Manpasand Beverages IPO

Posted on by balajithinks

Warren Buffett’s words on IPO continue to ring true — “It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).”

  • 2008-2013 soft drink market has been growing at 20% CAGR
  • The soft drink market is expected to grow at 14% CAGR between 2013 and 2018
  • Mango Sip is a single product contributing to 98% of the sales for the company
  • 17 crores of net debt versus 157 crores of net worth; net debt is pretty low
  • Return on equity for last three years has been 11.9%; 30.4% and 21.9%
  • Net profit declined from 2013 to 2014 by 10% from 22 crores to 20 crores
  • First four months of 2014, the company clocked 15 crores in net profit and 148 crores in sales (against 293 crores preceding 12 months — goosed up before IPO?); 9M 2015 sales is 239 crores and profits are 13 crores;
  • The issue size is for 400 crores, the company has outlined proposals to use up around 270 crores to building a new plant, setting up a new corporate office, drawing down corporate debt etc. and rest to be used for corporate expenses (what does that even mean?)
  • At expected market cap at 1400 crores to 1600 crores based on the IPO price; and expected 12 months trailing earnings at INR 20 crores, we are looking at a trailing PE of 70 to 80;
  • Very aggressive sales growth assumptions are built into the IPO price to justify the valuations

As Warren Buffett mentioned above, we are going to sit aside and watch this company play over the next couple of years.

ITC

Posted on by balajithinks

“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”
— Warren Buffett, ‘Barbarians at the Gate’ on RJR Nabisco

Cigarette company discussions often start and end on moral stands that investors take about tobacco usage. While we will leave the individual preferences to the respective investors to evaluate and act upon, we will discuss a bit about ITC which commands over 75% share in the legal Indian cigarette industry.

Cigarette businesses comes with investment characteristics that are highly desirable (leaving aside the moral question of public good or increasing the value of the ecosystem they operate in)

  •  Cost a penny and can be sold for a dollar
  • Great brand loyalty
  • Government restrictions on ads and regulations means it is legally very tough to take market share away from incumbent players
  • India still does not suffer from the punitive legal hurdles present in the western world

ITC however has been going through a different challenge. Over 85% of Indian tobacco consumption is not legal or not subject to regulation. This has meant that companies like ITC bear the burnt of the high excise taxes which are increasing every year and VAT as well. Smaller companies that operate outside the legal boundaries have a huge cost advantage over the ITC’s of the world. If the government does get serious about tobacco usage and curbs the usage of illegal tobacco, it might actually strengthen ITC’s business model. Though, the chances are slim and might take a few years at least.

Currently, ITC is suffering a huge volume decline on the back of the big tax hike in the last few years. The volume decline has accelerated in the last two quarters. There is a possibility that the demand is not as inelastic as we believe it to be.

2014 2015
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
-2% -4% -2% -3% -3% -4% -13% -13%

In the backdrop of this, the already weak shares of ITC might see further weakness of the next few quarters. While we are not predicting the short term stock movements, as long term holders, we are hoping for a sale in ITC stock.

There are two catalysts that we see in the long run

  •  The sustainability of the cigarette over the longer period of time and its robustness. You cannot kill this business model except by banning cigarettes in India.
  • The cash engine ten years from now will be from FMCG along with Cigarettes that will ensure that the sustainability of the model will continue for the future. This change while tough to evaluate from a cash flow perspective is rather easy to evaluate from a predictability perspective.

You have a good cash cow, a new growth engine (yet to see cash flows though), a terrific management and a solid business model with a fair amount of predictability. For a long term investor, who does not care about short term weakness, price declines and can be  contrarian, some pain might be in order but definitely commands a look.

Disclosure: Long ITC

Buffett Partnership — in Today’s context

Posted on by balajithinks

The initial piece below in italics is adopted from buffettfaq.com

According to a business week report published in 1999, you were quoted as saying “it’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

If you are an investor in a market like India today, would this is applicable to you? What would be the things that would work for you and things that would hinder you…

  • Value investing works everywhere globally however it is the margin of safety that varies across the different region
  • In a country like India, where investor protection is very low, value traps and dubious management are the norm of the day, the statistical bargains  become a whole lot more riskier with the probability of permanent loss of capital increasing
  • The statistical bargains that Buffett talks about relies on two sources of safety — cheapness and concentration like he did in his partnerships. Even with these, it looks tough to create alpha without good investor protection. When one studies the Buffett partnership model carefully, Buffett created alpha through workouts and generals and in some cases, the generals that got  converted into workout e.g. Sanborn maps, Dempster and to some extent Berskhire Hathaway (though history ensured that Berkshire had a different fate) Without the strong investor protection, it is doubtful whether similar situations can be worked out in India
  • Other sources of Margin of Safety like quality, moats, superior business models, management with the backwind of a market like India where alpha has been created over a long period of time might have better probabilities of success. If one were patient and did not worry much about volatility and could handle concentration, the odds of success in the market magnifies several points over. It might be possible to replicate the sort of success Buffett had in India though with different sources of value than he did in the 50’s but it definitely won’t be a walk in the park like Buffett makes it sound.

Daniel Loeb’s hedge fund and the original Warren Buffett hedge fund structure

Posted on by balajithinks

Recently, Third Point’s Daniel Loeb launched a scathing attack on the Oracle of Omaha and his hedge fund structure. “I love how he criticizes hedge funds, yet he really had the first hedge fund. He criticizes activist investors, yet he was the first activist,” says Loeb.

It was must be recalled that Warren Buffett ran one of the original uber-successful hedge funds in the industry. Today, hedge funds are dime a dozen in the US. A closer look at the original ‘hedge-fund’ partnership of Buffett reveals the following:

  • The ‘Buffett Associates’ structure was a partnership. Not a limited liability partnership, just a plain partnership which meant that Warren was exposed to unlimited loses. His obligation to pay back was not limited to his capital. I think this was a very gutsy move. The confidence that Buffett shows on his own abilities is amazing. This does align his incentives with that of his partners.
  • No management fee.
  • To boot that, he also paid 4% interest on the capital. If the performance exceeded the 4% hurdle, Buffett got paid 25% of the profits. Now, consider this. If the partnership just broke even, Buffett had make good the difference to the tune of 4%. With liabilities not limited to his capital, on a base of $105K capital that Buffett raised, he had invested only $100. His potential losses would have been high. However, Buffett did have other money that he had accumulated. In a bad year, if the partnership was down 40% (say), Buffett would have to pay 4% and the partnership would lose 36%.
  • in 1958, Buffett amended the partnership further in favour of his partners, where he agreed to take 25% of all downsides. Which mean, if the partnership was down 40%, Buffett would pay 4% interest and 10% of the losses from his own capital. Buffett’s hedge fund structure was onerously favouring the shareholders in bad years and limiting their downside while leaving them with a sizable upside as well.

Compared this to Third Point’s 2 and 20 structure is in stark contrast where Loeb’s stands to make money of 2% even if the partners lose money with very limited liability. It is a classic screw the clients in a bad year and scoop their profits in good years. I think the difference between the two structures are night and day, a far cry from the shareholder orientation that Warren Buffett had in his partnership.

Kraft – Heinz and the Buffett Return

Posted on by balajithinks

We looked carefully at the Kraft and Heinz merger deal and we were blown away by the numbers. Let us look at it two separate ways to see whether it holds water:

Berkshire and 3G bought Heinz by investing $4.25B of equity each and Buffett topped it with $8B of preferred stock in Heinz. Berkshire has already received $1,440M of dividends from the preferred stock in two years. Chances are by the time the stock gets called, he would have received another $720M of the dividends.

Berkshire and 3G are adding $5B each to pay the $10B dividend @ $16.5/share. At today’s closing price of $88.95/share, ex-dividend, the share is worth $72.45/share. Buffett on CNBC said that post the $5B investment, he would own 320 million shares of the combined company. That is worth $28.3B. $5B of that is yet to be invested, so, $4.25B turned into $23.45B in 2 years. This is a mind-boggling return of 450% in 2 years. What an elephant he has bagged on such a big investment…..

To top it all, Berkshire will also get $8B back next year that he has to deploy elsewhere from the calling of the preferred stock. In addition, 3G has indicated that they will maintain the current 3% dividend, that is $2.2/share dividend on 320 million shares, about $700M/year will flow into Omaha starting this year.

The other way to calculate it is, Kraft’s market cap today is $52B; Kraft’s shareholders will get $10B dividends; 49% of the combined company that Kraft’s current shareholders will own, will be worth $42B; 51% of the rest will be worth $43B; initial equity investment was $8.5B equally by 3G and Berkshire; Implied value for the original $8.5B is $43B; (not taken into account the $10B dividend as it will flow from Berkshire and 3G in the future to Kraft’s shareholders)

Either way, Warren Buffett’s elephant gun has fired a salvo that will bring cheers to his shareholders as a new equity position that will be his largest or second largest position once the transaction is closed depending on the stock price on any given day.

What are we thinking?

Posted on by balajithinks

We are thinking quietly about the Kraft Heinz deal. What is the hidden margin of safety that Buffett is counting on?

When we look back on Berkshire’s acquisition of BNSF, the deal initially looked crazy. Here is Warren’s justification for it and here is what some of the value investors thought about it. Investors believed that Warren had gone loco. The deal turned out to be very good for Berkshire shareholders. Five years since the deal, BNSF has provided $15B dividends back to Berkshire on the purchase price of $26.5B that he paid to own the rest of the company. (Link) Part of that was luck due to oil being transported more on rails compared to five years ago that even Warren could not have anticipated. Nevertheless, when Warren has capital of tens of billions of dollars that needs to get allocated, he is still finding deals with the required margin of safety and returns proving that he is a continuous and an innovative learner. If one were to value the railroad at where the competitors are trading it, it looks like BNSF will be worth about $66B.

One has to sit back and think about what are the margins of safety is Warren counting on the Kraft-Heinz deal? One, of course is 3G’s focus on cost. But is there something beyond it? What does it mean for the Shareholders? It will be the second biggest security in the Berkshire’s portfolio soon.