Using multiples – why? which ones? & what does it mean?

Why use multiples?

There is no doubt that discounted cash flow technique is the fundamental valuation measure. But multiples are a useful tool in an investor’s tool kit. They help you:

-          cross check your DCF forecast by comparing it to market’s forecast (e.g. by backing out implicit growth rate forecast by the market based on the multiple at which the company currently trades);

-          compare between peers – multiples are a great way to compare peers and get a feel which companies the market believes have better prospects & which ones the market things are likely to suffer); and,

-          are a great way to search for bargains. I use multiples as a useful starting point for bargain hunting. However, it is very important to recognise that a high multiple does not necessarily mean overvalued stock; and a low multiple does not mean there is a definite bargain to be had. There can be real economic reasons for why a stock trades at a low or a high multiple, and searching for those reasons are what lead to investment decisions.

Which ones?

There are three widely used multiples for investors:

-          Price to Earnings (P/E)

-          Enterprise Value / Earnings before interest, tax, depreciation and amortisation (EV / EBITDA)

-          Enterprise Value / Earnings before interest and tax (EV / EBIT)

P/E is a widely used measure in stock valuation and there are many research reports supporting low P/E as a good measure of value. On average, low P/E stocks have returned more in the long term than high P/E stocks. However, I don’t like to make buy decisions simply based on low P/E; I only use low P/E as a good starting point for further investigating a stock. P/E has its drawbacks, the main ones being:

-          Firstly, P/E is distorted by GAAP & non-operating items such as one off gains & losses, write-offs, amortisations etc. This can cause significant distortions and be difficult to wrap your head around if you want to make the adjustments to get to a comparable P/E;

-          Secondly, P/E distorts the picture by mixing the capital structure with the operating performance. For example, two similar business will show very different P/E ratios if one is highly geared and the other has nil or negligible debt. It’s better to use a multiple which is a good gauge of operating performance and is not distorted by the capital structure.

In spite of P/E’s drawbacks, I would suggest using it in screening for value stocks, but don’t buy simply based on low P/Es as it is likely that low P/E is for a reason, and that reason could be a blow up coming soon.

EV/EBITDA is a widely used multiple by practitioners. In my experience this multiple is used commonly in the private equity and M&A world – for example, it is common to see new releases by buying & selling companies where they talk about the EV/EBITA multiple at which a business is being bought or sold.  It is also common to see a sector or industry EV/EBITDA multiple. However, a major drawback of this measure is that it ignores depreciation – which is the accounting equivalent of capex required in the future to sustain the business. If a true measure of value is the free cash flow, it is dangerous to ignore depreciation as it will come out of cash flows at some point. Followers of Buffett will note that he hates this measure for the same reason. However, this can still be a useful measure in industries with very little maintenance capex requirements (e.g. some new technology or social media companies).

EV/EBIT solves for the depreciation issue inherent in EV/EBITDA by accounting for accounting depreciation. However, EV/EBIT too has its drawbacks:

-          Firstly, EBIT accounts for amortisation expense which tends to be a accounting only measure – e.g. if a company has made acquisitions at a premium and recognised intangibles to account for the premium, it would amortise the intangible. This will distort its multiple compared to a similar business which has grown organically (organically generated intangibles don’t need to be recognised or amortised for accounting purposes).

-          Secondly, two companies may have very different depreciation based on the market value they paid for their assets being depreciated.

-          Thirdly, there may be a big difference between accounting depreciation and the actual cash required for maintenance capex.

In summary, the best multiple to use depends on the specific circumstances of the company being investigated. I would personally start off with EBIT and make necessary adjustments as follows:

-          Compare accounting depreciation to real cash required for maintenance capex and use the latter if it significantly differs to the accounting depreciation – i.e., EBIT + accounting depreciation – maintenance capex. The cash flow statement is usually a good place to check for capex; try to estimate the average capex to sales ratio over the years and use this to predict capex needs based on your forecast sales.

-          Secondly, I would also add back amortisation expense to EBIT for my multiple measure.

The Mckinsey book on Valuation has a very good chapter on how to use multiples to triangulate results. It recommends using a EV/EBITA measure which his similar to the above.

What does it mean?

It is important to never forget the fact that the value of an asset is equal to the present value of its future cash flows. A multiple based valuation measure is only of use if it links in with the fundamental valuation measure based on cash flows. In order to make sense of multiples, I love the explanation in the Mckinsey book on valuation and I have had good success in being able to use this method in practice to make sense of multiples between peers which is rare for most theoretical measures.

If you accept that free cash flow is the fundamental driver of value, then value can be expressed by the following formula:

NOPLAT is basically your estimate of free cash flow (e.g. EBITA). Using your estimated EBITA, the fundamental value driver formula translates to:

Note that T is the effective tax rate, which most companies will report. The (g/ROIC) determines the amount the company needs to keep re-investing in order to grow at the projected rate. ROIC can be estimated based on growth in sales over growth in capital employed, alternatively you could simply use the return on capital employed achieved by the business; as for growth rate, this should be the same as the forecast you have used for your DCF. WACC too should be your estimate for the cost of capital – cost of debt is easy to calculate, whereas cost of equity will depend on your assumption for the premium you demand as an investor.Now the next step takes you to the key formula which relates the multiple to the free cash flow formula. Simply divide both sides by EBITA:

The above is what a multiple tells you about value. In particular, the multiple is a function of the following variables – tax rate, growth rate, Return on Invested Capital achieved by the business, and its cost of capital. Always remember this when using multiples.

Variables	Impact on multiple
Tax rate	Higher (lower) the tax rate, lower (higher) the multiple
Growth rate	Higher (lower) the growth rate, higher (lower) the multiple
ROIC	Higher (lower) the ROIC, higher (lower) the multiple. However, is very important to note that if ROIC is < WACC then higher growth actually wipes out value. ROIC always must be greater than WACC for growth to add value
WACC	Higher (lower) the WACC, lower (higher) the multiple

As you will know, the above variables are key in calculating a DCF value. And by knowing how they link in with a multiple based value, it is possible to test your DCF assumptions with what the market is saying, and also a useful measure of comparing between peers.

Other important points to bear in mind when using multiples

Enterprise Value

When using Enterprise Value based multiples, it is important to calculate the Enterprise Value correctly. Note that Enterprise Value is the price a buyer of the company will need to pay when taking over the whole thing. Therefore, it not only includes the value of equity (market capitalisation), but also the debt, minority interest, preferred shares, pensions liabilities, and any other fixed obligations (e.g. capitalised leases), and from this you will need to deduct cash & cash equivalents and the value of any non-operating assets (e.g. investments not used in the operations) held by the company. Although most online tools give you a number for the Enterprise Value, I would highly recommend that you work through the company’s balance sheet and detailed notes in arriving at this number. There can be a lot of useful details on fixed obligations hidden in the notes which some of the freely available tools ignore. Broadly, use the following as a guide to calculate Enterprise Value:

Enterprise Value = Market Cap + Debt (both short-term & long term) + minority interest + preferred shares + lease obligations + any pensions deficit + other fixed obligations (e.g. litigation expenditures) – cash & cash equivalents – non-operating assets or other long-term investments

Using the right measure

When using multiples for valuation ensure that you are using the denominator consistently across comparables – e.g. if you are using EBIT and adjusting it for amortisation and maintenance capex, ensure you do the same across comparables.

Using the right peers

If using multiples as a relative value measure, it is important to use the right peers (i.e., companies within the same sector and with similar operational characteristics).

In conclusion - If you use multiples correctly, you will be able to see the differences between peers, reasons for them, and be able to compare your assumptions with those of the market. It is a great way to identify mispricing and form a thesis. The other opportunity is where you have a conglomerate with discrete businesses where you can compare the component parts with listed peers and identify value add if/where that component part is being spun-off by the conglomerate. 

Metro AG’s proposed demerger should unlock significant value

·         Metro AG, the large German conglomerate, last week announced its intention to demerge its wholesale foods division (Metro) and its consumer electronics division (Media Saturn); the demerger is scheduled to complete by mid-2017.

·         The demerger makes perfect operational sense – both divisions have very little overlaps and hardly any synergies; a demerger should bring more focus and better execution in a highly competitive sector.

·         The demerger also makes sense for the shareholders – the current conglomerate is a hotchpotch of businesses trading at a discount to peers. The demerger, by creating two distinct pure-play sector leaders, should unlock significant value by removing the conglomerate discount inherent in price.

·         In my opinion the demerger should unlock significant value for the shareholders generating between 50% - 60% return in the next 12-15 months with little downside.

After significant fall in sales between 2012 and 2014, the group has managed to arrest the decline, with like-for-like sales recording a 1.5% growth in FY14/15. Media Saturn, is growing at just over 3%, with the whole sale foods division (Metro) growing at a negligible 0.1%. EBITDA margins have been consistent at around 4% for Metro and 3% for Media Saturn. Management have been upbeat and have shown confidence that the sales decline has been arrested and the positive trend in like-for-like sales should continue.

Consensus forecasts from the 35 analysts covering Metro indicate a conservative forecast with median FY16/17 sales for Metro showing negligible change and Metro Saturn sales showing a 3% growth. The conservative forecast is understandable given the shock analysts would have received when sales fell by 30% in 2013, and as is usual, it will likely take a while before they start correcting for the like-for-like trend. For my valuation purposes, I have used the conservative forecasts. 

Structure post demerger

The demerger is to be implemented by way of a spin-off of Metro, the whole sale food division, from Metro AG. Post the demerger, Metro AG will be left with the consumer electronics division, Media Saturn.

 Source: Metro AG

The demerger should create two distinct pure-play sector leaders – with Metro and Media Saturn. 

Below are select wholesale & foodservice sector players by sales. 

Below are select consumer electronics sector players by sales.

Source: Metro AG

Not only will Metro and Media Saturn offer pure-play in their respective sectors, they will also be sector leaders becoming the second largest players globally in whole sale foodservices and consumer electronics sector.

Valuation

Metro AG currently trades at just under 6 time enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (EBITDA).

Metro trades a multiple which is significantly below its peers. A look at the multiples for the sector peers shows that the whole sale food services peers trade at a EV/EBITDA multiple of~12 and consumer electronics peers trade at a EV/EBITDA multiple of ~8.

A crude valuation for Metro which assumes that the demerged businesses will trade at EV/EBITDA multiple comparable to peers would should a share price for the combined divisions of €73, generating a 174% (2.74x) between now and post the demerger. See below.  

However, such a crude valuation would completely miss the point. Multiples cannot be compared in isolation of individual business fundamentals and key variables such as growth rate, return on invested capital (ROCE), cost of capital, and tax rate need to be factored in. Peers are a good starting point, but there are valid reasons why peers don’t always trade at the same multiples. Take the example of Sysco, the largest player in the wholesale foods services sector. It trades at EV/EBITDA multiple of over 12, and its business is fairly similar to Metro. But there are valid reasons why Metro shouldn’t trade at the same multiple as Sysco – Sysco has a higher growth rate, higher ROCE, and lower cost of capital compared to Metro. If enterprise value is a function of free cash flow discounted at cost of capital, then multiple should be consistent with this. In short, multiple should be a function of the following formula:

Using the above, we can see the difference between Sysco’s multiple and Metro’s multiple.

Using this methodology, I have calculate a multiple for Metro AG’s wholesale food services division of ~7.9 and for the consumer electronics division of ~8.1.

It is worth noting that the multiple for Media Saturn is similar to Darty, a peer with very similar characteristics as Media Saturn (i.e., both trade in similar markets and have a similar profile).

Using the above derived multiples to value the separate divisions gives a value per share of €43.2, a return of 62% based on current share price. 

Below, I have modeled share price and returns sensitivity to multiples.

As can be seen, there is very little downside, and significant upside. Metro AG already trades at a very low multiple, and with the improving trend in sales and the proposed demerger, upside is more likely than downside.

Risks

As with every thesis, there are risks involved. I have briefly discussed the key risks below.

Governance - Erich Kellerhals, the founder of Media Saturn who still owns 22 per cent of Media-Saturn, has had several run-ins with Metro in recent years. The main reason for the demerger to be structured by way of a spin-off of the wholesale foodservices business is to isolate that business from the legacy structure with Media Saturn in it. However, there is a risk that the Media Saturn business may continue to face problems with Erich Kellerhals. This was raised in Metro’s call with analysts last week when the demerger was announced. Metro’s management strongly believe that the new structure will not give rise to any governance issues (apparently Erich Kellerhals’ stake will be restricted to the subsidiary of Metro AG, and Metro AG will have full flexibility in running the Media Saturn business – e.g. make new acquisition, expansion etc. – without any hindrance. Management went on to state that in spite of media reports re issues with Eirch Kellarhals, the Media Saturn business has performed very well in recent years and management have full flexibility to run the operations. It is worth noting that a spokesman for Mr Kellerhals’ investment vehicle, Convergenta Invest, has said they did not see any issues with the proposed demerger. Even assuming that the market discounts 10% of value for this governance risk, I get a share price of €38.9 or a 46% return.

Tax, legal, commercial, and execution risks – Management have confirmed that they have undertaken detailed preliminary analysis of the key risks and no red flags or showstoppers were identified. In particular, indications are that the demerger should not be a taxable transaction.

Assignment of assets and liabilities between the divisions – Management have not yet made it clear as to how the assets and liabilities will be split between the two divisions. In particular the split of debt. This will be made clear as they work out the details – most likely in Q2 earnings call. That said, my valuation estimates should not materially be impacted by the chosen split.

Conclusion

Metro AG’s proposed demerger of the two divisions which have limited synergies is a great move and should be able to achieve management’s stated objective of creating two distinct pure-play sector leaders in the wholesale foodservices sector and consumer electronics sector. The move should also reward shareholders by unwinding the conglomerate discount. 

EMC-Dell merger provides arbitrage opportunities

Summary

Trading EMC’s merger with Dell provides arbitrage opportunities – a decent upside potential with limited downside risk.

The opportunity arises because the market is significantly mispricing the VMware Tracking Share portion of the consideration Dell is paying. I believe that the significant discount on the VMW Tracking Shares implied at current price will narrow once the merger closes.

There are a number of strategies one can adopt to trade this opportunity. I have explored 3 in this blog – going long EMC Corp, buying EMC calls, and a combination of buying EMC calls and selling OTM VMW calls. Each strategy offers different risk-reward.

As with any investment, there are downsides. I believe three main downsides to this trade: merger doesn’t close, VMW Tracking Share discount doesn’t narrow, and VMware shares experience significant volatility. The strategies discussed either mitigate the downside, or offer a decent enough reward for risk taken.

The deal

Dell, owned by Michael Dell (founder & CEO), MSD Partners and Silver Lake, is to acquire EMC Corporation, while maintaining VMware as a publicly-traded company. EMC Corp currently owns 81% of VMware, with the remaining 19% being publicly listed.

Under the terms of the deal, EMC shareholders will receive $24.05 per share in cash in addition to tracking stock linked to a portion of EMC’s economic interest in the VMware business. Broadly, the tracking shares will track 65% of EMC’s current 81% interest in VMware (i.e., equating to 53% direct economic interest in VMware). EMC shareholders are expected to receive approximately 0.111 VMW Tracking Shares for each EMC share held by them.

The transaction is expected to close in mid-2016 (expected between May and October 2016). Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline.

Deal Structure

The below diagram shows the commercial deal structure post closing.

The key features of the VMware Tracking shares are:

-        -  they will be listed and freely traded (there will be 223m VMW Tracking shares compared to just 80m VMware shares currently traded; this should offer a liquid market for the VMW Tracking shares);

-        - they will track Denali’s 53% economic interest in VMware (Denali is the parent of Dell which will acquire EMC Corp);

-         - Denali will have the ability attribute other assets of equal value in exchange for the VMware shares tracked (subject to authorization by an independent committee which will take care of the interests of the VMware Tracking shareholders;

-        - VMware Tracking Shares will have no voting rights in VMware;

-        - VMware Tracking Shares will be exposed to credit risk of Denali (i.e., if Dell / Denali goes kaput, the Tracking Shares go kaput); and,

-        - Denali will retain the right to redeem and/or buy-out the VMware Tracking Shares or convert them to Denali or a Denali sub common.

The mispricing

Based on the most recent share price for VMware’s publicly listed shares, the market value for the 0.111 VMW Tracking Shares which will be issued as part consideration equates to $5.75. However, based on EMC Corp’s most recent share price, market’s implied value for the 0.111 VMW Tracking Shares is just $2.72. The market is pricing the VMW Tracking Shares at a ~53% discount when compared to VMware’s publicly listed shares as the following tables show. 

In my opinion the market is significantly undervaluing the VMW Tracking Shares. Once the merger closes and these shares get listed, the discount should narrow to a more meaningful range of 10% - 20%. Although the VMware Tracking shares don’t offer voting rights or a direct right to VMware’s assets and liabilities, they economically track VMware. In addition, the independent committee provides sufficient safeguard’s from Denali’s being able to strip value from the tracking shares. Furthermore, the VMW Tracking Shares should offer a liquid market to trade VMware – currently there are ~80m publicly traded shares of VMware; Denali will issue ~223m VMW Tracking Shares, creating significant liquidity. Taking account of all these factors, I believe that the VMW Tracking Shares will trade at a 10% - 20% discount to VMware’s listed shares.

Trading strategies

Strategy 1 – Go long EMC Corp

An easy way to trade this situation is by buying EMC Corp and holding till the merger closes in 4 – 7 months’ time. The VMW Tracking Shares will be listed at this point, and the discount on them should narrow. Using EMC Corp’s current share price, and assuming that the publicly listed VMware shares trade at current price levels and the VMW Tracking Share discount narrows to 10% of VMware’s listed shares, this strategy should generate a 9.2% return (see table below).

However, the above is a simplistic scenario and doesn’t capture the impact of volatility in VMware’s publicly listed shares (which will impact the value of the VMW Tracking shares) and the extent to which the discount narrow’s on the VMW Tracking Shares. The below table captures the returns under different scenarios and is a more realistic view of possible outcomes.

As can be seen from the above, all scenarios generate a positive return bar where VMware shares fall by 50% from current levels. Fall in VMware shares of less than 50% from current levels should generate positive returns as long as the discount on the VMW Tracking Shares narrows to 20% or less. Furthermore, any increase in VMware shares increases also has a positive impact on returns.

Strategy 1 is a safe and easy way to trade this situation if you believe that the VMW Tracking Share discount should narrow to 10% - 20% level. The returns may not look great, but this is a clearly defined situation with a short holding period of ~ 4 – 7 months (or max 1 year if one wants to give the listed VMW Tracking Shares some time).   

Strategy 2 – Buy EMC Corp Call

The July 16 EMC Corp Call option with $24 strike is available for a premium of $3.2. Buying this call could generate a 64% return assuming VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%.

The below table shows the returns for a selected menu of EMC Corp Call options (I have used July 16 and Oct 16 expiring options & strike prices ranging from $24 to $26). As can be noted, longer duration increases the option premium and reduces the return; similarly, higher strike price increases the cost and reduces the return. The best option seems to be the July 16 option with $24 strike price. 

The above table doesn’t fully capture the impact of volatility in VMware shares and VMW Tracking Share discount. The below table shows the available returns under a number of scenarios and offers a more realistic picture. I have used the July 16 call option at $24 strike price as the basis.

As can be seen from the above table, all scenarios generate a positive return bar where VMware shares fall by 50% from current values. Furthermore, the returns generated are significantly higher compared to Strategy 1 – for example the above strategy returns 64% compared to 9.2% returned by Strategy 1 for the base case scenario where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%. However, it is also worth noting the higher risk being assumed under this strategy for where VMware shares fall by 50% from current levels.

The gearing offered by the option clearly juices up the returns, but also exposes one to higher downside risks if VMware tanks significantly. But it is worth noting that VMware shares have fallen by 37.09% over the last 12 months, and have just rebounded from 1 year low of $43.25, currently trading at $51.8. The median price target of 26 brokers covering VMware is $60, with a low target of $40. The probability of VMware falling by 50% from current levels in the next 4-7 months appear low.

Strategy 3 – Buy EMC Corp Call & sell VMware Call

This strategy is aimed at reducing the overall cash cost by selling Out Of The Money (OTM) calls over VMware shares. The premium earned by selling calls partially offset the cost of buying calls of EMC Corp, and increase the overall returns. The EMC Corp Call used for this Strategy is the same as the one shown in Strategy 2 above (July 16 expiry with a $24 strike). As for the VMware calls that can be sold, a number are available – depending on how much OTM one would like the call to be. The more OTM the call, the less the premium earned and lower the overall return; but on the other hand, way OTM calls protect the downside if VMware shares were to go up.

Below is a table showing the available returns for a selection of VMware calls sold in combination with buying EMC Corp July 16 call at $24 strike (again assuming VMware shares trade at current levels and the VMware Tracking Share discount narrows to 10%).

The below 3 tables show the available returns for each of the VMware call option listed above taking account of the impact of volatility in VMware shares and VMW Tracking Share discount.

This strategy has the potential to significantly increase returns compared to Strategy 1 and Strategy 2 – for example, under Strategy 3a, the base case where VMware shares trade at current levels and the VMW Tracking Share discount narrows to 10%, the return generated is 1194%. But the potential downside under this strategy is way too high in my opinion. Furthermore, you can see from the above tables that the more OTM the sold VMware call is, the less the return, but better the downside protection VMware shares increase in value.

In conclusion, Strategy 1 is the easiest and most risk averse to implement but I believe that Strategy 2 – Buying EMC Corp call option – provides the best risk-reward outcome.

Other risks

As discussed upfront, there are three major risks to this thesis:

The Merger doesn’t close- I believe that the risk of this merger not closing is low. Based on recent updates from EMC and Dell, the merger is on schedule and should close within the anticipated deadline of between May and October 2016. The regulatory approvals are progressing smoothly, and it looks like the EMC Corp shareholders should vote in favour of this deal. Dell needs to raise $50 billion of finance to close the deal, and given Dell and its promoter’s track record, it doesn’t look like this will be an issue. It is worth noting that significant termination fee is payable by either party in case of termination (EMC will have to pay $2.5 billion if it terminates the deal, and Dell will have to pay anywhere between $4 billion and $6 billion if it terminates the deal).

VMW Tracking Share discount doesn’t narrow –I see no rationale behind the current 53% discount market is applying to VMW Tracking Shares. As noted earlier, there is no doubt that the VMW Tracking Shares should trade at a discount to VMware’s publicly listed shares, but this discount should be in the region of 10% - 20% instead of the current 53%. Once the merger closes and the VMW Tracking shares are listed, they should clawback the discount.

VMware publicly listed shares experience significant volatility – Significant volatility (in particular fall) in VMware shares will lead to a fall in VMW Tracking shares. VMware shares are down 37% over 12 months, and have been clawing up from their 12 month low of $43, currently trading a $51 - $52. Both Strategy 1 and Strategy 2 generate positive returns under all scenarios excepting where VMware shares fall by 50% from current levels. Strategy 3 – being the high risk strategy – is exposed to higher downside risks if VMware shares increase or decrease in value significantly (depending on which VMware call option is sold). But overall the less risky strategies (Strategy 1 and Strategy 1) are naturally hedged against significant volatility in VMware shares. I also see less likelihood of VMware shares falling by more than 50% from current levels.

Afterword

I am sure there are many more creative ways of trading this special situation. For instance, Strategy 1 could be combined with selling VMware OTM calls. This should reduce the cost of that strategy and increase returns – for example, roughly 1 VMware OTM call could be sold for every 9 EMC Corp share purchased (roughly 9 EMC Corp share equate to 1 VMW Tracking Share). Such a strategy provides a natural hedge to the sold OTM VMware call (VMW Tracking Shares will also increase in value if OTM VMware calls turn In The Money).

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).