I recently finished off re-reading of Pabrai's latest book - Dhandho, and must admit it is fundoo!
There he has described the concept of buying into defunct industries, at bad times, in bad businesses undergoing worst conditions (Jim rogers, or Templeton's point of maximum pessimism!!?) In fund management industry, its easier said than adopted. Its a nerve wreaking experience for most seasoned guys to see things becoming worse and worse.
In present market conditions (with Nifty hitting 5000, and multiples of 23x), distressed industries (or under some temporary uncertainty) present a good opportunity.
I recently came across a company which was pitched to me at a price of 140 (Market Cap of Rs 340c). Now the price is around 80 (Market Cap of Rs 200c or around USD 50m). The company had given 2 consecutive quarters of exceptionally poor performance, and is heavily in debt. The nature of business is agri-crop-processing. Its a market leader with strong brands, in country which produces 75% of global-produce.
The company possesses debt - most of which is short term - required to support the working capital. Long term debt was taken to buyout a defunct processing plant at throw-away prices last year.
The company faced 2 main issues - which hit at the same time. (1) Their procurement of crop went haywire as the prices of crop went up and they delayed procuring, thinking that rise is due to speculative activities (2) $ depreciated, leading to loss of value of exports.
How do I see the 2 problems?
First one, is it permanent or temporary? Will the company never to able to get cheaper raw material? I think the answer to it is simply NO. It happens all the time, when we try to wait for the better prices and the price of the assets shots up (Buffett calls it "the error of omission"!)
Second - currency problem? India has 75% market share in the global market (with rest 25% held by another country - Pakistan), and our player has close to 10% of India's export market. I think the dominance of the producing countries and difference of quality of Indian produce Vs Pakistan's produce, gives a edge to Indian producers. Its like saying to buyers that if you wish to buy my product, you have to pay more. Do they have choice? I don't think so!
The nature of product may not let them make exorbitant margins - but, I think some economic moat comes from the fact that India controls three quaters of the global basmati trade. Its a "nature's gifted" economic moat, which will let these processors maintain decent returns, and give some pricing power against the falling currency.
How about owner's equity?
I am buying equity - which is at nearly half the book!! I am getting operating leverage of 3:1 (almost 1 parts of operations are utilised, as they added rest of assets recently. The company bought a defunct plant at throw-away price - which I think was a good capital allocation decision!). The promoters are century old (veterans who have seen many such cycles!). The effect of currency is reducing, as the exports are getting smaller and smaller and diversified (Indian consumption is growing). And growth of the business is phenomenal (25% CAGR for last 5 years at Operating profit levels, except last year). Isnt it good for vultures VIs like us!. Yield is ok - 2% in this bad year (capital required to maintain the yield is not much). Tax provisioning is the best in the industry - close to 30%! PB, PSR, PE, ROC, are all favourable to me! Plus brand is pretty strong.
How about the cash flows?
Cash flow after working captial has been unpredictable and negative manytimes - for the entire industry. As the business is WC intensive (inventories forming nearly half of assets), capital requirements are high. This year the company has shown remarkable improvement in WC management and done substantial capex from that release of capital, but how it manages its WC in future is uncertain to me. The cash flow after working capital is negative (not a healthy sign from traditional VI concepts), but I think that the Free-Cash-Flows (capital left after maintaining the business as-it-is, and without any spending any money for growth) is healthy.
As I pointed earlier, the entire current assets - highly liquid - can be liquidated to pay off all the loans, giving enough solvency to the company. (Infact, inventory is booked at market price or purchase price - whichever is lower, but the market price is usually higher due to value-addition after aging process).
Net net, with such economics, as WEB says, I am getting lottery ticket for nothing. The chances of good things happening are very high, and chances of permanent loss of capital are very low. Heads I win, tails I don't lose much!
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PS - please read post # 1.
