Thursday, October 18, 2012

Hic...Hic..Hurray !!!

This post elaborates a probabilistic thinking framework we used to evaluate an idea. Worked well in the end, but with dollops of luck!

Circa March 2012

The December quarter results of United Spirits (UNSP : Price was Rs 575) were a disaster. Volume growth YoY was less than 1% (historically in the region of 10-15%). What’s more, standalone EBIDTA of ~ 200cr was at a margin of 10.2%, significantly lower than the high teens that the company had normally demonstrated.

Shareholders, already grumpy that they were not getting free tickets in Kingfisher Airlines (another UB group company) inspite of having funded the failing airline indirectly were unimpressed. Debt at nearly 8000 cr meant that operations at these levels were barely sufficient to bear the interest burden, leave alone any meaningful profit for the equity holders. Soon the stock was punished to ~ 500 Rs. translating to a Mcap of ~ 6500 cr and an EV of ~ 14000 cr, a fraction of historical valuations.

The Indian alcoholic beverage market as a whole has grown around 16-17% volumes in the last decade. It is estimated that the rising middle class in India will make it the largest alcoholic beverage market in the world in the coming couple of decades. There are large barriers to entry given that liquor is a state subject and a single business group (Also a Member of Parliament) controls more than 50% market share of this lucrative market.

Positively inclined towards the Indian alcobev story at the margin, we decided to evaluate if the price fall provided an attractive entry opportunity. Our thinking moved along the following lines.

  1. Earnings based valuations: Given the business dynamics, one offs are fairly commonplace for UNSP. We however did not feel that ~ 10% margins could be considered to be the new normal based on last quarters performance alone. We were happy working with a base case of quarterly standalone EBIDTA of 250 cr and consol EBIDTA of 300 cr. Thus the market was valuing the stock at an EV of ~ 10-11x on (our) stressed case EBIDTA [14000/(300*4)]. Reasonably attractive for a past darling (Historical valuations of 15x EV/EBIDTA).

Imagine that you are the CEO of a top 5 global alcoholic beverage company. Given that developed markets are hardly growing, does it makes sense for you to look at this opportunity given by Mr. Market? Does it make you really salivate if also know that the promoter holding is only ~27-28% (chance of a hostile bid)?

We thought there to be a potential for rerating. Surely a plump Aishwarya Rai still has suitors.

  1. Asset Based valuations: As is widely reported in the press, UNSP has multiple levers available for deleveraging its debt of ~ 8000 cr. A) Treasury stock of 7-8%, b) 3.2% stake in United Breweries (market value ~ 500cr) c) IPL team Royal Challengers Bangalore (we put a value of Rs 1000 cr with many ifs and buts..) and d) above all, the reason why the bulk of the debt is there in the first place, Whyte & Mackay, a subsidiary acquired in 2007 for a billion dollars for its scotch inventory (More expensive in theory today as aged alcohol is more precious). When push came to shove, we were hopeful that all this family silver would come in handy.

UNSP to us thus looked interestingly cheap on conventional valuation parameters as compared to its own past. The deafening roar of Kingfisher Airline had of course still not been silenced. Our evaluation of the external factors led to the following decision tree. For the record the UB group & Vijay Mallya own ~ 28% of UNSP, nearly all of which is pledged against the group debt obligations including Kingfisher Airlines.

A brief explanation of the reasons behind some of the probabilistic assumptions are in order.

Option1 is self explanatory. We did not believe that KFA had the ability to attract external capital.

However, what was the reason for us assigning a low probability on option 2 ?? Isnt the media , market and financiers banking primarily on that outcome??

Imagine your house is on fire. It is likely that your first reaction would be not to care for your own safety and try and retrieve your property. However, there comes a point when you overcome the bias of commitment and realize that further efforts will only endanger your life. What is it that you are likely to do?? Cut your losses and probably run for your life !!

The question to ask is at what point Mr. Mallya in his efforts to douse the fire at Kingfisher Airlines and has he managed cross the hump on his bias of commitment. We thought he had and thus in our view it was unlikely that the UB group would inject further capital into a failed venture. Sale of stake in UNSP and other group entities would only result in bankers queuing up for the sale proceeds. The net result would be Mr Mallya losing control of his prized liquor business and be an owner of a bankrupt airline in exchange. We were unable to figure out, why he would wish to do that. What’s in it for him?? Contrary to market opinion, we were happy assigning a low probability to this event.

Option 3 is simply the balancing event/figure. In our view it was the most probable event. As can be seen in the decision tree however, contrary to market opinion, this was not necessarily a bad thing for UNSP. Suitors like Diageo had long been wooing the company. Any sale of stock and change of control was surely going to whet their appetite. Bankers would be stupid to fire sell UNSP pledges in such an environment though you couldn’t rule it out entirely. We thus assigned a low probability to the event. An auction for the highest bidder would have been a very bullish scenario leading to an open offer, probably at a rich price. Interestingly, even though we felt option 2 was unlikely, the result would still be favorable leading to a similar open offer.

Inspite of the nearly heads I win, tails you lose scenario, why was Mr. Market succumbing to its sentiment? Were we missing something??

We thought the following biases largely responsible for this extreme mood swing.

Representativeness: The promoter is also associated with an airline which is likely to go belly up.

Vividness & Recency: The media is flush with news flow about bankruptcy, invocation of pledge shares, sale of personal assets by the bankers. What if the bankers decide to sell the pledged promoter stake in the market? (Think of the multiple small and midcap companies falling more than 50-60% in a matter of 3 days when a single financing company decided to pull the plug)

Recency Again: The last quarter results are showing signing of slowdown and cost pressure along with rising interest burden for this spirited company. For a good long period of 7-8 years, the company had enjoyed higher than market multiple simply valuing it as a growth stock.

We were satisfied on most counts of business, valuations and external factors specific to UNSP. It was time to buy!!!

Circa October 2012 – Cut to the present

UNSP trades at Rs 1200 and beyond. Rumors are rife Mr Mallya is on the verge of ceding control of UNSP to Diageo. Option 2 is a done deal as per the market.

Where do we stand now?? First the valuations.

Two more quarters have gone by. The march quarter saw no improvement in EBIDTA margins as compared to December. However, June saw a sharp reversal with standalone EBIDTA jumping to 350 cr (16.9%). Coupled with the potential M&A news Mr. Market is on a high. At an EV of Rs. 25000 cr UNSP is trading at 15.5 times last quarter annualized EBIDTA and ~ 21 times our stressed case annual EBIDTA of Rs .1200 cr. Not much room for error. As regarding asset based valuations, nothing much has changed. UNSP continues to have the same deleveraging options.

What about KFA dependant decision tree. That also does not change, but obviously there is room to tinker around with the probabilities with the knowledge that the passage of time provides.

Probability of Option 1 reduces further. Inspite of FDI in aviation, we are happy to all but rule out the interest of outsiders in this now “locked out” airline.

But surely, the probability of option 2 increases?? The newspapers are full of the smell of smoke from the supposed fire that is brewing on deal street between UNSP and Diageo. Stake sale and UB exit should lead to an open offer??

But isn’t there something wrong?? Have we found out the answer to our earlier raised question? What’s in it for him?? We don’t think so.

On further thought we introduce Option 4 in our decision tree. Something we had admittedly missed out earlier.

The deal if at all any, would be made purely to delever the UNSP balance sheet and not have any meaningful bearing on KFA. Options available could be sale of treasury stock and/or dilution of equity. Little money could also flow to the UB group through a small sale of equity stake which might be used for a symbolic token recapitalization of the airline, thus paving the way for restructuring of debt and who knows even some more short term debt funding. The PSU banks would thus end up holding not only the can but also putting in some additional money into it.

Lack of support from an open offer, disappointed investors due to no change in management control and extremely ripe valuations make for a richly valued stock indeed. We have sold into the party and will change our view when we figure out..Whats in it for him??

Now where is the skill and how we turned out to be lucky with nearly 100% in less than six months?

In our opinion, the skill was clearly in staying away from newsflow, evaluating the underlying business on a realistic base case and keeping emotions at bay. The post elaborates on the probabilistic framework used to evaluate the idea and arrive at a decision. We were hopeful of around 40-50% return over a 6-9 months framework once the dust settled and people starting focusing back on the alcobev business. The luck part of the trade was Diageo deal newsflow, opening up of FDI aviation and many more reasons (we can now think of with the benefit of hindsight) that led to doubling up of our expected return.

Best of Manufactured Luck!!


  1. Excellent thought process bhai-log..really enjoyed reading the post..
    BTW, how about doing some primary research together about the products of the company?

  2. Anytime sir !! Doing primary research is of prime importance in any investment process.. actually both of us did a lot of it just forgot to mention about it in the blog ..

  3. Excellent post Abhinav and Niren.

    Really liked the way you have analysed the whole situation using decision tree and probability.

    1. Glad you liked it!! While all kinds of feedback is welcome, positive feedback on your first post is particularly gratifying..Thanks

  4. Really enjoyed reading the process of analysing the Special situation.

  5. Great first up on the blog guys !!!...Congrats both on the blog and the stock... :-)....Wondering why Mr. Mallya got into this shitty business of airlines in the first place - aspirational value i suppose...Screwed up his position in the cash rich liquor business....Can the Parliamentarian come up with something to surprise us all and save his stake in UNSP?? Time will tell....As far as the airline though, it surely seems to be grounded...Look forward to your future posts...All the very best.

    1. Glad you liked the post Abhishek...While we got lucky on the stock, we lacked the skill to allocate a meaningful portfolio weight to really move the needle..the wait to get lucky on both counts continues: )Thanks & Welcome

  6. Guys, interesting thoughts and made money!

    My comments - asset-based valuation in March 2012:
    1) Treasury stock will not add much in anaysis particularly if you consider that stock price was depressed. Treasury stock has to be 'sold back' so that it generates cash. Why would any one buy it under low conditions?
    2) Value of 3.2% stake in UB comes to only 459 crores in March.
    3) 1000 crores to IPL franchise - well, I don't know the economics of this franchise but your estimate should be fine considering recent offer for Deccan.
    4) That leaves only scotch business (bought from Whyte & Mackay)assets and the company's own assets to make up for that whopping debt of 8000 crores - not sure if that holds good.

    I have not analyzed earning power of scotch business bought. Assuming that transaction makes sense, it is only the collective earning power of assets that should drive the value. Another way to look at could be how much it would cost to replicate this spirits business for a new entrant.

    1. Hey Anonymous,

      Thanks for sharing your thoughts.

      1. We were happy to value the treasury stock at a healthy premium to CMP. We felt that if offered, the 7-8% stake could attract sufficient interest from foreign liquor majors interested in getting a ‘foot in the door’. In the past as well UNSP has successfully sold treasury stock to PE investors at a premium to CMP.
      2. We agree. Value of UB stake was approx (~) 500 cr
      3. Our views of RCB in IPL were admittedly simply an assumed base case no. While Deccan is a distress sale, the last BCCI auctions of Pune and Kochi happened at an obnoxious 700 million $. There must be a science to the valuation but we haven’t applied our mind to it.
      4. W&M is primarily valued on its large inventory of scotch. Think of it simply as being an owner of a cellar full of alcohol. You can keep selling some bottles annually to keep the cash flow going or sell it all in one go if you want. However, more mature alcohol generally commands a higher price. Of course alcohol prices can fall, but they haven’t done so in our knowledge in the last 4-5 years, atleast since the time UNSP acquired W&M. UNSP does put out an external valuers estimation of the valuation of the scotch. Irrespective, we thought it fair to assume that the business was worth at least as much as paid for originally (given the passage of time and more mature scotch inventory)

      Would like to point out that other than W&M which contributes to earnings in a some way, the rest of the assets are not revenue generating and thus not “core”. Sale of these assets would not impact present or future earnings. The goal of the exercise was not to calculate residual liquidation value for shareholders, but to judge if the co has sufficient family silver, sale of which could bring its balance sheet in order, thereby improving valuations. Liquidation value would also involve valuation of fixed assets and most importantly brands, but sale of these would come with an impact on revenue. We did not venture into that line of thinking.

      Welcome again to the blog…

  7. Great stuff!

    You hit the nail in the head with the 2 things you said:

    -Probabilistic approach can be used to manufacture your own brand of luck... agree 100%

    -The common investor's(myself included) portfolio does not zoom up/down with a single correct decision, because of lesser weight.
    Eg. 1lac/10 stocks = Rs.10,000 per stock. If one UB in your kitty becomes double, you still add only 10% to you net value.

    However, the probability of error increases with each position one For each UB in your portfolio
    you might end up with a Onmobile/Suzlon/Deccan Chronicle/Reliance communication. Mean reversion!!!
    Hence, beating index(nifty/sensex)returns is a big feat.

    Would really like your views on not blowing one's portfolio despite having focused(read less than 3-5)investment in fewer stocks.

    1. Hi Akash,

      Thanks for the encouragement. While most discussions tend to focus on what to buy/sell, we feel how much to buy/sell is equally if not more important. Sadly, this topic gets discussed only rarely. Hope to share our thoughts with you on the subject in greater detail in future posts.


  8. Guys,
    Simply loved the detailed note and effort in explaining the probabilistic framework

    Keep the good stuff flowing ... hic hic :)

  9. Why the fire sell of UNSP shares in open market by bankers is negative (In decision tree). I understand there will be temporary drastic decline in market prices, but interested bidders can still acquire stake from open market and their action should bid up the prices.

    1. Hi Anil,

      That might be true in the long term. But the interim uncertainity and the extremely high price risk in that environment, was beyond our threshold of risk taking.