60% growth for next two years, followed by another two years of 40-50% growth

Navin Agarwal: One of the important factors supporting the present valuations of Infosys is the perceived sustainability of growth rate of its top line and bottom line. Would you like to comment on:

• The sustainability of the present growth numbers in the short term and

• How do you visualize the long-term growth of this company to be?

Vipul Mehta: I think Infosys has done very well in growing to its present size. There are few companies in India, which have sizes bigger than Infosys. And so there is no reason that Infosys, given its history, should not be able to manage the growth rate in terms of number of people, in terms of top line, and in terms of bottom line. Infosys has been following a de-risked model. Given the common knowledge that opportunities in the area of IT are tremendous and Infosys is well ahead in keeping pace with the latest in technology, there is no reason why Infosys should not be able to sustain growth in top line and bottom line.

To add to it, given the highly valued currency that Infosys has at its disposal, there will always be opportunities of top line growth coming from acquisitions. There is a huge arbitrage opportunity available to Infosys in terms of its own valuations compared to companies that are valued at probably a hundredth or a tenth of valuation. The challenge here is going to be integration of human resources, work culture, the areas of business etc. But given that opportunities are going to be available to the company and given the resources that are available to the company, I have no reason to believe that Infosys will not sustain its growth for the next three to five years. I would put the growth number at about 60 percent for the next two years and going down to about 40 to 50 percent for the next two years after that.

Valuation difference emanate from difference in margins and growth potential

Chetan Parikh: Vipul, I have got a Morgan Stanley report on Infosys which is dated October 11, 1999 in which there were comparisons between Infosys Technologies and Cambridge Technologies Partners. This is with respect to the issue you mentioned about the stock as a currency for takeovers. In Cambridge Technology Partners, the operating margin is 14.6 percent and net margin is 9.4 percent. Undoubtedly, Infosys has better margins at 39.6 percent and 25.9 percent respectively. But the return on net worth is not very different between Infosys and Cambridge Technology Partners. In the case of CTP, its about 30 percent and in the case of Infosys it is about 34 percent. Now the price-to-sales ratio are vastly different. As of that point of time the price to sales of CTP was 1.5 and the price to sales of Infosys was 52.9. I don't know what figure it will be today but it will be dramatically higher. Undoubtedly one stock is better than the other but is this sort of valuation discrepancy between peers justified? Is it of any concern at this point of time?

Vipul Mehta: I think the differential in valuation comes from the basic differences in the environment in which these two companies function. CTP functions in a market that is obviously much more mature than India and which more importantly has a cost structure which is much higher than the Indian cost structure. I don't know the yearly per employee billing for Cambridge Technology Partners but it is something like $40-45,000 per person for Infosys. So the price to sales ratio differentials emanate from the fact that Infosys does a 39 percent gross margin while Cambridge Technology Partners does a much lower margin. Also, given India's IT cost structure a whole, lot of business could shift or at least ensure a sustainable growth rate for an Indian IT company and more so Infosys, given its strengths. So it is probably not so much of a concern as far as Infosys valuations are concerned.

Moving up the value chain & sustaining growth are the biggest challenges

Navin Agarwal: What do you think are the major challenges facing Infosys today?

Vipul Mehta: Basically to sustain the growth will be the biggest challenge. Having said that Infosys has had a history of sustaining growth rates at well above hundred percent in top lines and very close to that in the bottom-line. I think the biggest challenge for Infosys from here on will be to scale up its business model. Given the acquisitions that Infosys will be doing, meshing of cultures, meshing of businesses, and meshing of technologies will be the major challenges for Infosys going ahead.

Also in terms of moving up the value chain, Infosys has been having a far less riskier model than at least the product companies that are available in the U.S. or the ERP companies which have run into volatile weather. Infosys has had a fairly de-risked model of business. So moving up the value chain would be an important challenge for Infosys, whether it is going into any sort of product or whether it is going to take that risk or continue following the IT services model of business and develop IT applications.

I think sustaining growth rates through various means will be the biggest challenge that Infosys faces. Also it has been getting to a size where sustaining growth would be far difficult than when it was at a size of $25 million. It's now at $200 million and acquisitions would further double that size

Also human challenges are obviously going to be there. But, human resources are going to be a challenge for every IT Company. Having said that Infosys is fairly well placed given the valuations of stock options and the history that the company has had in attrition ratios. I reiterate that Infosys is well placed in the face all these challenges.

Another challenge especially for the top management will be to manage expectations from the shareholders and the marketplace. I guess the valuations also reflect that the expectations from the company – a high growth rate and while there have been no complaints on meeting expectations, it is also a virtuous circle of performance surpassing expectations leading to higher valuations and in urn higher expectations.

Chetan Parikh: The geographical concentration of Infosys' business is largely in the U.S. and with the e-commerce initiatives that Infosys has taken may be it will, given the predominance of U.S. in commerce, will remain there. Would that be of concern to you in terms of the fact that the U.S. has had an unbroken period of prosperity for the past 10 years. A stock market crash over there could upset the entire fulcrum.

Vipul Mehta: I think that will be a risk for the IT sector as a whole in India and probably the IT sector around the globe. U.S. has been the biggest provider of IT services business to the IT players around the world. Given that e-commerce and Internet is such a huge potential for businesses in the U.S. and around the world, I think the cake is large enough for Infosys to have its share of the cake. I do not think that, that is going to be a major concern as far as the risk to Infosys is concerned. However, the risks in terms of valuation and prices on NASDAQ coming off their present levels will probably be applicable to an Infosys as much as to any other company. The impact will probably be lesser for Infosys given its history of a great management and great shareholder returns.

Having said that there is the question mark as to how much of IT is going to be sustainable. On one hand, we read about growth in IT being sustainable and that there is going to be absolutely nothing that is going to stop IT from growing. On the other hand, what happened to Y2K was a revelation in itself. I mean there was nothing major that at least came out in the press or any media on anything that was undesirable as far as Y2K was concerned. But there was so much of hype as far as Y2K problems were concerned. Probably something like $800 million was spent on the Y2K bug and nothing came out of it. So there could be a question mark as to how much of hype this IT business is about.

Even when you get down to the e-commerce business or the Internet business, all that one is talking about is pure eyeballs or page views. But there is no profitability or returns currently. A company like Levi’s has discontinued from e-commerce and selling through the net etc. So there is a question mark as to how much of hype will the IT business sustain as a whole. As it seems now there doesn't seem to be any stopping for the potential of the IT business from the U.S. or from around the globe for service companies or product companies or e-commerce companies around the world.

Acquisition is the biggest price trigger

Navin Agarwal: Vipul, coming back to the valuation of Infosys. Clearly the present valuation is probably not just a function of the organic sustainable growth of Infosys and you said that the valuable currency of market cap that Infosys has today gives it the ability to acquire almost any IT services company in the world. So that seems to be one discontinuity. Could you elaborate on this discontinuity and do you believe that there is any other discontinuity, which is also presently built into the valuations of Infosys?

Vipul Mehta: I tend to agree with you that this is the biggest discontinuity in Infosys. What the market is looking at today is probably a halving of valuations, from 60 times sales to 30 times sales and from a price earning ratio of 200 to 100, when it acquires a company of its own size. Therefore the stock becomes cheaper than what it currently is. This really is the biggest price trigger for Infosys.

Having said that I guess Infosys is also getting a premium for the leadership status in the IT industry. I have talked at various instances in the whole conversation of Infosys that the management of Infosys has been setting various precedents and their listing on the NASDAQ was another first for Infosys. So given the returns that Infosys has given to its shareholders and to the society at large I think the price premium that Infosys commands is a deserved one. I cannot think of any other discontinuity. I would probably see a rather sustained steady growth as far as Infosys is concerned. I am not aware of any of their efforts as far as something like product development or getting into a big size product or any such thing is concerned. So I think it's a fairly well managed and sustainable business model, as it seems now.

Infosys does not have to run after business, like other IT companies

Navin Agarwal: When you talked about scalability what happened in Infosys over this entire decade is that it's moved from relatively lower end services job including staffing to significantly higher value added solutions. You just said that you are not very sure about Infosys getting into products or something. So going forward what is the transition in terms of moving up the value chain for Infosys beyond the high end IT services work that it is doing today?

Vipul Mehta: It will probably have to encompass the entire range of domain knowledge - the insurance business or the telecom business – and encompass the whole range. It will have to get into things, which could be as abstract as convergence, the wireless and Internet.

There was a very interesting instance that I could quote from one of the conversations that we had with Infosys when we questioned them about the competition in the IT industry and whether there was a potential for undercutting in terms of rates for IT services. And we got a very interesting reply. We were given to understand that the difference between Infosys and the various IT companies was that IT companies had to go for business given that they were looking to grow and Infosys having reached this level had a lot of requirements coming to it from the client side.

Managing expectations and balance sheet size are critical to stock performance

Navin Agarwal: Apart from the issues of managing manpower and digestion of an acquisition, would you have any other worries on Infosys today?

Vipul Mehta: I think it might be the balance sheet at the end of the day, if the acquisition does not come through pretty quickly or in good time. We have a balance sheet of around Rs.800 crores out of which Rs.500 crores is cash. This is diluting the return on capital on its core business. So, managing the balance sheet and managing expectations will be a very important factor as far as Infosys is concerned. Everyone in the country now expects Infosys to keep growing at hundred percent and the management has been very adept at managing expectations till date having surpassed expectations on almost all instances.

I would just like to add a point on Infosys when I go through the numbers and numbers available through the balance sheets and the quarterly reports. It has been very interesting to see how on a quarterly basis Y2K revenues have come down gradually and how e-commerce and Internet revenues, which is the hot thing or the hottest property today, have gone up on a quarter to quarter basis. This shows how the management is going to manage its business and scale up the revenues and try to maintain the top line and the bottom-line growth.

 Cipla

Cipla – Big upsides out of hidden potential

Navin Agarwal: Coming to one of the other bigger holdings in your fund. Cipla is something that your fund identified pretty early in the entire move. What is your investment case for Cipla?

Vipul Mehta: Cipla has been a company which has come out of the blue from nowhere to being one of the top companies in the industry and one of the best performers in our portfolios. I think the merits of Cipla lie in its amazing set of strengths that it has created over period of time. These lie in terms of sheer quality of resources that it now has at its disposal, the capabilities that Cipla has in the pharma sector, the facilities that Cipla has developed over a period of time and the sheer returns that Cipla has given to the shareholders. All these factors make Cipla stand out among its peers in the industry. I think the hidden potential that Cipla has is still not out in the public and no one knows about the big upside that Cipla is going to give to shareholders.

One of the largest spenders on R&D in pharma business . . .

Navin Agarwal: Could you tell us about the business positioning of Cipla?

Vipul Mehta: I think very much like the IT services model of Satyam or Infosys, Cipla was also one of the companies to capitalize on India's strength in pharma. Cipla has taken advantage of its reverse engineering skills and laxity in patent laws to create size for itself through the strength of its research team and the scientists, which have hitherto worked at lower levels in the value chain.

Cipla has now grown to a size of around Rs.500 crores in the domestic market and this was possible because of the huge marketing strengths of the company. So this has been the strength of Cipla all through and it has reached a stage where it is now poised to spend huge amounts of money on the basic research, new drug delivery systems or new chemical entities etc. And all these ideas are being driven by the vision of Dr. Hamied.

. . . which will certainly bear fruits in future

Navin Agarwal: How do you rate the R&D initiatives of Cipla in comparison with those of Ranbaxy and Dr. Reddy on one hand and companies like Wockhardt and Torrent on the other?

Vipul Mehta: I think it is probably a little pre-mature to talk about the research initiatives of Cipla at this point of time. What Dr. Reddy's and Ranbaxy have done, lends a lot of credibility to the Indian Pharma industry. Ranbaxy has a new drug delivery system endorsed by Bayer and Dr. Reddy's has new chemical entities going through advanced stages of the clinical trials through an international outfit.

Cipla is yet to display its potential. But I am sure that Cipla has a lot of aces up its sleeve. And to that extent there is no strict comparison between these companies. But given the public knowledge that Cipla is working on improved chemical entities and drug delivery systems, I am sure that Cipla will come out delivering results out of its research and development effort. Incidentally, Cipla also has one of the highest absolute spends on R&D which is of the tune Rs. 35-40 crores per annum and increasing every year.

Navin Agarwal: Cipla seems to have already developed its first chirally resolved molecule, salbutamol, which is an anti-asthma drug. Could you tell us what the revenue potential of such a product could be?

Vipul Mehta: I wouldn't know the nitty-gritties of each of the products in specific.

Cipla will step into the patent regime equipped with Dr.Hamied’s vision

Navin Agarwal: But broadly could you tell us about the research pipeline of Cipla? It announced the filing of international patent for omeprazole and few other products.

Vipul Mehta: These could be on the same lines or at least of the same potential as something like Ranbaxy's NDDS deal with Bayer. But I guess we will all have to wait for some time till Cipla announces a few more things. And which will probably be on the lines of what Dr. Reddy's have done. I am sure Dr. Hamied's vision which we have seen over the years in getting Cipla to what it is will probably reflect itself in taking Cipla into the new patent regime.

Navin Agarwal: Apart from the proprietary R&D work that Cipla, Ranbaxy and Dr. Reddy’s are doing, is it possible for Cipla to also get into joint development deals with present patent holders of blockbuster molecules to develop improved versions by using chiral chemistry. For instance the Sepracor-Eli Lily deal to develop an improved version of Prozac, which is a multibillion-dollar market. You see something of that sort happening with Cipla given its strength in chiral chemistry.

Vipul Mehta: Absolutely. Cipla has had strengths in chiral chemistry. Over the years, Cipla has turned its strength in reverse engineering to develop improved versions of existing molecules. I feel that Cipla will definitely have a lot of potential and the CFC-free metered dose inhaler is a fine example of what Cipla could do. These are the levels to which Cipla can innovate and get to that scale of value addition in its business.

Huge potential for new products that Cipla develops

Navin Agarwal: The European market for metered dose inhalers alone is estimated at over a billion pounds and Cipla has already applied for patents, once again in some of the developing countries for the CFC-free metered dose inhalor that you talked about. Would you be able to you know throw some light upon what is this opportunity like?

Vipul Mehta: All I could say is that it could be a huge potential given the size of the market that is available. Cipla has basically followed the export model for capturing revenues and improving profitability. Its innovations, strengths in various developing countries, the cost base at which Cipla is, definitely provide a huge potential for top line and profitability growth for Cipla. It could be a huge market though I would not hazard a guess on the potential size for Cipla. But, definitely it has the ability to get there.

Navin Agarwal: Exports of Cipla have risen at a much faster pace than the domestic sales in the recent past. What is the strategy behind this?

Vipul Mehta: I think Cipla has very consciously followed this strategy of getting into developing markets where U.S. patent laws have not been applicable with an eye on a much higher profitability. Cipla has very good marketing insights into all these export markets and it's been a very profitable model for Cipla in the last two or three years. This has helped in improving the operating margins of Cipla by a few percentage points and it has been a very good model for Cipla to follow.

Huge potential exports of anti-AIDS products to Africa

Navin Agarwal: Could you explain to us the export opportunity for Cipla in the South African AIDS infected market for the anti-AIDS products that Cipla has developed?

Vipul Mehta: In the last interaction with Cipla, it mentioned about the huge potential of the AIDS market in the whole of Africa, not only South Africa. This could, in turn, be a huge potential for Cipla given the anti-AIDS product that Cipla has developed and the amount of money that Cipla is spending into AIDS program. But the size of the market would be a difficult guess to make. Surely it's going to be a big potential for Cipla in all these developing and under developed market, specially the whole of Africa, which I am told is a huge market for anti-AIDS products.

Fastest growth with highest ROCE among Indian Pharma companies

Navin Agarwal: You talked about Dr. Hamied and his vision for the company. Could you also comment on the breadth of the management of Cipla?

Vipul Mehta: Dr. Hamied's vision has taken Cipla from where it was to where it is today. Cipla has been able to achieve among the highest growth rates in the industry. It is probably one of the highest ROCE companies in Indian Pharma and is very close to the low capital intensive MNC Pharma. Cipla ROCE is in its higher 20s or the early 30s in terms whereas the other Indian Pharma companies, the Ranbaxy’s and the Dr. Reddy's have been in their teens. Dr. Hamied's vision has definitely been something out of the top drawer. While I have not met him, but feedback from various people who met him definitely talk very highly of Dr. Hamied.

I think what Cipla has done in history and what Dr. Hamied has done for the organization is to get the very basics right. To do basic things right, to get its act into the right place and that's what's been the success story of Cipla. Not being too flashy about anything, not getting into high-risk profile etc. That's been the strength of Cipla, though on the strength of Cipla's second line management not much is known and there's not been an opportunity to interact with the second line management of Cipla. So there are question marks on the breadth of Cipla's second line management, which though will not take away any credit from Cipla's strength in research, which is at the core of a pharma company’s efforts in growth.

Revenue potential from R&D-related revenues could exceed the present profits

Navin Agarwal: Given the merger of several multinational Pharma companies globally and the resultant consolidation in India, what do you think are the strategic alternatives available to Cipla to maintain its present position in this business?

Vipul Mehta: I think this is a point that is applicable to the Indian Pharma industry as a whole. The top level companies in the Indian Pharma industry are at a stage where, you are not at a very high base in terms of the potential of revenue that is available from basic research. I think Indian Pharma companies have done very well to realize the importance of research in drug development and drug delivery systems, new chemical entities and improved chemical entities. Given the potential of revenues in each of these businesses is unlimited. A Ranbaxy deal with Bayer could give them $50 million of revenue in terms of only milestone payments. This is more than the existing net profit of Ranbaxy itself. Similarly, when Dr. Reddy's anti-diabetes drug gets into the market it could give them profits that would far exceed the existing profits of Dr. Reddy's.

I think the top-level Indian companies like Cipla, Ranbaxy and Dr. Reddy need not necessarily have to go in for alliances. Having got into this game of basic research, if these companies can realize the potential for research and get products moving into the market, these companies will have a lot of strength to display over a period of time and probably acquire huge sizes. It will probably be more of a collaborative effort with multinationals companies rather than getting absorbed or acquired or being forced to forge alliances with these companies.

50% margins at a tenth of the prices of original patent holder

Also, the other potential that Indian pharma companies will have is the generic markets in the U.S. considering that the larger companies have had top-quality facilities available at their disposal, including things like U.S. FDA approval, UKMCA approval or approval from the Australian authorities etc. will definitely be available. It is then just a question of enabling this infrastructure with the vision to get into the generic markets and exploit the potential of generic markets. This brings us back to the same case - even at one-tenth of the price of the original patent the generic drugs presents a profitability of around 50% which is huge for an Indian Pharma company. So profitability potential for Indian Pharma company is huge and at least the top companies will be on an equal footing with the strong research-based MNC Pharma companies, if they realize the full potential of R&D.

R&D revenues + Generic exports = Future success model for Indian Pharma

Navin Agarwal: So, over the long term what Indian Pharma companies would really look like is that a significant portion of their revenues will come in from R&D revenues and the balance revenues will come in from generic product sales, and both of these segments could be extremely profitable?

Vipul Mehta: Absolutely. While the Indian markets will be there to remain, I think that they might get desperately competitive because everyone in the coming years, till the patent regime comes in, will want to get in as much of revenue as possible out of their existing product range. These might force the Indian companies to get into every field, making the field more competitive. We are already witnessing this in the domestic formulations market and the margins are definitely suppressed. But, on the export front I think the strength of the Indian research will drive the profitability and valuations of these companies. The generics and the new, research-driven drugs or the new drug delivery systems will drive the profitability of these companies. All this will generate significant revenues for the Indian Pharma companies.

Navin Agarwal: Vipul, A more longer-term question. Would you imagine the balance of power shifting gradually over a period of time away from R&D happening in the West to R&D happening in emerging markets? This analogy is drawn from the software sector where development work happening in developed countries is gradually shifting to emerging markets. This, in turn, is being driven by huge labor cost arbitrage combined with the availability of the required skill sets in emerging markets?

Vipul Mehta: No, I think we are talking of a different ballgame altogether. I think even when we talk of software services or when we talk of research in pharmaceuticals, we are not talking of blockbuster molecules or big drugs that need a huge R&D base. This would be very similar again in the case of software, where a Microsoft Windows product will probably be developed only by Microsoft because they need huge product development resources as well as huge marketing skills. So the very high-level research will probably remain with the MNCs and the best way is that Indian pharmaceuticals will have its strength into improved chemical entities and other Dr. Reddy's type of a research where it is an improvement on an existing entity rather than a Viagra being invented.

Focus on low value, high volume products

Probably there will be two distinctive levels of research that holds true for both software and for pharmaceuticals, both the knowledge-based industries. We have basically seen Indian product companies in software, the Visualsoft’s or the Satyam’s of the world, having products which are limited to very low-value and concentrating on a much higher volume. Higher-end products like Windows etc. are limited to a Microsoft or the very big companies in its areas. And similar will be the case with pharmaceuticals too.

Indian Pharma more attractive than MNC Pharma

Navin Agarwal: To generalize, could we say that the Indian Pharma company’s have stronger upsides as compared to the overall MNC Pharma sector based on your observation of rising R&D initiatives and generics opportunity, combined with increasing competition on the domestic side?

Vipul Mehta: I think so. I think that the competition on the domestic side is going to be more of a downside. On the lower base, the generic and the research opportunities for the top rung Indian Pharma companies are going to be a huge potential for them.

Navin Agarwal: Could you explain to us the valuation case for Cipla?

Vipul Mehta: The valuation case for Cipla is the hidden potential of their research efforts. We have seen Ranbaxy realizing its research potential having created a marketing infrastructure in the U.S. for its generics. We have seen Dr. Reddy's realizing its potential to start with its marketing strength and now its original research.

I think the expectations are very high on Cipla's part and I'm sure Dr. Hamied has reached at a level from which he can exploit Cipla's strength, Cipla is not going to die out as a me-too in Indian Pharma. It probably has a lot of aces up its sleeve and which is why Cipla is quoting at comparable valuations of Dr. Reddy's and Ranbaxy. On the other side, the return numbers for Cipla have been far superior than Dr. Reddy's and Ranbaxy. So, it is a combination of these two factors that Cipla enjoys these valuations.

Navin Agarwal: Would you have any worries on Cipla?

Vipul Mehta: Having not known the second line management of Cipla, one would tend to think that Cipla is Dr. Hamied's baby. Given that he is not online and on to the management of Cipla and he is basically a research driven gentleman, that could be the only risk. But having said that Dr. Hamied has had a vision and I was reading somewhere that Dr. Hamied, when asked that what would he have been had he not owned Cipla, he said would have been a research teacher. So, given that he has a passion about research, I'm sure Cipla will have a lot of aces up its sleeve and the worries will therefore be a little diluted.

 ZEE TELEFILMS

ZEE TELEFILMS – A GIANT SIZED OCTOPUS SPREADS ITS TENTACLES

Navin Agarwal: Coming to the next darling on the stock market and once again you have dated this darling before the others in the stock market. What is your investment case for Zee Telefilms Limited?

Vipul Mehta: In the potential that the Zee stock has to offer, given its current valuations, might not sound very attractive as it is quoting at 500-600 PE. But the sheer potential of the business of Zee can be described by illustrating a giant sized octopus that can spread its tentacles into every possible related area of huge growth that is available to tap in the entertainment business and in related businesses today. I think that is the valuation case for Zee.

Sky is the limit for Zee

Navin Agarwal: How do you rate Zee on your management criteria?

Vipul Mehta: it would be an excellent exercise to track Zee over how it has evolved over the last three or four years. I would never forget times when Zee was quoting at a price of Rs.100 and kept hovering there. At that time, there were all sorts of apprehensions about the management, its quality, and the sustainability of its growth. The evolution process was quite a gradual one and the stock finally took off from April of 1999 to where it is today. It’s been a great credit to the management to transform the company completely. While the potential of it’s business looks great, I would like to credit the management in building an institution for which only sky is now the limit in terms of its scalability.

Most scalable business model – Cable, Pay channels, Internet . . .

Navin Agarwal: Could you tell us in a little greater detail as to what really is the scalability about?

Vipul Mehta: The scalability is not necessarily in the core areas that Zee is into today. Going back into history, Zee was basically a programming entity where it used to receive commissions on a fixed margin on the programs that it sold to the broadcasting companies and fixed commissions that it received through its subsidiary on advertising income. From there Zee has come a long way into merging all entities and becoming a full-fledged software programmer for cable and satellite television to various other areas that it now has under its fold from entertainment to news to music channel. It has under its subsidiaries a cable distribution business, the potential of pay revenues that is available, and to top it all, the Internet business potential that Zee could look into.

Having said that the core business of Zee might not be the most lucrative over a five-year timeframe as a whole lot of quality channels with quality programs will come in and advertisers will have a lot of avenues to exploit these channels. So, advertising revenues and advertising margins are going to be under pressure.

. . . and the resultant potential is UNLIMITED

Zee has been at the forefront of expanding prime time band. But, there is a limit to how much the prime time can be expanded. While advertising revenue and profitability is always going to be under pressure, the IPR which Zee has created over a period of time equips it with the ability to get into various businesses. And all this will be done leveraging the present infrastructure. In India, the pay channel revenues are yet to be tapped. Revenues from a pay channel are negligible compared to similar revenues in other countries and this alone is a huge potential for Zee. The aggregate size of the potential of all the opportunities in Zee could be said to unlimited.

Limits on expansion of core business - Prime time already expanded significantly

Navin Agarwal: Coming back to the core business of Zee, you said there is a limit on how much Zee could expand the prime time. Could we say that given the size of Zee’s ad revenues today, the volatility in it’s ad revenues going forward will be similar to the volatility in the overall ad revenues for the industry as a whole.

Vipul Mehta: I would think so. Zee has established itself as a clear leader in cable television with the highest TRP ratings in terms of its programming. It has a strong IPR that will help it in re-broadcasting of programs. It has expanded the prime time from the two hours that were traditionally available to four hours, then to six hours and now to eight hours. And prime is, and will remain, the most significant component of revenues.

But now it's got competition in the form of Sony that is fast closing in the gap. So I think there is definitely going to be a pressure on programming and this will probably be applicable to both the top channels available today, and also the government-owned Doordarshan. The three will compete for the ad revenues and given the similarity in profiles, the differentiation will be determined by the quality and the TRP ratings of programming. On a like to like basis, I think we will have a similar profile of ad revenues. However, these could differ if a channel broadcasts events like blockbuster movies. Revenues would also differ from company to company if they come with things like news channels or business news channel, etc.

Penetration of cable and satellite television will keep increasing

Navin Agarwal: Given the loss of market share of DD over the last few years would you write it off or you expect a worthwhile response from this terrestrial broadcasting monopoly?

Vipul Mehta: One cannot afford to write it off. DD will remain a prime entertainment provider or prime news provider or prime software provider for the television media. Having said that, the penetration of cable television is increasing with every passing day and Zee and Sony are definitely going to be worthwhile competitors to DD.

Virtuous cycle created by the first mover advantage

Navin Agarwal: You said earlier that Sony is the only worthwhile competitor to Zee. You now have Star significantly increasing the focus on Hindi content creation. Several other software providers are now announcing plans to launch channels, including Shri Adhikari Brothers, Nimbus, etc. Each one of these players are likely to slice the market to position their channels in various niches. How do think this will change the overall competitive landscape and, as a result, the business dynamics?

Vipul Mehta: As far as Star is concerned, the focus is a very big factor. Star can afford to sink a large amount of money into capturing market shares and into capturing eyeballs. But as far as the other channels go, it will be a long way for them to be worthwhile competitors. In the entertainment business the first mover obviously has the biggest advantage and Sony, in that respect, has come a long way in catching up with Zee. Having said that, there are a lot of qualitative factors, which go into offering quality programming and increasing market shares. The reputation and the comfort level of software programmers and producers are at the top of the list of the various factors. Just imagine the kind of comfort that a producer would have with Zee or Sony. The potential of his product being watched by several million eyeballs more than what a channel like Shri Adhikari Brothers or any other such upcoming channel will drive him to the top channels, creating a virtuous cycle. As a result, channels like Home TV, have not been able to get anywhere at all.

Pay Revenues could be 2x Ad revenues

Navin Agarwal: You also talked about the huge potential from subscription revenues in future through direct to operator platform that Zee is planning to launch. Could you put these revenues or the magnitude of the revenues in the context of the present advertising revenue of the group as a whole?

Vipul Mehta: As I am told and I am not very sure about these numbers, pay revenues are supposed to be twice as big as ad revenues. And this is the reason why Zee and Sony are looking at it. This though is a very tough proposition right now as cable distribution is not very organized or a regulated market. We have a whole lot of fragmentation in the cable industry where smaller operators are still present. No matter how much Zee and Hinduja, who have own cable networks, try to get this organized, I guess we still have a very long way to go. This is also reflected in the disclosure of number of homes that are penetrated.

The biggest factor is who takes the lead, given that there are two equal competitors in Zee and Sony. So it will be a delicate balancing act on the part of both of these channels to get into pay revenues. But based on global trends, I guess there are huge revenues to be made out of pay channels though in India it still has a very long way to go.

Regional channels is a big opportunity

Navin Agarwal: Zee has launched a few regional channels and the market for non-Hindi content seems to be no smaller than the market for Hindi content. Given the huge content library of Zee, is it practical for it to leverage on this media library?

Vipul Mehta: Oh, absolutely. The regional channels offer a huge potential. I'm told that the potential for ad revenues out of South India is probably some significant size as compared to the revenues throughout the country. But quality of programming will be a very important factor as far as regional channels go. I do not think that dubbed programs and pure translations out of the existing Hindi programs into regional languages have been a very great success. So a very important factor will be the quality of programming that goes into these channels and that will ultimately determine the success of the regional channels.

Having said that, there are all sorts of rumors floating in the market that regional channels will be gobbled by major channels. Zee, like Infosys, can leverage on the expensive currency that it has and get initial penetration into regional channels. Assuming that Zee produces quality programs, there is a huge potential for it in regional channels too.

Navin Agarwal: Is the response to the dubbed programs a reflection on the true valuation that the investor should ascribe to the media property of a media company?

Vipul Mehta: No, not necessarily. I think the IPR value of any media or software programmer does not only lie in dubbing it into regional languages. There is far more to it than just that. So I don't think that necessarily is a constraint in valuing the IPR of a media company.

Leverage cable infrastructure to be an ISP

Navin Agarwal: Would you like to comment on the cable operations of Zee and what upsides it presents to Zee in the foreseeable future?

Vipul Mehta: I can only comment on what we all hear and read. Zee will leverage its cable infrastructure by being as ISP and this would involve providing Internet services through television to all its subscribers. How that will shape up and how that will translate into revenues is going to be a question mark. Given that there will have to be a front end for providing Internet services, what portal is going to be used and how it's going to translate into revenues remains to be seen.

Navin Agarwal: Could you explain the convergence theme in Zee?

Vipul Mehta: The convergence theme basically is all media merging into one - the Internet business, the television business, probably telephony at some point of time and all these businesses being mopped up by Zee through its distribution network.

Navin Agarwal: What would be the implications of the acquisition of substantial stake by Subhash Chandra in his personal capacity in ICO and Iridium?

Vipul Mehta: I don't think there will be any substantial implication for the shareholders of Zee as such. This investment is being made by privately owned companies of Subhash Chandra that might later turn into a publicly listed company. But I do not think that there will be any significant implications for Zee.

Powerful currency of market cap will be used to strengthen positioning

Navin Agarwal: In the context of Zee, could you tell us the role of fulcrum that market cap is playing today?

Vipul Mehta: I think media companies are at a very crucial juncture. Zee is getting an astronomical valuation today and organic growth will not be the only instrument for growth for Zee. Given this heavy currency that Zee has in its pocket there is a huge opportunity to buy out a whole lot of other businesses, like channels or portals or other web sites. This has major implications on the media sector as a whole. It forces other media companies, say someone like Sun TV, to go public and get expensive valuations themselves or get swallowed up by the likes of Zee.

As every thing is available at a price, Zee can easily use its own expensive currency to pay higher sums to acquire existing businesses. This creates a win-win situation for the investors. And TV 18 is a fine example. The valuation that TV 18 is getting is probably a reflection of this fact, though there is no direct relation between Zee TV and TV 18.

Navin Agarwal: And what is the valuation case for Zee today?

Vipul Mehta: As I said earlier, the valuation case for Zee is a tremendous potential that it has, the leadership status that Zee has or at least that Zee has enjoyed over this period of time, and the value that Zee has created for its shareholders. It is a fact that competition is breathing down Zee's neck. But, Zee has the potential to leverage on its available expensive currency to acquire regional channels, portals, or any sort of revenue generators or market cap generators today. That is probably the valuation case for Zee.

Chetan Parikh: Zee has announced an ADR issue in addition to some placement with Goldman Sachs that they have done. What is a necessity for such large capital inflows?

Vipul Mehta: I'm not too sure of this development as it is as recent as today. The deployment could be into new ventures, into expanding its cable distribution, improving its entertainment resources, etc. But, I'm not too sure of what exactly this issue is going to be for.

Zee is in a league of its own

Navin Agarwal: What do you think would be the global benchmark companies to do a comparative valuation of Zee today?

Vipul Mehta: It is difficult. I guess there will be no companies singularly comparable to Zee and given that companies like Time Warner have merged with AOL, such companies would be in a league of their own. It is very difficult to pinpoint one single comparison point for Zee's valuation. I guess at the end of the day, you have mergers between media companies and Internet companies and content companies and Internet companies and probably they have a comparable model of AOL Time Warner though on a very different scale but very difficult to pinpoint a singular point comparison.

Web casting to reach a bigger part of the world

Navin Agarwal: With the rising footprint of Zee and the resultant increasing coverage of the globe, do you see Zee ultimately becoming a more global media company than it is today?

Vipul Mehta: Yes, definitely. This is happening through Zee TV’s channels, which are broadcast through various DTH platforms or otherwise into various countries of the world. There is a large Indian population wanting to see the programs of Zee and in that lies a large potential to be tapped for Zee. But I guess this will be exploited more through the Web casting or the Internet media where Zee probably has a whole lot of its programs web casted through the net and this will be watched across the globe on a much larger scale than a television medium directly.

Zee offers too many upsides

Navin Agarwal: What would be your concerns, if any, on Zee?

Vipul Mehta: Competition from the other channels is definitely a concern. What sort of areas will Zee get into and the potential risk of these areas is another area of doubt. I wonder whether one knows whether the most successful ISP business will be through telephony or through cable or satellite. I am not too sure of that. So as Zee gets into an ISP business, one has to assess as to what is going to be the risk profile of this business. The sustainability of these valuations is going to be a risk for Zee. At the end of the day, will the expectations that investors have at these valuations be met is another question mark.

Having said that that are a lot of upsides that Zee offers and, overall, I think it is a great business to be in.

Mirza Tanners

Mirza Ghalib to Mirza Tanners - 'Ek dundho, Hazar miltain hain' to 'Ek hi milta hain'

Utpal Sheth: Vipul, we have talked about quite a few biggies in terms of market cap. And during our interaction on your investment philosophy, you did talk about that last 20 percent which provides the kicker to ultimate portfolio performance. Can you share with us one of such ideas?

Vipul Mehta: I think this is a company that not many people would have heard about. Mirza Tanners is a company that I have seen growing from a negligible size in its IPO days. Even after what it has already achieved, it still has a long way to go in terms of achieving the market cap that it deserves. I believe that Mirza will achieve its deserved market cap over a period of time. It is an absolutely close fit to most ideal philosophies of investment - where a company follows a perfect business model, avoids negative free cash flows right from the start and goes from strength to strength in a business as mundane as making shoes. Avoiding negative free cash flows is a very important parameter that investors ought to look for, and managements ought to practice.

Management maturity and focus . . .

Utpal Sheth: Vipul, the key element of your investment philosophy has been management quality. Given that you have seen the management over such a long time frame, how would you evaluate the management quality at the different phases of Mirza's evolution?

Vipul Mehta: To start with, it is fundamentally a very, very high-quality management. It has been a management that was absolutely focussed on its business, and very well tuned in to the industry i.e. to the leather shoe-making industry. Mirza developed its acumen of marketing shoes in the Western European countries. Like the other companies that we have discussed today, it built strengths on volumes, reached critical mass, and extended itself to areas that were not its traditional strengths.

It is a family management, which could be a concern to many investors. But Mirza has been a very, very different case study. It is a story of a father and his four sons who floated Mirza, with each one of them having respective strengths in a particular area of shoe making - right from buying of hides, to making shoes, to marketing of shoes. Each one is strong in his respective area of expertise, and not very well versed with the other areas. This unites the management as a whole. To track this company, one must understand what it is today and what it can reach to over the next five years. This management has developed maturity over the last four years, the maturity of changing leagues in terms of size, in the reputation that it has, and in the perception that people have about it's business and it's brands. It has evolved to become one of the most visionary managements that I have seen over a period of time.

. . . result in impressive financials

Utpal Sheth: And in their operating parameters, have they given you as much satisfaction as most of your other picks have?

Vipul Mehta: Absolutely. The company has grown in terms of its top line on a sustained basis, it has also grown in terms of its operating margins and profitability, as well as it's bottom line and its return on capital employed and return on equity. It's been one of the most ideal graphs of operating parameters that a company can have, a secular up-trend in each of these parameters.

Margins derived from value addition

Utpal Sheth: Have you been impressed with the reasons behind the operating margin growth? I mean, have they been due to just squeezing the customer, or have they been due to cost reductions?

Vipul Mehta: I think it's a combination of many factors. Margins have improved more due to cost economies and value addition rather than squeezing the customer. The most important attribute for improving operating margins is it's excellent understanding of its market and of it's consumers, and then getting the right products into the right place. I think exploring markets and supplying to the world majors like Bata, which does not source from its own subsidiary in India, is in itself a big credit to the management's understanding of it's market. The quality of its product is a big plus for this company. Mirza has not compromised on the quality at all, and over a period of time, the average realization per shoe itself shows how the management can increase its operating profits over a period of time due to it's understanding of its business.

Intangibles to lead to re-rating

Utpal Sheth: Does its branding initiatives become a cause for ultimate re-rating of this company?

Vipul Mehta: I think it does over a period of time. I mean there's no reason why a re-rating should not happen. Look at its business model - it has grown exceptionally well in the export segment. After having got a feel of what developed world shoe markets are, and having a good understanding of what the design conscious consumer psyche is, Mirza has done a wonderful job by getting into the branded market, both in India and abroad. It's been an ideal model where there have not been any investments in real estate, or in it's own outlets. It has just been a pure distribution through the right outlet, along with a de-risking strategy that would mean that if this exercise doesn't succeed, it could be withdrawn at a very low-cost. It's branding initiative is all the more commendable since it has no successful branding peers in it's target segment where it is the largest brand. So branding is definitely a huge cause for re-rating this company.

Hare beats the Tortoise

Utpal Sheth: Vipul, given that the financials are not really a key factor in your decision-making, how do you perceive a situation where, in two years time, Mirza's profits will probably be greater than that of Bata, whereas Bata has been a 50 year plus company in India?

Vipul Mehta: I think it's a tremendous tribute to what Mirza has done in its market - in terms of its business management, marketing, production, and achieving the financials which follow as a logical consequence. You talked of Bata. To me, for some reason, Bata has not been able to get its act in place, although it seems to have turned around from the tight corner that it was in. In spite of Bata being in the right low price segments, which are more relevant to India, it could not deliver the top line growth that is a key requisite for any company operating in India.

So, it doesn't come as a surprise. Given the understanding and acumen that Mirza has, the quality of its products, and the focus on marketing; Mirza will surpass Bata in net profit numbers this year, or in the next year.

Management vision enlarges investor vision

Utpal Sheth: What is the vision that you as an investor would have for this company three to five years from now?

Vipul Mehta: I have met every single person of the family and the professionals in each of the management functions. I think, Mirza is set to grow at a 50 percent compounded rate for the next three years. Mirza has systematically expanded capacity, de-risked itself from various risks, and has launched a much higher potential volume ladies shoes without any sort of risk whatsoever. The quality of shoes that Mirza produces has been sustained, and it sells to some of the best names in this business globally. I have absolutely no doubts that Mirza will be able to grow at a 50 percent compounded growth in sales for the next three to five years. I definitely see a huge market cap for this company.

Utpal Sheth: Any concerns on Mirza's subsidiaries in UK and South Africa?

Vipul Mehta: I think it's a well-laid out structure to carry out the marketing operations efficiently. Having said that, we have addressed the concerns of investor perception to the management, and I believe that the management is taking care of such investor concerns in the current year.

Fatal distraction?

Utpal Sheth: What would be the thing that could make this investment go wrong?

Vipul Mehta: Operationally, I don't think there's anything that would make this investment go wrong. It is essentially turning from a production company to a production-cum-marketing outfit to a purely marketing outfit. The management vision of getting shoes out-sourced and ensuring quality by an effective outsourcing model will turn Mirza into a high RoCE marketing company. The only risk I see as far as the fundamental business of Mirza is concerned, is if the management diverts its attention out of shoes into other businesses which I don't think is going to be the scenario. I think shoes will remain the core competency of Mirza Tanners, quality will remain the focus of Mirza Tanners, and growth will be the logical end to this forte of the management.

Navin Agarwal: Well, Mirza is actually planning to extend its 'Red Tape' brand across a wide range of products from casual wear to watches to several other products. What are your views on this move?

Vipul Mehta: As long as no significant capital or resources are committed into this, and as long as these efforts are only ancillary to shoes, and shoes keep contributing to a very high proportion of the profitability, I don't think there is significant risk in this business for Mirza Tanners. I think the management is well equipped to take care of this extension, and I think it's only a means to increase revenue and extend the brand without any risk whatsoever.

Lack of liquidity overshadow various investment virtues

Utpal Sheth: Mirza's track record of dividend payouts and bonuses notwithstanding, it has not yet caught investor's attention so far. What according to you could be the catalyst for Mirza to be appreciated by the investing community?

Vipul Mehta: I think it will be a matter of time before Mirza catches the eye of every category of investors. I cannot forget the day, only about 16 months ago, when Mirza used to quote at 35 rupees a share. Today, it's gone up 10 times, and I don't think that the company can do anymore than have such a liberal bonus policy, such a liberal dividend payout policy, and such good return numbers. I think liquidity has been a constraint on this counter, especially as the management owns 75 percent of the stock. But there have been n number of managements which have owned 75 percent of the stock. So it's only a matter of time when market capitalization catches up with its low valuation.

Good, better and best of the industry!

Utpal Sheth: Does it worry you that other comparables in this business, if at all one can compare, like Liberty and Lakhani, are quoting at much lesser valuations?

Vipul Mehta: I don't think it does. As I said earlier, it's probably one of the better business models run by one of the better managements. There have been a lot of other factors for me not to go into companies like Liberty, Phoenix and MS shoes. There's nothing, which makes me feel that Mirza Tanners could go that way.

A recent development – Under a licensee tie-up Mirza would sell its own shoes under the Hush Puppies brand name in UK increasing volumes and profitability. Other client names include the like of Barrats, Clarks, Florsheim etc. I do not think any of the above companies have such credentials.

Capex is not a cap on capitalization

Utpal Sheth: Shoes have never been an exciting business from an investor's point of view. And so far, Mirza has been concentrating only in such select segments. Yet Mirza has been able to show a scorching pace of growth. Given that these growth rates have to be backed by capital expenditures in shoe manufacturing capacity and tanneries, are you comfortable with the sustainability of the growth rates?

Vipul Mehta: I think Mirza has amply demonstrated its capabilities over the period of last three years. Mirza has managed to expand capacity from 50-60 thousand pairs to about 250,000 pairs for this year, and going ahead, it will have its capacities well in place without any disproportionate capital expenditure. I think the free cash flows are enough to take care of these expansions, and to ensure the growth of Mirza. In the vision of the management of Mirza Tanners, the company is out to look for an outsourcing model where quality will be ensured. So I don't see any problem in the capital expenditure plans of Mirza and therefore the future growth of Mirza Tanners.

Utpal Sheth: For companies of this size to really move into to the league of multi-baggers, which Mirza has already done, there has to be...

Vipul Mehta: I'm sorry to interrupt, but I think Mirza is yet to realize it's full potential, and so it could still be a multi-bagger in the making.

Utpal Sheth: Okay, I stand corrected. There needs to be a serious effort in terms of investor communications. In your opinion, has Mirza lived up to that, or is there scope for improvement?

Vipul Mehta: An effort has already been made into doing that, and as time passes, and there are more merits to show, then these things will be well taken care of.

Gujarat Ambuja Cement

Gujarat Ambuja Cement – Leader in a moderate industry with best credentials

Navin Agarwal: Vipul, coming to our next company, which is very differently positioned from all the stocks that we have covered up to now, could you articulate your investment case for Gujarat Ambuja Cement?

Vipul Mehta: Gujarat Ambuja is probably an out of fashion stock today as it is not an IT stock, not a communication stock, and nor an entertainment stock. It is a story of one of the entrepreneurs who has made a mark in the Indian corporate world today. It had no family legacy and having grown from an entirely new entity to what it is today. Basically a lot of credentials that Gujarat Ambuja has - a leader in the cement industry with the best operating parameters and the best qualitative credentials that a commodity company can have in the corporate world. It is all these qualitative factors that will help Ambuja sustain the growth and the profitability of Ambuja more than any other company in this industry. This is the investment case for Ambuja.

Great management’s can contribute to reducing cyclicality

Navin Agarwal: Vipul, you mentioned in your investment philosophy that when betting on cyclicals you cut your possibility of going right by half. How does Ambuja meet that test?

Vipul Mehta: I think in Ambuja's case, it is the sheer strength that has been created out in the company. We talked of a good management in a moderate business. Ambuja is a living example of that. It is in a business which is sustainable but cyclical in nature and which a great management can undo by reducing the cyclicality element and giving it a sustainability element. I think that is where Ambuja's risk narrows down significantly in a cyclical scenario.

Cement is a highly predictable business

Navin Agarwal: How do you rate the cement business itself over the long-term in India?

Vipul Mehta: It is a very predictable business. Historically it's been growing at 1.5x GDP. There is no reason why that should not continue over a long period of time, although there definitely will be aberrations / cycles happening. But, it is a reasonably predictable business over a period of time. In terms of companies, there will be company’s which will come out as winners and there will be company’s which will come out dominating the whole industry in terms of every possible parameter of returns.

Navin Agarwal: While cement industry, as you just said, is predictable and is growing at 1.5x GDP growth, Ambuja and most other cement companies have barely covered their cost of capital in the whole of the last decade. Does that still keep the business attractive?

Vipul Mehta: I think, yes. I think that Indian industry has had a very typical scenario where there have been as many as 60 plants contributing to about hundred million tons of cement producing capacity. These many number of plants have been over a significantly higher number of companies, contributing to a very low per company tonnage capacity of cement available. This is not necessarily the scenario in case of some of the stronger companies, which have had a return on capital of as much as 25 percent.

But this is a scenario that is changing over a period of time. As I mentioned in my investment philosophy, there are companies that with growing rates of return on capital and which will probably have a much higher case for increasing market capitalization. I think cement industry could be one of those and definitely the leader in the cement industry will enjoy this privilege of higher returns to shareholders.

Volatility in cement prices mitigated by improvement in operating parameters

Navin Agarwal: How comfortable are you with the high leverage of Gujarat Ambuja given the volatility in the cement prices in the recent past?

Vipul Mehta: Gujarat Ambuja had the knack of getting this leverage into control over a period of time. Ambuja started with a manufacturing capacity of 0.7 million tons. From there, with a couple of dilutions in its early stage, it has grown to a level of about 9 million tons of its own capacity basically through leverage. In the last few years, it has been able to leverage on the back of its cash flows of the next few years and is able to get its leverage into control. Ambuja has been able to mitigate the volatility in cement prices through better and better operating performances year after year after year. To that extent, the risk of high leverage in a commodity cycle is reduced so much.

Navin Agarwal: Could you explain to us the strategy behind the seven percent stake that Ambuja has picked up in ACC and at an extremely high EV per ton of capacity of ACC?

Vipul Mehta: At the outset, I would like to mention that I have no opinions on developments of the Ambuja-ACC deal of which a lot is being heard and said. As far as common-sensical knowledge goes the game plan of Ambuja as it appears is as follows –

1. ACC has been managed by the Tata’s with a 14 percent stake and with the support of institutions all through.

2. ACC has had very fragmented operational facilities and along with that goes a bigger marketing strength all over the country.

The game plan of Ambuja seems to be to acquire this 14 percent stake and get into the management of ACC and therefore get leadership in cement capacities in India and, as a result, pricing power through this leadership. It also adds to the distribution network of Ambuja over the whole of the country. This basically seems to be the game plan of Ambuja by acquiring a 14 percent stake, if it finally manages to acquire a management control on ACC.

Several payoffs in the ACC stake acquisition

As it seems now, there is a caveat in that various developments seem to be happening on this 14 percent stake and the caveat being that if Ambuja has to make an open offer the whole story will be quite different. But as of now Ambuja has probably taken advantage of this loophole of the takeover code and is trying to acquire a management control through a 14 percent stake. So a 14 percent stake at a high-cost amounts to a management control of 11 million ton capacity at that cost, which will further be compensated by pricing powers, by availability of distribution and increased profitability to Ambuja and ACC over a period of time.

The deal can result in various possibilities going forward over the next five years. It could give Ambuja pricing power, resulting in improved profitability. Ambuja can also improve the efficiencies of ACC and also to make it much more profitable than it is today. Ultimately, Ambuja can merge the two companies.

Lucrativeness of Southern market is a myth

Navin Agarwal: Despite some of the recent acquisitions by Gujarat Ambuja it is still predominantly a West Indian and a North Indian cement company. It has still not been able to get a foothold in the lucrative Southern market. Is that any cause for concern?

Vipul Mehta: I think the lucrativeness of the Southern market itself is a myth. To start with the cement market is a very regional market. The best cement model that a company could have in a country like India with high transportation costs and high costs of reaching consumer markets is localization. Opinions from various experts combined with my personal belief suggests that it is better to be a No.1 or a No.2 in a regional market rather to be a No.1 in the country and a No.4 in a particular region.

So given that I think Ambuja has its strengths in place, having established itself in leadership position in these markets, it's in a position to capitalize on the pricing power in these markets, more than anyone else. Also the southern market that you are talking about is no more as lucrative as it used to be with traditional capacities having come up in the last two years. It used to be a very lucrative market about a couple of years back but as we see now the Southern market no more remains a market as lucrative as it ever was earlier. So Ambuja is probably in a better position to capitalize on the regional markets of the West and the northern regions.

Jetty offers it the flexibility to transport cement to the Southern market

Add to it the jetty of Ambuja. Ambuja is the first company to use sea transportation route for its cement. In case there is upside in the Southern markets, Ambuja is also placed to capitalize, to exploit it. I am told that Ambuja’s cost of transporting cement from its jetty in Vadinar to Cochin is a third to fourth of its cost of transportation by road. In fact, the cost of transporting cement from its jetty to Bombay is about Rs.400 per ton as compared to over Rs.1,800 per ton by road. Those are the economics, which Ambuja works on and these are the strengths, which Ambuja has. It has the ability to leverage on the Southern markets as well as the Western and the northern markets.

Navin Agarwal: On a scale of 0 to 100, what part of this 100 would you allocate to the structural changes being a reason for your investment and what part to the cyclical opportunities if 100 represent the total positive change for the cement industry and in turn for Ambuja?

Vipul Mehta: By structural changes you would mean?

Major structural change in the cement industry

Navin Agarwal: A continuous consolidation of capacities in a few hands, resulting in improved pricing power, combined with a sustained growth in demand and with not much fresh money going into capacity creation but capacity acquisition.

Vipul Mehta: I think it has been a very significant point in the cement industry in the country where consolidation has become the norm. I think it all stems out of the fact that the cement industry turned into a huge over capacity in the years of FY97-FY98 when demand started dropping and pricing power was lost by all companies. To add to that, the fragmentation didn't help anyone and the smaller companies basically contributed to price discipline not being maintained.

A typical scenario of recent times is in the eastern markets where, as news goes, Lafarge slashed down prices to capture market share as a new player. I would like to believe that it was rather the lack of discipline of the smaller players, which cracked the prices and Lafarge was therefore forced to follow and therefore the profitability of all these cement companies was affected.

So consolidation is definitely going to be a very significant factor also stems from the fact that a couple of companies have not done themselves any good as far as the financial institutions and the repayment of loan goes. The most important player being Sanghi in this case and the institutions are not willing to lend to new cement capacities. And in any case a cement capacity to put up now would take another two or three years and with demand projected to grow as it is, we are looking at a much more favorable demand supply scenario than the last two years. A lot of consolidation is happening with the smaller companies being acquired. So this would give the price discipline and the pricing power back to the cement companies. I think it is going to be a very important structural change working in favor of the cement industry and the same goes for Gujarat Ambuja cement.

Economic profits will be generated in future

Navin Agarwal: So with this structural change happening, would you expect companies to start generating economic profits i.e. cash flow after considering a capital charge?

Vipul Mehta: This would happen but this would be more in case of companies like Ambuja which have had such superior operating parameters than all the other companies which have had inefficiencies that has not been rectified over the last few years which Ambuja has done so successfully.

Lot of intellectual capital has gone in to the company

Navin Agarwal: What would turn this investment into a mistake in your opinion?

Vipul Mehta: The ACC thing?

Navin Agarwal: No. The investment in Ambuja stock into a mistake.

Vipul Mehta: If something goes wrong with the ACC stake that the company has acquired or if it were to turn a pure investment, then that would hamper the valuations of Ambuja. Operationally, as far as the cement performance goes, I think everything seems to be going very well for Ambuja. There is no reason why something should go wrong. Incidentally, where Ambuja had things going for it right away from putting up a 0.7 million ton plant. To start with, the limestone mines where Ambuja put up its plants gave out limestone which is as soft as it can get and this reduces the power requirements for Gujarat Ambuja quite significantly besides reducing costs on mining of this limestone. Additionally the qualitative factors that have gone into reducing of costs, the parameters on costs which Ambuja has used, the small things which have gone into the plant, have all helped.

If one goes on a plant visit to Ambuja one probably realizes how far Ambuja has modularly expanded and where Ambuja has saved cost. The new plant stands on the old limestone mines and this is the extent to which qualitative factors have gone into the making of Ambuja as a cement powerhouse. So I don't think operationally Ambuja could go wrong. The acquisition of DLF itself is very synergistic, linking up the whole chain of Ambuja from the West end to the northern markets with DLF providing the link in the Rajasthan markets. The northern plants of Ambuja in Himachal Pradesh and the grinding unit in Punjab itself is an example of what Ambuja's vision is in the cement industry. The northern market was a deficit area and Ambuja put up a plant in the Himachal regions, closer to the mines and a grinding unit in Punjab which was a very lucrative market. So Ambuja has had things going right for it from outset and that's what made Ambuja grow to this size from its starting capacity of 0.7 million tons to around nine odd million tons right now.

MNC’s have no advantage over Gujarat Ambuja

Navin Agarwal: Could the entry of multinationals make this investment a mistake by any chance?

Vipul Mehta: As it is new investments will take time to come and if the multinationals acquire plants it will be the same capacities. So why should a multinational have any operating strengths or marketing strengths that an Ambuja does not have. I don't think multinationals are going to make any difference whatsoever and if at all it will only be an advantage for Gujarat Ambuja.

Best placed to capitalize on the favorable scenario in coming two years

Navin Agarwal: What would be the valuation case for Ambuja at the current prize?

Vipul Mehta: I think the upside which Ambuja has, given that the whole ACC thing works out in favor of Ambuja, is the huge pricing power in its markets and this will translate into a much much bigger profitability for Ambuja. Ambuja is the best placed to capitalize on the favorable scenario of cement in the coming two years. Though it quotes expensive than most of the other cement companies, it is not without reason that Ambuja is quoting at the levels.

Vision to grow into a large sized cement company

Utpal Sheth: When you first invested in Gujarat Ambuja what were the management traits, which appealed to you the most besides its operational parameters?

Vipul Mehta: I think it was a pure vision of Ambuja to grow into a large sized cement company given the resources and constraints that it had, within the parameters of shareholder returns and shareholder values. I mean even over the last few years Ambuja has always talked of becoming a 20 million company when it was a five million company. It talked of a 12 million in the next three years and 20 million in five years and Ambuja seems to be well ahead of its targets assuming that things don't go wrong as far as the ACC deal is concerned. You also know all expansions going right and all this is happening only through a very minor dilution through a GDR or an ADR. It's not a shareholder return dilution. So this is what Ambuja has done.

Besides all the operating parameters of Ambuja are absolutely well known to everyone in the markets. Every operating parameter of Ambuja has been secularly upward in every single scenario. This has been a credit to the management of Ambuja.

Utpal Sheth: Are the treasury operations of Gujarat Ambuja of any serious concern for a large investor like you?

Vipul Mehta: Not really. In fact, treasury operations of Ambuja have of late been helping them in all the deals that they have been clinching and the financial structuring that is being needed for all these operations like acquisitions and mergers. So I don't think it's too much of a concern as the stock market exposure is now very insignificant for Ambuja. I think there is a much bigger thing to look at, which is the cement business of Ambuja and the potential that business has.

Investment Chronicles

New economy, New valuation paradigm

Utpal Sheth: Vipul, after all the enlightening discussions on stocks, we would be very keen to learn from your rich experience in capital markets. Could you share with us some of the big successes and big failures in your investing career, and the things that you learnt from those successes and from those mistakes?

Vipul Mehta: Tough question. But there have been a lot of experiences along the learning curve, and a very long way to go. It has been interesting to see how fast markets have evolved, how times have changed, and most importantly, how valuation parameters have changed. There was a time when P/E used to be one of the most important parameters. Nowadays, valuations are driven by intangibles and RoCE. The IT sector is redefining valuations, with new pricing parameters. Price to sales is now a ratio that is more relevant than P/E. Price to sales ratios of many stocks are equivalent to P/E of a whole lot of pivotal stocks. So it has been a huge transformation and it's been exciting to learn how markets have been much more efficient than what they have earlier been. From the 1992 and 1994 broad market bull runs to the selective polarization of the 1999-2000 bull run, markets have matured vastly. One segment of the market is northward bound, while the other segment is gravitating southward.

The early bird gets the worm . . .

It's been a very interesting learning. I have learnt that it is imperative to be able to catch these structural movements early. Timing too has become an important factor in investing - much more than what it ever used to be. We have seen how restructuring has come to play an important role, how valuations are assigned to companies which have valued shareholder wealth creation. These have been the most important lessons to learn, and to distinguish how market values two-three years' growth or the lack of it, and discounts it so much well in advance. Also India is now a part of the global market. To an extent, transformations take place in sync with what happens on a global level, or at Asia levels. So these have been some of the values and concerns to learn, and to implement them into your investment philosophy. The fund managers' job has become tougher today than ever before.

. . . and then rides the wave

Utpal Sheth: Could you be a little stock specific in your historical successes and failures?

Vipul Mehta: Obviously the biggest successes have been stories like Infosys, which has been a big success story for everyone. Of course, no one can claim fame of being the only identifier of Infosys. There have been other success stories like Software Solutions, Mirza Tanners, Hero Honda, Cipla, Vikas WSP etc. The key to all these success stories have probably been to identify these stories at very early stages of their growth cycle, and then ride the wave. There have not been too many success stories in terms of the economy stocks that have been exploited by fund managers. A two bagger or three bagger story would have been relatively cold-shouldered. One of the more satisfying success stories is a story like Cummins which had so many strengths under its belt, and then catching the cycle right.

The failures - obviously a lot of disappointment comes from companies that have done very well operationally, but their stock prices have not done well due to variety of reasons. The most regretful failure comes from a stock like MRF, which stems from the management's principle of not sharing wealth with shareholders. MRF has been a relatively closely held company, not in terms of the shareholding pattern, but in terms of shares not being dispersed widely. With a result, MRF is an illiquid stock. But the fact is, the management has done absolutely brilliantly in its business to turn MRF into what it is, a tyre super house today. But in terms of the shareholder wealth creation, it's done absolutely nothing. The balance sheet structure is skewed badly. The capitalization of the company is virtually negligible in comparison to the size of its reserves, or to the size of its turnover, or to what it's capitalization could have been after four or six bonuses, or to what it could have been after a 25 percent or a fifty percent payout.

Catch IT if you can - it's never too late

In terms of mistakes in investing, the biggest mistake was not to catch on to the IT boom as early as it could get. This was probably due to the fact that the IT boom had a lot of apprehensions attached to it at the start. The body shopping models followed by a lot of companies, the low end Y2K work which was a big chunk of a lot of IT companies' revenues, and a lot of other factors which made one think that the IT boom was akin to those of the other aquaculture or finance company booms that had happened earlier. But there was a lack of personal vision to realize that these IT companies could get better, or the lack of vision to realize the potential of these IT businesses on a global scale. I think it's never too late. Having missed the cream of multipliers, there's still quite some way to go. One would still want to stick to quality IT companies or quality ICE companies. The other regrets have been the lack of maturity in the markets to an extent where 'the herd mentality' of the markets' has manifested itself to the hilt. This 'herd mentality' could hurt people more than anything else can.

Another lesson has been that investing in illiquid stocks has frequently not delivered desired results in spite of company merits due to the difficulties in entering and exiting such stock positions. Virtue of discipline - the kind of stocks to invest in, the number of stocks to invest in, and fads like sunrise industries and turnaround companies have all been lessons that markets have taught. More often than not, turnaround companies have never turned around. Markets have transformed themselves over the last few years.

All that glitters is not gold

Utpal Sheth: Vipul, you mentioned management indifference to shareholders as one of the key reasons for mistakes. Other than that, what are the other key causes of most mistakes that you have identified?

Vipul Mehta: Some of the mistakes have been reading too much into businesses or business potentials, or maybe reading too much into cyclicals. It is difficult to quote examples at this point, but riding an economic recovery cycle too far is probably an example of a good management and a not so good business. Here, businesses over a two-year or a three-year timeframe did not do greatly, but the management did not have any doubts or question marks about the future, but in the ultimate run these stocks did not do well. These were amongst a few lessons that also had to be learnt.

Well begun is half done - Start with quality, end with quality

Utpal Sheth: Vipul, you mentioned early entry into quite a few impressive stocks as a reason of your success. Could you share with us the initiators of these investment ideas? What triggered your thought processes on to those?

Vipul Mehta: The strengths of the businesses and the vision of the management. The strengths of the businesses could be exemplified by companies like Hero Honda, which had strengths of its product and the strengths of its marketing. Other examples of strengths that companies have had are - a vision like Infosys, or like Software Solutions. Examples of early starts could be a good industrials run where we have had stocks like Telco doing well in our portfolios, or stocks like Cummins which were in the dumps of valuation but just recovering in terms of their business cycles. So these have been good performers as far as our portfolio stocks are concerned.

Utpal Sheth: And what mantra will you advise investors in going forward, Vipul?

Vipul Mehta: I have always stressed quality of the management. Secondary factors would be the business itself and thirdly the valuations. Everything is at a price, and one can't be over paying for anything, or under receiving for getting out. These are the three factors, in that order of priority that should indirectly be the mantra for investors.

Having stressed so much on management, I would like to make an interesting point – there is a cycle in which one has to be at the right point. The managements do tend to reflect market capitalization in their interaction and there could be a possibility that one might miss the future fundamentals or vice-versa get bearish on a company with a great future. So there is an international school of thought which dissuades interactions with the managements which though can only be a very selective philosophy.

What you see is what you get - Look out for Vision

Utpal Sheth: Vipul, what in your opinion are the characteristics of successful investors in the long run, besides discipline that you did mention?

Vipul Mehta: Besides discipline, a lot of thinking and vision go into buying a stock. At times, timing does get important, especially in markets that are volatile, or which are not in a secular trend. It is nice to catch and identify stocks early. Obviously reading into the history of each of these companies, and analyzing balance sheets also play a very important role in identification of companies. Valuation parameters and return on capital ratio that shows how effective the management has been in utilizing the resources at its disposal, are also very important parameters in successful investing. Obviously all these are going to have aberrations with markets in the state that they are now in, where everything with an 'ICE' tag turns into gold. But I guess all these get normalized over a period of time and I believe investors ought to stick to these principles of investing.

Utpal Sheth: Vipul, any international or domestic investors that you would cite as your idea of a great investor for a long, long time?

Vipul Mehta: I guess in terms of international investors everyone is thrilled about the genius of Warren Buffett, or George Soros who identify businesses right or time things right. These have been great investors.

Chetan Parikh: Thank you, Vipul, for all the time that you have spent. It is well past midnight again. On behalf of capitalideasonline.com, I'd really like to thank you for sharing with us your thoughts and giving us some of your best ideas.

Vipul Mehta: No, I think it was an interesting experience for me to share my ideas, and getting questions as drilling as they were, at times putting me into a tough situation. It was definitely an experience, which added a lot of value to me. Thanks a lot for inviting me.

Utpal Sheth: Vipul, we wish you all the very best, and hope that you will keep on creating as much wealth as you have done in the past, and for sharing your wisdom and experience in investing with us. Thank you.