Other Income – Is it one of the most critical metrics in judging a bank’s management’s effectiveness?

We have been analysing the banking space for the last 5+ years now and today wanted to talk about something which is perhaps not given its due attention. It is the ‘Other Income’.

Other income, also known as non-interest income, which includes loan processing fees, distribution (MF, insurance etc) fees, brokerage, income from dealing in forex, treasury gains, loans write backs, forex profits, dividends, and few other smaller heads. CEB, (commission, exchange, brokerage) income is looked at separately as it represents the ability of a management to generate extra sources of income using the already existing infrastructure and sales personnel (may be some are specially hired for generating CEB but not much). Thus, CEB flows directly to PBT, contributing massively to profitability. We can call CEB as core other income (OI).

Now let’s understand why is it important?

OI is generated using the already laid out infrastructure and is a measure of how effectively management is able to sweat its resources. Since there isn’t much aditional cost for generating OI, it directly adds to ROA/PAT (adjusting for taxes).

Lets take a look at the ROE tree below comparing New Private Banks with Old Private Banks:

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Highlighted row at the end of the table above shows contribution of total OI to PBT for the last 5 years for the private banks under study. For few banks, almost all of PBT is coming from other income which essentially means core lending is not profitable enough to keep the bank afloat.

If we just remove CEB income, ROEs fall below 10% for most of the banks including Yes, IndusInd and Kotak

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However, one can argue that some components of OI such as loan processing fees is an integral part of lending operations and most of other non-interest income is generated using the various resources such as branch infra, personnel, customer deposits which are into place only because of core lending operations. Lot of other income is generated because of cross selling. We also agree that existence of OI relies on core lending operations of a bank, however, an efficient and focused management can use the resources in a way that brings all the difference into the profitability of the bank. From the first table, it is pretty evident that new private banks are much more focused on generating other income than their old counterparts. In my view, this is making all the difference to their return ratios.

Role of management in generating OI becomes quite evident when we look at CEB (core OI) metric for 5 largest PSU banks. As expected, none of the banks including country’s largest lender, SBI, comes closer to any of New Private Sector lenders.

Capture

Its amazing to see how private banks specially new private banks have been able to generate high core OI (CEB). Table below shows this stark comparison of new private banks vis-a-vis old private and PSBs (public sector banks). A major outperformance in PBT is being generated by outperformance in core OI thereby reiterating the significance of OTHER INCOME.

Capture 1

Other takeaways from the comparison table –

  • Improving other income metric could be a good leading indicator of a bank’s strategy
  • CUB is the best bank amongst all private banks on ‘return on risk weighted assets’ (RORWA) metric; it generates more risk adjusted returns than even HDFC bank though the out-performance is in few bps 🙂
  • RBL stacks up in bottom quartile on ROE but still gets P/B multiple which is comparable to IndusInd and Yes
  • Yes is highest ROE generator amongst all private banks while at the same time it is one of the most levered as well
  • Leverage – Old banks are more levered than their new counterparts, despite that they generate lower ROEs. PSBs’ leverage is shooting through the roof.
  • Credit costs (provisioning for bad assets in P&L) – Both, old and new, banks are at par on this metric, but provision coverage is lower for old banks (69%) vs new banks (72%) indicating that new banks are more progressive in providing for bad loans
  • Tax rate – some of the old banks such as CUB, KVB and Karnataka almost always pay less taxes (~20%) than other banks (~33%) mainly because of tax deduction claimed under section 36 (1) (VIII) for creating special reserves

Asset quality trends in banking sector – Q2’FY17 update

Of total of 38 listed scheduled banks (barring 3 listed SBI associates), 37 banks have declared their results (J&K Bank is expected to declare on 30th Nov). Our listed universe^ has an outstanding (o/s) loan book* of ~7,100,000 Cr and GNPAs* (gross non-performing assets) of ~619,000Cr, 8.7% of loan book. Clubbed with restructured loans (RLs), total gross stressed assets come out to be ~860,000Cr, 12% of gross advances (up by 30 bps qoq).

Pace for stressed assets (GNPAs + RLs) formation has slowed down for the listed universe, it grew by just 2% sequentially (qoq) as compared to 6% in the previous quarter (June’2016).

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After a poor show in June’16 quarter, Sep quarter seems to be showing signs of positive asset quality trend though no conclusion can be drawn by looking at just one quarter.

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# qoq change within 20bps is classified as stable

However, further digging throws some surprises (positive or negative, your call!), increase in GNPAs for the listed universe is led by private banks while the PSBs have reported flat GNPAs. It is mainly, ICICI and Axis, which have led this deterioration in asset quality. Similar trend is visible when we look at stock of restructured loans. It is only the ICICI bank which has led the increase in restructured loans. Pace of GNPAs has picked up for private banks while it slowed down for PSU banks, counterintuitive, isn’t it?

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Going granular, for the first time in last 3 quarters, PSBs have shown improvement as a lot. During the June’16 quarter, all PSU banks deteriorated in asset quality but in the latest quarter 4 PSU banks (Corporation, PNB, UCO, Vijaya) have shown reduction in GNPAs as % of advances.

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Private banks have reported more stabilization in GNPAs than their public counterparts. Only Karnataka bank reported improvement in GNPA % (by 28 bps).

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I could not resist putting up following two charts, which show ki koi itna nichey bhi gir sakta hai. Some of the banks have more than 1/4th of their advances in bad assets.

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The chart below shows naked exposure (NNPA + RLs) of banks to their net worth. Not surprisingly, most of the PSU banks have bad loans in excess their net worth, an indication of quantum of capital requirement for these banks. Though ICICI and Axis have reported very poor numbers in this quarters, their naked exposure to net worth is still very low at ~20%.  This number stands at 95% for 38 banks put together.

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Notes

`^ total of 38 listed banks which does not include 3 state bank associates

* For the banks whose numbers are still not available, have taken them to be at par with last quarters numbers

Moving onto next indicator of asset quality, slippages – addition to GNPAs. It indicates incremental stress recognized during the quarter. This indicator is highly encouraging for PSU banks, as many as 12 banks have shown reduction in slippages ranging from 23% to 73%. Only 4 banks have shown increase in slippages. Amongst the private banks only 1 bank has shown improvement of above 20% (RBL) while 5 banks have reported increase in slippages ranging from 15% to 175%, counterintuitive, yet again, isn’t it 🙂

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My take – Overall, asset quality seems to be moving in the right direction after a long time. Number of banks reporting stable or improved asset quality is equal to number of banks reporting deteriorated asset quality. Slippages data points to even better picture, only 9 banks seems to be in negative territory, rest all have either stabilized or have improved from where they were in last quarter. Data is especially encouraging in the PSU space. This could be because of cleaning exercise that happened in last 2 quarters of FY16 under AQR scheme of RBI. Private Banks are marred primarily because of Axis and ICICI banks, both the corporate lenders are expected to see more stress in asset quality from their pending watchlist. Barring these 2 banks, most of other private sector banks have stabilized or improved.

Some of the macro indicators seem to be in favour of banking sector – low inflation leading to lower interest rates which would result in profits from large investment books of these banks. It would be a good opportunity for these banks to clean up their balance sheets. We expect growth in the economy to pick up as interest rates go further down resulting in increased consumer demand and capex from corporate India after a long pause. However, effects of demonetization seem to be uncertain. I’ll try to give a shot at what I understand could be the possible effects of demonetization on the banking sector –

  • Positives
    • Banks get loads of low cost deposits, we can expect some of these deposits to remain with the banks for a longer period, resulting in lower cost of funds
    • Decline in country wide demand leads to softening of inflation which can result in multiple rate cuts, which will benefit the banks as value of their bonds holding goes up. This will particularly be helpful as banks can park some of their deposits in bonds.
    • More people will have bank accounts now. As a result more people will have credit history and they will become target customers for the banks, currently served by non-banks
    • Government of India (GoI) might get one time windfall gain (net of new currency related costs and lower tax revenues) which can be utilized into recapitalizing the PSU banks
    • GoI can also utilize the windfall gain to do capex in infra activities which can then be followed by private companies leading to increased demand for credit in the system

 

  • Negatives
    • A standstill in the economy (witnessed in most of the industries over last few days) might result in cash flow crunch at the borrowers end, NPAs can go up
    • If demonetization is followed by more curbs on black money, it could lead to substantial decline in business activity in the country. India being primarily a cash economy it will take some time for everyone to move to cashless transactions systems. Business sentiments will also be very low as lot of people would have lost their income or the source of income itself. Decline in consumer sentiments will follow next. Who will banks lend their money to?
    • Prices of real estate market are expected to fall by 15%+, it will add to already stressed balance sheets of real estate companies; these NPAs could be sticky.

I’m sure there would be many more possibilities which can play out for the banking sector because of demonetization. Would be great to have your comments pouring in.

Thanks.

Company Analysis – Career Point

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Kindly do your own analysis.

Career Point is a test prep company based out of Kota, Rajasthan, hub of medical and engineering test prep centres in India. Company is witnessing a revival in its core test prep business and is expected to take benefits of high operating leverage embedded in business model. As per the latest con-call, management is trying to monetize assets worth 35-40Cr and plan to utilize some of the proceeds to either pay dividends or buy back shares.

Key positives

  1. Revival of core Earnings – At peak CP used to generate core EBITDA of 36Cr (FY12), of which test prep used to be a major contributor  Post FY12, the company saw a downward trend in earnings from the tutorial division. The reason was adverse regulations regarding the engineering entrance examinations by the government. Engineering exams, post the new regulations carried a higher weightage for XII board exams. This impacted the enrollments – Career Point was exposed heavily to the engineering exams with ~ 60% of enrollments were for AIEEE. CP’s long term enrollments fell from 23K to ~ 10K in FY15. As enrollments fell, reverse of an operating leverage played through leading to precipitous fall in earnings and even a loss in FY15. Since FY13 the company has been able to move its mix of enrollments towards medical students which now contribute ~40% of the overall mix. Things are now looking up for the company from a regulatory stand-point both for engineering & medical exams. On the engineering front – the weightage of XII boards is being removed. This will give enrollments a shot in the arm as students will again solely  focus on entrance exams. On the medical side – there will be a central exam (instead of multiple state level exams) that will be conducted (the Supreme Court has passed a decision in favour of the same) soon, most likely from the coming academic year. This  will benefit organized coaching players like Career Point. Both these should improve enrollments and will help in earnings revival due to operating leverage,
  2. Improvement in asset heavy business leading to higher probability of monetizationCompany had invested heavily in 2 universities and 2 Engineering colleges post its IPO in 2011-12. As per the management – in its con-call its university in Hamirpur is cash positive and profitable. Its university in Rajasthan should follow suit in the next 12-18 months. As this business improves – gets more enrollments and becomes cash flow positive the chances of it getting monetized improve. Management in its previous con-call has alluded to it. The cash generated from this can be utilized towards buyback/dividends (Source: Q4’16 Con-call). Further as the cash flow improves the share of management revenues (charged by CP to the university to run the university) accruing to Career Point also improves. This is a direct add to the bottom line.
  3. New revenue streams – monetizing video content through offline and online channels and contract with NSDC to aid to top as well as bottom line handsomely.

Key negatives

  1. Capital mis-allocation – historically management has invested lot of money in capital intensive businesses such as schools, colleges. These assets lead to poor returns in earlier years because of long gestation period. Business generates lot of cash intrinsically and will have good amount of cash because of asset monetization, further deployment of cash in asset heavy businesses remain a concern.
  2. Limited growth opportunities in core business – We believe, growth avenues are limited in core business of test prep leading to management look out for deployment of excess capital in new revenue streams. Historically this has led to poor return ratios and diversification into completely different line of business of NBFC.
  3. Regulation – any adverse regulation by ministry of HRD can put business in bad shape again.

Valuation – at CMP of 118 it is trading at 0.6x book value. Downside looks limited from here.

Key things to track

  • Volume growth in test prep vertical
  • University asset monetisation
  • Subsequent utilisation of cash to reward shareholders
  • Traction in management fees, skill development verticals

About the company – Career Point is one of the few listed entities into education space in India. Offerings of the company are summarised below:

  • Test Prep
    • for entrance into engineering and medical colleges
    • 8 company owned centres in Rajasthan including flagship center in Kota and 7 franchises outside Rajasthan
  • Management fees –
    • Manages school and colleges (currently, company owns these assets through trusts) and book revenues under different heads such as mess services, hostel services etc
  • NBFC –
    • Education loans and trade financing to businesses in kota only, 2-3x collateral
    • target customer is well known directly or indirectly
    • 35Cr of loan book, duration less than a year, disbursements all through equity, no debt
  • Skill development – for GoI and state govt
    • 10yr agreement with National Skill Development Corporation (NSDC), total cost to execute the project will be ~17Cr of which soft loan of 12Cr from NSDC
      • 20-25% EBITDA margin in first year and 30-35% from 2nd yr onwards
      • 7K students to be trained in FY17 @ INR15,000/student @ 20-25% margins – ~10Cr revenues, 2Cr EBITDA (source: CNBC interview)

Business Mix – test prep business is the major contributor to revenues and company is one of the top 5 players in Kota test prep industry. Below is business mix info about the company:

business mix

Key characteristics of engineering/medical test prep business –

  • High operating leverage – scope to grow volumes by ~40% without any incremental fixed costs. There will only be inflationary increases in other costs and even lesser in employee costs as company is not hiring any new employee in last few years because of overcapacity of teachers post the regulatory problem led to drastic decline in students volumes. Company did not fire any teachers post the problem and it also did not hire to replace 5-10% natural churn of teachers.
  • Regular price hikes – In the education space, bargaining power remains with the education provider. Price hikes of 5-15% are regular in this business.
  • Cash cow – core test prep business generates lot of cash as is visible from investments in balance sheet although not very prudent. (350Cr of investments at cost of which ~115Cr came from IPO, rest is all internal accruals over last 10 years)
  • Growth challenges – difficult to scale outside Rajasthan as competing with local brands is a tedious task and there is no economies of scale
  • Role of regulation – very much vulnerable to any regulatory change. Witnessed the same during FY13, enrolments dropped to ~10k from 23k at peak kicking in reverse operating leverage.
    • Adverse regulation in 2012As per a new regulation issued in 2012, high weightage of 40% (earlier it was nil) was given to class 12 scores for admission into engineering college including IIT/NIT etc. This led to decline in tutorial students to Kota over ensuing 2-3 years as students preferred staying at home so as to prepare for class 12 as well. Though IIT board did not follow this regulation and came out with its set of criteria i.e. a student should either secure 20% percentile or 75% marks, lower of the two will be minimum required to sit for IIT exam.
      This weightage to class 12 results has been withdrawn from 2017 session. Now, all types of engineering entrance exams have same criteria as IIT. This, change in regulation is expected to bring volume growth in coming years.

Test prep industry

India sees 12l students appear for engineering exam every year, of this, 2lacs students clear for advance level and 10k get selected across IITs

Kota coaching market is estimated to be INR 600Cr industry (expected to grow by 15% every year) with presence of 150 institutes. It has ~1.2lacs students across engineering and medical, of which Allen has 50-55% of market share. Other players amongst top 5 are CP, Resonance, Vibrant, Bansals.

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Registration Status with SEBI: I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

 

 

Public Sector Banks – Will History Repeat Itself?

At the moment public sector banks (PSBs) are going through a rough patch – increasing stressed assets and scarcity of capital are two major causes of worry.  This has meant very low valuations for these banks and inability to grow at historical rates even if the economy starts to pick-up in near future.

Last 3-4 years have been very challenging for banking sector as a whole and more so for PSBs. Low credit off take in the economy coupled with crippled risk management at PSBs ensured poor asset quality. Below is a snapshot depicting how situation has deteriorated over last 4 years –

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A look at previous down-cycle of 1998-2002 shows that PSBs had stressed assets at ~13% of loan book. Couple of the banks# had stressed assets as high as ~30% of their respective loan book. Credit growth slowed down to 16%. Banks* traded at an average P/B valuation of 0.6x during this period. What followed after that is history – from 2002-2008, loan book grew at a CAGR of 24%, stressed assets declined from 11% to 3%, stock prices** returned an average of 800%. During the same time period benchmark index BSE SENSEX returned 350%. What triggered this outperformance? There are several reasons for that, all intertwined with each other, namely 1) decline in interest rates, 2) GDP growth, 3) declining NPAs 4) recapitalization by promoter

There are similar examples of banking crisis in other countries. Common measures undertaken to improve the situation of banks were, recapitalization by respective govt, interest rate cuts and regulatory reforms. Please see below for a brief summary of banking crisis in Sweden, Japan, Spain and Mexico.

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Changing Scenario

Economic growth seems to be the top priority for the Modi govt. As per Madan Sabnavis, chief economist, CARE Ratings, 8-10% real GDP growth (base year 2004-05) will require credit growth of 18-20%. Historically, credit growth has seen a multiplier of 1.3x of nominal GDP growth rate. PSBs form 76% of total credit in the system and their full-fledged participation will be crucial for the desired economic growth rate of 8-10% (base year 2004-05). As per some estimates PSBs are expected to grow at a meagre rate of 8-10% for next 4-5 years because of scarcity of capital. This will lead to slow credit growth of ~12-13% in the system which will not be sufficient to grow the economy by 8-10%. From the above argument, we can deduce turnaround of PSBs should be the indirect top priority of Modi govt.  In fact there are some early sings of changes already in place such as declining interest rates, improving macro numbers such as inflation, IIP etc and announcements around banking reforms which include more autonomy to banks, top management hiring from private sector, performance linked salary structure for top management, longer duration of MD, separate posts for chairman and MD for better board governance, construction of bank board bureau, recapitalization and reforms in industries causing maximum NPAs etc.

Is there a pattern that we can draw between last down cycle and the current one? Table below compares two down cycles on few key metrics:

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In addition to this, the other pattern that emerges between the two down cycles is recapitalization^^ by govt of India. Until 2002, recapitalization was done to the extent of 12,000 Cr, which provided enough liquidity to grow by the time economic growth picked up, which acted as a strong catalyst for turnaround of PSBs. Between FY02 – FY08, loan book of PSBs grew at a CAGR of 24%. We see similar pattern emerging this time around, by fiscal 2015 end, govt had already infused ~65,000 Cr of capital into PSBs and has further plans to infuse 70,000 Cr during next 4 years. Capital being the life-line of a bank, these recapitalization plans might, once again, provide required breathing space to PSBs. Using this capital, they, once again, have an opportunity to improve their balance sheet enough to attract outside capital which can further provide them breathing space to grow like before.

Inverse Relationship between growth of GDP and of Stressed Assets

Banking is a cyclical industry in-tune with economic growth. Asset quality of banks deteriorates sharply when economic growth engine slows down because of poor cash flow generation at borrowers’ end. Asset quality situation reverses when growth picks up as visible from the chat below:

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Current valuations of PSBs seem very attractive if we compare them to last down cycle and how they improved during the ensuing economic recovery. Chart below demonstrates strong correlation between asset quality (stressed assets) and valuations (P/B):

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We might question quality of the book PSBs carry on their balance sheet making P/B metric irrelevant. Well, that has always been the case, is this time any different?

Comments Invited!

Notes –

# Bank(s) refer to PSBs unless stated otherwise

* There were 10 PSBs listed on stock exchange starting 1998

** There were 17 PSB stocks listed in 2002

^^ During whole of 1990s govt infused ~16,000 Cr of capital, 2% of GDP and over the last 15 years govt has infused 81,000 Cr of capital into PSBs, majority of which came during last 5 years

Source: Ace Equity, RBI, Press Search

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Registration Status with SEBI: I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

Genesis of Multibaggers

With the aim of understanding the origin (in terms of market cap) of multibagger stocks of the last decade, we performed an analysis wherein we looked at the returns of all the listed stocks. We did this analysis with a hypothesis that small/micro cap companies, as compared to mid and large cap, would be the home to majority of multibagger socks today. Though the hypothesis turned out to be correct but it amazed us how small rather micro cap companies turned out to be the den for ~98% of all the 50x+ stocks (46 in total) in the last decade.

Before running into the analysis, few points to help a reader:

– There are four market cap categories – A) below 50 crores, B) 50-500 crores, C) 500-1,000 crores and D) above 1,000 crores

– Returns are expressed in the form of ‘number of times’ stock price has become from starting date, 01 June 2005

– There are three time periods across which this analysis has been performed A) 10 year: Jun 2005 – Jun 2015, B) 5 year: Jun 2010 – Jun 2015 and C) 3 year: Jun 2012 to Jun 2015

– Stock prices are split and bonus adjusted

– Market cap in INR cr is as on starting date

– Source: Ace Equity, there could be some misses because of the availability of data on the database

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Top gainers – Symphony Ltd, Manappuram Finance, Optiemus Infracom, Caplin Point, Bliss GVS, Urja Global, Dhanuka Agritech, Shilpa Medicare, Mayur  Uiquoters, Cera, Ajanta, Pharma, Kitex, Relaxo, EPC Industrie, Ashiana, Poddar Developers, Amara Raja, SCUF, Vinati, La Opa

5

Top gainers – Cigniti Technologies, Ajanta Pharma, Arrow Coated, Avanti Feeds, Caplin Point, Indo Count, Kellton Tech, La Opala, Stampede Capital, Optiemus Infracom, Kitex

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Top gainers – Indo Count, Arrow Coated, Atlas Jewellery,  Marksans Pharma, Smiths & Founders, Trinity Tradelink , Cressanda Solutions , Pressman Advertising, Nutraplus India , PI Industries

For the 10 year period there were 261 stocks which became 10+ baggers. Of these, more than 50% belonged to <50 crore market cap, 24% belonged to 50-500 crore and rest 20% to above 500 crore.

Based on this analysis one can not overlook the importance of analyzing smaller companies.

Starting today, we intend to initiate a series of posts, Catch Me If You Can, where our effort will be to understand, of course with the benefit of hindsight, whether there was a way to figure out the improving fundamentals of these (multibagger) companies while they were small. To perform this analysis our major focus would be on management commentary for the last ten years and on the financial statements.

Catch Me If You Can #1 – PI Industries

Products and services

Operating segments – Agrochemicals and custom synthesis and contract manufacturing (CRAMS)

Agrochemicals – PI has a portfolio of herbicides, insecticides, fungicide and specialty plant nutrient products & solutions

CRAMS – For agrochemicals, pharma intermediates and other niche fine chemicals for global innovators

Salient features of this compounding engine

Diversification into new business line (2005) – Entered CRAMS, which is a high margin low capex business. CRAMS also provides cushion, to P&L, against cyclical nature of domestic agrochemicals business

Focus on core business (2011) – Exited polymer compound business, which had a low margin and volatile earning profile

Introduction of new products at regular intervals – Strategic introduction of 4-5 new products every year leading to top-line growth irrespective of how monsoons had been

Business model

  • CRAMS – Agreements with innovators at early stage of molecules provided an opportunity to PI to benefit from the entire life-cycle of the final product there by leading to predictable revenue stream for long term
  • Agrochemicals – Marketing and distribution tie-ups with foreign innovators in agrochemicals to manufacture and/or sell their product in India putting PI on high growth trajectory

Distribution network – Well penetrated network of 9k distributors and 40k retailers

How were numbers behaving – was there any clue?

FY09 proved to be the inflection point in the history of PI, a look at below table shows how improvement started taking place in FY09. In this year, company’s gross margins improved by ~200 bps, EBITDA margins by ~400 bps, for the first time in last 3 years revenue grew by ~24%, debt levels declined and all of this resulted in improved ROCE and ROE of 18% and 30% respectively. PI recorded such returns ratios for the first time in the last decade.

excel

If we go back and take a look at the annual reports for the year 2008 and 2009, there are quite a lot indicators which point towards improving business profile of the company, in terms of both – growth as well as margins. For e.g. in 2008, management talks about depressed earnings during the year because of high investments in fast growing highly profitable CRAMS business indicating margins improvement from here on.

Posting some clippings of management commentary from annual report for the year FY08 and FY09.

Snippets from FY08 annual report

all

Snippets from FY09 annual report

2009

Stock price performance

chart

During whole of FY09, PI was available in the P/E range 5-10x TTM earnings. It continued to trade in the P/E band of 3-13x TTM earnings till FY12. Table below shows average TTM P/E of PI for the years – FY08 till FY13. This was a long window of opportunity to buy this business at an attractive valuation without taking any undue risks on business quality.

PE

As mentioned above this whole analysis has the huge benefit of hindsight. But what we are trying to do through this look-back is to  find  clues which could perhaps have helped us if one was in the past. Using these clues we can perhaps learn a few mental hacks that can be given much more importance when we read the annual report of a new company which mentions similar things.

Comments invited!

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Registration Status with SEBI: I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

MT Educare: A play on For Profit Education in India

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Kindly do your own analysis. MT Educare, is one of the largest coaching institutes in India. It is an undisputed market leader in the Mumbai market and is slowly expanding into adjacent markets of Maharashtra, Karnataka & Andhra Pradesh in an asset light model. It provides coaching for Science, commerce, Engineering entrances, CA and MBA entrances. The company has 128 coaching locations in 7 states and has serviced ~ 82,000 students in the FY gone by. Coaching business has strong economics and MT Educare has executed very well in the Mumbai market. This expansion in Mumbai is driven largely through standardizing its teaching methodology and not on ‘Star teacher’ concept. The sector in general has not seen many scaled up players owing to lack of standardization and low entry barriers leading to local players becoming leaders in their respective markets. MT’s strategy of slowly expanding outside Mumbai is an interesting one in our view, they have executed well in Karnataka with revenues reaching ~10% of the overall pie in two years. Further they have walked their talk on selling their PuC college in Mangalore which they had bought to establish credibility in the market. In our view the approach (asset-light, variable cost model) taken by MT to expand in new markets is a low risk high reward model. Company has recently also expanded in Andhra Pradesh in this similar fashion by partnering with an educational institute which has around ~35K students under various PuC colleges. The business has an attractive profile with strong pricing power, improving profit margins and negative working capital. All these points coupled with the positive management feedback through scuttlebutt and initial success in Karnataka give us comfort that MT can expand beyond its ‘home-turf’. We like MT Educare because of the following reasons:

  • Strong position in Mumbai- MT Educare started in 1988 with a single class has expanded to ~ 90 centres in Mumbai in 2014-15. This is noteworthy, especially, given the scalability issues in coaching market. Other dominant local players such as Sinhal, Kalra Shukla, and Thakkar Classes haven’t been able to scale up as much as MT has. The brand MT is extremely strong in Mumbai with huge network advantages through coaching centres across length and breadth of the city. This is very difficult to replicate for a competitor. We believe that the company will continue to hold its market position in the Mumbai market. The company also has strong pricing power, evidenced by strong increase in ARPU/student of 15% CAGR over the last 5 years (FY10-FY15).  We attribute the strong position in Mumbai market to successful execution by the MT team. The school segment is highly fragmented and largely an unorganized market. MT has used a standardized approach for delivery and has used extensive teacher training to reduce reliance on key/star teachers. This hasn’t been the case for competition which has affected their scalability
  • Strong financial performance – MT Educare has demonstrated strong growth in both top-line and bottom-line. It has grown its revenues and PAT at a CAGR of 24% and 37% over FY11-FY14. Company has generated >20% return ratios over the last 4 years. The company also works on a negative working capital model with students paying fees in advance. As utilizations levels has improved at its various centres its operating profit margins (EBITDA) have also increased from 11.5% in FY09 to 20.5% in FY15.

 Financial Performance

  • Expansion in adjacent markets in an asset light model- MT is looking to slowly expand into Karnataka, Andhra Pradesh and other regions in Maharashtra. After its successful expansion in Karnataka through the asset-light model, the company has further used a similar model in A.P through its partnership with Sri Gayatri Education Society (SGES).  In addition to being asset light, the model is also variable cost driven with PU colleges taking a share of the revenues. This will limit losses on fixed costs such as rent etc for MT as it expands in new geography. We believe that a large part of the future growth for MT would come from non-Mumbai markets. Below is a brief on the model adopted by MT in each market
    • Karnataka: The company first expanded in Karnataka in 2012 through its own PUC college. The company subsequently expanded in this market by partnering with existing PUC for premises. The company in FY 15 sold its college premises as they feel they have now got a foot hold in the market. Partnering with PUC college is an asset light model and completely on variable cost as MT doesn’t own any asset and only pays a share of the revenues in lieu of the premises. The company has 14 tie ups in Karnataka and plans to reach 30 colleges by FY18. Karnataka at the moment contributes ~ 10% of revenues for MT
    • Andhra Pradesh: MT has recently partnered with Sri Gayatri Education Society (SGES), which has 35,000+ students in its junior colleges. Under this partnership, MT would provide coaching to the students under SGES. MT would provide coaching for 4 courses. This is again an asset light model wherein MT hasn’t done any investments in real estate and would share a portion of the revenue with SGES. SGES in return will provide real estate and a captive audience for MT
    • Other markets: MT through its acquisitions of Lakshya has presence in Punjab & Haryana. Further, MT is looking to leverage this brand by expanding in its other established markets viz- Mumbai, Karnataka. It plans to leverage its strong brand in Mumbai in other parts of Maharashtra. It has also made TN a hub for CA coaching centre

  Risks

  • Unsuccessful expansion in non- Mumbai market- We believe that a large part of the future growth for MT will come from its expansion into non-Mumbai market. If the company is unable to successfully expand in these markets, growth will be a challenge. Coaching in general is a highly fragmented, localized market with many local leaders in each city/region. Further, MT/Mahesh brand is still largely a new name in its new regions such as Karnataka & A.P and thus may find difficult to compete with established players. In the event of no/low growth from these new markets, MT could become a value trap
  • Regulatory issues – Any changes in the regulations may impact the company negatively. For example, CBSE has made board exams optional for 10th standard students. Further many competitive examinations have undergone change in pattern for e.g.- In 2012 IIT JEE exam under-went a major shift from a paper pencil model to an online model and competitive exams frequently see a change in pattern and are also moving to an online model
  • Concentration risk in Mumbai- Mumbai contributes 80% of the revenues and 66% of the centres are in Mumbai. Any change in exam patter or any adverse regulation against coaching institutes in Mumbai/Maharashtra can adversely impact MT.
  • Threat from online test prep players – With many competitive exams such as CAT, IIT-JEE etc. moving online, there has been a surge of online test-prep players over the last 2-3 years. As students become more adept with technology and with increase in mobile and internet penetration, online only players could pose a threat to offline players such as MT. MT with its ‘Robomate’ offering is trying to counter this threat by offering its digital solution on mobiles and tablets to MT & non MT students. It has tied up with local coaching classes in Tier 3 & Tier 4 towns in Maharashtra & Gujarat for sale of Robomate. In FY15 Robomate did revenues of ~ INR 3 Crs

Valuation & Upside As mentioned above in the note, MT Educare has an attractive business profile with expanding margins, negative working capital, high return ratios and pricing power. The business is facing growth challenges as it looks to expand beyond its core market of Mumbai. We believe that the strategy adopted by the company is both scalable and economically prudent. Company is currently trading at P/E of ~15-16 and an EV/EBITDA of 8.5 If the thesis of expansion outside Mumbai plays out well, we expect the company to increase its revenues and earnings at a CAGR of 25% over the next 3-4 years. In the event of that happening, we feel the business will also get re-rated as it will allay the investors’ fear of being a non-scalable business. A business with such a profile (High ROCE, negative working capital etc) and similar growth (>20%) should command an earnings multiple of greater than 20X (P/E) Revenue Mix Revenue mix About the Industry

  • Market size & Growth drivers – Non -School education is a large market in India. According to CRISIL estimates, the Indian coaching industry is expected to clock 17% CAGR (over FY2011-15E) from `40,187cr to `75,629cr. Bottom up estimates also suggest that IIT JEE & Medical test prep itself is a 5,000 crore industry.  This market would continue to grow driven primarily by rising disposable incomes, increasing household spend on education and higher private sector participation.
  • Competition – Coaching Industry in India is a highly competitive market. With low entry barriers the market is highly fragmented with very limited pan India players. Some of the key players in the coaching/test prep market are outlined below:

Competition Key Metrics to track

  • Volume & value growth in Mumbai & non Mumbai markets
  • Revenue contribution from non Mumbai markets
  • ARPU & EBITDA per student
  • Attrition of teachers
  • Revenue from Robomate and Lakshya

Disclaimer: This is not a recommendation to Buy/Sell/Hold. Safe to assume I have vested interest in the company as I am a shareholder in the company. Registration Status with SEBI: I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”

Notes from MOSL Wealth Creation Study 2014

Motilal Oswal in their most recent wealth creation study, have talked about the secret sauce of finding 100X stocks. While some of it is intuitive for many investors, it is still worthwhile to share the same, as it puts everything in perspective and summarizes it in a nice framework.

Framework for finding 100X Stocks

  • Size –The study talks about focusing on companies with small revenue size and market cap. The lesser known the company the better it is, low market cap, limited analyst coverage, low institutional holding further add to the advantage of making a 100X. Some interesting data points that the study mentions
    • The average revenue of 100x companies in the year of purchase was about INR3 billion;
    • Only 3 of the 47 companies (Crompton, Godrej Industries, NMDC) had revenue in double digit billion.
    • Average P/E was 6x, confirming no major investor fancy
  • Quality – Quality on two dimensions a)Quality of Business –competitive advantage, nature of industry, the RoCE/RoE it earns . b)Quality of Management – Corporate governance is a key, Competent management- ability to allocate capital efficiently, growth mindset.
    Other interesting points from the study on the point of quality are below

    • Quality without growth is not a very attractive play (more on that below)
    • Most business that delivered 100X came from industries from a large profit pool. Thus market size or size of opportunity is important.
    • Commodity plays also give 100X returns- largely driven by demand-supply mis-match and thus increase in prices as a result. This in turn results in earnings growth and multiple re-rating. Though, only 8 of the 47 companies were these commodity plays in the MOSL study. Experience says, it is tough to predict these cycles, but if you are lucky/or have figured out the cycle you can very well play this
  • GrowthThe single-most important time determinant of stock market return is GROWTH in all its dimensions – sales, margin and valuation
    • Sales growth driven by volume growth (demand which may have several factors behind for e.g. – move from unorganized to organized plays or movement from high cost to low-cost base the report titles this as value migration)
    • Margin growth- driven by pricing power (realization growth), operating leverage etc
    • Both the above lead to growth in earnings which is one part of the equation
    • Valuation re-rating is another part of the puzzle- The report says “The simplest way to improve the odds of valuation growth is by ensuring favorable valuation at the time of purchase”

 

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  • Longevity- Usually determined by the moat that the company has. Management also has a key role in this as per the report. Talks about two key things
    • Extending Competitive advantage displayed in the ability to earn Return on capital higher than cost of capital for a long period of time. This is inspite of new players entering the market driving the overall RoEs down. Companies with enduring moats are able to earn high RoCE/RoE inspite of higher competition
    • Delaying reversion to mean of high growth rate- Usually the role of management is key here. Depends on the strategies adopted by them. Inorganic growth/organic growth etc

This is a key factor in differentiating between transitory multi-baggers and 100X stocks

Interesting debate on buying Quality v/s Growth- The report has an interesting section which dissects quality only and growth only stories, and goes on to say that these could either become quality traps, if there is no growth and one buys it at a high valuation owing to the quality, or they could become transitory multi-baggers.

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While quality to a large extent is the return on capital it earns, growth is dependent on trends, tailwinds, demand-supply mis-match etc. We found this segment particularly interesting as it distinguishes clearly that quality alone or growth alone- doesn’t make the cut to find enduring multi-baggers or the proverbial 100X. It may good to dissect the two when analysing a company next time and asking the question – Is there growth in the company, and will that be quality growth i.e. will the company earn ROCE/ROE going forward.

Some other Interesting takeways from the study

  • 7 of the top 10 Fastest Wealth Creators had single-digit INR billion market cap in 2009 and/or were quoting at single-digit P/Es
  • Most of the Wealth Destroying companies and sectors are deeply cyclical and/or those affected by policy paralysis during UPA-2 regime. With a new government at the helm, major policy reforms coupled with economic recovery, could be hugely positive for many of them
  • Transitory multi-baggers attract a lot of crowd and media attention, but they always give nasty end-results. Deep cyclicals and fad companies broadly fit into this category. The tragedy with this class of companies is that if you cannot sell in time, you are left with no gains, and most often, with a permanent capital loss. Enduring multi-baggers are those companies, whose wealth creation is long-lasting. Great businesses run by good managements purchased at huge ‘margin of safety’ will create enduring multi-baggers.
  • The average 100x period in India is about 12 years i.e. 47% return CAGR; interim period returns too are very attractive. As investors, the key takeaway from this is that we need not worry even if we have missed a multi-fold price rise in a potential 100x by not buying into it 1, 2 or even 5 years ago. In other words, when it comes to 100x stocks “it is dawn when you wake up!” Or more accurately, “when the 100x idea dawns on you, simply wake up and buy the stock!

The entire report can be found  here – MOSL Wealth Creation Study_2014