Caution: Sharp turn ahead!

When we started writing in late 2007, we had said that 2008 could be full of uncertainty (refer: Ab kya hoga?). At that moment we did not know and did not have an iota of conviction where we could end up after 2008. At this juncture, however, we believe that 2H 2008 could be far more correction oriented(bumpy ride) than most people think it will. The reason for this ‘pessimism’ could be in what we are seeing lately on the macro front and its effect on the corporate performance has still to show up, according to us.


What’s up with the Sensex?

There are umpteen articles published recently comparing our markets with those of the rest of the emerging markets. The BRIC economies which had a spectacular run in the last four years have all corrected recently, but the arguments put forth are that the Sensex is amongst the cheapest of the lot, in terms of valuations. For the record the Sensex trades at around 16-17x FY09 earnings compared with other emerging economies which trade more than this multiple.
For one, Sensex companies have had a spectacular run in the last four years making them from ultra cheap in 2003 to overvalued by early 2008. For instance, the erstwhile (consolidated) Reliance Industries Ltd. was trading around 16-17x 1yr forward earnings in 2004, while now it trades at around 22-23x 1yr forward earnings. Sure it has corrected from 28x it was trading in early 2008. But we believe that to make an entry into Reliance Industries, we still have time on our side, right through 2008. This is true for most of the Sensex companies.

Secondly, sector wise we think that it would be prudent to move away from high beta sectors (read; rate sensitives, high growth, high multipliers), to defensive yield oriented and low beta sectors.

Thirdly, we believe that the near term could throw up certain sectors which could end up gaining from the current slowdown. Counterintuitive you might say. We meant in terms of relative performance.

Slippery when wet!!

Its like running while wearing rubber gripped shoes on a concrete surface. When the surface is dry the rubber provides grip and powers us forward. But what if we hit a patch with water on the surface. Just can’t imagine that, can you? The same, we argue, is that case with rate sensitives, high capex sectors, and ultra growth movers. A little lower octane (capital) provided than before can slow these sectors more than a few percentage points.
As a result of the successive liquidity squeeze, which in all probability does not seem to be over, the octane for certain sectors suddenly has been cut.

Real estate, banking, capital goods, construction, autos and manufacturing in heavy industries are the ones which could have visible lack luster performance in FY09. This situation could get complex as a result of commodity inflation, resulting in another set of industries such as Metals, cement, transportation & logistics and processing companies getting margin squeeze.

We believe that it is indeed a time to get defensive, albeit move into a watch mode from here. This situation could persist for maybe a year before the next leg of performance by the heavyweights of capital consumption.

The formula (if we can call that) to get over this trying phase is to look back at those sectors which display a secular demand which is devoid of economic cycles. FMCG, F&B companies, Pharma, IT and related services and of course medical care.

These stocks will display continued growth, could be available cheaper than those stocks in the cyclical sectors and could assure you decent returns which may not be provided by cyclical or growth stocks in this period of pain.

One could therefore look at stock such as ITC, Indian Hotels, Apollo Hospitals, PVR, and TCS.

Therefore, if the hare is resting bet on the tortoise.

Picking beaten angels - Part II - LMW (BSE: 500252)

Amongst all the clutter and noise at present in the market, we believe that there are companies which are plugging away slowly, beaten down more than necessary due to market pessimism and worthy of mention as a result of attractive fundamental story. LMW or Lakshmi Machine Works, (BSE: 500252; NSE: LAXMIMACH), is one such name. Below, we present our case:

Investment Rationale:

Lakshmi Machine Works Ltd (LMW) is a Coimbatore, Tamil Nadu based textile machinery manufacturer. LMW is India’s largest and world’s third largest textile machinery manufacturer. LMW is a 40 years old company and sold almost 2.3mn spindles in 2007 with almost 60% of the domestic market. Swiss based Rieter is world’s largest textile machinery manufacturer and has a long association with LMW. LMW acquired the technology to manufacturer textile machines from Rieter’s only. In 1999, both the companies called off their collaboration, but Rieter still continues to hold 13% in LMW and has its own production unit in India as well. Before we start narrating the entire script, here are the following major pillars of our investment thesis:

1. Orders of Rs.4500 Crores in hand, leading to a sales visibility for next 2 years.
2. Gets 10% of the order as advance from the customer, leading to negative working capital
3. Debt free with a cash of ~ INR 600 Crores at FY 07 end
4. Gets 1.75% of the textile machinery bill amount as subsidy from GOI under the EPCG scheme. Sales of textile machinery to 100% textile EOU are considered to be deemed exports.
5. Stable OPM of 17-18% and PAT of 11-12%
6. Implementation of VAT in TamilNadu is saving Rs.2.5-3 Crores every month for the company
7. Exploring other major Asian textile manufacturing hubs like Pakistan and Bangladesh
8. Textile Up-gradation Fund Scheme (TUFS) has been extended till 2012 by GOI

9. No price change since June 2005 with iron & steel, aluminum, brass, copper and pig iron as the biggest raw materials
10. Invested ~Rs.400 Crores in last few years to double the production capacity to 3.5mn spindles in 2008 from 1.8mn spindles in 2006
11. No plans to expand the capacity going forward

One Immediate Trigger

Voltas provides presales, order booking and installation services to LMW. In its latest results announced by Voltas, the company has gone on record saying that “Textile Machinery division achieved 20% growth in equipment sales”. Applying the same logic to LMW, the company should post the same growth in its textile machinery business also leading to Rs.2000-2100 Crores of sales in FY08 with Rs.1682 Crores of sales in FY08.

LMW is scheduled to announce its results on May 19, 2008.

Indian Textile industry – Key Facts

1. Accounts for 14% of industrial production and 4% of GDP
2. Employs approx 35mn people, second largest after agriculture
3. India’s textile exports in 2006-07 - $17B. Target to export $50B by 2012
4. India’s expected domestic textile market in 2012 - $50-60B
5. Installation of 38.8mn spindles (21mn supplied by LMW) out of which:
1. 29.8mn are active
2. 10mn are waiting to be scrapped
3. 15mn are fit for modernization
6. 6. India’s textile machinery market (3.9mn pa) is second largest after China (7mn pa). Pakistan is third largest with 1.1mn spindles pa.
7. 7. India is expected to add 3.5mn – 4.8mn – 5.4mn spindles every year under worst, base and best case scenario till 2012 to reach its $50B export target.

Business Profile

1. More than 4 decades old
2. Sold 2.33 mn spindles in 2006-07, with ~60% of the Indian market
3. Third largest textile machinery manufacturer worldwide with Rieter of Switzerland and Schlafhorst of Germany bigger than LMW
4. Long-term association with Rieter has helped the company to learn the technology with 90% of raw material and components locally procured. Reiter holds 13% of LMW. Reiter has its own production unit in India.
5. Large localization helps the company to sell the products at 15-20% less than its global peers.
6. Invested Rs.410 Crores in last 2 years to increase the capacity from 1.8 mn spindles in 2006 to 3.5 mn in 2008.
7. Takes 10% of the order as advance, leading to negative working capital. Similar amount on Rieter BS seems to make this a worldwide phenomenon.
8. Increased capacity and improvements in production has helped the company to decrease the delivery period to 10 months from 18 months.
9. Worldwide textile machinery demand peaked in 1HFY07. LMW is expected to end FY08 with an order book of Rs.4500 Crores as against Rs.5400 at Q2FY08 end.
10. Plan the production at the beginning of the quarter by getting an approval from the customers.
11. Irrespective of the date of arrival of the order, the customer is charged at the time of delivery of the machinery.
12. The pricing is done as per the prices prevalent at the time of delivery, as per the competitor’s rates and the market conditions. Due to this practice, the margins are expected to remain stable going forward.
13. The company has been following the current pricing rules since last 40 years and has never faced any issue with any customer.
14. No price hikes since June 2005.
15. The company gets 1.75% of the bill value machinery sold as exports or to EOU’s as benefit under EPCG scheme from GOI. The company previously used to share (50:50) the benefits with the customers but now has stopped the practice.
16. Implementation of VAT in Tamil Nadu is helping the company to save Rs.2.5 Crores - 3 Crores every month.
17. Holds investments worth Rs.60 Crores. JV with Rieter had sales of Rs.121 Crores and PAT of Rs.9.85 Crores in 2006-07. LMW has invested Rs.12.5 Crores in the JV.

Product Profile

1. Textile Machinery Division – 90% of the sales
2. Machinery tools & Foundry Division – 10% of the sales.
3. As the technology in the machinery tools division is highly guarded by some of the world major’s, the sales mix is not expected to change dramatically going forward.

Shareholding Pattern

Association with Voltas is strategic as the same provides presales, order booking and installation services to LMW. Voltas charges 3%-4% of the bill amount as commission.

We would like to resist from giving any projections considering the uncertain economic environment we are in. Also as per our philosophy, is it what he have that matters and not the uncertain future.

Conclusion

LMW with its leading position and strong order book is a strong defensive investment available at cheap valuations. We expect the company to do well in future and the share price to mirror company’s financial performance.

Sasken Communications – UPDATE… (BSE: 532663; NSE: SASKEN)

Wow!!! We like this! While the prices of real estate in Bangalore have stabilized, why has Sasken communication gone up in Value?
For starters, the stock is up > 60% since we last wrote about it last month. Yes we agree that the stock was close to 80% down from its 52wk high, but what the heck!
Wasn’t it a golden opportunity to average out to a decent price and maybe exit at the next up move if you felt skittish? We hear people screaming out “Falling Knife” and won’t fall for that one. Well that’s where those who test the business model WIN.

IT is the next in thing…
Well, we are not saying this. Its’ the GURUS who are saying it. We always maintained this ever since we starting writing on it late in 2007. (Refer: Ab kya hoga?)

We believe that the long term IT story is pretty strong. Margin may come under pressures, business model will change, and the sector will look more like cyclical over a decade from now and probably there will be a shakeout with some bruised and battered companies.
The trend could also change, slower growth, more controlled performance, steady dividends and yes acquisitions. Finally there will be winners.

Let get fundamental…

1. There are a few things that we look at in a company when we invest into it (at least this is the philosophy that we believe in).
2. Is the company in a domain in which it has a first mover advantage?
3. As a result has the company able to maintain a top slot in the sector?
4. Are there catalyst that we dethrone the company in the near future?
5. Is the business model in for a fundamental change in the future/is threatened by forces (external or internal)?
6. Is the company favorite / dumped by the street for a longer lengths of period in time (in simple terms – valuations)
   

The results are good or bad?

Sasken reported Q4FY 2008 numbers yesterday and while we see them in the comfortable, the street seems to be reiterating its SELL mantra. We believe that the street has got it right as far as next 2-3 quarters are concerned.

Citi (analyst Surendra Goyal, a good friend of ours) has a SELL report in the market reiterating very valid concerns in the short term. But we disagree with him certain macro fears he puts forth.

Metrics would continue to drag, performance might be subdued and risk could look overwhelming. We believe the opportunity might come over a longer period (12-18 months) is

1. Telecom space (where the company operates) improves as a result of continued penetration in the domestic and Asian markets. We would see revenue growth steady and continuous
2. Margins hitting bottom and then reverting back to saner levels of higher double digits (possibly mid-teens).
3. Employee costs stabilizing over the next 18 months as a result of overall lackluster employment opportunities

Sasken for now has done two important things to keep nervous investors some comfort.

a) Given a 40% dividend on a INR 10 FV share. This translate into a dividend yield of little under 3%, so this is a positive, a minor one you would say. But we conclude a positive nevertheless.
b) Sasken board has approved for a buyback upto INR 40 crores, an authorization for buying shares upto INR 260 / share. CMP at around INR 144. We believe that even though this also will not really lift EPS materially. The signal from management at the moment is the company is undervalued. We believed this for the last 3-4 months.

Time to speculate, then?

Well we believe that there will be lots of activity in this counter from now on. The triggers are the buyback, dividend stripping and bullish traders getting in the make a quick buck while the undertone is positive.

The safety net is therefore stronger than before. However, we think that investors should look at this counter only for a fundamental story rather than a speculative opportunity.

Easier said than done.

We think we could see this counter moving up nicely to around INR 220-240 effortlessly. So a good 40-50% from here in the next 3-6 months. Over a longer term however, we continue to maintain that the upmove could be a lot more painful than it appears. Investors who entered this counter at various levels starting at INR 300-400 price band have caught a falling knife and made a few deep cuts to themselves.

But were they intelligent enough to buy some more when it reached INR 86 (all time low) a few weeks ago?

We don’t know that for sure.

Until next time….

UPDATE: Gold fever - It still ain't what it used to be....

Gold: Is it a Consolidation phase ($900-$950 level) or things are really going wrong?

What is going on behind the scene?

Gold still remains the best bet in precious metals. Gold has given an annualized return of 46.28% YTD and around 40% annualized since we wrote our first thesis and recommendation on gold (see article date January 21, 2008). Gold roared to a lifetime high of $1,030.80/ troy oz. on March 17, 2008 but then tumbled to a two-month low of $872.90 in early April in a broad commodities sell-off. It has bounced since then and stood around $935 an ounce on April 15, 2008. There has been increasing media reports and speculation about future of gold. In our opinion, the concerns like, “is the bull run over”, “has gold seen its golden season”, are baseless and we have reasons for our strong view. Many on the street are also arguing that the shining in gold was due to the increased money flow in the commodities complex (Commodity ETF’s/funds), however we think this remains one of the factor but certainly not the underlying one, gold has its own reasons supporting the price movements.

The answer to the first question in the headline is affirmative and second question is negative.

Recent concerns/factors working for gold:

1. Strong fundamentals: Increasing supply concerns from South Africa:

Gold still enjoys the case of strong fundamentals where demand is still more than supply (see our previous analysis "Gold: its ain't the fever what it used to be Jan 2008")

South Africa (SA) is one of the top producers of gold. In terms of 2007 mine production it accounted for around 11.1%, Just behind China which enjoyed 11.3% (see production chart). Lately SA is having growing imbalance between the power consumption and generation. As a measure of regulation and in order to control things, SA govt. is controlling all the power allocation to all the business’s which primarily includes gold mining. As per last update, SA govt. is now allocating around 90% of the power which the mines used to consume earlier. This is regardless of which mine is producing how much in terms of efficiency and cost, hence even if the producer may want to allocate 100% or more of the power to some low cost and more efficient mines and keep certain high cost mines closed , it has no option but to suffer on rising costs for non-efficient mines.

As per experts and power industry consultants the power problem is a structural problem on account of lack of build up of new generation facilities coupled with increased usage and bad weather, hence the situation might take around 2-3 years to get fully normalized. Major gold producers like Gold Fields, Anglo American (400,000 ounces shortfall) have already announced reduced production guidance on account of power shortages.

Source: http://www.goldsheetlinks.com/production.htm
Source/further readings supporting the thesis: 2007 world gold production fell marginally and 2008 output to stabilize – GFMShttp://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50465&sn=Detail

2. Renewed demand from Asia particularly India: Seasonality

Though there is no denial of the fact that demand was subdued in India and China due to high gold prices, the fact remain that gold is the party essence for every celebration in India. This time the pullback is attributed to or rather spurred because of the wedding season (ending May 2008) and The Akshaya Tritiya festival (May 7, 2008). Jewellery demand may see a major spur due to these two reasons. We have studied the data from 1970 for gold demand and came to the conclusion that gold does have seasonality factor. The first and fourth quarters are the periods when there was rise in gold price on account of higher demand, while the second and the third quarters were seen as quiet or flat demand during the particular year. Having said that, the analysis is based on normalized data and we have removed specific outliers to improve data quality.

Source/further readings supporting the thesis:
Indian demand keeping gold markets alive
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50690&sn=Detail
Return to gold by Eastern jewellery markets means price may have bottomed
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=49719&sn=Detail
Citigroup warns of waning gold investment, seasonal slack - but positive long term
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=50688&sn=Detail

3. IMF sales – a perspective. The gold for sale is different from the rest!

The recent announcement from the US Treasury on 25th February, approving in principle the proposal for the IMF to sell some of its gold reserves, marked a reversal of policy and generated a knee-jerk reaction in the gold market, with prices dropping by $10 to close at $938 that day.
It looks as though any sales by the IMF will be restricted to 400 tonnes used in a previous sale and repurchase agreement – and in any case would be made within the existing CBGA sales Agreement. The market is right to remain unfazed!

This looks very much like the gold that was used in sale-and-repurchase transactions with the IMF in 1999 and 2000. In these transactions the IMF sold gold to Brazil and Mexico at prevailing market prices and then immediately accepted it back at the same price in settlement of financial obligations of those countries to the IMF. While the net effect on gold holdings was zero, the gold thus accepted was entered onto the IMF's books at the prevailing market price rather than the official price of SDR35/ounce. In accordance with the IMF Articles the equivalent of SDR35/ounce from the proceeds of the sales was retained in the General Resources Account. The increase in the value of the gold held on the balance sheet was deemed to offset the liabilities of Mexico and Brazil to the IMF.

There are three things which needed to be noted in this regard as observed by Crockett Committee:

Firstly the undertaking-sale of gold-should be qualified in important ways that limit its impact on the gold market. In the first instance, the amount should be limited to the 400 tons I mentioned, without envisaging any additional sales.

"Secondly, the sale should take place within the existing Central Bank Gold Agreement, that is to say it would not be additional to sales already programmed by central banks, but would be accommodated by reductions in the amounts of gold that the central banks might sell under the Central Bank Gold Agreement.

"And thirdly, we have emphasized that the sale should be undertaken in a very careful way in terms of their periodicity amounts and manner of sale such as not to disturb the market.

Source/further readings supporting the thesis:
IMF sales – a perspective. The gold for sale is different from the rest!
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=48222&sn=Detail
Swiss Central Bank gold sales – further analysis
http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=49939&sn=Detail