Description

This is a special situation based in India. To cut a long story short, a $1bn+ market cap grocery retailer completed a spin-off in May 2016 where two companies were created: Future Retail (FRETAIL IN) which housed the “front-end” retail operations and Future Enterprises (FEL IN) which housed the back-end logistics for the retail outlets (furniture, fittings, IT etc.). FEL’s core business is to fit out FRETAIL stores with their fittings and take an annuity income for that. Their cost of funds is approx. 10-11% and their rental yield is approx. 14%... simple arbitrage business.

FRETAIL was the actual spinoff, it is the high value, “sexier” company which has direct exposure to the rapidly growing Indian middle class consumer. It’s market cap is close to $1bn. FEL, the company left behind, is a ~$100m market cap company loaded with a pile of debt (~$680m net debt). If this sounds familiar to people who admire a certain special situation fund manager from the 1990s, it is because it is very similar (think Host Marriot).  

Reasons why FEL stock is extremely attractive (all figures are now in Indian Rupees):

1.       The debt looks daunting but is very well structured:

a.       Total gross debt is 44,000m but 90%+ of that debt is through bonds which have 5-6 year maturities. They have recently refinanced loans at 9.75% whereas many of their outstanding tranches currently have ~11% interest. All the listed bonds are trading above par (bond market thinks the credit is pretty safe).

2.       The majority of FEL’s earnings are contracted annuity income streams

a.       FRETAIL is contracted to pay FEL around 6,000m to 7,000m each year for the back-end logistics for the next 6 years or so (FRETAIL’s AR mentions this in the notes, and has been confirmed by management). FEL has officially guided these “lease rentals” cash flow  to be 5,500m to 7,500m. The opex for these lease rentals is minimal (100 to 200m per year).

b.      FEL also has certain clothing manufacturing facilities which churn out products for Future Group companies. Again, the earnings and margins here are pretty stable as the customers are group entities. FEL has guided annual cash flow of 1,000m to 3,000m for this part.

3.       FEL has investments worth approx. 43,000m in group companies and other JVs, which are slated to be monetized in the coming 3-4 years (they have already part monetized their stake in Future Supply Chain, a supply chain logistics company). Some of the investments are in publicly listed companies while others have good comps in the market… I am fairly comfortable with the 43,000m valuation but people can discount as they think fit. The details of these investments can be found in the presentation link below.

4.       Theoretically, debt and investments more or less cancel out

a.       This effectively leaves you with a company with 7,000m market cap and minimum 8,000m EBITDA less maintenance capex. Cynical folks can discount value of investments by 50% and still get an adjusted enterprise value of 7,000m (mkt cap) + 44,000m (net debt) minus 22,000m (associates) = 29,000. That works out at approx. 3.6x multiple

5.       The business is a cash machine - maintenance capex requirement is minimal. In fact, maintenance cost of the equipment is borne by FRETAIL, not FEL (according to management). Having said this, the business does require significant growth capex to grow earnings… but that can be financed with the EBITDA inflow. The company has said they intend to be “a zero net debt” company in 4 years or so. We can debate if that is efficient for a business model like this but we can at least conservatively assume that they won’t net borrow more. They have been refinancing debt recently.

6.       Insiders own approx. 60-70% of the stock (depending on your definition of insider)

a.       Insiders include Future Group (main controlling group), Bharti Group (merger partners, context below) and Bennett Coleman Group (one of India’s biggest media houses, they own the Times of India newspaper etc… they historically got an equity stake for providing the company discounted advertising)

b.      The ParentCo merged with Bharti Retail last year prior to this spinoff… Bharti got their equity stake at the time

c.       The core insiders (Future Group) actually owns 72% of the B class stock (which has rights to 20% extra dividend but has 25% less voting rights). This tells me that if the stock doesn’t move up, the insiders might announce a huge dividend instead with the rapidly building cash pile.

d.      In summary, Future Group owns ~48%, Bharti owns ~9% and Bennett Coleman ~10%. There are a couple more corporate entities in the shareholding disclosure that may be part of this group, which own a further ~2% or so, but I can’t verify that.

7.       Institutional shareholders hate the stock and their reasons are not fundamental

a.       Top 3 institutional shareholders were in the ParentCo stock (all non-Indian funds) because it was fairly liquid and gave them direct exposure to the Indian consumer story

b.      Quite comically, the biggest institutional shareholder has publically stated on their website (direct quote): “If "you cannot eat it, drink it, wash with it, wear it or shop in it...we are not interested".” Music to my ears. These guys have been aggressively dumping the stock.  

c.       The other two big shareholders are seemingly not allowed to own market caps below $0.5bn (from my research in to their fund documents and media interviews).

d.      All 3 are forced sellers. The remaining that are not forced sellers probably got scared with the optical debt burden and also dumped the stock

e.      The shareholding pattern and exchange disclosures suggest most of the dumping by these guys is over (I would hazard a guess that about 80-90% of the forced institutional selling is over).

8.       The company is really, really cheap.

a.       The EPS of the company is hidden by depreciation which does not need to be replaced with capex. On a “cash eps” basis, the company has close to 10rs per share in earnings. The stock price is 16… Even a modest 10x multiple makes this a INR 100 stock. The Indian market trades at 15-16x fwd PE (for context). The Indian 10 year bond is hovering around 6.3% yield (for further context on valuation).

b.      The stock price is 16 while debt is ~95rs per share and investments are 92rs per share. If they cancel out, then clearly stock price should at least be 95+16 = 110 or so (give or take a few rupees).

c.       The stock doesn’t need much fancy valuation analysis… if the cheapness doesn’t come out and hit you in the face, you are probably not meant to be in stocks like this.

A lot of the background info can be found in their May 2016 presentation, as well as AR and spinoff disclosure doc (note FRETAIL was the spinoff).

Links:

FEL presentation

http://www.futuregroup.in/pdf/Future_Enterprise_9_May_16.pdf

FEL AR:

http://felindia.in/pdf/Annual_Report_2015_16.pdf

FRETAIL spinoff doc

http://www.bseindia.com/downloads/ipo/2016825183424FRL%20-%20Information%20Memorandum.pdf

Catalyst

Catalysts: Stake sales, insiders “revoking” their pledged shares (already happening), better market understanding of the story given messy numbers post spinoff, institutional selling almost over, debt pay down.