In fact, the drop in the US equity markets somewhat understates the extent of the panic. Consider the high yield bond market, which generated fourth straight month of losses – a first for the asset class since 1994. Alternatively, consider VIX, a measure of future stock market volatility which is popularly known as the fear index. US VIX crossed 40 in late August. Last time that happened (in Q3 2011) we were dealing with the Euro crises and a US downgrade. The price action in the emerging markets such as Brazil, Indonesia, Malaysia, Turkey and several others, was even worse.
The Indian economic story was quite a bit different. Consumer price inflation steadily came down to sub-5%. Industrial production data, though still weak, progressively got better. The country, being net commodity importer, reaped substantial benefit from the commodity sell-off. The prime minister was busy selling the country to foreign investors, and they liked what they heard. FDI inflows are close to record highs. Finally, RBI cut the benchmark repo rate by 50 bps, a substantial loosening resulting in the lowest rates since April 2011.
We, at Willow, could not have asked for more. As mentioned in our previous letter, we had been busy shopping in Q2. We accelerated our pace in August and are now close to fully deployed. Like everyone else, we don’t enjoy marked-to-market losses on our investments. However, if we can trade some un-realized losses for a chance to invest at extremely cheap valuations, we would do it all day long. Q3 gave us just the opportunity. As usual, we will present a detailed overview of our portfolio composition our annual letter. Meanwhile, we describe our two most recent purchases below.
PTC India Ltd.
PTC India is the largest power trading company in India. It has around 35-40% market share in power traded through bilateral contracts and power exchanges (IEX/PXIL). Like any trading operation, it collects a spread in the short term spot market, and earns annuity income through long term power purchase and sale agreements. The company was founded in 1999 by Power Grid Corporation of India, NTPC, NHPC and PFC - all government entities with clean managements. They together own 16% of PTC India. Apart from its regular business PTC owns investments in group /JV companies led by its two subsidiaries – PTC Financial Services, PFS (60% stake) and PTC Energy (100% subsidiary).
The current market cap of PFS is Rs24.5 bn and PTC India holds 60% stake in PFS, which results in Rs14.7 bn of value. We believe that PFS itself is fair to under-valued. PTC also has about Rs9 bn in cash and equivalents. Add everything and we get Rs23.7 bn in market value. It has substantial stakes in several power generation assets through JVs. There is no debt. The company currently trades at Rs18 bn. In other words, the core business of PTC is available for NEGATIVE Rs5.7bn. Perhaps even lower.
The company generated Rs2 bn in net income last year. It has not been in the red for the last 10 years. It should generate about Rs1 bn in free cash flow next year and likely higher thereafter. It’s a regular dividend paying company with 30% payout and 3.5% current yield.
So why is this business available for less than free?
The power situation is extremely grim in India and will require far more space to explain than we have in this letter. Currently, approximately one-fifth of the electricity produced in India is lost or stolen during distribution. Adjusted for per-capita income, India faces the biggest per-capita power deficit in the world. In other words, its power deficit is one of the biggest embarrassments for India. Modi and his power minister are laser focused on fixing this. Judging from their past record, there’s a fair chance of resolution to this problem. However, things move slowly in India and we cannot put too much faith in things getting better quickly. Apart from the sectorial issues, the company has had problems of its own in the past. It has recently faced competition from other independent players. It has also had problems collecting receivables from a few states.
We believe that the management as learnt from its past bad experience and is taking several steps in the right direction. It’s aggressively litigating and collecting from the problematic states. In fact, there’s an incoming Rs2 bn payment from the state of Tamil Nadu which is not factored in the current valuation. It’s also doing its business more selectively. Lastly, it’s getting into more annuity PPAs and PSAs where the receivable risk is lower and the competition is sparse. The company has consistently grown its units traded, revenues and profits since inception. Most importantly, the company’s reporting is conservative and its management is clean.
We believe that PTC is an OK company in a terrible sector. Its financial situation is solid and we have little doubt regarding its future profitability. Most importantly, the stock was trading at less than half its fair value in August. We bought the stock around INR 55 and expect it to move significantly higher within a year or two.
Triveni Engineering and Industries
Sugar in India has always been a tricky commodity. It’s tricky because the usual capex-driven cyclicality, typically associated with global commodities (oil, metals, cement, steel, etc.) is irrelevant here. Sugar in India is deemed an essential commodity, which means that sugar-mills have to keep crushing sugarcane to produce sugar regardless of supply-demand. Moreover, for largely political reasons involving the farmer vote-bank, the state governments mandate floor prices for sugarcane sales to the mills. These artificially high prices have little relation with the global sugar prices, which the mills receive when they sell their sugar.
As expected, these factors bring about a rather distorted ecosystem. However, there is no incentive for either the government or the opposition to rectify it. Ultimately, the sugar-mills bear the brunt. When the global sugar prices are low, as they are currently, they make crippling losses. Sugar mills in India have been in the red for the last four years. So much so that the annual floor-price increases in certain states have led to negative gross margins for some companies. There are strict rules against shutting down unprofitable facilities and the mills can do little but wait.
Of course, this is not the first time that such a situation has transpired. Usually, normalcy is restored when the sugar prices move up, or when Indian farmers stop planting cane. We have no view on the global sugar prices but since we are seeing the most oversupplied market in six years, there’s hope. That aside, locally, the more important question is - when will the farmers stop planting cane? Historically, they have stopped planting when the mills have stretched their sugarcane payments to unsustainable levels. And this was rampant this year - the mills’ dues to farmers went up from about $1b in 2012 to about $4b in 2015.
Banks that supplied working capital to mills to meet their dues to the farmers stopped giving loans to sugar mills. These loans are usually tied to the sugar inventories and the banks are obviously worried about the value of that collateral. There were a couple of minor schemes, that the government floated to help the mills out of their cash-crunch, but it was too little too late. The sector is now facing mass defaults by the mills which will ultimately lead to a turnaround. Typically, when their dues are stretched to more than a year or two, the farmers switch from sugarcane to other crops. We saw some early signs of that happening in the last quarter.
Having followed this sugar saga for a while now, we recently started sifting through the rubble looking for well run and well capitalized companies trading at fire-sale prices. We found one in Triveni Engineering and Industries Ltd. It has one of the strongest balance sheets in the sector and is run by an extremely progressive management. It owns 22% of a highly profitable sister company that manufactures specialty turbines. The value of just this proportional ownership stake is more than the entire market cap of Triveni. Apart from sugar, Triveni has two other businesses (specialty gears and water treatment) that are both profitable and growing. Most importantly, Triveni’s management is working to restructure and separate these diverse businesses through tax efficient spin-offs. We estimated the intrinsic valuation of this company to be 2-3x the price we paid for the stock, and we believe that there’s an imminent catalyst which will unlock this value. At the end of the quarter the stock was up close to 50% from where we bought it. We are closely monitoring this situation.
In closing, our long term confidence in India remains high, and fortunately we were able to buy some deep discounts last quarter. We believe that we are now sitting on the most lucrative portfolio since mid-2013. The seeds have been sown. Now we patiently wait for the bounty.
If you have questions regarding this letter or your portfolio, please do not hesitate to ask. As usual, you will receive your statements from NAV Consulting Inc.