Moats & Floats: Info Edge (India) Ltd.

Disclaimer: This blogpost draws heavily from the teachings of Prof. Sanjay Bakshi, Warren Buffett and Pat Dorsey.

There are a lot of ways to make money in the stock markets. You can scan the stocks on frequent basis and try to find any anomalies between market pricing and perceived intrinsic value of the company. Then you bet on closing of this gap.

There is another way. A better way, but the one that requires more hard work. In this method, you avoid looking at the markets at first place. You see, if you pick a company by scanning from day’s winners or losers list, your valuation would be colored. This is what is known as Anchor Bias and it will have an adverse effect on your judgement skills. So, you pick a company – a random pick. You go to the website and download last 10 years of annual reports and start going through them one by one.

You don’t have to read all these annual reports cover to cover, you can pretty much focus on just Chairman’s letter and MD&A (a tip I got from Jana’s awesome blog Seeking Wisdom).

The rationale behind going through earlier annual reports is that you should view the business as an unfolding movie, not a still photograph. Also, you want to know how they arrived at their current position in the market today and whether management is aggressive or conservative and delivers on its promises.


Moats
You also want to find out whether the business has any economic moat – hallmark of a solid company. Economic moat is nothing but sustainable competitive advantage the business might have over its competitors which will allow them to earn above normal profits for years to come.

Moat around the castle

You can assess whether there is a moat in the business is by looking at their historical return on capital. High return on capital in the past is usually indicative of wide moat. But it is not the sufficient condition. You want to look at how much free cash flow the firm is generating as the second test. If the business has to reinvest most of its earnings then it is probably not a sustainable moat.

Once you have figured out all this, then the game plan is simple:

1. Identify businesses that can generate above-average profits for many years.
2. Wait until the shares of those businesses trade for less than their intrinsic value, and then buy.
3. Hold those shares until either the business deteriorates, the shares become overvalued, or you find a better investment. This holding period should be measured in years, not months.
4.  Repeat as necessary.

Let’s understand all this with the help of a company – Info Edge (India). The company is a market leader in online classifieds business in India. Their main businesses include recruitment classifieds service (Naukri.com), property listing business (99acres.com) and matrimony services (jeevansathi.com).

The firm provides networking access and offers a platform where users can sort and match their job, home, marital partner requirements. It benefits from a network effect. For example in case of Naukri.com, it is a virtuous cycle. High quality corporate clientele ensures that Naukri.com is the portal of choice for a large number of prospective job seekers. The portal makes sure that the applicants come in contact with the appropriate recruiters, and increases the probability of a successful fitment. Equally, the presence of a large number of job seekers ensures that companies continue to use Naukri.com as a source of tapping talent. This model also allows them to consolidate operations through a large number of repeat transactions and referrals for from our comprehensive database.

Let’s run through some numbers. Here is the income statement of Info Edge (India).


You will notice that firm earns a PBT margin of around 20% and Net margin of 10%. You will also notice that the firm gets almost 10% of its topline from dividend income, interest income etc. labeled under other income. This is mostly income from short term investments in money market securities and dividends/interest income from investments in associate companies. Remember this line item, we will use it further down the road in our analysis.

Let’s take a look at their Balance Sheet now.

You will notice that firm has negative working capital. Current assets (excluding cash and current investments) – current liabilities is a negative figure.

Current assets = trade receivables (Rs. 91.67mn) + ST loans and advances (Rs. 107.05mn) + other current assets (Rs. 76.83mn) = Rs. 275.55mn

Current liabilities = trade payables (Rs. 547.65mn) + other current liabilities (Rs. 1,584.93mn) + ST provisions (Rs. 301.86mn) = 2,434.44mn

Working Capital = Rs. -2,158.59mn

Negative working capital usually arises in a distressed firm where current liabilities or obligations of the firm are higher than current assets it has on its balance sheet. It is a indicator of liquidity problems.

But, info edge is not facing any such issues. How do we know that? First, the firm has no debt, so no point of distress here. And about liquidity, firm has huge cache of short term investments which it can liquidate at a very short notice and fulfill obligations if any.

So, why is the working capital negative?

If you notice the amount under the label “other current liabilities”, it is higher than trade receivables, short term loans and advances and other current assets put together.

So what this “other current liabilities” are? Let’s take a look at this extract from annual report.

Of all “other current liabilities” income received in advance (deferred sales revenue) alone are worth Rs 1,525.54mn. Info Edge received lot of money in the form of licensing fees, subscription money in advance from users of Naukri.com, jeevansathi.com and 99acres.com which it books as “deferred sales revenue” to be recorded proportionately over the period of licensing/membership contract.

And lot of money it is.

It only speaks of strong brand recognition and solid reputation of business that customers will pay them first and then expect the business to provide them service. Not to mention its market leader position in online classified market in India which can enable it to enjoy pricing and strong bargaining power.

Now let’s come to the returns calculation. As we all know ROCE = EBIT / (Net Fixed Assets + Net Working Capital)

The firm earned a EBIT before extraordinary items of Rs. 1,256.65mn (1,226.86 + 29.85) mn in FY14.

Capital employed is the sum of money invested in Net Fixed Assets (1024.52mn) and Net working capital (-2,158.89mn). Capital employed turns out to be a negative number going by the conventional definition. But since we have included income from dividends and interest earned on ST investments in our EBIT calculation, we are going to adjust denominator with amount of ST investments. Even better explanation is provided in the extract from the book - Corporate Finance: Theory and Practice.

As we can see from the table below, the firm has generated average ROCE of 122% over its public life. It needs to be noted here that the volatility in the ROCE is because of the fact that lot of firms’ businesses are in different life cycles and require different quantum of investments at regular cycles.

Below I chart out FCF generation over the listed life of the firm, with FCF as % of sales is also charted to show how strong the FCF profile of the firm is.

So, as Pat Dorsey recommends in his wonderful book: The Little Book That Builds Wealth, there are reliable signs that firm has got economic moat. Here’s your list: 

1. A company can have intangible assets, like brands, patents, or regulatory licenses that allow it to sell products or services that can’t be matched by competitors.
    
2. The products or services that a company sells may be hard for customers to give up, which creates customer switching costs that give the firm pricing power.
    
3. Some lucky companies benefit from network economics, which is a very powerful type of economic moat that can lock out competitors for a long time.
    
4. Finally, some companies have cost advantages, stemming from process, location, scale, or access to a unique asset, which allow them to offer goods or services at a lower cost than competitors.

All signs of economic moat are present in the business of Info Edge (India) ltd. Not just the moat is present, it is widening with time as network economics creates the favorable “winner takes all” scenario for Info Edge.

Floats

The concept of “float” was popularized by Warren Buffett. In his 2009 annual letter to shareholders he writes:

So, float is being in a position of holding vast amount of money which does not belong to you, but you get to keep it for sometime and maybe invest it and earn some decent money for yourself.

Let’s take a look at Info Edge’s balance sheet once again.

Let’s re-organize the asset side of the balance sheet into financial and non-financial assets (operating assets).

Financial assets = Current Investments + cash

Financial assets = Rs. 4,295.01mn + Rs. 3,071.71mn

Financial assets = Rs. 7,366.72mn

So, the total breakup of financial assets and operating assets is as under.

Financial assets = Rs. 7,366.72mn

Operating assets = Rs. 3,233.15mn (balancing figure)

Total assets = Rs. 10,599.87mn

Now, let’s check out the liability side of the BS.

Equity: Rs. 6719.92mn

Debt = Rs. 4.38mn

Float = Rs. 3,875.57 (balancing figure)

Total liabilities = Rs. 10,599.87mn

So, balancing figure of “Float” is nothing but “Other People’s Money” (OPM) which carries no interest. Notice that this float occurs on the liability side of the money, as it is the money which business owes to other people, just like debt. But it is not debt. It does not carry any interest rate.

So, the reason that Info Edge is nearly debt free is that it has access to free money provided by other people. It does not need to borrow any money to finance its operations.

Notice that Float (Rs. 3,875.57mn) is more than Operating assets (Rs.3,233.15mn) and since float is cost-less, it can easily be inferred that other people are financing Info Edge’s operations without charging anything for it.

How could Info Edge achieve this feat?

Same mean talent with which it had negative working capital.

Of the total float of Rs 3,875.57 mn, income received in advance (deferred sales revenue) alone are worth Rs 1,525.54mn. Info Edge received lot of money in the form of licensing fees, subscription money in advance from users of Naukri.com, jeevansathi.com and 99acres.com which it books as Deferred sales revenue to be recorded proportionately over the period of licensing/membership contract.

Here is a chart from Google Trends which shows that interest in Naukri.com has always been leaps ahead of its competition in Jobs and Education related portals category. Please do notice the yellow box in the chart which explains how interest is charted.

Now the big question is how does all this affect me as a shareholder?

Let’s assume for a moment that the business does not have any float and but it needs Rs. 3,875.75mn worth of money to finance its operations. So, what are the avenues available to it?

Debt and Equity.

If Info edge employs debt, then it has to pay atleast Rs. 387.575mn in interest expense every year, assuming cost of debt is 10%. This interest expense will reduce the PBT of Rs. 1,200.85mn to Rs. 813.293mn, a decline of 32%.

And if it decides to raise money via equity, it has to issue fresh 4.5mn shares at say current price of Rs.865, it will dilute the equity base by 4% without any incremental benefit to the business.

So, to conclude this long post, I would mention again that finding good solid business is an essential ingredient for any long term success in investing. And for any business to be successful, it needs to have a strong and sustainable competitive advantage which will be reflected in its moat strength over the period of time. It also needs to have cheap access to funds (floats) to finance its operations. And when we have found such a business we just need to wait till the business is available at less than intrinsic value as mentioned above.



Happy Investing!!