MCX – Undervalued?

Back to blogging after a long long pause.

Anyway, given the hullabaloo around NSEL, FT and MCX, there have been certain conclusions that NSEL is a gone case and so is FT. The only remaining entity of Jignesh Shah’s empire is MCX. And an opportunity to buy an exchange with a significant moat in the commodity trading business for about 2000 cr seems enticing for many.

For those who are new to MCX and want to understand more about MCX, Rudra has got a very comprehensive explanation about its business model, its competitive advantages and risks here. He has covered all angles (the blog is obviously before all the ruckus on NSEL in August).

The price action of MCX below – 1 year back, it was quoting at about Rs.1500/-. Around start of this financial year, it quoted at about Rs.850/- (The budget in Feb’13 proposed and imposed a commodities transaction tax (CTT) on all non-agricultural commodities which led to a drastic fall in volume). Then about August, the NSEL saga struck and the price dropped to a low of Rs. 238/-. It recovered a bit, and HDFC Mutual Fund bought a large quantity at about Rs. 293/-. Yesterday, it quoted at around 410/- and today, it was up by 10% to 455/- (a market cap of Rs.2300 cr).

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We are all fascinated by bottom-fishing, but we are always unsure of getting stuck at the bottom. And so it was with MCX. Nobody bought at Rs. 238/- (when cash per share, seemingly on B/S and again confirmed by Sep 2013 B/S was about Rs. 180/- a share). Now, when the price has doubled (seemingly after FMC has ring-fenced and necklace-spiked MCX from the vultures), people have developed an immense interest in MCX’s seemingly unbreakable moat, its multitude of competitive advantages and why it’s a great buy at these levels, given normal profitability.

Given the state of affairs, I decided to see the volume of contracts at MCX (obviously, more the no. of contracts, the more MCX revenues and profits boost up, just like a toll-bridge). The major products traded at MCX are only four – Gold, Silver, Copper and Crude. Rest of the commodities are too small to be even counted (inspite of MCX’s major push towards agricultural commodities – FCRA hasn’t yet come up with regulations for options on commodities, which are crucial for agricultural commodities – and given the NSEL fiasco, they won’t be in a hurry). So, here I plot the contract volume of all 4 products –

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As you can see, volumes have plummeted in the initial part of the year due to CTT, and most probably plummeted further after the NSEL fiasco. Of course, not much commodity volatility globally across these 4 commodities is also one of the reasons for this poor performance. On an average, y-o-y since August, Gold’s contracts have gone down by 60%, Silver by 63%, Copper by 63% and Crude by 74%.

For the year ended FY13, MCX ended up with 299 cr of net profit. Analysts who assumed this profit to be the base case, and who assumed that volumes at an exchange will ALWAYS grow are in for a rude shock with MCX. The profit for Q1 FY14 was Rs. 60 cr, Q2 FY14 was 27 cr and given the severe contract volume drop in Q3, I would expect MCX profit to end up somewhere around 18 – 20 cr (if not less). Net-net, if a similar trend continues through to next year, I would expect MCX to end up with profits around Rs. 125 – Rs 130 cr.

In my view, this needs to be the base profit expectation (maybe even lower, given that Gold is about to break $1200 internationally and there might be further lack of interest due to absence of options) to evaluate MCX rather than the elusive Rs.300 cr as the base case. Applying a 20x P/E (it’s at 10 P/E TTM, but exchanges with such moat I think should trade fairly at 20 P/E), we arrive at a market cap of Rs. 2600 cr, a measly 13% above current price levels.

Contra-viewpoint: Of course, all of these fundamental valuations go out of the window if a reputed player like HDFC/Kotak take over 26% of the company (from Jignesh Shah). In that case, the market price can fly anywhere, maybe even double. But I am still not buying.

Long term view: Even considering a HDFC/Kotak buying out the stake, the price may double from here in quick time (< 1-2 years). But am I confident that the volume of commodities traded at MCX would increase 20% year-on-year for the next 10 years? I am really not sure. Hence, I am not taking a bet for now, inspite of a decently high probablity that there are a couple of good triggers for an increased market price in the short term. As and when I learn more about MCX’s business or about FCRA’s view on introducing commodity-related options at MCX, I may change my view. But for now, I am letting this pass, purely based on fundamental valuations than bet my money on any buy-out speculation (which may come true after all).

Disc: Not invested. Still studying the MCX stock (business)

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Special Situation: Jindal Poly De-merger

I had shared this note with a few of my investor friends a few days ago –

The brief summary is as follows –

a) Jindal Poly wants to focus on its polymer business and wants to de-merge its holding/investment arm.

b) For every 4 shares of Jindal Poly (JP), you would get 1 share of Jindal Poly Inv. & finance (JPIF)

c) All investment & holding related stuff moves from Jindal Poly to Jindal Poly Inv. & Finance

The record date is July 18th. And here’s the link to the demerger details (http://www.thehindubusinessline.com/multimedia/archive/01364/Click_here_for_pdf_1364878a.pdf)

Behind the 23 page of legalese pdf, the key messages are –

a) Jindal Poly wants to move its investment of equity shares in Power business off to this investment arm (from what I read, its only investment and not debt associated – needs more readings)

b) All MFs and other investments move to this JPIF.

Both JP and JPIF will have the same shareholding structure. JP will continue to be listed, while JPIF will be listed on BSE & NSE.

Here’s the interesting bit. JPIF will have the following –

a) 43.6 cr shares of Jindal India Powertech limited

b) 17.82 cr shares of Jindal Poly Investment limited

c) 4.4L shares of Coal India

d) 11.86L shares of Consolidated Finvest

e) 187 cr worth of mutual funds

Now, with most conservative assumptions, let’s value

a) at Re. 1 per share, b) at Rs. 0 per share c) 4.4* 285 = 12.6 cr d) at Rs. 0/- and e) at 187 cr.

which would give us a total of Rs. 240 cr (approx).

Let’s apply a massive 70% discount (since it’ll be treated as a holding & inv. company) which would give us Rs. 72 cr.

After de-merger, JPIF would have 1.05 cr shares, which would give us the value of JPIF to be 69 bucks per share. The current market price of JP is Rs. 158 bucks per share.

There are a couple of options:

a) We can buy JP before record date and sell after record date and since the shareholding remains the same (no dilution) and the investment timeframe is short and the de-merger not tracked too much and shareholders would be happy to get rid of the power investment, we can expect maybe only a very mild correction (if at all)

b) We can buy JPIF after it’s listed and since institutions hold a fair bit (7%) and they may not wish to hold to a holding company, any listing/selling below 69 bucks a share should be bought quite comfortably.

Aftermath:

I had bought into a miniscule position (very tiny) at about Rs. 158/- and sold it today at Rs. 148/-. That is I created a JPIF share at about Rs. 40/- share (4 shares of Jindaly Poly and at Rs.10/- loss for 1 share of JPIF).

Since the position was tiny, the opportunity cost of this Rs.40/- getting stuck for say 6 months (before listing) will not impact my overall portfolio.

Let’s wait and see if JPIF will list above Rs.40/- or below Rs.40/-

Disclosure: I bought and sold my entire position in Jindal Poly to create JPIF shares. This post is not a buy/sell/hold recommendation of any stock mentioned on the blog. Please do your own due diligence before investing

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Numbers don’t lie!

Today was a very humbling experience. I did a mammoth exercise of plugging in all numbers since the time I have been investing (6 years). This included stocks, debt (this is a combo of debt mutual funds+cash – not loans), equity mutual funds, one ULIP (yes, I had one ULIP). I didn’t consider PF. Over the past 6 years, my CAGR is 18.2% as of today’s closing prices. And here I was, thinking that I was doing 30-35%.

A few facts upfront, before I dive into details:

i) My broad portfolio as of today is 39% in Stocks, 23% in Debt and 39% in Real Estate. The real estate consists of my home back in my hometown. Technically, it is an asset (I have already paid off the entire loan) but my parents live there and I don’t think I’d be selling the house ever (unless, a massive black swan strikes).

ii) I have not included Gold in the portfolio calculations. Gold is an asset, inflation hedge etc., but we Indians never sell Gold unless and until it’s an emergency. So, again, technically, it is an asset but not really. If I include Gold in the total assets ratio, it’d be 34:20:34:12 (S:D:R:G).

iii) In general, I have tried investing as carefully as possible (one of the prime reasons being, if I fail, I don’t have a inter-generational wealth to back me and pick me up again). This also included taking max. term insurance to protect my family from black swan.

iv) Although I am invested in stocks since 2007, active investing was only since the last couple of years. Before that, it was a combination of pure luck for gains, and pure speculation for losses. The last couple of years have been pretty good in terms of % gains, but not very high in absolute numbers.

Alright, that story done, let me dive into a few details.

a) Let me put the 18% CAGR in perspective. 18% handily beats all ‘Large&Midcap’ and ‘Midcap&Smallcap’ funds. However, my target has always been atleast 25% (else, not worth the effort). My aim is to hit 25% p.a on average till I hit atleast a 8-figure number on the Stock+Debt portfolio. So, 18% did come as a big bummer. Here I was, thinking I could easily beat the markets, value the business, discuss and argue cogently with hallowed investors and then there was this number that stared me in the face (I double checked the numbers, just to ensure I have not under-performed, willingly).

b) The last 2 years of active investing has been pretty good, but so has the record of the midcap/smallcap market in the past 2 years. If I eliminate the first 4 years of my passive investing, the last 2 years CAGR came to about 40% p.a. This again, is due to a combination of extreme luck (forums like valuepickr/theequitydesk in no small measure), effort (constant lurking on wonderful blogs like I mentioned before) and a bit of reading (which helped me avoid the dumbest mistakes). However, since there were a host of factors like paying off my home loan, wedding expenses (oh my!) etc., the lack of sufficient capital led to not much of absolute capital appreciation. I hope I can sustain this luck and learning for a long time so that my capital grows too.

c) Drilling down to the details. HDFC Bank is a clear winner, not much in % terms (it’s like 5x in 6 years) but I put in a quite a lot of capital. In fact, I would boil this down to luck too. I accrued ESOPs since I worked for HDFC Bank, and I bought all ESOPs that got accrued when I left the Bank (split-adjusted price of Rs.125/-). In fact, I had taken a personal loan to buy all the options. Thankfully, Mr. Puri is carrying the Bank along well. A combination of extreme luck (working for the bank and hence ESOPs) and monstrous stupidity (taking a personal loan to buy stocks) – but it is now an anchor stock and has served me well. Too bad, I didn’t buy this one yet again in the 2009 bear market.

d)  Out of the 38% in stocks, 10% of it is in a venture. When I mean, venture, I mean an unlisted company. There is this very good friend of mine who had an aeronautical spare parts company. He was committed to his company and grew it by leaps and bounds. He then got an opportunity to tie-up with a major company and asked me if I’d invest. I knew this guy to be honest&committed, he was putting in a lot of his personal stake, and the major company also put in 50% of the total capital. I saw a large scope of opportunity and committed management and invested 10% of the stock capital in it last year. Thankfully, it is going well. Of course, if and when the company goes for an IPO, I am committed to write a glowing IPO note to pump the stock :). Let’s see how far this goes. Yet again, outlier event, extreme luck of having him as a friend, and he asking me if I’d be interested in investing.

e) In the last 2 years of active investing, forums, blogs and books galore. Inspite of major undervaluations in very good stocks shared by one and sundry, I had the heart to commit major capital to only two stocks – Mayur Uniquoters and Atul Auto. Of course, I have exposures to Astral Poly, Kaveri Seed, Muthoot Capital, PEL etc., but even if they go 3x, at the current capital allocation level, they are not going to make much of a difference to overall wealth. Inspite of multiple people urging me that ‘Pharma’ was simple, it was simply my laziness and lack of interest that I didn’t dig through the story of Ajanta Pharma/Unichem etc. Ajanta Pharma, in hindsight of course, was a major miss. This 40% p.a return in 2 years, I would admit, involved a lot of effort, apart from luck. Effort in reading up valuepickr/theequitydesk every day and see if I can invest in a stock or not.

f) In essence, if you remove my top 4 stocks – HDFC Bank, Venture investment, Mayur Uniquoters and Atul Auto, my portfolio % returns is okish, but the absolute capital is very meager. It is surprising how Buffett’s rule (top 25% stocks make most returns) is discrimination-less even for an amateur investor like me.

g) Of course, contrary to Buffett’s rule, I have made far more than 20 purchases (20 punch-holes). And in most of them, the returns are less and some are even negative. I should have just stuck to buying more of the success stocks rather than diversifying into many and multiple.

h) As I was doing the analysis all of today afternoon (I had to pull out 6 years worth of reports etc.), the experience was very taxing and liberating at the same time. I understood some of the mistakes I made, some of the portfolio allocation decisions I took, portfolio sizing problems that I encountered and will encounter in the future etc. So to say, it was a meditative experience. Till, I hit the ‘Enter’ button on the XIRR formula. After that, everything came crashing to the ground, which is currently leading me to deep questioning and introspection. I don’t know what will come out of it though.

Not sure if this post helped you in any way. Not sure if 3 facts and 8 ramblings made the post long and/or boring. The key takeaway though is I needed extreme luck and constant lurking on different forums to make any of my gains 🙂

I look forward to interactions with any senior investors reading this – a) Were you in this situation before? b) How do you go about correcting flaws in thinking/approach? and any other tips/tricks to help me survive and grow in the market.   

P.S: If you are a novice/amateur investor, and haven’t done the exercise of pooling in all the stock&debt portfolio at one place (I recommend Google finance, simply for the reason that excel sheets tend to get lost in nested-nested-nested folders with the same names), please do so. I can assure you, even if the XIRR value is not too exciting, the very fact of putting down those numbers is tremendously educative.

DISCLOSURE: The stocks that I mentioned or referred ARE NOT be taken as recommendations for a Buy or a Sell. Please do your own due diligence before investing.

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Random thoughts…

It’s been close to 2 years since I started this blog. A 2 year anniversary gives me the permission to distribute some learnings and hence a few random thoughts I’ve learnt over these couple of years –

a) The curse of ‘value investor’: The term ‘value investor’ is a burden. In fact, I think it’s a burden to be categorized into any one particular type of investing theme. Almost everybody in the world is trying to buy stocks cheap in the hope of selling it at a higher price (even a speculator thinks he is buying Rs. 1 worth of stuff for Rs. 0.90 in the hope that the market will eventually correct itself in the next 1 hour; a growth investor thinks a 60x P/E stock is worth it etc). Ben Graham himself called it a ‘mystery’ when he deposed in one of the Congressional sessions when asked what exactly causes an undervalued stock to reach its intrinsic value. Some others call it the Invisible Hand which corrects all prices. The axiom of ‘Markets are voting machines in the short term and weighing machines in the long term’ is said by all and sundry. And so is ‘Heads I win, tails I don’t lose much’. At times, I feel I don’t understand any of this stuff. And in other times, I feel that these axioms are too simple to encapsulate the complexity of investing. However, all the above afflicts almost every type of investor – value, growth, GARP etc. However, only one curse hits the ‘value investor’ very hard. It is the perennial search for the undiscovered stock. Nobody wants to hear the same old stocks anymore; stocks which have been wealth creators and probably will create wealth for a long time to come. ‘Value investors’ want their next kick in some unknown stock (or a stock that is not widely known). We sort of believe, after we have read ‘Intelligent Investor’ again and again (too much for our own good) that we have to discover an undiscovered stock (rather, we presume an undiscovered stock = inefficient market and hence larger chances of mispricing). We are like the addicts who screen for stocks for various parameters and miss gems just because they are widely known and we assume an efficient market in the stocks that are widely known. The faster I get out of this affliction, the better it is for me.

b) Concentration vs Diversification: This is a perennial question asked in many forums – which one is better? The real question underlying this seemingly innocent question is actually ‘which methodology would make me the maximum return in the minimum amount of time, without losing a paisa’? The answer, obviously varies from person to person and is entirely subjective. In my view, I think it is dependent on so many factors. I will just elaborate on what worked for me.

I have realized off late that I don’t have the skill to monitor and keep track of a lot of stocks (Ayush, Safir and a lot others have this skill as an instinct). In fact, I have fallen in the trap of spreading my little time available (outside of my day job) into researching every new stock that is quoted on twitter/other forums. In fact, not only have I spent time on these ideas most of which are outside my circle of competence, but have also made the cardinal mistake of investing in them. Now, given that I have been lucky to find guys like Ayush, Safir, Hitesh, Devesh writing about these different stocks, I haven’t lost money on them, but I haven’t gained much either in absolute terms. Let me explain. To quote a psychological term, I suffered from deprival super reaction syndrome. When these guys tweeted about certain stocks (let’s say pharma for instance, of which I am only learning baby steps now), I had found that over a period of time that these ideas made money (by and large). So, whenever these guys tweeted/wrote about some stock, I invested 1-3% of my portfolio in these ideas (given that these are usually outside my circle of competence, I can’t get myself to invest more) and made money – Nitta gelatine, Unichem, Ajanta, Smartlink being some of them. However given my limited time and resources, I couldn’t keep track of events, tweets, qtrly results etc. of all these stocks (and maybe I couldn’t understand even if I looked at all of these). Although the end result turned out alright, the process is clearly wrong.

On the other hand, stocks which I understood, which I researched and which I put in 10-20% of my money are clearly outperforming and wealth creating. HDFC Bank (my alma mater, and I had put in the greater part of my networth into this stock back in 2007), Cera (which I wrote on this blog long ago), Mayur (valuepickr’s choice, and the undervaluation and the business screamed at me), Astral, Atul Auto (this was a cinch), Oriental Carbon (to Ayush’s credit) are some of the examples.

The experience has taught me that a concentrated portfolio with 6-8 stocks have worked much better for me than spreading my bets across many different stocks. Of course, if I encounter a black swan event in any of these stocks, that’s when the chicken will come to roost, but I think given that I give a very high weightage to management integrity before it becomes a substantial part of my portfolio and I don’t play with F&O, the chances of a wipe-out are low and I hedge it off by not allowing more the 10-20% allocation for any stock.

So, net-net, identify where your strengths are, how your past experience has been, how much time/ability you have to analyze many stocks and then bet accordingly than listening to anybody’s opinion on concentrated vs diversified question.

c) Price anchoring: The fallout, of course, of a concentrated portfolio is that you will be subject to the extreme bias of price anchoring. For example, I saw Mayur at Rs.150/- (adjusted for bonus), bought quite a bit and then it went to Rs.230/- and then bought a little more. Now, given that the market was recognizing the undervaluation, and it was still undervalued at Rs.230/- levels, ideally I should have bought more and more (subject to my limit for the stock). But I didn’t. I fell into the trap of ‘let it come down, and I will buy more’. Today, it is at Rs.460/- and counting and although I don’t see a huge undervaluation from these levels, if it goes to say Rs.700/- in 1 year’s time, I am sure to experience hindsight loss aversion. The same thing got repeated in Astral (bought it first at Rs.130/-, bought some more at Rs.160/- and then stopped buying and now it has doubled) and Cera, and Atul Auto etc. I am slowly coming out of this bias (believe me, it’s been a very difficult process because you encounter a thought of – if the market falls rapidly from the elevated levels that I bought the stock, then what?) and I am slowly buying Atul Auto now (also, when you are trying to get out of this bias, you will keep hearing of the BSE small/midcap index overvalued, QE3 not having much effect, reforms not taking shape leading to a market sell-off etc. which makes this process excruciatingly difficult and you’d just want to hold cash and do nothing). Doing nothing is great, holding cash is great too if and only if your mentality allows you to invest all of this cash when the world is going down rapidly. For example, Charlie Munger held money in Treasuries for about 10 years and when the moment was right, invested 70% of net worth into one stock, Wells Fargo. You just got to decide(within yourself, not as a justification to others/in some forum) if you possess the same mentality.

d) Bailing out vs Doubling down: This has been one question which I loved playing around with. When do you bail out of a stock and when do you double down on a stock (in other terms, average down) when there has been a savage fall in the price. Let me state some recent examples.

SKS Microfinance, initially invested by Narayan Murthy (at Rs.300/- level) as venture capital and then IPOed at Rs.980 levels shot up to Rs.1400/- levels very quickly. Most forums claimed that it would be a great buy at Rs.700/- levels. One forum also claimed that it would be a blind buy at Rs.300/- levels, if and when it came down. And crashing down it did (allegations of fraud). From the highs of Rs.1400/-, it crashed to Rs.60/- levels (CMP: Rs.112/-). Nobody squeaked of buying this stock when it was crashing from Rs.1400/- to Rs.700/- to Rs.300/- and then to Rs.60/-. Everybody wanted the picture to be clear before they invested. Of course, we all forget from time to time that if the picture was clear enough, the market wouldn’t price SKS Micro at Rs.60/- levels.

Manappuram Finance, the premier gold loan provider, touched an all time high of Rs.95/- in Nov 2010. People started buying this as a proxy to multiple things (rising gold loan prices, rural growth proxy, network effects, rising acceptance of gold loans etc). It came crashing down to Rs.20/- levels as recent as June 2012. So, do you bail out or do you average down? In my mind, I have one criteria for further evaluation. Was there a fraud or not? If there was no fraud (or fraud allegation), I am perfectly willing to double down (rather average down). In this case, there was a RBI objection, there was a large investor bailing out, there were promoter pledged shares being sold etc., but there was no allegation of a fraud. A perfect case for further evaluation to average down (as usual, this is just the starting point to check on intrinsic value and buy cheap shares). If it was fraud, then treat as sunk cost and just bail.

In recent examples, IRB Infra was another which fell to Rs.100/- levels, moved up to Rs.150/- quite quickly (and now at Rs.120/- due to another allegation of a crime). Ajanta Pharma which quite a few in the forums that I am part of are invested, is facing some kind of tax evasion problem. Although the prices haven’t crashed yet, it’d be good to monitor and evaluate whether your reasoning tells you to bail or average down.  (When I say ‘double down’, I am not talking of doubling down blindly and get into gambler’s fallacy – that would lead to disaster).

e) Special Situations: I look at my blog search feeds and it delights me that most people land up on this blog because of special situation analysis, although I have hardly put up any actionable special situation which can lead to a profit. Evaluating Special Situations personally is very satisfying compared to let’s say stock analysis since there are so many parameters to consider and secondly, it helps in sharpening the stock analysis scenarios. Some of my friends have suggested that I start a paid special situations newsletter (actionable ideas) for a nominal cost. I am considering it actively, and would like to know your views in the comments section if that is something you’d like.

Disclosure: The stocks mentioned in the post are only for educational purposes and not a recommendation for buy/sell. Please do your own due diligence before investing in any of the stocks mentioned in the post.

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Special Situation – Open Offer Analysis – Brescon Advisors & Holdings

These guys were also known as Brescon Corporate Advisors till a few months ago (just in case you’d like to check on brokerage reports of the past – if there are any).

I will evaluate this special situation combining the principles/questions outlined by the Prof in this post (which, needless to say, is a must read for anyone who wants to do risk arb and the complexity is getting complexier and complexier 🙂 ) along with the analysis I had done for Tata Sponge Iron/Tinplate company in my previous post.

This open offer was brought to my notice by my friend Ashish Kila today morning. Also, at today’s closing CMP, there is no trade that can be done in this open offer on a profitable basis. This post is only for analysis (which reminds me, I need to come up with a mindmap kind of thing for open offers after the Prof’s complete post on the risk arb problem).

Anyway, Nusarwar Merchants Pvt. Ltd. (NMPL) has come up with an open offer to buy 26% of Brescon at a price of Rs. 123/-. Today’s current CMP is Rs. 113/-. The genesis of this offer was a 33.75% buyout from certain sellers (looks like a part of the promoter group, also called ‘persons acting in concert’ in the latest AR) in Brescon on 29/Sep/2012 and hence this open offer is a triggered offer. Here’s the link to the open offer.

Let’s go through the Prof’s questions to analyze this then (and given that all regulatory approvals are through and the chances of any regulatory surprises are close to nil, the relevant template would be template #2).

a) What’s the expected return of this operation?

Ans. The current CMP is Rs. 113/-. The offer price is Rs. 123/-. Payment would be done by Dec 25th, 2012 according to the schedule (2 months from current date). Since 33.75% has been acquired, theoretically, 66.25% can tender. Theoretical acceptance ratio would be 26/66.25 = 39.24% (approx to 39%). Let’s say I buy 100 shares and I expect the price after the open offer closes to be Rs. 100/-.

Investment = Rs. 113 * 100 = Rs,11,300/-

39 shares would be accepted at Rs.123/-. 39*123 = Rs. 4797 (Rs. 390/- would be the gain, on which 30% marginal tax would be applied since STT wouldn’t be applicable while tendering, but I’ll ignore this for now)

Remaining 61 shares would be sold at Rs.100/-. 61*100 = Rs. 6100/-.(a loss of Rs.793/- can be used to offset short term capital gains, if any)

Total return = 6100+4797 = Rs. 10897/-

That is, Investment > Total return, resulting in a loss, assuming a theoretical acceptance ratio.

b) Should you look at fundamentals of the target company? Why or why not?

We should certainly look at the fundamentals of the company since there is a chance that we can acquire shares of a good company at a very low cost. However, in case of Brescon, after looking at the fundamentals over the last 2-3 years and this slump sale arrangement (where they sold Brescon Corporate advisory business to their own subsidiary company on a slump sale basis citing some convoluted logic, read Item No. 3 on Page 6 of that arrangement for starters), I am not too comfortable in acquiring shares of this company for the long term.

c) What is the likely acceptance ratio i.e. how many of your shares are likely to get accepted under the offer (theoretical vs. practical) and what key factors will govern that ratio?

The theoretical acceptance ratio is 39% as stated in a). The practical acceptance ratio might be different. Given that only one part of the promoter group has sold out, the remaining promoter group has approx. 24% of the shareholding. Since this looks like a voluntary sellout by one part of the promoter group, the rest of the promoter group may not participate in the open offer. However, the chances of the promoter participating is non-zero. The retail shareholding is close to 20%. On a historical basis, not all retail investors have tendered for various reasons. Let’s assume 5% brain dead investors then. Let’s look at the two different scenarios then (am assuming the rest will tender)

S.No Scenario Acceptance ratio Possibility Probability
1 Promoter group doesn’t tender; 5% brain dead investors 71% Highly likely 70%
2 Promoter group tenders; 5% brain dead investors 43% Probably not 30%

A few calculations summarized in the table below –

No of shares 100
CMP 113
Offer Price 123
Investment 11300
Price post open offer 100
Gain if  
Acceptance ratio 71% 333
Acceptance ratio 43% -311
Expected value per share based on probabilities above 1.40
Gain% on expected value on an annualized basis 7.50%

Therefore, we’ll have a gain of 7.5% on an annualized basis without considering the effect of taxes, service tax, cess etc. This is poorer than the return if we invest the same money in a liquid plus mutual fund for 2 months. Hence, this opportunity is a pass.

d) How can you use the “inversion” (invert, always invert) trick to estimate market’s assessment of the acceptance ratio?

Ans. Let’s assume that the market cost of capital is 12%. That is, 2% for 2 months of money.

CMP is Rs. 113/-. At the end of 2 months, at the market cost of capital, the money should have been Rs.115.26. We can find the market’s expected acceptance ratio by

Rs. 115.26 = Offer price * Accepted shares + Remaining shares * Resultant share price after open offer.

Plugging in the values,

Rs. 115.26 = 123*x+(1-x)*100 and solving for x, we get an acceptance ratio of 66.34%. That is, the market is pricing to almost close to the best case scenario (refer table above) where the rest of the promoter group doesn’t tender and there are 5% brain dead investors. This is clearly very optimistic and hence the chances of a substantial upside is close to nil.

e) Should you borrow money to do this operation? Should you have done it in Template 1? Why or why not?

Ans. With the expected value of 7.5% p.a, and being a retail investor, I cannot borrow at less than 12%, if not more. This clearly is a losing operation for me. Hence, I wouldn’t borrow for executing this operation.

Segways:

a) There is certainly a price at which this operation can deliver a lot of value. Between now and 11 December 2012, if the market price of Brescon falls below say Rs. 100/-, this operation will have a quite a bit of value. It is not profitable just right now.

b) I have not considered the scalper syndrome scenario where you buy at Rs. 113/- and say if the market shoots up and if the price goes to Rs.118/- by end of next week, you can make some returns in quick time. However, then I would be speculating than evaluating.

Disclosure: No position in this open offer. This post is only for analysis and not for investment purposes.

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Interesting Corporate Actions – PVR Ltd and TV18

There have been a few interesting corporate actions over the past 2 months. I will elaborate a couple of them here.

a) PVR Ltd – The first one is from PVR Ltd. (of PVR Cinemas fame). I observed this strange set of events way back in August and yesterday’s Devesh’s tweet on the event was the final push required to write this blogpost.

In summary, PVR Ltd. did a buyback in 2011 (in the May-Oct timeframe) and now sold shares (in the Aug-Oct timeframe). You’d wonder if PVR was in the entertainment business or financial engineering business. On the whole, it seems to be value-accretive to PVR, but this buy-sell stuff in the space of 1 year is a little unsettling.

The details.

PVR in June 2011 announced a buyback of shares not exceeding Rs. 26.21 cr representing 9.99% of the company (as an aside, a buyback greater than 10% requires a EGM and hence most companies don’t do it), with the max. share price of Rs. 140/-. 10% of 27,149,372 shares (total equity) represented 2,714,937 as per audited Balance Sheet at March 31, 2011. The Company proposed to buy-back a minimum of 562,000 Equity Shares.

Anyway, cut to the chase, as per this September 2011 notice, PVR had bought back 1,388,328 shares utilizing Rs. 15.82 cr (excluding brokerage and taxes) and that was the end of the buyback (that is approx. 5.1% equity was bought back at an average price of Rs.114/-). As an aside, the book value (net of debt) of PVR Ltd. as of March 2011 was Rs.126.12 cr. That is, 12.55% of book was used to buy approx 5% of equity back – not a great buyback by any standard, but not extremely poor either.

Anyhow, that was history. Cut back to the present. Aug 2012. This news item indicates that a private equity player called L Capital wanted to buy 10% of PVR’s equity at a price of Rs. 200/- (a 7.5% premium on the then market price Rs.186/-). This translated to 28.85 lakh shares (well, there were just 2.595 cr shares after the buyback and then PVR issued a some fresh shares (0.3 cr shares) to L Eco (at Rs.200/-) leading to equity dilution and hence now the equity is actually 2.85 cr shares). With this sale, PVR gets Rs. 57.7 cr for further expansion.  (There is a small bit on further Rs.50 cr investment from L Capital into PVR Leisure, a PVR subsidiary (and PVR will eventually have only a 35-40% stake in this business), but that is not pertinent to this discussion).

So, net-net,

PVR bought back 13.88 lakh shares for Rs. 15.82 cr in Sep 2011.

PVR sold 28.85 lakh shares for Rs. 57.7 cr in Sep 2012.

Is it value-accretive to PVR? Certainly. Even if you consider that the 13.88 lakh shares which were bought back were sold, the firm netted a gain of 75% within one year without considering the extra benefits of the network of a private equity player, the extra investment into the PVR subsidiary etc. Also, the debt has not increased due to the equity sale, so hurrah!

But should PVR indulge in this buying and selling of equity frequently? The jury is still out on that one.

b) TV18 – This Network18 group has always fascinated me. Not like a Page Industries fascinating, but fascinating with their ingenious financial engineering capability.

This time, the Network18 media group decided on the rights issue part of engineering. Of course, all and sundry do know about the Reliance-Raghav Bahl-ETV-Network18-TV18 story and complications, so I will not get into it (please to google, if you are not aware of it – the twists and turns will put the movie ‘Race’ to shame).

I will analyze this TV18 rights issue as an ‘expert’. That is, I will try to exactly explain why the stock moved from the lows of 20 to the highs of 30 today. (Actually, to be fair to ‘experts’, I am cheating. I had done this analysis much before and only blogging about it today). I have had no positions nor will I ever have positions with the Network18 media group. Their skill in shortchanging minority shareholders is unparalleled and since I have a day job, I can’t monitor their schemes daily.

Anyway, here’s the analysis I had done once the rights issue was declared –

The rights issue size of TV18 is Rs. 2700 cr. For every 11 shares held, 41 shares will be issued on a rights basis, each share costing Rs. 20/-. CMP of TV18 Rs. 22/-. If I had 100 shares today (as total equity), post-rights issue, I will have 500 shares for the company. But since the equity is coming through at close to market price, major correction may not happen. In fact, there might be upsides (unless of course, the management dreams up something else). The management of Network18 stock will garner money through its own rights issue and invest in TV18 rights issue. Therefore, the chances of higher allotment are very low (and since the rights price is very close to market price, why would I want to go for a higher allotment?)

The stated intention of the management is that total debt of TV18 would be re-paid and remaining amount would be used to fund the acquisition of ETV channels. The possible increase in revenue due to acquisition of ETV channels aside, this debt repayment has very interesting ramifications on the EPS of TV18.

Consider the P&L statement for the year ending March 31, 2012 (I am looking at standalone results. The consolidated results are much worse, and they are losing money at an operating level). The EBITDA of the company is Rs. 97.42 cr. The interest payment is Rs. 93.48 cr. That is, 96% of the money generated is funding the interest costs. What would happen if the interest costs vanished, since the debt would be extinguished? Let’s do a small financial exercise –

Assume revenue doesn’t increase (which is a pessimistic assumption, since ETV channels are going to earn some revenue). So, EBITDA, say will be around Rs. 97 cr. Now, there are no interest costs to service since the debt has been extinguished, utilizing the funds from the rights issue. Depreciation of Rs. 25 cr. Therefore, PBT is Rs. 72 cr. Due to accumulated losses over the past 6 years (yeah, they have been losing money in all six except the year ending 2012), taxes would be zero. Profit would be Rs. 72 cr.

Now, the equity base currently is 34 cr shares. March 2012 profit is Rs. 9 cr. That is Rs. 0.26 per share. The equity base will increase by 135 cr shares, taking the total equity base to 169 cr shares.

Therefore, technically (forget the interest of June 2012 quarter for a moment), the EPS would be Rs. 72 cr/169 cr =  Rs. 0.42 per share, an increase of 63% in EPS, without any increase in revenue. Of course, now we consider June 2012 interest and Sep 2012 interest (sum approx to Rs. 58 cr). That would bring down the EPS to Rs. 0.09/-, but that’s only in the short term.

If the tailwind of digitization works (Safir Anand’s pet topic) and ETV revenues flow through, at the very least, TV18 is going to earn a decent profit, maybe equivalent to March 2012 profit, but with zero debt. A stronger balance sheet ideally should propel this stock to greater heights. Even considering consolidated results, if the management pays off the entire debt as claimed, I think TV18 will generate a decent profit at the end of FY13. However, I am not buying. Too many ifs and buts.

P.S: If you are on twitter and not following Devesh  (@_devesh_) and Safir (@safiranand), you are missing on interesting conversations. Go, follow!

Disclosure: I have no positions in PVR and TV18 (or Network18). This is not investing advice. This post is only for analysis purposes and not a buy/sell recommendation.

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Forbes Best under a Billion – Indian Companies

Forbes compiled, as it does every year, a list of ‘Best Companies under a Billion Revenue’ for this year too. Link to the full article here.

From the same link, the list of Indian companies below –

Forbes

Most of the companies are familiar names (Ador, Mayur, Eros, Kaveri, Jubilant, Mindtree, TTK, Ajanta) and some are not (Commercial Engineers, RPP Infra etc.). Some companies are shareholder friendly and some are not. Kindly do your due diligence before investing in any of these.

Disclosure: Invested in a few companies in the above list. This post is not a recommendation to buy or sell. This is only for informational purposes.

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Analysis – FCCB Issue – JP Associates

Deepak Shenoy and I had an interesting conversation on Twitter today and I thought, instead of ‘storify’ing it like everybody does, and the ‘storify’ link getting lost in the melee, a blog would be better to capture thoughts. Also, the more I thought about this, some more details emerged. Hence the post.

Disclaimer upfront. There is no investment opportunity in JP Associates through this blogpost. This is only for informational purposes. I am not invested in JP Associates.

Amongst the wonderful companies that issued FCCBs in the boom period of 2006-07, JP Associates stood tall with a $400mn FCCB (I think only Tata Steel was more than that, at $875mn). As this note (which was also filed with NSE) on the website says, JP Assoc. issued $400mn worth zero coupon bonds at Rs. 854.33 (around Rs. 113/- in current pricing terms (they had a 5:1 split in 2007 and a 2:1 bonus in 2009)) with the conversion price being Rs.1238.78 (a 45% premium, which is erroneous – I’ll come to this in a bit) (Rs. 164/- in current pricing terms) (I am not accounting for $ to Rs. depreciation here – if you account that, then conversion price would be Rs. 220/-).

The CMP as of today is Rs. 64/-.

Needless to say, it is quite disastrous. The bondholders obviously did not convert their FCCBs and promptly demanded their money back. So, a few points here considering this past issue before we get to the present.

a) The conversion price was fixed at Rs. 40.35/- to the dollar. In hindsight, that was quite a stupid move by the FCCB holders considering that the rupee is now Rs. 55/- to the dollar (a 35% loss straight out). However, back in 2007, rupee was all the rage and people were talking of Rs. 32/- to the dollar (yes, even the CNBC folks). So yeah, tough luck. Since FCCB holders are usually savvy investors, ideally they should have (maybe, they have!) bought calls above a certain rupee-dollar equation to hedge forex risk.

b) The note (yes, the same note link as above) quotes a 45% premium. However it also mentions that YTM (yield-to-maturity) at 7.95%. In my enthusiasm, I overlooked the semi-annual* bit, and randomly used XIRR which gave me a result of 7.7%. I assumed it was roughly right and got along fine (I usually am fine with approximations rather than calculate to the exact decimal). However, Deepak pointed out that with a semi-annual it would come to 7.57% (for the curious, you need to use the YIELD function in Excel for this. XIRR assumes it’s annual). And indeed it was. Curiosity got the better of me, and I had to leaf through Annual Reports of JP Assoc. There it was! The premium was not actually 45%, but was issued at a 47.7% premium (based on which YTM promptly comes to 7.95%). How can you quote one figure in the ARs and one figure to the NSE is something I have no clue on? I couldn’t find any corrected NSE announcement either. Is this allowed?

Anyway, back to the present.

JP Assoc. as of Mar 30, 2012 had a debt of Rs. 50,300 cr. (CAT question: How many zeroes in that figure?). They had set apart Rs. 780 cr as redemption premium (as of Mar 30, 2012). Deepak informed me that they had paid off $50mn recently. So, out of $400mn FCCB, $50mn was paid off.

So, calculating, $350 mn remains. They raised $150mn just yesterday/today (I’ll come to this in a bit). So, remaining $200mn. If $ to rupee was not fixed at Rs. 40.35/-, the payment would have been Rs. 1100 cr. since the $ to Rs. was fixed at Rs. 40.35/-, JP Assoc. has to pay only Rs. 807 cr. Since they had already set apart Rs. 780 cr as of Mar 30, 2012, Rs. 807 cr by now shouldn’t be a problem. Rs. 300cr was saved by just fixing the $ to Rs. equation (imagine!)

That done, let’s get to the current deal of $150mn (done yesterday/today). This was also run by Barclays (even the last one was). Why did JP Assoc. go for another FCCB yet again? Well, apart from seemingly cheaper funding outside (risk of currency depreciation notwithstanding), there are other factors. As this Business Standard article explains

However, replacing FCCBs with other debt might cause a problem of a different kind. Though the accounting system in India does not require companies to account for FCCB interest costs on an accrual basis, for simpler debts the companies will have to account for the interest costs and that will hit the profit and loss accounts. According to Bloomberg and IIFL Research, JP Associates could end up with an additional interest of Rs 345.6 crore, which will impact the earnings per share of FY14 by 22.9 per cent.

Also, the redemption premium can be directly adjusted against the reserves’ accounts in the balance sheets. This means the debt-to-equity ratios of companies will rise, as adjusting the redemption money against the shareholders’ funds means the latter, or the reserves account, will go down by a similar amount.

Hence, FCCB is the route yet again (to pay off the previous FCCB and so on and so forth till we squeeze the last investor interested in the term ‘FCCB’ I guess!). JP Assoc. had applied for $500mn, got approved for $250mn (by ECB and RBI) and got funding for about $150mn. However, unlike the previous deal, which JP Assoc. got on very sweet terms (peak of the bull run, remember? the party would never end!), this time FCCB holders were smarter. Instead of a zero-coupon, it is a 5.75% coupon payable semi-annually. The conversion price is at a 10% premium to yesterday’s price, which is around Rs. 77.5/-. These FCCBs are redeemable in 2017 (hence approx. YTM works out to be 9.46%). There has been no circular at NSE yet, and hence we do not know how they fixed up the $ to Rs. conversion (which if you recollect has saved JP Assoc. close to Rs.300cr). 9.46% interest rate seems pretty darn cheap for a company with Rs. 50k cr debt, don’t you think (if they have fixed the $-Rs. equation that is)?

So, why did JP Assoc. stock tank today? Well, maybe the market thought that Rs. 77.5 as a conversion premium was a darn good deal for FCCBs and they would convert in 2017, leading to excessive dilution. Or maybe some major investor sold off. Or maybe there is some jhol. Or maybe, realistically, I might be gunning for the ‘expert’ position in CNBC who can explain every market movement with authority. Who knows? 🙂

*Semi-annual is what it says it is. Interest payable every 6 months (although compounded yearly). Most bonds are semi-annual. So, how can someone pay semi-annual interest on a zero coupon bond? Well, in case of zero coupon bond, that semi-annual stuff is used for calculation purposes only (calculating YTM for example). Interesting background story for this semi-annual stuff actually. It seems that this practice came through 100s of years ago when farmers used to borrow for their 6 month crop and hence interest rate back then (and hence coupon) was quoted semi-annually. Hence, majority of the bonds in the US atleast pay coupon semi-annually.

Disclosure: Not invested in JP Associates in any form (not even in their fixed deposit scheme – yes, they have one! check it out on their website). This post is only for educational and analysis purposes and should not be construed as advice for a buy or a sell.

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Special Situation: Thomas Cook (India) – Analysis for Delisting

On May 21 2012, Canada’s Fairfax Financial Holdings Ltd had signed an agreement to acquire Thomas Cook Group 76.69% stake in Thomas Cook (India) for Rs 817 crore. Fairfax Financial Holdings (Prem Watsa is a well known value investor), the parent company of Fairbridge Capital, has been strategic investor especially in the insurance sector. In collaboration with ICICI Bank, the company had created ICICI Lombard, one of the largest private insurance players in India.

Subsequent to the stake sale, as per SEBI regulations, whenever there is a change in promoter (or more than 25% stake is acquired), the acquirer has to come up with an open offer. And they did. 24.17% stake at Rs. 65.48 per share. The offer closed on July 25th, 2012. And post offer public announcement here.

Sl.No. 7.9 in that announcement is very interesting. The acquirer holds 87.1% stake in Thomas Cook (India). All delisting fans should get excited by this percentage. According to SEBI’s delisting deadline, the group has to either delist before June 2013 or reduce their % shareholding to 75% or below. Given the spate of delisting offers (and at exciting prices) (and these guys are just 2.9% away from 90%), is there a possibility of delisting? Or will they reduce their shareholding to below 75%?

Thanks to Ashish Kila, who forwarded me the Delisting and Takeover code document (the new rules, effective October 2011), the answer is that (with 95% probability*) Fairbridge has to reduce its stake to 75% or below. What are the exact rules?

  • If maximum permissible non-public shareholding exceeds, say 75%, pursuant to open offer – the acquirer is required to bring down his or her shareholding to 75% within the time specified as per SCRR (Securities contract regulation rules).
  • The acquirer, whose shareholding exceeds 75% pursuant to an open offer, cannot make a voluntary delisting offer under the SEBI Delisting Regulations, for one year from the date of completion of open offer.

The second point clearly illustrates that Fairbridge Capital cannot come up with a delisting offer since the date of completion of open offer was July 25th 2012 and one year later, the deadline would have passed.

Ergo, Fairbridge has to reduce its stake to 75% or below. Current holding of Fairbridge is 87%. 12% dilution to go (which is a fairly large block of shares). If I were holding Thomas Cook (India), there is an avalanche of shares that could hit the market any time and hence I would sell at this moment.

*I said with 95% probability since two things can happen –

a) SEBI can extend the delisting deadline for all companies. Nobody knows what SEBI can/will do. This delisting theme is quite a speculation that is going on.

b) Fairbridge is not an inexperienced investor. Far from it. They would have obviously known that they have to dilute their stake (I think Fairbridge acquired the stake at Rs.50/- per share from Thomas Cook Group) to 75% or below before the deadline. Or, or get an exception from SEBI. Some legal loophole which might allow them to hold on to their 87% stake and also do a delisting. I wouldn’t know.

Given that, on an expected value basis, this remains a sell at these levels.

Disclosure: I don’t hold the stock (neither did I ever buy it). This post is only for analysis and educational purposes. Kindly do not take this advice as buy/sell recommendation. Please do your own due diligence before acting upon any of the information in this site.

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Special Situation: The Return of the Bonus Debenture

Update: The trade was completed. A bond with a face value worth Rs. 15/- was acquired at an average price of Rs. 4/- resulting in a terrific return. But as stated in the post, there was a bit of speculation in this trade and hence I had restricted it to only 1% of my portfolio. 

The title of the post obviously inspired from one of my favorite Star Wars movies, The Return of the Jedi.

Let me state the opportunity first and then move on to the logic of Bonus debentures.

Coromandel International had announced way back in October 2011 that they wanted to issue bonus debentures (unsecured redeemable non-convertible bonus debentures) to its shareholders as part of their Golden Jubilee (50) year celebrations. According to the latest announcement on 6-July-2012, a shareholder would get 1 bonus debenture (free) for every share held. These debentures would have a face value of Rs. 15/-, with a coupon rate of 9% p.a and would have a tenor of 48 months. The redemption would happen in 3 equal installments at the end of 2nd year, 3rd year and 4th year (along with interest on the remaining principal) (that is, you would be paid Rs. 6.35/- on 13th July 2014, Rs. 5.90 on 13th July 2015 and Rs. 5.45 on 13th July 2016 for a sum total of Rs. 17.7/-). These bonus debentures would be listed on NSE/BSE.

The trade was to buy at around Rs. 265 levels (already done by me) on say 09th/10th July and sell on ex-date 13th July 2012 at around Rs. 260 levels (will do tomorrow). There is also a dividend that has been announced (Rs. 3/-) and the ex-date of this dividend is the same as ex-date for bonus debentures (13th July). The bet is that the market would ignore/hardly correct because of bonus debentures (based on similar past corporate actions; explained below) and correct only to the extent of dividend paid, and we would pocket a Rs. 15/- worth debenture along with a 9% interest for the next 4 years for free.

Let’s not get too greedy. Let’s not say the acquisition price would be free. Realistically, let’s say your acquisition cost of the bonus debenture is Rs. 10/- i.e., share price corrects from Rs. 265/- to Rs. 252 tomorrow (Rs. 3 of dividend + Rs. 10 due to bonus debenture) (if it is Rs. 5/-, even bigger reason to celebrate and you can bump up your IRR by so much; if it is free, you can dance to Himesh Reshammiyya’s music) and as usual, you have to pay tax on the interest received on bonus debenture every year (say 30% tax). The IRR is as listed below –

Date Schedule (after tax on interest)
12-Jul-12 -10
12-Jul-14 5.95
12-Jul-15 5.63
12-Jul-16 5.31
IRR 20%

If you are in for fancy, you can hold on to this debenture and redeem it at the end of 4th year. An IRR of 20% is pretty amazing if you ask me. Coromandel International of course is well funded and is from the well-known and reputable Murugappa group (a cursory look at their history in P&L and Balance Sheet management attests to this fact). Therefore, redemption of these debentures (along with interest), unless there is Black Swan event, shouldn’t be a problem.

Depending on how much the stock correct by tomorrow, I plan to sell these debentures once they list and thereby generate approx 5% returns in the space of a month (from 13th July to listing, say 13th August) (one month period to list, based on past experiences).

The position size is restricted to 1% of my portfolio since there is an element of speculation in this (the stock price might correct severely throwing paani on my hare-brained scheme and the returns might be 0%).

If the trade goes right, 5% returns in a month after brokerage costs. Most probable scenario 20% IRR. Else, 0% returns. Heads I win, Tails I don’t lose much.

With the opportunity of making returns out of the way, let’s look at the logic and history of bonus debentures and why I think the price might not correct by much due to bonus debenture.

Bonus debentures as a concept was pioneered by HLL way back in 2001 (1:1, FV Rs. 6/-; 9% p.a). Subsequently, there was a long pause on the issue of bonus debentures before AstraZeneca introduced it in January 2008 (1:1; FV Rs. 25/-; 8% p.a). There were two more issues in 2010, one by Britannia Industries (1:1; FV Rs.170/-; 8.25% p.a) and the other by Dr Reddy Laboratories (1:6; FV Rs. 5/-; 9.25% p.a). In all these issues/corporate actions, the share price didn’t correct to the extent of the face value of the debenture (obvious reason being that the cash inflow for the investor will start only at the end of 2nd year, like in Coromandel International’s case and that too, only partly) (except in Astrazeneca’s case where the debenture had a tenor of only 1 year). There was also a debenture issue as part of a rights issue in Jyoti Structures, also a case where the share price didn’t correct by the value of debenture issued on ex-date.

Logic of Bonus Debenture: For taxation purposes, bonus debentures are treated as a deemed-dividend (that is, the companies pay out a dividend distribution tax when they issue these certificates, while it is tax-free in the hands of the investor). A note of caution: only the face value of bonus debenture is tax-free, the interest on the bonus debenture is taxable at marginal rate.

For the issue of bonus debentures, the company has to go through court approvals and some processes for listing the debentures. Why do companies opt for the issuance of bonus debentures inspite of all this jhig-jhig (trouble) instead of issuing a dividend? There are two reasons –

a) The interest paid on the bonus debentures is tax-deductible for the company

b) The cash outflow for the company starts only later, unlike a dividend where there is a cash outflow on an immediate basis.

All said and done, companies usually prefer the dividend route or the bonus shares route rather than the bonus debenture route (and hence analysis of bonus debenture is actually a ‘special’ situation 😉 ). Very quickly, let me quickly compare bonus debentures vs bonus shares/dividend to explain why companies usually take the bonus shares/dividend route rather than the bonus debenture route.

Bonus Debentures vs Bonus shares: In bonus shares, the equity of the company does not get altered. However, in case of bonus debentures, the company converts part equity into debt. If it is a highly leveraged company already, then this increased leverage might attract negative attention. Also, in case of bonus debentures (unlike bonus shares), there are three cash outflows – redemption principal, interest and dividend distribution tax.

Bonus Debentures vs Dividend: Bonus debentures as stated earlier have to go through legal proceedings and processes unlike dividend. Dividend though has an immediate cash outflow (and hence immediate cash inflow for investors) unlike bonus debentures. Therefore, shareholders treat dividend-paying stocks more kindly than companies which issue bonus debentures.

Let me know your thoughts on this special situation. Feedback invited.

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