Sometimes SuperNormal companies with persistent competitive advantages might be hiding in plain sight. However, to discover these hidden moats one has to dig deeper into the balance sheet to uncover the true operating RoE. There might be non-operating assets on the balance sheet which lower the reported RoE to look like that of a Capital Eroder.
“What absolute rubbish!”, exclaimed Whittle banging his iPad on the breakfast table. “Vikram, who would invest in this Capital Eroder. Look at it, it is compounding capital at an RoE (Return on Equity) of around 8%-10%. This company is not even earning the cost of capital for it’s shareholders. Why are such companies even allowed to be listed?” Whittle couldn’t contain his indignation and was visibly disturbed.
Vikram held out his hand towards Whittle for the iPad. He looked at the company which had upset Whittle and then burst out laughing.
“What bothers me even more is that you have it in your Omni Super Dividend portfolio and the Omni Power portfolios. How can you have such companies in your portfolios? And you are laughing!”
“Dig deeper Whittle, dig deeper”, said Vikram, handing the iPad back to Whittle.
“What looks like a Capital Eroder to you at first glance might yet turn out to be a moat in plain sight. Let us do an exercise. Why don’t you open the balance sheet and the income statement?”
“I have opened the financial statements, Vikram.”
“What is the profit for the last year?”
“It is around INR 3300-odd crores.”
“What is the total equity in the company?”
“That is around INR 36,000 crores”.
“If we calculate the RoE, it will yield around 9%, same as you mentioned, Whittle; definitely, not very exciting.”
“Exactly, Vikram, a Capital Eroder to boot!”
“Not so fast, Whittle”
“Now look at the non-current assets. You will notice that there is nearly INR 18000 crores of Capital wok-in-progress (CWIP). This capital is invested but not earning anything yet until the work-in-progress projects are fully implemented.”
“Ok, Vikram, that is interesting.”
“As you can notice, Whittle, the debt-to-equity for the company is approximately 1:1. We can assume that the CWIP is also equally split between debt and equity. That means that around INR 9000 crores of equity is invested in CWIP. If we adjust for this, the remaining equity is around INR 27000 crores. On this INR 27000 crores, the company earns 3300 crores. That is nearly a 12% RoE.”
“Now look at the net current assets. There is around INR 4000 crores of net current assets; practically all of it in cash. Again, assuming equal split between equity and debt, the operating equity can be further reduced by INR 2000 crores.”
“That means INR 3300 net profit on INR 25000 crores of operating equity. That is 13%. This is not a bad return on equity, especially for a utility, Vikram.”
“Precisely, Whittle. Further, the management has indicated that there would be an additional, nearly INR 1000 crores by FY 24 on an additional equity of INR 6000 crores. Incorporating that it becomes INR 4300 crores on INR 31000 crores, which is nearly 14% RoE.”
“Hmmm. Things seem to be getting better and better, Vikram. But what about the debt?”.
“You know that, typically, I don’t like high debt companies. But in this case, the debt does not bother me since it is a utility with long-term assets that earns significant cash flows over its lifetime through a regulated mechanism. Further, the credit rating of the company is AAA which means that in the opinion of the rating agencies the cash flows of the company are quite secure and stable.”
“Now let us see what Mr. Market is asking for this, Whittle.”
“I see a reported PE ratio of around 8 in one of the financial sites.”
“The market capitalization currently is INR 24500 crores. The net current cash is around INR 4000 crores. There is an additional financial assets of INR 6000 crores in non-current assets as well. That would effectively bring the market cap to INR 14500 crores.”
“Net of the non-controlling interest, the earning for the owners of the company is around INR 2900 crores. This INR 2900 on 14500 is nearly a 20% yield for equity holders. Even without adjusting for the cash, it is a 12% yield. Further, one is getting a dividend payout of INR 1500 crores. This is a 6% dividend yield.”
“Over next 3 years, the PAT is expected to go up by around 33%. That is 10% CAGR.”
“Whittle, a 6% dividend yield + a 10% growth is around 16% expected returns.”
“What would be the effect of a rerating on the returns? For example, the market could decide that instead of a 6% dividend yield a 3% dividend yield makes more sense. Or that a PE ratio of 12 is a more appropriate one.”
“Dividend yield going to 3% would nearly double the price in addition to the fundamental growth and the pay outs. If that happens over a 3-year period, that is an additional 25% CAGR return. In that case the total CAGR could be as high as 40% over the 3-year period.”
“Of course, when we look at these expected returns, we always remind ourselves that things could go the other way as well. Market conditions could be bad or Mr. Market might hate this company even more and derate it. That would bring the returns to be lower than 16%. However, in that case, one who has analysed the firm well could continue holding on and earning the 6% returns and the 10% fundamental growth in revenues and profits. Further, the firm has numerous projects in the pipeline to provide growth and a long-term holder would be quite happy with their reasonable returns.”
“Vikram, so how would you characterize this company?”
“I would call it a moat hiding in plain sight. And a company with a reasonable double digit expected return with a significant portion coming in as dividends with a reasonable chance of a very large upside. As always, remember there are no guarantees in the stock market and many unexpected things can happen. So always hold a company, however attractive, as part of a diversified portfolio and not as a single stock holding.”
Disclaimer: Equity investments are subject to market risks. Global investments entail currency and country risks. The above is not a recommendation to buy, sell or hold any of the stocks or sectors mentioned. We and our clients might have exposure to the above-mentioned stocks or sectors. Please consult your investment advisor and assess the suitability of investment products for your circumstances before investing. Please read the detailed disclaimer on omnisciencecapital.com/disclaimer.
[This is an authored article by Dr. Vikas V Gupta, CEO & Chief Investment Strategist at OmniScience Capital. All views, opinions and expressions are personal and limited to the author.]