Case 036Short sellingCore

Telora Print Media trades at 6x earnings. Print revenue of Rs 1,000 crore falls 8% a year, 70% of costs are fixed and the EBIT margin is 15%. Show why the stock may be a value trap by projecting EBIT for three years.

The situation

Telora Print Media publishes newspapers and magazines. Revenue from print advertising and circulation is Rs 1,000 crore and has been falling about 8% a year; nothing suggests that will stop. The EBIT margin is 15%, so EBIT is Rs 150 crore. About 70% of Telora's costs, printing plants, distribution contracts and staff, are fixed; the rest, mainly newsprint and ink, move with volume.

Telora has no debt and Rs 150 crore of net cash. With tax at 25%, earnings are Rs 112.5 crore and the market value is 6x that, about Rs 675 crore. Several value investors own it because the P/E looks low.

Your task

Project EBIT for three years. Is 6x earnings cheap, and what would make a short on Telora go wrong?

Quick check

If revenue falls 8% next year and costs behave as described, roughly where does EBIT go?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

With 70% of costs fixed, EBIT falls from Rs 150 crore to about Rs 90 crore next year, Rs 36 crore the year after and a loss of about Rs 15 crore by year three. The 6x P/E is on earnings that are disappearing: on next year's earnings the same price is about 10x, and on year two about 25x. That is the value trap. The short's risks are cost cuts, the cash pile and a buyer.

Step 1Why does EBIT fall so much faster than revenue?

A wedding hall with a fixed monthly rent and staff bill feels every cancelled booking almost entirely in profit, because only the catering bill goes down. When most costs are fixed, a small fall in revenue becomes a large fall in profit; this is operating leverageHow much profit moves for a given move in revenue. High fixed costs mean high operating leverage: profit swings far more than sales. working in reverse. Telora's costs are Rs 850 crore: Rs 595 crore fixed and Rs 255 crore variable, which is 25.5% of revenue. Every Rs 100 of lost revenue saves only Rs 25.5 of cost, so Rs 74.5 comes straight out of EBIT.

The relationship
EBITt=Rt×(1−0.255)−595EBIT1=920×0.745−595=90.4\text{EBIT}_t = R_t \times (1 - 0.255) - 595 \qquad \text{EBIT}_1 = 920 \times 0.745 - 595 = 90.4
R_trevenue in year t, falling 8% a year from Rs 1,000 crore
0.255variable costs as a share of revenue, Rs 255 crore on Rs 1,000 crore
595fixed costs, Rs crore a year
What it says in wordsWhat is left of each rupee of revenue after variable costs, less a fixed bill that does not shrink, gives EBIT.
Revenue slides 8% a year; EBIT falls off a cliff0255075100TodayYear 1Rs 920Rs 90.4Year 2Rs 846Rs 35.6Year 3Rs 779Rs -14.9Index, today = 100 (Rs crore on the labels)Revenue-22.1%EBITto a lossin threeyearsToday revenue Rs 1,000 and EBIT Rs 150 both = 100. Fixed costs stay at Rs 595 crore a year.
Indexed to today, Telora's revenue falls to 77.9 in three years while EBIT falls to 60.3, 23.7 and then -9.9, because Rs 595 crore of fixed costs stay put while revenue shrinks by 8% a year.
Rs croreTodayYear 1Year 2Year 3
Revenue1,000.0920.0846.4778.7
Variable costs, 25.5%(255.0)(234.6)(215.8)(198.6)
Fixed costs(595.0)(595.0)(595.0)(595.0)
EBIT150.090.435.6-14.9
EBIT margin15.0%9.8%4.2%-1.9%
Earnings after 25% tax112.567.826.7loss
P/E at today's Rs 675 crore6.0x10.0x25.3xn/a
Revenue falls 22% over three years but EBIT falls from Rs 150 crore to a loss of Rs 14.9 crore, so today's price of 6x trailing earnings is about 10x next year's and 25x the year after.
Step 2So is 6x earnings cheap?

A P/E is price over one year's earnings, and it says nothing about whether those earnings will still be there. A low multiple on a shrinking business with high fixed costs is often a fair or even high price, because the earnings the multiple is applied to are about to fall away. Telora's trailing P/E is 6x; on next year's earnings the same Rs 675 crore is 10.0x, on year two's 25.3x, and by year three there are no earnings at all. That is the pattern people mean by a value trap: the stock looks cheap on every screen and keeps getting cheaper.

Step 3What would make the short go wrong?

The model assumes fixed costs stay fixed. The biggest risk to the short is management cutting them: if Telora takes 5% out of fixed costs every year, year-three EBIT is about Rs 70 crore instead of a loss. Closing a printing plant or merging editions is exactly what a pressured management does. The Rs 150 crore of net cash is the second risk: it is over a fifth of the market value, and a special dividend or buyback can lift the shares on a day the business gets worse. The third is a buyer: a rival or a private owner may pay for the brands and the cash.

A short also costs money to hold: you pay to borrow the shares and you owe any dividends. So the short needs a catalyst inside your holding period, such as the next results showing margins falling faster than revenue, and it should be sized smaller than a long of the same conviction, because the loss on a short has no ceiling. The strongest pitch says what the market is missing, the fixed cost base, and when the market will see it.

Where candidates lose it

The usual loss is projecting EBIT at a constant 15% margin, so it falls 8% a year like revenue. That ignores the one fact the question gives you, that 70% of costs are fixed, and it makes the stock look cheap when the point of the case is that it is not.

The second is presenting the short as a sure thing. A strong answer names cost cuts, the cash pile and a takeover as the ways it fails, and says how you would size and time the trade around them.

What the interviewer asks next

  • What revenue decline would keep Telora's EBIT flat if management cuts fixed costs 5% a year?
  • How would you value Telora if you assumed it will be wound down over ten years?
  • Why do value investors keep owning stocks like this, and what would change their mind?

Company names and figures are illustrative.