Liberty Sirius (LSXMA/K)

Liberty Sirius closed at $30.19 / share on March 27th. Its main asset is 3.2B shares of publicly traded Sirius XM (SIRI). Since the start of the year, the  discount between SIRI and LSXMK has increased by close to 9 pts. (Courtesy: Yahoo Finance) Given the fact that LSXMK was trading at a discount at the beginning of the year, it is worthwhile to see the NAV discount that LSXMK is trading at.

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The key to note before we dive into the NAV calculation is that LSXMK financials consolidates SIRI as it holds over 71% of the shares outstanding. This is from an accounting perspective. In reality though, SIRI operates as a separate public listed company and the debt / cash are non-recourse at this point to Liberty Sirius Group or the Liberty Media group. The other way to think about it, the debt and the cash held at SIRI is at an operating company level.

Taking that into consideration, the NAV calculation shows a significant discount to the underlying asset which can be valued using market listed securities.

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There are four possibilities that could cause the discounts to be significant.

  1. The market is treating the SIRI debt as recourse to LSXMK and the given the higher level of debt at SIRI and deteriorating market conditions is discounting LSXMK further. This makes no sense because if that were the case, SIRI should be falling as well. Furthermore, SIRI’s FCF is good and the debt is at operating company level. This was shown clearly at the annual meeting. Furthermore, the churn during the last recession was actually much lower than people expect. It was in low single digit %.
  2. The market is assuming that given the drop in stock price, John Malone might pay a premium to buy Sirius completely. Given the disciplined nature of M&A that the Liberty complex has exhibited so far, that seems improbable.
  3. Ability to roll over debt in the near term (nothing alarming there)
  4. Since LSXMK is a tracking stock, the market has increased the discount considering the possibility of liquidation of entire Liberty Media complex with a deterioration for FWONK and BATRK.  Currently, there is nothing that indicates that FWONK or BATRK is impacted to the point of liquidation that will demand a 35% haircut on NAV of LSXMK.

It seems to be a case of the market discounting tracking stocks in general a lot higher in this environment. Time will tell.

Any comments on what I could be missing is welcome. contact@beowulfcap.com

Disclosure: Long SIRI and action expected in Liberty Sirius

 

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Managing downside risk in a downturn!

As value investors, a lot of us are starting to find the environment to be idea rich after a long time. Finally, the valuations are compelling, the companies we have researched are cheap, the war chest is ready to crack open, ready to be used. During such times, there are new risks that needs to be actively managed. While I watched the 2009 recession hunting for a job in the U.S, I did not live through the panic in the securities market during the recession of 2008/9. This is my first real test. There have been drawdowns in the past which have been sharp and never so deep.

One of the risks is through concentrated positions. A ton of wealth has been made through concentrated positions. 2-3 years from now, when the markets are back up (hopefully) there will be stories about investors who bought by the truckloads during the downturn and made a killing on some of the ideas. What won’t get said, are the ton of the people who got crushed during the downturn by investing in concentrated positions (2/3/4 positions) and the companies going to zero. Survivorship bias will exist in this regard. People recall Mike Burry a lot more than Bill Miller. It is highly preferable to give up some upside in order to reduce the chances of going back to Go on the board.

Here is where capital allocation and portfolio management go hand in hand. As much as tempting it is to back the truck into a certain securities and concentrate, a dose of diversification will prevent complete blow ups from happening. There are multiple ways this can be achieved. Buying a basket of stocks in a similar category, allocating a certain % to index funds, looking at preferred stocks, closed end funds, special situations etc. can provide other opportunities even in the securities space. Of course, this conversation here is limited to the securities space where we are finding bargains at this point. Other asset classes are not considered here.

Some of the steps that I am taking while managing through this downturn :

  1. Kept aside cash required to manage next 2-3 years + emergency cash even I were to lose my job.
  2. Had a clear plan written down on how portfolio management would happen in a 30-40% down market when I was clear and lucid.
  3. Diversifying more than usual while adding new bargains
  4. Baskets of stock in a similar story. Everything might not go to zero (unless my stock picking skills are similar to the CDO’s constructed by US banks a decade ago)
  5. Index funds / quasi index like Berkshire get a certain allocated % of the capital allotted
  6. The rules make is tougher and tougher to double down into the same ideas

I am very interested to see how this will pan out. While the ride has been painful, I am far from panicking yet. Just a pit in the stomach once in a while so far.

Piramal: Thoughts on current state.

Piramal closed on March 20th at a market price of INR 684 with a market cap of INR 15.4K crores. The shares outstanding as of Dec 31st was 20.45 crores with a dividend yield of 4%. Given the fall from grace the stock price has experienced, it will be worthwhile to examine both the liability side and the asset side and summarise what we know.

Networth:

  1. Company capitalisation and access to capital: A classic example of this was Yes Bank where they struggled to raise capital and the bad loans soured and the RBI stepped in. However, that is not the case with Piramal. With the recent cap raise and the sale of DRG, the net worth is estimated to be close to 34K crores or INR 1382 / share.
  2. DRG: Clarivate has confirmed that is has closed the DRG for $950M with a payment of $900M to Piramal Enterprises which amounts to close to INR 6K crores. You can see the link of Clarivate’s SEC filing here on March 2nd. We can safely assume that this INR 6K crores is available to Piramal for now. This is approximately 39% of the market cap of the company as of March 21st.
  3. The rights issue for INR 5,400 crores that the company executed in Jan was fully subscribed and the company has received the proceeds. It is important to note that the promoters of the company fully participated in the rights issue. This is another 35% of the market cap of the company.
  4. Less than 9 months ago, the company sold its stake in STFC for 2,300 crores.
  5. It is clear that the company has had access to liquidity from the stake sales very close to the market cap of the company today.
  6. In addition, the company has announced the monetisation of the Shriram stake, which is estimated to bring 7-8K crores into the coffers. However, it needs to be seen whether with the economy further deteriorating drastically and the Covid impact whether the Sep timeframe given by the management holds good.
  7. Furthermore, the company has announced that they are considering a stake sale of 20% in the Pharma business and the proceeds here will fund the further growth of Pharma and will ensure that any incremental capital is available for the financial services business.

Liabilities:

  1. The company needs to have the ability to roll over the debt or repay the debt over the next few months to a year while the economy suffers from both a prolonged real estate crisis and the impact of Covid.
  2. The company has moved from reliance on commercial paper and reduced the exposure from 18K crores 18 months ago to negligible amount as of Dec 2019.
  3. It has gone into longer term bank debt and bank funding has increased from 49% to 67% of the total borrowings. (See appendix A for points 2. and 3.)
  4. Recently, the company has accessed 1,900 crores at 9% per annum which provides further comfort that the cost of funding is coming down.
  5. What is even more important in my opinion is that the banks have had access to the books and have examined closely the assets of the book before lending to Piramal. This was confirmed by the management during one of the recent conference calls on March 12th. (Appendix B)
  6. The other thing that NBFC’s have to worry about is the ALM mis-match. Appendix 3 shows that close to 17K crores outflow is expected up to the next 12 months. Given the fact that they have close to 4.5K crores cash, Pharma generating proforma 1.5K crore operating cash flow over 12 months, capital raise and access to cash, high CAR of 32% before considering any payments coming from projects being refinanced or closed or the book run down, there should be a fair amount of comfort that the company will be fine in the next 12 months.

Asset Quality: The wholesale financing book is what seems to have scared the investors the most.

  1. The total finance loan book is INR ~51K crores. Housing finance is 6K crores, commercial real estate is 11K crores, CPG and ECL is 9K crores and the big chunk which is the residential real estate is 25K crores.
  2. So far, the company has reported only 1.8% GNPA and 1000 crores of provisioning so far. Again, given the recent experience with Yes Bank, the investors are being wary of companies that have exposure to stressed sectors but reporting very little GNPA and defaults.
  3. Firstly, it must be noted that, Piramal did not have any exposure to Yes Bank, Altico, IL&FS, DHFL, ADAG etc. which have gone bust. The fact that the company has dodged exposure to these stressed accounts indicate a certain level of quality of the book. Unlike Yes Bank, which had exposure to every stressed asset, Piramal seems to have dodged the bullet so far.
  4. In the housing finance segment, there is speculation that the government might provide some relief to MSME and non-salaried people towards EMI’s to help through the Covid situation. Hopefully, they will provide extended DPD guidelines to NBFC’s as well. Even if not, the GNPA’s might spike up. Unless Covid paralyses the economy over the next 6-12 months and things don’t get back to normal, the risk in the actual underlying defaults will be negligible. It must also be noted that the company has stressed multiple times that it is providing adequate LTV and security provisions in its loan book.
  5. The commercial real estate has not seen much stress in the last 2-3 years. Unless something new comes up as part of Covid and extended significant delays in construction, it would be fair to say that the commercial book will be fine.
  6. The corporate lending groups with its 9K crore book will see stress. We know that the Delhi Baroda truck financing with exposure of INR 75 crores is stressed. The Essel exposure from Piramal is close to INR 200 crores now. We should clearly expect to see more slippages from this and the GNPA shoot up over the next few months.
  7. The real estate wholesale financing segment is 25K crores. Piramal has run down close to 10K crores of the this segment over the last 18 months. The number of developers who were more than 15% of the net worth of the company has come down to 4 to 1. The one is Lodha.
  8. Lodha will have a INR 2500 crore exposure to Piramal by April.  A couple of positive developments. In the recent call, it was clarified that the capital under security for this loan is close to INR 6000 crores (Appendix D) Finished goods inventory is close to INR 2300 crores with another INR 1000 crores completing over the next 3 months. In addition, Lodha just tapped the capital markets to refinance and repay bonds. See link here. In addition, the last 12 months sales for Lodha was close to 7000 crores and continues to the largest real estate developer in India. While the current Covid shutdown and the resulting economic bumps might stagger payments, it is highly unlikely that Piramal will need to take a write down on  Lodha.
  9. In addition, it is worth noting that some of the accounts that Piramal has in stage 3 assets, they are moving to get the title of the lands and recover the loan. Easier said than done but the company has demonstrated that they can execute such moves well in the past.
  10. So far, the company has demonstrated that is can manage the risk and the recoveries from customers that it is lending to, have a low LTV ratio and a better than average risk monitoring system.
  11. It must be noted that no way does this mean that the loan book won’t sour in the near future or the stage 2/3 provisions will need to go up and more money needs to be set aside for provisioning, all we get comfort from is that the fact the management seems to have demonstrated reasonably well that it can manage the risk it is taking on.

Management: Understated in the market is what I call the Say-Do ratio of the management. Lots of companies make promises but it is execution that matters. Contrast the equity raising by both Yes Bank and Piramal around the same timeframe and the results each of them has had.

  1. Raising of capital through rights sale
  2. Completing the promise of bring in 8-10K crore equity into the business
  3. Reducing reliance on commercial paper. The management laid out the roadmap 12 months ago.
  4. Reducing reliance on exposure to single borrower names
  5. Piramal has put balance sheet strength over sheer growth reversing the earlier stance.
  6. The only con that I can direct to the management is the fact that they did not build a Fort Knox balance sheet from the start and had to go through several stake sales, cap raises (albeit at a premium to today’s stock price) to build a solid balance sheet. However, the management has shown that it will learn and correct mistakes quickly.

Unless it comes to light that the management is completely fraudulent, it is reasonable to assume that Piramal will weather the storm.

Valuation:

  1. The December end shares outstanding was: 20.5 crores. With INR 5,400 crores coming in at INR 1,300; approx. 4.2 more shares would be added. The total new shareholding will be at 24.6-24.7 crore shares.
  2. Total net worth at INR 34K crores or 1,382 per share and CMP is at 684 or 0.5 P/B.
  3. Total borrowings are at 50K crores.
  4. Enterprise value is at 64K crores: 50K borrowings + 14K  market cap.
  5. SOTP would be as follows (following Dec 2019):
    1. Shriram stake – INR 6-8K Crores
    2. DRG Cash – INR 6K Crores
    3. Rights issue – INR 5.4K Crores
    4. Commercial RE – INR 11 K Crores
    5. Housing Finance – INR 6K crores
    6. Pharma business – INR 15K Crores (@ 10X EV/EBITDA)
    7. Cash – INR 4.5K Crores.
  6. Sub-total of assets before residential RE and CPG/ECL assets is approx. INR 56K crores.
  7. The market is today valuing the INR 34K crores worth of assets at less than INR 10K Crores. It can also be reasonably shown that the INR 2.5K Crores to Lodha is reasonably safe. So, the market is valuing close to INR 31K crores of others at INR 7.5K crores.
  8. Depending on the risk appetite of the investor, it will open up interesting possibilities.

I am interested in your thoughts and comments. please mail me: contact@beowulfcap.com

Disclosure: Long several NBFC’s and Banks including Piramal.

Disclaimers: See FAQ here. Not a recommendation. Not a registered advisor. Just sharing my thoughts.

Appendix A:

Screenshot 2020-03-22 at 9.53.53 AM

Appendix B:

Screenshot 2020-03-22 at 9.57.00 AM

Appendix C:

Screenshot 2020-03-22 at 10.48.27 AM

Appendix D:

Screenshot 2020-03-22 at 10.22.57 AM

Market behaviour and its implications

Investing is easy but not simple. Investing can be skinned in many different ways creating possibilities that are extremely far off from each other yet produce similar results over the long run. Emotional equanimity through the process is a completely different animal with varied outcomes depending on the part of the cycle one is in.

While markets are largely efficient, it is just as often extreme in its views of certain sectors of the market. Either investors are completely enamoured by the business and its quality that they want to own it at any price and project the future with a lot of certainty that the underlying business might or might not possess. On the other hand, they completely shun some businesses and refuse to touch it even when the value proposition gets compelling. Couple this phenomenon with the narration bias where glowing articles galore on businesses that do well and doomsday articles on businesses that rile on businesses that are out of favour. This creates an interesting pond of opportunity as the market analyses the information fairly well but there are times when the market also struggles to separate the wheat from the chaff. Other times, the narration changes very quickly.

Let us look at a business that is viewed very favourably today by the market. Apple Inc. The market cap of Apple is $1.395T today and the shares trade at $318.31 as we speak. The PE is north of 26 and the dividend yield is just shy of 1% (Yahoo Finance)  The market is pricing in what is expected to be a strong holiday season sales; the subscription growth of Apple+, the newly launched streaming service last year; the AirPods pro launch and the upgraded iPhones; the 5G compatible phones that are expected to be released later this year. All are valid reasons and you can find several articles that dissect any of the above mentioned reasons and you can get a fairly good sense of the narrative. All in all, it is priced like a technology leader who relevancy is solid with a strong moat that will protect the business (at least for the next decade).

Rewind a year ago, the market cap of Apple was close to 50% of what it was today. Jan 21, 2019, Apple closed at $157.9 a share; a tad less than half of today’s price. In less than a year, the company has added close to $700B of market cap. Around the same time last year, the company was coming of a bad holiday season, profit warnings, gloom and doom articles appeared around how companies could bypass the App Store and even though Apple was better than RIM and Nokia, it faced an uncertain future in a technology driven market and was much better priced at a lower valuation like a declining business.

What a difference a year makes. In context of Apple though, it needs to be kept in mind that the market does not owe a down year just because it had a stronger than expected 2019. Nor does it mean that the momentum will continue forever either. Remember, the market is supposed to be largely efficient. Yet, the narrative changes quickly. This is why investing is simple but not easy. 8.2% of the entire S&P growth in 2019 came from Apple alone. Apple and Microsoft, accounted for 15% of the S&P growth. If you owned the market, you benefited largely from the technology growth of 2019 or if you owned Berkshire, the value of your holdings benefited from Apple (as the single largest equity held by Berkshire). If you were a single name investor and did not have the index or Apple or Microsoft in the portfolio or were not big into FAANG or technology in general, you had an uphill battle in 2019 to beat the market.

However, that was an easy one. If you are investing in the markets, you probably were aware of the Apple example. If you had to benefit from Apple’s massive run, you had to buy / hold the stock through some scary headlines. Just being contrarian does not work either. Every bankruptcy has been preceded with scary headlines. Differentiating the wheat from the chaff is the key there.

Let us look at some examples at the other end of the spectrum. Pan out from the US and pan in into the Indian banking and shadow banking system. A poster child of things gone wrong. DHFL posted close to a $900M loss on a $14B loan book; financial irregularities are being investigated and the company is going through a bankruptcy process in India. Yes Bank is losing all credibility in the market for waffling around instead of raising capital. As of 30th Sep, the bank had a book value of INR 109, the market clearly does not believe that Yes bank is still marked properly. It has valued the stock the close to 40% of the reported book value. Very rarely have banks that have fallen more than 90% recovered quickly from debacles like this. Even if one were to assume that the bank was technically insolvent because liabilities exceeds assets, there is still a large piece of the balance sheet that is healthy that will earn positive cash flow and earnings. The only way in the medium term, the bank can come out of the mess is through a cap raise. Then the question becomes. at what margin of safety will investors be willing to invest capital in the bank? 50%? 60%? 90%? If the bank is not able to raise any capital even at a massive discount to the book value, they might as well go the same way as DHFL. In the case of no capital being raised, the market essentially signalling that it has no trust in the bank and with no trust, there is no banking. If not, they need to quickly raise capital and reverse the downward spiral they have been on for the last 24 months.

Examples like DHFL and Yes Bank coupled with a beleaguered real estate sector, growing NPA’s and slowing growth in India has resulted in separating the perceived very good banks and non-banking financial companies (NBFC’s) in India from the rest. Companies like HDFC, HDFC Bank, Bajaj Finance that are perceived to have less risk continue to enjoy a massive premium over the rest of the sector. They trade at huge multiples of book value, enjoy strong growth, low NPA’s and solid ROE’s and capital cushion.

But the interesting companies are neither of these two buckets but the ones stuck in the middle. The in-between bucket today neither enjoys the premium of a strong franchise nor the discount of a capitally starved financial institution. They are associated enough with the mess that the valuations are discounted due to association effects but decently high enough due to their earning power and robust business models. A decent example of both would be Shriram Transport Finance and Shriram City Union Finance, both of which we have been following (and owned) for years. The stocks have gone nowhere over the last few years even though the capital position is robust, earnings are increasing, the valuations are decreasing. Shriram Transport, which caters to financing of used trucks and new trucks, is largely dependent on the small owners of commercial vehicles. While at first glance, the NPA’s or the stage 3 ECL’s look high; they are more a function of the business model than they are of the underlying business. With a low LTV and a solid guarantor system, the realized losses are far lower than what the NPA’s or the ECL’s suggest. With a ROA close to 2.5%, ROE of close to 17%, Book Value of INR 751 and decent growth of AUM and decreased corporate tax rates, the stock is expected to earn around INR 125 this year and is trading at INR 1050 as of today. The market seems to be projecting the gloom and doom of today well into the future. Shriram City Union Finance, which caters to the SME sector and the MSME sector, is a similar story. With ROA north of 3.5%, ROE north of 17%, low leverage, a segment that is almost captive, high ECL’s but low real losses on loans, with a book value of 1031 INR at the end of Sep is trading at INR 1380 creating interesting possibilities. However, if you owned one of these in the last few years, the stocks and the portfolio went nowhere. Coupled with some big investors and PE looking to cash out, near term tailwinds are capped.

In this context, if one were to tether oneself to beating the market index while picking individual names, one would have to gravitate towards the momentum driven stocks or high quality stocks which are at sky high valuations. On the other hand, if one were to look at through the cycle growth and compare them, the risk-reward function might be changing. So far, the momentum and high quality stocks are miles ahead in the race.

As I am thinking through these examples, there are three broad lessons that I think of: 1. It is very tough to predict markets short term. But through the cycle, they will reflect the fundamentals of the business. 2. Markets are largely efficient but far from always efficient as seen by the Apple example above 3. One can have different investing approaches — the more I think, the more I am inclined towards being more conservative through businesses that have earnings on hand today, trade at low multiples to cash flow than predicting longer term cycles.

Disclaimers: Own several indexes, Banks, NBFC’s, Single Name stocks etc. See FAQ’s. Not recommendations. Please do your own research.

Piramal Watch: Another strong quarter from the numbers!

We had written about Piramal Enterprises before here recently. Last night, they announced their results. Strong revenue and profit growth at 21% YoY. As expected, the focus on was their financial services portion of the business. The book was flat quarter or quarter with about 5K crores of repayment and 4.8K crores of disbursements.

Screenshot from 2019-07-31 04-52-13.png

The real estate book is starting to show signs of diversification with a lower wholesale residential RE portion but it is still 47% of the book.

Screenshot from 2019-07-31 04-56-07.png

The ROA and ROE seems to be holding up well for the business. GNPA actually fell in the quarter based on 90 dpd. It does look like payments are coming in through for Piramal as of now.  I suspect there is a lot of advance payments that is going on here that is causing this to look very strong and probably some better risk management as well.

Screenshot from 2019-07-31 04-59-05.png

A detailed book sensitivity shows that there are probably around 10% of the deals that need attention which is not concerning given that Piramal has shown an ability to actually implement corrective action and fix them in the last few quarters.

Screenshot from 2019-07-31 05-03-42

The key news was on the liability and equity side. The company informed that they were planning to bring in 8K-10k crores of equity on what they called significant growth and consolidation opportunities that are opening up on the NBFC.

I will also link here the CNBC transcript that shows a more aggressive yet cautious contrarian waiting for the right opportunities to open up in the NBFC space. It was good to see that they are treading with caution and watching instead of jumping into the first deal they get. With a solid quarter behind them, will this be a case of yet another counter cyclical aggression from Piramal? Only time will tell.

Disclosure: Long Piramal.

NBFC Watch Continues! Shriram City Quarterly Results!

Last night Shriram City Union Finance announced its quarterly results. Assets under management is up from 29,582 crores in March 2019 to 30,352 crores at the end of June 2019. RoA is marginally down to 3.41% in June from 3.44% in the prior quarter. RoE is down to 15.44% from 16.48% at the end of March. Disbursements are marginally down 5% QoQ. EPS was INR 38.4, Book value at INR 1005, CRAR at 22.5%. Asset quality only very marginally declined with net stage 3 assets holding almost flat at 5.03% with provisions just marginally up. Looking at the ALM statement, looks like their short term liquidity is fine.

And this was supposed to be a bad quarter. Results have help up well and the business model seems more steady than what the news will lead you to believe. It does look like this blood bath will eventually open up interesting opportunities for the patient investor.

Disclosure: Long Shriram City. Also read disclosure here

 

 

 

Piramal Watch: Distressed Seller or a Predator on Hunt?

With all the bearishness around the NBFC and the liquidity situation surrounding the industry, we are closely monitoring the status of several NBFC’s. Amongst them is Piramal. Depending on which source you read at or talk to, you have Piramal, either an overexposed real estate NBFC lender in a liquidity crunch, selling investments to fund liquidity issues OR a savvy predator hungry for more deals in the market when there is blood on the streets. Either way, when the results come out tomorrow, it will be a good indicator of what the reality looks like.

With so many stories swirling around, it is really tough to separate out the truth from the rumor. All we can say is, given the sheer number of permutations and combinations of the stories out there, it is evident that Piramal is talking to investors. But for what and as what? A distressed seller or as a bloodhound on a trail. We will have to wait and see how this plays out.

Some of the links to articles around Piramal:

  1. Piramal capital eyes $600M of buyouts in NBFC space (here)
  2. Can Piramal enterprises weather the NBFC storm (here)
  3. Softbank set to infuse capital into Piramal capital (here)
  4. LIC, IFC come to the aid of Piramal’s financial services business (here)
  5. Piramal’s INR 2500 Crore debt up for redemption in next 18 months (here)
  6. Piramal sharply cuts short term debt as NBFC crisis lingers (here)
  7. Piramal raises 1500 Crores from Stanchart through NCD’s (here)
  8. Reliance Jio and Piramal might setup a joint venture for financial services lending (here)
  9. Consumer finance focus can bring softbank to Piramal (here)
  10. The pathetic performance of the IndiaReit V fund (here)
  11. Piramal sells entire stake in Shriram Transport (here)
  12. Piramal is in talks to sell stake in Shriram group of companies (here)

Update: Added a few more links to the Lodha issue

  1. Piramal capital offloads 2,000 crore linked to Lodha (here)
  2. Piramal to pare 1,000 crore of Lodha developers debt (here)

Disclosure: Long Piramal.

Valeant Pharma Non-Gaap Definitions

It is one of those posts where I am just reproducing Valeant’s Non-Gaap definitions. I just cannot imagine all these expenses being excluded. Source is Q4 2015 results presentation. Link here

The reason I have reproduced this here is to remind myself when I see something like this in a management metric to run the other direction. All I can say is wow… just wow… and run… It is beyond me how to evaluate the operating performance for an acquisitive company with this disclosure…

Going by this disclosure; Bill Ackman can exclude his Valeant loss while reporting because it is a non-cash charge.

Adjusted EPS Management uses Adjusted EPS for strategic decision making, forecasting future results and evaluating current performance. In addition, cash bonuses for the Company’s executive officers are based, in part, on the achievement of certain Adjusted EPS targets. This non-GAAP measure excludes the impact of certain items (as further described below) that may obscure trends in the Company’s underlying performance. By disclosing this non-GAAP measure, management intends to provide investors with a meaningful, consistent comparison of the Company’s operating results and trends for the periods presented. Management believes this measure is also useful to investors as it allow investors to evaluate the Company’s performance using the same tools that management uses to evaluate past performance and prospects for future performance.

Adjusted EPS reflect adjustments based on the following items:

Inventory step-up and property, plant and equipment (PP&E) step-up/down: The Company has excluded the impact of fair value step-up/down adjustments to inventory and PP&E in connection with business combinations as such adjustments represent non-cash items, and the amount and frequency is not consistent and is significantly impacted by the timing and size of our acquisitions.

Stock-based compensation: The Company has excluded the impact of previously accelerated vesting of certain stock-based equity instruments as such impact is not reflective of the ongoing and planned pattern of recognition for such expense.

Acquisition-related contingent consideration: The Company has excluded the impact of acquisition-related contingent consideration non-cash adjustments due to the inherent uncertainty and volatility associated with such amounts based on changes in assumptions with respect to fair value estimates, and the amount and frequency of such adjustments is not consistent and is significantly impacted by the timing and size of our acquis itions, as well as the nature of the agreed-upon consideration.

In-Process research and development impairments and other charges: The Company has excluded expenses associated with acquired in-process research and development (including any impairment charges), as these amounts are inconsistent in amount and frequency and are significantly impacted by the timing, size and nature of acquisitions. Although expenses associated with acquired in-process research and development are generally not recurring with respect to past acquisitions, the Company may incur these expenses in connection with any future acquisitions.

Philidor Rx Services wind down costs – The Company has excluded certain costs associated with the wind down of the arrangement with Philidor Rx Services, primarily including write-downs of fixed assets and bad debt expenses. The Company believes it is useful to understand the effect of excluding this item when evaluating ongoing performance.

Other (income) expense: The Company has excluded certain other expenses that are the result of other, unplanned events to measure operating performance, primarily including costs associated with the termination of certain supply and distribution agreements, legal settlements and related fees, Philidor-related and pricing-related investigation and litigation costs, post-combination expenses associated with business combinations for the acceleration of employee stock awards and/or cash bonuses, and gains/losses from the sale of assets and businesses. These events are unplanned and arise outside of the ordinary course of continuing operations. The Company believes the exclusion of such amounts allows management and the users of the financial statements to better understand the financial results of the Company. 

Restructuring, integration, and acquisition-related expenses: In recent years, the Company has completed a number of acquisitions, which result in operating expenses which would not otherwise have been incurred, and the Company may incur such expenses in connection with any future acquisitions. The Company has excluded certain restructuring, integration and other acquisition-related expense items resulting from acquisitions (including legal and due diligence costs) to allow more accurate comparisons of the financial results to historical operations and forward-looking guidance. Such costs are generally not relevant to assessing or estimating the long-term performance of the acquired assets as part of the Company, and are not factored into management’s evaluation of potential acquisitions or its performance after completion of acquisitions. In addition, the frequency and amount of such charges vary significantly based on the size and timing of the acquisitions and the maturities of the businesses being acquired. Also, the size, complexity and/or volume of past acquisitions, which often drives the magnitude of such expenses, may not be indicative of the size, complexity and/or volume of future acquisitions. By excluding the above referenced expenses from our non-GAAP measures, management is better able to evaluate the Company’s ability to utilize its existing assets and estimate the long-term value that acquired assets will generate for the Company. Furthermore, the Company believes that the adjustments of these items more closely correlate with the sustainability of the Company’s operating performance.

Amortization and impairments of finite-lived intangible assets: The Company has excluded the impact of amortization and impairments of finite-lived intangible assets (including impairments of intangible assets related to Philidor Rx Services), as such non-cash amounts are inconsistent in amount and frequency and are significantly impacted by the timing and/or size of acquisitions. The Company believes that the adjustments of these items more closely correlate with the sustainability of the Company’s operating performance. Although the Company excludes amortization of intangible assets from its non-GAAP expenses, the Company believes that it is important for investors to understand that such intangible assets contribute to revenue generation. Amortization of intangible assets that relate to past acquisitions will recur in future periods until such intangible assets have been fully amortized. Future acquisitions may result in the amortization of additional intangible assets and potential impairment charges.

Amortization of deferred financing costs and debt discounts: The Company has excluded amortization of deferred financing costs and debt discounts as this represents a non-cash component of interest expense.

Foreign exchange and other: The Company has excluded foreign exchange and other to eliminate the impact of foreign currency fluctuations primarily related to intercompany financing arrangements in evaluating company performance.

Tax: The Company has (i) excluded the tax impact of the non-GAAP adjustments and (ii) recorded adjustments for the use of tax attributes and other deferred tax items plus any payments made for settlement of tax audits, in order to reflect an expected tax rate for the current period.

Molycorp

About a week ago, Molycorp, the rare earth minerals manufacturer declared a chapter 11 bankruptcy.

From google finance,

Molycorp, Inc. is a rare earths producer. The Company operates in four business segments: Resources, Chemicals and Oxides, Magnetic Materials and Alloys and Rare Metals. The Resources segment includes its operations at the Mountain Pass facility. The Chemicals and Oxides segment includes the production of rare earths at Molycorp Silmet; production of separated heavy rare earth oxides and other engineered materials from its Molycorp Jiangyin facility, and production of rare earths, salts of rare earth elements (REEs), zirconium-based engineered materials and mixed rare earth/zirconium oxides from its Molycorp Zibo facility. The Magnetic Materials and Alloys segment includes the production of Neo Powders through its wholly owned manufacturing facilities. The Rare Metals segment produces, reclaims, refines and markets niche metals and their compounds.

Often companies get into bankruptcy as they are unable to absorb the burden of the debt that they have undertaken and go through the bankruptcy process and come out stronger with better negotiated debt on the other side. The market that Molycorp operates in is dominated by Chinese firms . When the economic behemoth tried to strong arm the world by controlling supplies, Molycorp and Lynas came up with supplies with some non-Chinese mines. These two companies at one point contributed to 10% of the global consumption. Since then the Chinese have backed down and the world has been more than willing to buy from them at rock bottom prices.

When one looks at the financials of Molycorp, attention needs to be paid to the income statement rather than the balance sheet as we usually do in distressed conditions.

$M 2012 2013 2014
Sales 527.7 554.4 475.6
GP 18.8 -67.2 -99.6
GP % 3.6% -12.1% -20.9%

The company has been reporting net negative gross margins. The company has been losing money just getting metal out of the ground. This is even before the sales force is paid, the corporate expenses are paid and even before the interest payments are serviced on the debt. The only time when the GP’s were positive was during the Chinese induced shortages which resulted in a huge price increased in the market. Just restructuring the debt with lower interests or better terms or financial engineering is not the solution to this problem.

The company has not outlined any measures that can make the investor comfortable that a margin of safety exists in the bond even under distress. Unless there is another attempt to strong arm the rare earth market from the Chinese or the US is determined to use only US made rare earth metals, or the Chinese crack down on the black market,  financial engineering will only go far to stem this tide. A cautious investor will do well to sit this out and watch from the sideline!