Should we accept a lower level of growth?


Recently RBI came out with a report on how inflation impedes growth rates and they also published reports on the threshold level of inflation, from where it starts hurting growth.
Inflation does act as force against growth, but I was just wondering if it is not growth itself that leads to inflation.So inflation tends to act as a self correcting mechanism.But by repeatedly flaring up, as in the case of India, does it raise a red flag on the sustainable level of economic growth that can be targeted?


I dont know the answer but I will try to get a sense.
My analysis is very basic.I am neither capable nor equipped to do some hyper-mathematical regression to come up with a conclusion.

There are "n" commodities that go into making an economy and their weighted price index gives an indication of the inflation levels in the economy.

But I will concentrate on the basic commodities. Almost all other commodities are derivatives of these basic commodities and inflation in these basic commodities is what should generally be the driver of all other inflation.


The following is a table with growth rates for various basic commodities

Let us have a look at them:

Coal – We did well on Coal production before 2010-11. But last year was major disappointment. It looks like it will be worse this year. Looking at the overall scenario as of now, it is fair to asume that we are on are way to higher and higher coal imports.

Natural Gas – We were struggling to satisfy domestic demands and had a lot of hopes pinned upon the KG D-6 gas. It came in 2009-10. But now given recent problems, it looks like KG D-6 will struggle for production and so will India as a country as far as Natural Gas production are concerned. It should not be surprising that there are quite a few plans on the table to setup LNG terminals to enable import of LNG.


Crude Oil – That has been our weakest link in energy. Cairn Energy's find produced a bump in the production but now we are going to struggle again to grow it in any meaningful manner.

Except coal, we were always struggling with other energy sources.It had its own side effects of deficits and inflation but we somehow managed as global liquidity push helped India with capital inflows.
But now it looks as if coal is also going to go the crude oil way.

With limestone in abundance, we managed to get enough of our cement capacity in place.

Electricity - which is almost a derivative of coal in India, has done well. But with increasing problems in coal sourcing, it looks likely to struggle.

Steel has had a good going but even though we have abundant iron ore, we will have to import increasing amounts of coke to sustain steel production growth.

Fertilisers - that has gone nowhere. And no new capacities coming up, is likely to go nowhere.


Besides steel and cement, we will have to imports increasing amounts of all other basic commodities if we have sustain our growth momentum.

So where is the problem?


The problem is that all this leads to increasing trade deficits and we require higher amounts of foreign capital inflows to sustain our external balances.Higher Capital inflows helped us grow fast in the last decade.

But if we are going to struggle to produce enough of these basic commodities going ahead, our problems are going to exacerbate.And what happened in 2008 in terms of currency, inflation and growth shocks will keep coming back.Govt can try to induce growth with fiscal deficits. But given that we are a consumption driven economy, the govt effort leads to even higher trade deficits, inflation and currency fluctuations.And as govt tries to give a boost to a economy slowing because of inherent constraints and external issues, the next crisis becomes bigger.
Have a look at what happened in 2008 and later. The fiscal deficit went from the range of Rs.2 lac cr. before 2008 to more than 4 lac cr. And now this year it threatens to cross 5 lac cr. if we include the various subsidies being doled out.Inflation has been close to double digits for almost 2 years now even though we have not passed the full effect of the crude oil prices.
Rupee is back to 50 to the USD even before FIIs have sold anything substantial in the stock market.This is very unlike 2008 when Rupee did touch 50-52 to the USD, but after a heavy bout of selling by the FIIs.
(That does not necessarily mean that FIIs are going to turn big sellers in the Indian market, but I am just trying to say that the nature of the problem is more serious than it was in 2008.Or at least that is my feeling right now)

Agriculture - We are facing stagnant per capita availability in most agricultural products (except a few). In some cases the per capita availability is going down. This is happening at a time when the per capita incomes are going up. The resultant increase demand for basic cereals and proteins is pushing agri-inflation.As of now this looks like a structural issue, with the agricultural growth not keeping pace with rising incomes and the ancillary infrastructure around agriculture proving to be a bottleneck.Double digit food inflation for two consecutive years has already spilled over to higher wages.

Having put up this argument, it does come to mind that even China imports a lot of what it needs. But they have been able to avoid at least some of these issues.
Its true China imports a lot of the commodities, but I think there are some other differences when compared to India that helps it avoid these issues.

- Firstly consumption as a % of GDP is almost half in China. So they end up exporting a lot of what they import, which is reflected in their trade surplus.So they have current account surpluses instead of deficits. And thus their dependence on capital inflows is much lesser. In fact the trade surpluses can attract more capital in hope of taking advantage of a stronger currency. That this dependence on exports creates other issues is a different matter altogether.

- Secondly the massive infrastructure that they managed to build, a big chunk of which came in the 1990s and early 2000s when commodities were running at their lowest prices in decades.

 
- Thirdly productivity of almost all factors is higher in china except probably capital. It is routinely mentioned that India uses its savings much better.But China has used the capital to put up infrastructure which by definition is “low RoCE”. So they may have used capital a little less efficiently but then they have comparatively lesser inflation and bigger trade numbers.What we save on capital, we pay back I suppose by higher inflation and deficit problems.

Agriculture is probably the common place where both the countries face the same issues. Thus that part of the inflation is common to both.

Looking at at this very basic analysis, I would think there is a big fallacy with the Indian consumption led growth story. 

"We are wanting to consume much more that what we can produce"


What can change around the scenario:
- Collapse in global commodity prices, without having a big effect on the Indian export driven part of the economy. 
- Huge productivity improvements and removal of bottlenecks. (Basically taking advantage of the low hanging fruit)


I am not being critical of anyone, but just trying to put this as an neutral observer.

As of now, I think we would need to accept lower growth till we fix the systems or the commodity scenario changes. Slower growth is surely not acceptable to anyone. 

In that case it looks likely that markets will enforce lower growth on us through inflation and currency. That will be much more painful than a self-controlled slowdown.


There is a famous Indian axiom:
"Chaadar jitnee lambi ho, pair utne hi failaao".


But it is also true that a crisis is also an opportunity.

On that cautious note, I wish all a very Happy Diwali. And I hope everybody has a prosperous, happy and healthy New Year!!

USD INR - Technical Perspective

                                  Source: Bloomberg


USD was in bull market vis-a-vis INR from 1980 to 2002. Then its been a sideways pattern within a range of 40-52.
Only time will prove whether this was a consolidation of the previous 20 year bull market or whether we are going to be in this range for much longer or INR rupee will appreciate thus ending the USD bull market.
As of now I will lean towards it being a consolidation phase.If it breaks above the 50-52 barrier, then we have a renewed bull for USD against the INR.
And if that is the case, as they say in technical analysis, this is unchartered territory and targets are difficult to pin point.
If this analysis is correct, then tighten your belts,we might go into orbit. :)

Should Yuan appreciation be taken for granted?

Exchange rates for the Chinese Yuan has been a contentious issue for some time.Almost everybody other than the Chinese feel that the currency is undervalued. And some feel, by a huge margin.

USA constantly tries to impress upon the Chinese that they need to do more on the exchange rate front and probably to let appreciate Yuan much more and much faster.In fact a bill is being pushed in US Senate to allow USA to impose import duties on countries that undervalue currencies. Cannot think of any other major country, except China, against which this bill can be used, if passed by US and validated by International Law.

Basically its difficult to argue against Yuan appreciation, with all their reserves and trade surpluses across the board.

I am no currency expert, but just trying to put a few points together and see if Yuan appreciation should be taken for granted.

- After the 2008 crisis, Chinese banks, backed by the govt, went on a lending binge, the likes of which have not been seen before.That went onto create a real state bubble, or extend the real estate bubble and money went into projects which probably could not have been justified economically. Inflation came along and wages started to rise.

  Then, starting some time in 2010, they tried to control the bubble and its side effect, putting restrictions on lending, increasing reserve requirements on banks and increasing bank rates.And that is still going on.

  But it looks real estate in China has reached a point, where soft landing is not an option. A crash is more likely.The chickens have come home to roost.

- The low interest rates that are offered to the consumers, has also caused an "informal lending" system to take a stronghold in China. One of the signs of that is that the formal banking system has been seeing its deposit base shrink in the last few months. "Informal lending" offers higher rates to people,but how much of the system is actually legal is not known.

- The Govt has tightened credit through the banking system, for fear of taking the bubble even further. This has only added fuel to fast growing "shadow banking" system. The reserve requirements for banks is at an all time high.Inflation is still to be controlled.

- Given all this if the real estate does suffer a severe downturn, the whole banking system ends up in a huge mess. And the collateral damage on other ancillary industries will also be huge, further adding to the bad assets in the system.

- Lot of local governments in China have been running huge deficits funding questionable projects. some of these deficits are probably of the size same as Portugal or Greece. Local governments earn a significant chunk of the revenue from the real estate industry. Put these two things together, and it smells bad.

- Chinese demographics are turning towards becoming older. Their under-14 population has gone down from 28% in 1990 to 17% in 2010.The flow of new labour to the market has slowed down, one of the structural reasons for the rising wages.The rising wages are causing some other countries like Vietnam or Bangladesh to become relatively competitive. China's scale is not replicable in the near future and thus there is no immediate threat to its place as the world's leading manufacturer. Thus it is very likely that the deflation that China exported over the last 2 decades is unlikely to last.

Moreover with with an aging population, it is not going to be easy to replace export driven growth with domestic consumption driven growth. As is sometimes said "China will become old before it becomes rich".

All this would mean, they have to move towards higher value addition and technology, but that takes time.

- If the US and Europe go through another recession, then Chinese exports will also suffer.

If recession/stagnancy in the developed world combines with a real estate-cum-banking crisis in China, will the government launch another stimulus as it did in 2008?

Given that the present banking system problem and inflation is a result of that stimulus, its very unlikely, though nothing can be ruled out.

Can China be expected to keep appreciating Yuan, which will almost act as an "anti-stimulus"?

Commodities have already come down quite a bit fearing a Chinese slowdown. Thus argument of using currency appreciation as an anti-inflationary tool gets blunted.

Currency appreciation adds to the purchasing power of the domestic consumer, but in the aftermath of a Chinese real estate and banking crisis, a consumption led growth is also unlikely.And so currency appreciation may not serve that purpose as well.

In bad times, trade surpluses will also shrink.

Domestic interest rates are also likely to head down.

If its indeed a big banking bust in China, they might want to print more money and recapitalise the system.

Chinese Yuan is a controlled market, but generally all these factors would add to the depreciation pressure on a currency and not appreciation.

US Dollar and Euro, facing their own issues can get into a money-printing mode, more than what they have already done.Absolutely possible and changes currency dynamics. But then choosing a winner in a currency "race to the bottom" is tough, if not impossible.

I think its time I repeat myself. I am no currency expert. Its just an attempt to look at things with a perspective.

Let me know, if I have missed something very basic.

USDCNY = 6.36 today.

Underwear with holes??


In a recent edition of the DNA, there was an article titled "Underwear stands out as investors lose shirt". They had basically covered the underwear industry and written on the prospects of the industry.


Particular mention was made for Page Inds and the way customer has shifted to brands with Jockey being the most successful of them. The way the company reports numbers will surely make anybody feel that the business is really going great guns.


So I thought I will write down what I have understood from the numbers and otherwise.


- The promoters themselves offered their shares for sale in the IPO in March 2007. They probably got some 50 cr. from the sale of their shares. Company itself raised 50.8cr. from issue of new shares. Not too much to read into. But there was interesting point in all this. Company paid an issue expense of around 8.2cr. If it is for its share of the IPO, then that would have meant a fees of roughly 16% for the money that was raised. Since that number looks unbelievable I think its fair to assume that company paid for the expenses of the share sale by the promoter. Though its a small matter of 4 cr., it doesnt smell good. But anyways the amount is too trivial to be of interest to most.


- Lets have a look at the margin profile of the company:

Before 2006, the average operating margin for the company in the four years before would be around 12-13%. Company did the IPO in March 2007. So investors would have had maximum concentration on 2006 numbers. The operating profit margin changed dramatically in 2006 touching 19-20% range. And since then it has stayed there and thereabouts. That is interesting, isnt it?


- Now lets understand some inventory numbers for the company.In the table below I have just tried to come up with some basic inventory numbers. I have compared the Raw Material Consumed (RMC) in a given year with the year end inventory of the year and computed the inventory in terms of "number of days". I understand that inventory is for the future and not a reflection of the past performance, but here I am more focused on the trend than the absolute number itself.

As can be seen, the inventory has been going up almost one way, except for a dip in 2009. Given that growth rates of the company have remained in the 30-40% range throughout the period, it is very interesting that they had to support the growth with higher and higher inventory in terms of number of days.


- Now let us get onto something even more interesting.

Its just a simple calculation of the cumulative cash flows the company has generated since FY2007. As can be seen, the cumulative "PAT + Dep" number is 201.6 cr. That is for the cash inflows. Now if we add up the cumulative capex and cumulative change in working capital in the same time frame (229 cr.), it turns out the free cash flow generation has been negative. So even though  the profits have multiplied in these years, company has not been able to generate cash.
(Here the working capital changes have been calculated net off cash roughly)  


- Looking at all this, those who know the company might turn around and say how come the company has been paying dividends and has good payouts, when the cash flows were not existent?
Well, the answer to that is reasonably straightforward.

The approximate outflow on account of dividend since the year of the IPO, is roughly 100 cr. The total money raised through IPO and incremental debt in the same time frame is about 132 cr. So basically company has had to take debt to        
pay out the kind of dividends that they have paid. The difference of roughly 30 cr. between dividend paid (100 cr.) and total money raised (131 cr.) has gone to support the cash flow gap that I have explained in the point just before this one.


- And lastly, as of March 2007, promoters held 80.69 lac shares. As of June 2011, they held around 67 lac shares. They have sold roughly around 14 lac shares in the open market in these years at various prices. If I assume average sale price of 700 (CMP:2400), then they would have taken roughly 100 cr. by selling their shares in the market. In this time frame,their average holding of the company would be roughly 65%. So out of the cumulative dividends of 86.5 cr, promoters would have netted around 50-55 cr. And now if I add the share sale in the IPO of 50 cr., the promoters have netted anywhere between 200 cr to 250 cr. in these years.
As the promoters earned this money, the company has ended up with a debt of 115 cr, up from 25.3 cr., inspite of the having raised 42 cr. in the IPO.


I am finished with my numbers analysis of the booming undergarments business of Page Inds.


I just have one question to anybody who is reading this. Not exactly related to all that I have written above but nonetheless I will go ahead.


Have you ever worn an underwear with a hole? Does it last long?

Gold Glitters but gold loans......

Gold loan companies have had their share of limelight in the last 1-2 years. It had to happen with 50% RoEs and similar growth numbers.

But I am just wondering if these are actually such good businesses.

They charge an exorbitant interest rate on what is essentially AAA rated loan since it backed by gold with sufficient margin of safety in case of default.Agreed that gold loans are typically for people those who do not have access to formal sources of funds, but even then, the extraordinary levels of profitability in this business are little hard to digest.

I will try to give some food for thought for the two listed companies in the domain.



Manappuram:

- Gold loans typically have a duration of around 4 months on an average.Interest payment happens monthly. In that scenario Manappuram reports "Interest Accrued but not Due" entry in the "Current Asset" side of slightly more than 4 months. That is almost equal to the average tenure of the loans.Maybe Manappuram collects all the interest together. Highy unlikely though.

- It is only after 2006 that the company started to report such high RoEs. Almost as if they had figured out a magic formula. Numbers before 2006 were not flattering, to say the least. RoEs jumped for 2 years, lot of money was raised and now RoEs are down significantly from what they were at the point of making money. Some bit of it maybe due to the fact the leveraging process is still continuing and may improve later. Money raised in QIPs and placements now form 80% of the networth.I do not find it surprising that the "Accrued interest" entry that I discussed above came about only when the RoEs started to jump in 2006 and not before that.

Muthoot:


- I could not see anything interesting in the balance sheet of Muthoot that can be reported. But I have a more broader question on the business model itself.

They will probably end up roughly 22000 cr of AUMs FY12….

They claim to have an avg tenure of 4 months….lets take it to be 6 months….

That would basically mean they will disburse roughly around 40000 cr  in FY12….since they practically end up with a new book every 6 months….that disbursement figure is bigger than quite a few reasonable sized banks….and its all cash..

And of course similar quantum of collections as well…..

So they would roughly manage 80000 cr of cash in the year…

Just to get a perspective….

For M&M fin/Magma/Shriram…the tenure is roughly somewhere between 2-3 years…..

If we do a similar calculation for these three….the approx cash circulation they are managing is around 40-45K cr all the three added together….

So Muthoot alone does roughly twice the cash volume handling as all the above 3 put together…..when the avg ticket size of each of the three above is roughly 8-10 times that of Muthoot…

The challenge in this type of growth with this model is the same as what SKS Microfinance would have faced…..of course that Muthoot does secured lending is a big difference…..

And in all this to maintain margins….RoEs…..in the face of competition…..(In kerala every village junction has probably 3-4 gold lending shops within a radius of half a kilometre…excluding banks)

Gold prices have helped…value goes up without incurring any additional cost….

The physical enormity of the tasks to be performed boggles my mind....and as I said it is very "SKS-ish".

If Muthoot is managing all this, then they deserve their RoEs.


With the new RBI regulations on securitisation, these companies will probably out of that market. That should hurt RoEs substantially.

Their businesses are leveraged on gold prices. But since it is difficult to predict gold prices, I have not ventured into analysing effects of gold prices on the model. Broadly, rising gold prices favour the business.

A discussion on gold loans businesses should bring the colour "golden" to the mind....but I am more reminded of the colour (ever)"Green"!! :)