Beowulf Capital

The Folly of JC Penney

2014-10-26T07:18:00.002+05:30

Buy Price -- $27 and $19; Sell Price $9.

The security had most of the hallmarks of a good investment. A legendary investor was buying the security, he was bringing in fresh management to take out the excess he had painstakingly identified by comparing the company in question with its peers. The company had a huge margin of safety through the real estate assets it owned over decades (which were recognized on the balance sheet at historical cost). The investor was bringing in a realty firm specialized in spinning off the real estate assets. The new management's strategy was as tantalizing as it was bold. The new retail store design was as original as the new Apple stores and it was designed by the same man. We made an investment in what we thought was a sound security.

How did it play out?

Approximately 24 months later, the legendary investor had resigned from the board and had sold the shares. The CEO was fired, the new strategy was in shambles, the company was raising capital in the markets and drawing on revolvers, the realty firm had sold the shares and left the board, the old CEO was bought back and we had lost 65% of the original investment.

The company in question was JC Penney and we had followed Bill Ackman into the common shares on terms almost similar to the ones made by him. Ackman had bought in Ron Johnson from Apple to run the company with a bold new strategy. Johnson made a $50M investment in the company's common shares that he could not sell for the next few years; his incentives were aligned with the shareholders. He also ringed in Vornado Realty to the board and they invested in the common shares as well. Along with these changes, a vision of 'Store within a Store' was announced, which was as innovative and as disruptive as the original Apple stores. All brands would have their own stores inside the JC Penney stores; a bold vision.

The original thesis of the investment had a lot of merit. It is the un-examined risks that came back to bite us later. We had forgotten the old adage that turnarounds rarely turn. The story was so compelling that we forgot to evaluate what would happen if the real estate could not be sold and if the new strategy did not work out. In short, we had not tried to kill the company.

The value of the real estate of JC Penney was worth quite a bit more than the market cap of the company indicated. However, as long as JCP was an operational company, it had next to no value. It had a lot of value in bankruptcy. While it was clear that the leftover for the common after all the employees and the bond holders had gorged their share of the carcass was probably more than the value of the common, to get access to that margin of safety, one had ensure years of operational losses and misery as the company convinced itself that it was better off in bankruptcy than in operations. What was the several $s over 27 worth 10 years down the line? A closer examination of our margin of safety would have revealed serious holes in our original thesis.

Furthermore, the store within a store concept required customers to change behavior (which is a red flag) and a cynic would have pointed out that it was like Wal-mart trying to act like Tiffanys. The typical customer for JC Penney lived on the discount coupons that the company regularly sent out to them and convincing themselves that they got a great bargain shopping at JC Penney. Convincing these customers on what might look like a great strategy for Apple should have been a red flag.

What happened over the next 24 months was what can be plainly explained as a butchery of execution. Overnight, the company abandoned the pricing policy that had been in place for decades and in doing so alienated most of the consumers. Without a pilot, they tried to roll out the store within a store concept nationally. Overlaying all this, the management was trying to convince customers that they had got it all wrong and the company was built for greater heights. The management kept building sand castles to the investors while the key operational metrics like SSS nose dived and consumers started leaving the stores in droves never to return back.

Not one thing went right with JCP in these 24 months. Ron Johnson was fired, the previous CEO was bought in, credit lines were drawn, Vornado threw in the towel, Bill Ackman left the board and the strategy was buried deep in the sand it was unearthed from.

Fairfax and Base Effect

2014-04-12T19:20:00.000+05:30

In the previous post, we had spoken about 5, 10 and 15 year record of Fairfax.

So, why do we hold Fairfax?

a. Since 2008, Fairfax has publically had a different equity strategy compared to Berkshire and Markel.

b. If we consider 2009 to 2013 as base effect issues because they have taken a fairly different strategy as against the market.

c. Let us look at 1998 to 2008 and 2003 to 2008 and 2008:

Fairfax

1998 to 2008 9.3%
2003 to 2008 10.9%

Berkshire

1998 to 2008 6.4%
2003 to 2008 6.9%

Markel

1998 to 2008 11.2%
2003 to 2008 9.6%

Fairfax and Thomas Cook

2014-04-12T19:04:00.001+05:30

When Fairfax financial invested into Thomas Cook, every Tom, Dick and Harry went out and bought Thomas Cook in India as they thought they were buying into the 'Warren Buffett of Canada'. The 20% compounder, value investor supreme.

So, we decided to look at Fairfax financials - the actual parent company - and look at their performance versus Berkshire and Markel and see how the numbers stack up. The table below explains itself.

While this is not representative of what Thomas Cook will do, one must look carefully at how Prem has performed in the last 10 to 15 years. Please note that the annual change is Book Value change, there is no point in tracking the stock performance.

If you take out the first few years of Fairfax, it is a very different story.

FairFax Financials	100 $ Invested	Annual Change
	100
1998	130.0	30
1999	179.4	38
2000	170.4	-5
2001	134.6	-21
2002	144.1	7
2003	188.7	31
2004	186.8	-1
2005	156.9	-16
2006	171.1	9
2007	261.7	53
2008	316.7	21
2009	421.2	33
2010	429.6	2
2011	416.7	-3
2012	433.4	4
2013	390.1	-10

1998 to 2013	9.5%
2003 to 2013	7.5%
2008 to 2013	4.3%

Berkshire Hathaway	100 $ Invested	Annual Change
	100
1998	148.3	48.3
1999	149.0	0.5
2000	158.7	6.5
2001	148.9	-6.2
2002	163.8	10
2003	198.2	21
2004	219.0	10.5
2005	233.0	6.4
2006	275.9	18.4
2007	306.2	11
2008	276.8	-9.6
2009	331.6	19.8
2010	374.7	13
2011	392.0	4.6
2012	448.4	14.4
2013	530.0	18.2

1998 to 2013	11.8%
2003 to 2013	10.3%
2008 to 2013	13.9%

Markel	100 $ Invested	Annual Change
	100
1998	118.4	18.4
1999	105.2	-11.2
2000	157.5	49.7
2001	169.5	7.7
2002	180.9	6.7
2003	215.4	19.1
2004	258.1	19.8
2005	267.0	3.4
2006	352.6	32.1
2007	407.0	15.4
2008	340.9	-16.2
2009	433.6	27.2
2010	500.8	15.5
2011	540.2	7.9
2012	619.7	14.7
2013	732.1	18.1

1998 to 2013	14.2%
2003 to 2013	13.0%
2008 to 2013	16.5%

Disclosure: Long Fairfax for a very strange reason and a small portion of the portfolio. No position in Thomas Cook

Correlation and Concentration!!!

2014-03-31T20:27:00.001+05:30

Beware of the contents in this post!!!!

One of the cardinal rules in investing has been diversification to prevent concentration and correlation of risk!! Currently, I am in serious violation of the rule in a significant portion of the US portfolio on the rule and I am NOT losing any sleep over it.

Will my volatility be higher? The answer is yes. Will there be significantly higher volatility than the rest of the market? The answer is absolutely yes.

But in my book, volatility and risk are not the same. My correlation and concentration are between companies that I consider Fort Knox's of the world and while we may a terrible year because the all the stocks in the sector might go down in a particular year, we are not worried.

Our position derives from our significant exposure to the insurance businesses in the US. A significant piece of our US portfolio rests with four US insurers -- Berkshire Hathaway, Fairfax financials, Markel and AIG.

We expect all these companies to exist 25 years from now playing with their services still being required in the economy. While there might be a year or two, where due to natural catastrophes or bad year in the stock market or regulatory headwinds, we might see a significantly bad years but overall we do not intend to sell any of these four anytime in the near future and are willing to ride through volatility.

We were lucky to buy the companies that were well in discount to their intrinsic value. We bought Berkshire on two occasions when WEB gave a singing endorsement by buying back stock. (We are happy to buy with the same terms as WEB though his cost of capital is lower) We bought Markel at book value right after the Alterra acquisition and Fairfax at discount to book value a couple of years ago. AIG was acquired at 0.5 times book. All were purchased with a margin of safety and run by top capital allocators who will do a tremendous job in a downturn in deploying cash,

We are very comfortable with the management all these four companies and expect them to do very well over the course of the next ten years.

Intensifying Reseach

2014-03-31T20:07:00.001+05:30

At Beowulf, despite the decent results we have been cornering, we have decided it is time to step up the game and we will be intensifying the amount of research that we are doing and to post it on the blog.

Our AUM is growing at a very healthy pace and our returns while not spectacular has been compounding steadily and been giving fitful sleep at night.

We are not neither worried, bothered or irritated by the market going up so much. While the opportunities are not plentiful as they were several months ago, we are finding decent opportunities and are happy sitting on an ever growing big pile of cash.

It is a first class problem to have.

Our concentrated book in India is now with five names only. We are highly dependent on the underlying business performance of these companies over the next five to ten years in order to make a decent killing over the market. We are not worried what the everyday stock price is doing but it does not bother when they go up too much too quickly.

We are not good sellers of the stock....

Instead, we have decided that our hurdle rate and the standards have to go up in times like this when our cash pile goes up so quickly and that is precisely the reason why we are planning to intensify the research that we are doing at Beowulf.

Any new idea must be a killer one to get us interested!!!!

Flash Boys

2014-03-31T19:54:00.001+05:30

I had the chance to read through Flash Boys. It was an intriguing read about dark pools and how HFT have rigged the price of the stock market and chiselled money from the small investor.

As WEB and CM call it, it is legalized front running. Lewis again does a masterful job of capturing the story the only way he can.

A definite read.

My take on it --- as it stands now, it is like a tax on trading that all small investors and big investors have to bear with.

Another reason to minimize the trading activities. Such practices have existed for as long as wall street has existed. It is nothing new. I was surprised to the extent that the practice has spread but nothing about wall street will really surprises me anymore.

The only predictable thing in the book was the involvement of GS (of which we are long) The vampire squid has been involved in every single scandal of the 20th century and is unlikely to break the trend in the 21st century.

I will not be surprised to see outrage on HFT's but very little action. There will be probably more regulations and more ways to circumvent them......

The disparity between the underlying business results and stock prices

2014-03-02T13:21:00.003+05:30

What does Berkshire, Markel, AIG, Piramal, Shriram Transport Finance, Shriram City Union Finance, Yes Bank, Fairfax all have in Common?

All these stocks are in my portfolio and in the last 12 months despite a strong operational result, all these stocks are trading a good fair discount to their intrinsic value. While one might dispute with the Indian NBFC's whether the results can be called strong, it is undeniable that a good growth in book value backed by conservative accounting and management will deliver long term returns in the market. One must also consider how the NPA rules for NBFC's have changed in the last 12 months. This makes the NBFC provisioning even more conservative...

Patience and the ability to ignore the crowd is definitely an advantage in this market.....

Piramal Glass

2014-03-02T13:21:00.001+05:30

Piramal Glass ---

We were caught dead wrong about how we had anticipated Piramal Glass would pay out. A couple of days after the delisting offer was made, we decided that if the scrip continued to trade below INR 80, we would buy a stake in it.

On Monday morning, it was trading at about INR 92. We thought the price was too high and sucked some more wind. Tuesday morning, it was INR 110 and has been hovering around the INR 103 mark.

At Beowulf, we had been sucking our thumbs since the early 70's without any decision and it costs us quite a few bucks....

Well, can't win them all.

Berkshire Hathaway Annual Letter

2014-03-02T13:01:00.001+05:30

The awaited Berkshire Hathaway Annual letter came in last night. It was a little pale by most standards but the performance of the company continues to be very strong .

The company generated about $20B of profits for the entire year of 2013. The book value at the end of 2013 was about $135K per share... On the two occasions that we have purchased the stock the book value was $100K and $115K in 2011 and 2012 respectively. The juggernaut continues to roll on.

It is clear from the letter that both Warren and Charlie are looking for more acquisitions in the future. There is also an indication that the 2014 might be a better year than 2013. Insurance business and regulated utilities are firing on all cylinders and all the acquisitions are performing fine.

Based on last Friday's closing of $172K per share of Berkshire -- it still looks like a steal. Warren would want to buy Berkshire at 1.2 times book. The stock is trading at 1.27 times book.

It will interesting to watch the performance on Monday morning. If the price hangs around where it is now (which we highly doubt) -- we might make some additional purchases to supplement our already large positions.

Disclosure -- Berkshire is the second largest holding in our portfolio.

Wockhardt -- Another Update

2014-02-16T17:34:00.002+05:30

We had posted that the pain might be over for Wockhardt last summer. Looks like the stock is down in the dumps at this point.

Management ethics and governance is almost everything in India...

On the other hand, Lupin is still steady... After careful review last July and August, we decided to do nothing at this point on the Lupin stock...

Lupin & Wockhardt

2013-07-14T14:51:00.000+05:30

Below is the warning letter that FDA sent to Wockhardt for the same facility that the UK regulator MHRA banned the imports from in 2013. It looks like Wockhardt has had warning letters in 2006, 2008, 2010 and 2012 from either FDA or MHRA across its global facilities. A little bit of research would have saved investors a lot of pain.... (below is the performance of Wockhardt in the last 6 months)

http://www.accessdata.fda.gov/scripts/warningletters/wlSearchResult.cfm?qryStr=wockhardt&webSearch=true

Public Health Service Food and Drug Administration
	Rockville, MD 20857

Warning Letter

Via FedEx

WL: 320-06-01

FEB 21 2006

Mr. Raju Krishna Swamy
Vice President - Manufacturing
Wockhardt Ltd
L-1, MIDC Area, Chickalthana
Aurangabad - 431 210
India

Dear Mr. Swamy:

We have completed our review of the inspection of your pharmaceutical manufacturing facility in Walju, Aurangabad, India, by Investigator Alicia Mozzachio, Microbiologist Raymond Oji and Chemist Felix Maldonado, during the period of November 8-11, 2005. The inspection revealed significant deviations from U.S. Current Good Manufacturing Practices (CGMP) in the manufacture of drug products and active pharmaceutical ingredients (API's). The deviations were listed on an Inspectional Observations (FDA-483) form, issued to you at the close of the inspection. These CGMP deviations cause your drug products and API's to be adulterated within the meaning of section 501(a)(2)(B) of the Federal Food, Drug, and Cosmetic Act.

Our review also included your December 7, 2005 response to the FDA-483 observations . We believe the following deficiencies need more comprehensive corrections.

1) Written production and process control procedures were not always followed and documented at the time of performance. 21 CFR 211.100 (b)

A. The process Validation protocol of [redacted] tablets was not followed. (Observation #5 on the FDA-483) The protocol states [redacted] which results in a sample range of [redacted] to [redacted] mg. The samples that were taken were documented as 115g, 3.5g and 115g, which are all outside the range allowed in the protocol. Your response to this deficiency is not adequate in that it states that the 3.5g sample was erroneously documented, and was actually a 35g sample . This does not address the taking of excess amounts of material for testing. The investigators also noted that it was unclear in the [redacted] individual samples were maintained separately or combined. Please demonstrate tot us that this protocol is accurate or that a new protocol was carried out correctly. Also, pleas provide corrective action for not following approved protocols.

B. The locations of [redacted] used for environmental monitoring during the execution of Protocol [redacted]were not documented until eight months after the execution of the record. (Observation #3 on the FDA-483)

Your response states that a drawing of the locations of the [redacted] during the [redacted] effectiveness study was prepared for the investigator; however, this drawing was pre are d from memory. The observation is citing failure to define or document the location of the [redacted] prior to or during the study. Your response also did not address the issue of preparing and approving validation protocols which lacked this important information. Relying on the recollection of an employee eight months after the protocol was executed is not good practice. Further, no preventative actions were submitted for future protocols and studies.

2) Control records do not include complete and accurate information relating to the production and control of each batch. 21 CFR 211.188

A. The [redacted] preparation record did not include documentation to confirm the addition of [redacted] to the[redacted] used for environmental monitoring . (Observation #4 on the FDA-483)

Your response states that the SOP for "Storage, preparation and sterilization of the [redacted] has been revised. Although the of the SOP addresses this problem going forward, revision response does not explain how your firm knows whether [redacted] was added to the [redacted] prior to the revision. The lack of documentation supporting the addition of [redacted] the environmental monitoring calls into question whether or not this addition did indeed occur, especially since other additions to the [redacted] during inspection documented. Documentation reviewed during this inspection as well as the last inspection showed extremely low counts on your environmental monitoring. Without the [redacted] addition to the [redacted] the [redacted]nature of the drug many not have been inhibited. Please demonstrate that the environmental monitoring of your [redacted] products is representative and accurate, and includes accurate documentation for these products prior to shipment.

B. The [redacted] logbook did not contain complete and/or accurate documentation. (Observation #1 on the FDA-483)

Your response indicated that the SOP cited was updated to include the signature of the person performing the operation. We expect that all entries in logbooks, batch records, laboratory documentation and all other documentation be signed by the person who performed the operation. Having a supervisor sign does not give the same level of accountability. Your response did not contain a global evaluation of other logbooks where entries may be performed similarly.

Complete, true and accurate records are the foundation for good GMPs. Reliable documentation is a control which raises assurance of the quality of the product manufactured. Violations concerning inadequate documentation are serious and should be handled as such.

We are also concerned that the two previous inspections also noted failure to maintain complete and accurate records, and that your firm may not have taken this type of discrepancy seriously and thus has not corrected the documentation practices of your employees. In addition, during a regulatory meeting with your firm on May 7, 2004, management indicated to us that inappropriate documentation practices have occurred at your facility . Practices such as back dating and signing for actions not performed are serious violations.

Failure to correct these deficiencies may result in FDA denying entry of articles manufactured by your firm into the United States . The articles could be subject to refusal of admission pursuant to Section 801(a)(3) of the Act in that the methods and controls used in their manufacture do not appear to conform to Current Good Manufacturing Practices within the meaning of Section 501(a)(2)(b) of the Act.

Please respond to this letter within 30 days of receipt. Your response should include data collected in your correction to the deficiencies cited as well as copies of procedures not already included. Please identify your response with FEI 3004540156 . Until FDA can confirm compliance with CGMP's and correction to the most recent inspection deficiencies, this office will recommend disapproval of any new applications listing your firm as the manufacturer of Active Pharmaceutical ingredients and finished pharmaceutical drug products . Please contact Carole Jones, Compliance Officer, at the address and telephone numbers shown below, if you have any questions, written response or concerns regarding these decisions.

U.S. Food & Drug Administration
CDER HFD-325
11919 Rockville, Pike
Rockville, MD 20852
Tel : (301) 827-9054; FAX (301) 827-8909

To schedule a re-inspection of your facility, after corrections have been completed and your firm is in compliance with CGMP requirements, send your request to: Director, Division of Field Investigations HFC-130, 5600 Fisher's Lane, Rockville, MD, 20857. You can also contact that office by telephone at (301) 827-5655 or by fax at (301) 443-6919.

Sincerely,

/s/

Nichalos Buhay
Acting Director

Division of Manufacturing and Product Quality

Center for Evaluation and Research

We added Lupin to our portfolio in Jan 2013. Since then, it has gone up about 46%. Above, is the performance in the last six months

Below is the warning letter that FDA sent to Lupin in 2009. The charges seem to be serious. While the facility survived repeated re-inspections from FDA and MHRA, little information is available on how the culture in the plant was changed to be totally complaint now. There has not been many 483's or warning letters to Lupin since then.... but it is the nature of the letter below that continues to concern us....

We are carefully looking at the stock again. Permanent risk of capital is not a risk we are interested in.... The onus is on us to make sure that Lupin is not the next Ranbaxy or the next Wockhardt....

http://www.fda.gov/ICECI/EnforcementActions/WarningLetters/2009/ucm162745.htm

Public Health Service Food and Drug Administration
	CENTER FOR DRUG EVALUATION AND RESEARCH Office of Compliance International Compliance Team 10903 New Hampshire Avenue, WO Bldg 51 Silver Spring, MD 20993

Warning Letter

Via FedEx

WL: 320-09-05

May 7, 2009

Dr. Desh Bandhu Gupta
Chairman
Lupin Limited
Plot No. C-25, Laxmi Towers
"G" Block, "C" Wing, 4th Floor, Bandra Kurla Complex
Bandra (East) Mumbai, India 400 051

Dear Dr. Gupta,

This is regarding an inspection of your sterile and non-sterile pharmaceutical manufacturing and sterile active pharmaceutical manufacturing facility (Mandideep), in Bhopal, India by Investigator Michael R. Goga and Microbiologist Parul M. Patel during the period of October 31 - November 12, 2008. The inspection revealed significant deviations from U.S. current good manufacturing practice (CGMP) regulations (Title 21, Code of Federal Regulations, Parts 210 and 211) in the manufacture of finished drug products.

These deviations were listed on an Inspectional Observations (Form FDA 483) issued to Vilas S. Satpute, Senior Vice President, API Manufacturing and Site Head at the close of the inspection. These CGMP deviations cause the drug products and APIs to be adulterated within the meaning of Section 501(a)(2)(B) of the Federal Food, Drug, and Cosmetic Act (the Act), [21 U.S.C. § 351(a)(2)(b)]. Section 501(a)(2)(B) of the Act states that drugs are adulterated when they are not manufactured, processed, packed, and held according to current good manufacturing practices. Failure to comply with CGMP constitutes a failure to comply with the requirements of the Act.

We have received your December 9, 2008, January 13, 2009, February 12, 2009, and March 10, 2009 written responses to the FDA-483 observations. We acknowledge that some corrections appear to have been completed or will soon be implemented. However, your responses do not adequately address some of the deficiencies. Specific violations include, but are not limited to:

1. Failure to maintain production, control, or distribution records associated with a batch of drug product for at least 1 year after the expiration date of the batch. [21 CFR 211.180(a)]

A. Numerous boxes were observed containing production, control, or distribution records in the destruction area of a separate building (Plant [(b)(4)]). For example, one of these boxes contained a Batch Packing Record (BPR) for Ceftriaxone for Injection USP lOg, Batch Number[(b)(4)], dated August 25, 2008 and August 26, 2008 was awaiting destruction as observed by Investigator Goga. Refer to FDA Form 483, Observation #2.

Your Quality Corporate Management explained during the inspection that Plant [(b)(4)] had no involvement with the Mandideep drug production facility in any way. Yet when our inspection team visited Plant [(b)(4)], they observed 20 boxes containing documents and files from the Mandideep Plant [(b)(4)] facility. Please explain the discrepancy in the information given by your Quality Management to our investigators.

You state in your December response that the documents seen by our investigators during the inspection, and referred in Form FDA 483, Observation #2, were either expired or outside the specified retention time period specified in your document retention policy. In addition, you explained to our inspection team that the 20 boxes of documents stored in Plant [(b)(4)] were being held waiting for destruction. Your December response referencing Batch Packing Records (BPRs) from 2006, does not explain why the partial BPR for Ceftriaxone for Injection USP l0g was awaiting destruction. This record falls within the storage period specified in your document retention policy. Your response should provide an explanation regarding your decision to destroy these records.

2. Failure to follow appropriate written procedures designed to prevent microbiological contamination of drug products to be sterile. [21 CFR 211.113(b)]

A. All personnel who enter the aseptic filling area are not monitored. Refer to FDA Form 483, Observation #7.

Our inspection team reviewed documents of individuals entering and exiting the aseptic fill area. Personnel such as maintenance, cleaning, supervisors, and operators (i.e.: filling machine operators, [(b)(4)] operators) were not required to follow written procedures that they be microbiologically monitored. Your December response (Attachment 15) is incomplete in that it did not specify the roles of personnel who completed training for the "Environmental Monitoring Procedure - Vial Filling facility" your firm provided. Please provide more detailed information showing the roles of employees such as maintenance, cleaning, and supervisors who completed this training.

3. The controls to prevent contamination in defined (critical) areas are deficient regarding operations related to aseptic processing of products. [21 CFR 211.42(c)(10)]

A. Smoke studies of Class [(b)(4)] in critical areas were inadequate in that they were not performed under dynamic conditions and the results were not recorded for subsequent review. Refer to FDA Form 483, Observation #5.

You included a CD ROM of the smoke study summary report with your December response. However, this CD ROM was unable to be opened for review, thus we could not read the attached documents. Re-submit the supporting documentation including the video showing the smoke study your firm conducted on November 19, 2008.

4. Failure to routinely calibrate, inspect, or check according to a written program designed to assure proper performance of automatic, mechanical, or electronic equipment, including computers, used in the manufacture, processing, packing and holding of a drug product. [21 CFR 211.68]

A. The Enterprise Resource Planning System known as the firm's Systems Applications and Products (SAP) computer database allows rejected batches of drug product to be in Unrestricted Status (to be released for distribution). Refer to Form FDA 483, Observation #3.

Please provide additional information to support that your current Enterprise Resource Planning SAP system provides limited access to only "approved QA personnel" versus warehouse or production personnel. Your December response states any correction or change in Usage Decision (UD) will require next-level QA authorization in SAP. Explain how you are able to ensure that only QA authorized personnel are changing the status of the lots in the SAP system, and how it is documented and/or tracked.

In addition, your December response in Attachment #4, "Performance Qualification Report for SAP R/3 Enhancement", shows lots that can be "Partially Approved" without selecting a Usage Decision. Provide an explanation as to what "Partially Approved" is defined as, who has the authority to make this decision, how it is documented, and why this status is "not applicable" in the Usage Decision status.

B. Failure to retain original calibration data for [(b)(4)] used in the re-qualification of the [(b)(4)]. Refer to Form FDA 483, Observation #4b.

During the inspection, you provided our FDA investigators a spreadsheet that you stated contained data for calibration of [(b)(4)], however, you were not able to provide the raw calibration data. In addition, the calibration data for the [(b)(4)] that you provided in your December response in Attachment #9 do not correspond to the[(b)(4)] observed by our FDA investigators. The [(b)(4)] observed during our inspection had a different manufacturer, tag number, and temperature range than the [(b)(4)] for which you provided data in your response. Please explain this discrepancy.

C. Written records of calibration were not adequately verified. Refer to Form FDA 483, Observation #9.

The inspection team was shown internal calibration certificates for [(b)(4)] that were performed at readings of[(b)(4)], yet the raw data does not document these readings. This data was verified and signed by a second individual and calibration certificates were generated. In addition, the calibration of a [(b)(4)] shows incorrect entries on the Instrument Calibration record. Yet this record was also verified and signed by a second individual. Your response do not show that investigations were conducted. Please provide the investigation reports.

Your December response states all data is now concurrently verified by immediate supervisors, however this is not stated in your attached, revised procedure, "[(b)(4)], Calibration of Instruments." In addition, you stated in your response that calibration records will be routinely reviewed by QA. Provide the relevant written procedure(s) to reflect this review is conducted.

5. Failure to follow written procedures describing the receipt, identification, storage, handling, sampling, testing, and approval or rejection of components and drug product containers and closures. [21 CFR 211.80(d)]

A. Approximately [(b)(4)] bulk empty glass vials were not labeled with any identification such as an item code, material code, SAP code, lot number or acceptance status. These vials were located in a separate building - Plant [(b)(4)] Refer to Form 483, Observation #1.

Your December response stated that these vials were segregated due to minor cosmetic defects and were labeled with an item code. Yet the inspection team reported that they did not observe any type of identification on the vials or the containers. Please explain how you determined which vials were destined for the Indian market without an item code. Include an explanation of the [(b)(4)] vials [(b)(4)] Type ([(b)(4)]) that were "approved" that were stored in Plant [(b)(4)]. Please provide supporting documentation showing that the defective vials were dest1byed as stated in your written response. Your December response states that the[(b)(4)] vials had been stored in Plant [(b)(4)] due to storage space constraints in the main warehouse. Your responses do not address whether you will continue to use Plant [(b)(4)] to store drug components, including drug containers and closures.

6. Documentation of each significant step in the manufacture, processing, packing or holding of the batch was not performed by the persons performing each significant step in the operation. [21 CFR 211.188(b)(11)]

A. The batch production records for the system simulation (Batch#: [(b)(4)]), do not document the results by the individual who performed the actual visual inspection of the media fill vials in Phase [(b)(4)]. Refer to FDA Form 483, Observation #6.

Your written responses state Quality Assurance (QA) is now responsible for recording the observations of the media fills. Please provide further details on the microbiological qualifications and GMP training of the QA personnel who will be recording the media fill results.

7. Failure to maintain buildings in a clean and sanitary condition used in the manufacture, processing, packing, or holding of a drug product. [21 CFR 211.56(a)]

A. The inspection team observed a collection of water with black residue in the surrounding area underneath and in the area adjacent to the [(b)(4)]. Refer to FDA Form 483, Observation #12

Your responses did not address the investigation conducted or the identification of the black residue. Provide in your response the investigation report with your findings including the cleaning methods you performed. Please provide the location of this sampling port and the equipment surrounding it. Also, explain if any drug processing, holding, or repackaging is conducted in this area.

In addition, the inspection team observed an accumulation of water on the floor in the [(b)(4)] treatment plant which can become a source of [(b)(4)] contamination. A greenish film was observed in the bottom of the water drain channel in the [(b)(4)] plant. Refer to Form FDA 483, Observation #8.

Your responses did not address if an investigation was conducted or confirmation that the green color on the bottom of the drain was identified as paint or if it was biofilm. Provide the investigation report and supporting documentation.

8. Failure to investigate the failure of a batch or any of its components to meet any of its specifications. A written record of the investigation shall be made and shall include the conclusions and follow-up. [21 CFR 211.192]

A. The QA monthly report dated 01 JAN 08 included one finished product sample that failed, however there is no record that an Out-of Specification investigation was performed. Refer to Form FDA 483 Observation #13.

You explained in your December response that the OOS reported in the January 2008 Monthly Quality Report was a typographical error. Please provide the documentation for the investigation you performed to make this conclusion.

Please provide further explanation regarding your position that QA monthly reports are not subject to GMP requirements, given that the reports include information such as testing summary, Out of Specification results, audits, complaints, and changes implemented. At the end of the inspection. you explained to our inspection team that the QA monthly reports were considered [(b)(4)] reports and not GMP documents. We have reviewed the information collected and agree with our inspection team that the QA monthly reports are subject to GMP requirements. Your December response to Form FDA 483, Observation #13 states the monthly report "is used as a management tool only." In addition, your response states this document is prepared and issued to your Corporate Management to apprise them of potential adverse quality trends.

GENERAL COMMENTS:

Regarding your written responses to FDA Observation #4:
In your December response, Attachment #7 describes the Performance Qualification (PQ) Validation Plan for the [(b)(4)] Mapping Plan of the [(b)(4)]. The validation plan of the [(b)(4)] describes [(b)(4)] studies, however does not include any [(b)(4)] Test (single run for l0ml vial). Since the [(b)(4)] is used for [(b)(4)] provide the justification as to why an [(b)(4)] test was not performed as part of your PQ. In addition, for other size vials shipped to the U.S. market, explain the justification to perform your PQ using a single run for the l0ml vial.

In addition, your firm stated in your responses that you compared the [(b)(4)] logger data obtained using your new data logger with the data from the earlier qualification reports and found the new and old data to be comparable (Attachment #8). Provide an explanation with supporting documentation as to the actual raw data generated from the older data loggers used in the earlier qualification reports and how you compared the older data with the data from the new data logger.

Regarding other documents observed in Plant [(b)(4)]:

The [(b)(4)] logbooks 2006-2007 and Operational Log for Air Handling Unit 2007 are documents that pertain to equipment usage. Your December response states that these documents were not required to be retained by the previous record retention policy. These logbooks maintain information relating to system functioning, prior, during, and after the manufacture of drug products, and need to be retained. Please provide further explanation as to the reason for their planned destruction and which other production-related documents are destroyed under this policy.

There were additional files observed in different locations of Plant [(b)(4)], referred as "corridor boxes", but not mentioned in the FDA Form 483 such as Daily Observation and Complaint file, Raw Data Cleaning Validation, Environmental Monitoring Record for the year 2006, [(b)(4)] Analysis Reports, Manufacturing Differential Pressure Monitoring Record, to name a few. When this observation was discussed at the end of the inspection, your management did not provide our investigators information as to the final disposition of these records, or why they were being held at Plant [(b)(4)] for destruction and not Plant [(b)(4)].
Please explain.

The CGMP deviations identified above or on the FDA-483 issued to your firm are not to be considered an all-inclusive list of the deficiencies at your facility. FDA inspections are audits, which are not intended to determine all deviations from CGMPs that exist at a firm. If you wish to continue to ship your finished drug products and APIs to the United States, it is the responsibility of your firm to assure compliance with all U.S. standards for current good manufacturing practices.

Until all corrections have been completed and FDA can confirm your firm's compliance with CGMP, this office will recommend disapproval of any new applications or supplements listing your firm as a manufacturing location of finished dosage forms and APIs. In addition, shipments of articles manufactured by your firm are subject to refusal of admission pursuant to Section 801(a)(3) of the Act in that the methods and controls used in their manufacture do not appear to conform to Current Good Manufacturing Practice within the meaning of Section 501(a)(2)(B) of the Act.

Please respond to this letter with requested documents translated in English within 30 days of receipt and identify your response with FEI# 3002807511. Please contact Yumi Hiramine, Compliance Officer, at the telephone number shown below, if you have any questions or concerns regarding this letter.

U.S. Food & Drug Administration
Center for Drug Evaluation and Research
Division of Manufacturing and Product Quality
International Compliance Branch
Building 51
10903 New Hampshire Avenue
Silver Spring, Maryland 20993
Tel: (301) 796-4166

To schedule a re-inspection of your facility, after corrections have been completed and your firm is in compliance with cGMP requirements, send your request to: Director, Division of Field Investigations HFC- 130, 5600 Fisher's Lane, Rockville, MD 20857. You can also contact that office by telephone at (301) 827-5655 or by fax at (301) 443-6919.

Sincerely,

/s/

Richard L. Friedman
Director
Division of Manufacturing and Product Quality
Office of Compliance
Center for Drug Evaluation and Research

Nestle India

2013-07-14T14:12:00.000+05:30

Nestle India has generated great returns for its investors in the last five years.

It is time to consider this.

As of last Friday, it was trading at 52x last year earnings and 6.5X sales. Dividend yield is about 0.4%. Nestle grew its profit 5.5 times in the last ten years. Even if one assumed that it does the same in the next ten years, it would be trading 10 times 2023 earnings (which makes no sense)

If it was trading 30 times earnings, it would worth about 150,000 crores or $ 25 Billion in 2023. That is a 11.6% growth over the next ten years....

As against the perception of the users that Nestle India can provide a risk free return, I think this scrip will probably have more return free risk!!! Investors must be drinking a lot of kool aid to buy into this story and become part owners at this stage. I think the best days are behind it at these valuations.... unless investors are betting that Nestle will buyback shares similar to GSK and HUL at these low levels of INR

Make no mistake about it... it is a terrific, terrific franchise with a great management and sticky brands but it is not worth an infinite price.

Ranbaxy Fraud and Wockhardt

2013-07-13T08:28:00.000+05:30

Lots of investors have been looking closely at what is happening at Wockhardt for the last few months.

The parallels between the Ranbaxy story and the Wockhardt story is too hard to miss!!

A great article http://features.blogs.fortune.cnn.com/2013/05/15/ranbaxy-fraud-lipitor/ on Ranbaxy was published by fortune and is a must read for all Pharma investors.

A prime case as to why management quality is important for investing in India

Berkshire Holding

2013-07-13T07:25:00.001+05:30

We are going to use a series of posts to talk about some of our holdings.

Berkshire is the single largest holding at Beowulf Capital and we have bought at three separate occasions and sold once. (Green circles are buys and red circles are sells)

Everyone knows the Berkshire story and it has been a good stock to own at Beowulf as well. We have been following it for years now and have acted only occasionally on it.

The first occasion when we bought the stock, it was fairly evident that BRK was going to get included in the S&P index but the market was shrugging it off and not pricing it in the stock. We thought it was a great opportunity and a chance to get even with the efficient market thesis guys and bought a fair amount of the portfolio at that time and we sold shortly after making a tidy sum!

The second occasion was in the Aug / Sep time frame in 2011 when Berkshire was trading at book value and I started buying the stock as I was comfortable with the assets I was getting at that price. Three days after we bought it at about $66 to $68 / share, Warren announced a buyback that immediately took the price up. We bought some more but not a lot. (Thanks Warren for nothing because if the prices had gone down further, we would have built a bigger position)

There was an event that happened in between. I attended the Berkshire Annual meeting in Nebraska in 2012. I recall concluding at the end of the meeting that this was a company I wanted to be associated with for a longer period of time but I was uncomfortable with the price. Later in the year, Warren's book 'Tap dancing to work' by Carol Loomis came out. In one of the articles, an reporter in 2002 asks Berkshire, 'Is it a good price to buy Berkshire now?' (Not exact words but along the same lines) Warren's reply was approx. 'Mumble... Mumble... Not now... It was a singing endorsement when I offered to buy back in 1998/9'

We made a mental note to buy Berkshire the next time we got an endorsement from Warren. We kept our intrinsic valuations regularly updated but never got comfortable on our own with the price. It was a high quality asset but we wanted it at book value or at a value with the same deal terms as Warren.

In December 2012, Warren offered to buyback around $1.3B of stock from an owner at 1.2X Book. The key was the board authorized Warren to buy unlimited amount of stock at or below 1.2X book for an unlimited time. This time, we leapt at the chance. Close to 25% of our portfolio in the US markets were re-directed to Berkshire. We were not disappointed! (Thanks Warren)

What are we doing in a mega-cap company run by a 82 year old?

a. We don't care whether it is a small cap, medium cap, large cap etc. The market run-up in the last couple of years have dried up opportunities that we are ready to settle for acceptable rates of return from high quality assets irrespective of their asset class. We have bought only one other stock in the US since we purchased BRK in December.

b. We are not worried about the succession plan. Berkshire has a lower risk profile than other similar large cap companies. We actually know more about Berkshire's second line managers than at other large cap companies.

c. Quality of the assets are good and will continue to deliver acceptable rates of return.

However, it must be noted that we continue to be concerned with the run-up in the markets in the last one year. We do not plan to do anything with our Berkshire holding. If there is a downturn, Berkshire will put the massive cash-pile to work and come out stronger. With such a high concentration of Berkshire and cash in our portfolio, we actually wish for a downturn.

However, our wish has got nothing to do with what the market will do.Six months ago, we would not have predicted the markets would have run-up this much by today. To now claim that we have a clue what will happen in the next 12 months is foolhardy. If markets are up now, they will go down in the future (don't know when), if they are down now, it will go up in the future. Basically, we have no clue about the market. We only act on stocks we know at a price we understand.

YES Bank -- Red Flag!

2013-07-05T08:13:00.002+05:30

From the Economic Times a few days ago ---

Shagun Kapur Gogia can't succeed her father on the board: YES Bank to Bombay High Court

RanaKapoor-led YES Bank BSE 1.28 % on Monday told the Bombay High Court that only a living person has the right to nominate directors, in response to the plea filed by MadhuKapur.

The Kapur family had moved court to establish its claim as an equal business partner to MD and Chief Executive Rana Kapoor. The court will now hear the case on Friday, as the bank's lawyers sought more time to amend their petition.

"The bank is not willing to recognise Shagun Kapur Gogia as the Indian partner after the death of her father Ashok Kapur. This is the point of contention," said a person following the court tussle.

Usually, as minority shareholders, we do not pontificate on all matters however, this is something that caught our attention.

a. A stock holder is a part owner of the business. A stock is not a piece of paper but part ownership in a business. Shagun Kapur owns about 12% of the stock. She own one-eighth of the bank. One-eighth of every branch, every loan, every deposit belongs to her (net of liabilities)

b. If a person who owns one-eighth of the bank does not get a voice in the board, who does?

c. Part of the duty of the board is to protect and shepherd the management towards returning value to shareholders. If big owners are not part of the board and not heard to, where does that leave small minority shareholders?

d. What is the purpose of the bank if not working for the shareholders?

e. Apart from Rana Kapoor, who owns a chunk of the shares, what is the incentive for the other directors to take the right decisions for the shareholders? Are they there to protect their jobs or that of the shareholders?

Joys of Compounding!

2013-04-21T19:02:00.001+05:30

Joys of Compounding.pdf by balajisridharan9651

ICRA meeting comments

2013-04-10T05:56:00.001+05:30

As a small retail investor, I often write to the investor relations trying to talk to them, typically in order to improve my understanding of the business. I have had varied success with this approach.

Last week, I had the opportunity to have a call with the rating officer at ICRA. Readers will be familiar with the skepticism we have with the business model of the credit rating agencies that we blogged about last december.

The rating officer openly admitted that they did not want to commit in writing, so the phone call. So here is the gist of the conversation

a. IRB Model is definitely a threat to the credit rating agencies
b. The advisory business of ICRA is working with the big banks to help to the IRB model.
c. Banks can apply for the internal models from 2014
d. 2 Years of parallel testing between the bank's model and the credit rating agencies model. The higher of the CAR will be adopted for the banks. After this, if the the RBI is satisfied, they will let the big banks move to the new model.
e. 2014 through 2016 is parallel testing period. So no threat for another three years.
f. All Basel II loans are eligible for internal rating. From annual reports, 2011 and 2012, 45% of all loans rated were Basel II loans.

If you are a long term investor and wondering about whether it is a good idea to invest in this.... caveat emptor....

Last few weeks

2013-03-24T09:37:00.001+05:30

The last 3 to 4 weeks, the emerging markets stock indices have been underperforming the developed world.

In particular, the Indian stock market which crossed 20K briefly this year is back to the high 18's. While this is not a significant downturn, it is a correction that also caused a carnage among the mid-cap stocks.

As always, at Beowulf Capital, we ignore macros and invest in companies that we believe will grow and thrive in the long run. As the carnage was underway, we were net adders of capital into the market. Some of these bets will take a while to make money but we always like discount sales in the stock market. We especially are tuned to discount sales of stocks on our watchlist. Volatility in the market does not bother us, we have balls of steel. We are interested only in performance and ethical management.

In the last few weeks, we have added to our positions in YES Bank, Shriram Transport Finance, Titan and initiated positions in ICRA and Voltas.

In dec, we had sold out of our positions in ICRA at about 1,450 citing concerns about the IRB model and its impact on ICRA. At 30% lower price, we think we are comfortable owning the security. We bought into the positions when the market cap was a little shy of 1,000 crores. With about 278 crores in marketable investments, a good business model is available at a fair discount. It is a small position that we have initiated and we are comfortable that it does not form a big portion of our portfolio.

In the investing world (especially the value investing world) majority of the folks tend to look at price to book for financial stocks. For a long time, we were firm believers in this logic. One cannot go very wrong with buying stocks at or under liquidation value. However, at Beowulf, we are of the opinion that growth is part of value. We like to underpay for growth as well. Whenever, we find stocks whose growth is underpriced, we look at the probabilities that the stock will be worth a lot more a few years down the line and we buy the stock. Of course, we need to be comfortable to a reasonable extent with the management as well.

Two stocks that has caught our attention are very expensive using traditional price to book ratio. Both of them trade at or around 2.5 times book value. One might argue that at these levels the growth is fully priced in. We are skeptical of it. If the last twelve months earnings are north of 20 to 25% of total book value and if the business model suggests that these level of earnings will continue in the future without taking on undue risks on the balance sheet, our hypothesis is that, 7-8 times pre tax income is a better indicator of the value of the firm. This multiple ensures that all the future growth is still available to investors. Else, the firm will end up trading at 2 to 3 times earnings, which does not make sense to us.

We deliberately tend to keep the portfolio positions in financials at a relatively smaller levels compared to our bigger stocks. Our top three positions make up around 60% of our portfolio. So, net-net, we felt comfortable adding to our positions in YES Bank and Shriram Transport Finance. Both of them are terrific franchises. We had initially initated YES Bank positions in Dec 2011, this is first time we have added to the positions since then. Shriram transport finance is another niche player with little competition that allows them to earn above average ROA. The volatility is higher on the stock but we are not bothered. We use the opportunities to add to our existing positions.

We have also initiated position in Voltas. As the stock crashed through 52 weeks low, we initiated the position and added more as it continued to drift downward. This is an opportunistic stock in a cyclical industry. We are not looking for overnight returns. With an ethical management from Tata group running the companies and with an insiders perspective on the HVAC industry (I work in it) I feel comfortable holding these stocks.

What to do in a downturn?

2013-03-24T09:21:00.001+05:30

Not so long ago, I was working for a COO of a fortune 100 company. I learnt some of the most important lessons about business from him. He frequently used to tell executives.

What do you do in a downturn?
Answer: Prepare for the upturn. Invest deeply in key projects and products.

What do you do in an upturn?
Answer: Prepare for the downturn. Serve customers and keep the cost structure right for the downturn.

This post is dedicated to him.

Hero Majestic -- a Value Trap?

2013-02-03T11:20:00.000+05:30

Is this company more dead than alive?

Hero Majestic Company Profile

The Company is engaged in the manufacturing of Mufflers, Fine Blanking Components, Electricals, Spokes, and Two Wheelers Spare Parts.

Basically a commodity manufacturer for Hero Motors. It trades at a PE of 6 and has a marketcap of 51 crores. Annual sales for 2012 was 165 crores and a profit of 20 crores. Debt to equity ratio of 1.2. 75% owned by promoters. None of these are eye popping numbers except for something on the balance sheet that caught my eye. It trades at 0.7 times book and here is the key --- there is a 7.3 crore investments on the balance sheets. These are held at cost. The market value of these investments are Rs. 324 crores. Six times the marketcap and five times the book value.

Without a management shake up, no dividend and a shareholder friendly management, this is a value trap. This is company is worth more dead than alive. The liquidation value far exceeds the value as a going concern.

For other companies like this, please look at Kalyani investments.

Questions for the Piramal Management

2013-02-03T10:22:00.000+05:30

Since we have received replies for all our questions from Piramal, we asked a couple of more questions that we think are very important for investors to know. We will post the reply if and when we get them.

Thanks for your kind reply. As you might have gathered, we are closely following the performance of Piramal Enterprises.

We are extremely happy with the direction that the company has taken to redeploy the assets from the sale of the healthcare businesses. We are happy investors in the company and hope to be a long-time investors in the scrip.

Having said that, we also have a few questions that we would prefer the Chairman / CEO, to address the below two questions either in the conference call on Feb 11 or before. We are happy to call in with the same two questions at the conference call on Feb 11, if need be.

a. What metric does the management / promoters prefer we use to measure the progress of the company over the next three to five years? Right now we are using book value as a conservative, albeit an understated, proxy for the intrinsic value of the firm. We would like the management to establish a clear yardstick (they can chose) and show the progress over the next three to five years.

b. The stock right now is trading at a discount to book value. The book value is conservative as the Vodafone investments are still held at cost. Given these two factors, why is the Company not buying back stock more aggressively? Is the IRR of the new investments so much more higher than buying back stock? Secondly, if the IRR is indeed higher, why is the company not taking more debt to do buybacks? If the IRR's for internal projects are higher, it implies that the company is trading at an even lower multiple / discount to book value?

Thanks for your patience in addressing the questions.

Piramal Conference CAll for Q2 2013

2013-02-03T09:36:00.000+05:30

It was an interesting moment when Piramal did not hold the conference call for Q2 2013. Also coincident with it was the fact that it was a quarter where the Piramal announced losses.

Instead of relying on speculations, I decided to ask the company and below is the verbatim answer I got back

"We have experienced that the participation of analysts / investors community in the results conference call has been dropped significantly. Management has guided us to organise conference call with limited frequency. However, we are happy to answer your queries over the mail or telecon."

Piramal Performance

2013-02-03T09:21:00.001+05:30

We have been bullish on Piramal on this blog for quite some time now. We decided to put up the performance of these buys against the SENSEX and NIFTY since our purchase. Until recently, Piramal Enterprises was our biggest holding in the Portfolio.

During the Fiscal debt cliff uncertainty last year, we bought one stock called Company A in the US that is the biggest portion of the portfolio and we are also invested in another Health Care company in India that is slightly bigger than our investment in Piramal.

However, we continue to believe that Piramal is still undervalued and the original thesis still holds good and we have listed below the performance against the Indian indices. Piramal has outperformed the Healthcare Index, Sensex and Nifty. We do not expect any big improvement in the Q3 results on Feb 2013. We are not counting on extraordinary performance to fuel returns in the long run.

Companies that are worth more dead than alive (Liquidation value far in excess of Market CAp)

2013-01-27T20:18:00.002+05:30

I have been looking into companies where the liquidation value is far greater than the market cap. I found about 3 to 4 companies. I will be blogging soon about them. Unless the management figures out a way to unlock value, these will be value traps though..

More to come.

CARE IPO (Dec 7th through Dec 11th)

2012-12-05T12:07:00.001+05:30

For all who are planning to invest in IPO's, there are a number of things to consider.

First and foremost, words from Warren Buffett on IPO's

Warren Buffett recommends avoiding IPOs, for the following reason: "It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer(investors)."

We truly buy that theory and we are generally leery about investing in IPO's. Despite that I decided to look carefully at the CARE IPO.

The big disclaimer here is that we have no clue whether the stock price will go up or go down when the IPO is completed. We are value investors who try to buy great businesses at good prices. The reason we looked at CARE was because we like the business model a lot. It is a simple business model with a lot of promise.

Before that, we have to disclose that ICRA has been an important position for us close to a year. We bought ICRA during the lows in Dec 2011 at an average cost of INR 800. After researching the CARE IPO and re-reading the CRISIL and ICRA reports, we exited the ICRA position as well at INR 1353 with a neat 75% gain in less than 11 months.

The CARE IPO has been positioned very attractively at 20-22 times earnings. (EPS was around 17.50 for the first half of the year) ICRA is trading at 23 times earnings and CRISIL at 37 times earnings.

The CARE financial details are as below (from http://www.chittorgarh.com/ipo/care_ipo/358/)

Particulars	For the year/period ended (in Rs. Million)
	31-Mar-12	31-Mar-11	31-Mar-10	31-Mar-09	31-Mar-08
Total Income	2,171.93	1,722.55	1,520.26	999.31	549.11
Profit After Tax (PAT)	1,157.02	879.49	856.90	523.99	266.85

About 0.7 crore shares will go public in this IPO with about 2.8 crores shares outstanding (25% of the company will be sold to the public)

The price for the CARE IPO is very attractive. Having held ICRA before, we are very much attracted to the business model. Barriers to entry are huge with government limited competition and very good pricing power in the market. It was actually the pricing power that led us to take the position in ICRA before.

When we were reading the prospectus, something caught our eye. We pay special attention to the risks section.

On page 16 of the prospectus (http://www.sebi.gov.in/cms/sebi_data/attachdocs/1317804515879.pdf)

If the banks whose clients avail credit rating services under the Basel II framework migrate to the

internal rating based approach for credit risk (the “IRB Approach”), it could have an adverse effect on our rating business, which may in turn have an adverse effect on our business, financial condition, results of operations and revenues. RBI has pursuant to a circular dated July 7, 2009 advised banks that they may apply for migration to an “internal rating based” approach for measuring credit risk from April 1, 2012 onwards. The IRB Approach will allow the banks, subject to the approval of RBI and fulfilling certain requirements, as may be applicable, to use their own internal estimates for some or all of the credit risk components in determining the capital requirement for a given credit exposure. RBI has pursuant to a circular dated August 10, 2011

(the “Circular”) issued draft guidelines for computing the credit risk capital charge under the IRB

Approach. As per the timeframe specified for implementation of the IRB Approach as set forth in the Circular, RBI may, subject to an 18 months detailed analysis of the applicant bank, commence grant of approvals by March 31, 2014. For further details, see the section “Regulations and Policies” on page 103 of this Draft Red Herring Prospectus. In the event that banks whose clients avail credit services from us apply for, and receive, approval from RBI to adopt the IRB Approach, it could have an adverse effect on our rating business, which may in turn have an adverse effect on our business, financial condition, results of operations and revenues. "

And on page 103,

Government Policies and Regulations
We are regulated by the SEBI CRA Regulations and are subject to detailed supervision and regulation by SEBI. In accordance with such regulations applicable to us, we require regulatory approvals, sanctions, licenses, registrations and permissions for operating our business, including our credit rating license. Our credit rating license expires on November 4, 2011 and we have applied to SEBI for grant of certificate of permanent registration, which is pending approval. We are also required to disclose key operational data and subject our operations to audits as per such regulations. See the section “Regulations and Policies” and “Government and Other Approvals” on pages 103 and 190 of this Draft Red Herring Prospectus. The laws and regulations applicable to us could change in the future, which could lead to higher compliance costs, reduce business opportunities or otherwise affect our business and results of operations.In addition, our business is driven, in part, by bank loan and facility ratings that we provide under the Basel II
framework. RBI has, pursuant to a circular dated August 10, 2011 (the “Circular”), issued draft guidelines for computing the credit risk capital charge under the “internal rating based” approach (“IRB Approach”). As per the timeframe specified for implementation of the IRB Approach as set out in the Circular, while banks would be permitted to apply to RBI from April 1, 2012 to migrate to the IRB approach, the RBI may, subject to an 18 month detailed analysis of the applicant bank, commence granting approvals by March 31, 2014. The IRB Approach will
allow the banks to use their own internal estimates for some or all of the credit risk components in determining the capital requirement for a given credit exposure. For further details, see the section “Regulations and Policies” on page 103 of this Draft Red Herring Prospectus. To the extent that banks whose clients avail debt rating services from us apply for and receive approval from RBI to adopt the IRB Approach, our business may be affected.

For CRISIL, rating business contribute to 33% of the sales and about 50% of the profits for the quarter through Sep 2012.

For ICRA, rating of the corporate bank loans form a significant portion of the revenue and profits. When we read through the risks of the business in the annual report, there was not even a mention of IRB. This raised a red flag for us.

For care, the revenue breakdown is as follows from the prospectus. (Page 94 of the prospectus) 60% of the rating assignments for CARE was related to BASEL II rating assignments. Now re-read the two risks listed above before we continue further.

Looks like RBI laid out the norms for IRB's late last year. (see end of the post for the document) A cursory glance through the document showed that the requirements were quite high for the IRB status. While we are of the opinion that from a systemic point, an external third party rating agency is better equipped to evaluate risks and rate better than banks themselves (who wants to call their child ugly), the banks are incentivized to make the move.

We decided to check and see how serious the banks where and whether they were making any plans for the future.

We did not find any reference on ICICI annual report. State Bank of India turned out to be totally different.

SBI Link

Risk Management in SBI

Risk Management Structure

• An independent Risk Governance Structure is in place for Integrated Risk Management covering Enterprise, Credit, Market, Operational and Group Risks. This framework visualises empowerment of Business Units at the operating level, with technology being the key driver, enabling identification and management of risk at the place of origination.

Basel Implementation

• In accordance with RBI guidelines, the Bank has migrated to the Basel II framework, with the Standardised Approach for Credit Risk and Basic Indicator approach for Operational Risk w.e.f. March 31, 2008, having already implemented the Standardised Measurement Method for Market Risk w.e.f. March 31, 2006.

• RBI has issued Guidelines on Implementation of Basel III Capital Regulations in India on 2nd May, 2012. These Guidelines will become effective from January 1, 2013. Bank is in the process of putting in place appropriate mechanism to comply with these guidelines.

Enterprise Risk Management

• During the year, the Bank has set in motion the due process required for filing of application/letter of intent to RBI for implementing Advanced Approaches under Basel II, comprising of the three Pillar I Risks viz. Internal Rating Based (IRB) approach for Credit Risk, Internal Model Approach for Market Risk and Advanced Measurement Approach for Operational Risk.

• The Bank has in place the Internal Capital Adequacy Assessment Process (ICAAP) Document as required by Pillar II of New Capital Adequacy Framework under Basel II as prescribed by RBI.

• The ICAAP process covers identification, measurement, management, capital assessment and stress testing of material risks and also detailed additional capital requirements on account of such risks. Besides the aforesaid three Pillar I Risks, the ICAAP also covers Pillar II Risks such as Liquidity Risk, Interest Rate Risk in the Banking Book, Credit Concentration Risk, Reputation Risk, Strategic Risk etc.

Credit Risk Management (CRM)

• In addition to implementing the Standarised Approach, well defined credit risk practices such as use of Credit Risk Assessment (CRA) Models, Industry Exposure Norms, Counterparty Exposure Limits, Substantial Exposure Norms, Macro Economic Stress Tests etc., have also been put in place to improve credit risk management

• The Bank has now set in process a project to migrate to Internal Rating Based (IRB) Approach.

- Models for estimation of Probability of Default (PD), Loss Given Default (LGD), and Exposure At Default (EAD) are being developed.

- Credit risk data mart is being set up.

- Retail scoring and behavioural scoring models are being implemented.

SBI is setting up exactly what RBI has proposed.

we also saw a recent request for proposal from bank of Maharashtra to help implement for the same mechanism.

As we stated before, we are not trying to predict the performance of the stock. We see some strong concerns for the base business. While we are confident that not all banks will switch overnight, and it will be a long time till all banks switch. Other markets like bond ratings and credit derivates are still in a nascent stages in the Indian market, that will provide opportunities. Oversees operations are another facet that CARE might exploit. At 20 times earnings, the risk might / might not be fully priced in. For us, it is too big a risk with 60% of the business in the banking rating sector. They have to grow other pieces of businesses to just replace the existing business. We like to buy great businesses at good prices that sustain over a long period of time. We cannot see where this business will be ten years from now given that the main bank rating business will not grow as in the past.

RBI Link