Health is profit!

The first equity IPO of this year is now announced. Interestingly, it is the first time a company from the Ratnapura District is coming for a listing on the CSE. (Which is a good thing as this is exactly what we need in order for us to develop the capital market). As I always mention, the other good thing is that this is a productive business (not a shell company with some investment holdings which are not generating cash!) and hence there is tangible business.

Singhe Hospitals

As mentioned in the Prospectus (page no. 25), “The Company was incorporated on 16 December 2009 as a Board of Investment (BOI) approved project to carry on a Private Hospital, including Laboratory and other connected Services in Sabaragamuwa Province. The Company started commercial operations in June 2012. Singhe Hospitals Limited (SIHL) is the only private hospital operating in Ratnapura District with modern health care facilities. SIHL is a fully equipped tertiary care hospital presently with 50 beds to accommodate patients and a range of medical specialists are available throughout the day for consultation. Patients for indoor treatment are admitted under the care of the visiting consultants and qualified doctors.”

Healthcare in Sri Lanka

Healthcare services are provided by both public and private sectors in Sri Lanka. The public sector plays a predominant role in the healthcare industry in Sri Lanka with a total bed strength of 74,636 and 1,084 hospitals (including 481 Primary Healthcare Units) around the country.

However, the public sector is unable to keep pace with the growing demand due to capacity constraints and limited funding availability from the government. Increasingly, people rely more on private healthcare organizations to meet the needs due to perceived higher quality of services and convenience. Hence, the demand for private health sector is growing at a rapid pace. This tendency is expected to continue as a result of certain other fundamental factors like ageing population, increasing household disposable income levels, the high prevalence of Non Communicable Diseases (NCDs), and the re-emergence of communicable diseases. Have a look at the below graph which gives a quick glance at what drives the overall healthcare market in Sri Lanka.

Like in many parts of the world, the private health sector in Sri Lanka is also fragmented to a large extent with small practices owned by medical professionals. By end 2013, 206 registered private hospitals with approximately 5,309 beds were in operation in Sri Lanka. (this was just 186 hospitals with 4,784 beds in 2011) Most of the private hospitals are concentrated in Colombo the main commercial city of the country. Apart from hospitals business, the private health care sector is characterized with other businesses like elderly and residential care, traditional medicine, ambulance services, diagnostic services and alternative medicine.

Demographics in Ratnapura

Ratnapura is a district in Sabaragauwa Province (SP) and as the name suggests it is the city of precious gems. The total population of Sabaragamuwa Province is c. 1.941 million of which majority lives in Ratnapura District (about 57% or c. 1.097 million). The gender split in SP is 51.9 female and the balance male. SP has the fourth highest elderly population (just behind Western, Southern and Central provinces) and that number is higher than the island’s average as well. Average household income in the province was only behind Western Province at LKR36,173 and it recorded the second highest income disparity in the island with the richest 20% earning 57.9% of the income. In SP, total Personal Care and Health Expenses as a percent of total household income was just 3.9% (this is at 5.7% in Colombo. May be people in other parts of the country are healthier than people in Colombo where in Colombo, people’s lifestyles are significantly different to the others).

Healthcare delivery in Ratnapura

Healthcare Delivery in Ratnapura is predominantly done through the public sector institutions, like any other part in the Country. The table below shows all the delivery points across Ratnapura District. (please note that these bed figures are based on CY2010 and I believe that the bed numbers must have increased over the period from then to now) Refer this report for more info:

Looking at above figures I estimate Hospital Beds per 1,000 people in Ratnapura to be c. 2.91. (Note that this is only considering the public sector institutions. However, the Central Bank of Sri Lanka Annual Report says that islandwide this figure is 3.6 beds per 1,000 persons) This I can contrast with figures from other countries as per this link. If we go by the WHO standard of 3.5 beds for a population of 1,000, Ratnapura District needs c. 3,840 beds to serve the current population of 1.097 million inhabitants in the District. (which is a 646 bed shortfall, going by the public sector no of beds of CY2010). Currently, it looks that the numbers are about right. But, if you look at this chart it is evident that as the population age, the need for beds increase. (Japan, Germany are countries with very high elderly population and similarly higher bed ratios). But, for Sri Lanka and hence Ratnapura, need for higher no of beds will not arise in the short to medium term. (may be in another 15 – 25 years!)

Singhe Hospitals Market Opportunity

Geography - Ratnapura is located fairly close to Colombo. It’s about a 2 – 3 hour trip one way. Hence, the well-to-do has always travelled to Colombo for private healthcare, mostly in case of acute illnesses. This distance (between Colombo and Ratnapura) would probably be further reduced if the planned highway becomes a reality.

Moreover, Ratnapura District is spread across a large extent of land and as a result cities like Kuruwita, Eheliyagoda and Awissawella are more closer to Colombo. Hence, people from those areas would most likely travel up Colombo rather than down to Ratnapura. Moreover, people from Embilipitiya would most likely travel to Matara or find it worthwhile travelling couple of more hours to Colombo rather than stopping half way down at Singhe. Hence, I believe that the addressable market for Singhe is a very captive one within a certain radius of the hospital.

However, as mentioned in the prospectus, SHIL is the only private hospital with modern facilities at the moment. (why I’m saying at the moment is because there is another hospital that is coming up very close to it. (have a look at the below map)) However, SHIL also enjoy location benefit so far as it is located very close to the Ratnapura General Hospital.

Average Length of Stay (ALOS) – Mainly due to geographic closeness of Colombo private sector providers and the abundance of physicians in Colombo, people from areas like Ratnapura would only make use of facilities in their locality as a make-shift venue. Thus, the ALOS in a Ratnapura facility would be very short compared to ALOS in Colombo based operators.

Feeder position – These operators in areas like Ratnapura actually act as feeders to Colombo based operators. Anyone, who can afford to go to a private operator in Ratnapura will go there for only OPD type treatments and initial screenings or testing. Afterwards, they would proceed to Colombo.

Bed Occupancy Rate (BOR) – One other thing that affects badly the local operators are the low level of BOR. This is in fact as a direct result of above two points, i.e., ALOS and feeder position.  

Perceived grandeur -  Still people in these parts of the country prefer to visit Colombo for treatments due to perceived grandeur in it. Hence, their first preference will be to visit so called ‘Navaloka’, ‘Appollo’ or ‘Asiri’.

Technology availability – That said it has to be also mentioned that people are also forced to travel to Colombo as some of the technology available in Colombo are not available locally. Hence, local availability of some of the latest technology might help retain some of the patients visiting Colombo, especially elderly who do not want to travel or those who want to save some time (well anyone wants that).

Supply issues – Connected to the above point is the limitations on supply side. For instance, I understand that lack of properly trained nursing and other staff at private sector has been a disadvantage for private operators (this problem is severe when you go out of Colombo). As a result, patients prefer to go to public sector hospitals and added to this is the advice given by doctors to always go to public hospital. The map below shows the density of nursing and midwifery personnel across the globe. 

As per this Sri Lanka has to go a long way to develop to other emerging nation status. Further, the low density of physicians in Sri Lanka is another supply side constraint which is again even worse when it comes to Ratnapura and the like. For instance, physician driven business will always be generated in Colombo unless some structural change happens in the country likelihood of which is zero as per my reading. As per the below map Sri Lanka’s density of physicians is very low at 0.68 for population of 1,000 (You can do a comparison through this interactive map given by WHO here). Supply side factors are common to all the operators including large players, however situation is comparably poorer in Ratnapura, I estimate. Which is a drawback for SHIL.

With that I wrap up on the industry and market opportunity and move on to value the equity of SHIL.

The intrinsic value

In order to value SHIL, I made use of the forecasts (for the first five years) that were given by the firm that did an equity valuation of the shares of SHIL. That valuation cannot be considered an independent one as the entity that did the valuation happens to be the auditors of the company (meaning that they are biased towards the management of the company and hence the valuation itself is biased upwards, technically). From the year 5 onwards, I’m using my own assumptions.

In terms of revenue growth I assume that over the long term it has to settle in at normal economic growth rate which I assume to be around 6%. Even if I assume that it grows at average inflation rate of the country that will be the case as I assume. Further, I assume that their EBIT margin will be at 11.5% which is similar to average margins recorded by Lanka Hospitals, Durdans over a five year period. Then beyond the explicit forecast period I assume the EBIT margins to settle at 9% (for the infinity) similar to current margins of Lanka Hospitals. As per the BOI agreement company will start paying tax at 10% for two years from year 6 to year 7 and thereafter at the rate of 20% for the infinity.

In terms of discount rate, I use a cost of capital rate of 11.98% for the first six years and thereafter a cost of capital rate of 12.5%. From year seven and beyond I assume that long term debt to capital ratio to sit around 30%. A risk free rate of 7.89% which is equivalent to current 5 year Sri Lankan government bond rates is used. Currently, the company is assumed to borrow at 11% from the banking system in Sri Lanka.

Based on all these assumptions, (assuming that it will generate Lanka Hospital like margins and Sales to Capital ratio of 2x) I get a value per share of LKR0.60. The offer is hence priced 318% over my valuation (which anyone can argue otherwise and I welcome anyone to do that) In fact, if you have different assumptions as opposed to mine I’m happy to run them through my model and see the impact on the value.

Missing by miles

At LKR2.50 per share the Investment Bankers of SHIL are valuing the entity at LKR995.6 as opposed to mine of LKR238.1. So, am I missing the value by miles or am I right? Well that is not a question that anyone can answer. Because, valuation is not a science!

Bottomline

Going by my valuation, I reckon that the IPO is overpriced and that is evident if you look at who valued the company and in which direction the biasness is (as any valuation is biased as far as what I learnt and what I believe). That said I welcome the entry of local business to CSE as it is exactly what the country needs.  

Learn from the past

As far as I understand, Credit Ratings are a big deal in other markets. There have been many research papers published on questions like; do the credit rating actions have any impact on the stocks/market?, how does the stock markets react to these ratings announcements, etc. Some have conducted event-studies to understand the nexus between credit rating announcements (positive or negative) and the stock performance on the listed markets. A paper by Magdalena Grothe of European Central Bank themed, “Market Pricing of Credit Rating Signals” finds that “The results show that the effects of rating actions on market prices are significant and depend on the current state of the market. While during favourable market conditions rating actions are not crucial for market pricing, they become very significant in the periods of crisis”. Another study from our neighboring India suggests that credit rating downgrades cause considerable negative reactions while upgrades tend to result negligible positive response.  However, to my knowledge, it has not been an area researched in Sri Lanka.

Credit Ratings were a major subject of discussion in the aftermath of the GFC. Credit Ratings Agencies (CRAs) were also partly blamed as one of the contributors to the financial crisis. This video from the famous 2010 documentary movie Inside Job gives you some thoughts which were critical.

In this background, the discussion moved further ahead with a search for better alternatives to conventional credit ratings. However, to-date I do not see any major alternative gaining ground over conventional credit ratings which seem to prevail and discussion seems to have tapered away. Interestingly enough, the ratings agencies also have not come up with different solutions to counter the arguments against them. (may be they think that the existing system works or their business was not threatened as yet by any new methods suggested or by any alternative providers like Invictus, INCRA  and Trepp. However the chairman Mr Kamal Mustafa of Invictus claims that couple of CRAs approached them to be acquired). This paper discusses in great detail the drawbacks of issuer paid credit ratings, alternatives for issuer paid credit rating agencies and resiliency of issuer paid CRAs.

In fact this post is not going to be about the global credit ratings industry, but I wanted to look at certain developments that have taken place in the Sri Lankan credit ratings environment. Firstly, I will give a brief about the Credit Ratings Industry in Sri Lanka.

One million dollar industry

Currently, there are three recognized Credit Rating Agencies (CRAs) in Sri Lanka. Fitch Ratings Lanka, Lanka Rating Agency and ICRA Lanka are those. These market intermediaries are regulated by the Securities and Exchange Commission of Sri Lanka (SEC). Credit Rating is not a mandatory thing in Sri Lanka though it is mandated if an issuer looks to raise money via the listed bond market. Further, the investor community has also demanded rated products making it necessary for issuers to obtain credit rating (entity as well as instrument ratings) if they are to tap the securitized market, commercial paper market, etc.

As shown in the figures on the table (the data were extracted from Annual Reports of SEC) the industry has now grown to be a one million dollar industry. Over the last three years, total revenue of the industry grew from LKR35 million to LKR136 million. This is equivalent to over 90% annual growth rate. Even more noteworthy was the fact that the industry has emerged profitable over this same period and the margins are pretty good at around 34% PBT margin at present. Given the current activity level in the credit markets in Sri Lanka, I expect the industry revenues to double in 2014. This growth might come as a hurdle to maintaining integrity, independence, quality of work, etc due to pressure from issuers.

  

Frictions among issuers and CRA

In a new development in the ratings industry in Sri Lanka there were differences in opinions between issuers and the rating agencies. Consequently, Hayleys PLC and LOLC pulled out from the original agency and contracted another one (RAM Ratings Lanka now known as Lanka Rating Agency in the case of Hayleys PLC and ICRA Lanka  in the case of LOLC). It’s not the interesting thing, with the new contract the issuers were able to gain the same rating back. Similarly, late 2014 Softlogic Holdings PLC got downgraded by Fitch Ratings Lanka and they were able to regain the original rating from Lanka Rating Agency.

Thus, it appears to anyone that these subsequent ratings are inflated (or the contrary may be true, i.e., the former’s rating is deflated). Moreover, investors are left wondering who’s right or wrong, where the process is heading, etc. In fact, from my experience I know that some investors consider the ratings provided by these agencies as substandard.

I believe that either there is governance issues at corporate level (both issuer and CRA level) and/or rating agencies do not possess the required technical knowledge to understand the businesses and the industries they are evaluating.

Market seems to be ignoring rating actions

Another noteworthy thing about ratings actions is that market seems to ignore the information contained in the ratings announcements. This may be due to the fact that this was not new information to the market and/or the market behaves totally irrational.

Technically, a rating downgrade means that the entity’s risks have risen and as a result, from what I know, the investors required returns are higher now. As a result the intrinsic value of the entity goes down. Hence, theoretically this should result in a drop in price.

On 25 August 2014 (a week before rating downgrade) JKH.N000 was at LKR243.00. As of 3 September 2014 it was at LKR249.50. On the same date the Company got downgraded to AA+ from AAA by Fitch Rating Lanka. One of my colleagues was asking me whether the share would come down due to this bad news. (that was his reading of the market). I told him that it will go up as the Lankan market behaves very erratically. As predicted, it kept moving up and by 12 Sept 2014 it was at LKR259.50. See the price chart below.

Watch out! The impact could be shocking

Recently, there has been a rapid growth in issuances in the market. In 2013 and 2014, there were 30 and 24 listed debenture issuances respectively on Colombo Stock Exchange. These issuances have raised a staggering LKR131,258 million (c. USD1 billion) collectively. Growth in listed debentures is known but the asset backed, commercial paper segments are not known publicly. The size of this segment must also be significantly high.

As Dion Bongaerts of ECB quotes, “The IMF has estimated that the losses incurred on largely AAA rated structured products amount to $3.4trln globally”. IMF has given a good explanation as to what the systemic risks are of a rating crisis in a boom cycle and a bust cycle. In a global context, IMF finds that there has been about one rating crisis every three years in the twenty two year period before 2009.

Bottomline

CRAs are operating in a for-profit market. Hence, there is always space for one agency to capitalize over other as evidenced in Sri Lanka in the recent past. Frictions among issuer and rating agency gives another agency a chance to poach the issuer. This will always be the case as long as the ratings are issuer paid. Nevertheless, alternative models have not yet been able to challenge the conventional rating form. However a rating crisis can wield significant impact on the financial system. It is of utmost importance to avoid a rating crisis in Sri Lanka. The systemic risks of a rating crisis can go even beyond the losses incurred in the listed debenture market. Market participants can also become contributors to a good rating culture by acting rationally. Thus, news such as rating downgrade or even worse swapping CRAs to get the same rating in a downgrade situation can be penalized by requiring higher returns to commensurate with the higher level of risks.

Right to buy Rights?

MTD Walkers PLC, known as KAPI.N000, has announced the dates for the proposed Rights Issue. I reproduce the announcement below:

As per the announcement, the Company is issuing 466 new shares at LKR45 per share for every 1000 shares held by shareholders. (please note that as I write this post KAPI.N000 is trading at LKR62.80 per share). With the proposed rights issue they plan to raise c. LKR2.4 billion and issue c. 53.3 million shares.

So, I asked the question, is it right to buy the rights in the market, as the subject suggests. The answer is not a straight ‘yes’ nor it is a ‘no’ as it all depends on several factors. To figure that out I did a quick back-of-the-envelope calculation.

What will it look like after Rights?

Firstly, I wanted to look at the effect of the Rights on the balance sheet, especially on the shareholders’ funds/book value.

With the proposed capital injection, the stated capital of the company is going to reach c. LKR6 billion as you can see from the Pro-forma section of the graph. On a pro-forma basis which converts to an adjusted book value per share of LKR46.22.

Similarly, some EPS calculations are shown below. 

As per my quick-and-dirty calculations, I forecast net profit attributable to shareholders of c. LKR981.5 million for the FYE15. On an adjusted basis this means EPS of c. LKR5.86.

KAPI trading multiples analysis

Then I looked at historical trading multiples of KAPI. 

From FYE12 through FYE14, KAPI has always traded at a discount to its book value (well before that it showed some errant movement). Ignoring FYE10 which was an outlier over the last five years, the average PBV during the last 4 years was 1.02x. It also recorded average PE of 7.13x over the same period. From the beginning of CY14 to date, it has traded at lowest PBV of 0.78x and PE of 7.71x and highest PBV of 1.93x and PE of 18.98x. Current multiples are also given in the graph. The Construction and Engineering sector is currently trading at PBV of 2.10x and PE of 17.7x.

Pricing post rights shares

I used relative pricing methods to gauge the price at which KAPI would trade post rights. Using average multiples and my earnings forecast, I obtain a price per share of LKR41.73. Similarly based on average PBV I derived a price per share of LKR49.17. (based on pro-forma numbers PBV based price of LKR47.04).

If I use the current multiples (which are very likely to continue post rights, unless there is a market crash), I obtain LKR62.42 and LKR69.95 respectively based on PE and PBV methods.

What is a right worth?

Rights are proposed to commence trading on 12 January 2015. If that is the case and assuming that post rights KAPI would trade at LKR62.42, I price a right at LKR17.42. I will be indifferent to buy rights at that price and if I can pick it up at any price below that I will be inclined to buy rights and execute.

If I take an alternative view and assume that my low end price is going to continue (i.e., LKR47.04) I wouldn’t opt to buy KAPI rights at any price above LKR2.04. But, chances are that this scenario is hardly unlikely.

Bottomline

There is a possibility that a trading profit be made by trading rights and also to buy KAPI at a lower price to profit from price adjustment post rights. Alternatively, I can buy KAPI and avail myself of the entitled rights which would make my average cost c. LKR56.94. Thereby, I can stand to benefit from post rights price adjustment (as I take the pricing view that it would trade at around LKR62.42. However, return potential depends on how much a right is priced at in the market when it starts trading. Well, everyone knows this and it's a fact, I guess. But, anyway, I suppose pricing effort of rights would give some inputs to a potential start.

Greetings for 2015!

2014 is now history. However, it was an exciting year for the economy, local capital markets, politics and so forth. Personally, I also started posting on Blogger late 2014 though I have been a member on Blogger community for a quite a while. Nevertheless, that was a good start and I thought I got some good traffic coming on to Lankanmarkets from around the world.

I know 2015 is going to be even more exciting. Hence, I wish all a happy 2015 and all the very best to you.

I will keep posting in to 2015 and probably at a faster pace than the previous year.

Thank you.

Where is Union heading?

Trust me that this is not another political article! In this post I’m hoping to give my views about Union Bank of Colombo PLC trading under the code UBC.N0000. The recent drastic changes in the capital structure and the governance structure and some of the comments that appeared on a Sri Lankan stock market related online forum prompted me to think of writing this post. To speak the truth everyone on the said online forum only spoke about the tip of the iceberg and was completely missing what was below the surface. Well, can’t blame them because they may be playing the trading game. However, I’d like to look at the bigger picture as my hunch suggests that I invest in UBC now. 

History of high-profile investing

The history of UBC is full of high-profile investments in it. In 2007, Middle Eastern investor Prince Faisal Al Abdulla Al Faisal Al Saud, the grandson of King Faisal of Saudi Arabia invested c. LKR210 million in the bank. Co-invested with the Saudi Prince was the local investor Mr Alex Lovell one of the most inspiring Investment Bankers in the country to me!) who brought in Rupee-to-Rupee as well. Both the investors acquired 10% stakes in UBC. Hence, the new investors valued the Company at c. LKR2.1 billion. The Saudi investor’s holding is currently worth about LKR373.5 million. That is approximately 1.8x the initial investment and a 9% CAGR over 7 years (ignoring dividend income). Returns to Mr Lovell were more likely to be slightly lower.   

June 2010, the Bank hit another milestone with another LKR1 billion capital infusion from Malaysia based Genting Group related parties. From the available information I assume that they bought a share at c. LKR11.40 per share for a stake of 26.41% (via two different entities, namely Vista Knowledge Pte Ltd and Select Gain Limited). At that price the investor was valuing the Company at c. LKR3.8 billion. Currently, their stake is worth c. LKR2.2 billion which is equivalent to a 2.2x the initial investment or 22%  4Y CAGR (in LKR terms ignoring the dividend income). (not too bad  right!)  

The Board of UBC approved another high profile investment in August 2014. The deal was a landmark transaction in the history of Sri Lanka and put Lanka on the spotlight globally.  

Compared to all the other strategic investors that UBC attracted so far, TPG are experts in running financial businesses globally. For instance, Saudi investor is not an expert in running financial businesses in the Emerging or Frontier market segment and similarly, the Genting Group is leisure and hospitality based business.  

Retailer hullabaloo

I came across some comments on a web based forum in Sri Lanka where the forum participants saw the entry of TPG as bad thing for the company.  In fact, under the transaction, TPG has brought in three times more capital that the other shareholders brought in over about 19 years since the inception. Without capital any company’s growth is hindered so I think capital from an investor like this should be welcome. 

TPG in Asian Region

As per the TPG website, their approach to investment is “TPG's approach to investing helps us recognize value – or the potential for value – where others cannot see it. This contrarian philosophy has delivered consistent and outstanding performance because we dedicate the right mix of capital, time, and management, and operational expertise, to make successful investments out of challenging situations. Some of TPG's most noteworthy accomplishments have been in situations involving complicated structures, cyclical and regulatory risk, and distressed and turnaround situations. We maintain a mid to long-term perspective on investments to help companies grow to meet their full potential”.

TPG entered the Asian region in 1994 and since then transacted several landmark minority and majority stake transactions within the region. I would like to shed some light on some of these transactions as they may give you some foresight as to what they would be likely to do with UBC going forward. (however, I will only focus on Finance Sector related transaction as there are many transactions in many diverse sectors).

TPG’s acquisition of Shriram TransportFinance Company Ltd was a classic example. The picture below shows the growth numbers achieved by STFCL after capital infusions by investors like TPG. 

Assets under Management of INR2.9 Cr inFY04/05 grew to INR53.1 Cr by FY13/14. (That’s a 9Y CAGR of  38%). During the same period, EPS grew from INR9.06 to INR55.72. If you want to do a further analysis you can find their FY08/09 Annual Report here and FY13/14 Annual Report here. It is believed that they exited the investment with hefty gains. The price chart of STFC on NSE is provided below. BSE chart can be accessed here. 

One interesting thing about their entry in to a firm is that they are able to bring in other PE or institutional investors to the investee company if there was further capital required. Moreover, they exit through trade sales or via public market through block sales to other PE or Instos. You can get an understanding about common PE exit strategies from here. This helps in avoiding sudden market price volatilities.

TPG’s successful entry in to China’s financial sector and its exit are also notable.  It’s ASEAN region presence was highlighted when they invested in BankThai, currently known as the CIMB Thai Bank. In Indonesia, they took a significant stake in BankTabungan Pensiunan Nasiona (BTPN.JK) in 2008. Later in 2013, they partially sold its stake to Sumitomo Mitsui Banking Corp (SMBC). This chart shows the performance of BTPN.JK since 2008.

In another investment by TPG, they took a 51% stake in Korea First Bank in 2000. TPG’s website mentions, “Korea First Bank: In 2000, TPG acquired a 51 percent stake in one of South Korea's oldest and largest banks. This represented the first foreign acquisition of a Korean bank. TPG rebuilt the failed franchise by creating new financial controls and risk assessment tools, and repositioning it as a retail bank”.  In 2005 they sold the stake in Korea FirstBank to Standard Chartered PLC. It is believed that TPG invested KRW500 billion and sold it in an all-cash deal of KRW3.4 trillion (c. USD3.3 billion). 

What’s next?

Right now UBC is sitting on billions of cash that was injected by TPG. Hence, the company will be in a position to grow the loan book rapidly with good quality credit. Why I believe so is because I think now they are in a position to compete with many players on a pricing perspective and penetrate in to their market very fast.

So, gathering from the above, I can predict that there will be quite a number of corporate activities over the next 4 to 5 years period at UBC. They may include allotment of shares under ESOPs, issuance of different types of financing instruments like convertible structures, amalgamations, acquisitions (of other banks, venturing in to stockbroking, insurance, etc), conversion of the warrants (the warrants offered to TPG in UBC were in-the-money even at the point of issuance and continue to be in-the-money as I write this), aggressive dividend payments, further ratingupgrades, etc.

Find the Directors views here.

Further, it is interesting to note the representatives that TPG have brought on to UBC Board of Directors. The three Directors are Dr. P. J. Nayak, Mr. Michael J. O’Hanlon and Mr Puneet Bhatia. Havea look at their profiles. They bring in a wealth of knowledge and experience to the table. For instance, Mr Michael was has served on all the boards of the discussed investments in Asian finance sector by TPG. So, I wouldn’t be surprised if UBC introduces commercial and residential mortgage products to the Sri Lankan market. 

Exit already designed, so keep watching!

There will be a gradual exit by TPG where I expect blocks of 15% of the Company will be sold to other strategic investors via Trade Sales (over the next 15 years). Also I suppose that there may be Secondary Equity Offerings (SEOs) to the general public in major sell down by TPG. Further, there will be further dilution as TPG exercises the Warrants. Hence, over the planned period there will be a huge increase in the shares in the market. (though I don’t expect the investors who join later to sell down in the short term causing price to crash.) However, it is worth watching the developments.

Bottomline

From what I believe the entry of a PE investor like TPG to a company is a good sign from all the investors’ point of view. I also think that in the next few years UBC.N0000 will be mostly driven by a variety of news that will flood the market. Value creation will be the ultimate motive for TPG as PE investor and a successful exit to them will only come through value creation. Hence, I think it is in the best interest of every shareholder that TPG will act.  

Black Swans in Sri Lanka

Well! Swans are not species of Lanka. (I have to confess that I’m not an expert on study of birds, so there may be something that I don’t know about birds in Sri Lanka). Anyway, I relate my post this time to the recent developments that took place in the Sri Lankan political landscape. Also I guess this may be the answer to my friend from UAE who was enquiring me about the recent developments (he’s keen as he is heavily invested in Sri Lankan capital markets!). I prefer to not write about politics due to many reasons, but I have to accept the fact that it’s part of our everyday endeavors and hence can’t be just ignored.

In an unprecedented move, as the ruling government announced early presidential elections, the General Secretary of the ruling president’s party as well as the Health minister of the government defected the party to join forces with others to contest as the presidential (Common) candidate. It should be emphasized that this incident was never predicted by anyone, the event in fact carries a massive impact and finally now we concoct that it was more predictable than it was. As a matter of fact, these three principal characteristics makes the event qualified to be called A BLACK SWAN, as Nassim Nicholas Taleb pointed out in his award winning book “the Black Swan”. As per Taleb, Black Swans are:

• Outliers, as it lies outside the realm of regular expectations (the question who is the common candidate was never answered until defection of ruling party member);
• It carries an extreme impact (this event had the extreme impact of shaking the ruling party and invigorating all the opposition parties and their sentiments and has the potential to even topple the ruling government. Also the event has changed drastically the investor sentiment in the CSE); and
• In spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable (also called as retrospective predictability).

History’s repetition of itself!                                                                                                        

I wonder for myself, when I look at Sri Lankan politics, that it’s true that history repeats. 

Further, What we dealt with over the last few years and currently dealing with in terms of politics is a result of the opposition’s inability to play a formidable role over the past decade or so inasmuch as we say it is the fault of the ruling regime (another way to look at the same problem, I guess).  

I narrate my expectation via the 2010 movie Black Swan the plot of which can be read here.

I hope that if the common candidate becomes the president of Sri Lanka in January next year that he remains a White Swan rather than becoming a Black Swan who is not acting on behalf of the citizens but the people who surrounded him to be appointed as the president. (Because we know that the people around him have shown that they were utter failures as leaders of this nation). Or if the current regime continues that the opposition exert the same pressure on the regime to act for the benefit of the citizens. (As they are doing right now). 

As the saying in Sinhalese go “INGURU DEELA MISRIS GATHTHA WAGE” or in English “like, getting chili to replace ginger”, I hope we as the constituents in the country will not have to face something like this by replacing ruling president with the common candidate. ( if that was the wish of the majority of voters) Why I’m saying this is because all this time we tried to replace existing with the hope of a better outcome which never happened. (we ended up in even worse situations). 

Bottomline

I hope for nonviolent resistance leading to peaceful transition to the desired state which ensures law and order, inculcates good governance, drives economic growth, maintains peaceful environment in the country, etc. 

Do it before it’s too late

I start this post by taking you back few years to 2010 to talk about a Sri Lankan company the story of which fascinated me for the entrepreneurial success, success as an equity IPO and a classic example of how the power of capital markets be used. Under the prospectus dated 26 May 2010, Odel Limited offered its shares to the public (offer was open for subscription from 5 July 2010). Unfortunately, I can’t find a link to the prospectus now. (If you need a copy I can share it though!) Odel offered 16.7 million shares (11.52% stake of the company) at a price of LKR15 to raise LKR 250.5 million. (thereby valuing the entity at LKR2,174,250,000 post-IPO and founder Otara’s stake at LKR1.2 billion, Believe it that this was an investment by her of LKR475,000, pretty amazing!). The objectives of the offering were manifold:

Investment in expansion (branch network) of c. LKR150 mn;

Settling debt, c. LKR100 mn; and

Expected to also benefit from the listed status, in the form of brand improvement, broaden ownership, marketability to shares and access to capital markets. 

The funding was supposed to be utilized by the end of 31 March 2011.

The Company, Zero to two billion revenue in 20 years

Odel is a venture started by Otara Gunawardene. I extract some stuff here directly from the prospectus “The Odel story began when Otara Gunewardene started selling clothes from the boot of her car to family and friends. Although she stumbled upon the fashion retailing industry accidentally, Otara saw the potential for retailing a range of stylish clothing to the fashion conscious Sri Lankan, and in 1990 she launched Sri Lanka’s most innovative brand – Odel, which is a combination of her first name, Otara, with her middle name, Del.”

The first store of the company was started in 1990.

As of 2010, “From the beginning, the brand has grown along with the business. The initial staff of 2 has expanded to more than 650, and Odel provides indirect employment to more than 500 individuals. Over 500 suppliers and 200 plus factories locally and globally supply Odel with a wide range of products.”

As of the IPO date, the company had 12 stores encompassing 125,000 square feet.

Summary financials of the company as they were presented in the Prospectus is reproduced to give some more details as to how it was performing financially.

Timing of the IPO

May 2010, just one year after the end of the conflict in Sri Lanka, the market was rallying (probably the best rally the market had ever seen) and valuations were pretty good, was the perfect time for anyone to list. On top of that Odel was a very well-known brand around in the main cities and hence marketing the IPO was not a very difficult task.   

Almost all the stock brokers were also of the view that at LKR15.00 a share, Odel was a BUY.  (was is it a good call at the time?) Have a look at the below table for some of those:

The shareholding pre-IPO and post-IPO were as follows:

IPO pricing

Unfortunately, by 2010 I didn’t do a valuation of Odel Ltd and hence I don’t have the chance to re-look at it (may be after writing this post I will be able to follow Odel, hopefully!) Anyway, let’s do some post-mortem on the pricing at the time of the IPO.

Let’s look at the performance of the company for the 5 years from 2006 through 2010.

Odel posted 11% 5 year CAGR of revenue and achieved 8.84% average EBIT margins (after adjusting for non-recurring gains in FY2010). In terms of NP margins, the company hit a 5 year average of c.2.82%.

As far as the information is concerned Odel was founded by Otara, Ajith Gunawardene and D.S Gunawardene with capital injection of just LKR 1.425 million. That converts to 142,500 shares issued at LKR10.00 per share (split equally among the three founding members). What was most impressive was that the company grew to be LKR1.2 billion by 2010 (that’s 20 years from its inception in 1990). You can see the growth in shareholders’ funds as per the graph.

Further, over the same period Odel managed to earn ROIC of 15.13% on average with an average Debt-to-Capital ratio of 1.37 times.

On the IPO year the gearing increased significantly on account of expansion as well as significant dividend payments (which I assume was debt funded immediately prior to the IPO and the IPO funds were utilized to settle debt which was almost equivalent to LKR148.3 million paid as dividend, pretty good ha!. This I’m guessing was paid out to Otara and Ajith with c. LKR99 million to the former and c. LKR49 million to the latter).     

The relative pricing table below gives an account of the pricing of Odel before adjusting and after adjusting for the IPO (on trailing FY10 figures).

Odel as a listed vehicle

Let’s look at Odel’s story as a listed entity. The price-volume chart below shows the behaviour of ODEL.N0000, the ticker for Odel PLC. Also by the side of P-V chart is the Return chart and it is evident that the stock has always provided positive returns to investors. (note that this is not the total returns)

Currently, Odel consists of 20 stores (up from 12 in 2010), which converts to 2 new stores a year since listing the company on CSE.  As opposed, to 125,000 sq.ft. of retail space by the time of IPO, currently the retail space with Odel encompasses c. 150,000sq.ft. The total staff strength, of Odel at present of 1,000, contrasts with 650 in 2010.

By the end of 31 March 2014, Odel managed to almost double its revenue to c. LKR4.5 billion as compared to c. LKR2.4 billion in FY10 (that’s in just 4 years after the IPO and a 4 year CAGR of 17.43%).

Even though the store expansion had helped Odel to boost its revenue (per square foot revenue has grown from LKR19,334.00 in FY10 to LKR30,633.00 by FY14), it didn’t come cheap! A government imposed VAT mechanism impacted ominously to the GP margins over the last two financial years.  As Odel added more and more stores to the network, admin costs have increased significantly.

In my opinion, I presume that some of the suburban stores must be eating in to profits at other well-established stores like Alexandra Place. Further, it is also noted that the three stores that came up in the second half of the financial year has not been in operational full cycle (however, drop in Adj. EBIT & EBITDA margins has started from FY13).

The drop in margins is also explainable from the industry perspective. For instance the competition in the retailing (clothing) has intensified such that there are many options available for customers right now. From my own experience, I know that Odel Battaramulla store is empty every time I go past it. However, the competitor, “Cool Planet” which is located just couple of miles from Odel is full at any given time. These retailers serve different segments in the market. Further, Odel may not be the option for the market segments in the suburban areas. I also know from day to day conversation with people that the suburban people perceive Odel as offering the same stuff that the local retailer offers at a higher price. There may also be one off expenses incurred by the company on behalf of the development projects that they have planned (going to be rolled out with the money raised through the rights issue in 2012. But such information is not disclosed).

This development may also be explicable from theoretical perspective under the concenpt of "Marginal Efficiency of Capital" which was advocated by Keynes (1936). The table above looks at the qaulity of growth of Odel. If you look at the marginal ROIC it has dropped starting from 2012. it has in fact turned negative. As you can also see from the quality of growth line, the costs of delivering growth (in revenue) have gone up meaning that LKR100 of marginal capital has only generated LKR12.39 of marginal revenue in FY14.    

The first exit

Odel’s story was further winched as Singapore based retail operator Parkson Retail Asia Limited bought a 41.82% stake in Odel via a sell down by the founding shareholders.  Here again Otara pocketed out close to LKR 1 billion. Post sell-down, Odel went ahead with a 1:1 rights issue to raise c. LKR2.9 billion although they ended up raising LKR2,543,588,620.00 on 17 December 2012. The monies were raised to go ahead with a mega expansion plan which to date has not happened and the money is just sitting in financial investments. (however, they bought a land adjoining their Alexandra Place store which may be used in the future for such planned expansion). Ideally, they should have raised this capital in a staggered manner through different equity structures like warrants, calls, etc. If that was the case there wouldn’t have been this much money stuck for almost two years.  Their ROIC ratio is negatively affected due to all these as you can see from the below graphs.

The second/full exit

In September 2014, the promoters of Odel took a decision to fully exit from the investment and similarly Parkson also decided to fully exit from their short-lived investment. Otara sold her entire stake in Odel to Softlogic at a price of LKR1,778,328,200.00.

Entrepreneurial success

I extract again from Odel’s 2014 Annual Report, “Otara has the distinction of being the first female entrepreneur to take a company public in Sri Lanka. When Odel launched an IPO in July 2010. Following the entry of Parkson Retail Asia 2012, Otara retains a 29.7% stake of Odel PLC. Her entrepreneurship was globally recognized in 2010 when she was named the best female entrepreneur at the seventh US Stevie Awards for Women in Business”.

To put it in to perspective, simply in language that I understand, I did a quick IRR calculation of her investment in Odel. Please bear in mind this is only based on the available information and certain approximations of timeline as I don’t have exact dates of cash flows. Also the fact that I don’t have info for a period of 15 years when the venture was privately held. Bearing all that in mind I wouldn’t say no to returns like that (IRR of 43% or more) and walking away with LKR1.8 billion in cash.

I think it's time to wrap this post up and I promise that in my next post I will look to value Odel. Then I can have a look at Odel as an investment given its current status.

Bottomline

Entrepreneurial success is not just start of successful ventures but it also encompasses the successful exit at one point. No matter how best a company is brought up in its life cycle, there is a time when it needs to be passed on to the next generation (may be to start a new cycle or to die as the company reaches decline stage). Further, the capital markets got the enormous strength to create wealth and push a business to heights which were not possible before. Moreover, it is a good place to smoothly exit. Odel is a best case study for Sri Lankan entrepreneurs as well as capital markets participants.