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Sanjay BakshiTuesday, 7 January 2015

Teaching Note

IKYA Human Capital — A Cash Generating Machine Called 1-800-5000

I am writing this note to help you ask interesting questions from IKYA’s CEO, Ajit Isaac who will be addressing all of you on 9 January.

Thomas Cook Buys IKYA

I first got to know about IKYA when, on 5 February, 2013, Thomas Cook India Limited (TCIL) made the following announcement.

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So, TCIL — a travel and forex company, was diversifying through an acquisition into the business of HR. When I read this, a couple of key questions came to my mind:

1. The averaged-out experience (remember baseline information?) of businesses diversifying into new areas is not good. Why is TCIL doing this?

2. Most acquisitions don’t create value for the buyers (baseline information again). Why would this deal be any different?

Prem Watsa

At the time, I had no position in TCIL. I did know, however, that the legendary value investor, Prem Watsa’s company, Fairfax Financial, had acquired a controlling stake in TCIL in May 2012.

Here is what TCIL’s Chairman stated in the company’s AGM in June 2012, just after the company had been acquired by Fairfax:

I knew that Prem Watsa had delivered a terrific track record for the long-term shareholders of Fairfax, and more importantly, that track record was created through both organic and inorganic growth over more than 20 years.

Key Question: Shouldn’t a terrific past track record of value-creative acquisitions be sufficient to discard the baseline evidence evidencing that the average deal is value destructive? Key question: What happens when an experienced, well-financed acquirer with an excellent track record of making value-creating acquisitions, negotiates with a distressed seller as was the case in this acquisition?

On 19th April, 2013, a friend of mine in the UK, sent me the Fairfax AGM notes taken by his friend.

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The statement that Thomas Cook’s cash flow will be “reinvested in India in other opportunities” was very interesting to me, given what I already knew about Prem Watsa’s excellent track record in capital allocation.

Clearly, there was something interesting cooking at Thomas Cook.

Sidecar Investing with Great Capital Allocators

Key question: Will TCIL become Prem Watsa’s investment vehicle in India?

If that was indeed the case, then I was very interested in looking into this situation, because I knew that there is a lot of option value in making “side-car investments,” an idea that was described in Richard Zeckhauser’s brilliant paper titled “Investing in the Unknown and the Unknowable.” He wrote:

“Individuals with complementary skills enjoy great positive excess returns from uU (unknown and unknowable) investments. Make a sidecar investment alongside them when given the opportunity…The investor rides along in a sidecar pulled by a powerful motorcycle. The more the investor is distinctively positioned to have confidence in the driver’s integrity and his motorcycle’s capabilities, the more attractive the investment.”1

In the past, I had used this “capital allocator” mental model to invest with Ajay Piramal. I had written about that in 2011 and as I write this, since that post, Piramal Enterprises’ stock has delivered an annualised IRR of 22% as compared at 11% delivered by Nifty.

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Prem Watsa on TCIL and IKYA

I downloaded Prem Watsa’s 2013 letter to the shareholders of Fairfax. Here’s what he wrote in that letter (dated 8 March 2013) about the TCIL acquisition and also about Thomas Cook’s acquisition of IKYA:

For me, the four highlighted portions in the above letter were key.

First, the travel business was going to grow a lot over the years. And I knew that the travel business of TCIL has negative working capital because customers pay upfront, while payments for travel components (hotel rooms, airline seats etc) are made much later. The word that came to mind, obviously was: FLOAT— an idea about which I have written in the past.

Key Question: Did Prem Watsa invest in TCIL because of its float? After all his company runs a very large insurance operation and he totally understands the power of float. Hmmm…

Second, Prem Watsa wrote that he paid just ten times operating cash flow (after adjusting for surplus real estate — an adjustment2 which a control investor can make but an OPMI (“outside, passive, monitory investor” — a term coined by one of my role models, Marty Whitman) can’t.

Key Question: Why?

Anyway, this was terribly exciting for me. Whenever I see a valuation of less than ten times operating cash flow for a wonderful collection of assets (and that’s what TCIL was even before it acquired IKYA), I feel like a teenage boy who is about to kiss a girl for the first time.

Key Question: Why? (Hint: the answer is to do with interest rates of 10% p.a. as well as the

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profitable growth prospects of the business).

Third, Prem Watsa wrote that he was going to use TCIL as his India investment vehicle.3 That, incidentally, is one very good reason to justify TCIL’s decision to diversify. Earlier I had asked about the logic of TCIL diversifying into HR. I had stated that the averaged-out experience in diversification is not good and therefore, the default position for an investor should be to look at such attempts with skepticism.

Many firms continue to use their resources to diversify, however, and justify this behaviour with rationales like:

“Our cash flows are very volatile and diversification into an unrelated business will make overall cash flows more stable.”

This is nonsense. After all, investors can achieve the benefits of diversification on their own within their own portfolios. That’s the big and important lesson from academic corporate finance. So, usually conglomerates are a bad idea. But there are exceptions. Like Berkshire Hathaway. And Fairfax Financial.

Warren Buffett provides his rationale to make BRK one of the world’s largest conglomerates. In Principle # 8 of his “Owner’s Manual,” he writes:

“A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.”

In other words, diversification makes sense, if value can be created in a manner which investors cannot replicate on their own. For example, when people buy BRK’s stock, they get access to Buffett’s deal flow. Most of these deals are private, negotiated transactions, not available to the general public. While public investors in BRK don’t have direct access to those deals, no one stops them from getting an indirect exposure through BRK’s stock.

Exactly the same logic, in my view, justifies TCIL’s attempts to diversify into HR. By owning TCIL’s shares, its public shareholders get indirect access to Prem Watsa’s deal flow in India. And IKYA was just first of such deals. I was almost certain there would be others.

Key question: If Prem Watsa is buying TCIL at what he believes to be a very attractive valuation (BEFORE CONSIDERING FUTURE ACQUISITIONS LIKE IKYA), then, isn’t the package deal involving: (1) TCIL owned by a well-financed, and rational, long-term owner; (2) IKYA (and other potential future value creating acquisitions); and (3) Prem Watsa looking after capital allocation (so risk of future misallocation of capital is hugely mitigated), even more attractive?

This seemed like a pretty good package deal (like a Thomas Cook Holiday Package Deal) to me, especially given the fact that the stock market had ignored it all and TCIL’s stock price was quoting below the price at which Fairfax had acquired control over the company. Nice. I wrote about that here.

For me, understanding the IKYA deal was instrumental in deciding to invest in TCIL or not.

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Well, the fourth highlighted portion in above extract of Prem Watsa’s letter was very encouraging. He wrote:

“Early in 2013, Harsha, Madhavan and Chandran identified an excellent Indian company run by a wonderful entrepreneur, Ajit Isaac.”

Ajit Isaac

When Prem Watsa calls someone “a wonderful entrepreneur,” you don’t just sit on your ass and ignore it. You get onto Google and type “Ajit Isaac.”You hit enter, and you end up here:

http://www.youtube.com/watch?v=AHzpJIgvp0Y

My wife saw me watch that October 2012 video over and over again. (I think she was a bit jealous.) In the video, Ajit describes his journey as an entrepreneur which should be quite inspirational to you. So, you should ask him questions about that journey.

There were, of course, other things Ajit said in the video which I found very interesting.

1. He bought a significant minority stake in IKYA (funded by India Equity Partners, a private equity firm).

2. IKYA acquired Magna Infotech (India’s largest professional staffing company).3. IKYA also acquired Avon which Ajit described as India’s fastest growing FMS (facility

management services) company.4. In 2009, when Ajit invested into IKYA, it had annual revenues of Rs 100 cr. and a

combined associate strength of about 10,000 people which had grown to 45,000 people at the time of the interview.

5. In FY13, the company would generate revenues close to Rs 1,000 cr. And Ajit’s plan was to deliver annual revenues of $0.5 billion by FY15 and he could see visibility for 70% to 75% of those numbers.

6. More importantly, IKYA’s margins had expanded over this period from under 1% to more than 4% which is the industry leading margin in emerging markets for HR companies.

7. In each of its businesses, IKYA was either #1 by growth or #1 by absolute size.8. IKYA is run on two dimensions. #1 is market penetration and potential for future growth (what

he calls “volume of revenues”). #2 is margin expansion (what he calls “quality of revenues”).

9. The key differentiator for IKYA was its ownership of Magna Infotech, a company involved in professional staffing services. Ajit mentioned that Magna has an industry leading position in this field as it was three times the size of its nearest competitor.

10. He said that IKYA is not a top-line oriented company despite healthy growth in revenues. Focus, instead, is on margin expansion.

11. IKYA’s internal norm for growth is 4 times GDP’s growth rate. Even if you think, Ajit is being over-optimistic, I think should heed to Charlie Munger’s advice: “Never under-estimate a man who over-estimates himself ” You should pay attention to his track record (which I cover later in this note) and not forget that Prem Watsa stands behind Ajit.

14. Ajit said that in the next 18 to 24 months, IKYA would become the #1 HR company in India and that it would be one of the very few companies to grow to a size of $0.5 billion in less than seven years in the services industry.

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After seeing this video, one thing was clear to me: Ajit and IKYA were focused on profitable growth, the only thing that really matters if your chief interest is to earn exceptional long-term returns from ownership of great businesses. No wonder, Prem Watsa had described him as a “wonderful entrepreneur.”

TCIL On IKYA

And then, in March 2013, I saw a presentation4 put up by TCIL on its website explaining the IKYA acquisition.

You should download this presentation and read it carefully. Here are a few interesting slides.

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Notice in the above slide, net revenues have been used instead of gross revenues. This is an important point. IKYA’s main cost is the money it pays to the tens of thousands of people it employs on behalf of its own clients, who pay IKYA for this service. IKYA appears to be a low margin company because in its financial reporting it recognises gross revenues. Had it used net revenues instead (money received from clients less money paid to associates hired), its true margin profile would be revealed. For example, for the 9 month period ended FY13, IKYA delivered net revenues of Rs 91 cr., on which it earned an EBITDA of Rs 36 cr. That translates into an EBITDA margin of 39%.

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IKYA’s Value Proposition

You should spend some time thinking about the value proposition that IKYA offers to its clients and how they relate to various sources of competitive advantage we talked about in this course. A politically incorrect way (in today’s world) of putting it would be to read this crazy ad.

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“Kelly Girl” was an idea that caught the Americans’ attention in post World War II 1940s. Erin Hatton, an Assistant Professor of Sociology at the State University of New York, Buffalo, is the author of “The Temp Economy: From Kelly Girls to Permatemps in Postwar America” (a book, which in my view, focuses on the negative aspects of temporary employment) writes in a January 2013 column in The New York Times:

“The story begins in the years after World War II, when a handful of temp agencies were started, largely in the Midwest. In 1947, William Russell Kelly founded Russell Kelly Office Service (later known as Kelly Girl Services) in Detroit, with three employees, 12 customers and $848 in sales. A year later, two lawyers, Aaron Scheinfeld and Elmer Winter, founded a similarly small outfit, Manpower Inc., in Milwaukee. At the time, the future of these fledgling agencies was no foregone conclusion. Unions were at the peak of their power, and the protections that they had fought so hard to achieve — workers’ compensation, pensions, health benefits and more — had been adopted by union and nonunion employers alike.”5

Here a few more “Kelly Girl” ads which I found quite fascinating.

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It’s always a good idea to read up both sides of the story. The other side of the story — the positive side— is laid out quite well by Chris Benner in, “Work in the New Economy: Flexible Labor Markets in Silicon Valley.” Benner argues in favor of flexible labor markets by showing

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how this flexibility is a key component in the long-term competitive success of firms and industries in the Valley. He writes:

“Certain aspects of the flexibility of Silicon Valley labor markets have been a critical component of the region’s economic success. Flexibility in work practices, for instance, helps ensure rapid adjustment to changing technologies and market opportunities while also providing valuable learning opportunities for large sectors of the workforce.”

“Employment in electronic manufacturing service firms is highly insecure. Employers need to be able to rapidly ramp up and ramp down production to respond to employers’ needs. Time-to-market is a crucial competitive factor in the industry, leading to rapid fluctuations in employment. Such fluctuations occur not simply on a week-to-week or day-to-day basis, but even hour to hour.”

“An important function intermediaries play in the labor market is managing risk. The information economy creates more risky labor markets than older, stable, production regimes, for both employers and workers Clearly workers face more dire consequences of unanticipated misfortune in the labor market but employers also face risk. Unexpected competition, rapidly changing markets, technological obsolescence, volatile financial markets, and so on, can threaten firms’ profitability and even survival in unexpected ways. Both employers and workers use intermediaries as part of their efforts to minimize exposure to risk and the consequences of misfortune in the labor market. Intermediaries attempt to minimize their own exposure to risk through diversifying their relationships among multiple firms and groups of workers.”

“The use of intermediaries to manage risk is particularly strong for employers. Here, both cyclical and structural factors play a role. On the one hand, all firms experience cyclical fluctuations in demand. By using intermediaries, they can delay hiring permanent employees till later in cyclical upturns and layoff temporary employees earlier in cyclical downturns. On the structural side, an increase in the volatility experienced by firms has led many businesses to attempt to reduce their own internal labor force and shift economic risk through a series of more short-term contracts with external agents. Firms also are able to shift risks to intermediaries by reducing their own human resource screening, hiring, and administration functions, reducing their exposure to unexpected downturns while still benefiting from access to workers during upturns.”

“In Silicon Valley it is not accurate to characterize firms’ use of temporary agencies as simply a cost-cutting strategy in an effort to shrink the size of their “core” workforce and reduce labor costs for noncore positions. Firms use intermediaries to find and employ people for many purposes, including many “core” functions within the region’s high-tech industries. To be sure, temporary employees do include many assembly, shipping, light industrial, and clerical positions, which combined still account for well over half the employment in temporary agencies in the region. Temporary employees, however, also include highly skilled technicians, engineers, and computer professionals, who are the most rapidly growing segment in the temporary help industry and form the core of workers placed through many of the other types of private sector intermediaries. Furthermore, many other private sector intermediaries specialize in highly skilled occupations and thus, as a category, private sector intermediaries cut across all skill levels.”

In the end it boils down to this: You can either get job security (think jobs for life) and very few jobs and high unemployment. Or, you can get very little job security and end up with more job creation. If a capitalist is not allowed to fire workers, he won’t hire workers. A job is better than no job.6 Flexible labor markets work better than rigid ones. If you want to “Make in India,” give it a flexible labor market or it will remain just a slogan.

In my view, IKYA has a hugely pro-social business model. It offers a fantastic value

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proposition to its clients: flexibility. It also offers jobs to people who may not find any in a rigid labor market. You only have to walk into a Samsung Store to see how this works. The people who sell you mobile phones there don’t work for Samsung. They work for IKYA. Samsung wants to focus on its own core competencies — product development and branding. It wants to be able to quickly expand or contract based on market conditions just like those companies in the Silicon Valley. It doesn’t want to worry about compliance with hundreds of labor laws, some of them more than 100 years old. IKYA fills a need for Samsung. It provides it with 10,000 people who work in its stores every day. For many of these people, this is their first job. This is the first step in their life towards financial freedom. And IKYA put them there in the first place.

And you know something, the whole world will ultimately trend towards flexible markets of Silicon Valley. This is an unstoppable force. It’s already happening all over America as the chart below from a story7 in the current issue of The Economist depicts vividly.

Those temporary Kelly Girl typist jobs may have gone, but the Kelly Girl company and its peers are still around. ManpowerGroup has a market cap of $5.8 billion. Adecco has a market cap of $12 billion.

The Sources of IKYA’s Moat

Apart from thinking in terms of the value proposition IKYA offers, it will also be useful to think about various sources of moat in its business model:

1. A low cost advantage — hiring workers though IKYA is cheaper than hiring them on your own, especially if you count the cost of rehiring workers in industries where churn rates are high, training costs, and compliance costs. Moreover, IKYA can derive a low cost advantage over its current and potential competitors because it has a large scale operation, which for workers is an important consideration when deciding who to work for.

2. High switching costs — Once Samsung hires IKYA, and has virtually handed over its HR department to the company, its unlikely to fire it.

3. Network effects — IKYA is a labor market intermediary where it helps people find

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jobs and helps businesses find people who will do those jobs. In that sense, its not very different from an “exchange” like naukri.com. Large potential customers come to IKYA because it has a large talent pool and complies with all laws. Employees want to work for IKYA because they get relatively more secure jobs because IKYA is a big company. It’s no wonder IKYA now has more than 90,000 employees on its rolls.

IKYA’s Post-Acquisition Performance

How did Ajit and IKYA actually do post acquisition by TCIL? We have data for two accounting periods, which I have aggregated and annualised in the table below:

Note that the EBIT margin looks low because, as I described earlier, revenues are being reported on a gross and not net basis. You should work out, how margins look on a net basis.

One of the slides in the March 2013 presentation (slide # 5) noted that net debt in the company, as on 31 December, 2012 was Rs 27 cr. Let’s assume no change in that figure until the date of acquisition. TCIL paid Rs 256 cr. to acquire a 74% stake. For a 100% stake, this would translate into a sum of Rs 346 cr. Adding estimated net debt, the acquisition cost for the business comes to Rs 373 cr.

The computations in the above table show that IKYA earned an EBIT of Rs 85 cr. for an annualised period of 365 days. So, in effect, IKYA was acquired by TCIL at an EBIT multiple of just 4.3x. Wow.

Segment data for TCIL’s results show that the capital employed at IKYA varied as under:

Average capital employed comes to Rs 134 cr. and annualised EBIT, as computed earlier, came to Rs 85 cr. This translates into an EBIT/Average Capital Employed of 63%. Wow.

This is quite astonishing, especially when you consider other players like Adecco, and Team Lease whose filings I obtained from Ministry of Corporate Affairs (MCA) website. In FY13, Adecco India delivered revenues of Rs 1,500 cr. and pre-tax earnings of just Rs 3 cr. and Team Lease delivered revenues of Rs 1,249 cr. and barely broke even.

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Key Question: Why is IKYA so much more profitable than its competitors?

There is one company, however, which is making money. That’s Indo-Edge, the owner of the popular website, naukri.com. That company’s earnings have actually shrunk in the last two years.

Here’s an interesting piece of statistic. Info-edge earned an EBIT of Rs 120 cr. in FY14 which is about 50% more than IKYA’s annualised EBIT of Rs 85 cr. Info-Edge is currently being valued by the stock market at about Rs 10,000 cr. On the other hand, TCIL, which owns 74% of IKYA, and also owns other highly profitable assets, is being valued at about Rs 4,200 cr.

Key Question: When will IKYA overtake Info-Edge?

Key Question: What role does naukri.com play in IKYA’s business model?

Recall that in FY09 when Ajit bought into IKYA, the company had revenues of just Rs 100 cr. In just six years — by the end of FY15, annual revenues will exceed Rs 1,500 cr. I think you’ll regard IKYA as a rapidly growing company.

To summarise, TCIL bought a highly-profitable business growing at an astonishing pace for less than 5 times earnings. Wow.

Key question: How did this happen?

Key Question: Where is this cash generating machine headed?

That brings me to 1-800-5000. This is the number that Ajit thinks about every day. He invented it in 2009 when he bought into IKYA. It means 1 decade from now, 800 basis points margin, and Rs 5,000 cr. of revenues.

Key Question: Can he do it?

Part of the answer to that question lies in Ajit’s ability to profitably grow IKYA inorganically. And given that he has already concluded three deals (at least one of them will astonish you) in the last few months, I won’t bet against 1-800-5000.

IKYA Acquires Hofincons

On 5 June, 2014, TCIL announced the acquisition of Hofincons by IKYA.

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The announcement did not mention how much was paid for this acquisition.

On 27 June, TCIL announced the completion of the deal and still there was no mention of what was paid for the acquisition.

With the help of a colleague, I got hold of the financial information filed by Hofincons with MCA for FY12 and FY13.

The numbers were very impressive. In FY 13, the company delivered pre-tax operating cash flow of Rs 14 cr. while employing average operating assets of only Rs 23 cr.8 There was no debt on the balance sheet. Indeed cash assets alone were Rs 33 cr. and total net worth was Rs 52 cr.

Key Question: This was a stunningly profitable business. Why was it up for sale?

A bit of search on the net provided the answer: The Australian owner, Transfield Services, was distressed.

We come back to the same question, I had asked a while ago.

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Key question: What happens when an experienced, well-financed acquirer with an excellent track record of making value-creating acquisitions, negotiates with a distressed seller?

Fast forward a few months. Recently, I obtained the FY14 financial statements of Hofincons from MCA. Revenues for the year were Rs 145 cr. Pre-tax earnings were Rs 15 cr., and post-tax earnings were Rs 10 cr. Cash on the balance sheet was Rs 43 cr. However, the company paid a dividend of Rs 25 cr., after the year end but before the sale to IKYA. Therefore cash would have fallen to Rs 18 cr.

And what did IKYA pay for this highly profitable business? I got the answer on 25 July, when TCIL made the following disclosure to BSE.

IKYA paid about Rs 50 cr. for this wonderful business which had no debt, had cash of Rs 18 cr., and pre-tax earnings of Rs 15 cr. At less than 4 times earnings. Wow. This is what happens when an experienced, well-financed acquirer with an excellent track record of making value-creating acquisitions, negotiates with a distressed seller.

IKYA Acquires Brainhunter

On 17 September, 2014 TCIL made an announcement to the exchanges informing them that IKYA had acquired Brainhunter in Canada from its distressed Indian owner Zylog Systems.

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It appears that Zylog’s lenders sold the shares in the company to IKYA. Zylog had acquired this business for $33 million in 2010. Although I do not know what price was paid by IKYA for this asset, the same pattern seems to be playing out: An experienced, well-financed acquirer with an excellent track record of making value-creating acquisitions negotiated with a distressed seller and bought the asset.

That Brainhunter is a Canadian company and that Prem Watsa is also a Canadian is not, it appears, a co-incidence. It seems to me that Mr. Watsa is taking active interest in building value in IKYA and TCIL.

Key question: How will this acquisition add value to IKYA?

That Prem Watsa is keen to build value in TCIL and IKYA became even more apparent, when Fairfax and IKYA entered into a JV, just a few weeks after the Brainhunter acquisition.

Joint Venture with Fairfax

On 4 November, 2014, TCIL announced that Fairfax Financial has sold a 49% stake in MFXchange Holdings to IKYA.

MFXchange, is the IT subsidiary of Fairfax which supports the IT needs of its insurance businesses. That this transaction was led by Prem Watsa is evident from a recent interview9 given by Ajit in which he said:

“Despite all the competition there's an opportunity to create another billion-dollar company in the IT services industry. Fairfax has been a phenomenal backer for us—they actually came to us and suggested we integrate their IT subsidiary with IKYA.”

Key Question: How will this JV add value to IKYA?

Key Question: How does Ajit think about M&A?

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Key Question: How has the Fairfax culture influenced him?

Partnering with an Intelligent Fanatic

A few weeks ago I had shared with you, this wonderful quote from Charlie Munger:

“You do get an occasional opportunity to get into a wonderful business that’s being run by an intelligent fanatic and if you don’t load up when you get those opportunities, it’s a big mistake.”

Key Question: Will Ajit achieve his dream of 1-800-5000?

Disclosure: I own shares in TCIL, IKYA’s holding company. This is not a recommendation to buy TCIL shares.

Ends

1 See “Investing in the Unknown and the unknowable” by Ricard Zeckhauser2 While this adjustment was made, the real estate assets of TCIL are yet to be monetised.3 This intention was subsequently diluted. See, for instance http://timesofindia.indiatimes.com/business/india-business/Watsa-lines-up-1-billion-investment-for-India/articleshow/45253323.cms4 See http://www.thomascook.in/tcportal/downloads/EGMPresentationonIkya.pdf5 “The Rise of the Permanent Temp Economy” - NYTimes.com.6 Manish Sabharwal, founder and CEO of Team Lease.7 “There’s an App for that: The Future of Work,” The Economist.8 Assuming Rs 25 cr cash as surplus, as compared to Rs 33 cr total cash on balance sheet. There was no long or short term debt.9 “IKYA buys 49 per cent stake in Canadian tech company MFXchange,” The Economic Times