October 20, 2011

A case of ignored liabilities

There is virtue in being patient, more so if you are a long term investor. I got a taste of this lesson again, recently with tata steel.
I had been analyzing tata steel for a few weeks and got extremely tempted when the stock hit 400 Rs a share. I would have pulled the trigger on this one, but decided to follow a time tested approach – Never buy a stock when you are in heat J
I usually spend a few weeks analyzing a stock. Once I have completed the first round of analysis, I leave it and try to come back to it after a few days or weeks. The advantage of this approach is that it allows me to sort of cool down and get a little more rational. It helps in reducing the adrenaline surge I get when I am looking at a good business, which also seems to be quite cheap.
The story behind tata steel
Tata steel is one of oldest steels companies in India. It has a capacity of around 6.8 MMT (million metric tons), mostly in Jamshedpur. In addition the company has a Brownfield project of around 3MMT at the same location, due in 2012 and another Greenfield project coming up in Orissa in around 2014.
Tata steel India is one of the most profitable steel companies in the world with operating margins in excess of 30%. Iron ore and coal accounts for almost 60% or more of the cost of production. Tata steel owns its own mines and thus has been shielded from the rise in the cost of iron ore and coal. In addition, it is also an operationally well managed company.
The Corus acquisition
Tata steel acquired Corus in 2007. You can read about it here.  Tata steel announced its intention to acquire Corus in 2006 and then got into a bidding war with CSN and eventually paid 12 billion dollars (around 55000 Crs) for the company.  You can read about Corus here.
Corus has three integrated steel plants in UK and Netherlands. In addition, the company also has multiple rolling mills and manufacturing locations across Europe. The company had around 50000 employees at the time of acquisition which has come down since then due to layoffs, restructuring and closure /sales of some facilities.
Tata steel invested around 3.7 billion (around 17500 Crs) in the form of equity and bridge loan. The rest was financed via an LBO (the acquired company took the debt on its balance sheet). So at the end of the transaction, tata steel at a consolidated level had a debt of around 54000 Crs against equity of 34000 Crs.
I am not as smart as the Tata steel managers or the banker who advised them, so I still cannot figure how this was a good deal for the shareholders. The Indian shareholder paid around 9 times EBDITA for the Corus. In addition, they used  the stock of tata steel to pay for it, which is a far more profitable company than Corus ( Tata steel India had an EBDITA of 511$/ tonne of steel where as tata steel Europe had an EBDITA of 122$/ tonne in Q12012).
Anyway, after the deal happened we had the financial crisis and the deal which appeared pricey to begin with, now looked like a complete disaster.
So what interested me ?
As I said earlier, the management of the company is very good from an operational standpoint (capital allocation is a different matter). The management has been energetic and proactive in tackling the problems in the European operations.
The high cost structure in Europe is being attacked by closing/ selling facilities. In addition there have been layoffs and work force reduction to improve the labor productivity. As a result of these ongoing improvements, the European operations is no longer losing money and has actually started making some money now. If Europe does not have a severe crisis due to Greece and other PIIGS countries (and it is a big if), then tata steel Europe should be reasonably profitable in the next few years
The management has also gone ahead and improved the capital structure by selling some non core assets such as shares in other tata group companies, interest in Riverdale mining etc. The net Debt to equity ratio is down to 1:1 in the current quarter and is likely to improve further. As a result the balance sheet is much stronger and can withstand a recession better than it could in 2008.
So what scares me?
As I said earlier in the post, the ongoing improvements in Europe and the new capacity in India (which will raise total capacity by 50% in the near future) got me all excited. I decided to cool it down and wait for a few days as I continued to dig further into the balance sheet .
I came across the following , for the post retirement pension plan (pg 218 of 2011 annual report). The numbers below are in crores.
Look at the above number and ponder on it for a minute.
Tata steel has a networth of around 35000 Cr last year and made a net profit of around 9000 Crores in 2011. The pension liability is 3 times the networth and 12 times the annual profit.
I cannot give a lesson on pension liability accounting in this post, but let me give a few points to think about.
The pension liabilities are covered by assets (think money set aside to pay for the pension) .In a happy situation as above, where the assets  exceed the liability, the company gets to carry a positive balance on its balance. If however the market weakens and the assets drop or do not earn the expected rate of return, then the difference is carried as a liability on the balance sheet.
As per Indian accounting, a company has to take this liability through its profit and loss and show a loss if required. However tata steel, very conveniently, decided to opt for UK accounting standards and carries the liability on its balance sheet alone. Now this is perfectly legal and there is no hanky panky in it.
In addition overtime, if this gap keeps growing, the company is required to cover the difference by charging the shortfall to the profits and by adding capital to the assets (set more money aside) . If you are thinking that the company can get away from it, think twice. This is a defined benefit plan – which means the workers have to be paid their pension, irrespective of the returns on the assets.
The liabilities are solid and will grow at a fixed rate. The growth in the assets depends on the returns on the stocks and bonds, which is anything but fixed. Finally this is Europe – you cannot  get away from such liabilities at all (short of bankruptcy)
Where’s the risk
The assets under the pension plan cover the liabilities for now.  However the gap is less than 2% now. How can we be sure that that the assumed returns on the asset (4.25-9.25%) will not turn out to be optimistic ? If that happens, then tata steel has a huge bill to foot in the coming years.
I am personally quite uncomfortable with this kind of an open ended liability. It is difficult even for the management to predict what will happen as it depends on the returns they will get on the assets (stocks and bonds) in the future. If there is a shortfall, the picture could get very ugly for the shareholders
So why is no one talking about it?
I think I know the reason for this. This is a long term, contingent liability. The shortfall may or may never happen. If you are an analyst, recommending the stock for the next 3-6 months, this kind of liability does not matter. If something does happen, you can always say – oops J
If however, you are a long term investor like me, such liabilities can make a big difference, especially if you cannot evaluate it with confidence. I have not given up completely on this – I have uploaded a sum of the parts valuation for tata steel here (pls have a look and leave me any feedback you may have)
Controlling my testosterone
As I said in my previous post, one of the key points for me as an investor is to manage my emotions and first conclusion bias. I generally try to stagger my analysis and purchase so that I can avoid the first conclusion bias and then the commitment and consistency bias, which kicks in after the first purchase.
In the above case, I have found a liability which may turn out to be immaterial eventually. At the same time, even if the probalitlity is low, the downside is very high if it is does materialize. This liability is in addition to the 40000 cr debt already held on the balance sheet and  weak European operations .  All these liabilities are supported by the highly profitable Indian operations. Lets hope they stay strong !

20 comments:

Vikas said...

Hi Rohit,
Nice digging of Annual report, which i think is a must for retail investor.
I usually avoid asking for opinions on particular stocks, but with this excellent analysis of yours I am tempted to do it.
My query is on 2 stocks.
1- Bajaj Holdings- Whats your thinking on these holding companies.
2 - Oriental carbon & Chemical Ltd.
For details posting the another blog link

http://purvismultibaggerstockideas.blogspot.com/2010/09/orient-carbon-and-chemicals-limited.html

Hope you dont mind.

Need your valuable insight on 2 of these.
Regards,
Vikas

Sachin Purohit said...

Woww..That's very smart analysis on pension liabilities of Tata Steel Europe. Makes me want to say what Detective Karamchand's secretary always told him once he cracks the case - "Sir, you are a genius!"

Talking about Tata Group, what do you think of Tata Sponge Iron, that is debt-free, having high returns on networth, good operational efficiencies and does not seem to have the kind of capital allocation issues in Tata Steel. I know you have covered it in a past article. But there have been some changes in the ground realities since then. Post-ban on iron mining in Bellary, its competitors sourcing iron ore from this belt could be facing problems while Tata Sponge has its captive mines. Doesn't that positively impact this company? What do you think?

Sachin Purohit said...
This comment has been removed by a blog administrator.
Anonymous said...

Hi Rohit,
What are the metrics you use to assess pension situation ? Obviously you would want pension assets to be greater than liabilities. What else ?

Thanks,
Gopal

kaho pyare said...

yes we should analyze this kind of liabilities as well. but not sure why you are checking this for just Tata steel.

wouldn't that be case with all big companies including your favorites Asian paints, CRISIL etc?

kaho pyare said...

Also can you please let me know on evaluating NCDs.

i see that india infoline NCDs are selling for ~957 Rs (a week back it was for 930). 11.9 is coupon rate on this.

so wouldn't it be wise to buy them and guarantee +14% compounded pa return if i buy it for 930.

i will get 119 every year for every 930 i.e 12.8%. additionally i will get 1000 rs back after 5 years. i.e another 1.46% return. so i will be getting 14.26

do you see any risk more than a company FD faces.

am i right in assuming that i will have right to receive interest from the day i bought NCD from "secondary market".

i assume that i will also have right on whatever accrued interest on NCD. however i do not take into calculation this accrued interest. whatever it is, it is going to add to my return.

INE866I07230 INDIA INFOLINE INVESTMENT SERVICES LTD - 11.9 NCD 18AG16 FVRS1000 Beneficiary 100 957.12 95712.00

Yogesh N Bang said...

Grt post rohit. So much to learn from your analysis. Looking fwd for more....

@ Sachin: I have come up with an article on Tata Sponge in my blog (www.fingerscrossedideas.blogspot.com), may be it might help you get a view on Tata sponge.

Rohit would like your feedback on the same.

Regards

Anonymous said...

Hi Rohit

your thorough analysis is really inspiring.

As I live in UK, I know couple of things regarding pension system here.

After recent change any yearly increase in pension pot(employer + employee's contribution) and pension pay-out are now linked to CPI(consumer price) rather than RPI(retail price inflation which on average is highter by 1%)

Although current CPI in UK is 5% historical average is around 3% and BOE expect CPI it to come down to 2% by next year!

So, I assume as long as long term investments return are more than 5% it could meet liabilities(long string of monthly payments though as life expectancy here is much higher(in decades) than in India.

Many times I come across in UK newspaper re ticking timebomb of pension liabilities both for private and public sector but don't really have much insight into this.

Investing in commodity companies: doesn't it require prediction of macro-economic issues and if I remember rightly Tata Steel was bleeding heavily in nineties and about to wipe out it's equity. SAIL was available at 50 paise/share!
Corus at one time was trading at 4 pence/share while Tata bought is for 600 pence/share.

Even if financial crisis avoided, harsh austerity measures in Europe/US are likely to cause slowdown impacting steel companies in my limited understanding from reading news paper!

Regards,

Ashok

Rohit Chauhan said...

Hi vikas
havent looked at bajaj holding. i am currently analysing oriental carbon. it was analysed by my good friend ayush and i have been digging into it since then. you can read the analysis on his blog - dalaal street

i am still trying figure out oriental

rgds
rohit

Rohit Chauhan said...

Hi sachin
i should get some carrots :)

i had looked at tata sponge earlier and havent looked at it for some time..you are right .with the bellary scam, companies with ore mines will definitely benefit. that said , tata sponge is 43% held by tata steel. i hope they are doing a clean transfer pricing as 30% is purchased by tata steel itself.

it is cheap ..but then it is a commodity and cyclical biz. so there may not be too much pe expansion, but if the earnings expand and so does volume, then there may be a good upside

frankly i am finding decent companies and hence have not look as much at commodity plays lately

rgds
rohit

Rohit Chauhan said...

Hi gopal
that would be a long topic ..but to keep it crisp

- are liability covered by assets
- what are the assumptions for both
- and finally how much is the liability as a portion of networth/ annual profit. if it is small...around 5% as it is for most companies , i will not worry about it much

rgds
rohit

Rohit Chauhan said...

kaho pyare
ofcourse i check for all companies. i read the annual reports cover to cover, but then for 99% of indian companies pension liabilities are small ..less than 5% of networth or profit

for example in apaints it was 10% of networth and less than 10% of annual profit. lets say instead of the 130 Cr as stated in the annual report, it turns out to be 200 Crs in 3 yrs ...what difference will 80-90 crs make in a 800 crs + annual profit. its like a small pinch

but if the liability was 10000 crs ..then a 20% difference would have meant a hit of 2 yrs profit. that will be a different matter. so its all a matter of context

if you invest in US or europe or in companies which are accquiring, then pension liabilities become critical. in purely indian companies it is not a worry yet

rgds
rohit

Rohit Chauhan said...

Hi kaho pyare
i have not invested in NCD ..so cannot be much help

in case of NCD ..the most important criteria is credit risk and you also need to see the senority of this NCD in the capital strcuture. is the NCD secured ..what are the coverage ratios etc. if possible, you should read the offer document for the NCD before investing

rgds
rohit

Rohit Chauhan said...

Hi yogesh
thanks for the comment. will have a look at the blog you mentioned

rgds
rohit

Rohit Chauhan said...

Hi ashok
on pensions ..you are spot on. US and europe has a ticking bomb on pensions and all such entitelements - both in public and private sector. look at what happend to General motors in the US. the company got swallowed by the pension liabilities - the equity holders got wiped out

on tata steel, late 90s was a tough time, due to slow down and high cost strcuture. since then they cleaned up the balance sheet and became efficient. the corus accquisition i think was a bad move ..the management of corus dressed it up and stuck it to the tata who swallowed it. now they will have the mess to clean up for years to come

if the equity and debt market hold up - a big if with the low interest rates - then it may turn out better. but if that doesnt happen, then we have trouble

rgds
rohit

AVG said...

Hi Rohit

your review technique is great. i am invested in Tata Steel and keep checking their parameters like P/E, P/B, EPS, ROE but never looked at this parameter which is interesting. By all other parameters, it has been a consistent performer. Operationally agree they have the best margins and well tied up for raw materials as well as fuel.
Will research more on this aspect and look forward to your as well as others advice.

regards..Amit

H.R. said...

Rohit, you are absolutely correct that General Motors provides a cautionary tale to the perils of giving lots of entitlements to employees. Back in the day when we did not have much competition, General Motors in fact pioneered the ‘social contract’ between corporations and workers by which workers enjoyed excellent job security and other benefits like pensions and firms got maximum loyalty and productivity in return. Many companies in other industries followed suit and it was a very happy period indeed for both workers and the companies they worked for. Unfortunately, in the wake of deregulation, increased competition, outsourcing, and plummeting productivity, firms had to scrap the much-hailed ‘social contract’ in the 1980s and 1990s and today, as you must be aware, times are quite tough for American workers. I am sure though we will persevere and overcome these difficult times like we have so many times in the past. I am glad to see though firms like Tata doing very well in emerging nations.

SHEKHAR said...

hi rohit,
i ve been an avid amateur market enthusiast since 2007. so far my experience has been pretty dissappointing.i however, still am interested in learning and since i ve heard a lot about u from my nephew i felt it prudent to ask you about my few holdings-
1)IDFC
2)IDBI
3)UNITECH(HEAVILY INVESTED HERE)
4)STERLITE(PRETTY BULLISH ON THIS 1 AS WELL)

TRUST IT WONT BE A PROBLEM
EAGERLY AWAITING YOUR RESPONSE,
SHEKHAR ARORA

sachin8778 said...

Happy Diwali to you Rohit and all the readers !!!

Sachin

Manpreet said...

Hi Rohit,

Nice post. However, even if we assume that the value of European business is zero, the stock is undervalued. I have some analysis done from my side at
http://the-value-stock.blogspot.com/

would be great, if you can tell where am i going wrong ..

thanks ...