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. 

Prevention is always better!

I thought this is a more appropriate thing to share before getting in to detail.

In a previous post, I discussed about the recent developments in the Credit Ratings industry in Sri Lanka and expressed my concern that the recent explosive growth in the industry would lead to certain undesirable outcomes like breach of integrity, lack of independence, loss of quality of work, etc. Before even 6 months’ lapse, some scary news are coming out. 

News Item 1: Restraining LRA from issuing new ratings

As per this news release  from Securitiesand Exchange Commission of Sri Lanka (SEC), the Lanka Rating Agency (LRA) is restrained from issuing new ratings with effect from 25 March 2015 until the LRA complies with regulatory requirements. The letter further says that they the decision follows their deliberations on “structural issues pertaining to the company”.  This to me means that LRA has failed to comply with their own Code of Conduct in which it says, “the Provisions, c. Integrity of the Rating Process, 1.11. LRA and its employees will comply with all the applicable laws and regulations governing its activities in each jurisdiction in which LRA operates”. Moreover, it is also questionable whether LRA was able to achieve what is expected under the Code provision which says “LRA will institute policies and procedures that clearly specify a person responsible for compliance, by LRA and its employees, with the provisions of this Code and with the applicable laws and regulations. This compliance officer will be substantially independent from LRA’s rating operations”. Because, if so the compliance officer should have devised mechanics to avoid issues or identified the structural issues pertaining to the Company, if they were present, to my understanding.

News Item 2: Breach of SEC Act by LRA

Five days later, as per the Directive SEC/LEG/15/06/04, the SEC directs that a recently proposed debenture issuance of EAP Broadcasting Company Limited be deferred until the issuer obtains an independent credit rating. The Directive says that they find conflict of interest in the rating of the above debenture issuance by the LRA as both the companies have a common director on respective boards and that two of the directors of the issuer company also sit on the Rating Committee as members. Most notably, the SEC finds that LRA are in breach of Part V D (vi) of the Schedule to the SEC Act.   

Here again, the rating agency has failed to comply with the Code, “LRA will structure its rating committees and rating teams to promote continuity and avoid bias in the rating process”.  (the Provisions, 1.A.1.8) Further, this situation raises the inevitable questions whether the rating agency dealt fairly here as per the Code “LRA and its employees will deal fairly and honestly with Issuers, investors, other market participants, and the public”. Moreover, there many other clauses in the Code that they have fail to comply/adhere with. I don’t think that this outcome will be tolerated by Association of Credit Rating Agencies in Asia of which they are a member.  

Bottomline

In essence, it can be pointed out that none of the stakeholders would expect to see such outcomes as a result of non-compliance to regulatory requirements on the part of a Credit Rating Agency as well to find that the rating process itself is tainted due to flawed procedures at the rating agency level. In fact, if the incident took place after the conclusion of the subscriptions there would have been many other unintended repercussions. Hence, it is praiseworthy that SEC took measures before the unfold of those events.       

Health is profit, (Update I)

Singhe Hospitals Limited (SINH.N0000) has now issued their first set of financials to the public as a listed entity. It’s now time to have a look at the projections and the actuals as well as revisit the valuation. Firstly, I would like to provide the Price Volume chart for SINH. As per the available data, it has traded LKR2.20 at the lowest and LKR2.80 at the highest.

For the year ended 31 March 2015, SINH recorded revenue of c.LKR234.89 a growth of 43% year-on-year. However, this compares with the projections (provided in the prospectus and prepared by the auditors) that I used in my valuation at the time of IPO as follows.

They were c.LKR22.8 million behind the forecasts or c.9% behind. Further, EBIT margin for FYE15 came in at negative 13.30% as opposed to the projections of -2.15%.

Accordingly, I have revised the inputs in the valuation model and hence the valuation has come down.

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.