Valuation in Motion: HDFC AMC IPO Valuation: Speed Demon

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‘Mutual Funds Sahi Hai’ says a famous Indian TV advertisement. While the slogan is used and abused several times over, the sentiment seems to ring true with many Indians. We know for a fact that only 2-3% of India invests in Equities directly or in Mutual Funds. However, the general trend is that the number of people investing in these modern savings schemes have increased drastically. So, it would be an understatement to say that HDFC AMC filed for an IPO at the most opportune of times. With HDFC AMC’s IPO opening today (25-07-2018), I wanted to register my thoughts on the company and its Valuation before I could be accused of hindsight bias from the Listing Price.

The Company

HDFC Asset Management Company was incorporated in 1999, at Mumbai. Backed by a stellar promoter in HDFC, HDFC AMC grew leaps and bounds. Starting with an AUM of Rs. 6.5 Billion in 2000 and multiplying it to an AUM of Rs. 3 Trillion in 2018, HDFC AMC clocked a mind-boggling CAGR 40% and then some. Along the way, the company picked up Zurich Asset Management and the more impressive, Morgan Stanley’s Mutual Fund Schemes in India, thereby increasing their reach. The funds managed by the company have received several awards over the years. So, I am confident in saying that the company’s quality is top-notch. Investors should exercise due diligence and refer to the company’s IPO Offer Document filed with SEBI, in order to familiarize themselves with the company’s business, key risks and financial statements.

The Industry

The Indian subcontinent has always been known for its high savings rate. So, it shouldn’t come as a surprise when we realize that India’s Gross Domestic Savings Rate stands at 29%, when compared to the Global Average Gross Domestic Savings Rate of 25% or so. Couple this with the fact that the AUM of Indian Mutual Funds grew at a staggering 25% CAGR (Equity Mutual Funds grew at 38% and Debt Mutual Funds at 15%) for the past half a decade and you have a clear trend.

HDFC AMC stands to gain a lot for this transition from traditional savings (Post Office, Fixed Deposits, Gold) to modern savings methods (Equity, Debt, Hybrid, Commodities, Derivatives). The fact that the promoter is HDFC, a well-trusted and household name in India, offers more solace for investors.

However, the Asset Management industry itself is gearing up for intense competition, the likes of which were already witnessed in mature economies like the US. A simple Google search will reveal that there are more than 11000 recognized Mutual Fund Schemes in India, managed by more than 40 odd Fund Houses. Data from Wikipedia enables us to visualize the AUM of the top 10 players, who make up almost 80% of the market:

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While ICICI AMC and HDFC AMC lead the pack, the others aren’t so far behind. In fact, HDFC AMC only commands a 13% Market Share, in spite of its massive AUM. So, my base case for HDFC AMC will be one of explosive growth, at the cost of eroding margins (Owing to cut-throat competition) and minimal reinvestment.

The Numbers

So, this is how the numbers are filled up in the Valuation model:

Ignore items like Company Beta, Industry Beta and Industry D/E. They are simply placeholders and I will not be using them in this Valuation (For reasons which will be revealed shortly).

The Capital Conversions

R&D (Employee Benefits Expense)

Here, we are faced with a conceptual roadblock. Manufacturing companies are more reliant on their Physical Assets. And so, Manufacturing companies report R&D separately. Companies like HDFC AMC rely a lot of their human capital i.e. their employees. So, whatever R&D they do are most probably reported under ‘Employee Benefits Expenditure’ as well. We do not get to know what part of that expenditure is short-lived (Expensed) and what part is long-lived (Capitalized).

This manifests itself as very high Returns on Capital Employed for companies reliant on Human Capital. In reality, as discussed, there arises a need to ‘capitalize’ a part of the employee expenditure to normalize the capital and earnings position of the company. A simplistic representation of this would look something similar to this:

As far as HDFC AMC is concerned, I’m going to assume that 50% of their Employee Benefits Expenditure is actually related to work that is long-lived (For lack of specific data) and that the gestation period for any new R&D is 5 years (That is, Employee Benefits Expenses until 5 years back will be capitalized):

When an expense is capitalized, 3 things happen: Profits go up, Assets go up and Depreciation/Amortization goes up. So what goes down? Well, as discussed earlier, since the Asset position of the company has gone up, it is the equivalent of demanding the company to earn a return on that ’employed’ Asset. So, the Return on Capital Employed goes down. In essence, it is only a logical adjustment to show the true financial position of the company. It has an offsetting effect permeating throughout the Financial Statements of the company, so nothing is lost in translation. To understand this better, I suggest reading a paper on the same by Prof. Aswath Damodaran. Here is how HDFC AMC’s important figures looks like, pre and post labor capitalization:

Equity Options

HDFC AMC has issued a small portion of its Equity as ESOPs. Although insignificant, here is how their ESOPs are valued:

With that done, let’s dive head first into the assumptions.

The Assumptions

Do you remember my story for Valuing HDFC AMC? Let me remind you: So, my base case for HDFC AMC will be one of explosive growth, at the cost of eroding margins (Owing to cut-throat competition) and minimal reinvestment. This is how the story materializes as numbers on the model:

I have also substantiated my assumptions with logic. A few key things to note here:

  1. Sales Growth is excessive in the High Growth period, but converges to half of the long-term Risk-free Rate. An economy typically grows at a little below the Risk-free Rate. So, in the long term, a mid-sized company is likely to grow at about half of that. Only newer industries contribute to excessive GDP growth.
  2. Operating Margins drop in the High Growth period, in line with my story and finally converge towards the Average Margins of the Asset Management industry in India (Data as obtained from Prof. Aswath Damodaran’s ‘Useful Data Sets’)
  3. Tax Rate converges to towards the Global Average Tax Rate.
  4. Also, as mentioned in the story, the reinvestments are very low
  5. The ‘Opportunity Cost’ is nothing but the 50th Percentile WACC of all the companies in India (Data as obtained from Prof. Aswath Damodaran’s ‘Useful Data Sets’). This is as good as saying that HDFC AMC has ‘Average Risk’. I usually use the Industry Average Beta to arrive at the Bottom-up Beta-based CAPM WACC. But for lack of enough (At least 3) listed peers, I chose to go with the above way of accounting for HDFC AMC’s Risk.
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The Diagnostics

No red flags here. A few ‘yellow flags’, but all of them are already discussed and substantiated.

Let’s move on.

The Cash Flows

This is how HDFC AMC’s Financial Position will evolve, based on our assumptions:

Nothing to change here, but observe.

The Value

Allowing for a 1% Probability of Failure and a 5% Margin of Safety, this is how I arrive at HDFC AMC’s Intrinsic Value:

In essence, I believe that HDFC AMC’s IPO is priced up to the neck, even when the company’s MD claims that the offer is priced ‘conservatively’. I’ve always held the view that IPOs were never a good bargain. More of my thoughts on IPOs here. Here I must insist that you read pages 113-115 of the IPO Offer Document of HDFC AMC. The company has shown how they have priced the offer and what assumptions went into their pricing model (In short, an explanation of their Book Building process). As a watchful investor, it is left to your vices to decide which set of assumptions make more sense to you.

The Sensitivity of Value

The Sensitivity of Value tool, which simulates the final Value based on changing assumptions for Terminal Growth and Cost of Capital, shows a Win-Loss Ratio of 0.75. The median Value of the simulation, as displayed in the middle, is Rs. 1036.

The Monte Carlo Simulation

As I keep reiterating in my blog posts, the true way to stress-test a set of assumptions is through a Monte Carlo Simulation. If I randomize all my assumptions in the range of +/- 15% (A nominal spread), this is how the output would look like:

After a few key strokes in Excel, a little formatting and the picture looks clearer:

If you understand Normal Curves, you will appreciate my interpretation of the graph above:

  • The Values at the far end (Rs. 298 and Rs. 1819) are bound to be wrong, meaning you should strongly consider Buying/Selling if and when they reach these prices respectively
  • The ones to the right, in orange and red-colored call-outs (Rs. 1276 and Rs. 1466) are increasingly overvalued levels
  • The ones on the left (Rs. 841 and Rs. 651), conversely, are increasingly undervalued levels
  • Rs. 1058 is the most probable Value for HDFC AMC
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The Model

Don’t agree with me on some of my assumptions? Does your story for HDFC AMC sound more logical than mine? You can download the model and try changing the assumptions yourself:

If your Value differs wildly from mine, do let me know in the comments below. A second opinion goes a long way.

This is all I have to tell you about HDFC AMC, Value-wise. The IPO opens today. If you have indeed bid for the stocks of the company, then I wish you all the very best. While my calculated Value is below the IPO price, I take pleasure in recalling a quote:

Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.

Charlier Munger.

That’s a very different perspective. Personally, I associate myself with the Warren Buffet School of Hard-knocks. I’m always paranoid. I Value stocks based on Discounted Future Free Cash Flows (The right to which, exactly, a stock provides). I try to buy things worth Rs. 100 for Rs. 50. I call myself, at the expense of sounding cheesy, a ‘Value Investor’. Well, whom do you side with?

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Dinesh Sairam

Dinesh Sairam

Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME
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