Quarter 2, 2016.

In a quarter filled with exciting news items like Britain’s exit from the EU, and Raghuram Rajan’s from the Reserve Bank of India, our views and our portfolio changed little.
 
Brexit, no doubt, has serious long-term repercussions for Britain, but what exactly those repercussions are, is anyone’s guess. Notwithstanding the knee-jerk effect on asset prices, Brexit’s effect on global economy is debatable. Its effect on the Indian economy is even less clear. Finally, its long-term effect on the health of companies we own, or would like to own, is likely nothing. And that is all we really care about.

​The other exit - Rajan’s, was of far more interest. Full disclosure: we have been Rajan fans for quite some time so we were disappointed to see him go. Under him the RBI was a bit more independent, a bit more data-driven, and a bit less unyielding to political pressure than in the past.
 
Almost everyone in politics, and many in the industry, argue that Rajan was more hawkish than required. With him gone, we will almost certainly see a more accommodative short-term monetary policy. This is not a happy outcome for a country repeatedly mired in high inflation and capital flights. However, the argument goes that the real reason for India’s chronic inflation is constrained supply, a problem that can be fixed with good governance. In other words, India needs more coal, more power, more spectrum, more roads, more bridges, more everything, and the current government will make these easier to come by. Amen!
 
We are stock pickers and try to stay away from macroeconomic analysis. However, if rates do stay low and supply unconstrained then Indian economy will likely outperform most expectations. Our portfolio, under such a scenario, will do extremely well. So as much as we like Rajan, we are secretly rooting for his critics.
 
We made the following change to our portfolio in Q2.
 
Bought Suzlon Energy Limited
 
Suzlon is in the midst of a turnaround. At least we hope so. In general, our view of turnarounds is rather grim. Most end up languishing for very long and frustrate shareholders. Yet, if done right and extremely selectively, turnaround investing can work. We have done it a few times before with net positive results. This new position in Suzlon is currently small (sub 2%) but we intend to add to it as the story unfolds.
 
Suzlon is the largest wind-turbine producer in India, and one of the largest in the world. At its peak in 2008, Suzlon did more than 50% of all wind turbine installations in India, and was the fifth largest wind turbine manufacturer in the world.
 
Wind generation business in India before 2010 was mainly motivated by a tax policy, which allowed for corporate buyers to depreciate roughly 85% of the deployment costs in the first year. The government also gave some generation linked sops to encourage wind power. Businesses got to save on taxes and government got a quick ramp up in wind install base. Everyone was happy. These were great times for Suzlon and it expanded aggressively, locally and internationally. It acquired Hansen Transmissions and REPower (later rechristened Senvion), a German powerhouse in high wattage and offshore wind segments. As usual, large amount of debt, a lot of it USD denominated, was used to pay for these purchases and ever increasing working capital. Eventually, the party stopped.
 
The first crack came from the government pulling back the incentives due to cost parity between wind and conventional energy. A large part of Suzlon’s customer base vanished. The next to crack were the turbine blades, literally. Although a manageable issue, it led to awful press and loss of marketshare. Due to an onerous German law, Suzlon was not allowed to use REPower’s cash flows to pay down the debt, or use REPowers technology to address the faulty blade issue. To do so, it had to acquire 100% of the outstanding equity of REPower, and that required more money. Problems compounded as a lot of capacity built up in anticipation of continued growth became underutilized. In 2011, the company sold its stake in Hansen Transmissions. In 2012, it defaulted in its USD debt. In 2013, it undertook a debt restructuring with its Indian lenders. Between 2012 and 2014, the company tried to shore up liquidity by selling equity and tried to reduce the debt burden by restructuring the terms of its debt.
 
In 2014, once the Modi government took office, it reinstated the accelerated depreciation incentive and started re-emphasizing clean energy, largely solar and wind. In 2015, Suzlon got a fund infusion by Dilip Sanghvi, the founder of Sun Pharmaceuticals, the largest pharmaceuticals company in India. It was able to successful restructure its long-term USD and Rupee debt. It sold REPower/Senvion and used the proceeds to pay down debt. In 2015-16, it showed its first yearly profit in 5 years. In our opinion, things will get better for Suzlon. Here’s why:
 
First, for Indian promoters, the most painful steps are to acknowledge the problem, reduce their span of influence by selling prized assets, use the proceeds to pay down debt, and move on. The difficulty and importance of these steps cannot be overemphasized. Suzlon is past this hurdle. Suzlon’s promoters seem sincere in their efforts and our checks suggest that they are basically honest. It is futile to hope for a turnaround unless at least this much it true (case in point: Kingfisher Airlines).
 
Second, we do not believe that the renewable bandwagon will stop anytime soon. Renewable use will grow for a long time and wind will remain a significant portion of renewable install base.
 
Third, Suzlon has enough spare capacity, meaning little capex for some time. It has about 3000 MW per year of wind turbine capacity, and it is presently making about 450 MW per year. It is growing around rapidly once again. In two years, it should do 1200 MW of turbine installations, which is about the size of its order book. The company is hoping to clear this up in 18 months. This can easily be a 1,000 Cr EBITDA operation with a market valuation that’s about 3x from here.
 
Finally, given the debt repayment schedule and the working capital needs we see little chance of further dilution. Suzlon is on a good track, but it still has a lot to prove. We will continue assessing Suzlon over the next 3-4 quarters and consequently increase our holding, or exit.
 
In closing, our portfolio composition or our investing strategy changed little in Q2. 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.