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May 11, 2000

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Devangshu Datta

The imminent shakeout

The higher they rise, the further they fall. That seems to be the story of the infotech, communication and entertainment (ICE) sector. Between November, when it was established, and February the sector saw valuations soaring by 349 per cent to a level of 449 points, according to the Business Standard ICE Index. Last week, the Index dipped below 200, which is a retracement of more than 55 per cent.

This week the selling pressure has continued with the bears paying especial attention to Zee Telefilms. There is an interesting change in mindset that becomes apparent when one probes for the reasons underlying the movements in Zee. The stock is on a Fortune top ten list of global buys for the next decade. It has shown apparently incredible growth, registering a 337 per cent increase in bottomline on a 110 per cent rise in revenue in this fiscal.

So why has the stock been sold down to the Rs 625 level from recent highs of Rs 1600-plus? So bad has the hammering been that the planned American Depository Share (ADS) has been cut back in size and punters in the entertainment industry leader have been wandering around shell-shocked.

That sort of catastrophic 61.7 per cent fall should be caused by serious fundamental problems. Actually looking at it from a technical angle, 61.7 is very close to a Fibonacci golden ratio of retracement. If you generate a standard Fibonacci ascending series of 1, 1, 2, 3, 5, 8, 13, 21 etc, the mathematical relationship between two successive ascending numbers tends to stabilise at around plus 62 per cent.

In a descending Fibonacci series of 21, 13, 8, 5 etc the second level of retracement, ie the retracement between 21 and 8, tends to be around 62 per cent. So this is a retracement/gain level where a lot of stock movement trends tend to peter out. This may be the case with Zee hitting bottom at Rs 620. In that case, market indices will see a degree of relief since the stock has significant weight in both Sensex and Nifty.

But looking for reasons for the hammering, I found several possibilities. One is that Zee is going through the standard wringer any company making an ADS has to live with. It is normal to see some hammering because foreign institutional investors can then pick it up cheap overseas. More heartening is the fact that some of the bearishness is attributable to the scrutiny of the fine print in the Zee results.

Zee has sold Rs 1.89 billion worth of archived film content to a subsidiary Asia Today (ATL). This has been shown as part of the normal revenue stream, which it patently isn't. It may become that if Zee goes through an annual process of transferring film libraries to ATL. But as an analyst who is a zealot about cash explained, "It is just an accounting entry. The cash situation remains the same." Quite. And, according to American generally accepted accounting practices (GAAP) norms, Zee would have to consolidate its balance sheet and then the debit /credit entries of Rs 1.89 billion would cancel out.

So, revenues have been inflated by Rs 1.89 billion, and bottomline has gained to the tune of an estimated Rs 1.85 billion as net profits of that sale. If this transaction was treated as extraordinary income, it makes a very significant difference to the numbers.

Zee registered net profits of Rs 2.67 billion for fiscal 1999-2000. After adjusting for the sale, it registered Rs 820 million in net. Adjusting gross revenues of Rs 4.86 billion, ZTL registered Rs 2.97 billion in normal revenues. Compare that to fiscal 1998-99 when the revenues were Rs 2.32 billion and net was Rs 612 million.

Adjusted growth rates now drop to the unexciting levels of 28 per cent up for revenues and 34 per cent up for net. This is not the stuff to enthuse investors, who are looking for 100 per cent growth rates. No company can expect to maintain a price-earnings multiple of 300 if it delivers 34 per cent growth rates.

But the really important thing is that people have started putting ICE balance sheets under the microscope. There are a lot of companies in this sector, which would be made uncomfortable by such scrutiny. The entertainment industry especially has always believed in unusual accounting practices.

For example, a blue chip, which I would rather not name, believes in amortising the expenses of making serials over a period of several years. Its logic - the serials can be revenue generators over that period. I have a problem with that - it offends the innate conservatism of best accounting practices in that it implicitly recognises income that may never materialise by inflating earnings per share. So far the market hasn't made an overt fuss, but maybe a critical scrutiny of Zee will create an atmosphere for a more critical look at every ICE balance sheet.

If you think of it another way, a more rigorous valuation process could eventually convince managements that transparent accounting practices are better for business. Zee has seen 60 per cent of its market value evaporating and this has seriously impacted the company's ability to raise cash via share issues as well as the notional net worth of its current stockholders. A premium on transparency in accounting practices may induce it to avoid such jugglery.

The other extremely interesting fallout from the hammering in ICE stocks could be the impact on the mutual fund industry. Almost every fund has been heavily overweight in ICE for the last year and a half - some of them have 80 per cent of their assets parked in this sector. This offends against the basic logic of a mutual in that the investor is usually looking for safety via diversification. It is fascinating to watch these funds wriggling as their net asset values plummet along with the melting ICE. This is the sort of shakeout that will separate the sheep from the real performers.

Devangshu Datta

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