly to the vagaries of the economic cycle. This leads to earnings volatility and a cyclical cycle for stock prices as a result of differing view of perceived and real risk. M&M's passenger transport (Buses) business is slightly less prone to the economic cycle; public transportation is an area of great importance, particularly with rising energy costs. It is less cyclical, because buying can be influenced by government policy during slowdowns. M&M's transportation (Trucks) are highly cyclical; recessions and downturns lead to lower levels of demand and reduced requirement for movement of goods and services. M&M's tractor business is a major growth area. Farm capital intensity in India will rise; it must for productivity gains to be seen. Productivity gains are a must to feed a growing population; food and water security are of prime importance. This part of the business introduces a slightly defensive touch to an otherwise cyclical product portfolio; I say this because demand for tractors is driven by demand for food, which is a staple item with low levels of demand volatility. In India, there is still a degree of cyclical risk to this business. To date poverty levels are high and people will purchase food to eat by the Rs (by affordability) instead of by the Kg (by need) – thus an economic contraction can reduce demand for staple items; it is sad but true. In addition, use of tractors and similar equipment is not limited to farms; there is strong usage in construction too and construction is highly exposed to the vagaries of the economic cycle.

All in all, I would classify M&M as a cyclical stock; which means pricing and earnings will be volatile over an economic cycle. Major share value gains can be had in the six months leading up to an economic trough and heavy losses can be incurred as the economy goes into contraction. But over an economic cycle or several economic cycles, performance can be expected to be consistent across sectors.

Financial Risk

M&M has been harshly and deservedly punished for the degree of leverage employed in the business. The debt divided by debt plus equity was high at near 58% at the end of fiscal 2009. During the period of elevated fear, the share price dropped to half of the expected bear value (Visit "The Quant Report" for details). M&M had two things against it; the first was the economic risk – the weak economy causes harsh declines in valuation of cyclical sectors; the second financial risk – the degree of leverage employed creates great uncertainty during periods of escalating risk aversion, the risk of dilution causes valuation to drop dramatically. Fortunately, the track of history demonstrates the low level of operating risk; M&M historic track record is impeccable which goes a long way in comforting investors on management competence.

Even today, the shares trade at below fair value. With FY2010 earnings expected to come in at Rs 73 at a minimum, I believe a fair value of near Rs 958 is reasonable. And I believe this discount to fair value is in place because M&M cannot permanently carry this level of debt embedded in its capital structure. I would feel far happier with a debt to debt plus equity ratio of 30%, but as credit availability improves and risk aversion abates, people tend to forget the threat to earnings from a dilutive event caused as a result of debt distress. However, the over-hang of the financial risk will probably cause valuations to remain subdued. In my view, assuming M&M outlook remains pointed towards growth of 12% annualized, which is low in comparison to growth rates during the past decade, M&M can look for a price target of Rs 1,150 to Rs 1,350 during calendar year 2010, so long as credit availability remains in place, as I expect it will. For 2014 price targets I would look for targets of Rs 2,000 rising to Rs 2,700 on bullish extremes. If debt is reduced and growth is in line with rates consistent with the last 10 years (19.61%), 2014 upside targets would open up; in such circumstances, a 2014 price target to Rs 3,200 is achievable.

Looking out to 2014 is dangerous, for it carries economic risk in addition to the financial risk. I have forward cycle fair value and bear value estimates of Rs 1,682 and Rs 1,138 respectively; since M&M carries significant economic and financial risk, I would expect bear value to break with downside to Rs 550 to Rs 650 range. For this reason, I believe M&M risks are elevated for buy and hold investors; however, persons with a shorter horizon can expect reasonable returns from a profitable future exit.

The good news is that M&M has a sound management team and hopefully the lessons of the crisis have been learned. I believe debt reduction of Rs 150 per share will leave M&M with a strong balance sheet. With the economic cycle in upswing, I believe the desired debt pay-down is possible over 3 years. This can be achieved with strong capex discipline and responsible financing of future expansion. With debt paid down, chances are 2014 bear values of Rs 1,137 will not be breached; in fact there is a strong chance that the fall will be arrested at end cycle fair value (Rs 1,682).

Conclusion

M&M is trading at reasonably low PE's relative to the Sensex and outperformance of the index over the next twelve months is possible. Because M&M has the capability to return to a responsible capital structure, hopefully before the next cyclical economic downturn, un-invested buy and hold investors, particularly those who believe with conviction that management is committed to a more responsible capital structure, can consider this stock. In addition this stock is a buy for persons with a shorter term exit horizon. I rate this stock a buy and recommend scaling into the stock on declines with an intention of reaching full allocation if the stock hits Rs 882.

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Bharti Airtel Q2 2009 – I See Spectacular Long Term Opportunity

Bharti reported results for the second quarter of fiscal 2010. The results were ahead of my estimates. After the report normalized EPS estimates for 2010 are being revised upward to Rs 26. The normalized EPS is the split and bonus adjusted EPS excluding prior period and extraordinary items.

Historic performance is a testament to management competence. Absent dramatic changes in management, there is no reason to believe this will change. The economy and circumstances might change, but the management response to minimize operating risk and exploit growth opportunities will not. In order to eliminate analyst bias, The Quant Report
projects growth in 6 year EPS Median at a rate consistent with real GDP (6%) and long term inflation (6%).

Bharti Airtel is in my view a global leader in its field. It has achieved this status, over a very short duration. If you bought the stock at annual average prices during FY 2001, the gain computed using FY2010 annual average prices would have returned 144% annualized. Bharti Airtel's first profit was established in FY2004 when normalized EPS was Rs 1.45; by FY2010 it is a towering giant in its field with expected FY2010 earnings expected to come in at Rs 26; that is an annualized growth of 162%. Management competence is clearly visible; accordingly I view operating risk as low. Bharti Airtel will be able to use its innovative capacity to monetization its huge client base; in addition the company is no new comer to competition. They can compete and grow despite risks on the horizon. I have no doubt that growth at historic rates are not possible; what Bharti Airtel has achieved is exceptional, but having grown to its present size, future growth will be more restrained. But there is absolutely no doubt in my mind that they can grow earnings at over 12% annualized. A further catalyst to growth could come through M&A activity; strong future cash flows will mean either growth (whether organic or acquired) in excess of 12%. Alternatively, absent M&A opportunities, a rapidly rising dividend is likely. Higher growth rates would create better multiples. A dividend would also be well received by markets; in my view Bharti Airtel could return value to shareholders of at least Rs 10 per year via a mix of dividends and buybacks without compromising growth at a rate of 12%.

The balance sheet is strong with a debt to debt plus equity ratio of just below 30%. As a result I see financial risk as low.

The economic risks have receded. While a meltdown in the future is possible; even likely; for now we are in a period of cyclical growth. The near term economic risks remain low, with high risk levels over a 6 year term.

I see the median 6 year EPS at 2014 to have reached Rs 45.82. I see little to no risk of Bharti Airtel not being able to grow earnings at 12% annualized from FY10 levels of Rs 26. Moderated multiple a person should be willing to pay for 12% growth with a 40% payout and a 16% investor required rate of return is 16.8. Using this multiple I come up with a near term target price of Rs 437. A longer term 2014 target is Rs 769. Keep in mind that with a lower payout ratio a multiple applicable as high as 28 could be reasonable, provided that Bharti Airtel is able to find good and profitable use for capital not returned to shareholders.

 

My call is to buy Bharti Airtel and to hold it for the very long term. The communication revolution has just begun; this stock is likely to go places.

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Reliance Industries Profit Fall

Reliance Industries reported results for the second quarter of fiscal 2010. The results were in line with market expectations with a slight downward bias. Yet the results were ahead of my Rs 94 estimate for FY2010. After the call normalized EPS estimates for 2010 are being revised upward to Rs 100.51. The normalized EPS is the split and bonus adjusted EPS excluding prior period and extraordinary items.

Historic performance is a testement to management competence. Absent dramatic changes in management, there is no reason to believe this will change. The economy and circumstances might change, but the management response to minimize operating risk and exploit growth opportunities will not. In order to eliminate analyst bias, The Quant Report projects growth in 6 year EPS Median at a rate consistent with real GDP (6%) and long term inflation (6%).

Over 10 years, RIL normalized EPS has grown from Rs 22.85 to an estimated Rs 100.51 for FY2010. The annualized growth rate is a strong 16%. During the same period, dividends grew 13.5% per annum. Shareholder returns including dividends reinvestment has been 23.71% annualized. The company has seen a strong period of recent growth as a consequence of incredible long term fundamentals in the energy sector. The six year Median EPS has grown at near 30% annualized. During FY2005 to 2010 the PE 6 multiple has run at median levels of 23.75. The PE 6 multiple is the six year median EPS divided by annual average prices during the fiscal year. The Quant Report uses six year median values to arrive at long term earnings trends which are less affected by cyclical economic shifts which cause annual earnings volatility; particularly for stocks which do not belong in defensive sectors. Management competence is clearly visable; accordingly I view operating risk as low.

The balance sheet is strong with a debt to debt plus equity ratio of just below 30%. As a result I see financial risk as low.

The economic risks have receeded. While a meltdown in the future is possible; even likely; for now we are in a period of cyclical growth. The near term economic risks remain low with high risk levels over a 6 year term.

I see the median 6 year EPS at 2014 to have reached Rs 149.24. If the market trades in line with historic PE 6 multiples, 2014 price targets would be Rs 3,519 to Rs 3,745. The moderated valuation on The Quant report is Rs 2,500 to Rs 3,342; this valuation is based on the multiple which the market should pay for assumed growth rates (12%), payout ratio (40%) and expected investor returns (15%/16%). The Mod 2 valuation works at Rs 1,293-Rs 1,670; the Mod 2 values are very pesimistic in that they assume 0% growth in 6 year median earnings. The most appropriate targets for Reliance are Rs 3,519 to Rs 3,745 in our view.

As mentioned, growth assumptions are modest for The Quant Report to eliminate analyst bias. However, my personal view is that Reliance will be able to maintain growth at 18% annualized. If that occurs 6 year median EPS during 2014 will be Rs 204. The resulting value range based on historic PE 6 multiples will be Rs 4,800 to Rs 5,100. Using the Moderated Values, the value range will be Rs 3,400 to Rs 4,600. In my view, the Rs 4,800 to Rs 5,100 targets for 2014 are achievable provided we do not go through another global meltdown and crushed commodity prices. Be cautioned this view contains analyst bias!

My call is to buy Reliance; book profits at Rs 3,500. And re-evaluate the stock to consider an exit at Rs 5,000.

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Axis, HDFC, HDFC Bank, ICICI Bank and SBI

Today I looked at six entities in the financial services sector. Axis Bank, HDFC, HDFC Bank, ICICI Bank and SBI are all solid Indian institutions. The threat of a rate rise caused a sell off and it is worth re-visiting the sector to decide whether to sell, hold or buy.

In my view, financial services starts outperforming about six months ahead of an economic recovery. This is a time when the yield curve is steep and there are no expectation of interest rate rises. Cost of finance to institutions is low and the spread between long and short rates high; thus financial institutions stand to gain. The higher margins associated with the high spread along the yield curve, results in improving health of financial institutions hurting from the slowdown in credit expansion and from rising default rates during the recession. The imporved outlook encourages risk taking and a minor credit expansion takes hold; higher margins also help offset the cost of recession default; it also helps earnings because with lower volume of credit, earnings will fall unless margins rise. This time is behind us.

The next phase is the flattening of the yield curve. Markets get concerned on the prospects of the financial services sector as short rates rise and the spread between long and short rates narrows. But the fact of the matter is that true credit expansion only starts at this stage. While the yield curve is steep; the demand for credit is just not there because of the economic climate. Credit demand picks up as the confidence in an economy expansion accelerates; this is about the same time when rate increase expectations start rising. Expansion in credit growth will offset margin pressure. A flattening yield curve is not bad news until the spread between corporate and long treasury yields narrow considerably. The time to start worrying is when credit supply expands vastly and causes the spread between long treasuries and corporate bonds to narrow. To be sure, the stock market prices this in - during the next phase financials can be expected to perform in line with broad markets; the time for outperformance has gone. However, a good entry point can be had as the market over-corrects initially.

Financials face 3 primary risks. Operational, economic and financial.

Operational risk arises from bad credit decisions; this has a direct impact on earnings because loan write offs and provisioning hurt earnings. It is largely controllable and in my view all of the lenders reviewed have done a reasonable job in containing operational risk. I do believe the loan covenents need to be stronger. Ultimately, in my view the degree of leverage employed by corporate India is unacceptable; look at Gujarat NRE, Hindalco, Jindal Steel, JP Associates, L&T, Lupin, Tata Motors, Tata Power or Tata Steel and you will see hugely over-leveraged company. Permanent debt embedded in the capital structure is quite unsafe; equity investors suffer the risk of dilution and lenders of non performing assets. While the borrower has primary responsibility for responsible borrowing; good credit policy would be helped by strict covenents on debt/debt+equity rations. The lending to households is largely sensible but that is more because of responsible borrowing embedded in the national psyche; and unfortunately its changing fast. Unrestrained speculative buying of real estate will end in tears; even where lending has been prime - think of it this way - if you buy a house for 100 borrowing 80; the lender is safe until the price falls over 20%. A lender who lends 80% of the home value to a borrower with the ability to service the debt might have good policy but a bad result when the bubble bursts. Lending to this sector really needs to be controlled to avoid further asset price inflation.

Financial risk is really about the banks leverage. At the end of fiscal year 2009, HDFC is excellent, ICICI and HDFC Bank are good. Axis is not great but acceptable. SBI is only just okay; and I am being polite here. SBI also suffers from being a PSU; a situation which often results in costs arising due to government intervention on loan grants and write off (particularly to the rural economy). Other than HDFC, much of the funds are mobilized through deposits. The loans, deposits plus equity are invested in financial assets. A small deterioration in financial assets can really hurt equity holders. Take and example. Suppose we have equity of 6 and deposits of 94. Financial assets include 20 in cash and 80 in debt. Supposing 10% of debt goes truant and only 80% can be recovered; we have a loss of 1.6. It does not sound like much but it is over 25% of equity. As said, the financial risk level is great with HDFC and good with ICICI and HDFC Banks.

Economic risks are uncontrollable. They come with the cycle. Yield curves play a particularly important part in the banks business as they will typically lend at the long end of the yield curve and borrow at the short end of the curve. It pays to watch for a yield curve inversion; because when short rates rise over long rates, financials cannot make money. Credit contracts and we are ready for a recession. Another way to look at it is that excessive risk (carry trade) taking drives the long end of the yield curve down and once it falls below the short rates, we have a recession on our hands. One thing is sure, a yield curve inversion is the best predictor of economic slowdowns and recessions.

To recap from The Quant Report (Must be read in conjunction with this post!):

10 year annualized earnings growth has been 20.95% (24.22%), 18.16% (12.19%), 17.99% (12.19%), 31.65% (24.59%) and 18.22% (21.29%) for ICICI, HDFC Bank, HDFC, Axis and SBI respectively. The numbers in brackets are annualized 10 year dividend growth. In terms of credit quality, I would rate HDFC as 1.

Shareholder returns including dividends reinvested over the 10 year period is 28.14% (35%), 28.5% (41%), 34.44% (41%), 45.38% (24%) and 26.13% (12.83%) for ICICI, HDFC Bank, HDFC, Axis and SBI respectively. The number in brackets is the dividend payout ratio (dividend divided by earnings). Median Dividend yield (dividend divided by annual average price) ran at 1.89%, 2.47%, 2.52%, 2% and 2.19% respectively.

The Median PE 6 (Median 6 Year Earnings divided by Annual Average Price) is 22.56 (15.87), 35.85 (15.5), 37.49 (17.25), 30.67 (12.65) and 10.77 (6.72) for the entities in the same order as previous. The numbers in brackets are the PE (Earnings divided by Annual Average Price).

Debt divided by debt plus equity ran at 87.9%, 90.2%, 85.7%, 92% and 94.4% at end 2009 for the entities in the same order as previous. Of more concern is that the book value percent of contingent liability (derivatives guarantees etc) was 5.4%, 3.5%, NA, 4.6% and 6.36% respectively. When a contingent liability exists it crystallizes on the occurence of an event; the instutution then becomes obligated to pay. In most cases, the institution has a right to recover from another party. However, a failure to recover would leave the institution on the hook for the liability and the shareholders in distress. The point has been taken, by the end of 2009 there was a sharp decline in contingent liabilities. This area needs regulation; eventually it exposes shareholders to significant off balance sheet risk. And to add insult to injury, it encourages unrestrained risk taking by limiting downside of the primary risk taker at a what was very nominal cost. I do not really think it is a bad instrument; it is good for risk management, but it is oh so mispriced historically.

Okay, so what does it all mean. Nothing really; we are past buying at fair and bear values as the cycle has now turned. Buying at fair and bear values has high perceived risks and low real risks. Buying now has low perceived risks and higher real risks. Problem is that markets tend to rise while perceived risks are low. So there is upside. I would look to buy ICICI at or below 575, HDFC Bank at 1,450, HDFC at 1,400, Axis at 850 and SBI at 1,400. In my view Axis offers the best balance of upside with limited downside.

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India Infrastructure and Random Thoughts

Good day today. I waded through data on 16 companies (See The Quant Report).

Bought some Bharti Airtel, sold some Cairn; nothing exciting really. I feel Cairn might face some challenges over crude quality; the potential buyers are overseas and with the baltic dry continuing upwards, transport cost will be an issue. They need local buyers. Also, the market is well supplied; I see no reason for buyers to go with Cairn crude unless its on pricing - which might not look great on Cairn's P/L. To offset this is the longer term prospects for Cairn which are positive; even very positive. Bharti Airtel on the other hand is trading at a small premium to fair value - does not sound great cause it is after all a premium to fair value; but it is a big deal when you look at the premium to fair value on several other stocks as well as the broad market. That is not to say I think the markets will fall very significantly; normal values are at significant premiums to fair values most of the time; in fact the opportunity to buy at fair and values rarely visits outside of recessions.

I think infrastructure is over hyped; eventually resource constraints (both capital, equipment & human) will constrain growth rates; I still expect 12% (6% real GDP + 6% inflation) will be achievable. But the market is pricing much more than that. Besides, decade forward growth rate expectations really do not translate into long term growth rates; nobody seems to look at sensible terminal growth rates and that can have a huge impact on valuations. I also think this sector will face serious cost control problems as a result of rising long term commodity prices. Now if you thought operating risk and economic risk was all there is to it; consider the financial risk. Other than BHEL and NTPC the extent of leverage employed by the infrastructure companies is awsome. Sure it might have got better since the year end but since Indian companies do not report balance sheets, I would not know, how much better. Okay, there has been a lot of capital raising this year; but (a) thats been dilutive, (b) it might have not even reduced leverage as funds to finance ongoing continuing activity were constrained too and I am not sure how strong operating cash flows have been during 2009. If you look at DLF and Unitech's history, it is amazing to see that those companies did not really create any operating cash flow leave alone free cash flow during the bull years. I looked at BHEL, Jindal Steel & Power, JP Associates, L&T, Tata Power and NTPC today; and while I would hold all (with a 6 year view) I would buy none. On Jindal Steel & Power and Tata Power, I would book profits and hold only capital. With a shorter horizon I would book profits on the lot except perhaps BHEL. The degree of financial leverage employed verges on bad governance!

Was pleased with the RBI actions. Good to see rising rates being adjusted into expectations; perhaps it is not good for the Real Estate space, but that is not a space which interests me at all. Still think that bubble needs to unwind further - read this to figure why. All in all I am happy that rates are now looking like they will rise cause that means the economy is on a firm upward trend. I will start getting worried once the 10 year GoI bond crosses above 9% together with narrowing on AAA corporate bond spreads.

Sensex closed at 16,283 which is getting close to my downside target of 16,046, though to be honest I thought 16,400 would hold. SP500 is still at 1051 which is over my downside target of 1038.

All told, I still see solid upside long term. However, value can be found in pockets; its not widely available compared with late 2008 and early 2009. Its time for cycle investors to start looking at sector valuations to make sure money moves with value. I also think Indian investors should consider value plays on the international markets. A lot of global players are beneficiaries of the BRIC growth story and today they are cheaper on valuation than Indian stocks simply because the Indian stocks have benefitted from broad market based enthusiasm.

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Lupin Q2 FY2010

Please visit The Quant Report to access The Mini Quant report for Lupin. Also review the file "Understanding the Quant Report" to understand the methodology employed in determining valuation referred to in this report.

Lupin is expected to announce earnings shortly. Lupin is an excellent company; to appreciate it one must really look at historic performance which clearly establishes management credentials. There is nothing better than history to highlight a successful management; and while past performance is no assurance on future results in that history might not repeat itself; management is well capable of making it rhyme.

Between FY 2005 and FY 2009 earnings grew at a spectacular 53% annualized. During the same period dividends grew at an annualized rate of 31%. Average annual price grew near 0% annualized. Including estimates for earnings and dividends of Rs 83 and Rs12.5 for FY 2010, earnings, dividends and ytd average annual prices will have grown at an annualized rate of 49%, 31% and 8% respectively. The growth performance is spectacular and forward growth expectations remain strong.

Lupin has a strong record in driving growth and there is no reason to expect this to change; in the US the generic market size is over $90 billion, and Lupin with over 90 US product filings and 32 approved is poised to grow market share. Lupin also has good geographic diversity which reduces product portfolio risk. It has over 50 submissions and 22 approvals in EU. It also has 24 submissions with 18 approvals in Australia/New Zealand. It is true there is an element of risk associated with the FDA warning letter on the Mandideep facilities, but I remain confident that the management will successfully resolve the issue. As of recently, there has been no product recall, manufacturing remains un-interupted and supplies continue as usual. In R&D, Lupin has migrane, psoriasis and TB remedies in clinical trials. There are further pre clinical programs addressing mental disorders, inflammation and CNS. Overall I see Lupin as being well positioned to achieve its objective of building market share, achieving R&D success, growing is generic pipeline and developing its brand. I also see Lupin as making an attractive M&A target for global big pharma. Global big pharma is facing significant pressure from patent expiry's in upcoming years; searching for growth through acquisitions of both generic and branded business has been high on the action list. I expect this to continue. I also see the Obama healthcare actions to benefit the generic manufactures greatly. And finally, I see a pick up in the FDA's speed in recent months - after seeing exceptionally slow progress over the last several years, this is encouraging.

At over Rs 1,250 Lupin is not cheap. However, the earnings growth cycle has resumed. For the cycle just ended I had fair value targets of Lupin at Rs 661; at these levels I viewed the stock as attractive for long term investors. Our bear target was at Rs 230; at these levels the stock was seen as compelling. The stock did trade down to a low of Rs 462 during the harsh bear market; I was surprised as defensive stocks rarely fall below fair values unless there is something fundamentally wrong with the business. Falls towards bear values is what is expected for cyclical sectors such as financials, consumer discretionary, IT, materials, energy; not for defensives like health, consumer staples, utilities and telecom sectors. But that time & buying opportunity is past. At Rs 1,250 it is expensive. Our upper buy limit for Lupin is Rs 928 but we consider Rs 1,000 as an attractive entry target given the broad market conditions; this Rs 1,000 level reflects our forward bear value for 2015; I feel confident that this stock will not lose money over an economic cycle if bought below this level. I do believe there is long term upside from Rs 1,250 - I am looking for minimum price targets of Rs 928 for FY 2011, Rs 1,207 for FY 2012, Rs 1,480 for FY 2013, Rs 1,650 for FY 2014 and Rs 1,850 for FY 2015. A 5 year 48% upside from present levels is not a great return when one considers alternative opportunities amongst the more economically sensitive stocks.

I like the company very much, but in light of alternative opportunities, I would wait patiently for a better entry value. At below Rs 1,000 the downside risk is limited while there is upside to capture; unfortunately at Rs 1,250, the downside risks to a long term investor are high (you will almost certainly get a better entry level during the next economic slowdown), while the upside is limited. At the right valuation, I see Lupin as an excellent pick for the defensive allocation within a portfolio.

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NTPC FY 2010 Earnings - Great Opportunity but is the value right?

Please visit The Quant Report and link through to NTPC's Mini Quant Report for data on which the comments below are based.

NTPC reported earnings recently; I was pleased with what I saw. Half year earnings are at Rs 5.27 per share leaving the company well positioned to grow FY 2009 earnings to Rs 10.74 at a minimum.

NTPC is a public sector undertaking operating in the power utility segment. To an extent, this is what I do not like about it. The sector in which it operates has enormous growth potential. Coming with the growth opportunities are significant operating risks. NTPC has demonstrated the ability to manage operating risk well and there is no reason to believe this is about to change. Non operating risks include risks from the new tax code; a 2% asset based minimum alternate tax could seriously hurt viability of this asset rich company with massive capital investments in capex. In addition there is risk from an interventionist government - the government in its duty to balance public interest versus commercial reward often results in subdued shareholder returns relative to private sector peers. If you look at valuations of oil marketing companies and strong PSU banks and compare valuations to the private sector you will see what I mean. This is the primary reason why I avoid investing in any PSU; though truth be told NTPC is a company where I want to make an exception to the rule.

Between FY 2005 and YTD FY 2010 annual average prices on NTPC have moved from Rs 76 per share to Rs 204 per share. This is an annualized capital growth of about 22%; and in addition there is a healthy dividend adding to shareholder total return. During this period earnings per share is expected to have grown from Rs 7.29 to Rs 10.74 at an annualized growth rate of 8.1%. Dividends during this period will have grown from Rs 2.4 per share to an expected Rs 3.9 per share at an annualized growth rate of over 10%. On the face of it the growth looks disappointing as it is well below nominal GDP rates which have run over the FY 2005 to FY2010. But NTPC's performance is commendable when you consider the growth in operating cash flow between FY2005 and FY2009 has run at near 19% annualized while growth in capex has run at an annualized rate of over 20%; these rates are well over nominal GDP growth rates. In my view, the investment in capex over the past cycle and over the coming cycles will deliver rising earnings growth - at a minimum I am looking for a forward cycle growth rate of 12% annualized from NTPC.

So overall in my view NTPC is a good company. But a good company is not always a good buy if the valuation is not right. At present NTPC trades at Rs 215. In my view, a company with an FY 2010 EPS of Rs 10.74 and growth expectation of 12% annualized together with a dividend payout ratio of 37% should be valued at approximately Rs 193 per share for an investor seeking an annualized capital gain of 16%. As far as fair value is concerned; I would value NTPC at Rs 122 per share; but given that the economic cycle has turned, it is unlikely that the stock will drop to fair value. As a result, I would look for Rs 193 as an upper buy limit for this share. At this price an investor can expect capital gain potential of 13%/14% annualized over the long term with returns from dividends raising total return to over 15%/16% annualized. In my view a return expectation of below this level is not commiserate with the risks associated with NTPC, particularly considering alternative large cap investment opportunities available in the market.

I would place the median forward cycle fair value at Rs 200 per share and believe that buying above this level is a risky proposition. My FY 2015 price target for NTPC is Rs 340; a fair value for 2015 is Rs 200 and a bear value for FY 2015 is Rs 129. Price targets are calculated assuming annualized earnings growth of 12%, an investor required rate of return of 16% per annum and a dividend payout ratio of 37%. Fair values are calculated using an adjusted Gordon's Growth model which values a notional dividend assuming annualized dividend growth of 12%, and an investor required rate of return of 16% per annum. Bear values are also calculated using the adjusted Gordon's growth model; however compared with the fair value calculation, the bear value is computed pricing in the risk of a cut in the notional dividend.

FY2011 target prices are Rs 215 with fair and bear values of Rs 89 and Rs 132; like I said, with a turn on the economic cycle it is unlikely that prices will trade down to fair of bear values. For this reason, I would look to enter NTPC on any pullbacks to levels below Rs 192 and adding to positions if it falls toward Rs 156 and getting to full allocation if it reaches the Rs 122 FY2010 fair value level.

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Sensex Technicals & Fundamentals

Please visit The Quant Report and link through to the Sensex Quant Report.

Technicals

Sensex has approached a key Fibonacci resistance at 17,992. After reaching 17,457 as an intra day high, it has pulled back. At this stage, the markets are likely to retrace some of their gains. The 16,046 level has now become support. A drop in markets is highly unlikely to reach this level. In my view the market can be expected to pull back to 16,800-16,400-16,050-15750-15,300; I expect strong support at 16,050 and would be very surprised if that level breaks; realistically I would expect the market to resume upward momentum once it reaches 16,400. From this level, I would expect the Sensex to challenge and overcome the final Fibonacci level; the next challenge is the Sensex prior all time high.

Fundamentals

Macro economic environment remains positive. Quarter on quarter GDP growth together with leading indicators are flashing signals indicative of an increase in the pace of growth. Interest rate expectations are now pointed towards rate rises and this causes people to become nervous; but one must keep in mind that rising interest rates, off historic lows means that the economy is growing again and does not need the kind of support from monetary policy as previously. In January 2009, the 10 year GoI bond was at 4.62% and it is encouraging to see it normalize and rise to 7.18% by October. The yield curve is still steep and supportive of credit expansion; at this stage some flattening of the yield curve must be expected.

Inflation expectations are creeping up; six month out projections now call for WP inflation to rise to 6% which is in line with median levels of inflation over the past few years. At the same time it is encouraging to see CPI expectations remain in control.

Earnings are above expectations and revenue growth and outlook improvements all point to a strengthening market. In my view we are now at a stage where earnings upgrades are likely to occur - further multiple expansion is likely to be muted, but rising earnings should support continued strength in the markets. In my view FY 2011 earnings will start rising rapidly towards Rs 1,100.

Factors to watch are (a) abnormal strength in Rs (indicative of excessive risk taking) - say below 42 is a good time to start getting concerned; (b) inflation levels rising at both CP & WP levels to levels over 7.5%; at over 10% hit panic buttons! (c) GoI bond 10 year yield rising over 9% (d) A falling corporate bond premium of 1% over the GoI bond can also be indicative of excess risk taking. At the same time a GoI bond at over 9% with a 2% premium for corporate bonds (i.e. effective rate of 11%) might not be healthy for a capital intensive growth period.(e) Oil prices over $100 - this is the maximum level I feel the economy can absorb with the Rs at 44/45 range.

In the meantime FY 2010 target for Sensex at 19,500 is very achievable. For 2011, 20,800 is likely and 23,000 is achievable.

US Market Influence

All in all we have some risks of a global double dip recession, but I feel that is a way off; the economy during 2010 will be firmly supported by stimulus (including accommodative {albeit less accomodative compared with present} monetary policy) and additional stimulus measures overseas; 2011 should be supported by growth stimulated by falling unemployment rates - employment growth should resume in Q2/Q3 2010. Mid to late 2012 is when I expect risks to start rising again.

The open risk to India is global; as foreign capital seeks risk, the Indian Rs has strengthened. At the same time the $ weakening has caused oil and commodity prices to strengthen considerably. Input costs remain somewhat stable as a result of the stronger Rs despite higher $ commodity and oil costs, but weakness in export markets can hurt. Frankly, it would be in India's interest to have a stable $; our growth requires massive investment in infrastructure and the pace of investment can slow as a consequence of rising input costs.

US earnings season so far has been encouraging on earnings growth. Top line growth has been mixed, which is an encouraging change from last quarter when top line growth was dismal. Outlook upgrades have generally been encouraging but cautious. Leading indicators provide strong support for robust upcoming growth; rising unemployment (at a slower rate of deterioration) is to be expected until mid 2010 after which it should decine. Like India, I expect the SP500 to see earnings upgrades - I expect 2009 will end with operating earnings of $55; for 2010 my expectation is to see robust recovery with operating earnings of $72. Technically SP500 is also facing a key Fibonacci resistance level at 1,121. A pullback is likely, however economic and earnings data should limit downside; in my view a worst case downside would take the SP500 to 1,038 - from this level it should be able to meet the challenge of its 1,121 Fibonacci target on the subsequent up move. The next Fibonacci challenge for SP500 is 1,228 and I expect this resistance to come into play mid 2010.

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Sensex Not Over Valued

Please visit The Quant Report and link through to the Sensex Quant Report.

Focus on multiples without an understanding of the math of multiples can be a major investing error.

Consider this; during fiscal 2003 the market bottomed with a PE (Annual Average Price divided by 14.40. During fiscal 2004, the PE rallied up to 14.90 but the market was driven higher because of the rising E.

Now compare this to fiscal 2009. The markets bottomed with PE running at 16.14. During fiscal 2010 the PE rallied to 16.68 (year to date annual average price divided by EPS estimates).

At first glance it would appear that the market is very over-valued. But is that trully the case? It is not.

Consider this; the dividend payout ratio (Dividends divided by EPS) during fiscal 2003 and 2004 were 31.3% and 33.6% respectively. By fiscal 2009 payout ratio had fallen to 24.6% and by fiscal 2010 it is expected to down to 21.33%.

Falling payout ratios are consistent with growth economies; companies will retain a larger part of earnings to drive future growth. High growth expectations means that an investor can expect to pay a higher multiple. Investment gains arise from two sources, dividends and gains. When payout ratio's are low, the earnings retained for future growth are worth more; during such periods, investors can expect to earn a higher part of their investment gains from capital growth relative to dividends.

To compare multiples during periods when there is a significant difference in payout ratio's, adjusting the PE ratio's is important. Adjusting the multiple to compare like with like is easy; to understand the maths please read my prior post "The Math of Multiples". The adjustment is simple, you simply take the PE and divide it by (1-Payout Ratio) to arrive at the adjusted multiple.

During 2003 the PE was 14.4 and the payout ratio 31.3% and during 2004 it was 14.9 with 33.6%. Adjusting the PE to reflect a 0 dividend payment gives us an adjusted multiple of 20.96 for 2003 and 22.43 for 2004.

During 2009 16.14 with a payout of 24.6% and for 2010 it is expected to be 16.68 with a payout of 21.33%. This gives an adjusted multiple of 21.46 for 2009 and 21.2 for 2010. Assuming earnings of 874 for fiscal 2010, the market would need to close 2010 at an annual average price of 19,603 - at this level the adjusted PE will be 22.43 which is the same level as 2004 which was the first year of the prior cyclical bull.

For 2010 to close at an annual average price of 19,600, the market would have to trade at levels significantly higher than 19,600 for the second half of the fiscal year; recent annual average prices are in the 14,500 to 15,000 range and to drag this up to 19,600 means that the market needs to trade the third and final quarters of 2010 at about 24,000 levels. This is very unlikely to happen. All in all, I would consider the market inexpensive relative to 2004 until it reached 19,600; after that a higher degree of caution would be called for.

On an absolute basis, the market is expensive relative to estimated forward cycle fair value (16,200); however once growth has resumed there is no reason for valuation to revert to fair value until growth is threatened again. For this reason, my target for calender 2010 are 20,500 to 24,000 range.

Link through to the file "Sensex Fiscal Years Ended 31 March" valuation report on The Quant Report for a more comprehensive report on the methodology employed in valuing the Sensex.

For those of you who are not familiar with what Sensex is - the Sensex is an Index (compiled by the Bombay Stock Exchange) of thirty Indian listed entities. The companies are well regarded in India and come from across a variety of sectors. They include:

Company Name (Industry)
ACC (Cement - Major)
Bharti Airtel (Telecommunications - Service)
BHEL (Engineering - Heavy)
DLF (Construction & Contracting - Real Estate)
Grasim (Diversified)
HDFC Bank (Banks - Private Sector)
HDFC (Finance - Housing)
Hindalco (Aluminium)
HUL (Personal Care)
ICICI Bank (Banks - Private Sector)
Infosys (Computers - Software)
ITC (Cigarettes)
Jaiprakash Associates (Construction & Contracting - Civil)
Larsen & Toubro (Diversified)
Mahindra and Mahindra (Auto - Cars & Jeeps)
Maruti Suzuki (Auto - Cars & Jeeps)
NTPC (Power - Generation/Distribution)
ONGC (Oil Drilling And Exploration)
Ranbaxy Labs (Pharmaceuticals)
Reliance Communications (Telecommunications - Service)
Reliance Industries Limited (Diversified)
Reliance Infrastructure (Power - Generation/Distribution)
State Bank of India (Banks - Public Sector)
Sterlite Industries (Metals - Non Ferrous)
Sun Pharma (Pharmaceuticals)
Tata Motors (Auto - LCVs/HCVs)
Tata Power (Power - Generation/Distribution)
Tata Steel (Steel - Large)
TCS (Computers - Software)
Wipro (Computers - Software)

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Sensex Poised for Major Upmove

The Sensex is poised for a major upmove. Infosys, Reliance, Bharti and Tata Steel are four Dow Jones Global members which excite funds flow like nothing else. The infection of greed flowing from these four infects the entire market with enthusiasm. It is time for panic buying by retail and fund managers who have missed the rally.

Reliance has considerable short term upside. Once the clouds over the dispute with ADAG dissolve, forward earnings expectations can carry the stock over Rs 2,700 and towards Rs 3,000 very rapidly.

Tata Steel had a trough earnings quarter immediately prior. In my view, confidence in forward growth will be expressed this quarter together with incrementally positive quarterly results. Short term upside to Rs 790 levels can be expected once confidence in a reversion to mean 6 year earnings of Rs 75 is strong.

Bharti is deeply under appreciated at present. After it gets over its oversold position; I expect the share to recover to Rs 550 in the short term.

Infosys, is the only one which I see as fully valued and with downside potential; and that too is benefitting from IT services positive outlook for strength post economic recovery.

These majors have big upside potential which can be expected to move the Index upwards. Equally, enthusiasm on these stocks will move broader markets too. In my view, expect a broad market upmove; with large cap quality leading and mid caps participating. Target for 19,500 before year end.

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How Shareholder Value Gets Returned

Div Yld Payout Payout Med Adj Payout EPS Growth

XOM 2.3% 42% 36.5% 67.5% 12.75% (19.37%)

BP 7.6% 84% 42.8% 64.1% 7.62% (27.78%)

COP 4.4% 54% 18.0% 11.0% 12.5% (16.63%)

CVX 4% 66% 33.0% 45.0% 9.8% (19.27%)

Companies return and create shareholder value through dividends, buybacks and earnings growth.In this post,

a. the dividend yield is calculated as expected dividend for 2009 divided by the annual average price during 2009.

b. Payout is calculated as expected dividend for 2009 divided by expected earnings for 2009.

c. Payout Med is the median payout ratio over the years since the year end 31 December 2009

d. Adj Payout is the payout after considering buybacks net of dilutive events such as employee grants & share issuance on M&A activity.

e. EPS growth is the annualized growth in EPS using expected earnings for 2009 as the end date and earnings for the year end 31 December 1999 as the start date. The number in brackets are the median level of annual rate of change in EPS; this is a useful indicator during years when the start point or end point are a trough or peak earnings year because the annualized growth rates can be misleading during such times.

Detailed quantitative information can be viewed at The Quant Report.

Several investors have expressed dismay in XOM's low dividend. But the historic data indicates that XOM has the best return of shareholder value policy amongst XOM, BP, COP and CVX.

Dividends are nice because they create shareholder choice. The company pays cash, the shareholder pays tax and spends the rest of it. Dividends carry appeal to investors because they provide liquidity and income and the tax cost associated with a dividend is an acceptable cost. However, a institutional investors and investors who typically elect the dividend re-investment option, might not like a dividend because the tax cost makes it inefficient compared with earnings growth or share buybacks.

Buybacks are nice because they deliver exactly the same end result as a dividend paid with reinvestment, except that because no tax is paid on the number of shares acquired is higher. Thus this option carries appeal to a significant number of investors. The problem with buybacks is that most buybacks occur during periods when shares trade at a premium to fair or intrinsic value; if a buyback program was, like a dividend, designed to return shareholder value in a consistent and recurring fashion, it would work very well. The alternative would be to have a buyback program built on a market timing model where shares are only bought back when they are undervalued - very easy to say, but very difficult to implement since most companies really do not have inhouse expertise to either time markets or determine fair or intrinsic value; investment is not their business, running the company is.

And then there is growth. When a company can be trusted to use the surplus money better than the investor, reinvestment in growth is the best option for growth generates future capital gains which delivers shareholder value. The problem is that in the long term, very few companies can deliver growth at levels which justify retention of surplus capital; too much will be paid on M&A activity, overconfidence will cause overspends on organic growth, competition will eat away benefits of growth. In the early life of a company this option makes best sense; but as it matures a mix of methods to return shareholder value is worth considering.

A company needs to select the best method of returning value to its shareholders after considering the needs of different types of shareholders. Some succeed, as I believe XOM has, some like DELL do not. DELL does not pay a dividend; their share is thus unattractive to income investors; without investor interest from a significant investor group, the share price is severely punished during periods of distress. DELL's buyback program has not been the smartest, it lacks consistency and shares are not purchased when valuation is deeply distressed. And growth is something they delivered beautifully in their early years, but in since 1999, their annualized growth has been a spectacular 0.29%. Now I have long positions in Dell for many reasons including because their median level of annual rate of change in EPS is in excess of 20%; I believe the management can turn it around compared with where it is. I am investing on the basis that value will be delivered through growth ultimately; it is a risk a long term investor is willing to take, notwithstanding the lack of price stability caused by no dividend and a poorly executed buyback program. An good company need not be a financially smart company!

Personally, I like shareholder value returned via a mix of all three methods. Sometimes I will mix it up and use a higher dividend yield on one stock together with another stock which in my view might deliver better earnings growth through a turnaround.

Disclosure: Long BP, DELL.

Stocks: XOM, COP, CVX, BP, DELL

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Is it time to exit Tata Motors?

Please visit The Quant Report and link through to Tata Motor's Mini Quant Report for data on which the comments below are based.

In looking at Tata Motors the first thing that jumps out is the poor condition of the balance sheet. On 31 March 2009, the debt on the balance sheet was Rs 392.134 billion ($8.7 billion); that is an astounding Rs 763 per share ($17); after reducing cash and cash equivalents the net debt comes in at Rs 683 per share ($15). Shareholder equity was Rs 59.406 billion ($1.3 billion) or Rs 116 per share ($2.6). The net debt to net debt plus equity ratio is 86%. This is well over debt levels I consider prudent.

My tolerable net debt to net debt plus equity ratio is 30%. For a car maker, a slightly higher than 30% is okay in some circumstances; they typically use a quasi financial services business to drive sales growth through financing buyers. For instance, when I last looked, Honda Motor Company has a ratio of 48%. But in the case of Tata Motors the debt is not so high on vehicle finance; a significant part is to finance the acquisition of JLR. A recent corporate presentation shows Tata Motors debt incurred in respect of Vehicle Finance at Rs 76 billion (1.7 billion); which is only 21% of the total net debt.

In my view the capital structure is weak; very weak. Such high debt levels will limit access to capital and can lead to muted future growth prospects. There also remains considerable confusion about what portion of the company truly belongs to shareholders – the threat of a highly dilutive capital raising event is ever present. The good thing about a bad capital structure is that the risk is very visible and in times of crisis the risk gets mispriced; Tata Motors traded down to Rs 124 ($2.76) during the bear market and at those price levels the risks were mispriced. The question to ask is: What is Tata Motors worth with its structural risks fully priced?

I have a high level of confidence in the stand alone Indian operations being capable of delivering long term earnings of Rs 39 per share ($0.87) before interest; this can be expected to grow in line with India's nominal GDP growth of 12%. This amount is adequate to service debt; the interest is expected to be approximately Rs 25 per share ($0.56). The per share numbers are based on share count after the recent capital raising exercise assuming full conversion of convertible notes; see later in this post for additional details. This provides a very low interest cover; in addition, it does not provide any real ability to pay-down debt. For simplicity I will assume the debt is embedded in the long term capital structure (i.e. it will be permanently carried); and I will go with an expectation of rising long term interest rates. The consequence is an assumption that interest expense too shall increase at 12% per year. Rs 14 ($0.31), growing at 12% annually, for an investor with a 16% annual return expectation and a notional payout in perpetuity expectation of 40% returns a value of Rs 235 ($5.22). To this we need to add the valuation attributed to the long term contribution we can expect from JLR. JLR's contribution is difficult to estimate; visibility on historic data is low and forward expectations are difficult to form particularly when you consider the growth impetus which will arise once the brands aggressively entry India. In my view a very conservative long term earnings expectation from JLR, is Rs 16 per share ($0.36); this does not include the cost of the debt burden which has been included as what the long term India earnings will generate. This Rs 16 ($0.36) growing at 6% annually for an investor with a 10% annual return expectation and a notional payout in perpetuity of 40% returns a value of Rs 255 ($5.67). This puts a value of Rs 490 ($10.89) for Tata Motors. The Rs 16 ($0.36) JLR estimate does not include growth potential for India; in my view Rs 26 ($0.58) is not an unrealistic long term earnings expectation for JLR. This Rs 26 ($0.58) growing at 6% annually for an investor with a 10% annual return expectation and a notional payout in perpetuity of 40% returns a value of Rs 415 ($9.22). This puts a value of Rs 650 ($14.44) for Tata Motors.

Because of the poor capital structure, I view the level between Rs 490 ($10.89) and Rs 650 ($14.44) {Average Rs 570 ($12.67)} as a good target at which to book profits or exit positions. With a strong capital structure, these targets would be considered the upper end of a buy limit. The capital generated should at this stage of the cycle move towards quality and away from risk; Tata Motors would only come back on my buy radar if either:

(a) Its capital structure is cleaned up; price targets would be evaluated at that time

(b) it trades down to a level of Rs 250 ($5.56) where I would consider it a buy as all risks associated with the poor capital structure are largely priced; this is a bear target and I would buy and accumulate if it fell further.

(c) pricing excessively negative sentimental in addition to poor fundamentals as a result of the bad capital structure would create a buy point at Rs 115 ($2.56); this is a bear bottom target.

(d) Short term horizon investors might consider buying at Rs 410 ($9.11) level. This is what I see as fair value and believe gains to Rs 650 ($14.44) levels are possible provided that risk aversion does not return and sentiment remains possible.

Above conversions to $ have used a long term Rs/$ rate of Rs 45=$1.

Notes on capital structure and growth prospects

Growth Prospects

Tata Motors deals in a wide variety of vehicles. Buses are a great growth area; Indian public transport is an absolute mess and Tata buses help making it get better. Part of the Indian fiscal stimulus is geared towards investment in this area. Tata trucks are also beneficiaries of massive growth opportunities; with GDP expected to grow at 12% nominal over the coming years, logistics and the movement of goods will create incremental demand for road transport. Tata passenger vehicles also operate in a growth area; at the bottom end of the market, the Nano, recently added to the passenger vehicle portfolio, provides a wonderful growth opportunity. At the top end of the market, bringing the JLR brand into India will open up a significant premium vehicle market for the group. The middle end of the market has a decent product portfolio, which can in my view benefit greatly from the introduction of acquired technology & intellectual property to improve quality. The mid end can also benefit from JLR brand "rub off"; but here care is needed so as not to taint the JLR brand with the non premium product portfolio. The problem is that to benefit from this huge opportunity, Tata Motors must have access to finance; and with the terrible capital structure, access to incremental finance is unlikely to be available. Because of this albatross, I would use in line growth expectations to value the company. In line growth represents a long term growth rate of 12% for the group ex JLR & 6% growth for JLR; these growth rates represent long term nominal GDP growth expectations in India and overseas respectively.

Capital Structure

A significant chunk of the debt went towards the acquisition of JLR. On question which arises repeatedly is whether that was a good buy. In my view it was a good long term buy. No doubt I would have been happier with a lower price, but it was a good buy. Success does depend largely on execution; part of the acquisition benefits will come from future JLR income streams (including bringing the brand to India), but that is a small part of the story; the real success will come from brand positioning and from the acquired technology & intellectual property being applied to Tata Motors wider business. At this point in time, I do not believe Tata Motors has successfully leveraged the acquisition in any manner.

Now for the good news! Tata Motors is part of the Tata Group which enjoys high investor confidence in India. The access to debt is good even during periods of distress. The ability to refinance means that Tata Motors can carry the high level of debt embedded in its capital structure. Even through this crisis, Tata Motors has been able to refinance debt & improve its debt maturity profile; there is no reason to expect this to change. This is very important; it means that a dilutive capital raising exercise will not be necessary during a period of distress when shares are deeply under-valued. Any capital raised to pay down debt and improve the capital structure will be an active management decision. Improving the capital structure is something I believe is both highly desirable and inevitable. Access to incremental finance will be required to drive growth and capture higher market share and the management will ultimately recognize this; an effectively managed company will face a compelling force which will draw it towards a responsible capital structure consistent with good business practice. In my view a responsible capital structure will maintain a net debt to net debt to equity of no more than 30%. Incremental long term debt can then be accessed to drive the net debt to net debt to equity to a 50% level; but this incremental debt should be productive & profitable debt – that is debt undertaken to drive sales growth through the financing of vehicle buyers in the consumer and commercial segments.

My view as expressed in the prior paragraph is supported by Tata Motors recent and successful capital raising exercise. Tata Motors raised $750 million; $375 through the issuance of global depositary shares, which valued each share at $12.54 (approximately Rs 580), and an additional $375 million from 4% coupon convertible notes (due 2014) to be converted at $13.48 (approximately Rs 625) per share. Share count at 31 March 2009 was 514 million; if all convertible notes are converted, the share base will rise to approximately 572 million – this is dilutive but it is an important first step towards improving the capital structure. After this transaction, I expect the net debt to net debt plus equity to improve from 86% to 74% assuming the hybrid notes are treated as equity. In my opinion this should be the first of further capital raising exercises to be conducted as confidence improves and the share price strengthens.

Disclosure: Indirect Long Positions in Tata Motors

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Infosys – Is it Over valued?

India has four Dow Global members. These include Reliance Industries, Tata Steel, Bharti Airtel and Infosys. In this post I want to cover Infosys which reported earnings earlier today.

Infosys is a core long term holding for any global portfolio. But valuation is an issue; and it is something which must be borne in mind.

Please visit "The Quant Report" and link through to the INFY report for a decade's worth of historic data and the various valuation metrics applied in arriving at below referred indicative out values.

Between the year ended 31 March 2000 and 31 March 2009, INFY has delivered annualized earnings growth of 37.91%. By end March 2010, annualized earnings growth since 31 March 2000, is expected to have fallen to 32.63%. Dividend growth has been even stronger with a dividend growth rate of near 41% annualized expected between the year ended 31 March, 2000 and 31 March 2010. Payout ratio has run at a median rate of 15.17% between the year ended 31 March, 2000 and 31 March 2009 and are expected to rise to just below 20% by end March 2010 – the dividend is safe. The balance sheet is unleveraged and the management is top quality.

PE ratio (Annual Average Price / EPS) for Infosys has run at median levels of 34.7 between the year ended 31 March, 2000 and 31 March 2009. PE 6 (Annual Average Price Divided by Median 6 Year EPS) has run at median levels of 71.32 during the same period. However, the multiples have dropped dramatically in recent years; during the year ended 2009 it was down to 14.72 and for the present fiscal year to date, it is running at 18.

The historic multiples were high and investors must bear in mind that Infosys has grown from $0.12 in earnings to over $2.10; growth at these levels going forward will not be as easy. With lower growth expectations, I would be a mistake to look for median reversion on multiples. Growth has numerous challenges; firstly IT Services is intensely competitive and the competition is intensifying; secondly the financial services, a key user of IT services, has been badly hurt by the implosion of the debt bubble; thirdly outsourcing and off-shoring is and is likely to become more politically unpalatable; finally the telecom sector, another major market for IT services is going through pain of its own in terms of growth expectations.

There is an added problem, India's IT services face high inflation and Rs cost pressure on input costs; at the same time outputs (revenue) are derived from states with lower inflation rates. What this means is margin pressure. Furthermore, with India's demand for capital, demand for Rs is elevated and this leads to an expectation of a strong Rs. Because revenue is $ denominated, a strong Rs leads to slow top line growth in Rs terms; and that is a great dampener on valuation. Slow top line growth in an era of rising input costs adds even more margin pressure; in addition a strong Rs makes competition in US more challenging.

There is a lot Infosys has done and will do to mitigate these risks; they can be expected to improve productivity and continue making productivity gains; they can move staff closer to customers & hiring locally (diversify their input cost base); they can diversify their revenue stream and reduce dependence on US (India is a huge growth market for IT services & gains in Europe are very likely). But the fact remains that there are challenges to growth which lie ahead.

I am working with a base case scenario which will allow INFY to grow earnings at 12% annualized going ahead. The calculated multiple an investor should be willing to pay for 12% long term earnings growth, 16% investor long term return expectation and a P% payout ratio is 16.8. For P% we use the median payout ratios over the last 10 years, or 40% if higher. Based on this the value we can expect by 2014 is $41; the share price trades at near $50 today. If we reduce the investor long term return expectation to 14%, a multiple of 33.6 would apply making for a price target of $82.50. If we reduce the investor long term return expectation to 15%, a multiple of 22.4 would apply making for a price target of $55. In my view, a reasonable valuation range for INFY is $55 to $85 by 2014.

Through this crisis the stock traded at a low of $21; this is 20% over my estimate of 2009 fair value; this indicates the very high quality of the holding. Because of the stock quality and its place as a core holding for long term investors, I would add positions at $35 and look to accumulate if it falls towards $30. Infosys is not a share I would recommend selling simply because it got expensive; this share is best held for the long term.

Disclosure: Long Infosys.

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Bharti Airtel is a Must Buy

Please visit The Quant Report and link through to Airtel's Mini Quant Report for data on which the comments below are based.

During the years ended 31 March 2009 to 2004, Bharti has delivered earnings of Rs 22, Rs 18, Rs 11, Rs 6, Rs 4and Rs 37 for a six year average of Rs 10 and a six year median of Rs 11. The company does not pay a dividend as it has had high capex demand for future growth; it has also exploited a wonderful growth opportunity delivering annualized growth of over 40% during the five year period.

The question that arises is can they continue to deliver this level of growth? And to be honest, the answer is no. However, this is a smart company. It is included in the Dow Global together with Reliance Industries, Tata Steel and Infosys; its management is impeccable.

The big question on mobile phone companies is: Where will the growth come from once everyone on Planet E has a mobile? The answer to this question becomes even more pertinent when you consider the intense competition which puts incredible pressure on revenues; this in turn hurts earnings growth expectations. I share these concerns; but I think it is way overdone. Ultimately, in my view the communication revolution has just begun; it is not ending, it is only just beginning. And mobiles will have a major role to play in the revolution; "services in your hand" is a huge potential growth area.

Think of it this way; in India, the government has embarked on a major project to create a unique identification (UID) for every citizen. This project is led by Nandan Nilekani; the ex CEO of Infosys. It is a huge project, getting over a billion people identified has to be huge. The present intention is to use mobile phone networks as the first step in creating the UID. You see there are over 700 million mobile subscribers in India, so it is a good place to start. The mobile operators have a massive network of consumers waiting to be monetized; so far the networks have been monetized only using voice and data services. Eventually, the mobile operators are in a unique position to monetize the network; but to do this the emphasis must change from voice and data services to the broader consumer services segment – this is where the growth will come from and the potential is huge. There are so many on hand consumer service applications. Already money can be wired using an SMS; a check payment can be issued via mobiles; videos and music can be downloaded onto a smart-phone – the mobile operators need to take the initiative and profit from this potential instead of leaving it mainly to the smart-phone manufacturers. As of today, mobile service operators profit from data and voice charges associated with the value added services; but in truth, they need to re-invent themselves to transition to a broad consumer services provider instead of a voice and data services provider. The most innovative networks shall emerge big winners. The future is wide open; tomorrow perhaps it will be possible to use your mobile as a credit card; the day after could it serve as your passport? Would you like to carry your biometric data on your mobile; perhaps a global travel visa, with strong inbuilt biometric security features is something needed in this increasingly dangerous world.

The game is open wide for the best innovators and in my view Bharti Airtel is the global leader in this area – it is possibly the only mobile operator who has recognized that it is not a mobile service provider but a consumer services provider.

Okay, so can Bharti manage long term growth of 12% annualized going ahead. My guess is without a doubt; this rate of growth is no more than real GDP growth in India plus long term inflation. Targets of 500 million users are in place for India; that is up from 300 million presently. While Bharti will face competition more intense compared with the past, they are well placed to take a sizeable chunk of the incremental market.

Put it this way, if we cut off Sunil Mittal's right arm; stitch his right toe to his left ear, while piercing both ear drums; blind him in both eyes; brand his lips so he tastes no more; lightly grill him all over so he loses his sense of touch - and then wait & watch, we will find he will use his sense of smell to achieve 12% growth easily!

As investors what should we pay for this great company? In my view, Rs 310 is an excellent entry price; chances are it will not get there – I would buy Bharti as a long term core holding at anything below Rs 350. The Rs 310 entry price is suitable for an investor who has (a) a long term return expectation of 16% and (b) a growth expectation of 12% and (c) an eventual long term payout of 50%. In my view the worst we will see for Bharti at the next cyclical bear is Rs 271 as a bear value and a fair value of Rs 440.

Disclosure: Long Bharti Airtel

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India Real Estate

Affordable housing became a big buzzword amongst the real estate industry in India. It is not going to go anywhere. With per capita GDP where it is, the buying power is low; even with wide disparity in income, it is a matter of decades before housing can become affordable. At present affordable housing will end up meaning big compromises on space and quality; that is not something the few buyers that exist will be interested in.

Residential real estate in India needs to have the nexus between brokers and builders broken; at present it is mainly a ponzy scheme driving up prices and leaving the few genuine buyers over paying by far. This can work for a short while, but it will be a disaster in the long term.

There is a better model. But it is probably a bit too clean for this dirty business. Housing is not affordable to the public at large. However, income disparity means that there is a significant pool of investable money which could be attracted to real estate. There are others who might no be able to afford a house; but might be interested in owning part of a house. People lack capital to pay down; the interest rate risk coupled with employment risk is high too. But where there are people who do not own property, there are renters.

What builders need, is long term money for investment in residential real estate; a simple REIT format should work. Look at it this way; for $60 million, I could probably buy a self contained residential development of 300 homes in Gurgaon. I could rent these units at an average of $6,000 per year; that is $1.8 million for the complex. About 25% would go towards mainting the units in immaculate condition. The rest is investor yield; a 2.25% yield is not bad considering the capital appreciation potential.

If we assume rentals rising at 6% per year and assume real estate prices will rise in line with GDP and inflation for a total of 12% per year, an unleveraged investor could look for an annualized return of near 13.5% over 20 years. An investor with leverage of 30% initial property value, borrowed at 10%, could expect near 14% in annualized returns over 20 years; however, the rental yield would go towards pay down of debt. An investor with leverage of 30% initial property value, borrowed at 10%, could expect near 17% in annualized returns over 20 years; but again rental yield would go towards paydown of debt not for investor returns. A 12% annualized capital appreciation is very reasonable; chances are it will be higher if the location is chosen with care.

The key is to have availability of capital committed on a long term basis; where is the long term money when investors of today run for the hills at the first hint of trouble! Today's world has a major problem in that the quality of capital is weak, very weak. People lack commitment; people lack confidence and people lack character; frankly it disgusts me.

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An Ode to Pepsi

In 1994 you were finally mine. But then as I aged, you remained young. You were too fast for me; I could not keep up with the pace. By 2000 our value systems bore no resemblance and we parted ways; you represented growth, I value. Since then, I have watched you grow; I have yearned for you; I made a mistake, will you ever take me back?

Pepsi is what I see as a classic mistake I made. I bought the share during 1994 and exited during 2000. I am a cycle investor; but I tend to book capital and let the profits ride. For Pepsi, in 2000 I took a full exit and I lost a great company, with good defensive characteristics, which help limit the pain during cyclical contractions. In 2000, the stock had gone as far as it would; I had a rock solid profit; I felt I would buy it back at a good value later. I patted myself on the back until early 2004, the stock went nowhere; but it never came to a level which I considered good value; and I never buy unless I see good value. The lesson I learned was that while cyclical stocks (typically stocks in financials, discretionary, energy, materials, industrials and IT sectors) will almost always reach what I define as fair value, during the course of an economic cycle; defensive plays in (typically stocks in staples, utilities, healthcare, sectors) will make you wait much longer for a value entry point. Once you buy a good defensive at great value, it is worth holding long term, instead of trading it through the cycle. Not being able to buy it back later in the cycle, might cause a deterioration in portfolio quality; and for defensives, the higher the quality the better the defense characteristics.

I have been watching Pepsi with intent since 2000, I am still waiting. I am patient, but my patience wears thin. I think I missed an opportunity when Pepsi traded in the late $40’s earlier this year; I missed it because it was still higher than what I call fair value. I did not get a chance to look specifically at PEP because, it never fell to fair value - I was more focused on acquiring cyclical stocks; and strangely enough, several defensives, gave good value opportunities as the market got hammered.

Please visit "The Quant Report" and link through to the PEP report for a decade’s worth of historic data and the various valuation metrics applied in arriving at below referred indicative out values.

Pepsi is an exceptionally well managed company. It has a great portfolio of products and access to all major growth markets; both in terms of product and in terms of geographically. Since the year ended 1999 through the year ended 2008, earnings grew at an annualized rate of 11.25%; dividends grew at over 12%. 2008 was a trough earnings year for Pepsi as earnings fell from $3.34 in 2007 to $3.21 in 2008; during 2009 earnings expectations are at an achievable $3.6. The six year median earnings have also grown at a stable rate of over 11% annualized. The year on year change in earnings has been strong with median earnings growth rising at over 11%; this stability in earnings is remarkable; since 1999, the year on year change has been negative only during 2003 and 2008. On The Quant Report, on a cycle basis, Pepsi earnings expectations for 2009 are shown at normal risk levels; a low risk level would be indicated if earnings expectation for 2009 were more than 1 standard deviation below median levels and a very low risk would be indicated if earnings expectation for 2009 were more than 2 standard deviation below median levels. High/Very High earnings risk would be indicated if earnings expectation for 2009 were more than 1 and 2 standard deviation above median levels. For 2008 and 2009, earnings risk is rated as high and very high, but these can be ignored because history suggests that Pepsi has been able to deliver consistent earnings growth over long periods of time – as a consequence it is unlikely that a single or forward year will ever indicate normal or low earnings risk levels.
Pepsi’s dividend provides a yield of 3% with a payout ratio of 48%; this compares with a long term median payout ratio of just shy of 38%. In my view the dividend is safe. There is less scope for dividend growth at the same pace as historic dividend growth rates, until earnings growth reduces the payout ratio to levels consistent with historic median levels. We would need to see earnings hit near $4.7 before high growth in dividends can be expected to resume.
I love this stock and I hate it too; it has tested my patience too long and has pushed me to a point when I am desperate to buy. On the rare occasion, I do buy in desperation, but the relationship has not always been a happy one.

I would gladly buy PEP at $38; but I doubt that price point will be achieved; $45 would have been a good entry point, but I missed it. I would buy at $51, but even that seems unlikely. I expect the share to trade at $70 this year and $80 next year. By 2014, in my view the stock should trade at $110. Buying at $60 would give a return expectation of near 13% plus the dividend. This is good, but below what I can expect from cyclical opportunities. But I want some defense soon; so I might buy anyway. I am undecided; but if the stock trades down to $51, I will buy; $51 is my estimate of Graham’s intrinsic value.

Disclosure: No holdings.

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Reliance Industries Bonus Issue

Please visit The Quant Report and link through to Reliance's Mini Quant Report for historic and forward looking data.

Reliance announced a bonus issue of 1:1. Dividends were declared at Rs 13 per share. Whats changed?

During the years ended 31 March 2009 to 2003, Reliance has delivered earnings of Rs 103, Rs 135, Rs 83, Rs 68, Rs 54 and Rs 37 for a six year average of Rs 80 and a six year median of Rs 75.56. During this period dividends have been Rs 13, Rs 13, Rs 11, Rs 10, Rs 7.5, Rs 5.25 for a six year average of Rs 10.50 and a six year median of Rs 9.96. The long term payout ratio is 12.5%. Based on the long term payout ratio of 12.5%, a long term growth rate of 12% (in line with India long term GDP + Inflation expectations), I would value the stock at Rs 1,850 for an investor looking for an annualized return of 16% per annum.

Why the excitment about the bonus? After all if a company has 100 shares in issue and has a market cap of 100, it is worth 1 per share. Double the shares to 200 and all that happens is that shares become worth 0.50 each. But a bonus does have some interesting implications.

The first is that halving of the share price will make it more liquid; this tends to attract more buyers and results in stronger prices.

The second is that in India, normally the dividend per share is not cut following a bonus issue; which means the yield doubles. Suppose the Pre Bonus Share value is Rs 2,000 with a dividend of Rs 13. Post bonus you have 2 shares worth Rs 1,000 each with a total dividend of Rs 26. So thats an improvement.
Thirdly is understanding what the company is implying with the bonus issue. What Reliance is telling us is most interesting; it is saying that we expect a dividend of Rs 26 (per pre bonus share) to reflect a payout of 12.5% over the long term; they are expressing confidence in achieving median earnings over the next cycle of Rs 208. Now this is big news; if they achieve this, 6 years out Reliance shares could command a value of Rs 5,096 (i.e Rs 2,548 post bonus value); that is the value based on the long term payout ratio of 12.5%, a long term growth rate of 12% (in line with India long term GDP + Inflation expectations), for an investor looking for an annualized return of 16% per annum.

What the bonus means can differ for people. Some might view it as Reliance saying there are limited growth opportunities and so we are raising our long term payout ratio to 25%. My own view is that Reliance will maintain its 12.5% long term payout ratio; the journey for Reliance lies ahead not behind the company.

I would rate Reliance a strong long term buy and persons other than buy and hold investors, can look for an exit value of over Rs 5,000 by 2014.

Reliance Industries Ltd Sponsored 144A Gdr equals 2 shares in Reliance Industries. It is lightly traded on the pink sheets and for that reason, it is not a GDR I would recommend to anyone other than a buy and hold in perpetuity investor. However exposure to the stock can be acquired via ETF's which have considerable exposure to RLNIY; and of course non resident Indians (NRI's) can buy the shares directly on the Indian National Stock Exchange or the Bombay Stock Exchage.

Disclosure: Long Reliance

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Alcoa Reports

Alcoa reports today. Please visit "The Quant Report" and link through to the Alcoa report for a decade’s worth of historic data and the various valuation metrics applied in arriving at below referred indicative values.

It’s been an interesting decade for Alcoa. Between 1999 and 2007 earnings per share grew from $1.41 to $2.95, dividend grew from $0.40 to $0.68. Strong commodity prices supported by growing demand from emerging market and a healthy construction and automobile sector were the key factors in explaining the underlying growth. Then in 2008, the bursting of the debt and housing bubble caused demand for automobiles, aircraft and construction to collapse. Commodity prices collapsed with a massive flight of capital to safety. Alcoa saw 2008 earnings collapse to $0.28 per share; for 2009 my estimate calls for a loss of $1.1 per share. Dividends were slashed to $0.12 per share; the situation was ugly. And the share price responded and traded at under $5 in the recent past.

I like Alcoa at its present valuation. It is a cyclical stock, its present valuation is based on a single years performance which is crazy. The construction and automobile segments are now bottoming and while growth might not be huge, growth there shall certainly be. Aircraft demand will pick up with rising defence demand; furthermore BA's Dreamliner and demand from EM's, will trigger future growth once credit growth resumes. In addition, commodity prices are rising again; the demand from emerging markets has not disappeared. In my view Alcoa is capable of generating long term cycle earnings of at least $1.48 over the coming economic cycle; this number is the median 6 year EPS. In truth, I expect median 6 year EPS to be closer to $1.64 by 2014; but I will go with the lower estimate.

Using $1.48 as long term earnings, Ben Graham would have calculated an intrinsic value of $26.64 and a buy target of just over $9. Using a modified Gordon's Dividend Growth model gives a valuation of $15.61. So on valuation I rate Alcoa high. Once earnings visibility improves and confidence in growth rise, the share price should rise too. I would look to book profits at $24 and exit positions at $31.

Over the years, Alcoa has tended to go with a dividend payout of about 40%; so I do expect significant dividend growth once earnings grow and debt is cut. Their debt is at uncomfortable levels; in my view a debt to debt plus equity ratio of over 42% is unhealthy; but the company has acted to repair the balance sheet - over time a return to a more sensible debt to debt plus equity ratio of 30% will be welcome.

Disclosure: No positions.

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Sensex Valuation

Between the year ended 31 March 2000 and 31 March 2009, the Sensex has delivered annualized earnings growth of just under 14% and a dividend growth of a similar amount. The six year median earnings growth has run at an astonishing 28.91%. Using 31 March 2010 estimates annualized growth rates have been solid at 14.77%, 13.19% and 26.35% for earnings, dividends and six year median earnings respectively.

If you had invested Rs 100,000 in the Sensex at average prices which prevailed during 2000, and re-invested dividends at average prices during the year of dividend receipt, today your portfolio would have been worth Rs 428,906; in addition you would have had a dividend income stream of Rs 4,666 per year. Rs 4,666 is more than you would earn of a fixed deposit of Rs 100,000 post tax today and your initial investment would have multiplied 4.29X; that is a rock solid performance.

Earnings expectations indicate that the year ended 31 March 2009 was a trough earnings year. During the year ended 31 March 2010 earnings are expected to rise to Rs 874 which is up from the prior years earnings of Rs 765. With long term GDP growth of 6% and inflation running at similar level, corporate earnings can be expected to grow at a long term rate of 12% per annum.

The financial crisis caused by the bursting housing and debt bubble in US led to massive risk aversion and drying up of liquidity. The risk aversion is now abating and liquidity is starting to return to markets. A crisis of the size and intensity will leave a nasty hangover; in all probability the multiples seen at bullish extreames during the past decade will not recurr.

During the year ended 31 March 2000 and 31 March 2009, average PE's ran at 17.5X earnings, while median PE's ran at 16.5X. During the the year ended 31 March 2000 and 31 March 2010, PE 6 (annual average price divided by 6 year median EPS) ran at median levels of 28.83X. So despite calls of over-valuation, there is considerable money on the table. Earnings estimates for 2010 are average in the context of the forward cycle expectation so the earnings risk on a cycle basis are at normal levels. Performance in line with the past decades is indicative of a normal valuation of 34,754 by 2014 with rises to 40,551 on bullish extreames. More conservative valuation measures are indicative of targets of between 20,252 and 27,002. In my view a 2014 target of 27,000 to 34,500 is very likely. On a 12 month basis there is a strong case for significant upside from where we are; I would look for at least 19,354 by end March 2010 and for 22,212 sometime during the following 12 months. Of course none of this will occur if risk aversion returns; what needs watching is liquidity flows and the US economic recovery. Other risks include drought impact of rural India, which is in my view unlikely to cause huge downside risks as of now; the risk of early interest rate rises looms, in my view moderate (not aggressive) rising interest rates are a long term plus as it is indicative of a return to economic health.

The bad boy to watch out for, is India losing competitveness as a global market, as a result of loss of investor post tax returns - there are good changes in the new tax code which seek to eliminate tax abuse; but coupled with bad tax policy of taxing foreign gains in India, may result in drying up of liquidity flows into India. I expect to see first signs of nervousness in Q1 2010 because it is likely that the budget will drop securities transaction tax, which will lead to long and short term capital gains coming within the tax net. In Q1 2011 (or earlier - depending on when the final version of the new tax code is enacted), the response could be more severe. It is sheer foolishness to assess capital gains tax on passive foreign investment in India - no developed market does it - not the US, not the UK or other West European countris, not Australia, not anyone with an ounce of sense. Foreign pension funds & investors who enjoy tax exempt or tax defered status in their home jurisdictions, are not going to be amused about losing money to taxation in India. Other emerging markets including China, Brazil, Russia will gain in relative attractiveness versus India and the impact on funds flow will be high; this slowdown in liquidity can have an adverse impact on valuations. Keep in mind that valuation can have a significant impact on the real economy - strong valuations allow corporates access to cheap capital. What I find really disappointing is that the statement that India has grown not because but inspite of the government remains true. Why, why must we cut our legs at the knees just as we stand up?

Nonetheless, India remains an attractive market; reduced liquidity may cause low valuations short term; this would be a buying opportunity. Long term valuations might not rise to bullish extreames seen in the past; but is that a bad thing - even using normal value levels as bull targets for the next cycle allows for significant capital appreciation. Growth might slow due to lowered access to equity capital, but the impact is unlikely to be more than 0.5% of GDP; and it might even lead to better managed growth and less volatility. In consideration of this risk, I would reduce overweight positions back to equal weight at 18k levels, using significant pullbacks to increase overweights; keep in mind that pullbacks caused by what is viewed as bad policy can be severe in the short term; but once the disinterested liquidity is gone, markets will return towards normalcy fairly rapidly.

In my view global economic risks to the downside remain; but these risks will likely be 15 months to 18 months away - so far the crisis has been managed well - we need to watch for the first crisis management error to start worrying.

Have a look at The Quant Report (Sensex) for historic data and the various valuation methodologies applied in arriving at indicative out values.

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Thoughts on Inflation & Saving Rates

Inflation:

Capacity utilization is at multi year lows. This is indicative of low levels of inflation in future years. Offsetting this is the sheer size of liquidity which is indicative of rising future inflation levels.

One factor to keep in mind is that core CPI has been an area of focus for monetary authorities for several years. There is a high chance that CPI will remain elevated because of high and rising food and energy prices while core CPI remains subdued.

Ultimately, monetary authorities will need to respond to CPI and not core CPI. US discretionary spending is down; savings are rising. The part of house hold budgets dedicated to necessities (food) and energy has risen; the energy intensity of the US economy is no longer as low as it was. A low food and energy intensity economy can absort rising CPI provided core CPI remains low; but as food and energy intensity rises this is not the case.

To tackle rising CPI, a strong $ policy will be required ($ and commodities have a fairly inverse relationship). A strong $ will remain with elevated risk aversion and as the risk aversion fades, higher interest rates will likely be necessary.

All in all, I expect rising CPI with stable core CPI, coupled with interest rates rising earlier than most believe. Rising interest rates are good as long as the economy is growing at a healthy rate and can be expected to continue in that vein. What I hope for is that rising rates will elevate risk aversion; this elevation will strengthen the $, reducing the need for a Volker style rising rate cycle. And this will allow the economy to continue to grow; albeit at a slower rate compared with long term trends (i.e. below 3.5% real) - I would look for 2.5% to 3% over the next few years. At the same time, inflation can be expected to be moderately higher than long term trend (2.5%); I would look for 3.5% to 4.5% on CPI (not core CPI). So growth in nominal terms can be expected to continue at 6% to 7.5%, which is broadly in line with long term trends.

Saving Rates

Several observations have been noted about how US savings rates need to rise. In my view, US savings rates do need to rise and a rate of 7% to 10% will be healthy for the economy; to maintain savings rates once the economy resumes growth, unemployment starts falling and disposable incomes start rising will be the challenge.

There have also been comments on how savings rates in emerging nations such as India and China need to fall. This too makes sense. But expectations for falling saving rates needs to be kept low. Keep in mind that during 2009 the nominal GDP per capita in India is $1,018 per year; China is $3,185. Compare this to United States where GDP per capita is 44,721. India and China are rapid growth economies; but true prosperity at per capita level lies several decades away. As of now, staples carry a very significant proportion of household budgets - what gets left over is not spent on discretionary items, simply because what is not consumed today needs to be saved for "bare survival" in retirement. For savings rates to fall, it will first be necessary for GDP per capita to rise. I would look for per capita GDP levels of over $6,500 before a meaningful decline in savings rates can commence.

Even when looking at the so called purchasing power parity per capital GDP (which in my view are pretty useless), India and China have per capital GDP's of $2,780 and $5,970, compared with the global average of $10,415 - there is a long way to go before savings rates in poor emerging countries can rise; these economies remain poor no matter how influential their economies might appear because of the sheer size of their population.

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Is COP a Potential Multi-Bagger?

If you bought $100 COP at average annual prices prevalent during 1999 and reinvested dividends received over the years, by now the capital value would be $327.525 and you would have a dividend income flow of $13.634. Between 1999 and 2009 earnings have grown at an annualized rate of 12.48%; dividends have grown at 10.7%. The median payout ratio has run at just over 18% and while the expected payout ratio in 2009 is expected to be 53.71%, in my view the dividend is safe, provided that oil prices sustain at levels above $60. The company has exhibited exceptional ability to generate FCF ahead of its competitors which is supportive to the ability to maintain dividends through temporary disruptions in the market. At recent prices, the dividend yield is a healthy 4.2%.

The company also returned considerable value via share buybacks during 2007 and 2008. With the benefit of hindsight this might not appear to have been a great idea because the share prices peaked during these years; however, it must be noted that the share buybacks were conducted when PE ratios ran at between 6.7 and 7.84 which are indicative of good value.

The net debt to net debt plus equity is 33.34% which is somewhat higher than the 30% level I look upon as an acceptable degree of leverage. This level of leverage is understandable in the case of COP because of the 2006 acquisition of Burlington; furthermore the degree of leverage is acceptable, after considering that the company has exhibited exceptional ability to generate FCF ahead of its competitors - this is indicative of ability to pay down debt to lower levels fairly rapidly should the situation call for such action.

In my view, the energy sector has unrivalled strong fundamentals; you can read the reasons why on a prior post here. Over the coming years, I expect elevated inflation; furthermore, even if inflation as measured by core CPI is stable to restrained, the inflation levels measured including food and energy is likely to be high; even very high. The massive investment in drilling vessels during the past five years provides a better balance between drilling rig demand and supply; accordingly COP and other oil majors can expect lower levels of operating and capital expense inflation compared with the past five years. Even with nominal/low growth in production, COP is likely to deliver earnings growth at 7% annualized because of higher than inflation growth in oil prices coupled with comparatively lower operating and capex inflation levels. Keep in mind that I am not implying COP production will not grow; I am merely pointing out that their earnings can grow considerably even without production growth. COP's growth portfolio is high potential and well diversified across most major deep and ultra-deepwater markets (Gulf of Guinea, Brazil, US Gulf, West Africa (Angola) are amongst the most high potential deepwater opportunities available today) in the world.

My 2014 target price for COP is $140 with upside potential to $170; on an annualized basis that translates to a return expectation of 25% to 30%, excluding the returns which will be earned through dividends. I believe the company valuation has been punished relative to competitors, because COP's leveraged balance sheet does not compare favorably with the immaculate balance sheets of XOM and CVX. Nonetheless the company quality coupled with return potential make it my favorite E&P at present.

Please refer to COP on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings.

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CVX and Opportunity

If you bought $100 CVX at average annual prices prevalent during 1999 and reinvested dividends received over the years, by now the capital value would be $310 and you would have a dividend income flow of $11.787. Between 1999 and 2009 earnings have grown at an annualized rate of 9.8%; dividends have grown at 7.93%. The median payout ratio has run at just below 30% and while the expected payout ratio in 2009 is expected to be 66.50%, in my view the dividend is safe, provided that oil prices sustain at levels above $60; the balance sheet is strong which allows CVX to maintain sustainable policy unaffected by temporary disruptions. At recent prices, the dividend yield is a healthy 3.8%.

The company also returned considerable value via share buybacks during 2007 and 2008. With the benefit of hindsight this might not appear to have been a great idea because the share prices peaked during these years; however, it must be noted that the share buybacks were conducted when PE ratios ran at between 7 and 9 which are indicative of good value.

The net debt to net debt plus equity is a meager 5% which provides a strong balance sheet; this provides adequate resources to invest in growth.

In my view, the energy sector has unrivalled strong fundamentals; you can read the reasons why on a prior post here. Over the coming years, I expect elevated inflation; furthermore, even if inflation as measured by core CPI is stable to restrained, the inflation levels measured including food and energy is likely to be high; even very high. The massive investment in drilling vessels during the past five years provides a better balance between drilling rig demand and supply; accordingly CVX and other oil majors can expect lower levels of operating and capital expense inflation compared with the past five years. Even with nominal/low growth in production, CVX is likely to deliver earnings growth at 7% annualized because of higher than inflation growth in oil prices coupled with comparatively lower operating and capex inflation levels. Keep in mind that I am not implying CVX production will not grow; I am merely pointing out that their earnings can grow considerably even without production growth. CVX's resource replacement during 2002 and 2008 has been the best amongst all major E&P companies; in addition CVX has 40 projects where CVX's net share is in excess of $1 billion and a further 90 projects where CVX's net share is in excess of $200 million. Their growth portfolio is formidable; Agbami in Nigeria, Tengiz in Kazakhstan, Blind Faith & Tahiti in US Gulf of Mexico, Frade in Brazil and Tombua-Landana in Angola, all provide visible growth opportunities. Longer term, investments in Australia and a leading position in the US Gulf can be expected to provide sustainable growth. Their growth portfolio is high potential and well diversified across most major deep and ultra-deepwater markets (Gulf of Guinea, Brazil, US Gulf, West Africa (Angola) are amongst the most high potential deepwater opportunities available today) in the world.

Priced at $70 CVX is a good buy for almost every buy side investor; buy and hold investors, cycle investors, 12 to 24 month investors and shorter horizon investors can all expect good upside. The energy sector can be expected to start outperforming once the early cyclical (financials, materials, discretionary and industrials) have outperformed for six months or so. Energy tends to underperform during the last legs (say three months) of an economic contraction (early bull April 09 to June 09); the sector typically comes into strength three to six months after the end of economic contractions (expect end of recession July 09); so energy should start outperforming during q4 2009 to q1 2010. Now feels like a good time to buy.

My 2014 target price for CVX is $150 with upside potential to $180; on an annualized basis that translates to a return expectation of 16.5% to 20.8% excluding the returns which will be earned through dividends.

Please refer to CVX on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings.

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Vodafone

I am looking at Vodafone and I like what I see. Earnings have grown at an annualized rate of 21.8% while dividends have grown at 20.45% during the 1999 to 2009 period. Net Debt divided by net debt plus equity is 29.75% which is within my 30% extra due care required threshold. Operating cash flow is strong and growth in estimated free cash flow (EPS + Dep – Capex) has been strong growing at over 17% annualized over the past decade. The stock is yielding over 6% and is trading at a multiple of 8.21X 2009 expected earnings and 9.18X average 6 year EPS (including 2009 estimated EPS). This is cheap. The payout ratio is up at 58.7% which is considerably higher than the 44% median payout level which rand during 1999 to 2008; however I believe the dividend is safe provided buyback activity is kept on the backburner until EPS growth catches up with dividend growth. Vodafone has used buybacks as part of its strategy in returning shareholder value. In my view, the buyback plan has been particularly smart. The company used its shares as an acquisition currency when shares were trading high; during 2000, Vodafone shares traded at an annual average price of over $35. 2005 and 2006 saw significant buyback activity while the shares at a discount to intrinsic value. By the end of 2008, the company had bought back just shy of 15% of the shares outstanding at end 1999; it had done this despite issuing new shares to buy assets and earnings while its shares traded at a premium to intrinsic value; and then they turned around and bought back far more than additional shares issued on acquisition, while the shares traded at a discount to intrinsic value; that is smart.

The big question on mobile phone companies is: Where will the growth come from once everyone on Planet E has a mobile? The answer to this question becomes even more pertinent when you consider the intense competition which puts incredible pressure on revenues; this in turn hurts earnings growth expectations. I share these concerns; but I think it is way overdone. Ultimately, in my view the communication revolution has just begun; it is not ending, it is only just beginning. And mobiles will have a major role to play in the revolution; "services in your hand" is a huge potential growth area.

Think of it this way; in India, the government has embarked on a major project to create a unique identification (UID) for every citizen. This project is led by Nandan Nilekani; the ex CEO of Infosys. It is a huge project, getting over a billion people identified has to be huge. The present intention is to use mobile phone networks as the first step in creating the UID. You see there are over 700 million mobile subscribers in India, so it is a good place to start. The mobile operators have a massive network of consumers waiting to be monetized; so far the networks have been monetized only using voice and data services. Eventually, the mobile operators are in a unique position to monetize the network; but to do this the emphasis must change from voice and data services to the broader consumer services segment – this is where the growth will come from and the potential is huge. There are so many on hand consumer service applications. Already money can be wired using an SMS; a check payment can be issued via mobiles; videos and music can be downloaded onto a smart-phone – the mobile operators need to take the initiative and profit from this potential instead of leaving it mainly to the smart-phone manufacturers. As of today, mobile service operators profit from data and voice charges associated with the value added services; but in truth, they need to re-invent themselves to transition to a broad consumer services provider instead of a voice and data services provider. The most innovative networks shall emerge big winners. The future is wide open; tomorrow perhaps it will be possible to use your mobile as a credit card; the day after could it serve as your passport? Would you like to carry your biometric data on your mobile; perhaps a global travel visa, with strong inbuilt biometric security features is something needed in this increasingly dangerous world. The game is open wide for the best innovators and in my view Vodafone is.

In my view VOD is a buy for traders, investors with a 12 to 24 month horizon, investors who adopt a cycle view of 5 to 6 years and for buy and hold investors at prices below $25; prices at $17 are unlikely, but at those levels I would consider it a strong buy. A bullish price target of $57 by 2014 is not unreasonable to expect. The "normal" expected value of VOD is in my view $43-$45 by 2014; this is a small premium to forward fair value of $39.

Please refer to VOD on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings; with intent to buy a position fairly soon.

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MCD: What Are They Thinking?

When I read McDonald's (MCD) had increased their dividend, I almost fell out of my chair. The company has done a good job of increasing earnings over the years; about 10.72% between 1999 and 2009. The dividend has grown over 25% during the same period. It also has great international exposure, which is a driver of future growth.
The payout ratio is over 58% which compares with historic payout ratios of 28% at median levels over the past decade. What this means is that a lower multiple must be applied - if value is returned via dividends, the value delivered via capital appreciation must fall. The rate hike puts a lid on future dividend increases.
But gosh; how do they have the nerve to pay, let alone hike the dividend? Their balance sheet is so terrible; their net debt to net debt plus equity is up over 73%. What this means is any impairment of its assets will cause shareholder equity serious damage - and consider that 2.18 of its book value of $3.02 comes from Goodwill. In a rising rate environment this stock could suffer serious damage.
Their operating cash flow is decent and their ability to create free cash flow is good, so that's a positive; but because of its terrible balance sheet I would rate the stock a buy only at the very low $30's.
On valuation, I would not pay more 12X for a company with a dividend payout of over 58% with long term growth rates of 15%. I suspect MCD long term growth is closer to 7%/8% at which level I would refuse to pay more than 11.25X. And these are multiples where the company has a healthy balance sheet. With a highly leveraged balance sheet, I would not look at paying anything more that 8X-10X EPS estimates for 2009 (mine is $3.85).
Please visit The Quant Report and select the link to MCD at the bottom of the page for details on the numbers used in this post.
Disclosure: No holdings

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HMC a Buy on Pull-backs

HMC has grown earnings at negative 5.41% annualized between 1999 and 2008. By the end of 2009 the annualized rate is expected be negative 10.91%. When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the average year on year change in EPS for HMC during the 1999 to 2009 period was 5.22%; the damage to earnings was inflicted on HMC during 2008 and 2009; it is pretty clear that the stock as suffered as a consequence of the crushed consumer following the popping of the property bubble and debt bubble.

What is encouraging is how well they have held up in very poor industry wide conditions. HMC has grown dividends at an annualized rate of over 13% between 1999 and 2009. This is good, but the payout has risen to over 87.50% even after the 2009 dividend cut. Because operating cash flows have remained strong running at over $2 over the rolling 12 months, I believe the reduced dividend is safe, provided that 2009 is a trough year with a fairly robust recovery during 2010.

HMC uses a mix of dividends and buybacks to return shareholder value; the payout ratio including buybacks has run at a median of 20%. Unlike the vast majority of buyback programs, HMC's program is not disappointing; they have reduced share count by 7% 1999 and 2009 and they have purchased shares during 2003 and 2004 – years when the shares were trading cheap. Buybacks are good; they boost earnings growth and it offer a tax effective method through which continuing shareholders in effect reinvest dividends with no tax consequences. But they are also bad, because they remove choice; personally I would not re-invest dividends in a stock which was trading at a premium to fair value; I would prefer to pay the tax and invest net proceeds elsewhere. Buybacks only work well when shares are trading at a discount to fair values and I will never understand why companies buyback when shares trade at premium levels.

HMC has a reasonable balance sheet with a net debt to net debt plus equity ratio of 48.39%. This is well over my "normal" debt acceptance level of 30%, but frankly, for the industry, investment in financial services is essential to drive growth and maintain market-share. I am glad the balance sheet is not leveraged to over 80% as is the case in several US Industrials, because HMC's exposure is to lower quality consumer debt. Over-all I would consider HMC's balance sheet sound in the context of its industry.

The stock is yielding over 1%; which is not great. It is also trading at a premium on value relative to SP500 on a 2009 basis and the 6 year basis is in line; so HMC is not cheap.

HMC is a global leader in its space; I expect it to consolidate and increase share over the coming years. HMC's presence in emerging and lesser developed economies is a major plus because it provides access to growth markets. In developed economies, HMC can look forward to acceleration in earnings growth, 2008 and 2009 have been hard years; but eventually cars must be replaced – some recovery in 2010 is likely as consumers recover from the recession – 2011 can be expected to be even stronger. As a discretionary stock, HMC can expect to mark time during the first six months of an economic expansion and then outperform during the subsequent six months.

In my view the stock is a buy on weakness play; I would buy half of my intended allocation at $29, a further half if the stock falls to $28. The dividend yield together with capital gain potential to 2014 is attractive; I believe the scope for dividend growth from $0.35 presently is considerable and am looking for dividend to double by 2014. I estimate a bullish price objective of $58 for 2014; with a higher confidence lower target of $48.

Please refer to HMC on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings.

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An Opportunity Beckons at HD

HD has grown earnings at 6.62% annualized between 1999 and 2008. By the end of 2009 the annualized rate is expected to fall to 3.42%. When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the average year on year change in EPS for HD during the 1999 to 2009 period was 8.28%; the damage to earnings was inflicted on HD because of negative earnings growth during 2007, 2008 and 2009; it is pretty clear that the stock as suffered as a consequence of the popping of the property bubble. What is encouraging is how well they have held up in very poor industry wide conditions. HD has grown dividends at an annualized rate of over 23% 1999 and 2009. This is good, but the payout has risen to over 64%; not really a problem in that the dividend is safe, but it does hint at a slowdown in future dividend growth. HD uses a mix of dividends and buybacks to return shareholder value; the payout ratio including buybacks has run at a median of 40%. As with the vast majority of buyback programs, HD's program is disappointing; they have reduced share count by 3.35% annualized between 1999 and 2009 but they have purchased shares during 2004, 2005, 2006 and 2007 – years when the shares were trading at a premium to fair values. Buybacks are good; they boost earnings growth and it offer a tax effective method through which continuing shareholders in effect reinvest dividends with no tax consequences. But they are also bad, because they remove choice; personally I would not re-invest dividends in a stock which was trading at a premium to fair value; I would prefer to pay the tax and invest net proceeds elsewhere. Buybacks only work well when shares are trading at a discount to fair values and I will never understand why companies buyback when shares trade at premium levels. HD has a reasonable balance sheet with a net debt to net debt plus equity ratio of 30.26%. The stock is yielding over 3%; which is not bad. It is also trading at a discount on value relative to SP500 on a 2009 and 6 year basis which is indicative of further upside.

On the negative side; HD is not really poised to benefit from global markets as it does not have major outside US outlets – operations are primarily in US, Canada and Mexico with a small 12 store presence in China. In fact a weakening $ could pressure costs. Offsetting this negative, is my expectation that as housing in US bottoms HD can look forward to acceleration in earnings growth. As a discretionary stock, HD can expect to mark time during the first six months of an economic expansion and then outperform during the subsequent six months.

In my view the stock is a buy on weakness play; I would buy 1/3^rd of my intended allocation at $25, a further 1/3^rd if the stock falls to $23.50 and a final 1/3^rd if it gets to $22. The dividend yield together with capital gain potential to 2014 is attractive. I estimate a bullish price objective of $55 for 2014; with a normalized value $48.

The market is long overdue a pullback and this could provide a nice entry point for HD. A pull back will not occur while the majority of investors expect one. I do not expect any more than shallow falls while we work our way up to 1,120. However, once we reach 1,120, market valuations will be stretched too far and hopefully it will provide an 8% to 12% dip which can be used to accumulate high beta stocks.

Please refer to HD on the Quant Report for insight into numbers referred to above.

Disclosure: No holdings.

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JNJ Watch to Buy

JNJ is a great defensive play. The balance sheet is unleveraged, cash flows are strong; sector is defensive and not prone to cycle volatility. Earnings growth between 1999 and 2009 can be expected to come in at an annualized rate of 11.69%. During the same time, dividends have grown at an annualized rate of over 13%. Much to my annoyance, management used buybacks to return value during 2006, 2007 and 2008 while shares were trading at a premium to fair value; why do they do this?

Earnings have sailed through both the recessions without volatility of any significance or a hint of trouble. The stock looks cheap relative to the SP500 on a 2009 earnings basis; yet on a cycle basis, the stock is expensive – the stock PE 6 (Average Annual Price / 6 year average EPS) relative to the SP500 PE6 is at 1.09. The stock can weaken as investors pursue risk in the early expansion; $49 is an attractive entry price.

At present dividend is yielding 3.1% compared with a decade median of 2.1%. This should provide some support to downside as money chases risk for returns in the early expansion. The expected 2009 payout ratio is at 42.89% - moderately higher than median levels of 37% but still at a level indicating the dividend is safe as safe can be.

A 2014 price target of $100 to $120 can be reasonably expected. Together with the dividend; this provides a healthy long term return. More importantly, the defensive characteristics of the stock serve to limit portfolio downside risk.

Disclosure: No Holdings.

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Buy GE

Between 1999 and 2008, GE had grown EPS at 5.82% per annum. The 6 year average EPS grew at 6.48%. Dividends grew at 10.87%. Then came 2009; by the end of 2009, annualized EPS, 6 year average EPS and dividends were negative 0.67%, positive 4% and negative 2%. When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the median year on year change in EPS for GE during the 1999 to 2009 period was 7.02%; a single devastating year has caused the annualized growth rate to fall to negative 0.67%.

All in all, GE is a decent investment opportunity priced at $16. Industrials are a sector with some significant growth triggers coming from emerging market; GE is well situated to capitalize on that growth potential. The big drag on US industrials such as CAT, DE and GE is the degree of leverage. Each has a balance sheet where the debt to debt plus equity ratio is just over 80% because of their involvement in financial services. CAT and DE's leverage is effectively an investment in growth; they finance buyers of their equipment and profit from both the "industrial" business and "financial services business"; this is not something I like, because I feel they should focus solely on their core business and leave the financial business to financial institutions. Yet, it is acceptable because having the financial business as an option to buyers, does drive growth of the core business. In addition, because the sectors to which they supply are in fantastic fundamental condition, the credit risk is probably lower than most would like to believe. GE on the other hand has a financial business as a stand-alone core business; that I do not like; no I do not like it one bit.

For this reason, my feelings about GE are mixed. On the one hand I love their "Industrial" segment, I even like their media business, but on the other hand, I hate their "financial services" segment. Leaving aside my personal likes and dislikes, GE is very investable. Their balance sheet is much healthier than a few quarters ago. The dilution from capital raised during 2004 (for Vivendi) and 2009 (Crisis), net of buybacks (at peak prices during 2005, 2006 and 2007), has caused some dilution; share count has risen an annualized 0.75% between 1999 and 2009. This is disappointing, but far from the end of the world. Over-all, absent aggressive credit growth, which is only to be expected in a deleveraging economy, with potentially high real interest rates, EPS growth could be restrained during the coming years. But this is priced. In the very long term, in my view, GE can grow EPS at a steady 7% (inflation plus real). I expect 2009 earnings at $1 to be an earnings trough; using a 7% long term growth rate and an investor long term return expectation of 11% and a payout ratio of 40% gives a value of $16; a value where the stock is reasonably valued. However, $1 is likely the trough earnings figure; in my view there is a reasonable case that the 6 year average EPS will be at $1.81 (same level as 2008) by 2014. Using an investor long term return expectation of 11%, a long term growth rate of 7% and a payout ratio of 40% provides a 2014 price target of $29.05; this together with a dividend of $0.90 (based on a 40% payout ratio) provides a very good total return expectation.

To conclude, GE is a buy on valuation.

Please refer to GE on the Quant Report for insight into numbers referred to above.

Disclosure: Long: CAT, DE; No Holdings: GE.

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XOM is a Buy

XOM has grown earnings at an annualized rate of 12.75% since 1999; growth has been volatile with the economic cycle. Estimated Cash Flow (EPS+DEP-CAPEX) had grown at an astounding 28% annualized between 1999 and 2008. Dividends have grown at 7% annualized over the same period. The stock is yielding over 2.4% at present; this compares with median dividend yields of 2.61% over the past decade. The expected 2009 payout ratio is 42%; not low, but over the 31.88% median levels seen over the last decade – nonetheless it is not unreasonably high so the dividend is safe. The company returns value through a mix of dividends and buybacks; the buyback program is not smart – 2006 to 2008 were periods during which buybacks were in operation; years during which the annual average price was at high valuations; low buybacks have occurred while the stock traded at low levels early in the decade.

The balance sheet is very strong and unleveraged – this provides adequate funding for acquisitions and organic growth; XOM is a very smart buyer with immense skill in buying interests when valuations are sensible.

In my view there is potential appreciation to $140 to $180 by 2014. This translates to an annual return potential of over 15% excluding dividends with upside potential to a 20% annual return excluding dividend. Materials and Industrials have been outperforming in recent months; it is now time for energy to outperform in its place in the economic cycle. The current price level ($70), is an excellent entry level for traders, cycle investors, and for buy and hold investors; at this level XOM trades at a 30% discount to my estimate of the Graham Intrinsic Value and at a nominal discount to my estimate of fair value. The strength of the balance sheet adds significant defensive characteristics to what is primarily a cyclical stock and thus downside risks are in my view limited.

Please refer to XOM on the Quant Report for insight into numbers referred to above.

Disclosure: No Holdings.

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Coke

Coke has grown earnings at an annualized rate of 8.72% since 1999; growth has been stable and progressive with the economic cycle having little to no impact on earnings growth. Dividends have grown at 9.87% annualized over the same period. The stock is yielding over 3% at present; this compares with median dividend yields of 2.43% over the past decade; a reversion to median yields could come from price appreciation. The expected 2009 payout ratio is 54%; not low, but not unreasonably high so the dividend is safe. The company returns value through a mix of dividends and buybacks; the buyback program is smart – 2003 to 2006 were periods during which buybacks were in operation; years during which the annual average price was at $40 and below; no buybacks have occurred while the stock traded at a premium to intrinsic value during 2007 and 2008. The balance sheet is strong with a debt to debt plus equity ratio of just over 13%.

In my view there is potential appreciation to $75 to $80 by 2014. This translates to a return potential of over 10% including dividends. As money flow chases risk, the stock might under-perform and if it does, $47 is a decent enough entry point; though I'd feel happier at $44. $44 is a slight premium to intrinsic value and I believe the stock quality, stability and growth in earnings, demand the premium. In my estimation downside risks are limited to $36 level; this level can be attractive for bottom fishers.

Please refer to KO on the Quant Report for insight into numbers referred to above.

Disclosure: No Holdings.

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Wondering About Wal-mart

There is a lot to like about Wal-mart. It has brilliant defensive characteristics. When the broad markets are bearish, this stock tends to be less bearish at a minimum, with a high probability that the stock will rise as the broad markets fall. As Wal-mart approaches its bullish valuations it says; sell me & buy cyclical stocks. The other great thing about Wal-mart is that when it approaches fair and bear values, it says buy me and sell cyclical stocks. One of these signals helps you preserve wealth and the other helps you create wealth; both very important aspects of investing. You can read more about bear and fair values in addition to other valuation metrics on the WMT valuation report and User Notes on The Quant Report.

There is a lot more to Wal-mart than its defensive characteristics. Between 1999 and 2008 it had increased earnings at an annual rate of 11.5%. While 2009 has been a hard year, the annualized earnings growth at the end of 2009 is expected to be 10.9%. While the yield is 2% or thereabouts, the annualized dividend growth has been near 20% annualized; this is very strong. The dividend payout ratio is still low which leaves plenty of room for increasing dividends over the next several years. If you invested $100k at average annual prices in 1999, and re-invested dividends, today you would own 2,633 shares with a capital value of $133k and an annual income of $2.8k - better than a kick in the teeth keeping in mind what the broad markets have done. The stock is trading cheap vis-à-vis the SP500; the relative PE is down to 0.75; yet on a PE 6 basis it's not so cheap; the relative PE 6 is 1.27; that's not so good as it points to further downside assuming that we are now in a cyclical bull market at the very least. The beta equity over 1999 to 2009 is a low 54.6% which points to the stability in stock prices compared with the SP500; this is consistent with defensive stocks tendency to trade in a narrower band compared with cyclical stocks. The 1999 to 2009 earnings beta is an impressive 19.15%; this is a very low relative earnings volatility measure which reduces long term risk. Wal-mart also has an adjusted payout ratio after considering share buy-backs of about 48.5% at median levels. This is good as it indicates a company focused returning shareholder value; it is even better when you see when value is returned – Wal-mart is amongst the few companies what has bought back shares when the average annual share price was low – this buying support is probably why Wal-mart rarely ever trades down below fair values towards bear values. Their balance sheet is okay; debt (including lease obligations) divided by debt plus equity is at 35% which is high in my view – but it is acceptable considering the broad market, the company's ability to raise finance and the strong and stable operating cash flow.

To summarize, Wal-mart appears to be a good company; a great defensive selection. So what is the take on valuation? At just over $50, I reckon the share is trading over fair value and at Graham's intrinsic value. I put the next cycle bear value at just over $37; this is a level, I do not expect Wal-mart to reach as share buyback support will enter long before this stage. I'd be looking to buy into Wal-mart once its buyback program accelerates; I'd also be looking to buy if the market is at 1,120 level which is my expectation of a normalized market valuation; I would certainly buy if the market so much as dreams of coming to my bull value estimate of 1,492. At present there are better return opportunities amongst the cyclical, but I would certainly look at buying some defense if the stock trades down to $44 and would look at buying further positions if the stock hits $37.

Useful Links:

The Quant Report

User Notes

WMT Report

SP500 As Reported and Operating Earnings Reports; I am tending to follow Operating Earnings report but am willing to switch back to As Reported on the first hint of reversal in economy.

Disclosure: No holdings

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Finally Reliable Data to Assess Index Valuations in India

One of my biggest issues with investing in India has been the lack of quality quantitative historic data. While this has not changed, there has been a very positive development; the Bombay Stock Exchange has started publishing data which provides PE ratio's, Price to Book and Dividend Yield going back to 1991. You can view the data here.

I have published a valuation report for the Sensex and you can view it here. If you do read this report, it might be worth reading the two pages of notes on using the report. It might also be worth spending a brief moment reviewing my post on the math of multiples. If you do read it, if possible, please leave feedback (via comment) on the report as I am soon to launch a company specific value service for several Indian companies with sufficient longevity.

To summarize, the Sensex is trading in bullish territory based on prior year earnings. However, enough of 2009 is now behind us, which makes forming an expectation on 2009 earnings somewhat easier. Based on 2009 earnings expectations, the Sensex is trading very much within historic norms. With 2008 representing a trough earnings year, I am fairly confident of upside to 18,500 during 2009 (the market is presently trading at 16,216).For 2010 I am looking for a range of 16,700-19700-21,200; these are based on future expectations for 2009 and 2010.

There are a couple of unpriced risks (the monsoon failure and rising deficit are largely priced); the first is an early interest rate hike. Interest rates are low and the yield curve steep; with growth taking hold and CPI running at over 10%, I expect a rate hike by late 2009 to early 2010. The initial response to a rate hike could be negative; but on balance it is something I would welcome - when rates rise early in a new economic cycle, it means confidence in growth is high; that is good news. The second catalyst will be q1 2010 tax selling; investors will be wary about an elimination of the low securities transaction tax with a re-introduction of a tax on long term capital gains. If tax selling does not occur in q1 2010, I expect a dip post budget as it is very likely that the change will occur; such a move would be consistent with the new tax code to be introduced in April 2011; you can read a brief post on my views on the new tax code here.Both potential dips would be well worth buying into.

Disclosure: Long on Indian Stocks

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The Math of Multiples

Mathematics is a language; a number talks to you and as is the case with any language, you can understand what you will.

There have been a number of analysts commenting on high PE ratio's; many have commented on how the median PE since 1929 has run at 15 to 15.5; they go on to observe how the median PE ratios have climbed to 22 over the last 10, 15 and 20 years. They have then concluded that the market is over-valued because the PE ratio has risen over its historic norms.

You can have a high PE ratio and still have a market cheaper compared with a period when the PE ratio's were lower even where the expectations of long term growth and investor returns are identical. An investor gains from dividends and capital gains, the PE is useful in forming an expectation of the future capital gain potential.

Suppose you expect long term earnings growth to run at 7%. Suppose further you have a long term return expectation of 11%. You will derive your return from dividends and capital gains. The long term dividend payout ratio is 50%.

Your multiple is 1 *(1+G)/(R-G)*(1-P); where G (7%) is the long term nominal earnings growth expectation, R (11%) is the investor total return expectation and P (50%) is the payout ratio. The multiple of earnings you should be happy to pay is 13.375 (1*(1+7%)/(11%-4%)*(1-50%).

Now suppose you have identical growth and return expectations, but your long term dividend payout ratio falls to 40%. The multiple of earnings you should be happy to pay is 16 (1*(1+7%)/(11%-4%)*(1-40%).

Now suppose you have identical growth and return expectations, and the company ceases to pay a dividend. The multiple of earnings you should be happy to pay is 26.75 (1*(1+7%)/(11%-4%)*(1-0%).

In the above example, despite the difference in the PE multiple (13.375, 16 and 26.75), all markets are equally valued on a total return basis; there is no relative over-valuation simply because a PE ratio is higher.

To compare like with like you need to adjust multiples. If you take the 13.375 multiple and divide it by (1-P {50%}) you get 26.75, if you take the 16 multiple and divide it by (1-P {40%}, you get 26.75. And of course the 0% payout ratio value is 26.75.

The median PE 6 multiple since 1929 to 2009 has been at 36.95 assuming a 0% dividend payout. The 2009 multiple assuming 0% dividend payout is 28.70. In a historic context, the market is considerably under-valued; the market would need to rise to 1,300 to be valued in line with historic valuations.

The real question to ask is whether the multiple reflects realistic long term growth assumptions and investor return expectations. The Corporate Baa bond yielded 6.6% over the past economic cycle; during this period the 10 year treasury yielded 4.27%. Investors in equity can expect total returns of 9.6% long term; this 3% premium over the Corporate Baa bond which is broadly in line with historic performance of total shareholder returns. The long term dividend payout ratio at present is 40.5%. With the markets at 1,016; the long term growth expectation implicit in the present multiple is 5.91%. As confidence rises, a growth expectation of 6.7% would support a market level of 1,300. Even a subpar real GDP growth rate of 2.5% would make the 5.9% number achievable with an inflation expectation at 3.4%.

With several SP500 companies having significant overseas earnings, a real global GDP growth rate expectation of 5% plus 3.4% inflation would make nominal earnings growth of 8.4% possible; but if this occurs, expect higher interest rates and investor return expectations closer to 11%. This would support a market level of 1,475 assuming a payout ratio of 40.5%.

On balance, for this economic cycle, I believe a 7% nominal earnings growth rate expectation together with a 9.6% long term investor return expectation and a 40.5% payout ratio will take the market to near 1,450. After that it all depends on the long term outlook at that time.

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Despite Disappointing Results Buy Tata Steel – It’s Cheap

Please visit The Quant Report and link through to Tata Steel's Mini Quant Report for data on which the comments below are based.

Tata Steel is trading at Rs 430. It is cheap at the price.

Over the last five years, the average earnings for the company were Rs 75 per share. Before interest average earnings over the past five years was Rs 115 per share. We see this as at the low end of sustainable earnings over the next economic cycle, together with growth at 6% annually. We would be surprised if average earnings ex interest for the five years ended 31 March 2014 fall below Rs 150 per share. Depreciation is running at Rs 65 per share. Adding back depreciation, we have an expected average annual cash flow from operations of Rs 215 per share over the next 5 year economic cycle. This level of cash flow can be used to pay interest (Rs 54 per share) and dividends (Rs 16 per share) and leave Rs 145 per share to pay down debt (Rs 912 per share). In theory, the company could pay down all of its debt in less than 6 years.

Tata Steel shares traded at Rs 137 on concerns over its ability to access finance in an illiquid market. These fears were added to with a fear of dilution; a rights or public offering was seen as necessary for Tata Steel to repair its badly damaged balance sheet. Tata Steel's reputation has resulted in access to finance at reasonable prices. Yet the balance sheet is weak and in our view not consistent with best business practice. We believe raising new capital to pay down debt is both desirable and necessary. How would a rights offering work? Tata Steel has 656.7 million shares in issue and a book value at 3/31/2009 of Rs 422. Suppose each share in Tata Steel came with a right to acquire 1.2 shares at Rs 426; this would raise Rs 336.158 million which could be used to reduce debt; post acquisition the company would have a debt to debt plus equity ratio of 0.3 which is consistent with good business practice for a capital intensive business. Total shares in issue after the IPO would rise to 1,444.6 million and the book value per share would be close to Rs 424. Because of the new shares in issue, long term earnings expectations would come down to Rs 40 per share; the earnings ex interest of Rs 115 per share less Rs 23 per share (reduced from Rs 54 per share due to debt reduction) would translate to Rs 40 per share as a result of the higher share count. With Rs 40 in earnings coupled with 7% earnings growth potential, the Rs 16 dividend is sustainable; the payout ratio is not unreasonable at 40%.

Removal of the overhang of a weak balance sheet should do wonders for the balance sheet. In my view, a company with a sound balance sheet, with long term earnings potential of Rs 40 per share and a 7% annual growth potential, should have a fair value of Rs 535; this value is simply derived using a modified Gordon's Growth Model; we take the long term earnings at 50% as indicative of a notional dividend of Rs 20. This number is multiplied by 1.07 to take account of earnings growth of 7% per annum and then divided by 4% (long term return expectation of 11% less a growth rate of 7%). A mid 2014 forward fair value target would be Rs 900 (including dividends reinvested).

If the balance sheet stays leveraged, the risks will remain high; there is the risk of higher volatility in earnings as a result of the high interest burden, which adds stress in economic downturn. And the threat over the Company's ability to access finance in future periods of constrained liquidity will remain elevated. The sustainability of the dividend will also remain questionable because of volatility. As the risks are high, so too is the reward potential; without a rights (or other capital raising) in my view Tata Steel will be able to bring its leverage down to levels consistent with good practice in 3 to 4 years (most certainly by mid 2014) if it remains disciplined about cost control and limits major capex expansion plans. What will emerge by mid 2014 is a company with lower earnings volatility and no dilution of earnings and reasonable debt; the projected price target in such a situation would be closer to Rs 1,800 (including dividends reinvested).

I personally prefer the rights issuance route, despite the lower return potential, because I believe good business practice is something every responsible company must follow. Good financial discipline and business practice is synonymous with good governance, and good governance is the key to lasting success.

So despite the disappointing results, Tata Steel remains a buy at prices below fair value. Short term, Rs 428 is a decent entry level. Rs 407 is the next level to add positions at. If adverse sentiment prevails, and the market continues to decline accumulate further positions at Rs 342 and Rs 266. Since commodities tend to outperform following the end of recessions, I do not believe adverse sentiment will carry Tata Steel below Rs 407, though Rs 342 is not out of the question.

Long Tata Steel

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Bear Value, Fair Value & Bull Values!

I am an optimist, but I spend a lot of time on speculating on what pessimists might think. So far we have had major economic events which drove the markets downwards. We have had a significant rally of the lows and are in my view trading at a premium to fair values. Expectations are tending towards consensus of a subpar recovery, with significant risks to the downside. Most believe that we are in a cyclical bull within a secular bear market.

My own view is that we will have several years of subpar growth; but we have seen a generational low in the nominal index. Yet it is likely that we will see a lower low in the real index at the bottom of the next recession.

What would really surprise everyone is if the market went on to record new highs, and came in with a next cycle low, higher than the recent lows in both nominal and real terms. The market has a way of surprising everyone and since this outcome is the only one which would surprise all, it is something that needs to be contemplated. I told you I was an optimist!

Bear Value – 620, close enough to the 666 we saw

We saw SP500 dividends at the end of 2007 at $27.73. They had grown from $15.74 in 2001, which market the end of the prior recession. Dividends tend to be less volatile than earnings; the standard deviation between 2001 and 2007 came in at $4.61. With the severity of the crisis, a fall in dividend of one standard deviation is a reasonable expectation. A trough dividend of $23.12 was to be expected; but after that they could be expected to grow. The rate of growth I have assumed is 3.5% in real terms and 3.5% growth via inflation. An investor seeking a long term return of 11% for a dividend stream of 23.12 growing at 7% annually would be willing to invest 620.

A 3.5% global inflation expectation is not unreasonable with the amount of monetary stimulus which has been injected into the system. It is true that subsequent deleveraging will mean that the inflation is somewhat moderated, however, the pressure from global growth expectation in real terms of 4.9% annualized between 2009 and 2011 will act as an offsetting force. While post recovery growth expectations in the United States are expected to be subpar (2.2% to 2.8% range), the SP500 companies should benefit from globalization and participate in the higher real global growth rates of 4.9%; I do not see 3.5% real earnings and dividends growth as a challenging target.

Fair Value - 950

The six year average operating earnings at the end of 2009 is expected to be $71.32. To grow at a 3.5% real rate, no more than 50% of earnings would be required for re-investment. The remaining 50% is what I call a notional dividend. An investor seeking a long term return of 11% for a notional dividend stream of 35.66 growing at 7% annually would be willing to invest 950. Keep in mind that if a dividend is not paid, there is higher earnings growth coming from either reverse dilution due to share buybacks or from earnings growth from re-investment in profits; so it does not matter that the notional dividend is way in excess of the actual dividend.

Normal Value – 1,521

Most people do not invest at bear value or fair value as these events occur during periods when perceived risks are high. Most would invest at a premium to fair value and hope to gain as the market works up towards its normal valuation levels. The median 6 year PE between 1998 and 2009 ran at 21.3X 6 year average operating earnings. If the market trades at these levels during the next economic cycle, with an average 6 year earnings of $71.32, we could expect an index level of 1521. Using the bottom quartile 6 year PE between 1998 and 2009 would take us to an index level of 1,485.

Bull Value – 1,906

The top quartile 6 year PE between 1998 and 2009 ran at 26.73X 6 year average operating earnings. If the market trades at these levels during the next economic cycle, with an average 6 year earnings of $71.32, we could expect an index level of 1906.

Conclusion

The above normal and bull value levels assume that there shall be no growth in the 6 year average earnings over the course of the next economic cycle. As it happens, I expect the forward cycle 6 year earnings to come in at closer to 76. If this occurs, the forward cycle normal value would be 1,621. Using the bottom quartile 6 year PE between 1998 and 2009 would take us to an index level of 1,583. The forward cycle bull value would be 2,031.

In the cycle just concluded, the peak value of 1,566 was attained at median PE 6 levels; the multiples never did reach the bullish extremes of 26.73X at the top quartile. The peak was significantly lower in real terms compared with the prior cycle high. I can stretch my optimism only so far; I expect the next cycle to peak lower; the optimist in me looks for 1,485 at best; the realist in me is looking for 1,250-1,300. I speculate on a next cycle nominal low at 950; but that is too far ahead in time for now. And this is why it would not surprise me to see the market break 2000.

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Sentiment Data

The historic data tells an interesting story. Consumer sentiment rises from lows during the late stage of a recession. As the economy emerges from the recession, it is not unusual for sentiment to dip - it usually does. I think this is fairly logical. As the recession enters its late stage, leading economic indicators start looking upwards. As this occurs, the market rises and so does hope and sentiment. But hope lifts sentiment only so long. Unemployment is a lagging indicator and it rises past the end of a recession; as the rise continues, sentiment must be expected to decline, following its rise on hope. The fall in sentiment last week could well indicate that we have emerged from the recession. Sentiment should turn up after ISM starts rising and monthly moving average for initial claims stops rising.I view the dip as a final buying opportunity. There may well be better buying opportunities in future economic cycles, but for the present cycle, I think this is it for those who did not buy earlier!

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