Warburg Pincus’ dud investment in Moser Baer: An honest mistake?  

May 16, 2012

Warburg Pincus, a private equity giant, sold its investment in Moser Baer after taking a massive loss. It is strange that Warburg took 12 years to realise what was apparent long time ago

Moneylife Digital Team

The private equity giant Warburg Pincus has sold almost its entire stake in Moser Baer, for a huge loss, a few days ago. Warburg Pincus' love affair with a dubious company like Moser Baer has been an eternal mystery to us. What took Warburg Pincus so long to figure out that done a terrible investment? Moser Baer's share price has been down over 70% in the last one year. It touched its 52-week low of Rs10.95 (BSE) on 15 May 2012.

Those who have an elementary knowledge of Indian companies and corporate governance would have watched with eternal surprise how Warburg believed and funded Moser Baer's different dubious business ideas. We had pointed out that Warburg Pincus had made a terrible bet on Moser Baer three years ago in passing (Cash Machine-Check the 'Empire Building' section of the article). Let's go back 10 years when Warburg should have got alerted on the telltale signs. Moser Baer was a fast-growing, high-tech, export-oriented company having huge margins and 10% of the global market of its products in early 2000. And yet, it P/E was just around 7. The extraordinarily fat margins, ballooning revenues and bumper profits in a commodity business should have made Warburg suspicious. Few analysts ever covered Moser. When it was in the business of CDs, Moser Baer claimed to have a 10% of share of the global market. Its two key competitors Ritek and CMC Magnetics (both of Taiwan) at that time supplied nearly 50% the world's recordable, compact discs (CD-Rs). Their gross margins were under 20% in 2001. What was Moser Baer doing better than even the world leaders? Nobody could tell.

Moser Baer claimed to have a cost advantage of around 20% over its competitors. The business, which was high-tech and fully automated, is apparently labour-intensive too. The company claimed to employ 2,000 engineers and technicians for its 700 million capacity. Labour costs were claimed to be 4.7% of total operating costs compared with roughly 15% for the Taiwanese companies. That apparently accounted for half of the gross-margin differences with the Taiwanese. Secondly, for a company operating in high-cost India, Moser claimed that its capital cost was 20%-25% lower than competitors. Thirdly, its raw material cost is also supposed to be lower due to vertical integration and making in-house dyes. One bizarre explanation came from an ignorant analyst, quoted in the Asian Wall Street Journal:  Moser Baer's cost of power was 75% of that of its Taiwanese competitors because the Taiwanese factories were located across several floors, while Moser Baer's factory is all on one floor! "Maybe it requires more power to move things vertically than horizontally, because it takes more traction and energy to move upward than sideways," the analyst has been quoted as saying.

Another analyst speculated that Moser negotiated a lower royalty payment with Philips, which holds a patent for CD-Rs. But Ritek's spokesman Shaun Lee was quoted by the Journal as saying that "Ritek's royalty payment is 3.5 to 4 cents per unit, and it's the same for the whole industry." Moser Baer corroborates this. The management even offers a technology factor for lower costs. In an interview to the Journal, Ratul Puri said: "We are able to coat one disc (with dye chemicals) in about six to seven seconds compared with the conventional process that takes eight to ten seconds. That improves capacity (now 760 million pieces per year), resulting in 25%-30% cost savings." He also said the technology enables the company to price some products 10%- 30% higher. While there is no way to verify this, the market obviously does not believe this. Meanwhile, lots of questions are unanswered.

•  Moser's products are commodity products. There is overcapacity in CDR and prices are not going up. Inventory build-ups are common. How can a manufacturer command high margins in this situation?

•  The company claims to have nine major global brands as customers to whom it provides just-in-time delivery/local packaging/product & distribution management. It also claims to have strong brands and has penetrated large superstores in Europe. How does it manage such fine logistics out of a country like India when other exporters are frustrated?
   
• There were several strange accounting signals. Although its margins and cash flow are very high, MBI has huge debts and high interest burden. In shady companies, this is a sign that cash routing is taking place to boost sales through borrowed money. While this may not be the case in MBI, it creates suspicion and explains the terrible P/E. Moser Baer claims that its investment cost is 10 cents of working capital and 27 cents of capital investment leading to 10 cents of PBIT. But only when it stops investing will the financial picture be clear.  

The business model was clearly hollow. If that was not enough of cause of concern for Warburg, alarm bells started ringing loudly when SR Batliboi, auditors of Moser Baer, resigned mid-way without certifying the full-year results for 2003. It is extraordinary that Warburg continued to back Moser management after this.

When a business model does not work, Indian businessmen either restructure or plan for a new business. As oil prices have been high since 2007, Moser cooked up the idea of getting into solar power-with more cash from Warburg. When you saddle a company, especially in one whose product is essentially a commodity, with lots of debt (and convoluted ideas), its interest costs alone will eat up the profits, leaving little or no room to not only service the debt but also to do any sort of business and a drastic decline in governance. The markets will be able spot this from a mile which is why Moser remained a 'cheap' stock.

But all such tricks come to an end and not surprisingly, the company has reported losses for the four consecutive years preceding 2011. In fact, its numbers have got so bad that it is currently undergoing Corporate Debt Restructuring for its businesses. Very few foreign institutional investors seriously bought this stock. Warburg Pincus was alone in keeping the faith for a very long time.

According to Bombay Stock Exchange filing, a company called Global Town Investments, which operates from Seychelles, has picked up Warburg Pincus' stake sale. Interestingly, the promoters of the firm hold only 16.29% of the company while Global Town Investments hold 24.5%  of the stake (which is just shy of an open offer trigger), making the latter the largest single shareholder of the company.

The question is, was it all an honest mistake on the part of Warburg, a large and smart global PE player? And that too, for over a decade? Or were Warburg managers were active partners in this game of value destruction?