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Oil down 50%+, Ruble crashing. Rupee on its way down and maybe  the stock market too !

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.

The major events over the last few weeks created a small scare for some of the Indian banks. The fear was the level of exposure to the Lehman Brothers bankruptcy and the ongoing credit crisis.

Considering that a lot of us including my family and me have our savings with ICICI bank, I decided to have a look at the Annual report of the bank in detail. Following is the analysis of the bank from a depositor’s perspective (and not an investor’s perspective).

Some positives
The bank raised 20000 Crs in 2007. As a result of the issue, the CAR (capital adequacy ratio) now stands at around 14%. The bank has an annual profit of around 4150 Crs and a consolidated profit (including subsidiaries) of around 3100 Crs.

ICICI has several subsidiaries. In aggregate the subsidiaries are making losses, mainly due to the insurance sub. Due to the insurance accounting (expensing the policy expenses in the current year), the insurance subsidiary has been showing increasing losses as it grows. However the subsidiary has value, which is growing. In all, my personal estimate for the valuation of subsidiaries is around 23000 Crs, which is around 30% of market cap and almost 50% of book value

Negatives
The bank has been in the limelight due to the losses incurred by the collapse of Lehman brothers. This has been a case of availability bias. The market has been focused on the dramatic instead of the important (as usual).

The derivative related losses (dramatic) incurred by the bank have been to the tune of around 887 Crs which have been charged to the P&L statement (marked to market) and around 203 Crs, which have been charged to reserves.

AS 30 accounting requires mark to market accounting (and P&L pass-through) for certain derivatives and reserves adjustment for others (read AS30 to understand the details).

At the same time there has been a rise in the Gross NPA from 4850 Crs to 8350 crs. This increase is more important for the bank and its valuation as retail assets account for around 60% of the bank’s assets. However the market did not react strongly to this important change as it is hidden in the Balance sheet. The NPA have increased further in the current quarter. In addition the provision are around 55% of Gross NPA. So there is still an exposure of around 3500 Crs, which could hit the P&L in the future.

accounting is pretty complex
Bank accounting and especially derivative accounting is complex. It is very difficult to make out whether the bank is making or losing money on its entire derivatives exposure at any point of time. The bank discloses the total notional exposure which is atleast 1000 times or more of the net exposure. The profit or loss is a multiple of the net exposure. So it is difficult to figure out the profit or loss on the derivative book based on the bank disclosures alone.

In addition mark to market accounting is also misleading. It is equivalent to drawing your personal profit or loss based on change in share prices. If you think a stock is worth 100 rs, and you bought it for 50 rs and the price dropped to 30, how will you account for it ?

Mark to market accounting says, report a loss of 20 now. If the price jump to 70 in the next quarter then reverse this loss and report an ‘income’ of 40. However you may choose to ignore these swings and say I intend to hold the share for next 3 years and believe the market is mispricing the stock in the interim.

So what is the truth ? frankly there is no objective truth. It depends on the specific instrument and circumstances. Accounting requires being conservative and hence the loss of 20 in the current quarter.

This is the kind of complexity we are dealing with derivatives. The bank may very well have losses on the portfolio or they may right in saying that these are only notional losses as the underlying credits are still intact.

are there solvency issues ?
I think there are no solvency issues for the bank based on the current losses and statements from the bank. The bank has reduced the credit derivatives by almost 800 Mn usd. This does not mean that the bank will not have losses in the future due to derivatives. There is a huge derivatives exposure (notional) on the banks balance sheet.

As of March 2008, the fair value for the derivatives was positive and for interest swap is midly negative (page 116) , so the bank is not losing money on those derivatives (as of march 2008) . However this value may turn negative in the future.

However the point to remember that the bank is making around almost 1000 crs per quarter on a standalone basis. In addition it has a high capital cushion and assets in the form of subsidiaries. So there is a decent amount of capital cushion to absorb any of these losses. There is always a risk of unknown losses hiding in the balance sheet in the derivative books due to black swan events. I frankly cannot evaluate and estimate those losses from publicly available documents.

Finally the trump card for the bank is the concept of ‘Too big to fail’. Do you think the Indian government would risk allowing the bank to fail (second largest bank in the country) and jeopardize the financial system?

valuation based on book value ?
I am amazed at the simplistic valuations done by a lot of people and analysts. For ex: ICICI is selling at X times book value and hence it is a buy !! If you read the Annual report, you will realise the complexity of this company. It would be silly to value the bank based on book value alone
The bank has assets (subsidiaries) and risk (derivative exposure) which are quite difficult to estimate (atleast for me). A simple book value based valuation is a foolish way to value this bank.
The minimum analysis to arrive at the final valuation is to value the bank and its subsidiaries. The derivative exposure and other liabilities need to valued separately and the net value should be derived from the difference. Luckily, investing in stocks is not like exams where I will get flunked for not answering a question. I can always pass on the stock.

The crisis is now full blown. I have not seen panic at this scale personally. I have read about it, but not seen it personally. It almost feels as if companies are being targeted one at a time. Lehman went into bankruptcy and AIG just survived through government help, though equity holders have been wiped out (almost). Now it seems the market has moved on to Morgan Stanley, Goldman Sachs and Washington mutual. It almost feels as if the market is killing one company at a time. Scary!

How does it impact us in India?
I think, the impact would initially be limited to companies with Global businesses. So IT companies with revenues in this space could get hit in the short term. However I think it should work out for these companies in the medium to long term as they find new clients, geographies and start growing again. The business model for IT companies is not under threat. However in the short run, IT companies are and could keep getting hit. However I would be worried about small IT companies with high exposure to the Financial and associated sector.

The next in line to get hit could be banks like ICICI bank and others, which have foreign operations and derivatives on their balance sheets. I am currently analyzing ICICI bank and I can tell you that complexity for most banks have gone up. As I wrote earlier, I exited banks quite some time back when I realized that I could not evaluate the risks correctly. That said, I think none of the Indian banks are under serious solvency threat. The profits could get hit, but most of the Indian banks do not have massive exposure of derivatives. I am analyzing ICICI and other banks from a depositor’s point of view and not from an equity investment point of view. So I am looking at these banks from a safety point of view.

Other than the above two sectors, I cannot think of any broad sectors, which could get hit hard by this crisis.

Second order and higher order effects
What is missed out in most analysis, is the second and higher order effects of an event. Indian companies may not get hit directly, but a recession in developed countries and lack of liquidity and risk aversion is bound to affect us in the medium term.

For the last, 3-4 years almost every asset class in India has gone up. There were all kinds of reasons given for this rise, but rarely was liquidity mentioned as one of the key reasons. Now with the liquidity drying up, I don’t think we will be seeing such double-digit growths in Real estate and other markets.

What am I doing?
I don’t get worried about drops in stock prices. Such drops are a part of the game. When I invest in equity, my main worry is permanent loss of capital and not temporary losses due to volatility.
Personally, I had put my buying on hold for the last couple of months. For some reason, I felt that the markets could go south in the medium term. As a result I stopped buying some time back. However I did not back this hunch by going short, as I may very well may have been wrong. I did buy some puts, but did not build a decent position as I was not sure. I think I should start trusting my gut more.

I am still standing pat and not planning major activity for some time. I personally don’t expect these issues to get worked out in a few weeks and feel that I could be getting better bargains in the near future.

I have a question and would appreciate if some could answer, as I have not been able to figure it out – If the bank/ DP fails, what happens to my shares. Is it similar to a savings account where you can lose your savings or are the shares held by NSDL or someone else and hence I am safe?

First it was Bear stearns, but the US treasury (similar to our Finance ministry) and the Fed (similar to our RBI) engineered a bailout. Bear stearns, an investment bank was bought out by J P morgan, a commerical bank, in March. This bailout was done to calm the markets and reduce systemic risk.

Well, next in line were Freddie Mac and Fannie Mae which were nationalized (federal takeover) for the same reason last week. Now this week it is the turn of Lehman brothers which seems to be on the verge or ready to file for bankruptcy protection. Merrill lynch, another Investment bank and brokerage, is in merger talks with Bank of america. After Lehman brothers, Merrill lynch seems to be the weakest firm and so it could come under attack.

More companies at risk
AIG, one of the largest insurers has fallen by 30% and is at risk now. So is washington mutual, another large bank. So we have a situation where the credit crisis (acutally bad investments on part of the banks and institutions) is now engulfing the financial system. Finally the S*** is hitting the fan !

We could very well see a domino effect and the US government may decide not to bail out any more companies. We could be in for some nasty times.

What does it mean for us ?
So how does it effect us ? Well if you are into medium to long term investing, not much. Actually the panic could create opportunities for us in india. I really don’t see Indian companies getting impacted (other than IT or export oriented companies due to a possible recession in the US and other economies). The impact for IT companies in the long run should not be too much. However there could a short term impact in companies with a high percentage of revenue in the BFSI segment.

All this mess, makes you wonder what kind of risk our banks and financial services firms are taking. I am repeatedly reminded of this statement by warren buffett

‘When you combine ignorance with leverage you get some pretty interesting results’

Infosys recently announced the accquisition of the Axon group. Most of the analysis I have seen is centred around whether the deal is EPS accretive or dilutive. I think this kind of analysis is superficial and misses the point. A deal can be EPS dilutive and still be adding value and vice versa (more on that in a later post).

In this specific case, Infosys is accquiring an ERP (SAP in this case) consulting firm with net margins of around 10%. ERP consulting is a high margin, high growth business for Infosys. The typical gross margins are sometimes in excess of 50%.

How do I know ? disclosure : I worked with infosys in their ERP practise in the past. The ERP business for Infosys has seen phenomenal growth in the last 8 years and has done exceedingly well. Their Oracle and SAP practises have done very well too (I have personally seen the practises grow in the last 6-7 years). Infosys has managed to constantly increase the offshore component of ERP projects and thus maintain high margins.

Axon has gross margins in the range of 25-30%. In addition they are based out of UK, US and Malaysia. I am not sure of how much offshoring Axon does, but any improvement in the onsite/ offshore component of their existing projects due to the backend infrastructure of Infosys will enhance their margins. This is a good deal where Infosys gain the front end part of the business ( clients, onsite consultants, relationships , Knowledge etc) and Axon (which will be now be a part of infosys) will see improvements in margins due to higher offshoring.

Is everything hunky dory then ? Not necessarily. Integration of Axon into infosys will be a challenge. Infosys has an ‘Indian’ company culture (I do not mean it in a negative way). They are very conservative on expenses and there are other typical ways of doing things. Axon (about which I do not have any special insight) must have a more European culture. Integrating two such diverse culture will be a challenge. The key asset for an consulting company are its people. If the integration is poor, then employees from Axon (or even from exisiting practise in Infosys) could leave. I think that may not be a major issue in the long term. The company will work on retaining the key employees.

So overall, there is more to this deal than just plain EPS numbers. The ERP practise (especially SAP) is doing well for the company. Addition of Axon will provide further scale to the SAP consulting business of infosys and will add value down the road.

Additional disclosure : I hold infosys stock