Taking advantage of fading novelty in listed equities

The dragon year lived up to its billing.  Most major equity markets rose, even as they trailed a massive rally in Greek and Portuguese bonds – S&P CNX Nifty ended 28% higher in 2012, well ahead of 13% increase in S&P 500 and FTSE Eurofirst 300, and 15% increase in MSCI Emerging Markets.  Our investors did significantly better – Globe Minerva Underserved and Globe Minerva Undervalued were up 39% (unlevered) and 37% (unlevered) in C2012, closing our second consecutive year of double-digit outperformance vs. the S&P CNX Nifty.
We are confident that we’ll continue to outperform the widely-followed benchmarks in 2013 in what appears to be a great market for bottom-up stock pickers.
How it pays to ignore the initial noise in India’s “sunrise” industries.  Vast majority of Indian equities have listed post-1991 and majority of them were listed over the last decade.  While India’s market concentration is impressively low, quite a few of its industries could be viewed as “sunrise”.  We note that in the absence of enough precedents, the novelty-factor substantially inflates early valuations for “sunrise” businesses, often setting up newly listed businesses as some of the worst pockets to invest in.
Across sunrise industries in India, we have noticed the magnitude of valuations drifting significantly lower as more industry peers get listed and novelty factor fades off.  There have already been a couple of instances of us initiating long exposures within our India Underserved strategy (including picking a Media name in 4Q12), where we picked businesses that had seasoned, had become more operationally focused, had divested profitability dragging assets, and yet were trading at much more reasonable valuations vs. the ones when they got listed.
Note how relative multiples drifted materially lower for the following “sunrise” industries as the listed universe expanded, after financial sponsors and promoters had exited at inflated valuations.  While the extent of downward drift changes with the industry, the directional trend is visible across “sunrise” industries – Relative multiple downward drift for Media and Pharmaceuticals is a case in point (see Exhibit 1a and 1b).
 

In 4Q12, we picked 4 new names, while selectively booking substantial profits in our biggest position, an Entertainment name – Among new names, 3 were added in our India Underserved strategy and 1 in our India Undervalued strategy.  The three new inclusions in India Underserved book were a Media name (details later in the newsletter), an Internet name, which has immaterial dependence on advertising revenues, and an event-driven investment we made in another Entertainment business.  The 2 strategic positions picked in the Underserved strategy are market leaders, cash-rich, and report very strong and sustainable cash-flows.
The new inclusion in our India Undervalued book is a Logistics name – The company is a leading container logistics company with 3 segments: container freight stations (CFS, which are off-dock facilities near ports used to decongest port), railway freight (this segment owns several inland container depots (ICD) which handle containers inland), and cold-chain (53% ownership in the largest organized pan India cold-chain player).  The CFS and Rail Freight segments make up over 90% of revenue/profits but the cold-chain segment is growing capacity rapidly.  We like the company and the near-term tactical and long-term strategic prospects of the business model.  India’s logistic industry overall is valued at $130b (expected to grow at 15-20% with highest growth in the miniscule organized sector) and containerization levels for general cargo are 15-20% below that for China, Europe, US, and Brazil (even though growth in container traffic has been in the low-teens since F1997 vs. ~10% globally).  Container traffic growth has been double the rate of overall cargo growth, effectively equivalent to India’s nominal GDP growth.  GDL has done better with near-term top-line CAGR of 31%, compounding earnings in the high-teens.  Due primarily to high margin and steady CF S operations in Navi Mumbai and Chennai the company has delivered FCF improvement (F2012 FCF yield of 6%) even after investing more in the other 2 faster-growth segments.
Our work suggests that the chairman and his management team have a clear vision and the balance sheet allows prudent demand-driven capacity expansion in all 3 segments.  The story is more than just a macro growth or lower rates story – the business model is largely self-funded, complementary, and run by long-term focused management who understand the logistics business (and its vital importance to India’s growth/modernization).  Also, a steady 4%+ dividend yield should keep all you “show me the money” crowd interested as story plays out.
Detailing our Media pick in India Underserved – In 4Q12, we initiated a long position in a radio broadcasting name.  Interestingly, this exposure was initiated in a fiscal year when radio advertising growth would likely decelerate to about 6-7%, comfortably the slowest industry growth in recent memory.  Our chosen name however continues to deliver double digit growth.
We note that since F2008 (Mar), stock price (net of liquidity) had been cut by more than 60%, while core earnings run-rate had nearly tripled over that period.  Consequentially, valuation had compressed to a level where the situation was no longer perceived as “novelty” and it looked pretty compelling to us.  It was particularly interesting since potential benefit from the Phase III rollout wasn’t built into the price (more on this later in this letter).
Before we explain our decision behind picking this broadcaster, we would like to briefly explain the following two key features of this space – 1. Limited reach, and 2. How protective policies ensure that larger established players continue to enjoy (and expand) their lead over others.
We expect radio as a category to sustainably ramp-up over the next decade.  While a host of industry participants talk about mobile being a key (future) listenership growth driver, it appears a bit of a stretch – India already has very high mobile penetration and more than a third of all mobile owners listen to radio over their phones.  Mobile listenership penetration in itself is among the highest in the world and it’s hard to side with any view that counts this among the chief (future) drivers of growth.  The real upside in Indian radio advertising, in our view, will not be so much driven by increase in listenership within geographies with existing channels (unless content restriction goes away).  Instead, it would likely be driven by station expansion in new cities, improved ad inventory utilization, and better rates – Industry revenues per capita per hour of radio (weekly consumed) are miniscule relative to global averages (see Exhibit 2) and it’s hard not to bet on this being a key driver over the next few decades.  Just in the prior two years, our chosen name has expanded revenues by more than 30%, despite flattish listenership.
Limited reach has restricted radio from expanding to its potential.  Guess what’s common between Philippines and India ? – Both countries have a shoddy record of rural and semi-urban development.  As a result, while their overall population density might be considerably lower than the densest countries in the world, their cities consistently feature among the densest cities (thank disorderly urbanization for that).  Both countries also boast an extensive reach of Radio in their major cities – Since commute times are longer, mobile phones (vast majority) and in-car listening (minority) contribute heavily to OOH (out-of-home) listenership.  However, unlike India, where radio accounts for a sub-par 4% piece of ad-budgets, more than 15% of ad spending in Philippines goes to Radio, significantly ahead of global average. The reason for that disconnect is “reach” – Talk to any media buyer in India and odds are that he/she would lament radio’s limited reach outside major Indian cities.  Regulation has prevented pan-India mushrooming of radio stations, with current FM network reaching less than a quarter of India’s population (the name we picked broadcasts to 3/4^th of this subset[1]).  And that’s in a country that already boasts among the highest proliferation of television channels in the world.  Not surprisingly, radio advertising in India has existed as a support medium.  While by no means ideal, that did present us with a fairly compelling investment opportunity.  We noted how the overall radio advertising pie is much more attractively distributed within broadcasters than what we are used to seeing in say, US, France, Italy and several other Western markets.
Policies restrict smart disruption of archaic models.  Any media is hugely dependent on variety of content and policies have disincentivized variety to protect state-owned broadcasters.  These white elephants employ more than 30K people and continue to burden taxpayers[2].  Consider the insane stipulation in the upcoming Phase III auctions – Post Phase III auctions, I&B ministry would be “kind” enough to allow private broadcasters to broadcast news but they won’t be able to generate the content for such news broadcasts.  Instead, broadcasters will have to outsource this from India’s state-owned radio broadcaster, AIR.  Effectively, if you want a non-partisan political view on a range of subjects, look beyond radio (for now).  Thankfully though, Indians heavily plug into radio for music and that continues to offset the content variety limitation.  While broadcasters face an intense challenge in differentiating themselves, we do note that there are a handful of radio jockeys (RJs) that get significantly more attention than others – RJ Malishka (Red FM, Mumbai) and RJ Mir (Radio Mirchi, Kolkata) are prime examples.
For Phase III, I&B ministry has decided to establish the highest bid placed during Phase II auctions as the base bid.  In its quest for “federal revenue maximization”, the ministry obviously didn’t look around hard enough – Vast majority of Indian private broadcasters continue to run operating losses.  Our chosen player has paid ~INR 420 million in federal income taxes over the past 7 years (on a stand-alone basis), with nearly entire outflow happening over the last 2 years.  Over this period, our chosen player has averaged pre-tax margin in the mid-teens.  If the rest of the industry enjoyed that kind of margin, they would pay about INR 300 million in income taxes in F2013E (Mar).  That is obviously miniscule relative to what the government gets from auctioning frequencies, let alone the license fees annuity over the period of the license.  So, while we find it hard to empathize with most players who had aggressively bid during Phase II auctions, we would argue that, given the precedent, government should eliminate the current minimum bid-clause and allow Phase III bids to align with market realities.
After extensive discussions with several industry players, media-buyers, and pan-Asian industry observers, we initiated this media exposure in our India Underserved strategy.  It all came down to 3 key factors – 1. We expect strong and sustained growth within the radio space and this player to benefit disproportionally; 2. We expect our player to be the primary beneficiary of major industry consolidation over the next decade, and 3. Capital deployment decisions had incrementally improved (for this player).
[1] Our chosen broadcaster prefers to selectively broadcast in larger markets – Its typical market (adjusted for competition) is 40% bigger than for the average Indian FM broadcaster.

 
1.       Strongly positioned to benefit from industry distress; Phase III benefits will accrue to few. We strongly believe that no player is better positioned than our chosen player to benefit from what we anticipate would be widespread industry distress over the next decade.  It is anticipated that the auction process for FM Phase III would begin sometime this year and is aimed at opening 839 stations in over 290 towns and cities.   That’s >3x the number of currently operational stations.  That said, there is limited visibility on when the auction process will get finished and by what extent listenership would eventually expand.  With several players having burnt their fingers overbidding in the first two phases, we expect a tepid bidding response in Phase III auctions.
Our expectation for industry distress is largely attributable to 1. A government instituted auction structure that is oblivious to underlying market realities, and 2. An array of fringe players that have aggressively bid in markets where garnering a par-share of the market isn’t enough to generate material cash flows.  Facts strongly suggest that our chosen player would by far be the best positioned to advantage from such industry-distress.
Of vital interest is expansion in existing cities, where broadcasters could be allowed to own more than just one station. As things stand, conservative players have preferred to selectively focus in the biggest markets and would want to expand further in these markets (given size, far better rates, and inventory utilization).
Consider what could happen in India’s biggest radio market, Delhi – Unless increased frequency separation is guaranteed, Delhi would have only one more channel up for auction in Phase 3.  Delhi currently has 8 private broadcasters and 4 state-owned stations.  Our discussions suggested that at least 3 of those private broadcasters are on the block (even though 2 of those 3 might not be bleeding in their Delhi ops).  We note that 5 private broadcasters each retain 10% or more share of the Delhi market.  Assuming Delhi’s listenership pie and inventory utilization remain unchanged, by our estimate the overall revenue potential of the market would be somewhere around INR 1.1 Bil[1].  We know that the minimum post-Phase III OTEF for Delhi would be INR 314 mil (highest bid by Radio One in Phase II auctions), which would be depreciated over 15 years.  We think that it would only be prudent for any winner to contemplate broadcasting other language music channels to a large bilingual audience in Delhi, given that they already have local language-focused channels.  However, such a channel would likely have more local advertising (and fewer national advertisers) than is the norm in larger cities.  If winning bid is say 2x what it was in Phase II, then a new player would need close to 10% share of the market just to break-even (assuming that inventory utilization for this new channel is in line with existing channels).  With only one channel up for bidding in India’s biggest radio market, it is possible that bidding is aggressive, leaving maybe 2-3 players, including our chosen player, to have realistic chances of landing up that new channel.  Let’s dive a bit deeper to better appreciate why Phase III benefits would likely only accrue to a select few.
i.            It makes almost no sense for regional and marginal players to bid in Phase III.  Let’s begin by looking outside the top 17 markets.  Even assuming that new OTEF in these markets is established at 10% over the minimum bid, our work suggests that only 7 markets in the remaining field (4 in Southern India, 2 in Eastern India and 1 in Western India) are viable for a new player to establish a studio.  Of the top 17 markets, 11 would have 21 new frequencies come up for bidding in Phase III auctions.  Using the same yardstick we used for non-top markets, each of the top markets appear viable.  However, across all markets, new presence would only make sense to a new player if 1. OTEF doesn’t get materially raised over Phase II’s highest bid, and 2. The winning bidder is able to command a solid share in the territory.  For all practical purposes, that shuts out new and marginal players in these markets (assuming their bidding rationale is purely based on economics).
ii.            Already burdened with distressed assets, most existing players don’t have it easy either.  Let’s evaluate the position of private players in 11 of the top 17 markets, where new frequencies will come up for bidding – There are 15 different players spread across these markets, 8 of which have more than one channel across these markets.  Our discussions suggest that at least 3 of these 8 players (accounting for 30% of the 58 private channels in these markets) are up for sale and are burdened with distressed assets.  Our chosen player is among the remaining 5 and has comfortably the strongest balance sheet in this field.
Let’s assume that an existing player successfully bids for another frequency in the same market (OTEF is say 10% over Phase II’s highest bid, which is unlikely), expands this market, and this new channel by itself grabs 10% share of this expanded market à Even this sequence of events, in our view, would render 3 of these markets unviable (these 3 markets account for about 40% of new frequencies on offer among these top markets).  The remaining 8 cities have 13 frequencies available and we expect ferocious bidding in at least 4 of them.  It’s likely that economics fly out of the window if bids escalate in such a scarcity situation.  It is this fear that has kept investors on the sidelines.

Even if we ignore Phase III impact, we wouldn’t make the mistake of ignoring our chosen player.  We believe that Phase III auctions (in its current avatar) will bring little if any benefit to new and marginal players.  Most optimists have been burnt over the past few years and only a handful of players remain competitive.  Our work strongly corroborates our belief that we have set sights on a player that is clearly on a different trajectory vs. the market and one whose execution is unparalleled in this space.  In 1H of F2013E, our chosen player reported 86% inventory utilization in its top 8 markets, while 2/3^rd of the inventory in its other markets (non-Tier I) was utilized.  Still, we note that it utilizes more inventory in comparable markets than any other player.  Despite winning several bids outside Tier-1 markets during Phase II auctions, we note that it is running operating profits in 94% of its stations.  Consider this – During Phase II auctions, it was the highest bidder in 8 non-Tier-I markets.  Collectively, it enjoys more than 50% share in them and has virtually shut out any incremental presence by a new player in these markets.
Choice of auction mechanism is redundant, in our view.  While the government is focused on the ascending auction mechanism, players are arguing against it.  While this divulges a player’s evaluation of the market, it does help cap unreasonable bids (nothing prevents a player from not bidding, if the preceding bid is high enough to make the successive bid unreasonable).  If we are a shareholder and our management team is absolutely focused on placing bids that are backed by economics, we don’t see how such an auction mechanism could hurt us.  Our discussions with management and competitors confirm our belief that our chosen business is fully focused on shareholder value and wouldn’t overbid for expansion during Phase III auctions.  That is despite the fact that this is a zero-debt business and generates ample cash to afford considerable leverage and is likely the only radio broadcaster that could profitably buy distressed radio assets.  This management strongly believes that expansion at the expense of profitability is an exercise in futility, a priceless virtue among Indian management teams.
Unless the fee regime is radically altered (govt. needs to let the market determine base OTEF), we expect to see plenty of distressed radio assets around the country in a few years.  We strongly believe that players with strong balance sheets are better served by waiting and buying these distressed assets on the cheap over time vs. trying to counter unrealistic bids of broadcasters that are unable to comprehend the concept of shareholder value maximization.
3.       Capital deployment has improved and earnings power has shifted materially higher.  Over the past 5 years, the core business has generated $54 million in free cash flow, but continued support for two small bleeding subsidiaries sucked nearly $70 mil in free cash over that period.  That’s more than just déjà-vu for us – remember PVR Pictures?.  These subs weren’t particularly bad in generating operating cash flows (their cash cycles were actually shorter).  Instead, it was continued capital support from the parent that continued to overshadow what was otherwise a healthy core radio broadcasting business.  Management has now fully de-emphasized these businesses.
We saw material differential vs. our absolute value estimate and got valuable Phase III and potential consolidation benefits for free.  While we see this exposure as a strategic position for us and are focusing on continued execution, we noted about 30% absolute upside to the then valuation (in extremely conservative terms).  That of course excludes what we believe are material incremental benefits from Phase III auctions and potential consolidation.  On a relative basis, our chosen player trades at just under 20% discount to its global peers.  While EBITDA growth at some global peers might be in line with that of our chosen player, its cash-conversion is extremely impressive.  That ensures that it’s OCFF growth (operating cash flow to firm, before taxes) is unparalleled in the space (see Exhibit 5).

Our only concern on the name is material dependence on real-estate related advertising (~8% of revenues come from real-estate advertising), which is a space we avoid, through direct and second-degree linkages.  As we view it, a potential real-estate blow-up shouldn’t be enough to offset what we view as solid quantifiable catalysts elsewhere.
Performance and Attribution summary
In 4Q12, Minerva Underserved and Minerva Undervalued were up 9.9% and 9.8% respectively, vs. 5.2%, 3.5%, 7.7%, 5.2%, and 4.6% increases in BSE 500, Nifty, BSE Midcap, BSE Smallcap, and Eurekahedge India respectively.  In 2012, Minerva Underserved and Minerva Undervalued were up 39.3% and 36.9% respectively, vs. 31.2%, 27.7%, 38.3%, 33%, and 15% increases in BSE 500, Nifty, BSE Midcap, BSE Smallcap, and Eurekahedge India respectively.
Majority of our names outpaced all benchmarks in 4Q12.  In 4Q, gains in our long book contributed a double-digit gain to our performance vs. a -1% contribution from our losing long book constituents.  Our highest conviction bets have consistently demonstrated superior performance vs. benchmarks.  Our best performing name in 4Q was an entertainment name (up 45%).  Our worst performing position in 4Q was an agricultural name (down 17%).  However, since we had sold out majority of our holding in the latter in 3Q, the drag from this position was minimal.  We continue to retain substantial cash (with nearly 30% gun-powder across both strategies).  Our volatility in 2012 was 3, 6, and 9 points below our Eurekahedge India peers, Nifty, and BSE Midcap respectively.
Since inception in Nov ‘10, Minerva Undervalued is up 15.7%, vs. -5.0%, -1.9%, -14%, -30.2%, and -15% declines in BSE 500, Nifty, BSE Midcap, BSE Smallcap and Eurekahedge India respectively.  Since inception, Minerva Underserved is up 24.4%, vs. 0.6% and 1.2% increases in BSE 500 and Nifty respectively, and -0.8%, -15.3%, and –9% declines for BSE Midcap, BSE Smallcap, and Eurekahedge India respectively (see Exhibits 6a and 6b).

Bottom-up stock pickers should continue to thrive in 2013.  While global earnings estimates continued to adjust downwards in 2H12, Indian equity benchmarks outperformed most global markets.  We note how large-cap estimates have stopped their downward drift even though mid-cap and small-cap estimates continue to trend lower.  Our book of names however has clearly bucked the broader estimates trend within small and mid-caps – Over the past year, vast majority of our names continued to execute in the face of unwarranted skepticism while sell-side estimates played catch-up.  While bottom-up estimates for Indian listed equities have continued to drift downwards (see Exhibit 7), we believe our book is well positioned to outpace the Indian listed equities universe in C2013. Nearly our entire book of names (across both strategies) has immaterial FX linkages.  We see little to no direct impact to our strategies if the rupee deteriorates further in the face of rate cuts.

As we write this, analysts are busy throwing darts across the board to put out their earnings estimates for C2013.  Interestingly, consensus appears to be building on low-mid teen earnings growth for benchmark names.  With such clouded visibility, it’s hard for us to see how mid-teen earnings growth can be generated for benchmark names.  Nonetheless, we remain busy with identifying strong absolute return stories, almost all of which lie outside the top 100 names.
Since inception, all but one of India-focused diversified onshore AMC strategies trail us (see Exhibit 8).  To our best knowledge, nearly all India-focused offshore peers handily trail us, regardless of their strategy currency.  While our net exposure went up meaningfully in 2012, it still remained well below our onshore peers – India Underserved finished 2012 with 28% cash on hand, while India Undervalued had 36% cash.  Our current focus is to ramp up exposure in India Undervalued, without compromising on our estimated potential upsides.  We believe that it’s even harder now to find any meaningful upside within India’s large-caps, and consequently, our focus would remain on small and mid-caps.  We are also fully cognizant of earnings divergence within our immediate focus area.  If this earnings-price divergence within the small and mid-cap universe is any indication, we believe that 2013 could turn out to be a strong year for bottom-up stock pickers.  It is here that we anticipate further stretching our lead over the small and mid-cap universe.

 

To read the complete report download it from our Reuters Store.