Description

Millennium India

MQC

 

 

Millennium India is a US-listed SPAC that plans to buy 21% of a financial brokerage business in India called the SMC Group for roughly half the multiple of its Indian publicly traded peers.  This is an established company that advertises on CNBC in India and has an extraordinary runway for future growth based on demographics and the low penetration of financial services in India.  There are some “trust buyers” in the stock who have levered the historical spread between the share price and the cash in the SPAC’s trust and would likely sell at around the current trust cash value of $7.94 in sufficient volume to make this interesting.  At a price of $8.00, the market is currently valuing this investment at 17.7x current year fully-taxed Indian GAAP earnings (FY Mar 08) and 11.1x forward.  I would point out that this trailing multiple is slightly misleading as it fully takes into account all the new shares associated with the recent capital infusion including warrants bought back on a treasury basis but gives no credit for the productive use of that capital.  Still, this fully-diluted valuation compares favorably to SMC’s projected 60% EPS CAGR through its fiscal 2010 as well as comparable publicly traded companies in India which trade at multiples between 25x-75x on FY08.  The merger proxy with US GAAP financials (audited by PWC) is available (this has been the major holdup in other international SPACs) and a final vote is anticipated in mid-January.  While most VIC members would probably agree that 17.7x is not the world’s cheapest trailing multiple and the $76m primary market cap is very small, there are no other US-listed pure play Indian brokerage stocks.  I believe the stock has 80-100% upside to its peers valuations and could continue to compound going forward while the discounted multiple provides some cushion in the event of a steep correction in this richly valued sector. 

 

Business Description

 

While I would refer you to the proxy filed on 12/6/07 and the investor presentation filed as an 8-K on 11/23/07, here is an overview of the companies involved and the transaction:

 

Millennium India (MQC) raised $57 million in July 2006 to acquire an operating business in India.  The two primary managers, Jacob Cherian and Suhel Kanuga, are US residents of Indian decent who were former financial services consultants at CSC with experience in India.  While not brand names themselves like in some other SPACs, the pair successfully raised capital and found a good deal; after reviewing 50 transactions, the company announced an agreement to buy a minority stake in the SMC Group in May 2007.  MQC and SMC did an initial roadshow in late July / early August as the market corrected and they were not particularly well received because they did not want to drill down on their projections.  They seemed much more willing to be helpful when they came around again in December and the reception was far better (this is also indicated by the recent increase in the stock and warrant prices). 

 

The SMC management viewed this as an attractive transaction because it will allow them to change the profile of their company by augmenting its scale and permitting it to expand internationally. Given the increase in sector valuations between May and today (the comps are up about 100%), SMC management thinks MQC got a great deal.  Unlike some SPAC deals, SMC management will not receive any cash in the deal. MQC also has a number of affirmative rights that help to protect its minority position (restrictions on capex, right to a board seat etc).  Mechanically, MQC is investing directly into SMC up to the maximum 14.9% ownership position allowed under Indian law and then another 6% will go into a GDR in Luxembourg that does not count under the ownership cap.  This structure is common and other companies have used a GDR to achieve similar ownership objectives. 

 

SMC, originally founded in 1990 by the current management team is as a full service financial services company.  I have met with the top 4 members of the management team though I have spent the most time with the COO, DK Aggarwal. As founders of the business they have been at this a long time but most of their experience has been at the company.  It is a branch-based business with 925 locations in 225 cities in India.  40 of the locations are company-owned and the rest are franchisees.  This franchise model is far more flexible and limits the potential losses to SMC in the event a branch runs into trouble.  Over the next three years management believes it can expand its retail network to 1,600 offices in 345 cities.  The company is also expanding internationally and has acquired a seat on the Dubai Commodities and Gold Exchange (DCGX).  Since Non-Resident Indians have $1 trillion in assets and send substantial capital to India annually, the primary goal of the international effort is to capture this audience.  Non-India growth will continue into the Persian Gulf region where many Indians are prohibited from investing locally as well as to Singapore, Hong Kong and New York.

 

SMC’s product lines include equities and commodities brokerage, online equities/commodities/derivatives trading, equity research, mutual fund + IPO distribution, depository and clearing services, merchant banking, corporate finance and insurance brokerage.  It also has a significant prop desk that primarily conducts arbitrage (cash-and-carry not risk arb).  Currently, arbitrage is 39% of revenues (admittedly a concern) while equity and commodity brokerage are 45% of revenues.  The other 16% are nascent business lines and other income (interest on fixed deposit receipts and investment dividends).  Management believes that within three years 40% of revenues will be generated by the brokerage business while 20% will be arbitrage and the remaining 40% will be merchant banking, IPOs and insurance brokerage (only 25% of the insurable population are insured in a country with 17% of the world’s population).

 

To understand the relative scale of the SMC business today, here are a few metrics:

• It’s the #1 commodity trader in India
• It’s the 6^th largest distributor of India-based IPOs in 2006
• It’s a top-5 contributor to trading volume at the Bombay Stock Exchange in 2005 and 2006
• It represents 10% of the total volume on the Dubai Gold and Commodity Exchange
• It’s ranked by Dunn & Bradstreet as the third largest brokerage by number of trading terminals
• Another point worth mentioning is the entry barrier created by SMC’s numerous licenses.  SMC believes it would take 2-4 years to recreate their regulatory licenses. 

 

With a projected 60% EPS CAGR over the next few years, a sanity check on this growth makes sense.  This surge in the business will be driven in two ways: (1) by entry into new areas like portfolio management services (private client services) and margin funding for high net worth individuals and (2) branch expansion.  First, portfolio management services are fee based rather than commission based which would help to diversify the business and the company recently received the necessary regulatory approvals to enter the area.  Meanwhile margin funding is a spread business where management anticipates earning 18% interest and a 12% brokerage fee against a 12% borrowing rate. Only certain people will qualify for this service.  The company also plans to make a push into the institutional brokerage business.  Finally on the branch side, management anticipates growing to 1,050 branches by March 2008, 1,200 by March 2009 and 1,600 by March 2010. 

 

No discussion of a financial services business is complete with out mentioning risk management and controls.  SMC management says they have a centralized online surveillance system that extends to the client level at the franchisees.  This system looks at all accounts 5 times a day.  In the event of a breach of SMC’s risk parameters the company closes out a client’s account immediately.  The team characterizes the infrastructure as “very mature” but plans to spend more capital on it as internet trading scales up. 

 

The underlying macro tailwinds to this investment are powerful and obvious.  India is the 10^th largest economy in the world with GDP growth expectations of around 8% for the near future.  Meanwhile, financial assets represent 160% of GDP which is low relative to other emerging economies like China and South Korea which are more like 200 to 250% of GDP.  SMC believes that equity trading volume will increase 16% annually from $1.5 billion in 2005 to $6.5 billion in 2015.  SMC also believes that only 3% of the population invests in the capital markets and only 5% of household savings are invested though the overall savings rate is 25%.  Another potential source of growth comes from pension plans which have $100 billion of assets but can only invest 5% of their assets in equities currently.

 

Financials and Valuation

 

Understanding SMC’s consolidated US GAAP financials requires some careful reading of the proxy statement because there are three components (SMC, SAM and SMC Comtrade) that are currently separate but will be consolidated in one entity after this transaction.  In particular, SMC Comtrade is treated as an unconsolidated investment (SMC owned 40% as of the end of FY07) in the most recent financials but will be fully consolidated going forward because the remaining 60% was acquired in April 2007.  (The equity in earnings needs to be backed out and the full financial performance, which is found in a footnote, must be added).  The financials are more clearly laid out in the investor presentation.  Another source of information are the annual reports on the SMC website – the financials contained therein only represent a portion of the total business but it is helpful to see nonetheless. 

 

It should also be noted that MQC pays full taxes of 34% unlike some other US-listed international companies (like those in China) that often trade at a low P/E multiple due to a short-term tax break but appear more expensive if those tax savings are merely capitalized on the balance sheet and a full tax rate is used. 

 

The following tables provide some detail on the historical and projected financial performance of SMC:

 

SMC Group Financials (FY March)
(US $ in Millions)
		3/05A	3/06A	3/07A	3/08E	3/09E	3/10E
Revenues:
SMC		$       5.7	$    11.1	$    16.0
SAM		$       3.7	$      6.7	$      9.6
Comtrade		$       0.5	$      2.0	$      8.1
Total US GAAP Revenues		$       9.8	$    19.8	$    33.7
Indian GAAP Revenues		$       9.3	$    18.4	$    34.3	$    66.0	$    94.9	$  128.2
Net Income
SMC		$       1.1	$      3.5	$      4.3
SAM		$       1.2	$      1.3	$      3.2
Comtrade		$       0.0	$      0.5	$      4.7
Total US GAAP Net Income		$       2.3	$      5.3	$    12.2
Indian GAAP Net Income		$       1.2	$      5.4	$    13.4	$    25.8	$    40.9	$    57.8
Note: INR/USD=40.66

 

Revenue by Business Line (FY March)
			3/06A	3/07A	3/08E	3/09E	3/10E
Equities and Commodities Brokerage and Services			10.53	15.31	24.95	37.65	53.01
Equities and Commodities Arbitrage			6.72	13.35	21.25	26.25	27
Distribution of Financial Products and Services			0.16	0.67	4.55	7.83	11.63
International DGCX Business			-	0.43	1	1.5	1.88
Merchant Banking and Advisory Services			-	0.73	1.25	5	10
Online Trading			-	-	1.13	4.5	6
Other Income			0.97	3.84	9.55	14.6	19.33
Total			18.4	34.3	63.68	97.33	128.85
Equities and Commodities Brokerage and Services			57.3%	44.6%	39.2%	38.7%	41.1%
Equities and Commodities Arbitrage			36.6%	38.9%	33.4%	27.0%	21.0%
Distribution of Financial Products and Services			0.9%	2.0%	7.1%	8.0%	9.0%
International DGCX Business			0.0%	1.3%	1.6%	1.5%	1.5%
Merchant Banking and Advisory Services			0.0%	2.1%	2.0%	5.1%	7.8%
Online Trading			0.0%	0.0%	1.8%	4.6%	4.7%
Other Income			5.3%	11.2%	15.0%	15.0%	15.0%
Total			100.0%	100.0%	100.0%	100.0%	100.0%

Note: Mgmt told me that the revenue projections do not match the above table due to currency and minor revisions (the first table is from July and the second is from December)

 

The following chart lays out the capitalization of the company:

 

MQC Capitalization
Share in Offering		7.25
Insider Shares		1.8125
Finders Shares		0.45
Insider Warrants @$6		2.25
Public Warrants @$6		7.25
Primary Shares		9.5125
Fully Diluted Shares		19.0125
Share Price		$          8.00
Non-Insider Mkt Cap		58.0
Primary Market Cap		76.1
FD Market Cap		152.1
Treasury Method
Buyback Price		$          8.00
Warrant Cash		57.0
Shares Bought Back		7.1
Treasury FD Shares		11.9
Treasury Market Cap		95.10
MQC Ownership		20.90%
Implied SMC Valuation		455.0

 

MQC Treasury Method Valuation Multiples (FY March)
	Input	3/05A	3/06A	3/07A	3/08E	3/09E	3/10E
SMC Net Income		$         1.2	$        5.4	$     13.4	$        25.8	$          40.9	$            57.8
MQC Share of Net	20.90%	0.25	1.14	2.80	5.39	8.56	12.07
EPS	11.9	$       0.02	$      0.10	$     0.24	$        0.45	$          0.72	$            1.02
P/E	$8.00	379.2x	83.6x	34.0x	17.7x(1)	11.1x	7.9x

(1) This 17.7x multiple assumes that the cash infusion from MQC is valued at zero and gives no return.  This is extremely punitive.  The treasury method also assumes that MQC raises capital at $6.00 per share then immediately buys it back at $8.00 per share which is also extremely punitive. 

 

Comparable Companies

 

There are a number of publicly traded brokers in India, many of whom have received investments from US hedge funds and private equity firms. 

 

The following table illustrates the current valuation of several other publicly traded Indian brokerage companies.  Note that all of these companies trade in India and are subject to Indian GAAP.  Therefore, SMC’s Indian GAAP financials are used for comparative purposes although the historical US GAAP financials are about 6% lower.  Edelweiss Capital and Religare are recent IPOs that were massively oversubscribed and there are no forward estimates for them yet. 

 

Comparable Indian Brokers

(US $ in Millions)

US $

Indian GAAP P/E Multiple (FY MARCH)

Company

Ticker

Mkt Cap

3/07A

3/08E

3/09E

3/10E

Indiabulls

IBULL IN

$  5,178.2

49.8x

28.0x

20.7x

16.7x

Edelweiss Capital

EDEL IN

$  2,793.7

101.2x

India Infoline

IIFL IN

$  1,966.0

102.4x

73.4x

56.7x

45.8x

Motilal Oswal Financial Services

MOFS IN

$  1,269.9

73.3x

34.2x

25.8x

20.4x

Religare

RELG IN

$  1,007.8

211.6x

IL & FS Investsmart Ltd.

ILFI IN

$     453.7

26.6x

22.4x

22.0x

Geojit Financial Services

GFSL IN

$     443.8

69.4x

SMC at Deal Price (Treasury Method)

$     455.0

34.0x

17.7x

11.1x

7.9x

Note: INR/USD=39.815

 

From a FY07 net income perspective, SMC is slightly smaller than India Infoline and Motial Oswal but clearly possesses a valuation nowhere near those companies.  MQC and SMC management argue that India Infoline is the most similar peer company because it has successfully employed a franchise-based brokerage model from which it can roll-out additional financial products.  While SMC is stronger in commodities, India Infoline has moved into insurance and home loans in the last year.  I believe Motial Oswal is also a good comp because its revenues are heavily weighted towards equities and it has roughly 700 branches. It has also recently entered into margin lending and merchant banking.  This differs from the Indiabulls model that is largely company-owned and trades at a discount.  Geojit has a strong Non-Resident-Indian business which is an area that SMC also plans to expand.  Like SMC, Edelweiss has a substantial presence in arbitrage. 

 

Using forward P/E multiples towards the lower end of the comparable range (see table below) suggests that MQC is more appropriately valued at closer to twice its current share price.  There is also the matter of the warrant overhang: MQC has 8.5m warrants outstanding that strike at $6 and become callable if MQC stock trades at $11.50 for 20 out of 30 trading days.  Obviously raising almost half the market cap at a discount to the stock price would not be accretive to the valuation unless the capital could be deployed wisely.  For the purposes of this analysis, I have assumed that the warrant cash is invested at my target multiple and is used to purchase an incremental 5.9% of the company.  There is also no effect on the projections to reflect the additional capital infusion.  Perhaps I am being overly conservative by using 35x FY08 but I want to show that the upside is still excellent under this scenario. 

 

Valuation of MQC (Fully-Diluted)
Incremental Warrant Investment:
Target Purchase Multiple on FY 08		35.0x
Target Premoney Valuation		902.3
Warrant Cash to Invest		57.00
Post Money Valuation		959.3
New Ownership		5.9%
Existing Ownership		20.9%
Total Ownership		26.9%
(US$ in Millions)
FY March		3/08E	3/09E	3/10E
Indian GAAP Net Income		$       25.8	$      40.9	$     57.8
Target Multiple Based on Comps		35.0x	25.0x	20.0x
Total Value		$     902.3	$ 1,023.5	$1,155.4
MQC Owns		26.9%	26.9%	26.9%
MQC Value		242.4	275.0	310.4
FD Shares		19.0125	19.0125	19.0125
Target Price		$     12.75	$    14.46	$   16.33
% Upside		59%	81%	104%

 

 

From a downside perspective, if SMC was only able to achieve 50% of its projected growth next year (approx $34m of net income) and if it traded at an 8.5x multiple, then ignoring the out-of-the-money warrants there could be approximately 20% downside from here to $6.31.  I believe this 4:1 risk skew is attractive. 

 

One other thought on valuation: ultimately SMC will list on the Bombay Stock Exchange which will provide another valuation signpost/exit option for MQC.  This may be a year or two away. 

 

Risks and Concerns

 

Deal Does Not Get Completed: Many current shareholders have purchased MQC at a discount to the value received if a transaction is voted down (or the “trust value”) They lever this small guaranteed spread and regardless of the merits of the transaction they vote “No” and collect their arbitrage.  Hence if 20% of the shareholders vote no then the deal could get voted down and you would get $7.94 + interest between now and liquidation in July 08.  Therefore investors at or around current prices are protected from capital impairment.  Another deal-related risk revolves around the potential need for an extension on the vote date:  SMC can terminate the merger agreement if there is not a vote by December 27^th, which seems tight given the holidays and the fact that MQC would have to mail definitive proxies by December 17^th.  I would think that SMC would agree to a short extension to the deal and get the capital rather than have to go through all of the time, effort and risk of raising capital from scratch even if it could get a better valuation.

 

Quality of the Projections: I am unhappy with the level of disclosure on the projections.  MQC management has provided details only on the revenue breakdown of its projections though it has a very detailed financial model that it is unwilling to share due to disclosure requirements.  They are willing to speak anecdotally about some of their assumptions (such as the capital employed and return on capital of their arbitrage business) but when pressed to provide the unit economics of a typical branch and they refused.  While they have probably provided more detail than investors typically receive in an emerging market stock, if I were in their position I would give investors as much detail as possible to assure the deal gets approved.  No investment is perfect and I think this is the weakest element because it is very hard to verify the analytical rigor of the projections other than by looking at the comps and concluding that the numbers are probably directionally correct.  To the degree that you have questions I may not be able to provide you with much more information. 

 

Over-reliance on Arbitrage: In answering questions about the sustainability of the arbitrage business, the team pointed out that it has generated 24% returns per annum over the last 10 years.  Management assumes the returns are 17%, 14% and 12% over the projection horizon.  That said, when full convertibility occurs in 2009 and foreign investors can invest in the Indian market it’s hard to believe that the profitability of its arbitrage business will not suffer.  SMC management believes arbitrage is its “biggest strength” and arbitrage exposure has clearly not hurt the reception of the recent IPO Edelweiss Capital but I think it is an area of concern. 

 

Margin Pressure from Increased Competition:  While the projections imply margin improvement based on the economies of scale of rolling out new financial products across an existing distribution network, it is certainly possible that increased competition could threaten that additional profitability.  There are a number of public brokers now with access to capital and I am sure there are others waiting in the wings. 

 

Financials Vulnerable to Weakness in Indian Markets: SMC is directly levered to the performance of the Indian capital markets.  A slowdown in capital market activity would have a large affect on SMC and would also decrease the trading multiples of the businesses in the market.  In 2Q06 volumes fell as the market corrected.  Longer term the macro tailwinds should drive value appreciation however. 

 

Microcap:  While the underlying SMC company is actually a decent size, the tiny tradable market cap of MQC may limit the investor universe. I also do not know what the liquidity profile will be after the deal is approved other than to observe that many other SPACs that did not really trade prior to deal approval saw improved liquidity post-deal. 

 

One-line reporting will be confusing: Because SMC will be a minority investment, all of the financials will flow through MQC’s equity in earnings line on its income statement. Further detail will be supplied in the footnotes which it will require investors to delve into the details.  This may cause the stock to trade at a discount. 

 

DISCLOSURE:  We and our affiliates are long Millennium India, and may buy additional shares or sell some or all of our shares, at any time.  We have no obligation to inform anybody of any changes in our views of MQC.  This is not a recommendation to buy or sell shares.

 

Catalyst

(1) Approval of Deal

(2) Improved Trading Volume and Increase of Market Cap to a More Investable Size

(3) Further Growth Based on Creation of a Margin Lending Business

(4) Listing of SMC Group in India