US Govt- Different strokes for different folks?

The US Government, through the US Treasury and Federal Reserve, stepped in to save the Fannie Mae and Freddie Mac; refused to do anything about Lehman Brothers, let Bank of America help Merrill Lynch save itself and threw AIG a lifeline. Why this partiality? There’s reason ! Lets see why!

The Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC) all are Government Sponsored Entities (GSEs) and they are known by the names Ginnie Mae, Fannie Mae, and Freddie Mac. Each purchases mortgages from lenders to provide funds for mortgage loans.
The agencies issue three types of mortgage-backed securities: mortgage Pass-through securities and collateralized mortgage obligations. and stripped mortgage-backed-securities. This process of combining many similar debt obligations as the collateral for issuing securities is called securitization. The primary reason for mortgage securitization is to increase the debt's attractiveness to investors and to decrease investor required rates of return, increasing the availability of funds for home mortgages.

Ginnie Mae, Fannie Mae, and Freddie Mac all guarantee the timely payment of scheduled interest and principal payments from their mortgage-backed securities. They are able to do this because they only purchase or underwrite loans that conform to certain standards regarding borrower credit ratings, loan size, and the ratio of each loan to the value of the property securing it.

The US Government, through the US Treasury and Federal Reserve, stepped in to save the Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac account for almost half of the $12 trillion mortgage market. By law, they are not allowed to hold sub-prime mortgages or refinance them. But they are listed companies and when the market value of their capital base falls below the mandated capital adequacy levels, how good the assets are is irrelevant.

As GSEs, many foreign central banks (including Japan, China, India) have invested their reserves in the bonds of these agencies. So it was very unlikely that the US govt was going to let its own GSEs go bankrupt.

Reference: Businessworld, CFA Institute Level 1 curriculum

environmental waste

A brilliant piece in today's times by Bjorn Lomborg, one of my favourite environmentalists. While the world goes mad jumping on every passing bandwagon with a climate change banner, there is precious little common sense being applied. Lomborg's simple case that we should cost actions in seems to be ignored by the vast majority of environmentalists. His calculations suggest that for every pound the UK is spending, we will receive roughly 4p worth of good. The money could and should be spent elsewhere.

I can't disagree with a thing he says. His analysis is spot on.

What irritates me more than anything about the whole climate change debate is the almost total ignoring of the effects of future technology with its consequences for business and social change.
All the projections of doom and gloom rely on technology staying similar to today, yet the assumption is that we will still consume more and more. So environmentalists take full account of increasing wealth and consumption, without taking any account of what we will actually be consuming, or how it is made or used. We still see lots of ads telling us how important it is to switch off TVs and other IT and not to leave them on standby. The fact is that these devices don't use 30W on standby any more, it is now more like 0.1W. Recent rises in oil prices have already led to car manufacturers accelerating their plans for electric cars, and caused hundreds of entrepreneurs to get into new energy technology. Panic is not required, solutions are being developed and will be delivered. Not tomorrow, but easily early enough to prevent anything like the doom and gloom being forecast for the long term.

In this light of rapid technology development and the mid term solving of climate change, and the certain aversion of long term doom, Lomborg's criticism of the extreme waste of money on reducing CO2 emissions becomes even more appropriate. Governments are spending extreme amounts of money on very little gain, whereas if they spent much less in the right areas, such as technology R&D, they would accomplish much more.

So why is this in my finance blog rather than my grumpy old man rant? One day, in the not too distant future, the tide will turn, and it will be obvious to everyone that the money has been misdirected. Companies that are developing genuinely useful technologies will flourish, whiloe those sustained by the financial fallout of environmental hype will suffer and most will die.

Time to start looking at your portfolio and weeding out shares in so-called ethical companies, and any that spend a lot of effort to tell everyone how environmentally sound they are. I'd rather have sound financial and business management any day than a CEO whose main effort is to appease the stupid end of environmentalism. The day of reckoning will come sooner than you think.

bank collapses and the suspension of logic

I have been asked several times recently to comment on the economic collapse and have refused to do radio shows because I know too little about economics to make any sensible comment. Or so I thought. But the decisions our leaders have been making in response suggest I am not the only one who knows nothing. I am astonished at how much absolutely obvious sense has been thrown away in the panic. Our UK treasurer has responded to the collapse of Bradford and Bingley by selling much of the bank to the Spanish Santander, while keeping most of the debt. Fair enough if the deal was sound, except that the price he sold it at was only sensible if Santander also took on most of the debt. As far as I can tell from the figures in the morning papers, he effectively sold £21Bn of safe cash for £610M, while the UK taxpayer kept all the debt. Sure, the bank shares were worthless, but cash is cash, and debt is debt, and even if the overall sum is low, the cash bit is still cash, bank branches are still branches, and still worth just as much. Banco Santander must be laughing themselves silly at the stupidity of the UK treasury. I am feeling rather let down, having had a large chunk of my hard earned money given away to a bank for no good reason. Along with every other UK taxpayer. Why is our government so panicked into doing something that they will do anything, regardless of whether it makes any sense? Surely in time of crisis, actions need more than ever to be thought through sensibly.

In any case, I am rather puzzled by this whole thing, and I am not alone. Why is it such a big problem if some banks go under? They can't all fail. The world economy is perfectly sound. People are working, generating wealth. Some people have surplus, others want to borrow. If every bank went broke, new ones would spring up on the internet tomorrow to ensure that borrowers are put in contact with savers, for a cut. As it is, some banks have overstretched, and bought bad risks from other banks, and they deserve to suffer the consequences of their own bad decisions. Other banks who haven't done so will survive, since their assets outweigh their bad risks.

Of course, the situation has created an atmosphere of distrust, and slowed liquidity, but throwing away good money at people who have already proven should not be allowed to manage it does not seem a good idea. Capitalism hasn't failed, the companies failed, that's all. If they are allowed to die, no big deal. Life, business, and the flow of money, will quickly return to normal. The real problem is if taxpayers' money is thrown away, taxes increased, and people can't afford to live well. That will certainly collapse economies.

So, I don't get it. Perhaps I am missing something, but I suspect not. I suspect the real problem is that our leaders don't get it, and are far too willing to listen to bad advice from people who stand to gain a great deal of money from it. If I were in power, I would leave the market alone. It will be very turbulent, lots of people will lose money, and lots will gain. And the banks that survive might be a little more sensible in future. Bail them out, and the pain will affect everyone for a very long time, and the banks will still take bad risks, because that is how their executives are incentivised.

Why is Rupee depreciating then?

The US Economy is weakening, why is Rupee depreciating (as compared to dollar) then?

The rupee slumped to a five-year low of 47.10 in spite of the slowdown in the US Economy. Ideally when a country is in the slowdown the currency of that country should depreciate. Fine that India is slowing down too but is still growing at a rate more than the US. But why is the Rupee depreciating then.

There is heavy dollar-demand from oil refiners and importers.
Sentiment for the local currency was further dampened by losses on the stock markets on Monday (29-Sep-08). But the central bank intervened by selling up to $1 billion which helped prop up the rupee.
We have the inflation climbing the ladder very fast with remote signs of coming down. The crude oil prices are extremely volatile. The GDP forecast is also trimmed every now and then. The current account deficit is widening.

With not many positives in sight, traders see the rupee trading in the 47-per dollar range for the next few days. At the current levels, the rupee is still the second worst performing major Asian currency against the US dollar as it has dipped by 18% since January after the South Korean Won which dipped by about 23% in the same period. Though many other competing Asian currencies, like the Malaysian Ringgit and Thai Baht, have also depreciated against the dollar, they have still fared better than the rupee while the Chinese yuan has actually strengthened against the dollar.
The central bank is not protecting any level as such. It is just protecting the market from excess volatility. At the moment, there are a number of underlying negatives, with constant dollar-outflows from the markets and a widening current account deficit. Given that the central bank is not proactively supporting any particular level, traders are not ruling out possibilities of the rupee depreciating beyond the 47-mark in the next few weeks either.
In the domestic market, the rupee touched a low of 47.10/11 against the dollar during early trade on Monday, a level last seen in June 2003. However, its slide was halted by heavy central-bank intervention, following which the rupee ended the day at 46.96/98 levels against the dollar, weakening from its previous close of 46.54/55. Cash conditions also went through a major squeeze, with banks collectively borrowing a record Rs 90,075 crore from the central bank, over both its daily liquidity adjustment windows.
RBI has been intervening heavily in the forex markets for the past couple of weeks, with nationalised banks selling dollars on its behalf. The RBI is estimated to have sold up to $2 billion in its intervention on Monday, in an attempt to shield the rupee from a steep fall. Also, dollar demand was enhanced on Monday, since the currency and bond markets will be shut on Tuesday for the half-yearly book-closing of banks.

Yield on the 10-year benchmark bond, the 8.24% bond maturing in 2018, rose to a high of 8.73% during early trade. It finally ended the day at 8.62%, three basis points above Friday’s close of 8.59%. According to a dealer with a private bank, some banks picked up positions in the 10-year bond, in an attempt to artificially bring the yield down, so that they wouldn’t incur mark-to-market losses in their half-year closing.
[Remember, yield is inversely related to the price; so when the yield comes down, the prices go up and thus the mark-to-market losses come down] Inter-bank call rates also remained high and touched a high of 16% during the day.
I am not really sure if I have answered the question myself that why is rupee depreciating as compared to the dollar. But yes, there are enough reasons for the rupee to depreciate.

Any better answers? Please post !!

source: extracts from The Economic Times (30-sep-08)

Accounting Impact - SOX

Accounting Impact
From an accounting perspective, the focus in the United States has been on:
• Convergence
• Moving from rules-based standards to principles-based standards
• Trending away from recording assets and liabilities at historical cost and moving to fair value.

Convergence
With the global environment in which companies operate, the FASB and the International Accounting Standards Board ("IASB") have dedicated themselves to improve financial reporting by evaluating the differences between US GAAP and IFRS and reducing those differences where possible. The two bodies are currently in the short-term phase of a longer-term convergence project. The goal of the short-term project is to reduce a variety of differences between US GAAP and IFRS.
The short-term projects are those where significant differences do not exist and the Boards believe that they can reach agreement without a major overhaul of the current requirements.
In addition to the convergence project, the FASB and IASB have joint projects where, from the beginning, they are working together to find the best accounting answer. One such project is business combinations.

Rules-based standards to Principles-based standards
Historically, the accounting standards in the US have been very detailed and rules-based; sometimes to the detriment of properly reflecting the economics of the transaction. Consequently, businesses have sometimes structured transactions to achieve a desired accounting treatment.
A study performed by the SEC entitled, Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System (dated 25/7/2003) indicated that principles-based standards would result in more transparent information for financial statement users, and provide information that conforms to the spirit or objective of the accounting standard versus meeting detailed rules.
Principles-based standards, however, will require company management and auditors to use more judgement in applying a standard as there will no longer be a list of rules to check-off, but the spirit of the standard and the economics of the transaction must be reflected appropriately.

Historical Cost to Fair Value
A trend in US standard setting has been a move to recording transactions at fair value versus historical cost. While this determination is currently being made on a standard-by-standard basis, the FASB has found that more frequently, fair value is proving to be the most relevant and reliable measure of financial value.
The trend toward fair value is not isolated to standard setters in the US. The IASB has also been trending toward fair value and seeing the benefit of recording financial statement items at fair value.
Fair value versus historical cost is causing quite a bit of debate within the financial community. Some question the reliability of fair value as often it is the result of management's estimate and judgment versus an observable market transaction or contract price. Others question the cost/benefit of providing such information. Determining fair value can be more costly and time consuming for companies than determining historical cost.
Regardless of the debate, standard setters are seeing the benefit of fair value accounting and many new standards are requiring its use.

SOX - International Impact

International Impact of SOX
Foreign Private Issuers ("FPIs") registered on US Exchanges must comply with the Act in the same manner in which a US company does, with limited exceptions. The Act introduced additional requirements that many foreign companies did not anticipate when first deciding to enter US capital markets. As a result of these and other environmental changes, the direct and indirect costs of being an SEC registrant have increased and some foreign companies are reconsidering the US capital markets as a place to raise capital. Additionally, the PCAOB regulates the non-US auditors who have clients that are listed on an exchange in the US and registered with the SEC. This makes the non- US audit firms subject to the regulatory requirements, inspection process, and penalties dictated by the PCAOB.

In response to the increase compliance costs, in March 2007, the SEC finalized rules allowing Foreign Private Issuers to deregister with the SEC if they meet certain requirements.

A link to the final rules is provided (http://www.sec.gov/rules/final/2007/34-55540.pdf)

Although many countries or territories do not have a Sarbanes-Oxley equivalent, many regulatory bodies and Exchanges are expanding their accounting, regulatory, and corporate governance standards in order to prevent large scale corporate scandals as those experienced in the US.

As a result of increased scrutiny by the regulators and investing public, company officials of multinational entities have stated that much of their time has been redirected from strategic business initiatives to matters of compliance. The amount of time and money spent globally on regulatory compliance has increased dramatically in recent years. The increased costs, however, have not gone without benefits. Companies have identified and corrected weaknesses in their internal controls over financial reporting which should improve the quality of the information they are providing to the market. This translates into more informed investors and increased trust in the capital markets

Sarbones Oxley - Overview

Sarbonex Oxley Act (SOX) or Investor Protection Act 2002

The Act was written by Senator Paul Sarbanes and Congressman Michael Oxley and enacted by the Congress of the United States in response to corporate management, accounting, and reporting scandals.
The Act has heightened the role of regulation within the accounting industry and with it the role of the US Securities and Exchange Commission ("SEC") and the newly created Public Company Accounting Oversight Board ("PCAOB") in that regulatory process.
The Act represents the biggest change in the US corporate governance and reporting since the federal securities laws were first enacted in 1933 and 1934. The Act has required the SEC to issue more regulations within six months than the SEC had ever issued before in a similar period.
Among other things, the Sarbanes-Oxley Act establishes new or enhanced standards for corporate accountability and has increased penalties for corporate wrongdoing for SEC registrants.

The Sarbanes-Oxley Act was enacted in an effort to prevent accounting scandals and other reporting problems from recurring, and to rebuild public trust in US corporate business practices, financial reporting, and in the capital markets.

The Act created a new oversight organisation, PCAOB, which now regulates the auditors of US public companies; the SEC continues to regulate the public companies.

The Act requires the PCAOB to establish:

• auditing and related attestation standards
• quality control standards
• ethics standards
• professional standards on the independent auditors’ attestation report on management’s assessment of the effectiveness of internal controls

The Act also authorises the PCAOB to establish rules to implement and enforce auditor independence requirements. Previously, independence rules were established and enforced by the SEC for auditors of public companies and the American Institute of Certified Public Accountants ("AICPA") for auditors of private entities.

The Act gives the PCAOB authority on how it will develop and adopt its standards. The Act does recommend that the PCAOB gather input from outside experts during its standard setting process. The PCAOB agrees with the Act's recommendation and, consequently, develops its standards in an open, public process in which investors, the accounting profession, the preparers of financial statements, and others have the opportunity to participate. In order for a PCAOB standard to become final, however, it must be ratified by the SEC.
The purpose of the Sarbanes-Oxley Act is to protect investors through:

• Disclosures that are more:
• Accurate
• Timely
• Comprehensive
• Understandable

• Enhanced Corporate Governance rules

• Stricter enforcement of the auditing profession by creating the PCAOB

• Improved internal controls over financial reporting

Section 404 of the Sarbanes-Oxley Act requires the annual report (Form 10-K or Form 20-F) of each US SEC registrant (except a registered investment company) to include a report addressing the following:
• A statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting for the company
• A statement identifying the framework used by management to conduct the required evaluation of the effectiveness of the company’s internal control over financial reporting
• Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year, including a statement as to whether or not the company’s internal control over financial reporting is effective
• A statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s assessment of the registrant’s internal control over financial reporting

The cost of compliance with the Sarbanes-Oxley Act, both in dollars and hours, has been a source of debate within the US. So much so that the SEC, with the PCAOB, held and will hold public roundtables to discuss the Act with constituents. The result of such roundtables has been further interpretive guidance from the PCAOB, including the June 2007 release of Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements to assist in the most effective and efficient implementation of the Act's requirements.

Valuation in Mergers & Acquisitions

Valuation is a critical part of the merger process. A deal that may be sound from a business standpoint may be unsound from a financial standpoint if the bidder firm pays too much. The purpose of a valuation analysis is to provide a disciplined procedure for arriving at a price. If the buyer offers too little, the target may resist and, since it is in play, seek to interest other bidders. If the price is too high, the premium may never be recovered from postmerger synergies. These general principles are illustrated by the following simple model.

ANALYSIS
Mergers increase value when the value of the combined firm is greater than the sum of the premerger values of the independent entities.

NVI = VBT – (VB - VT)

where NVI = net value increase
VB = value of bidder alone
VT = value of target alone
VBT = value of firms combined

A simple example will illustrate.
Company B (the bidder) has a current market value of Rs.40mn. Company T (the target) has a current market value of Rs.40mn. [Please note that this assumption of same market value for both the companies is rarely found]. The sum of the values as independent firms is therefore Rs.80mn. Assume that as a combined company synergies will increase the value to Rs.100mn. The amount of value created is Rs.20mn.

How will the increase in value be divided? Targets always (usually) receive a premium. What about the bidders? If the bidder pays a premium of less than Rs.20mn, it will share in the value increase. If B pays a premium larger than Rs.20mn, the value of the bidder will decline.

If the Bidder pays Rs 50mn the value of the bidder is (40+10) = 50mn implying that the values are shared equally.

If the Bidder pays Rs 60mn the value of the bidder is Rs (100 - 60) = 40mn implying that all synergies go to the target, the bidder gets no incentive to buy the target.

If the Bidder pays Rs 70mn, the value of the bidder is (100 - 70) = 30mn. This is dangerous. It implies that the value of bidder declines and the acquisition is not advised.
On the contrary, if the Bidder pays less Than 50 mn the value of the Bidder may be higher (100 – amount paid) but in this case the target does not accept the acquisition. As already said, the target always receives a premium.

Suppose B exchanges 1.0 of its shares for 1.0 share of T. Since the combined firm is valued at Rs.100mn, T will receive .5 X 100mn, which equals 50mn. The premium paid is 25 percent. Based on their previous 40mn values, B and T each owned 50 percent of the pre-merger combined values. Post-merger, the percentages of ownership will remain 50–50.
If B exchanges 1.5 of its own shares per share of T, this is equivalent to paying Rs.60mn in value for the target. Company T shareholders will own 60 percent of the combined company. None of the synergy gains will be received by the bidder shareholders.

Also note that the target shareholders will have 1.5 shares in the new company for every 1.0 share held by the bidder shareholders. The situation is even worse if B pays more than Rs.60mn for the target. Assume B pays Rs.70mn for the target (1.75 to 1 shares). Since the combined company has a value of Rs.100mn, the value of the bidder shares must decline to Rs.36.36mn. The consequences are terrible. The shares of the bidder will decline in value by Rs.3.64mn, or 9.1 percent. Furthermore, the B shareholders will own only 36.36 percent of the combined company; for every 1.0 share that they own, the target shareholders will own 1.75 shares.

Valuation Methods

The leading methods used in the valuation of a firm for merger analysis are the comparable companies or comparable transactions approach, the spreadsheet approach, and the formula approach.

In the comparable companies or comparable transactions approach, key relationships are calculated for a group of similar companies or similar transactions as a basis for the valuation of companies involved in a merger or takeover. It is a commonsense approach that says that similar companies should sell for similar prices.

Let’s look at an example. We need to value Potential Target (PT) Ltd. and we have three comparable companies. Potential Bidder1 (PB1), Potential Bidder2 (PB2) and Potential Bidder3 (PB3).

We take three ratios into account for simplicity purposes,
Enterprise Value / Revenues (EV/R) - 1.4, 1.2 and 1.0 for PB1, PB2 and PB3 respectively. Thus the average comes to 1.2

Enterprise Value / EBITDA (EV/EBITDA) - 15, 14 and 22 for PB1, PB2 and PB3 respectively. Thus the average comes to 17

Enterprise Value / Free Cash Flow (EV/FCF) - 25, 20 and 27 for PB1, PB2 and PB3 respectively. Thus the average comes to 24.

Next we need to apply these ratios to PT Ltd. Lets assume that Revenues, EBITDA and FCF of PT are 100mn, 7mn and 5 mn respectively.

Applying the respective averages we get Enterprise value in each case

EV based on Revenue = 100 x 1.2 = 120mn

EV based on EBITDA = 7 x 17 = 119 mn

EV based on FCF = 5 x 24 = 120 mn

The average EV would thus be (120 + 119 + 120) / 3 = 120 mn

Wow! pretty close huh? I doubt how often would you find such close figures from the three given methods. But still you now know just one of the methods of valuing a company in case of mergers / acquistions.

One of the advantages of the comparable companies approach is that it can be used to establish valuation relationships for a company that is not publicly traded. This is a method of predicting what its publicly traded price is likely to be. The methodology is applicable in testing for the soundness of valuations in mergers also. Both the buyer and the seller in a merger seek confirmation that the price is fair compared to the values placed on the other companies. For public companies, the courts will require such a demonstration if a suit is filed by an
aggrieved shareholder.
Typically, merger transactions involve a premium as high as 30 percent to 40 percent over the prevailing market price (before news of the merger transaction has leaked out). The relevant valuation for a subsequent merger transaction would be the transaction enterprise prices for comparable deals. The result would be a higher indicated price. We will use 30 percent as the premium factor. The indicated enterprise market value of company PT would be 156 million.

If there had been no comparable companies to be considered, we would go by the valued arrived at by comparable companies approach. But that is just the starting point. Mergers generally involve a lot of negotiations and PT would always seek high premium over its current market price.

We have used three ratios in case of comparable companies approach. In some situations, other ratios might be employed in the comparable companies or comparable transactions approach. Additional ratios could include sales or revenue per employee, net income per employee, or assets needed to produce Re. 1 of sales or revenue. Note that market values are not included in the ratios just listed and in the practical scenarios a veriety of methods are used to come to a Price.

Lehman Brothers - Bankrupt

Lehman Brothers was founded in 1850 by two cotton brokers in Montgomery, Ala.
Lehman Brothers (ticker symbol: LEH) is headquartered in New York, with regional headquarters in London and Tokyo, and operates in a network of offices around the world.

• The Company operates three business segments: Capital Markets, Investment Banking and Investment Management.
  On September 14, 2008 Lehman Brothers Holdings Inc. (“LBHI”) stated that it has filed a petition under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York. None of the broker-dealer subsidiaries or other subsidiaries of LBHI was included in the Chapter 11 filing and all of the U.S. registered broker-dealers will continue to operate.
  In conjunction with the filing, LBHI intends to file a variety of first day motions that will allow it to continue to manage operations in the ordinary course. Those motions include requests to make wage and salary payments and continue other benefits to its employees.
  LBHI is exploring the sale of its broker-dealer operations and, as previously announced, is in advanced discussions with a number of potential purchasers to sell its Investment Management Division (“IMD”). LBHI intends to pursue those discussions as well as a number of other strategic alternatives.
  LBHI on Monday night was negotiating a last-minute plan to sell large portions of itself to Barclays PLC, the U.K. bank that has been circling the U.S. investment house. Barclays Americas Chairman Archibald Cox Jr. was leading the talks, and an agreement is hoped to be reached by Tuesday.
  
  Neuberger Berman, LLC will continue to conduct business as usual and will not be subject to the bankruptcy case of its parent, and its portfolio management, research and operating functions remain intact. In addition, fully paid securities of customers of Neuberger Berman are segregated from the assets of Lehman Brothers and are not subject to the claims of Lehman Brothers Holdings’ creditors.
  The directors of certain UK companies including Lehman Brothers International (Europe), Lehman Brothers Holdings Plc, Lehman Brothers Limited and LB UK RE Holdings Limited have concluded that in the absence of ongoing financial support from the ultimate parent company, they are or are likely to become unable to pay their debts as they fall due and accordingly have taken steps to place those companies into administration.
  Net Revenue ($mn)
• Qtr May 08 - (668)
• Qtr May 07 - 5512
  Net income ($ mn)
• Qtr May 08 - (2774)
• Qtr May 07 - 1273
  Diluted EPS ($)
• Qtr May 08 - (5.14)
• Qtr May 07 - 2.21
• Closing stock price (Nov 2007) $62.63
• Assets under Mgt (Nov 2007) $282 billion

The stock closed at $0.21 on 15th Sep vs $3.65 on Friday. It was trading at $59.5 on 14th Sep 2007.

"The economy is very weak, the recession wolves are pounding down the door and the financial system faces new deflationary threats from the bankruptcy of Lehman Brothers".


Eyes on AIG
Moody's Investors Service cut AIG's rating to A2 from Aa3, a two-notch downgrade. S&P lowered the rating to A-minus from AA-minus, a three-peg reduction, and Fitch Ratings reduced its standing to A from AA-minus, a two-notch cut.

AIG turned to the Fed late on Sunday after failed talks with several buyout firms and Warren Buffett's Berkshire Hathaway. The company has also said it was exploring asset sales.

AIG’s price fell 61% on Monday 15th Sep from $12.14 on Friday 12th Sep to close at $4.76. The stock was trading at $64.96 on 14th Sep 2007; a 93% fall YoY.

FCCD

A convertible bond (CB) is debt at issuance and through its life, until converted into shares. Conversion into shares happens if the share price is above a certain share price (“conversion price”) either at maturity or through the life of the bonds. Typically on the day the convertible bond is priced, the volume weighted average price of the shares or the closing price of the shares is taken as a base price (“reference price”).
Conversion price is then calculated as (reference price x (1 + conversion premium)), where the conversion premium is typically between 10% and 30%. The number of shares per bond is fixed by dividing the denomination of the bond with the conversion price. This defines the maximum number of new shares that can be issued at any time, limiting maximum dilution for existing shareholders.

In order to see how this works, let us take a simple example:

• Assumptions
• Issue Amount: USD 25m
• Reference price (closing price of shares): USD 100
• Denomination of bonds: USD 100,000
• Premium: 25%
• Outputs:
• Conversion price: USD 100 x (1+0.25) = USD 125
• Number of shares per bond: USD 100,000 / USD 125 = 800
• Maximum number of new shares: (USD 25m / USD 100,000) x 800 = 200,000

Premium attained over the prevailing share price can be quite an attraction for issuers as it means using the same number of shares, a convertible bond can raise more money for an issuer compared to straight sale of the shares at the market price.

Illustration of maximizing funds raised via CB using the example above:

• Sale of shares at market price raises: USD 100 x 200,000 = USD 20m
• Extra funds raised via a CB: USD 25m – USD 20m = USD 5m

With CBs, issuers have the flexibility not to pay the dividends on the underlying shares (the shares into which the bonds convert) until conversion happens. This has an impact as dividend is paid from profits after tax while any coupon on the convertible debt gets a tax shield. For small and mid cap growth companies, prudently structured and priced convertible bonds can be quite an advantage. At early stages of growth it can be useful to raise cheaper debt (vis-à-vis conventional unsecured capital markets debt) and simultaneously defer any potential equity dilution (actual dilution occurs only upon conversion) that too at a premium to the current price.

One word of caution here pertains to the size of the CB relative to free float of a company and liquidity of its shares. Upon conversion, new shares of the company come into existence. This increases free float and affects liquidity. Some investors might want to sell the shares they receive upon conversion to realize gains. If the issue size is large relative to the free float and liquidity then sale of these shares is difficult. A downward impact on the share price can be a likely outcome if discounted selling begins. Some Indian corporates have raised money via FCCBs such that the issue size is over 50% of free float and represents over hundreds of days of trading volumes. Such high issue volumes also put an immense pressure on the balance sheet. As the share price underperforms, the issue size ratio to market cap only increases (issue size remains constant while market cap keeps reducing), implying a huge redemption obligation for the issuer. Going forward, in my humble opinion, Indian issuers must pay heed to the issue size and not get carried away.While we discussed benefits of CBs for issuers, for investors, the option to participate in the upside of the company’s shares via a CB is also an appealing proposition. To begin with, in convertible bond participation, principal investment is protected unlike investment into equity capital of a company (in the worst case scenario shares under perform and bonds are redeemed for cash). If the shares perform well, beyond the premium level, investors can have 100% participation in the share price performance. For companies that have transparent and stable credit, this equity option is quite cheap and hence can prove to be lucrative for the investor community.

Taking the same example as above, let us see how the share price at maturity impacts an investor’s decision to convert into the underlying shares or redeem the bonds for cash.

• Share price at maturity: USD 120
• Worth of the 800 shares per bond: USD 120 x 800 = USD 96,000
• Value of each bond: USD 100,000

Hence the investor opts to redeem the bonds in cash as economically he is better of and gets his principal back (ignoring any interest for the time being).

However, consider the following scenario:

• Share price at maturity: USD 130
• Worth of the 800 shares per bond: USD 130 x 800 = USD 104,000
• Value of each bond: USD 100,000

In this case, the investor will want to convert into shares. If he sells the shares in the market then he gains USD 4,000 over the value of the bonds (ignoring any transaction costs and assuming share price remains constant). Thus we can see that as the share price increases, the incentive for investors to convert also increases.

Investors, whose mandates do not allow them to invest directly in equity, use convertible bonds as a proxy to get equity exposure. Equity investors like to invest in the riskier companies via convertible bonds to protect their principal. Fixed income investors look at convertibles as a yield advantage product while dedicated convertible bond investors use both the equity and debt characteristics of the product to make returns. Hence, convertible bonds are appealing to a wide ranging investor base.Most Indian FCCBs have a high bond floor (please refer to the previous post for an explanation) and hence are more debt like. Thus, for India in particular, in the absence of sovereign international capital markets debt, FCCBs provide global investors an alternate means to get exposure to India credit.There is large merit in the product, however, it needs to be structured and priced prudently.

Let us now look at the regulatory aspects of issuing a FCCD (also GDRs) for Indian Companies
Eligibility of issuer: An Indian Company, which is not eligible to raise funds from the Indian Capital Market including a company which has been restrained from accessing the securities market by the Securities and Exchange Board of India (SEBI) will not be eligible to issue (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993 of RBI.

Eligibility of subscriber: Erstwhile Overseas Corporate Bodies (OCBs) who are not eligible to invest in India through the portfolio route and entities prohibited to buy, sell or deal in securities by SEBI will not be eligible to subscribe to (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993.

Pricing: The pricing of GDR and FCCB issues should be made at a price not less than the higher of the following two averages:
(i) The average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months preceding the relevant date;
(ii) The average of the weekly high and low of the closing prices of the related shares quoted on a stock exchange during the two weeks preceding the relevant date.
The "relevant date" means the date thirty days prior to the date on which the meeting of the general body of shareholders is held, in terms of section 81 (IA) of the Companies Act, 1956, to consider the proposed issue.

For unlisted companies:

Unlisted companies, which have not yet accessed the GDR/ FCCB route for raising capital in the international market would require prior or simultaneous listing in the domestic market, while seeking to issue (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993.

It is clarified that unlisted companies, which have already issued GDRs / FCCBs in the international market, would now require to list in the domestic market on making profit beginning financial year 2005-06 or within three years of such issue of GDRs / FCCBs, whichever is earlier.

Answering to a question asked by a reader, there are no sectoral restrictions/reservations on Indian companies to issue FCCB (at least as far as I know and could find out).

http://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=2498
http://tanushree-bagrodia.blogspot.com/2008/06/fccb-it-is-equity-upon-conversion.html

Sales forecasting

Sales are the lifeblood of any company, and getting a reasonable estimate of sales revenue scale and growth is highly critical in any ensuring business planning exercise, such as capital investment decisions, hiring of staff, expansion of business operations and allocation of operating budgets, etc.

Hence, forecasting demand for a company’s products and services, and the resulting revenues accrued is probably the most critical step a financial analyst needs to undertake when building a financial model.

In order to arrive at a realistic and reasonable revenue forecast for a business, a good financial analyst should conduct a detailed revenue modeling / demand analysis of a company’s products and services, by examining its usage potential and a customer’s willingness and ability to pay.

A demand analysis would entail determining current demand and using assumptions for demand build up to predict future demand over the time period of the financial model. There are a number of qualitative and quantitative methods that can be used to conduct a demand analysis.

Sales Forecasting Using Qualitative Methods
These methods rely essentially on the qualitative judgment and information of highly experienced practitioners or experts in a specific area, and translate their opinions into quantitative estimates of the revenue model of a specific business, product or service.

Jury of Executive Opinion Method: Very popular in practice, this method calls for a group of experienced executives and experts to get together in a structured discussion forum, and in which a moderator would work towards pooling the contrasting views of these executives on expected future sales and demand and combines them into a revenue and demand estimate that they can all agree on.

Delphi Method: The Delphi method also relies on the views of a pool of experts, but they do not interact face to face, and the demand forecast and revenue model is constructed through an iterative process. The advantage of this method is that it avoids “group-think”, which may sometimes creep into the Jury of Executive Opinion method, when the pool of executives start agreeing with one another without through independent and objective thinking.

Sales Forecasting Using Time Series Projection Methods
Demand projection methods based on time series generate sales and revenue forecasts on the basis of historical data and trends. The important time series projection methods include:

Trend Projection Method: The trend project method involves the direct extrapolating historical sales and revenue trends in the future, primarily those of growth and customer conversion rates. This method works well for stable businesses that have not experienced significant change in their financial profile in the past years, and expect to continue on a similar track going forward.
Exponential Smoothing Method: In exponential smoothing, sales and revenue forecasts are modified by examining potential bumps or errors in observed historical demand data trends, to ensure that historical demand rates that are exceptionally high or exceptionally low due to a one-off event are not carried into future revenue projections. This method is useful for discounting the impact of exceptional events (such as a sudden spike in sales due to an unsustainable trend) on the historical sales performance of a business.
Moving Average Method: In the moving average method, a simple arithmetic average or a weighted arithmetic average of a reasonable historical sales data window are used to forecast future demand. This method works well for businesses which periodically experience adjustments in their revenue profile or structure, but bounce back to similar historical levels after a certain time period.

Sales Forecasting Using Casual Methods
Even more analytical then either of the qualitative or quantitative methods alone, casual methods take a statistical correlation approach to develop sales and demand forecasts on the basis of cause-effect relationships in an explicit, quantitative manner. Some of the more important casual methods used in financial modeling and forecasting include:
Chain Ratio Method: This method applies a series of factors for developing sales and demand forecasts, in which the quantitative impact of each factor is layered upon another in a structured, analytical approach.
Consumption Level Method: Useful for a product that is directly sold and consumed, as such fast moving consumer goods or telecom services, this method estimates demand / consumption levels on the basis of elasticity coefficients, such as the income elasticity of demand and the price elasticity of demand.
End Use Method: The end use method develops sales and demand forecasts on the basis of consumption coefficients of the product or service for various uses, and is most suitable for intermediate products / services.
Leading Indicator Method: Observed changes in the leading demand indicators for a product or service are used to predict the changes in lagging demand variables, most suited for products / services with predictable (or seasonal) demand cycles that are predicated on the occurrence of certain related events or customer behavior.

Sales forecasting using a combination of methods
It cannot be denied that forecasting sales usually requires a lot of subjective judgment as well. Now these subjective assumptions and judgments may not lead you to a sales number. Thus generally the analysts (including myself) use a combination (generally the weighted average) of various methods in order to estimate the next quarter/year sales.

Confused? Let’s use the DLF numbers to understand this!
Say we need to forecast the sales numbers of DLF for the 2Q09. We use the sales number of
1Q08 [112,187.00]
2Q08 [112,119.00] QoQ sales growth of -0.06%
4Q08 [161,332.00]
1Q09 [127,861.00] QoQ sales growth of -20.75%
Without getting into complex and disputable weights and assuming equal weights, we can forecast a sales growth rate of -10.41%. The sales forecast for 2Q08 would be 127861*(1-.1041) = 114551 for 2Q08.

MS Excel [2003 onwards] has introduced functions like FORECAST, LINEST, TREND, GROWTH etc that may be used to forecast sales. But the use of these functions may be questioned at this stage, so please be sure before you use these.

Oil price $30 per barrel by 2030

Oil is a valuable commodity and the subject of a great deal of panic right now. The panic is based on ill-informed doom-mongering, with little basis in reality. Some long term perspective might be useful.

By about 2030, as a result of technology development, stimulated at least in part by high oil prices today, solar energy farming will be a big business. Already, work is under way to start building solar farms in the Sahara, where suitable land is both plentiful and cheap.

The staring point for a calculation must be the energy equivalent of a barrel of oil, since that is the prime purpose of oil today. Each barrel contains approximately 6 gigajoules of energy.

Assuming that solar panels can be mass-produced, with a sunlight conversion efficiency of about 12%, at a cost of $200 per sq metre, in today's money, a 1 sq metre panel will generate approximately 8.5kwh of energy per day, equating to 1 barrel of oil every 6 months. The land also needs to produce a good income for its developer, who would presumably be happy with a return of $50,000 per hectare for otherwise worthless land, i.e. $5 per sq m per year, and assuming that 50% of the land is covered by panel, that translates into $10 per panel + depreciation costs, of say $50 per year for a 4 year write-off. With total revenue of $60 per panel per year, 6 months is $30.

If the energy equivalent of a barrel of oil can be generated for $30, it is reasonable to set this as an upper limit on the market value of oil, when used for fuel. Prices of oil for other purposes such as plastics manufacture or specialist industries may be higher.

However, since oil is mainly used for fuel, substitution in this market by cheaper alternatives such as solar power will lead to a gradual collapse in the oil market as supply far outstrips demand. Therefore, most oil will probably be left in the ground, and it will be much cheaper than today in real terms.

Equity Linked Note (ELN)

An Equity-Linked Note (ELN) is an instrument that provides investors fixed income like principal protection together with equity market upside exposure.
An ELN is structured by combining the economics of a long call option on equity with a long discount bond position.
The investment structure generally provides 100% principal protection. The coupon or final payment at maturity is determined by the appreciation of the underlying equity.
The instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk.
An Equity-Linked Note (ELN) is a debt instrument that differs from a standard fixed-income security in that the coupon is based on the return of a single stock, basket of stocks or equity index (the “underlying equity”). An ELN is a principal-protected instrument generally designed to return 100% of the original investment at maturity, but diverges from a standard fixed-coupon bond in that its coupon is determined by the appreciation of the underlying equity.
There are many groups of investors who incorporate ELN’s into their investment strategies, including:
Conservative, risk averse equity investors or intermediate-term fixed-income investors.
Tax-exempt/tax-deferred accounts and off-shore accounts.
Investors for whom structural problems prohibit or limit equity allocations (e.g., certain trusts, retirement accounts/pension funds or insurance companies).

The Equity-Linked Note can be constructed by packaging a call option and a zero coupon bond. The call option provides the note buyer with exposure to the underlying equity. The zero coupon bond provides the note buyer with principal protection. A zero coupon bond allows for principal protection since it accretes from its discount value to its par value over a specified period of time without periodic payments of interest. The discount from the par value of the zero coupon bond can be used to purchase the call option on the underlying equity.

Bond + Call Option => Equity Linked Note => Principal Protection + Equity Participation

The payoff of a typical equity-linked note is equal to the par amount of the note plus an equity-linked coupon. In general, the equity-linked coupon is equal to either:
(a) zero, if the underlying equity has depreciated from an agreed upon strike level (usually the index level on the issue date of the note), or
(b) the participation rate times the percentage change in the underlying equity times the par amount of the note, if the underlying appreciated.

The participation rate is the rate at which the ELN investor participates in the appreciation of the underlying equity. For example, a participation rate of 100% implies that a 10% increase in the underlying equity will result in a final equity-linked coupon of 10%. If the participation rate were instead 75%, a 10% increase in the underlying equity would mean a final equity-linked coupon of 7.5%. The participation rate is typically adjusted so that the ELN may sell at par.

As an example of an ELN, assume an investor buys a hypothetical five-year 100% principal protected Equity-Linked Note with 100% participation in the upside of the S&P Nifty Index for Rs. 1,000. The starting index level is 1,400.

At maturity, if the S&P Nifty Index level is above 1,400, then the payoff of the note will be Rs. 1,000 in principal plus an equity-linked coupon equivalent to any increase in the index.
For example, if the index level in five years is 2,100 (an appreciation of 50%), then the coupon would be Rs. 500 (100%*50%*1,000) and the total payoff would be Rs. 1,500 (1,000 + 500).
If the index level is below 1,400 at maturity, i.e., the underlying equity performance is negative, the final payoff to the investor will be Rs. 1,000 in principal.

Upside potential. The upside potential for this hypothetical ELN is unlimited. The potential positive return on the notes is the same as the positive price return on the S&P Nifty Index.
Downside risk. The downside risk is limited. The equity-linked note provides full principal protection. Regardless of the final S&P Nifty Index level, principal is returned.
Opportunity Cost. Although ELN’s repay an investor their principal at maturity, there is an opportunity cost even where an investor receives a return of principal in down markets; i.e., that investor has lost the use of his/her invested principal for the term of the ELN (in an investment in a risk-free asset like a T-bill, for example).
Opportunity cost can be defined as the forgone “risk-free rate of return” that could have been achieved had the principal been invested in safe fixed-income securities, such as T-bills, for the same period. For example, an investment of Rs. 1,000 on a 6% per annum coupon bond will return Rs. 1,338 at maturity, Rs. 338 higher than the ELN. The equity-linked note will outperform the bond as long as the S&P Nifty Index reaches a level higher than Rs. 1,875 at maturity.
Synthetic Equivalent. To synthetically create an ELN, an investor would (1) invest in a five-year 6% discount bond for Rs. 747.26 (1,000/(1.06)^5) and (2) buy a five-year, S&P Nifty at-the-money call option on Rs. 1,000 notional amount with a Rs. 1,400 strike for Rs. 252.74. The initial investment for this structure is Rs. 1,000, the same as for the ELN (Rs. 747.26+ Rs. 252.74).

If the S&P Nifty Index level in five years is above 1,400, then the call option expires in-the-money. For example, if the S&P level is 2,100, then the payoff of the option is Rs. 500 (50% appreciation of the index multiplied by Rs. 1,000 notional amount). The payoff of the option, combined with the Rs. 1,000 principal from the bond equals the Rs. 1,500 payoff of the ELN.
If the S&P Nifty Index level is below 1,400, then the call option expires out-of-the money, or worthless. The total payoff is therefore Rs. 1,000 from the discount bond, same as the ELN.

Equity-Linked notes are flexible securities that can be structured to match the investor’s risk-reward objectives. For example, the equity-linked coupon can be based on a variety of domestic and international market indices and individual stocks. By adjusting the amount of principal protection or capping the upside potential, there may be opportunity for increased participation and/or higher potential returns. The note can be designed to have coupons payable on a monthly, quarterly or semiannual basis. For international indices, the equity component can be priced with and without currency exposure. Finally, the note can be structured so as to achieve a desired participation rate.
Factors affecting Price of an ELN

• Increase in Equity Price (+)
• Increase in Volatility (+)
• Increase in Interest rates (+/-)
• Increase in Time to Expiration (+)
• Increase in Dividend Yield (-)
• Improved Credit Rating (+)

Let us take another example of an ELN (also called "Equity Linked Derivative", ELD)

Source:

Equity Link Notes

The Business Telegraph (Kolkata, India - 1-Sep-2008)