Monday, August 15, 2005

Fixed cost vs Variable cost structures..

Is it fair to say that an industry with a high fixed cost structure is more cyclical than one which isn't?

If most of the costs in the industry are fixed and are up-front - say construction of a plant - variable (marginal) costs would be low. There is almost always a give-take relationship between variable and fixed costs - businesses with high fixed costs invariably have low variable costs and vice-versa.

If an industry characterized with high fixed costs faces a downturn, companies would be willing to lower prices to the marginal cost of production as it would still cover part of their fixed costs. As marginal costs would be very low in this industry, pricing could indeed take a nosedive. During an upturn however i.e when demand firms up, prices would rise, and as marginal costs are very low, almost everything would fall straight to the bottomline.

A substainable business is one where ROE > cost of equity. This can happen if either of the following three hold:
a) Either/or low fixed costs and variable costs, so that EBITDA and/or FCF margins are high
b) High asset turns - Wal-Mart has 3-4% operating margins but still survives because of high asset turns.
c) Financial leverage.

Sunday, August 14, 2005

Blogs of my friends


Saturday, August 13, 2005

Earnings revisions - end of bull market?

Our equity strategist has written a piece today, where he talks that if earnings revisions are high for asector/stock, it might be time to become cautious. Makes sense. I guess earnings revision and price momentum are drivers of stock price, but only till these are not in the range of wildly positive or unduly negative. He thinks that the oil sector is now in this dangerous zone of earnings revisions. So is the materials sector. Does materials sector include steel?

Looks like investors are becoming more positive on steel - it is already up 30% since May lows. Mittal Steel reported yesterday and stock was up, similarly Nucor was upgraded at Citigroup the other day. But oil prices continue their steep climb up - how will this impact steel? Meanwhile, interest rates have taken a knocking for 2 consecutive days now - they have fallen from 4.4% to 4.24% today. I guess the bond market is hoping that finally maybe $65 oil would slow the economy down and stop Fed from raising interest rates. But I think Fed would rather cool the housing market than slow down on interest tigheting. There was a report in WSJ which indicates house market might have started cooling already. So that might have also sparked the bond rally in the last two days, the thought being that if it has started cooling, there is no need to increase interest rates further.

One way or other, it looks like the bull market is nearing its end. What would drive the stock prices higher? If coroporate earnings keep growing. Interest rates are rising, housing market is slowing, oil prices are higher. Maybe stock markets worldwide can continue their rise, if increased globalization is working to remove some "ineffeciencies" in the world capitalist system. Inefficiencies show up as higher costs on the income statement of companies.

Thursday, August 04, 2005

WSJ article extract: (Fed Sees Bond Market Hampering Its Steps to Keep Inflation in Check)

Many factors influence bond yields: expected inflation, which erodes an investor's purchasing power; the world-wide supply and demand for credit; what economists call a "term premium," the extra yield that investors demand for the many risks of lending money over a longer term, including fluctuations in economic growth and inflation; and Fed actions.

Last month, Mr. Greenspan told Congress that a declining term premium is the main reason bond yields have stayed low for the last year, not economic weakness. Those low rates, he said, are the main fuel for the buoyant housing market. The U.S. Treasury is also expected to exploit the cheap borrowing costs by reintroducing the 30-year bond today.

In a recent speech, Fed Governor Donald Kohn suggested some decline in the term premium is appropriate, because economic growth, inflation and Fed policy appear to have become more predictable.

But Mr. Greenspan last month strongly suggested that he thought investors may be complacent. "Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons," he said. "Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress."

His comments are eerily similar to ones he made in 1999 about lofty stock prices. "An unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable...[which] could create problems for our economy when the inevitable adjustment occurs," he said in July 1999.

Wednesday, August 03, 2005

Bongaigaon Refinery (BRPL)

BRPL paid Rs 12 dividend last year. On a stock price of Rs 90, that is 13% yield. The company is still profitable, despite the lid on retail oil prices that the government has kept over the last year. Last 2 qtr EPS has been around Rs 3.50, implying a annual EPS of Rs 14.00 and P/E ratio of 6.5x.

Indian Oil owns approx. 75% of the company, and has requested the government to merge BRPL with itself. Merchant bankers have been appointed. Considering that valuations in oil sector in India are at their troughs due to the continued governement meddling, this is the opportune moment for IOC to buy good assets cheaply. As IOC owns 75% of the company, it is very likely that the exchange ratio they come up with to exchange BRPL shares into IOC stock screws existing BRPL stockholders. But can they offer an exchange ratio below where the stock has traded over the last 6 months, which is the Rs 85-Rs 104 band approximately?

The stock is going ex-dividend on Aug 12. Say stock price before that is Rs 90. After the pay-out of Rs 6 dividend, stock will go to Rs 84. If a I-banker would calculate the exchange ratio that day, how would he incorporate the future dividend streams in his valuation of the company? Or would she say that Rs84 stock price discounts the future dividend payments, and so no adjustment needs to be made? But if we see dividend paying stocks in US, like Citizens Communications and Panamsat - they derive their value precisely because they are high dividend paying. As such, investors in BRPL who are their for dividend yield would not like to be invested in the lower yielding IOC stock. So maybe, the exchange ratio would value BRPL at higher than Rs 84. Tricky question, but this is THE catalyst for the stock..