Saturday, October 22, 2011

Working Capital Concerns.

The flow of cash through this channel of events gives rise to the working capital requirement for a company. The ability of a company to manage its working capital in all market conditions influences its rate of growth. 


Companies either borrow short-term loans or use internals cash accruals to procure raw materials and to meet day-to-day requirements. These loans are paid once the cash is received from customers. This process is termed as the working capital cycle of a firm. The lesser the number of days in which the company earns back the cash invested in operating activities, better is its working capital management. Companies, which have smaller working capital cycles, tend to deliver better profitability since their short-term borrowing requirement is lower compared with firms that have longer working capital cycles. Working capital efficiency assumes greater significance during tough economic situations. During a low-growth phase, demand for goods and services erodes thereby increasing the amount of average inventory at hand. 

For companies that undertake execution of turnkey projects, investments made to procure materials are blocked until the execution of the projects. When the implementation of such projects is delayed, the short-term borrowing requirement of such players shoots up. When working capital remains tied up in receivables or inventory for longer than the average period, the company will have to borrow additional capital to meet daily expenses. Given the current scenario of rising interest rates, higher borrowings will increase interest outgo thereby putting pressure on net margins. When working capital cycle deteriorates, the company would either have to slow down its operations or increase borrowings. In either case, it will not be able to meet its profit targets. Let's look at companies whose working capital requirement has increased in the past one year. 

Patel Engineering
Patel Engineering is a construction and engineering company operating in hydropower, roads and irrigation segments. The working capital requirement of Patel Engineering has increased due to a delay and stoppage of work in a few of its projects. The company's largest irrigation project in Andhra Pradesh worth more than Rs 1,500 crore was delayed due to political turmoil in the state. The hydropower project at Loharinag Pala in Uttarakhand, where work had commenced and which was expected to be a major contributor to revenue growth was cancelled by NTPC due to environmental issues. Work at two big hydro electric projects had to be stopped for a certain period in the last financial year due to floods. However, work on the projects has commenced since the last quarter of FY11. 

Excluding the delayed projects, the company's current order book stands at Rs 6,500 crore which is nearly two times its FY11 revenues. It has failed to receive any major orders since the last two quarters. This gives a low revenue visibility for the company. The pace of execution and clearances for the delayed projects will be the points to look out for in future. 


The country's largest transfer of development rights (TDR) player has high working capital requirement as close to half its exposure is to slum rehabilitation projects. Even though the company has lower debt as compared to its peers, the high gestation period of its projects poses a risk for earnings. 

On the flip side, income from the TDR, which has relatively insulated cash flows can provide a cushion to the company's earnings. The company will take at least 2-3 years to record reasonable cash flows since it's expanding in the mid-housing segment to diversify its earnings mix. 


Tuesday, October 18, 2011

Short Term: Gold may loose it shine.

Stocks and other commodities were being dragged down Tuesday by slowing growth from China, which is a mixed bag for gold. China grew 9.1% in the third quarter, which was below estimates. The number combined with slowing export results have made investors nervous that the country, a voracious consumer of all commodities, will stop buying.
Goldman Sachs wrote in a note that downside risks to growth remain, with external demand expected to weaken in the fourth quarter but that China might shift its monetary policy as a result. China has been aggressively raising interest rates and raising reserve requirements to try to drain money from the system with inflation at 6.1%. Goldman estimates that inflation could fall to 5% in the next quarter and that the lower level plus growth pressure could trigger a relaxation, by either stopping rate hikes or freeing up more cash.
Interest rates are at 3.5% and even if inflation falls to 5%, interest rates would still be a negative 1.5%, which typically has been good for gold. When an investor's money is losing value in the bank, gold becomes an attractive alternative asset to own. On the flip side, if slowing growth means less inflation in China, then gold will also become less attractive as a hedge against rising prices.

Wednesday, October 12, 2011

The Derivatives Bomb.

In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller

The four banks in question: JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS).

Derivatives played a crucial role in bringing down the global economy, so you would think that the world's top policymakers would have reined these things in by now - but they haven't. 

Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market. 

A governmental default would panic already anxious investors, causing a run on several major European banks in an effort to recover their deposits. That would, in turn, cause several banks to literally run out of money and declare bankruptcy.

Short-term borrowing costs would skyrocket and liquidity would evaporate. That would cause a ricochet across the Atlantic as the institutions themselves then panic and try to recover their own capital by withdrawing liquidity by any means possible.

And that's why banks are hoarding cash instead of lending it.

The major banks know there is no way they can collateralize the potential daisy chain failure that Greece represents. So they're doing everything they can to stockpile cash and keep their trading under wraps and away from public scrutiny. 

Although American banks have limited their exposure to Greece, they have loaned hundreds of billions of dollars to European banks and European governments that may not be capable of paying them back. 

According to the Bank of International Settlements, U.S. banks have loaned only $60.5 billion to banks in Greece, Ireland, Portugal, Spain and Italy - the countries most at risk of default. But they've lent $275.8 billion to French and German banks. 

And undoubtedly bet trillions on the same debt. 

There are three key takeaways here:

  • There is not enough capital on hand to cover the possible losses associated with the default of a single counterparty - JPMorgan Chase & Co. (NYSE: JPM), BNP Paribas SA (PINK: BNPQY) or the National Bank of Greece (NYSE ADR: NBG) for example - let alone multiple failures.
  • That means banks with large derivatives exposure have to risk even more money to generate the incremental returns needed to cover the bets they've already made.
  • And the fact that Wall Street believes it has the risks under control practically guarantees that it doesn't.
Seems to me that the world's central bankers and politicians should be less concerned about stimulating "demand" and more concerned about fixing derivatives before this $600 trillion time bomb goes off.


USA: Its not a Recession. Its a Balance Sheet Recession.

I view share prices of many companies as having become generally more attractive over the last two months, but, at this point in time, there are four factors that keep me from being more heavily committed to equities:
  1. the stock market's continued volatility and instability;
  2. the growing sovereign debt contagion in Europe (and failure of their leaders/central bankers to respond intelligently);
  3. continuing political partisanship (and failure of our leaders to properly confront our fiscal imbalances and to promote pro-growth policy); and
  4. an inability to gauge whether the erosion in the August sentiment measures (impacted by U.S. stock market and domestic/overseas economic uncertainties) will translate into weakness in hard domestic economic data.
I see the following four potential outcomes:
Scenario No. 1 (probability 15%): The pace of U.S. economic recovery reaccelerates to above-consensus forecasts based on pro-growth fiscal policies geared toward generating job growth), still low inflation, subdued interest rates and the adoption of aggressive plans by the government to deplete the excess inventory of unsold homes. Corporate profits meet consensus for 2011, and 2012 earnings estimates are raised (modestly). Europe stabilizes, and China has a soft landing. Stocks have 25% to 30% upside over the next 12 months. S&P 500 target is 1500.
Scenario No. 2 (probability 15%): The U.S. enters a deep recession precipitated by a more pronounced negative feedback loop, a series of European bank failures and likely sovereign debt defaults in the eurozone. While 2011 corporate profits and margins disappoint somewhat (we are already well into full-year results), 2012 earnings estimates are materially slashed. China has a hard landing. Stocks have a 20% to 30% downside risk over the next 12 months. S&P target is 885.
Scenario No. 3 (probability 30%): The U.S. and Europe economies experience a shallow recession. Earnings for 2011 are slightly below expectations, but 2012 corporate profits are cut back to slightly below this year's levels. Stocks have 10% to 15% downside risk over the next 12 months. S&P target is 1030.
Scenario No. 4 (probability 40%): The U.S. and European economies "muddle through" in a modest expansion mode (hat tip for the term to John Mauldin). Profits for 2011 meet consensus expectations, but slippage in margins brings down 2012 corporate profit growth projections somewhat. Stocks have 10% to 20% upside over the next 12 months. S&P target is 1355.
While I appreciate the uniqueness of the current balance sheet recession and the growth-deflating impact of deleveraging, I am also mindful that the typical conditions that precede a recession are not in place:
  • large private payroll drops in excess of 175,000 a month (adjusting for nonrecurring issues, payrolls are still averaging about 95,000 growth over last four months);
  • an inverted yield curve (it is positively sloped);
  • acceleration in inflation (inflation is contained and so are expectations);
  • an increase in real interest rates (anything but!);
  • bloated corporate inventories (low inventories to sales in place now);
  • retreating retail sales (they are expanding);
  • negative year-over-year leading economic indicators (advancing now);
  • a drop in factory orders (also rising) and;
  • outsized durable spending relative to GDP (housing and autos remain at or near cyclical lows).


Tuesday, October 11, 2011

Buy Lanco Infratech, target Rs 30: Nomura

Pushback in project timelines, materially lower near-term realisations and higher cost of funds largely explain the sharp earnings downgrade.

Nomura has given a buy recommendation on Lanco Infratech with a target price of Rs 30.

"In our view, Lanco's current market price ignores potential value accretion from its project pipeline beyond FY12; instead it partially reflects the risk of a funding gap and overhang from unresolved contractual/legal issues. We expect FY11-13F EBITDA and normalised EPS CAGR at 70 per cent on the back of higher contribution from power generation. At 0.7 times P/B and 4.5 times P/E on FY13F earnings, multiples are arguably ‘distressed’ and at a discount to its peers. We maintain a buy on the stock, but cut the 12-month target price to Rs 30 (from Rs 51) on reduction in value of power business (down from Rs 41 to Rs 22) and higher CoE," the brokerage said.

Pushback in project timelines, materially lower near-term realisations and higher cost of funds largely explain the sharp earnings downgrade.

"In our view, earnings sensitivity to these variables entails a fair risk-reward payoff from our base case; lingering contractual/legal issues remain a risk," the brokerage said.

As much as 82 per cent of equity required for its 5.9GW pipeline (ex-renewables, Udupi) is already invested; while group cash flows would suffice for the balance equity funding and AU$250 million required for Griffin Coal. Loan disbursals are on schedule; AU$483 million loan repayable in FY15/16 will require refinancing.

Commissioning of 1870MW capacity by March 2012 and operating its 3.9GW diversified capacity at healthy utilisation levels would restore execution credibility. Other catalysts include visibility on gas allocation/availability for KP-III and resolution of project-specific contractual/regulatory/legal issues, it added.


Thursday, October 6, 2011

Indian FCCB Hacks

Act in haste, repent at leisure. India’s well-functioning and globally popular capital market almost always manages to take the attention off its debt market. Consequently, a lot of people are completely unaware of the crisis of sorts being faced by Indian companies which have issued Foreign Currency Convertible Bonds (FCCBs) and are scouring the horizon for funds. Some, as we shall see later, are also getting ready to unleash dirty tricks to get out of a tight situation.

FCCBs are bonds issued in foreign currency and sold offshore with an embedded option to convert to equity at pre-determined conversion prices.

FCCBs became the favoured instrument to raise capital for Indian companies during the bull run from 2004-05 to 2007-08. Most companies that issued them were on a high growth trajectory and assumed that increased earnings in future would induce investors to convert their bonds to equity in the future.

The lack of strong bankruptcy laws in India combined with their ineffective implementation doesn’t leave the holders of the FCCBs, which are classified as unsecured debt anyway, with much recourse to get their money back. The corporates use this fact to their advantage.

Different companies are following different tactics based on their financial position, connections and level of corporate governance. Here are the major ones:

1. Internal accruals: This is an ideal case scenario. However most of them don’t have enough cash on the books to redeem their FCCBs in entirety.

2. Company buyback: The Reserve Bank of India (RBI) opened a one-year window in 2009 under the automatic route for Indian firms to raise foreign currency loans to buy back their bonds at a discount to the conversion price from bondholders. This window has now been extended till March 31, 2012. While some companies were successful in repurchasing their FCCBs, many faced stiff resistance from bondholders, especially hedge funds, who were unwilling to exit their position at a haircut – discount to the price mentioned in the FCCB.

3. Promoter buyback: There have been a few cases in which the FCCBs were trading at a discount in the secondary market and have been bought back by the promoter under his personal account and/or in the name of some ‘friendly’ parties. The promoter then does one of two things:

Roll over the bonds: Since the promoter owns a super majority (either directly or indirectly), he alters the terms and conditions of the bonds and extends the date of maturity, sometimes by as much as 10 years. This way the company doesn’t have to service the debt in the short to medium term.

Redeem the bonds: This enables the promoter to take cash out of the company and put it in his pocket as effectively he is just paying himself. Moreover, since the bonds were bought at a discount from the secondary market but redeemed at the redemption premium, the promoter realises a neat profit.

4. Refinancing: This is the preferred way of repaying the bonds by most Indian companies. However, with banks tightening their credit, a lot of companies won’t be able to secure bank loans. A few large companies like Bajaj Hindustan and Bharti Shipyard have managed to raise funds domestically to meet their obligations. At the same time many mid-cap companies have been knocking at the doors of various foreign hedge funds to obtain private debt which won’t come cheap. Bigwigs like Reliance Communications Ltd, which has secured a US$ 1.33 billion loan from China Development Bank, are also looking at foreign banks, especially Chinese ones for refinancing.

5. Issuing new FCCBs: Many companies like Assam Company have tapped/are tapping the international markets to place a new issue of FCCBs. While some of them have chalked out large capital expenditure plans and claim that only a part of the proceeds shall be used to service outstanding FCCBs, others are quite open about their intent regarding the funds raised.

6. Raising equity: Not only is raising equity in this market difficult but it would also lead to substantial dilution of the promoter’s stake in the company. However, many companies don’t have a choice as they are highly leveraged and can’t take on any additional debt. While some of them are issuing global depository receipts, many others are rumoured to be in talks with private equity (PE) players to get funding.

7. Negotiations with bondholders: A few corporates have entered into talks with their bondholders to either roll over the existing bonds with a lower conversion rate or a higher redemption premium. Unfortunately for them, not many hedge funds are willing to take a haircut on their investment and are examining their legal options.

In conclusion, the experience of Indian companies and bondholders alike has not been good with FCCBs and if there are a large number of defaults over the next 12-15 months that might well be the last nail in the coffin for this debt instrument. This would be very bad news for smaller companies which aspire to be a Tata or an Infosys but won’t find an audience next time they come to the international markets to raise funds. Things might start looking up though if one or more of the following happens:

— RBI accelerates the growth of credit default swaps, a form of insurance cover purchased by lenders against the risk of default by borrowers. This shall allow foreign institutional investors (FIIs) to hedge their credit risk in India and shall give them some comfort.

— The Indian equity market improves drastically in the same period and most bond holders convert to equity.

If not then a large crisis looms over this former love of international investors for sure. Watch this space.


China Currency Bill will Backfire.

A Senate bill that aims to restore American jobs by punishing China for its undervalued currency may resonate with a frustrated American public, but it won't work.

In fact, instead creating jobs, the bill is more likely to trigger a damaging trade war with China and increase retail prices for Americans - further hurting the consumer spending that has already been undermined by high unemployment.

"This move is idiotic on so many fronts, I don't know whether to laugh or cry," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. 

The Chinese have already threatened to retaliate, and Fitz-Gerald says there are three other reasons why China currency the bill will backfire:

  • Tariffs on Chinese goods will raise prices for consumers in the United States, particularly at such retailers as Wal-Mart Stores Inc. (NYSE: WMT) and Target Corp. (NYSE: TGT).
  • China holds $3.2 trillion in foreign reserves, much of it in U.S. securities, while U.S. national debt is over $14.7 trillion.
  • And China's exports to the United States account for only 4.8% of the country's gross domestic product (GDP).


Monday, October 3, 2011

Shale Gas.

Today, most financial newspapers have reported on state-owned GAIL acquiring a 20 percent stake in the US-based Carrizo Oil and Gas’ Eagle Ford shale acreage. The deal involves an upfront cash payment of $64 million to Carrizo, with the overall investment valued at around $300 million over the next five years.
The acquisition is a clear attempt to gain expertise in an energy segment that might soon become very significant for India over the next few years. It marks GAIL’s first shale gas asset acquisition and follows billion-dollar-plus purchases by Reliance Industries to gain similar energy assets abroad as well. So, why are companies interested in acquiring shale gas assets? Here’s a quick primer on this unconventional energy source and why it is becoming important for India’s energy companies.
What is shale gas?
Shale gas refers to natural gas that is trapped within shale formations. Shale is a fine-grained sedimentary rock containing an organic material called kerogen, which, when distilled, can produce oil and gas.
Shale gas is often considered an unconventional source because it is found in difficult-to-produce reservoirs, which require special completion, stimulation and/or production techniques to achieve economic production.
Is it a new source of natural gas? 

Not really. The presence of shale gas has always been known, but extraction was not vigorously pursued because of high costs. But in recent years, some medium-sized companies figured out smarter ways of drilling. As technology improved, the recoverable reserves were rapidly upgraded. The technology used to extract shale gas is primarilyhydraulic fracturing  (or fracking) – bombarding rocks with millions of litres of chemically treated water, which releases the gas.
Does India have shale gas reserves? Are Indian companies tapping these reserves?
While there are no official estimates of shale gas reserves in India, according to oilfield services provider Schlumberger, the country has shale gas reserves of between 300 and 2,100 trillion cubic feet (tcf). Shale formations have been observed in the Damodar basin, Jharkhand and West Bengal.
ONGC is among the state-run companies in the country studying these formations. Last year, with drilling and fracking assistance from the US-based Schlumberger, the company successfully tapped the shale beneath the Damodar basin in West Bengal. It also said it was encouraged to explore shale possibilities in the Cambay, Krishna Godavari, Caurvery and Assam-Arakan basins.
Currently, private companies are barred from exploring for shale gas until an official policy is announced and implemented.
Companies like GAIL and Reliance hope to acquire the skill sets for shale gas exploitation before the country throws open its shale gas assets for bidding in the next few years. It has assumed even more importance because current production from the Krishna Godavari basin’s D6 field – India’s largest natural gas field – has been far below expectations. If the shale gas reserves prove viable, it could be a game-changer for India’s gas industry, which currently has to rely on imports to meet increasing demand.
What kind of demand does India have for natural gas?
India’s natural gas demand is expected to nearly double to 320 million standard cubic metres per day by 2015, according to a report by global consultancy firm McKinsey last year. To manage this growth, India’s natural gas industry will require investments of around $40 billion to $50 billion across the value chain, the report said. Natural gas can be used for fuel, fertilisers and cooking.
How important is the shale gas industry to the energy industry?
Around 32,500 trillion cubic ft (tcf) of shale gas reserves have been identified globally. The US is the leading producer of shale gas, with the fuel accounting for 17 percent of its domestic gas production.
The exploitation of shale gas has revolutionised American energy markets, helping the US in 2009 to overtake Russia as the world’s largest gas producer. Shale now accounts for about 20 percent of US gas production and total output is expected to keep growing, although a recent estimate suggested reserves in one basin could be far lower than previously thought.
Earlier, this month, news reports have talked about an area in northwest England that might contain 200 trillion cubic feet of shale gas, which puts it in the same league as some of the vast shale-gas plays that have transformed the US energy industry. That will certainly give further momentum to the global natural gas industry.
Are there any concerns about shale gas?
The top concerns about shale gas are environmental. While natural gas is cleaner than fossil fuels, the requirement of vast quantities of water shale in gas drilling has sparked considerable opposition from environmental activists, especially in Europe. Indeed, the controversial fracking technique is banned in France and in several American states.
Fracking requires large amounts of water, which sharply reduces the availability of water for other uses. Also, these processes generate large amounts of wastewater containing dissolved chemicals and other contaminants that require treatment before disposal or reuse. That makes wastewater treatment and disposal an important and challenging issue.


RMB Globalization.

With the internationalization of the RMB progressing on scheduleit is predicted that atleast 40 percent of the trade volume of 2015, or about 100 million U.Sdollars, betweenChina and Africawhich is equal to the total trade volume of 2010 between China and Africawill be settled with RMBaccording to the lasted research report issued in thebeginning of September by the largest bank of Africa Standard Bank Group

This is another achievement China has made since it launched the cross-border RMBsettlement in 2009. Pang Kaigechief executive officer of the Standard Bank (China),also said that it is quite possible that countries including South Africa and Nigeria willtake RMB as their foreign reserves

Nowit is two years since China decidedly launched the cross-border RMB settlementpilot project in the wake of the financial crisisand cross-border RMB settlement has grown from a few domestic pilot cities to all of ChinaHoweverthe RMB's process of"going globalis still in its preliminary stageChina's foreign reserves are still increasingand China still has to face risks from the depreciating U.Sdollar.

China's foreign reserve issue is a reflection of the current imbalanced global economy and turbulent global systemOnce the credit of the U.Sdollar is shakenthe economy of the whole world will sufferWhoever depends more heavily on it will suffer more

Economist Li Caiyuan said, "China's huge foreign reserve indeed has made China in passive positionIn the long runChina will suffer lossesBut practically speaking,China should really not abandon the interest of the securities before finding better investment channels." 

He believes China has only two fundamental ways to solve this problemOneChinashould use the U.Sdollar less while expanding its domestic demand greatlythus reducing the exports to the United States and increasing the importsTwoChinashould use RMB more and expand the scale and range of cross-border RMB settlements

Guo Shengxiang from the China Actuarial Science Development and Research Centerunder the Peking University predicts that if a bidirectional exchange agreement isestablished between the RMB and other currenciesa "one-to-manyexchange,financing and settlement system with the RMB as the center will be establishedIf currency exchange center is established around this system and a financing cash pool is established in itit is possible that the RMB will be the "third pole of the global financial center." 

Only when the RMB can "go global," "stayin the world and "come backthrough smooth channels can China's economy shake off the yoke of the U.Sdollar or the euro fundamentally

Obviouslyit will be difficultLi said that the U.Sdollar has been the world's reserve currency since World War II thanks to the countrys great industrialscientific andmilitary strength as well as the rapid overseas expansion of U.Senterprises and financial institutionsAt presentthere remains a considerable gap between the comprehensive strength of China and the United States

"China is taking a unique economic development pathand the RMB cannot copy the success of the U.Sdollar," Li saidThe U.Sdollar is becoming increasingly "hollow,"with most of the country's industries transferred overseas except the arms and financial services industriesBy contrastthe RMB remains "solidbased on China's strong manufacturing industry and real economyWhile paying attention to European and U.S.marketsChinese companies should also make investments elsewhere to expand their living space.