Amira Nature Foods Ltd (ANFI:NYQ)

            

       Summary
       On first look, Amira Nature Foods appears to be an attractive small cap stock with a very simple business, impressive growth, and appealingly priced at a PE of 7. 

       However, upon closer inspection, cash flow is a real concern. The company’s reliance on expensive short term debt to fund its operations and material working capital requirements means that it does not generate any free cash flow for equity. In fact, it needs to keep borrowing more simply to fund its costly short-term debt. This business model is not sustainable. 

The risk is compounded by the nature of the business – there is no moat or pricing power, and the business is exposed to margin squeeze. In short, there is plenty of downside on margins but the costs (due to the expensive short-term debt) are high and fixed. 

Unless the business can materially change the way it funds its working capital needs it is not a safe investment for those investors who value preservation of capital above chasing high returns. 

       

       Brief overview of the business
       Amira’s business is simple – it sells Indian specialty rice and related rice based products, with sales in over 60 countries. Approximately 67% of its revenue come from the sale of Basmati rice, a premium long-grain variety of rice grown only in certain regions of the Indian subcontinent.

Amira buys rice paddy from the farmers (via independent agents), processes and ages the paddy before selling it as finished rice. Basmati rice requires ageing – typically 8-12 months before being sold. This exposes the business to significant working capital needs.

       Based on FY2015 results – approximately 41% of its sales were in India and 59% abroad (bulk of foreign sales were in EMEA and Asia Pacific). Amira sells rice both under its own Amira brand, as well to 3rd parties who sell it on under their brand.

       Moat and pricing power

       In terms of the businesses moat and pricing power, this is not a great business. If we take the sales in India, most of India’s retail still happens through so called mom and pop shops. Here brand hardly matter. Shop keepers and buyers don’t care about packaging and shopkeepers frequently sell rice loose in quantities demanded by the buyer.

       India’s organised retail market, where brand matters, is very small at present (approximately 10%), but should grow in future. However, there are many large players in this market who have better scale and visibility than Amira. Furthermore, rice as a product hardly offers significant distinguishing features so suppliers with scale and market share at the outset have a distinct advantage.

       As for the international market, Amira not in the top brands at present. For example, a visit to some of the retailers in London where Amira claims to have a presence shows that it has negligible shelf space compared to the other brands (Tilda is by far best known rice brand in Europe).

       In short, although the business is simple, it is highly competitive. To keep and grow market share requires fighting on price.

       Income statement

       Analysing the last three years income statement since Amira’s IPO paints a strong growth story with revenues showing 30% CAGR, operating profits showing 35% CAGR, and EPS showing 52% CAGR. Consensus estimates for revenue growth at 25% predicts a continuing positive trend for the income statement.

       However, this doesn’t paint the real picture in my opinion. Due to the high risk inherent in the business model and cash flow, I want to look at the quality of the business. To understand the risks behind the current business model, one needs to look at the business working capital, cash conversion cycle, and cash flow.

       Working capital

       Amira procures most of its Basmati paddy in the 7 months between September and March, processes it and holds it for approximately 8-12 months for ageing before it sells the rice as finished product. Due to the amount to time between procurement of raw material and sale, significant amount of working capital is tied up in the business. The company finances this working capital with expensive short-term debt secured by its inventory.

       Of the total assets on balance sheet of USD 490 million, USD 470 million constitutes current assets (mainly inventory, receivables, and cash required in operation). Over the last 3 years, the company’s working capital needs have grown at 44% CAGR (compared to sales growth of 30%) as the table below shows.

       

       The debt to fund working capital doesn’t come cheap at 15%. As you will see from my analysis of the cash flow below, this debt more than eats into Amira’s operating cash flow. Therefore, Amira needs to be able to borrow more each year simply to repay interest on the short-term debt. This, in turn, is only possible by building up higher and higher inventory (as debt is secured on inventory). Any downward pressure on margins exposes the business to significant crisis. This is a vicious cycle for a business that doesn’t have a strong moat or pricing power.

       Cash Conversion Cycle

       Based on my analysis of the company’s Cash Conversion Cycle [Days inventory outstanding + Days sales outstanding – Days payable outstanding], it’s on an average 280 days (or just over 9 months). The below table shows the cash conversion cycle for each of the last three financial years for which results are available. 

       Nine months is a significant amount of time for cash conversion for a business that is exposed to downside on profits – the business is exposed to margin squeeze if the price of rice falls in the 8-12 months after it has acquired rice paddy – but with costs largely fixed due to its short-term debt financing.

       Cash flow

       As discussed earlier, Amira funds its operations with expensive short-term debt. Therefore, I have adjusted the company’s reported operating cash flow for interest costs on the debt. In my opinion, interest cost should be considered as part of Amira’s operating cost. The company currently shows its interest cost as part of its financing cash flow (a treatment IFRS allows). In addition, I have also adjusted operating cash flow for capex (cost incurred to maintain its processing facility), and tax.

       As can be seen from the table below, once I make the above adjustments, Amira does not generate any cash from its operations. 

       In my view, I don’t see the current business model changing this situation. I don’t see how short-term debt getting any cheaper – banks in India are under pressure to tighten lending standards due to high exposure to NPLs from corporate loans.

       Therefore, unless there significant drop in the cost of Amira’s debt, I can’t see it generating positive cash flow from its operations. Any downward pressure on margins or sales also exposes the company to liquidity risk (as debt is secured by inventory which needs to continually increase to keep the funds flowing). This in turn exposes the shareholders to additional capital calls or dilution – with the worst case being insolvency.

       In conclusion

       Although Amira has shown impressive sales and earnings growth since its IPO three years ago, reliance on expensive short-term debt to fund operations means that it is unlikely to generate free cash for equity. Liquidity and financing costs make the risk of permanent capital loss high. This is compounded by the nature of the business –no moat, lack of pricing power, and exposure to margin squeeze – which has downside risks to profitability but where the costs are high and largely fixed. Unless the business can materially change the way it funds its operations, it presents significant risks for shareholders.  

       Afterword

       Short attack

       Prescience Point initiated a short attack on Amira in February 2015 where it alleged that Amira’s revenues were inflated, its related party transactions were not fully disclosed (implying that revenue inflation may be happening with the assistance of transactions undisclosed related party transactions), its margins are were stressed due to falling spread between rice paddy and finished rice, and that Amira’s CEO was mismanaging company assets and possibly stripping value. Prescience Point reiterated its allegations with a few additional ones in another report in July 2015. The Prescience Point report led to a material fall in Amira’s stock price – to a low of $2.51 at one point.  But Amira’s stock price has largely recovered from the height of the short attack and recouped most of its loss. The market appears to be giving the benefit of the doubt to Amira, largely due to the robust and confident defence put forward by the company.

       In December 2015 Amira filed a formal complaint in District Court in New York against Prescience Point and affiliates stating false accusations and disseminated materially false, misleading and defamatory information about Amira. The Company is seeking damages for defamation, trade libel, tortious interference with business relations. In addition, Amira commissioned an independent forensic analysis with respect to some of the allegations made in Prescience Point’s report. The outcome of the independent forensic analysis cleared Amira of any wrongdoing.

       Having been though the Prescience Point reports and Amira’s stated defence, I have summarised my take on the key points raised.

       Inflated export sales – This is Prescience Point’s main allegation, and it is based on data from an Indian Government agency which publishes market values for exported Basmati rice by licensed exporters. Based on data reviewed by Prescience Point, it claims that Amira may have inflated its export revenue by 145% in FY13 and 117% in FY14 – broadly, the difference between Prescience Point’s estimate for Amira’s Basmati sales and Amira’s the reported Basmati exports in the Government Agency’s records.

       Amira has countered Prescience Point’s allegations by saying that not all basmati exports appear in the agency’s export list. For example, some of the rice which is sold as basmati may not meet the stringent requirements for what qualifies as Basmati rice under Government standards – due to breakage etc. In addition, Amira claims that not all of its sales consist of rice exported directly in its name as it also buys rice from 3^rd parties (both from India and abroad). Amira also disputes Prescience Point’s estimates for Amira’s Basmati sales – Amira doesn’t report this number specifically, whereas Prescience Point has derived this from assumptions.

        I would like to give Amira the benefit of the doubt on this one – its financials have gone through a forensic analysis to check this point and apparently there were no issues raised. However, I would have liked Amira to have provided a more detailed rebuttal with numbers backing up its position – e.g. how much of its total sales consisted of Basmati rice, what proportion of this consisted of rice which did not qualify as Basmati under Government standards, and how much was purchased from 3^rd parties.

       Inflated domestic sales – Here Prescience Point alleges that Amira may be inflating its domestic sales by over 100%. But Prescience Point’s allegations here appear weak and the analysis shallow. For example, Prescience Point’s estimate of market size for rice in India (USD 767m) and for Amira’s share of that market (5%) seems to be based on telephone conversations with Amira’s competitor and not on thorough independent analysis.

       A bit of research shows that the Indian rice market is likely 2 times the size estimated by Prescience Point and there no clear rationale behind its claim that Amira only has 5% of the market. Here again, I would give Amira the benefit of the doubt.

       Related party transactions – Here Prescience Point has alleged that Amira has numerous undisclosed related parties which may be being used to inflate sales. Prescience Point’s allegation is based on the fact that there are a number of company’s which share Amira’s corporate address, and have Amira’s CEO and his affiliates on the board. In addition, there is mention of a Dubai based related party – a company owned by the father of the current CEO – being Amira’s largest customer.

       However, there doesn’t appear to be any evidence showing transactions between related parties other than names, addresses, and a passing remark by a previous director (who has denied making any remark of this nature). Amira has strongly denied that there are any undisclosed related party transaction, and stated that no transactions have occurred with the Dubai entity since IPO. Considering Amira has got its last three year financials re-audited and undergone a forensic test, I would give Amira the benefit of doubt in this regard.

       Promoters land sale to Amira – In addition to raising a number of red flags on misuse of corporate resources and personal enrichment by the promoter and CEO, Prescience Point’s main allegation in this regard is a proposed sale of a land by the promoter to Amira for $30 million. Prescience Point claims that this land it overvalued by ~3 times and that this is a case of value stripping by the promoter. Prescience Point also alleges that Amira doesn’t need this land, and the capacity expansion it aims for can be achieved in the land that it already holds.

       Amira in turn claims that it has always been transparent on this land deal and this was clearly disclosed in the IPO documents. Amira claims that the market value for the land is supported by a third party valuation report it has obtained, and that this transaction has been signed off by the board as a whole. In addition Amira defends the need for and the benefits of this land by stating that the additional processing capacity cannot be obtained without this land. Amira claims that the increase in processing capacity will bring more of its processing in-house and increase its margins (currently 1/3^rd of its rice is processed by 3^rd parties, where its margin is eroded).

       Considering the fact that Amira had has been transparent about this transaction, I don’t see this as being fraudulent.

       Paddy – Rice spread not reflected in Amira’s margins – The other allegation of Prescience Point’s is that Amira’s financials do not seem to reflect the falling margins between rice paddy (raw material) and finished rice. Prescience Point claims that even though Paddy – Rice spreads have been falling, Amira’s reported margins seem not have taken a hit.

       I could not find any clear explanation from Amira on this particular allegation. I would have like Amira to provide a more robust defence on this point – with a detailed explanation backing its reported margins – other than simply rubbish Prescience Point’s allegation.  

       Cash flow and liquidity issues- Prescience Point also focuses on the cash flow and liquidity issues at Amira and claims that the current situation is unsustainable. Amira simply rubbishes the allegation that it is haemorrhaging cash, without providing any detailed defence.

       

       Issues around Q4 15 numbers – In its July 2015 follow up report, Prescience Point has alleged that Amira’s inventory may be inflated, that its Q4 receivables have shown a suspicious increase (implying inflated sales), and that it was highly suspicious that the Q4 freight, forward, and handling expenses declined by 66.5% when its sales went up by 21.6%. Prescience Point points out that the fall in freight costs accounted for all the reported growth in adjusted EBITDA in the quarter – making this even more suspicious.  

       To me the above questions seem important and I am surprised that Amira has not provided a robust defence. In particular, the fact that freight costs so significantly when sales increased, needs a better explanation than simply a claim that more was sold as Free On Board (FOB). This is not entirely convincing – e.g. why a sudden material change in what must be key terms of business with buyers, and is FOB a trend that Amira expects to see continue?.

       In summary, I am not entirely convinced that Prescience Point has got most of its allegations right and its analysis appears loose and based on hearsay. However, although I give Amira the benefit of the doubt with respect to the material allegations (e.g. inflated sales, land transaction, related parties), that still leave some valid questions raised in Prescience Point’s report for which Amira should have provided a more detailed rebuttal (e.g. with respect to margins, cash flow, and the Q415 numbers).