For the last few years inbound (coming into the country) tourists have been around 2.5 m while out bound (going out of the country) tourists have been around 30 m. Out of the inbound, a large part of the travelers to the country are of the business class, while the rest are leisure segment. Connectivity between cities in the form of better road infrastructure, airports and seaports also play a vital role in increasing the share of India in the global tourist pie. India is a country of various cultures and has some of the world-class heritage sites, which when promoted in the global arena, can attract the global tourist.

On the domestic leisure travel front (i.e. people traveling within India for both commercial and leisure reasons), there is lot of seasonality involved. Besides, as income increases, aspiration level of the population also gains ground and consequently, spills over into better occupancy rates for hotel chains. While it may not be true for luxury hotels, players in the budget hotel sector and time-share segment benefit in a large way.

Average room rates (ARRs)
Without getting into complexities, there are three classes of rooms in a hotel i.e. business, leisure and luxury. It is important to understand that room rates are less elastic to a fall in price at the higher end of the segment (luxury) than at the lower end of the spectrum (business/leisure). Therefore, even in a downturn, players like Indian Hotels are relatively able to maintain higher operating margins than EIH. Established players in India have an edge over MNCs and the unorganized segment, due to properties near heritage sites.

Competition also plays a vital role in determining the sector’s ARRs. Currently, the big hotels have average occupancies of 60%. This points to excess supply. That itself is sometimes a dampener on ARRs.

The global scene
International hotels are derive a big chunk of revenues from casinos and betting arenas. Margins in this segment are also higher. But for Indian hotel majors, setting up casinos and betting arenas is not allowed according to Indian laws. However, when domestic hotels are compared to international hotels then they are fairly competitive in terms of average room revenues.

How to put a value to a hotel chain? Net Asset Value (NAV) is the answer.

* depending upon the area of setup

Coming to the NAV of domestic hotels, on the basis of replacement cost method let us see the value of the hotels at current prices. By NAV we can arrive at the actual value of the properties of the hotels. Based on that, NAV per share can be calculated, which gives the actual value the shareholder should be paying for being a part of the company. However, for hotels, which have been in the industry for a period of time their NAV would be on the higher side, as the property bought would be at a much lower rate than the present times. Like for instance the NAV of Taj and Oberoi Hotels would be higher than that of ITC Hotels and other hotels.

Key things to look at before investing in a hotel stock

1.      What are the strategy and the capex plans of the company over the next 5-10 years? As mentioned earlier, hotels are capital intensive in nature having long gestation periods, which not only has a bearing on the free cash flows of hotels but also affects the return on capital employed (ROCE) for a period of time. So the bigger the capex plan, the more caution one should exercise. This criteria is favorable for established hotel chains.

2.      Economic cycles also determine earnings prospects (during a downturn, properties are cheaper and hotel chain generally tend to increase capacity). Moreover, in tough times like September 11, hotel stocks take a beating. It is at this time that the established players should be looked at, for when the concerns fade away, these will be the first ones to benefit from an economic upturn.

3.      A hotel chain should not be leveraged on any specific segment i.e. luxury or leisure. Though elasticity is lower at the premium end, when tourist flow is affected, this player could be the worst hit. Diversification reduces volatility in earnings, to an extent.

While growth prospects continue to remain heartening, the sector is typically a high-risk-high-return game due to the vulnerability to external factors. Buyers beware!

Total revenues = Revenues from generation + transmission + distribution.

Generation
For a company involved in generation of power, revenues will be a function of electricity generated and tariffs applicable. Generation of electricity is a function of PLF (plant load factor) and the capacity installed. PLF, in simple words, is like capacity utilisation. The level of PLF varies depending upon the kind of generation plant. Generally, a hydro power plant or a wind energy plant have low PLF (industry average 35%-50%). Thermal and nuclear power plants have higher PLF (industry average 50%-65%), which ultimately results in higher production.

Investment in capacity in the power sector depends on various factors like: demand-supply gap (in simpler words we can say deficiency), availability of funds, economic growth and regulatory framework. All these factors are inter-related to some extent.

Demand and supply
One critical factor when it comes to analyzing a power company is the fact that demand expands as per supply. There is nothing like a ‘market size’ per se. The level of the growth in the industrial sector, per capita consumption of consumer durable and electronic goods would indicate the growth potential. For instance, the penetration level of air conditioners in India is just 0.5%. If more people buy A/C or television or refrigerator, demand for power will increase. Therefore, as far as demand-supply gap for a developing economy like India is concerned, it is irrelevant. The country is power deficient.

Availability of funds
As we had mentioned before, the sector is capital intensive. It costs almost Rs 40 m to Rs 45 m to set up one megawatt (MW) of capacity. If a company is planning to increase capacity by 1,000 MW, it requires Rs 40 bn. From a retail investor perspective, look at the cash balance and the current debt to equity ratio of the company from the balance sheet. This will give an idea whether the company really has the muscle power to expand the stated capacity in the time frame mentioned.

Economic Growth will lead to increase the purchasing power of the people, which will raise the living standard and in turn increase electricity demand. So, the circle starts again.

Regulatory framework
If a company is just into generation, it has to supply to a distributor for realising value for the quantity of power sold. If the distributor is a SEB (i.e. state electricity board), the chances of delayed payment are high, as SEBs are in poor state. Failure to receive money from SEBs could hamper a company’s capacity expansion plans.

Having looked at the capacity side, consider factors involved on the tariffs front.

For a generation company that supplies electricity to a SEB, the respective state governments fix tariffs. However, a power generation company can also supply to the national grid at a specific rate. The national grid say, Power Grid Corporation, in turn could take the onus of meeting SEB requirements. While the advantage is lower risk of delayed payment and fewer losses on account of T&D, the disadvantage is that the tariffs are lower compared to a T&D player. To put things in simple terms, the generation company gets a specific rate on power supplied whereas it is not the case with a T&D player where there is differential tariff structure.

For a distribution company (like Tata Power or BSES in Mumbai), tariffs are different depending upon the customers. Usually, industrial units are charged higher as compared to households (cross-subsidisation). Agricultural sector is a mixed bag. While some states actually charge for power supplied (like Tamil Nadu), in most other states, it is free. The advantage for a generation and distribution company is that it can pass a rise in cost to customers in a deregulated market. However, power theft and default rates are high for a distribution major. Watch out for this as well.

Transmission
There can be independent transmission companies as well (like backbone service providers in the telecom sector). The revenue model is similar. A transmission company buys power from a generation company and hands it over to SEBs or a distribution company. When it comes to advantages, it is like less capital and technology intensive. But a transmission company faces the risks of default of payment by a distributor, high leakage losses and a cap on transmission charges. Approximately 30%-35% or power generated is lost in transmission currently.

Distribution
The distribution company can also generate electricity in-house, but the process remains same. Distribution Companies have pre-defined areas called ‘circles’ where they can supply electricity. For a distribution company, metering plays a vital role. Metered units = Inhouse power generated (if any) + Power sourced from a generator to meet additional requirement – T&D losses. A major concern for the Indian distribution companies is heavy T&D losses due to poor infrastructure. Due to weak anti-theft laws, 10%-15% of power supplied is lost in distribution.

Key operating and financial parameters to be looked at

§         Guaranteed return: A power company is guaranteed a certain return on capital employed on generation by the government. If input cost increases, a generation company passes on the cost through increasing the capital employed to maintain margins. Watch out whether there is a possibility of the government reducing the guaranteed return. If it does, it could affect profitability of a power company.

§         Valuing a power company: Since this sector is all about assets, arriving a NAV is important from a retail investor perspective. It is simple and information is available in the balance sheet itself. As we mentioned earlier, it costs around Rs 40 m – Rs 45 m to set up one MW of capacity (including distribution costs). For a pure generation company, it could range between Rs 20 m to Rs 25 m.

NAV = (Capacity * rate per MW depending whether it is pure generation company or a combination of both) – Debt + Cash. Divide NAV by number of shares outstanding to get an approximate NAV. This could serve as a benchmark.

§         Dividend yield: Since power companies have strong cash flows, dividend is one key parameter to look at. Dividend yield is a very useful parameter. But if the company is in the process of expanding capacity, the dividend payout is unlikely to be high in initial years.

Apart from what all has been said above, the investor needs to look at the past record of the management, its vision and its focus on business. After all it’s the management of the company who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

Revenues
Revenues are a function of volumes and realisations. Lets look at the volumes side first.

Volumes
Volumes in case of oil sector are linked to economic growth. Why? Economic growth, as you know, is linked to the performance of the agriculture, industrial and services sector. When growth gains momentum , demand for petroleum products tends to increase and vice versa, as it is a source of energy. This is not just restricted to the industrial side but also from the retail market (more units of cars and CVs sold, higher is the demand for fuel).

·         The industrial side
Demand for petroleum products is relatively inelastic to change in prices. In case of industrial, the key user segments are fertilizer (naphtha or natural gas), utilities (naphtha or natural gas) and aviation (ATF). Any increase in power capacity, growth in tourism sector and better agricultural sector performance has a positive impact on petroleum companies. Hence, one should keep abreast of developments in these user segments. However, alternate sources of fuel like natural gas may adversely affect volumes growth.

·         The retail side
On the retail sector, demand drivers are primarily linked to income levels at the hands of people. Higher income growth will lead to a rise in automobile demand as well as usage of LPG. On the auto sector front, diesel accounts for an estimated 40%-45% of total consumption. Kerosene and petrol account for 8% and 13% of consumption respectively.

Realisation
One cannot however, ignore the realisation angle. Earlier before deregulation in 2002, the government fixed prices of petroleum products. Prices were cross-subsidised . While petrol prices were higher compared to the actual cost, kerosene, diesel and LPG were sold at lower rates. But with the dismantling of APM (administered price mechanism), prices of these products are now linked to international crude prices. What this means is that whenever crude prices go up, petrol and diesel prices will mirror the trend. Though LPG and kerosene continue to be subsidised, the government has decided to remove the subsidy in a phased manner.

As mentioned earlier, government has an active role to play in this sector. Hiking diesel and petrol prices is a politically sensitive issue, which could affect the vote bank of any ruling party. In this context, prices of LPG, diesel and kerosene are not based on reality. Government intervention and policies play a major role in determining the prices and hence one should be aware of these developments.

Expenses
Since the prices of crude oil (major raw material) are linked to international prices, one must be aware of the prevailing prices internationally. Crude oil price is known to be very volatile (has moved from a low of US$ 10 per barrel to a high of US$ 35 per barrel) and is a function of demand and supply and also various geo-political situations. This apart, currency fluctuations alter the cost significantly. Let’s take a hypothetical example to understand these currency fluctuations.

Consider that the currency rate last year was Rs 49 per US$. The crude imports were about 81.2 m tonnes. Crude prices were at US$ 27 per barrel. Now one year later, we assume that crude prices are at the same levels but the rupee has appreciated by about 6%. Then, the company that is sourcing crude will have to shell out less for the same quantity resulting in a saving of Rs 47.2 bn. Since refineries are now allowed to source crude independently, exchange rate fluctuations impact profitability.

Key parameters to look into…
Consider key things that one should look while analyzing the companies in the sector.

·         Refining capacity : To set up a 1 MT plant, an investment of Rs 10 bn is required. Of course, the cost goes down if one goes in for a higher MT plant. So, it is a very capital-intensive industry and therefore, barriers to entry are high. Besides, with environmental regulations expected to become stricter, watch out for the company’s status on this front. Higher contribution from light and medium distillates is beneficial. Higher the refining capacity, higher the chances of altering product mix to derive more revenues. Though branding is possible, petroleum products are largely a commodity.

·         Integration benefits: Another key aspect is to note whether a company is integrated forward (distribution), backward (crude oil exploration) or a standalone player (only refining). Standalone players have less bargaining power, as products have to be sold to consumers through an external distribution network. Integrated players have an upper hand.

·         Distribution network: Petroleum products are usually sold through retail outlets that offer lot of leveraging opportunity for a company. Look out whether the company owns most of the outlets or it is franchise based. It costs Rs 20 m to set up a retail outlet and if a company owns a major part of the distribution, it can be valued accordingly. By leasing out part of its distribution, a marketing company can maximize revenues (like ATMs).

·         Valuations: Since it is a commodity sector, valuations should be in line with the economic growth in the long-term. But some companies get lower valuations due to the PSU status . But if a player in integrated, valuations tend to be on the higher side. Price to earnings and price to book value are useful tools.

And last but not the least, the management’s past track record . Though the government owns some companies, watch out whether the management has been proactive in branding the product and new capacity expansions. But government intervention is still a reality and therefore to that extent, caution has to be exercised.

THE LEFT-HAND SIDE (Hours Worked)

Scalability
Not every software company has systems in place to manage large addition in employees per annum. A company can increase its staff strength to say 3,000 in the first three years. However, to increase the number to 6,000, the business model should be robust. Scalability therefore, is of high significance. To succeed on the scalability front, a software company needs to figure out the kind of capacity (physical infrastructure like development centres, marketing and distribution channels), people, and technology it needs to invest in. However, the most important aspect of scalability is to make sure that employees are absorbed and trained (including the understanding of the company’s culture and values).

Utilisation
Another aspect of scalability is the level of utilisation. A software company needs to make sure that its capacity is utilized as effectively and fully as possible. This will result in revenue maximization and higher productivity per employee. But both the factors listed above depend on the management vision, talent and ability to foresee future industry trends.

Employee retention
Owing to increasing competition for talent, the need to reward employees for the value they create is another critical factor that determines sustainable growth. The need to attract proper talent and retain it gains utmost importance. Software companies’ resort to measure like performance based incentives and ESOPs to reward their employees.

THE RIGHT-HAND SIDE (Billing Rates)

Having looked at factors that influences hours worked per annum, consider billing rates now.

The value-chain
Put simply, value chain has low-value add services like body shopping at the bottom of the chain to products at the higher-end . Moving up the value chain is delivering a service or product for which the customer is willing to pay a higher price because he perceives a higher value. However, moving up the value chain involves a whole set of issues. While marketing and branding play a key role, delivery of services is even more important. One way to measure the delivery strength of a software company is revenues from repeat business (basically, satisfied customers). Moving up the chain is an ongoing process. It takes time for a company to attain critical mass before it has the ability to bid for large value-add contracts.

Onsite and offshore
As per the outsourcing model, employees and their efforts are divided into two elements – onsite (at clients’ location) and offshore (at company’s premises). Although most of the Indian software majors are growing, success depends much on the way these onsite and offshore efforts are integrated in the most efficient manner to provide seamless services to clients. While onsite involves higher billing rates, offshore offers higher margins because costs are relatively lower.

Competition
Competition, both from domestic players and global players, also has a bigger say in billing rates. Since Indian companies are miniscule when viewed on the global scale, the bargaining power is on the lower side. Competition has surfaced from global majors setting up development centres in India in an effort to replicate the Indian offshoring model. Another thing to note here is, the higher a company is in the value chain, the lower the competition.

Key things to look at before investing in a software stock

·         Management:  A management with vision is one of the major competitive advantages. Since the software sector is dynamic in nature, management quality has a high weightage. The ability to foresee threats/opportunities without diverting from the vision is important. Retail investor could gauge this from how the company has performed in a downturn/upturn compared to its peers in their respective competencies. Scanning the companies’ annual reports or the official web site also gives an indication of the management’s future vision.

·         Employee productivity:  Productivity (revenue per employee divided by cost per employee) indicates how much value a company’s employees are adding relative to the costs that are incurred on them. These are relative terms and have to be compared with the peer group.

·         Revenue concentration:  Since this industry has a high risk-profile, it becomes important to understand from where (geographical mix), from whom (client concentration) and how (industry verticals) is the company generating its revenues. Though few clients accounting for larger share of revenue is not necessarily a negative, diversification insulates a software company from volatility. Remember, earnings visibility in the sector is relatively poor.

·         Financial ratios:  Some quantitative measures evaluating a software company stock are P/E (relative to the sector), Return on Equity, Return on Assets and Return on Capital (for profitability) and Operating margins (for efficiency). Some companies command a higher premium due to subjective factors like management quality and their position on the value chain.

A final note: Global IT spending and a move towards outsourcing

Apart from the inherent features as mentioned above, there are a few external factors like the level of global IT spending and the percentage share India is likely to get from the same (simply, move towards outsourcing). At some point, the advantage of low employee costs could dry out and the sector could get commoditised. Besides, India has competition from the likes of China and South East Asia as other outsourcing destinations.

So, building a competitive advantage is very important and for that, management quality plays a vital role. Investors do need to apply great caution before investing into software stocks.