Borrowed reserves: Politics or Economics?

This post was necessitated by two things. Firstly, the recent Currency Swap Agreements between the Central Bank of Sri Lanka (CBSL) and the Reserve Bank of India (RBI). Secondly, the recent upheavals in the political environment and the lack of clarity on how such swaps help the economy plus the mechanics. In fact, it is my understanding that the current political developments pushed the existing government to show that their economic management is better than the previous regime and hence there is no pressure on the LKR or the reserve position (as the opposition alleged).  

Some background

Central Bank currency/liquidityswaps are not new to the financial world. They are mostly used during crises. As per this Zerohedge article, China has become a prominent player in the currency swap market since of late.

In the South Asian region, India was utilizing the Swap arrangements with Bank of Japan (BoJ). Further, in May 2012 at the SAARCFINANCE governors’ meeting it was announced that RBI has offered a swap arrangement of up to USD2 billion both in foreign currency (USD and EUR) and Indian Rupees (INR) with a view to strengthening regional financial and economic cooperation. This facility is intended to be used to meet any balance of payments and liquidity crises till longer term arrangements are made or if there is need for short-term liquidity due to market turbulence. The very first swap under this agreement was signed in March 2013 between the RoyalMonetary Authority of Bhutan and RBI for a value of USD100 million.

Mechanics of the RBI arrangement

Under this agreement, RBI will offer USD, EURO or INR against the requesting country’s domestic currency or domestic currency denominated government securities. India is contributing USD 2 billion towards this. Any country (specified SAARC countries only) can draw subject to a minimum of USD 100 million and a maximum of USD400 million. Drawals can be made in multiple tranches. Each such drawal will be of 3 month tenor (with possibility to extend on maturity with the second rollover at a higher interest rate, i.e., 50 bps more than the normal rate). The normal interest here is 3m LIBOR+200 bps or RBI Repo Rate-200 bps on INR drawal. (Currently RBI Repo Rate is at 7.25%). From this it is obvious that this is no different to borrowing offshore. Only difference is that you don’t call it a borrowing rather a currency swap (which is difficult to understand!)    

   

CBSL’s signing of the bilateral swap agreements with RBI

In March this year, CBSL signed the Currency Swap Agreement with the RBI and the agreement is valid for a period of three years. (Expires on March 2018). Within this period, CBSL can draw up to USD400 million (or equivalent) in multiple tranches. (under above mentioned terms, of course) This I believe is an indication that there is a balance of payment or liquidity crises. (or is expected). This belief is further reinforced as the CBSL signed a Special Currency Swap Agreement in July 2015 for a value of up to USD1.1 billion for a period of 6 months. This special facility proposal of USD1.1 billion was approved by the Union Government of India. (So we can’t say it is not political). Plus during that period, the government of Sri Lanka was on the verge of announcing a general election. Hence, the ruling government would not want to let a currency related matter to disadvantage them in the forthcoming elections. (I assume and this is again politics!) I believe that they can show a higher reserve amount (taking in to account the drawing rights) and show that they were not borrowing (at least to the general person, as they were vehement against foreign borrowing by the previous regime) as the name hides the fact this itself is borrowed reserves.

As far as information is concerned, CBSL has not done any drawals so far. (My understanding). If CBSL did not make a drawing, it won’t affect unless there is some fees involved on undrawn amounts. (There is no such fees). 

  

Bottomline

Currency Swaps are good instruments to deal with short term currency crises and hence it is perfectly normal to tap that source. However, it is not a long term mechanism to cover up bad policy. Hence, these measures should be followed by more permanent long-term measures to deal with reserve management of the country. Or else the country will be deep in a vicious cycle.  

End of the day politics and economics go hand in hand.

Textured Journey

As per the Sri Lankan folklore, spinning of yarn dates back to as far back as 6th Century BC as narrated in the Vijaya & Kuweni story. Sri Lanka was also in the middle of the ancient “Silk Route”. Then in the contemporary times the biggest garments exporter. This brief start to the discussion is laid because this post is going to be about a Sri Lankan listed fabric manufacturer, Textured Jersey Lanka PLC.

In 2011, I had the opportunity to take part in the launch of the IPO of Textured Jersey Lanka Limited (TJL). Honestly, when I first heard about this company with Brandix nexus, I had some cynic thoughts running around my head. Some of these perception based questions were; why do Brandix want to ever list a company (because Brandix, to me, was perceived to be very reluctant to float a company), that let me to wonder if TJL is one of the unsuccessful ventures out of their all other businesses (one time they had a listed entity which went through an interesting cycle!),  hence; were they trying to exit this problematic business (because that was a time the Sri Lankan garment sector was going through some bad time as businesses moved to Bangladesh due to comparatively cheap labor there. Moreover, the market was ever more attractive to seek a listing at that point in time. Added to this was the fact that Hayleys Fabric PLC at the time was going through difficulties). I was also assuming that may be a listing was requested by their joint venture partner Pacific Textured Jersey HoldingsLimited. (PTJH)

However, the above analysis is just some subjective thoughts and hence it is worth taking an objective look at the company. Eventually, I want to value the company as I usually do. 

Little bit about TJL

Textured Jersey Lanka PLC (TJL) produce knit fabric. It is one of the two listed fabric manufacturers on the Colombo Stock Exchange (in fact only two to three companies from the garments industry, which is the largest forex earner to the country, are listed in Sri Lanka). The other listed fabric manufacturer being Hayleys Fabric PLC (MGT). Just to give an understanding, TJL for the FYE14/15 turned over LKR13.7 billion while MGT did only LKR8.6 billion.

To get a quick understanding of what TJL does as a business, have a look at this extract which I copied from its IPO prospectus, “The production process is capital intensive as it is highly mechanized. The Company processes cotton and synthetic yarn into weft knitted fabrics. The fabric production cycle undertaken by the Company can be divided into three main processes: knitting, dyeing and finishing which are illustrated in the following diagram”:

Some identified risky areas for the business that the investors should be aware of:

The reliance on a handful of customers for sales. Following is actually copied from the Prospectus, “For the financial years ended 31 March 2008, 2009 and 2010 the top five customers accounted for 94.1%, 94.3% and 91.0% respectively of overall sales revenues. Sales to the largest customer accounted for 37.9%, 36.4%, and 39.1% respectively of the Company’s overall sales revenue. The Company has had long term relationships with these brand owners”.

The other main risky area is the cost of yarn.

Needless to say that investors should keep close watch on the company’s gearing as higher debt can easily cause severe damage to the bottom line as well as cash flows. Currently, the balance sheet is nearly debt free.

Be aware of the exchange rate behavior and its impact on the financials of the company.

BOI status expires on October 2016 what is the impact?

Will the receipt of GSP+ result in increased demand for Sri Lankan apparel and thereby the demand for knit fabric? What was the impact of loss of GSP+ and hence if it was re-granted what will be the increase or expansion in the garments and apparel exports? Because, I don’t think that the presence of GSP+ or not has not really impacted TJL. 

Acquisitions I – Quenby Lanka Prints Pvt Ltd

TJL announced its first acquisition as part of its on-going expansion strategy with the acquisition of Quenby Lanka Prints (QLP) at a price of USD3.5 million.  

Recent acquisitions II – Ocean India Pvt Ltd (OI)

TJL recently announced its second acquisition of the year of Ocean India Pvt Ltd on a 50:50 cash to stock deal. The deal is valued at USD15 million (c. LKR2.006 billion). In regards to the 50% value of the target TJL is going to issue 35,197,368 shares in TJL. As per this, a share in TJL is valued at LKR28.50 (they have made our task easy by providing a value for the equity!). Hence, post-acquisition, it is expected that Brandix will increase its holding in TJL to 32.11% from 29.81%. While the current main shareholder Pacific Textured Jersey Holdings’ stake will dilute to 37.65% from current 39.65%. The announcement further says that afterwards PTJH will sell down part of its equity and thereby bring down its holding to about 27.65% (as per the announcement). However, in terms of M&A Code Brandix and Pacific will act in concert and hold not less than 51% of the company for a period of 5 years which will hopefully end by 1 April 2020. (so it looks like that they have set up a 5 year exit plan! And also I too skeptical because if these are great acquisitions on the long run why are they planning an exit). 

Thoughts on acquisitions

In both these transactions, TJL did disclose who did the valuations (E&Y) for them but it is difficult to assume in which direction the valuations are biased. (It is my belief that all valuations are biased also taught by a famous professor!). Moreover, it is difficult to gauge at this point whether these acquisitions are in fact value accretive or not with no information about the target companies being available. For, instance with the acquisitions the cost of capital of the consolidated firm will be higher or lower that current cost of capital (depending on the capital mix of the acquired firms. And the other thing is TJL has not mentioned whether the funds for these acquisitions are via bank funding or internal cash surpluses. However, given their huge cash balances, it is more likely that they will find the acquisitions with internal cash. In that case, on a pro-forma basis, I think that their net debt level will come down to around LKR113 million). Also we don’t have an idea about the target companies operating margin, revenues, etc. They may have positive or negative impacts on combined earnings and thereby on the value of TJL post-acquisition. On top of that TJL is acquiring private companies and thereby increasing the risk to TJL (as opposed to acquiring public companied which already have a market for its shares). However, let’s look at some numbers with the only available information.

Assuming that the acquired companies are in their steady states and assuming required return on equity similar to TJL (i.e., 11.57% as per my assumptions) QLP should generate post-tax earnings of c.LKR54.2 million (3.5x133.75x11.57%) to justify a value of USD3.5 million. Which means pre-tax earnings of c.LKR 75.3 million (LKR54.2/(1-28%). Similarly, OI should be generating post-tax earnings of c.LKR232.2 million. (15x133.75x11.57). Well ideally I should be using a required return for India and tax rate applicable for Indian context. (for now I think worrying about them will be a futile exercise!). 

My valuation of TJL

Before going straight on to valuation discussion, I would like to have a look at some of the performance metrics of the company. TJL has recorded tremendous growth in revenues over the last few years. (5 year CAGR of 10.37%). Within that period there have of course been ups and downs (given the nature of the business). 

The margin analysis shows the volatilities given its exposure to global commodity price movements and the trends in the global fashion retailing. 

Hence, over the last five year period, it recorded EBITDA margins of as low as 6.73% and as high as 8.78% as per the table. 

Another interesting development of the company has been the OCF to Sales ratio and the OCF to dividend paid ratio. The higher OCF to dividend paid ratio has increased significantly as the company has not seen organic growth (I opine) and returning of cash to shareholders in such an event is the best as TJL’s ROIC is likely to badly impact if they retain cash in the business earning around 6 – 7% in treasury (look at their ROIC in the below table). 

The net debt position is expected to reverse slightly with the recent new acquisitions at company level. (Interesting to see on a consolidated level).

Given the available information, as usual I looked to value the equity of TJL using the same DCF methods. Firstly, I valued TJL as it is currently (pre-acquisitions) and then added the values of acquired companies to the stand alone value. (here I’m relying on the valuations provided by the management. The valuation models are reproduced below.

Using my assumptions, I derive a value of around LKR21.93 for TJL which is currently trading at LKR28.2 in the market. I just could have tweaked around the numbers if I felt that my value is wrong. Guess what I always feel like my valuations are always lower than the market. But, I do not want to tweak my assumptions, because if I do that I can get whatever the number I wish. But, I think market is always right and I may have missed something. At least I have tried!

I reserve a pricing analysis to a separate post as this post will go too longer otherwise. I hope to compare TJL and Hayleys Fabric PLC in that post.  

  

Bottomline

If you are a good timer of markets I think you will do well with this stock in the long run. But if you are not (like I am) then play a very safe game over the next five years. Further, it is my belief that the current prices already reflect any upside that is expected from GSP+ and hence if you are buying on the basis GSP+ was granted you must be cautious. Also watch out for the global commodity price movements (cotton) and the trends in fashion retailing. My value may not always be equivalent to the market price but at least I know something now that I’m not buying based on hunch. It has to be also mentioned that I don’t own TJL shares personally and good luck for those who own.   

Now what?

This post is a quick follow up to two of my previous posts, Learn from the past and Prevention is alwaysbetter, those were mainly focused on the Credit Ratings.  

Today’s newspaper article puts it that “pursuant to the lapse of its registration, with effect from 1 July 2015, LRA is not entitled in law, to carry on business as a Credit Rating Agency nor review ratings; i.e. LRA is not entitled to carry on the business of assessing and evaluating or reviewing the credit-worthiness of any issue of listed securities or securities to be listed with regard to the issuers’ ability to perform any obligations imposed on the issuer thereon”. However, as of this time of my writing the LRA website still says they are registered under SEC.

The dilemma

However, the raise some serious fundamental questions as to how this will impact many stakeholders who were reliant on LRA’s ratings as well as on LRA as a company. Majority of the ratings issued by LRA were for Banks and Non-Bank Finance Institutions (NBFIs) and hence there is a large segment of depositors who are now left in dark. Moreover, there are a wide range of institutional investors (Unit Trusts, Insurance Companies, Banks, etc) who have invested billions in debentures rated by LRA. Similarly, many of these issuers are now at a decisive point. They will have to now go to another Credit Rating Agency (CRA) and they will have to bear the unexpected costs as a result of the unprofessionalism on the part of the CRA they used. On top of that there must be another segment of potential issuers who were getting their instruments rated with a view to tap the market. Now they will have to change the whole project and its timelines as LRA are not entitled to issue ratings (this will require incurring additional costs). On top of that timing of fund raising is of paramount importance to issuers and such delays are not at all good (I know from my own experience!). On top of that, what about those who were employed by LRA. I don’t think that even if LRA obtains the license again that they will be a viable business in the future.

Bottomline

It has to be noted that the failure of one entity is not just impacting its own industry but it spreads across many players in many industries, especially in the Financial Services Sector. Hence, ethics, professionalism are so important to ensure smooth flow of the system.