The Emperor's New Clothes

When I was a kid, I read this beautiful story by Hans Christian Anderson about a foolish emperor. The story (called “The Emperor’s New Clothes”) is about an emperor who cares for nothing but his appearance and attire and hires two tailors who promise him the finest suit of clothes that is not visible to anyone who is unfit for his position or stupid. The emperor himself cannot see the clothes but pretends that he can, lest he appear unfit for his position. Wearing the “suit”, he comes out in a public procession and everyone keeps up the pretense praising the emperor for the fine suit. However, a child in the crowd cries out that the emperor is wearing nothing at all. The emperor is embarrassed, realizing that the child is correct, but continues with his procession.

Alas this is just a story. In this real world, the child is severely punished by the emperor. What else can explain the sudden resignation of Deven Sharma, the president of rating agency S & P? His historic decision to downgrade the AAA rating  of USA evoked strong responses from everyone. While some praised him for having the courage and conviction to take on the might of the US government, many others, including US policymakers and economists like Paul Krugman, criticized him publicly. The US government alleged that S &P overestimated future government debt by $ 2 tn. S & P countered by saying that the US government had become "less stable, less effective and less predictable". Global markets have remained volatile ever since.

However, the US government seems to have the ‘shoot the messenger’ attitude rather than focusing on the real issue here. It’s not as if one fine day S & P woke up from a deep slumber and downgraded USA. This had been coming in for a while. The following is an extract from an article on S&P’s website dated April 18, 2011.

“ On April, 18, 2011, Standard & Poor's Ratings Services affirmed its 'AAA' ratings on the United States of America(AAA/Negative/A-1+) but revised its outlook on the rating to negative. Our opinion of the recent and expected further deterioration in the U.S. fiscal profile, and of the ability and willingness of the U.S. to soon reverse this trend, was the driving factor in our decision to revise the outlook to negative.

What Our AAA/Negative/A-1+ Sovereign Credit Rating On The U.S. Means

A Standard & Poor's sovereign credit rating represents our opinion on both the ability and willingness of aparticular sovereign government to pay its market debt in full, on time, and according to the terms of the obligation.

For the U.S., our sovereign rating applies to the $9.0 trillion in publicly held debt issued by the U.S. Treasury outstanding as of Feb. 28, 2011.

According to Standard & Poor's ratings definitions, an obligor rated 'AAA' is one that, in our opinion, has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating we assign. By comparison, when we rate an obligor 'AA', we are expressing our view that the obligor has very strong capacity to meet its financial commitments. Under our ratings definitions, the creditworthiness of a 'AA' obligor differs from the highest-rated obligors only to a small degree. We may assign a plus-sign modifier ('AA+') to what we consider to be the strongest 'AA' obligors.

Our negative outlook on our rating on the U.S. sovereign signals that we believe there is a likelihood of at least one-in-three of a downward rating adjustment within two years. We currently expect that if we do lower the rating, it would be by no more than one notch to 'AA+', reflecting only a small degree of deterioration in our opinion of the U.S.'s creditworthiness.”

The real issue of discussion here is the massive US debt (expected to be close to 75% of GDP), the corresponding deficits and how difficult it would be to close it out. Debts, taken to stimulate the economy in the wake of the financial crisis, have almost doubled since 2007 (as a % of GDP). In the meanwhile, the government has neither been able to raise taxes nor been able to reduce expenditures; nor is there any ideological consensus between political parties on how to handle this situation.

Given this backdrop, S &P’s call, though questionable, cannot be drastically wrong. It could only be right or marginally wrong. The fact that US faces a severe financial challenge is  unquestionable.

Having borne the brunt of public anger and criticism in the sub prime crisis of 2008, the rating agency seems to have learnt its lessons. They do not want to be caught in the same situation as 2008 where they kept on giving high ratings to structured financial instruments only to see them crumble like a pack of cards later.

However, given what we have seen in Greece and Ireland in the recent past, there is no denying that there is a serious threat on the ability of nations to repay their sovereign debt; and the US should be no exception. So Uncle Sam, instead of shooting the messenger, you should focus on getting your house in order and figure a way out to get out of this financial mess.

Bubblegum

Some crazy stuff is happening here. Recently, I read an article on vccircle that left me completely stunned. Flipkart, a company with FY11 topline revenues of approximately Rs 6 crores per month, is raising private equity funding at a $1 bn valuation. I have to admit though that I have no idea about the profitability of the company; but just the thought of a company with a $ 16 mn turnover having a $ 1 bn valuation seems bizarre. Just to give a comparison, Infosys reached a market capitalization of $ 1 bn some where in 1998-99 when its revenues touched $ 100 mn (and this was public market valuation, which are generally much higher than private market valuations)

Hot Internet companies seem to be commanding astronomical valuations these days; both domestically and internationally.

Facebook, the poster boy of the new dotcom frenzy, is currently expected to have a shocking valuation of $ 100 bn when it goes for its IPO later this year. Zynga, the social-network games company, has been valued at $9 bn. Profitless Twitter is said to be worth $10bn. Groupon, the pioneers of group buying, rejected a $6 bn offer from Google and is considering an IPO with a valuation of $15 bn.

It seems that investors are desperate for growth and hence are willing to take on more and more risks. One measure of the frenzy is the astronomical share prices for these Internet stocks relative to their earnings.

Take the example of Linkedin. It had a successful IPO in May 2011. It went public at $45, and the stock increased about 109% on its opening day to reach a price of $94.25. The current price of the stock is close to $80 with P/E ratio of 1200. That compares with an average P-E of 14.2 for the S&P.  For the 12 month period ending on 31/12/2010, Linkedin had revenues of $ 243 mn, net income of $ 15.38 mn and operating cash flows of $ 55 mn. However, the current market cap of the company is $ 7.5 – 8 bn! In the Marwadi school of economics (that I learnt in Kolkata), one of the basic methods of evaluating a business is to see the cash payback period from the business. Even if you assume that the cash flow from operations grows at an annualized rate of 50% per annum compounding (though that is a mathematical impossibility for any extended period) it would take close to 10 years to just recover the capital.

Take an another case - MakeMytrip (MMT) . For the 12 month period ending on 31/12/2010, MMT  had revenues of $ 122 mn and a net income of just $ 4.83 mn. This is the first positive PAT that it has reported; the previous 3 years were losses at the EBITDA level. Cash Flow from Operations is a negative $ 6.33 mn. However, the market cap of the company is an astounding $ 700mn ! In fact, the company has practically had negative cash flow from operations every year for the last 3-4 years (although the revenues have trebled in the last 3 years). Its currently trading at a PE multiple in excess of 150 !! Theoretically, if I buy the entire company today at $ 700 mn and if the revenues keep growing at 50% per annum compounding, then, at the same profit margins, it would take at least 10 years just to recover the capital ! Forget about the returns mate.

Maybe I am missing some big trick here that other shrewd investors are able to see. Coming back to Flipkart, if some investor is giving them a valuation of $ 1 bn now, and assuming that they want to exit in 3-4 years, then say at a 40% IRR, the company is expected to achieve a valuation of  $ 2.7 bn in 3 years in $ 3.8 bn in 4 years. Could be possible, given the way the markets are.