The Conundrum around interest rates

There is one question that is prominent in the minds of anyone who takes even a passing interest in the affairs of Wall Street. And it is this – How long and how much would Mr. Ben Bernanke, the new Federal Reserve Chairman, continue to raise the Fed Funds rate? The concern is legitimate, for the supply of money in the economy, which the Fed attempts to control through the Fed Funds rate, determines to a large extent the potential growth that American economy can exhibit in the coming year.

The Fed Funds rate is the rate that the Federal Reserve charges to lend money to its member banks. If the rate is low, member banks would have incentive to borrow money at a cheaper rate and lend it to their borrowers at a higher rate and pocket the difference (called the carry spread). The borrowers, in turn, would take more loans (perhaps to construct that extra plant, or buy an extra house) when they have to pay lower rates. As such, the Federal Reserve lowers Fed Funds rate when it perceives that the economy is slowing down and might perhaps go into a recession. On the other hand, the Fed increases rates when it feels that the economy is expanding at a faster rate than necessary (which might lead to inflation).

Following the Internet bubble burst in early 2000 and 9/11, the Fed dropped interest rates to historic lows of 1% in a succession of rate cuts by 2003. As the economy strengthened and gained momentum , the Fed started increasing rates beginning June 2004. In a succession of 14 rate hikes of 25 bps each, the Fed funds rate has climbed from 1.00% to 4.50%. It is widely perceived that Mr. Bernanke would increase the rates once more when he chairs the first meeting of the Fed since he took over from Mr. Alan Greenspan. But are there more rate increases after this, or will Mr. Bernanke be satisfied with the state of the economy and leave it at that?

That would most likely depend on the inflation numbers that the Fed measures going forward. While growth is important in an economy, it is even more important to contain inflation. For the biggest reason behind the economic expansion in US in the last 2 decades has been the ability of the Fed to control inflation effectively. Low inflation gives visibility to consumers and businesses visibility into wages and prices. As such, they are willing to take increased risks.

Measuring inflation is, however, not straightforward. Different measures of inflation, such as CPI (consumer price index), WPI (wholesale price index), GDP deflator etc. might give different pictures. Then again, these measures might include items (such as food prices and energy prices) that are more volatile, which might cause inflation numbers to be erratic month to month (Economists try to circumvent these problems by looking at inflation ex food and energy). The Fed also at various other metrics such as the rate of unemployment, capacity utilization etc to get a sense of inflation.

Most of the inflation numbers are currently benign. That makes the bulls argue that the Fed might stop raising rates after the next one. They point out that the economy grew at a mere 1.1% in the fourth quarter of 2005. Consumer spending was flat year on year in the all important holiday season. The house market has started cooling. With so many Americans depending on the home equity lines of borrowing to finance their spending over the last few years, any further increases in rates might cause the consumer to throttle back further, pushing the economy down, maybe into a recession.

Bears, however, contend that the various inflation measures systematically underestimate the real inflation in the economy. They also point out that the rate of unemployment is currently running at 4.70%, which is much higher than the normal rate of 5.0%. As such, it is very likely that wage pressures start building up in the economy (i.e. employees start demanding higher wages). And while the economy might have grown at 1.1% in fourth quarter, it is expected to rebound to 3%+ growth in the current one. They also point out the impact that high oil prices might have on core inflation.

The equity markets have remained range-bound in the last year and half, with the Dow Jones oscillating between 10000 and 11000 during this time-period. If the Fed decides to stop raising rates, the markets might move higher. But then, corporate profits have grown in double digits in the last 15 quarters – the longest streak that the US economy has had since World War II. Besides, this economic expansion has been driven by consumer spending and not business spending. The consumer is currently heavily indebted, the savings rate actually fell below at one time last year. Perhaps the consumer might slow down even if the Fed stopped raisi! ng rates, and business spending might not pick up enough to fill the gap. If that were to occur, one might not see the Dow crossing its all time high of 11, 722 hit on Jan 14, 2000 anytime soon.

The hype on Rediff

Disclaimer: This is not investment advice. Consult your investment advisor before making a decision.This could be factually incorrect. Author does not hold position in the stock, but could have a vested interest in seeing the publication of this article. This represents the author's fair opinion of the company, which might be completely incorrect. Author might not have any financial, accounting or valuation background. Again, contact your investment advisor.

These days if Jim Kramer as much breathes the name of a stock on Mad Money (CNBC) - the stock runs (or tanks) depending which side Kramer is on. He mentioned Rediff earlier this week, as a play on India, on Jan 24. Not surprisingly, the stock has jumped - about 35% since that day. http://finance.yahoo.com/q/bc?s=REDF&t=5d. So is Kramer speaking out of his hat, or is there some sane reason behind his bullishness?

Rediff was first (or amongst the first portals) that were launched in India in the late-90s. Most of them, such as indya.com, flamed out with the dot-com bust. Amongst the survivors, Rediff and Indiatimes are the biggest Indian portals. Rediff enjoys a very strong brand recognition amongst Indians - this writer has lived in US for 3 years and still visits Rediff, as do almost any other Indian that he knows. This has been achieved without heavy advertising spending - in contrast to Indiatimes. Indiatimes, owned by Bennett and Coleman (publishers of Times of India - the largest read Indian English daily), has been "cross-promoted" on an entire page in the Times of India every day for the past 7 years. And still, it lags Rediff in rankings.

On Alexa, Rediff.com is ranked globally as the 132nd most visited web site. http://www.alexa.com/site/ds/top_sites?ts_mode=global〈=none&page=2#. Rediff is the top-ranked Indian website - ahead of Google India (though there are a large number of Indians who go directly to Google US) and it closest competitor Indiatimes (ranked at 301). Yahoo India does not get ranked seperately. Does that smell gold? Not necessarily. Rediff ranks ahead of such websites as Monster, Best Buy and Netflix. Mere high internet rankings are not enough to translate into a high market cap or oodles of cash flow.

Rediff's ADS trade under the ticker symbol REDF. Each ADS is equal to 1/2 share.

Basic Shares outstanding - 14.39 million
Shares underlying Options - 520.8K equity shares at weighted average price of $8.29, or $8.29/2=$4.15 per ADS (As each ADS = 1/2 equity share). This adds another 261K share, at current price of $19.78 per ADS.

So, Diluted shares outstanding - 14.65 million

Current REDF ADS price - $19.78
Equivalent REDF share price = $19.78*2 = $39.56

Market Capitalization = $39.56 * 14.65 million = $580 million. The company has essentially no debt, so its Enterprise value (EV) is $580 million

Besides a web portal, Rediff also publishes two weekly newspapers: Rediff USA and India Abroad. Of the $12.6 mn revenues reported in 2004, $6.6 mn. were from the portal, while $6.0 mn. were from the newspapers. The Online business grew 53% each year over the last 2 years, while the publishing business remained essentially flat.

This year, the online business has accelerated. If we annualize the revenues reported in first 2 quarters of 2005 (Rediff has a March year end), the online business is set to show a 75% increases in revenues, from $6.6 million in 2004 to approximately $11.5 million in 2005. If it grows at 75% next year, we are looking at a revenue of $20 million for the web business in 2006. Add $6 million in publishing revenue (assumed flat), and total sales in 2006 will be $26 million.

Rediff has consistently made losses. This year, it will barely be profitable. As such, we use an Enterprise Value/Sales ratio to get a sense of Rediff's valuation. Rediff is trading at EV/06E Sales multiple of 22x ($580/$26) - which is expensive. Note that this multiple is on sales - 25% of which will come from a no-growth publishing business. Could this steep multiple be justified?

If one recalls the euphoria surrounding Chinese Internet stocks (Baidu, Sina, Alibaba etc) over the past two years, it would seem logical to get bullish on Rediff - the biggest Indian Internet portal. But Baidu and Sina are the top 10 ranked sites globally - Rediff is 132. Sina.com is expected to have $237 million in revenue in 2006. The company has a current market cap of 1.23 billion. Currently, it has a net cash position of $188 million. So it trades at an EV/Sales ratio of 4.4x. Besides, the company is profitable - 06E consensus EPS is $1.07 for a P/E ratio of 21.7x.

Maybe Rediff has a much brighter growth curve ahead of it than Sina. And then, News Corp acquired Myspace for $580 million when it had piffling revenues. Yahoo, Google and other big media companies are aggressively buying web properties. Rediff targets a particular demographic - and an increasingly important one at that. It might be a good acquisition target. But will any acquirer be willing to pay $580 million?

Lets look at Myspace. Myspace was the fifth most trafficked site in the US when News Corp bought it, and is the 13th most trafficked site globally. Its growth has been explosive, from a virtually nothing 2 years ago, to over 13 billion page views per month today. Rediff, on the other hand has merely increased from 400 million page views to 600 million page views over the same time period. Over this time, Rediff has constantly ranked below 100 in the list of most trafficked properties, indicating that a lot of the growth has come simply due to the widening reach of the Internet. http://www.alexa.com/data/details/traffic_details?&range=2y&size=medium&compare_sites=redf.com&y=p&url=http://www.myspace.com#top

And this is perplexing. The biggest Indian portal is not showing any explosive growth in its page views. This company, which has been existence for close to a decade, will barely touch merely $20 million in revenue in 2006. Over this decade, Rediff's management has done a few acquisitions, including the publishing assets, a calling card business (which was sold - why did a Internet portal invest in a calling card business in 2001 when lond distance prices were in free fall is mysterious, only to sell it off in 2 years at a mere 16% of the price paid?) etc. In the meantime, other India focused websites - such as privately held Shaadi.com - have been able to monetize their product more effectively.

One would argue that Internet penetration in India is rising exponentially, which might justify Rediff's valuation. But we do not see it in Rediff's numbers. Quarter-over-Quarter in 2005, growth in Online revenue is flat. There are still not enough users in India to cause massive shift of ad dollars to the Internet. Maybe they will come in 2 years, in which case the stock is 2 years ahead of its time.

Resources for Research on Indian stocks

India Research sites:

Regulatory sites:
1. SEC: For Indian ADR's like Infosys, Tata Motors, Rediff - searh for Form 20F (Annual filings), 424B4 (prospectus), etc.
2. http://www.bseindia.com/: Bombay Stock Exchange Website - get annuals, quarterly filings of companies.
3. http://www.nse-india.com: National Stock Exchange Website

News sites:
1. http://www.thehindubusinessline.com/iw/index.htm: Hindu Business Line - the best one in this writer's opinion.
2. http://www.businessstandard.com/: Business Standard - the second best
3. http://www.financialexpress.com: Financial Express
4. http://www.economictimes.com: Economic times

Finanace web sites:
1. http://www.moneycontrol.com/: Message board section gives rumuor mill on a company. Also there is a section where one can see the block trades for any stock.
2. http://www.indiainfoline.com: Some of the company information is often outdated.
3. http://www.myiris.com: Good source of corporate information - use with care.

Blogs:
1. http://www.rupya.com: For daily commentary on the market.
2. http://www.indiauncut.com: The most widely read blog in India, though it is not entirely on the financial markets.
3. http://www.indiastockblog.com: Blog from the "Seeking Alpha" network".

Oil, and The Impact of the Dollar Yuan Peg.

The other day I had the fortune of hearing P.Chidambaram speak at the India Investment Forum in New York. He briefly touched upon oil, and said that the every $10 rise in oil prices curtails the growth rate of India by roughly 0.5%. So I thought it would be relevant to understand the oil debate – the rapidly increasingly oil demand that threatens to overcome constrained supplies - and the role the dollar-yuan peg has played in making the problem worse.

Oil prices have risen sharply in the past couple of years after the US invaded Iraq, after having remained below $20 per barrel for most of the 90’s. In the wake of Hurricane Katrina, oil futures rose close to $70, their highest level ever, on the New York Mercantile Exchange, which on an inflation adjusted basis is still below the $104 peak that oil prices touched during the oil shock of the 1970s. While so far, the impact of high oil prices on global growth has been minor, it looks that $3/gallon oil might have started impacting consumer demand – at least in the US.

Oil demand has risen sharply in the past few years, while supply has remained stable. The current demand for oil is approximately 82 million barrels/day, and the total crude-oil producing capacity does not exceed it by much – just 1.5 million barrels/day, according to the Wall Street Journal. A more normal cushion is of the order of 4% of demand or 4.5 million barrels/day. The International Energy Outlook forecasts demand to rise sharply by 2 million barrels/day over the next decade, while supply will increase by only 1.5 million barrels/day. The supply remains constrained due to low levels of capital expenditures by the oil companies in new exploration and refining over most of the 1990s, when oil prices were in the low $20s. As such, there is not enough of spare capacity left, and demand can easily overwhelm supply if there was a shock to the oil production and refining infrastructure, which can take the form of Hurricane Katrina and Rita hitting the US Gulf Coast, or a political disruption in any of the oil producing nations.

There are three countries whose dynamics impact the demand side of the oil equation – US, China and India. US is the largest consumer of oil in the world– this country that accounts for 4% of the world population consumes 25% of its oil. On the other hand, China and India have been amongst the fastest growing consumers, and have helped push oil demand threatening close to supply.

The US consumes 25% of total worldwide oil, of which more than half is consumed by cars and trucks. US consumers have continued buying gas (petrol)-guzzling SUVs in the past couple of years, even as oil prices have shot up from $1/gallon to $3/gallon. US consumer demand has remained strong due to a sharp increase in wealth brought on by high real-estate prices and good returns from the stock market in the last two years. This has primarily been the result of low-interest rates. If interest rates went up slightly to calm down the real estate market and also make car financing less attractive, consumers would cut down on oil consumption.

But why have the interest rates in the US been so low? The Fed has tightened short-term interest rates from 1% to 3.75% in the last year and half, but the yield on the ten-year bond – the bond yield more relevant to the long-term house mortgages - has refused to move upward. If anything – at 4.24% currently, it is actually lower than when the Fed first raised interest rates in mid 2004.

Bond bulls say that even though US interest are low compared to historical standards, they are higher than what exist in the rest of the world currently. And so bond investors outside are investing in US treasuries to take advantage of their relatively high yields. Add to that the current uncertainty in the Euro area (Germany, the biggest Euro economy, has had a hung election), and that makes US Treasuries even more attractive.

The biggest buyer of US treasuries these days is China, besides Japan and Korea. China enjoys a huge trade surplus with US, and it needs to put this extra money somewhere outside the country, for otherwise it would fuel inflation within. That place is the US. There is no other place to invest. If EU had been growing faster, then some investments might have gone in Euro zone. That, unfortunately, is not the case. So why does China enjoy this huge trade surplus?

That is because of the yuan-dollar peg. Till before this year, yuan was pegged to the dollar at 8.28 yuans per dollar. This year, under pressure from its trading partners like US and Japan, the Chinese government changed the peg to 8.11 yuans per dollar, and also allowed Yuan to float in a very narrow the trading band of approximately 0.3% against the US dollar, which is too small to cause a meaningful revaluation. As such, Chinese goods remain very cheap in US dollars, and so WalMart, Dell and other US companies continue sourcing from China. So, the trade surplus that China enjoys vis-à-vis the US continues to exist and keep on growing.

If Yuan were to float freely, it would appreciate and dollar would depreciate. Chinese exports to the US would slow down, narrowing the US trade deficit that stands at around $55 billion/month. This would mitigate China’s problem of investing its trade surplus, which it currently does in US treasuries. As such, the demand of the US treasury bonds would decline and the US bond yields would inch up.

This would also help curtail Chinese oil demand. A stronger yuan would lower Chinese exports, and lower the growth rate of this export driven economy, curtailing demand in the world's fastest growing economy and car market.

India has contributed its small might in keeping domestic oil demand high. By keeping the lid on retail oil prices, Indian government has not allowed the oil demand to trend down, commensurate with the increase in global oil prices. HPCL, BPCL and other oil companies are incurring significant losses by selling oil to consumers at below the cost at which they purchase globally, and are on budgetary support.

One should remember that the oil price increase this time is different from the 1970's: then it was a supply side shock with a cartel of Middle East countries suddenly raising prices. This time it is demand driven - a demand that is inflated in US, China and India due to distorted macroeconomic policies. While correcting these policies might temper demand and economic growth in China and India in the short run, it would be healthier in the long-run as it would prevent unsustainable economic forces from building up in the global economy.

What Alan Greenspan has aimed to achieve by increasing the interest rates in the last year and half is to have a soft-landing in home and other asset prices in the US, without pushing the world’s largest economy into a recession. High oil prices have the potential to thwart his aim. The global economy has become more energy efficient in the last 30 years, which is the primary reason why oil price rise hasn’t had an impact on growth so far – however, there is a limit to which energy prices can rise without pushing the globe in recession and stagflation.

HPCL and BPCL - a long dated call option?

Investors in oil over the last year have had a great bull run worldwide. There has been no such luck for investors in HPCL, BPCL and the other public sector oil companies in India. With the government not allowing the retail prices of oil to rise to levels commensurate with the worldwide prices of oil, it is these oil marketing companies that have been taking all the hit between the price they pay to buy oil and the price at which they sell it to retail consumers.

So how much are HPCL and BPCL worth? I think that at some point over the next year, Indian retail oil prices will slowly catch up with global oil prices. And if global oil prices slip down below the retail price point - which they will, because current prices of $68 per barrel are not substainable (see below) - then the government will not reduce the retail oil prices. They will let both HPCL and BPCL get whole on the losses. And their stock prices will shoot up at that time. One should recall that it is dividends from these companies that had helped the central government keep its finances in shape in the last few years - and so the losses at these companies are very painful for the budget.

In the meantime, how low can HPCL and BPCL go? Clearly there is a value to the assets - the companies own oil refineries and petroleum distribution points across the country. I dont know what the value of these assets is - but it looks increasingly that this is as bad as it can get for both these companies. HPCL has consistently found support around Rs 285-Rs 290 levels. I think that the risk-reward in both these stocks is skewed heavily towards upside. But it might take a long time for this to play out - one year, maybe two - and so you have a long-dated call option will these stocks.

What is the story with oil? I had written earlier on how low interest rates in the US are continuing to fuel the housing boom and the consumer demand which is keeping oil demand high, and also the role China is playing by keeping its currency pegged to the dollar: http://gaurav1.blogspot.com/2005/06/oil-what-is-happening.html. One should remember that the oil price increase this time is different from the 1970's: then it was a supply side shock with a cartel of Middle East countries suddenly raising prices. This time it is demand driven, and there are some indications that at $3/gallon of gasoline, even the crazy US consumers start feeling the pinch. If Hurricane Rita takes out the oil refining capacity in Texas, and gasoline shoots up to $4/gallon, we won't have a merry Thanksgiving and Christmas in the US. Demand of oil will go down as economy hits a soft patch, and so will the prices.

The Fed after Katrina and the woes of US airline industry

The Fed Reserve meets tomorrow to decide on interest rates. In the past week, market participants have been split as to whether Fed would pause rate hike in the wake of Katrina, or will it continue to push to nip any signs of incipient inflation. Inflation has so far been contained in oil, but inflation ex oil might now start creeping up as the federal government starts spending billion of dollars to clean up the Gulf. The stock indices moved up nicely over the past week, on the theory that spending to clean up the mess would benefit businesses.

Airline industry has been in perpetual turmoil since 1978, after deregulation. This is what Warren Buffet told his shareholders at their 2003 annual meeting -"A great management in that business will not necessarily get a great result. In the airlines, you have a huge amount of capacity...something close to a commodity product with high fixed costs and no marginal costs.
That extra seat doesn't cost you anything, so the temptation to sell that at a terrible price is
overwhelming."

This is what I though of the other day, when I wrote on fixed costs and variable costs: http://gaurav1.blogspot.com/2005/08/fixed-cost-vs-variable-cost-structures.html.

Resources for research

Slowly and slowly I have become very efficient at searching for abstruse information and pulling it all together - at least that is what my last performance review reads. While I cannot help with analysis, I can certainly compile the list of sites to get useful information.

1. SEC: - the place to start any kind of corporate research. Search for a company, read its 10-K and 10-Q filings.
2. Yahoo Finance: For up to minute news, consensus estimates, message boards. Create virtual portfolios.
3. Briefing.com: The best up-to-minute commentary of what is happening in the markets.
4. Technorati: And other blog search engines. Unfortunately google doesnt search blogs currently (or more precisely, doesnt give an option to search blogs only - which might be more current than the mainstream media outlets, which would appear first if you type, say MTV 2005 awards).

India Research sites:
1. SEC: For Indian ADR's like Infosys, Tata Motors, Rediff - searh for Form 20F (Annual filings), 424B4 (prospectus), etc.
2. http://www.bseindia.com/: Bombay stock exchange website.
3.. http://www.moneycontrol.com/: Message board section gives rumuor mill on a company.
4. http://www.thehindubusinessline.com/iw/index.htm: Hindu Business Line is the most unbiased financial newspaper in the country.
5. http://www.indiastockblog.com: Blog from the "Seeking Alpha" network - this network ranked highest on Businessweek's list of top rated financial blogs.

General:
1. http://www.treasurydirect.gov/: To buy goverment bonds. 2 yr is yielding 4%.

Steel stocks and Tisco

There were reports in WSJ and other publications over the last month that steel prices would go up in the coming months, and hence the outlook for steel stocks is positive. Morgan Stanley upgraded its weighting on steel to attractive from neutral. Goldman however maintained that steel stocks were significantly overbought, having risen 30% from mid-April lows. Turns out that Hurricane Katrina, which stuck Gulf coast late last month, has helped the bulls - with the supply of a few key inputs to the steel production process dislocated, Mittal and Nucor raised prices.

Japanese steel producers like Nippon steel have also raised their prices, but the Chinese producers, who are suffering from significant overcapacity have not. Tisco in India has also raised prices.

I guess the key question for Tisco and other Indian steel producers is - how easy is it to import steel from China? If it is not, and Indian producers go on an expansion spree as Tisco is planning to - they would get hammered if demand turns down. They can definitely accuse Chinese steel producers of dumping and the Chinese government of subsidizing the steel mills through cheap loans (while Tisco pays market prices for its debt), and thus get the Indian government to impose some tarriffs and anti-dumping duties. But Tisco is planning to expand aboard - it bought a steel mill in Singapore and is planning to buy one more. 20% of its revenues now come from abroad. These revenues wouldn't be protected by Indian government tarrifs.

Long-Short pair and Residual Reversion: Tata Motors and Maruti

Many hedge funds run long-short equity portfolio, i.e. they go long one stock and short another to make money on the valuation spread. There are two key questions in analyzing a long-short pair: (a) Is there a valuation difference between two stocks which would converge over a period of time? (b) What is the return from the long-short pair on a risk-adjusted basis?

How should risk be thought of in the long-short world? We can measure the beta of the long-short portfolio to get a handle of the risk. Remember that beta is the square root of covariance of the two-stock portfolio, which in this case would be {Variance-1 + Variance-2 + 2sqrt(variance-1*variance-2)}. The lower the beta, the better it is.

If the two stocks have the same beta, then the beta of the long-short portfolio is 0. This is intuitive - if one stock goes up by x% and the second falls by the same, then the total return from the portfolio is 0, assuming equal weight of both stocks in the portfolio.

However, if between the two stocks that had historically had the same beta, one stock has fallen (or risen) more than the other recently, then the other stock would fall (or rise) more than the first over the coming time period - provided nothing changed fundamentally between the two stocks, and there is reason to believe that the historical relationship would hold in the future. This is what some analysts define as Residual Reversion.

Over the past year, I have become convinced that residual reversion exists between the stocks of Tata Motors and Maruti. Again and again, there share prices have diverged, and again and again they have converged. The stocks have similar betas, they operate in the same industry - Maruti holds 50% share in the Indian passenger market segment, while Tata Motors enjoys a 17% share.

One should however remember that Maruti shareholders might not enjoy the full benefit of Maruti's growth in the future as the Indian middle class expands - the new car plant proposed by Maruti is a 50-50 JV between Maruti and Suzuki, Japan. As such, Maruti's shareholders will get only half the growth from new car sales. So, TAMO might be a better buy in the long run.

Media business - sources of revenue

What are the various sources of revenue for a media/communications company? Most of the revenues of these companies are driven by consumer spend and corporate ad spend. They can fall in one of the following categories:

a) Subscription: Magazine subscription, pay channel (HBO, Cinemax, Showtime) etc, cable tv - satellite - telephone subscription.

b) Single-item purchase: Consumers buying (a) books (b) park entrance tickets, say to Disneyworld (c) Movie tickets (d) DVDs (e) Music sales (f) Other consumer product purchases, like kids buying Mickie mouse toys or sports apparel from ESPN.

c) Advertising (corporate): Biggest source of media revenues - on television, radio, magazines, outdoor advertising

d) Affiliate fees and other content fees: Fees charged by content companies from distributors (cable companies and satellite companies) to make their fare available. Cable networks charge affiliate fees, while programmers (and Hollywood) charges various networks for making their content available.

The movie and television business would be amongst the most complex businesses of all, with bizzare value flows amongst lot of players. The hit-driven nature of the business make it all the more difficuult to predict. Pixar and Dreamworks are prime examples. With just one movie release per year, their entire share price is based on expectations of how their next movie will do - which as any moviegoer in the world knows - is difficult to predict till one has seen the movie. Analysts for these companies are really throwing random darts in the air - but then, so are the investors in these companies.

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.

Blogs of my friends

Nancy: http://jasneet.blogspot.com/
Astro: http://astrospeak.blogspot.com
Hemant: http://www.livejournal.com/users/hemantk/

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.

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.

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..

Moschip Semiconductor (listed on BSE)

My friend had asked me to do some research on this company. I think I finally somewhat understood how off balance sheet activities can make the financials look better or worse than they actually are. For this company, the entire income is off the income statement.. And in the process, I found this section on moneycontrol website where one can search for block deals for any scrip..

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· Company Description: The company is in ASIC (application specific integrated circuits) space. It has a wholly owned subsidiary: Moschip USA. The product design and software development is done by MosChip India. The software is licensed to MosChip USA, which subcontracts the manufacturing and sells the chip through its distribution network. The entire revenue from sale of products is thus in MosChip USA. MosChip USA pays a license fee to MosChip India, which is linked to the gross margin on the products designed and developed by MosChip India.

· Complicated Capital Structure and Reported Financials: The capital structure of the company is complicated. The company acquired Moschip USA and Varsity using its shares. On the balance sheet, these acquisitions are accounted of as investments. The financials on BSE are for Moschip India. As such, the sales, income and share count associated with the investments is not on the BSE reported financials. So we don’t really know the consolidated financials of the company, which is critical, as all the sales are recorded by Moschip US. Economically though, as the subsidiaries were acquired using Moschip shares, any economic benefit from these subsidiaries will accrue to Moschip shareholders at some point of time.

· Critical drivers of stock price: Seems like there are two critical drivers of the company’s performace: (a) How fast does the company topline grow overall? (b) What is the revenue and profit sharing mechanism between the US subsidiary and its Indian counterpart? While this does not impact the financial outlook of the consolidated company, a higher royalty payment to the Indian subsidiary would increase the EPS reported to BSE.

Relied on prospectus filed in Feb 04 to get some of the numbers like cash and debt.

Valuation:
· Share count. Before the offer last year 30.64 million. After the offer, additional 3.34 million. GDR listing, additional 9.5 million shares. Total today should be about 43.5 million shares

· EV: 43.5 mn shares * 45 = Rs. 1957.5 mn market cap. As of 1Q:04 Moschip US has 30 mn. debt. Moschip India had 14 mn cash, Moschip US had 3 mn cash. So Enterprise value = Rs 1970.5 mn.
· Revenues: Don’t know Moschip US revenues. Need to approximate.

Method 1: Consolidated sales for 9 months ended 31/12/03 were Rs 94.6 million. Annualizing the consolidated sales, we come up to Rs 120 million in sales in the year ended 31/03/04. Moschip India sales were 3.8 mn during the 9 month period. (Business Standard article says the company’s revenues were Rs 12.63 crore in 2004 – pretty close).

Between the year ended 31/03/04 and 31/03/05, Moschip India sales went up 5.03 times. If it was all due to increased sales by Moschip US, and not increase in royalty payment rates from Moschip US to Moschip India, then sales companywide grew 5.03 times. This would imply consolidated 31/03/2005 sales were 120*5.03 = Rs 603 million

1Q:06 revenues for Moschip India grew 129%. If this is again companywide, and assuming similar growth throughout the year. FY 2006 sales would be around Rs 1200 million.

So EV/Sales would be 1970.5/1200= 1.64x
Risk: We don’t know whether Moschip India revenues are increasing because of increased sales companywide, or increased payments by Moschip US to Moschip India on the same revenue base.

Method 2: Sales increase in 2004 were 20%. In 2003, it was 25%. If it was 25% for FY2005, sales were 120mn*1.25 = 150 mn. If it is same for FY06E, sales next year would be 150*1.25 = Rs 187.5 mn. On that EV/sales = 1970.5/187.5 = 10.5x

· Conclusion: Blended EV/sales by the two methods is (10.5+1.64)/2 = 6.07x. For a company growing at 25%, this would be steep multiple to pay. For a company growing at 100%, this would be a bargain. I don’ t know what the growth rate is for this company.

Positives:
· Company is saying that they will become cash positive this qtr, and EPS positive by year-end – that is great. It is these kinds of companies whose shares run up.
· The company has survived for a long time, including the telecom bust.
· The commitment of the management seems to be there – same CEO since inception.
· The company is hiring - http://www.assureconsulting.com/indiajobs/showjob.php?id=1426, 4 software engineers and ASIC engineers. Engineering strength in 2004 prospectus is 57.

Negatives:
· This company doesnt seem to have any patent. That is very surprising. Prospectus says – “The company is in product development, initially it was in IP”.
· These type of companies are very order driven – no predictability in revenues. There might be substantial variation in revenues from one quarter to next. Because revenues were so high in 1Q:06, they might be depressed in the next qtr.
· No clue about how good the technology of the company is, and who its customers are. As such, we are clueless really to what might be happening.
· About 100 employees – still a small company. But it has great ambitions. Acquired two companies in last 5 years through stock issuance.

Issues:
· The company issued GDR? Listed at Luxembourg exchange? WHY – This is a very small company? Who bought this GDR?
· What is the profit sharing fundamental between the company and its subsidiary in the US?
· Many bulk deals for Moschip in the last week or so. Why this sudden interest in the scrip? Marshall Wace is a hedge fund – holding period typically less than 7 days – they will sell the stock soon. My former boss (Mike Seargent) is the CEO of its US operations. http://news.moneycontrol.com/stocks/marketstats/blockdeals_query.php

Other:
· Got R RamMohan Rao as director on June 4, 2003 – IIM-B ex Chairman.

China revaluing yuan

The news of the day was definitely China looseining the dollar peg (though not by a lot). This should lead to appreciation of yuan, and cause dollar to depreciate. This shouold help inch the 10 yr bond yields up as Chinese lower their appetite for US treasuries (why keep money in a weaker currency). Housing mousing should start cooling off a little bit...


When I was out of the markets, they went up, despite the London bomb blasts which killed 56 people. When I am back in, markets went down, despite the bomb blasts in London which apparently killed no one.. Microsoft has lowered guidance for next year, Google has missed on EPS.. That should be bad news for the market tomorrow

Earnings going through the roof

I think I made an intelligent decision to move back into the market the other day. Coming into the day, more than 85% of the 104 companies in the S&P 500 that reported earnings either met or beat expectations, according to data compiled by Bloomberg. And finally, it is corporate earnings and price momentum that determine the movement of individual stock prices, and the indices on the aggregate.

GM came in weak today, but that is company specific. While Intel and Yahoo missed analyst expectations, Amgen had an absolutely monstrous quarter. It must be remembered that for Intel and Yahoo, analysts have been ratcheting their expectations up all quarter.

Then Greenspan made positive comments about the economy, and oil inventories came out larger than expected, and the indices ended up positively. After close Washingtom Mutual, Allstate and Qualcom have reported big qtrs - that should be awesome tomorrow...

Indian markets - Cable and satellite.. Zee Telefilms

As I continue learning about the US cable and satellite industry, it looks like these are amongst the best businesses to be out there. While the content business (TV and movies) is very hit-dependent, the distribution business is subscription based. As such, there is a lot more predictability to the revenues. And I think this has implications for India.

Whether the Indian economy is growing or slowing down, consumers who have experienced cable service would continue to subscribe to a pay-tv provider (cable or satellite), as long as they can afford it. Because the alternative - Doordarshan - is so plain awful. So, as consumer incomes increase and video penetration increases in India, the cable and burgeoning satellite providers should see massive subscriber growth.

India currently has a dominant state network - Doordarshan, that is free off the air. That is the only channel that one can get for free. For the other channels, one needs to subscribe - till now mostly to a cable provider. Cable distribution in India has so far been heavily fragmented, controlled in many cases by criminal elements. The only big cable-tv provider in India is Siti Cable, owned by Zee TV. It is only now that satellite companies are starting to roll out plans for the Indian market.

As the cable distribution business has been fragmented, it has had a few implications: (a) Under-investment in cable network. (b) Bad customer service (c) Local monopolies within cities, implying prices that vary sharply in different zip codes. If there were to be an alternative, it might gain significant market share. Two alternatives are beginning to emerge on the Indian horizon: Satellite distribution, and Reliance Infocomm.

Satellite distribution has an obvious advantage over cable - low capital expenditures. Once a satellite is up in the sky, it can cover the entire country. The other major expenditure involved is in subsidizing the equipment (dish, receiver) in each subscribers home. But these equipment costs also follow Moores law (after all most of the equipment costs lie in silicon chips). And when subscriber additions reach a certain volume, equipment costs fall even more rapidly. Thus, this is a business with a high operating leverage, i.e. high margins for the marginal subscriber. And presuming that satellite distributors would be companies with bigger balance sheets (a satellite's cost of build, launch and insurance is roughly $250 million) and superior management than the local cable provider, customer service is where satellite companies can get a big leg up.

But Reliance Infocomm would have an even more powerful weapon, besides strong balance sheet and superior management, if it were to launch video service in India. That is the bundle. Having one bill for the land-line, mobile, Internet access and video servicess is a powerful motivation for a lot of consumers to switch from one company to other. And normally, the consumers would get a discount if they buy all the services from one company than if they purchased the services separately. But as Reliance doesnt seem ready to launch video service for a couple of years, we would focus back our attention on cable vs satellite companies..

There are a few other factors which we should take into account:
(a) Prasar Bharthi has ruled that their cannot be exclusive agreements between distributors and content providers (Star, Sony etc.). That basically reduces pay-tv distributors to a commodity channel. If viewers can see the same content on cable and satellite, the only reason to prefer one over other would be price, and maybe customer service.

What I need to figure out though is that whether Prasar Bharti has regulated the pricing at which content providers can provide their programming to the distributors. Because if it hasn't, distrbutors might be able to squeeze some savings, if they have a sufficiently large reach. This would imply that the bigger the cable or satellite company is (in terms of number of subscriers), the better it is for it.

(b) India is booming in the urban areas, agricultural incomes are stagnant. As such, incremental subscriber growth is more likely to come from urban areas than rural. Cable is dominant here, indicating satellite would have a rough time penetrating this market.

(c) Hyper-competition: There are many satellite companies that are planning to launch service in India. Only a couple will survive. It is important to identify which. Star can leverage NewsCorp expertise in DirecTV, BSkyB and Sky-Italia. Who are Zee's partners?

Zee seems to be betting on distribution - both cable and satellite - which is great. I think I need to study this company more. But the equity has moved from Rs 140 to Rs 175 in the last 10 days, since I thought about it..

The week that confounded everybody..

This was a week when almost nothing could go wrong - inflation remains tame, growth remains robust, consumer confidence remains high, oil drifts lower, and companies beat earnings estimates handidly. S&P now sits at 4 year high. I haved moved back all my cash back into S&P and small cap funds. So, these and emerging market funds are where I am invested in.

Right now I am a momentum person. Trying to time the market perfectly - which apparently no one has been able to do. What is the harm in trying anyway - I would learn something in the process.