Indian Energy Exchange Valuation: Odds, Bets and Handicapping

Indian Energy Exchange (IEX) is the premier Energy trading platform of India. The government's goals, tuned towards better infrastructure and better industrial output, puts IEX in a sweet spot. But is the market paying up for the growth ahead or is it overpaying for opportunities that aren't even there?

The Company

Indian Energy Exchange (IEX) is the market leader in the Indian Energy trading industry, commanding a Market Share in excess of 90% and change. The second largest and organized company in this space is PXIL (Power Exchange of India Limited), which is currently owned by NSE. Probably noteworthy is the point that while IEX is a good, cash-guzzling business, PIXL is quite the opposite. A minuscule portion of the market is actually captured by 40 odd private, individual traders who operate in this space. While we're at it, let's do a quick SWOT Analysis of IEX:

Remember, just like BSE, NSE, CDSL, NSDL, NC-DEX and MCX, IEX's revenues flow from the transactions done at their exchange portal. They allow companies to trade in electricity largely. But the CEO has plans for expanding into Gas too. However, just as SEBI regulates a large portion of the Capital markets, CERC regulates the activities of IEX.

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The Industry

The Indian Energy trading sector is at a very nascent stage. I would like to go in detail about explaining the industry, but two useful resources have already done an excellent job at this: Power Exchange in India and IEX's Investor Presentation. I highly recommend that you check both of them out. I would also like you to check out Power Market Regulations (2010), for reasons I will explain later.

I would like you to note some key points. First of all, the market size is MASSIVE and the penetration of Energy trading in India is abysmal currently, which means the TAM (Total Addressable Market), as well as the CAP (Competitive Advantage Period) are chunky too.

(Source: IEX's Investors' Presentation)

The next key thing is the fact that companies in the industry have little to no pricing power. CERC regulates them. Similar to what I had suggest in my CDSL Valuation, this cuts two ways. There is a downside protection on Margins, but just as well, there's an upside cap on Margins too. You can see this manifest in IEX's numbers as follows:

(Source: Screener)

Last but not the least, IEX or PIXL, like most Exchanges, would require very little by way of Capex. You can verify this with IEX's financials or several other articles online. This allows them (IEX anyway) to have a massive RoE/RoCE, which is quite value accrective to shareholders.

Equipped with this knowledge, let's proceed with the Valuation.

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The Numbers

I took the numbers from IEX's 2018-19 Q3 Results, 2018-19 Q2 Results and the 2017-18 Annual Report. I used sites like Screener, Yahoo! Finance and RateStar too, for making historical comparisons.

Straight away, you may notice a few anomalies. Let me explain them.

Note: Number of Shares

The actual number of outstanding shares in the company is about 30.323 Crores. However, the shareholders of IEX have approved a buyback recently:

(Source: 2018-19 Q3 Results)

This essentially means that 1.23% of the total outstanding shares will be bought back by the company and cancelled from the books. While the date of the buyback has not been announced yet, I am going to go ahead and assume that the company only has 29.95 Crore shares from the get-go.

Note: Non-operating Assets

The company has about Rs. 295.61 Crores worth of investments in liquid debt/arbitrage funds. If I include this in the 'Cash Equivalents' portion of the Valuation (Where it rightfully belongs), it will cause unnecessary complications. This huge cash balance has occurred primarily because of the IPO, which isn't a regular activity. But it does form an important part of the company's Value, so I have pegged it under 'Non-operating Assets'.

Note: Risk-free Rate

The Risk-free Rate in India (The 30-year GOI Bond Yield) is currently 7.79%:

(Source: World Government Bonds)

Note: Cost of Capital (Ingredients) 

You may notice that I have mentioned 'Filler' in a number of these columns, which are used to calculate the Cost of Capital for IEX. However, IEX has been trading in India only for about ~1.3 years. This is too little a period within which to consider for the calculation of Cost of Equity via the CAPM. This is why I have chosen to ignore them.

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The Capital Conversions

Operating Lease

Although IEX is a zero-debt company, it has Operating Lease commitments, which are proxy for Debt.

However, as you can see, the absolute amount of 'Debt' is only Rs. 13.58 Crores, which is minuscule compared to IEX's Equity Capital of Rs. 288.60 Crores.

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The Assumptions

We discussed at length about IEX and the larger Power trading industry. This is how those stories will manifest as numbers in my assumptions:

High Growth Period

Statutory protection and a near-monopoly status will enable IEX to have a longer Competitive Advantage Period (CAP) in the Power trading market. So, I have chosen the longest period in my model (20 Years).

Sales Growth

Revenues will largely be driven by GOI's policies towards a better power infrastructure for the country and the betterment of Power suppliers by institutions like UDAY. A smaller portion could certainly come in the form of entering new trading areas like Gas and geographies like Bangladesh or Nepal.

Operating Margin

CERC offers both a downside protection, as well as an upward cap on the Operating Margins.

Tax Rate

Corporate Tax Rate converges to India's Average Tax Rate and then to the Global Average Tax Rate.

Capital Turnover

Now, this is where it gets a little tricky. Notice how IEX's Capital base is Rs. 288.60 Crores, while its liquid assets position is closer to Rs. 412.33 Crores? What this implies is that IEX requires very little or in fact, no Capital to run its business. So, as a proxy for this, I have entered a ridiculously high numbers for the Capital Turnover figure. However, as the company matures, it will require some amount of Capex to stay competitive.

Depreciation

Depreciation remains fairly stable.

Opportunity Cost

As mentioned earlier, we cannot use the CAPM to arrive at IEX's Cost of Capital. Instead, I am going to use the figure 11.62%, which is the 25th Percentile Cost of Capital for Indian Companies, according to Prof. Aswath Damodaran's Useful Data Sets. I consider IEX a very low Risk company, so the 25th Percentile Cost of Capital is justified. Remember when I used the 50th Percentile Cost of Capital in my HDFC AMC Valuation? This is exactly the same concept.

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The Diagnostics

'The Diagnostics' tools checks if there are any wrong entries in the Assumptions above:

Since there are no Red Flags here, let us proceed.

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The Cash Flows

Based on our Assumptions above, this is how IEX's Cash Flows will evolve over the years:

Represented in a visual format, this is how the Cash Flows would look like:

More on Business Life Cycle on this site.

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The Value

In essence, this is how much I think Indian Energy Exchange Limited is worth:

Standard disclosure: I used a 0% Probability of Failure and 10% Margin of Safety because IEX is a very safe business, with stable revenues/profits. At this level then, I believe IEX is fairly valued at Rs. 148, which is indicative of a 8% overvaluation. In other words, I think IEX is more or less fairly valued at the CMP of Rs. 158.

The model shows the CMP as Rs. 159.63, because of our earlier adjustment for the buyback in the 'Number of Shares' entry. So incidentally, the buyback price at Rs. 185 should offer you a 25% gains from my calculated fair value. Of course, acceptance is always an issue in buybacks, which you should check.

As a side-note, I think IEX is destroying value for its shareholders by announcing a Buyback at Rs. 185, when the fair value is closer to the CMP. But let's be honest. At the outset, IEX is restricted by CERC from buying anything other than 'Safe Securities'. It is also restricted from doing businesses other than trading in Power / related businesses:

(Source: Power Market Regulations (2010))

In fact, the management's notes about the business too admit the same:

(Source: IEX's 2017-18 Annual Report)

Heck, even the MD/CEO of IEX is quoted saying in a YouTube video that the Rs. ~700 Crore IPO was largely aimed at giving an opportune exit for early investors. The company has very little use for the Cash as such. I mean, do they really have a better use for their Cash? Psst! If you ask me, I'd say the company should have never gone for an IPO.

To understand what I'm trying to get to, visit my CDSL Valuation post. In fact, the whole last part of the CDSL Valuation post could be copy-pasted here and it would make complete sense. In a cash-guzzling business without ample investment opportunities, Dividends and Buybacks become the most logical use of Cash, with the latter being more efficient. However, if the company is going to do buybacks at a steep premium to value, it is better off paying Dividends and let the investors earn returns on their own terms.

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The Sensitivity of Value

'The Sensitivity of Value' tool shows IEX's Value will change for proportionately for changes in Terminal Growth and Cost of Capital.

Once again, I'm going to skip on the 'Monte Carlo Simulation' part, which I usually do in most of my Valuations. IEX's revenues, like CDSL earlier, are fairly stable. Even if I did a MCS, the results would not be far from what you see above.

The conclusion from this is that it is better to purchase the stock (If you want to at all), towards the 'Pessimistic Value' level and think about selling towards the 'Optimistic Value' level. Well, buying is fine. But selling is a different monster altogether. I suggest you read up on the article 'Apple Juice Investing: Do You Know Your Cost of Capital?', I wrote earlier in this blog.

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The Model

But yes, there is always the possibility that I could be wrong. You may think so too. If you do, download the model and change the inputs as you see fit.

(Download 'Numbers and Narratives - Indian Energy Exchange (IEX) Limited')

Let me know in the comments section below if your Value differs drastically from mine. A good conversation will add perspective to both of us.

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Thinking in Bets

One of the primary reasons I was interested in Indian Energy Exchange was because it was touted by one of my friends as a 'high quality business' which should be 'purchased at any price'. Whenever this kind of drumming up occurs for any stock, I immediately recall the 'Parimutuel' Mental Model propounded by Charlie Munger (Here's an excellent article from SafalNiveshak on the topic).

"It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets. So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. The stock market is the same way – except that the house handle is so much lower. If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things. It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing."

—Charlie Munger (USCB, 2003).

To summarize the really long text, in horse racing/betting:

• The strongest and healthiest horse has the highest probability of winning. However, the strongest and healthiest horse also has the most number of bets for it.
• The bet for which the highest number of hands are against a horse offers you the maximum pay-off i.e. If you bet for the horse. However, it is usually the weakest horse that has the most number of bets against it.
• So, the sweet spot is neither in betting against the strongest horse, nor in betting for the weakest horse (AKA Betting against the most hands), it is where you find the probability-of-winning-per-bets-against-the-horse is the maximum.

Similarly in the stock market:

• The most proven business models will generate the maximum wealth. However, the company with the most proven business model will also trade at rich valuations.
• You make the most profits by purchasing stocks at the cheapest prices. However, the stocks with the cheapest prices are usually terrible businesses.
• So, the sweet spot is neither in purchasing the most proven business model, nor in purchasing the cheapest stock, but in purchasing the stocks where the quality-per-price / wealth-created-per-value is the maximum.

If you are still interested in exploring this, I suggest you read the 19-page article 'Worldly Wisdom is an Equation' written by Prof. Sanjay Bakshi. If you haven't already read it, I can assure you, it will dramatically change the way you think about investing in stocks or investing in general.