Case Study on MSTC

Posted on December 12, 2023 by fundooprofessor

Twice a year, I go to Flame Investment Lab at Flame University to teach a program called
“Case Studies in Business and Investment Analysis.” These case studies are based on real
businesses and sometimes the coverage is also in real time. In June 2023, I presented several
case studies, including one on MSTC.

In this post, I am reproducing what was presented in the class. Many aspects of this case were
not covered in the presentation such as potential competition from other private players like
Metal Junction, the risks of investing in government-controlled companies called PSUs
(public sector enterprises) and whether there is a way to reduce the chances of those risks
materialising by being very choosy, and also whether investing in PSU makes sense at a some
cheap valuation.

The presentation was followed by an excellent debate. Participants had different views about
investing in PSUs. What fascinated me were the strong views people had against investing in
such businesses regardless of valuation and regardless of the quality of the business ignoring
ownership structure. The prejudice was quite extreme, in my view. This, I think, is also
reflection of the prejudice outside the classroom, which is so widespread that it’s probably a
major cause for a few PSU stocks with excellent business models becoming extraordinarily
cheap and attractive as investments.

There were many other PSU businesses that were also covered in the program and the same
prejudice was witnessed by me when those cases were presented as well.

While these topics are not covered below, they were discussed in detail in the class
subsequent to the presentation of the case study.

As of this writing, I and my firm’s clients are invested in this stock. Nonetheless, this is not a
recommendation to own this stock, nor was it during the presentation of the case. The
platform business model of this company is unique. I presented it to the participants so they
could learn about it.

MSTC
“MSTC” stands for Metal Scrap Trading Corporation. The name is somewhat boring, but the
economics of this business is anything but.

MSTC as an Auctioneer
The jewel in MSTC’s crown is the “e-commerce” vertical, which conducts electronic
auctions (“e-auctions”) primarily on behalf of the government of India and related parties like
government-owned companies. The government of India has another entity called GeM
(”Government e-Marketplace”), which it uses for procurement. For sales, however, the
government relies to a very large extent, on MSTC. There is no significant overlap between
these two entities.

In 2022, the government of India auctioned 5G telecom spectrum with the help of MSTC.
This complex auction done over 40 rounds, was conducted in a fair and transparent manner,
and generated more than USD 18 billion for the government.

The two key characteristics of auctions, fairness and transparency, are essential not only for
attracting genuine buyers and sellers to a marketplace, but also to help the government in
another way. The government aims to avoid any perception of favoritism when it comes to
the sale of natural resources such as iron ore mines, coal, minerals, sand blocks, and
resources extracted by government-owned companies like iron ore and natural gas. This
principle also extends to the ongoing sale of scrap, surplus stores, old plant and machinery, e-
waste, and obsolete items belonging to different branches of both the state and central
government across India.

Indeed, after a huge coal mines allocation scam, numerous judgments issued by Indian courts
now require government departments to sell natural resources only through transparent e-
auctions and MSTC is often the only company that is trusted by the government to assist in
this process. As it is owned by the government, this brings monopolistic rights to MSTC.

For example in FY22, MSTC was given the exclusive rights to conduct e-auctions of 7,665
liquor shops in 34 districts in the state of Rajasthan on behalf of the state’s excise department.

Public sector banks holding assets such as land, buildings, and apartments seized from
defaulting borrowers, must sell them to recover loans that have turned into non-performing
assets (NPAs). In FY22, MSTC helped Indian public sector banks sell 6,134 properties for
about USD 650 million. This is a tiny number as of now but will grow significantly over time
as MSTC helps these banks convert their NPAs into cash. Indeed, MSTC has been hired by
Indian Bank Association to develop a platform for online auction of assets attached by its
members.

NPAs are not the only thing that needs to be converted into cash. In India many temples
receive enormous quantities of gold and jewellery from devotees as offerings to the gods.
These valuable assets too need to be converted into cash. Temple trusts in the south Indian
states of Karnataka and Tamil Nadu have hired MSTC to help them in this matter.

These are just a few examples to illustrate the diversity of auctions conducted by MSTC.
Some of these auctions are lumpy in nature — for example sale of telecom spectrum does not
happen every year. On the other hand, some auctions, such as sale of scrap metal by
government-controlled steel companies produces a significant and regular income stream for
MSTC. This diversity of earnings from conducting thousands of auctions every year means
that the company is not overly dependent on just one or two types of auctions. Indeed, the
company is very focused on increasing the diversity in its business as was described by the
company’s Chairman recently when he said:
We are entering into the new areas, new frontiers and new kind of clientele. We are not
limiting ourselves to the scrap sale. We are entering into new kinds of things, new kinds of
business.

I like the growth mindset of MSTC’s management. Indeed, the company is also working
towards helping private sector clients sell unwanted but valuable stuff via e-auctions. In the
company’s annual report for FY22, the company wrote:

MSTC is casting more focus on the untapped e-commerce business from the private sector
and in this stride MSTC has signed big ticket agreement with Reliance Industries, Indus
Tower, Tata Power, L&T, Jindal Group, Vedanta etc to name a few.

Online auctions are a form of e-commerce that takes advantage of the digital platform’s
capacity to breach geographical limitations, furnish real-time data, and minimise transaction
costs. This results in huge convenience benefits to both bidders and sellers transacting
business on the platform. The platform, of course, becomes more valuable to a seller if it
already attracts more buyers. In turn, buyers go where the sellers already are, which makes
the site still more attractive to sellers. These “network effects” are playing out in MSTC as
can be seen from the table below.

As gross merchandise value (GMV) has grown, so have the company’s revenues. But
operating costs have not risen in tandem — just what one would expect from a profitable, and
growing platform business. As a result pre-tax margins in this business have soared from
29% in FY18 to 69% in FY23.

Notice that MSTC’s revenues in FY23 were just 0.12% of the GMV generated by the
company in that year. This tiny percentage on GMV represents a significant entry barrier for
new entrants and add to the competitive advantage of MSTC derived from monopolistic
rights granted by the government as well as the network effects which attracts a large number
of buyers and sellers to its platform.

The government of India and its related parties will always have the need to sell off things in
a transparent manner. I expect the GMV to soar in the next decade or more. And as GMV
grows, even a tiny spread of 12 basis points will produce rapidly rising revenues. And thanks
to the significant operating leverage in the business, earnings should grow even faster.
One aspects that I really like about MSTC’s e-commerce business is that it
requires no incremental capital to run and grow. Indeed, surplus cash of INR 4 billion
matches the book net worth of the e-commerce business. This surplus cash can be
taken out of the business without affecting its ability to grow.

The attraction of a wonderful business which can grow without requiring incremental capital
has been mentioned by none other than Warren Buffett in the past. For example, in the 1994
annual meeting of Berkshire Hathaway, Mr. Buffett said:

There’s a huge difference between the business that grows and requires lots of capital to do
so and the business that grows and doesn’t require capital. And generally, financial analysts
don’t apply adequate weight to the difference between those. In fact, it’s amazing how little
attention is paid to that. Believe me, if you’re investing, you should pay a lot of attention to
that.

And in the annual report for 2007, Mr. Buffett wrote this about See’s candy — a wonderful
business owned by Berkshire Hathaway:

There aren’t many See’s in Corporate America. Typically, companies that increase their
earnings from $5 million to $82 million require, say, $400 million or so of capital investment
to finance their growth. That’s because growing businesses have both working capital needs
that increase in proportion to sales growth and significant requirements for fixed asset
investments.

A company that needs large increases in capital to engender its growth may well prove to be
a satisfactory investment. There is, to follow through on our example, nothing shabby about
earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the
owner is vastly different from the See’s situation. It’s far better to have an ever-increasing
stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

While MSTC is neither Microsoft, nor Google in terms of global dominance, it does enjoy
their ability to grow earnings without requiring incremental capital.

One big reason why MSTC’s growth requires no incremental capital from shareholders is the
presence of float. To deter non-serious bidders from ruining the sanctity of the auctions,
every bidder has to give a refundable deposit to MSTC before any auction. This deposit is
refunded on the completion of the auction but if a successful bidder fails to pay the final bid
price, it is forfeited. The table below shows that MSTC has enjoyed the possession of
significant interest-free float for the last several years.
While it has temporary possession of this float, MSTC invests the cash in short-term, high-
quality, fixed-income securities which adds to the operating profitability of this business.

Key point discussed in class: Are earnings from deploying this float money in fixed income
instruments operating or non operating earnings? In my view they are operating earnings
because they come from investing float which is an integral part of the operations. But that is
not how the company’s financial statements as well as databases treat MSTC’s treasury
income. They treat it as other income which is automatically considered to be a non operating
item which is not the correct treatment. So we have to make the necessary adjustment and
treat it as operating income. By the way, this is what Graham used to prescribe as well. He
used to tell his students to make the necessary adjustments to analyse the business properly.
In accounting one of the key lessons is to focus on substance and not form and this is what
we are doing here.

Another key point discussed in class: MSTC has a large amount of cash on its balance sheet,
but a significant part of it is represented by float money which is other peoples’ money.
Therefore, for calculating the return on net operating assets and also for estimating the market
value of the operating business net of excess cash, the float money should not be counted as
surplus.

MSTC as an IT Consultancy Business

The company is also helping clients set up their own auctions and, in effect, is becoming an
IT consultancy business. Over the years, the company has delivered e-bidding packages for
various ministries of government of India. For example:

1. During FY22, MSTC helped in making improvements in platforms for e-bidding

solutions like DEEP (Discovery of efficient electricity price) , TBCB (tariff-based
competitive bidding for electricity), eBKray (online auction platform for sale of assets
attached by banks)..
2. MSTC developed and operates the portal for Ministry of Coal to auction coal mines
and 25 mines were successfully auctioned during FY22
3. Developed the EXIM Portal for Petroleum Industry — the online bidding platform for
Export & Import of petroleum products for Indian Oil Corporation.
4. In FY22, MSTC launched e-RaKAM (e-Rashtriya Kisan Agri Mandi) a nationwide
electronic portal for trading in food grains, vegetables, fruits, spices and all
agriculture-related commodities.
5. Directorate General of Hydrocarbons has hired MSTC as one of the service providers
for conduction of e-bidding events for natural gas exploration.
6. Ministry of Power is using MSTC’s help for Tariff-based competitive bidding for
electricity transmission services including solar power and wind power projects.
7. National Thermal Power Corporation is using a procurement portal developed by
MSTC for the establishment of FGD (Flue gas desulfurisation) at its various sewage
treatment plants.

A Poor-Quality Legacy Business Camouflaged Earnings

Another interesting aspect about MSTC is just how much of the wonderful performance of its
e-commerce business was camouflaged by the performance of a poor-quality legacy business,
which produced losses, but is now an insignificant piece in the larger picture. Moreover, the
causes for those losses have also been fixed and this business is not expected to burn cash
going forward.

For many decades, well before the e-auctions business started, MSTC acted as a facilitator for
procurement of industrial raw materials like heavy melting scrap, low ash metallurgical coke,
HR Coils, crude oil, naphtha, coking coal, steam coal etc. for supply to industrial customers.
This was essentially a trading business in which, on orders received from customers, the
company would procure the raw material, hold it as its own inventory and then sell it to them
at a small markup over cost. Unlike the e-commerce business, this trading operation was
hugely capital intensive not just because of inventories but also because of receivables thanks
to sales on credit.

Given large capital requirements in this business, the small markup over cost meant that the
returns on capital were pathetically low. On top of all this, many of MSTC’s privately-owned
customers (but not government-owned ones), defaulted on their obligations to pay the
company for material supplied to them. This resulted in huge bad debts which brought down
the reported earnings of the company. Over the ten years ended on March 31, 2023, aggregate
provisioning for bad debts reduced pre-tax earnings of the company by a whopping 54%.

Thankfully, this trading operation has now been fixed. The company no longer supplies
material to its customers until it has in possession a bank guarantee for 110% of the value of
the supply. So, there will be no further bad debts. Moreover, this trading operation which
now breaks even, represented just about 3% of MSTC’s FY23 revenue.

MSTC is Also Into Scrapping and Recycling of End of Life

Vehicles
Yet another interesting aspect about MSTC is its 50:50 joint venture with the Mahindra group
called Mahindra MSTC Recycling Private Limited (MMRPL). This company is an authorised
RVSF (“Registered Vehicle Scrapping Facility”) for vehicles reaching end of their life. These
old vehicles are purchased for de-polluting, dismantling and converting the metallic parts in
an environmental friendly manner.

Since the Mahindra group is in the business of manufacturing automobiles, this joint venture
with MSTC gives it access to steel scrap which is cheaper that buying newly minted steel.
This also helps Mahindra group achieve the objective of reducing its carbon footprint.

But why is MSTC into this business at all? One key reason is that MSTC owns the
platform through which the end of life vehicles are sold via e-auctions. Notably, in December
2022, the Government of India issued a directive regarding its Scrappage Policy, a
government-funded initiative which seeks to phase out old passenger and commercial
vehicles, thereby reducing urban air pollution, increasing passenger and road safety, and
stimulating vehicle sales. According to the directive:
It has been decided that Government vehicles which are older than 15 years and owned by
Government of India and its Ministries/ Departments, State/ UT Governments and their
Departments, Local Government institutions, State Transport Undertakings, Public Sector
Undertakings, and Autonomous Bodies with the Government of India and State Governments
shall be scrapped immediately in order to achieve policy objectives… All condemned
vehicles (including vehicles which have been prematurely condemned) are required to be
scrapped through RVSFs.

In order to facilitate seamless scrapping of such vehicles, it is proposed that the e-auction
platform developed by Metal Scrap Trade Corporation Limited (MSTC) … be used to
conduct e-auction of such vehicles. RVSFS which have been commissioned as per provisions
of MoRTH Notification GSR 653 (E) dated 23rd September 2021 shall only be allowed to
participate in the auction. This would support operations of existing RVSFs by providing
them with a base volume of end-of-life vehicles and would also encourage private investment
in establishing new RVSFs.

This means that all government owned vehicles will be auctioned off on MSTC’s e-
commerce platform when they reach end of life. Over time, volumes will be huge. In FY23,
only 2,084 vehicles were auctioned by MSTC but the company estimates that 1.5 million
vehicles owned by the government and related parties are approaching end of life. So this is
going to be a big opportunity for MSTC and its e-commerce platform will enjoy monopoly
rights too.

Even more interesting is this — the commission earned by MSTC as auctioneer will be
between 2.5% and 3% of GMV and also that this commission will be earned by MSTC and
not the joint venture company. Recall that in FY23, the company’s revenues were just 0.12%
of GMV. So, this scrapping opportunity is not just going to be big over time, it will also be
very profitable.

And of course, if the JV company is the successful bidder in the vehicle auctions, then for
any vehicle it acquires, it will earn, according to company estimates, a return of anywhere
between 10% to 50% over the cost of the vehicle by removing and selling re-usable things
like the mirrors and stereo, and also from the sale of scrap steel, aluminium and rubber (from
tyres) — which again could get sold on MSTC’s auction platform creating another stream of
earnings for MSTC. Clearly, there are significant synergies between MSTC’s e-commerce
business and that of this JV.

At current valuation, one is not pay anything for this opportunity because the earnings from
the e-commerce activities alone are more than sufficient to justify its current market
valuation.

Ferro Scrap Nigam Limited (FSNL)

There is one last bit on MSTC before I talk about valuation. The company owns a 100%
subsidiary called FSNL which provides steel mill services such as processing steel mills slag
for recovery of iron scrap and other metallics. It also provides custodian service for
warehouse management to the clients of MSTC and valuation services for plant and
machinery, scrap, movable and immovable material and properties.

Interestingly, this business, which is profitable (see table below) is up for sale and the
government of India has started the process of divesting it completely. The bids have already
been invited and as per DIPAM (Department of Investment and Public Asset Management)
the planned divestment may happen in the near future.

In FY23, FSNL delivered pre-tax earnings of INR 512 million. While I don’t know if and
when the sale will happen and at what price, I do know that should the sale go through, all the
sale proceeds will come to MSTC and it’s likely that the company will either distribute part
or all of it as a special dividend and/or invest it in the recycling JV, which is a profitable but
capital-intensive operation. Either of these two outcomes will be fine. In any case, at current
valuation, one is not paying anything for FSNL because the earnings from the e-commerce
activities alone are more than sufficient to justify the company’s current market value.

On Valuation
At INR 339 per share in June 2023, the stock is quoting at less than eight times FY23 pre-tax
earnings, implying a pre-tax earnings yield of about 14% which compares favorably with pre-
tax AAA bond yields of about 8% a year. Equally important is the fact that the core e-
commerce business is growing rapidly (pre-tax earnings grew by an annual average rate of
38% over five years ended on March 31, 2023) but requires no incremental capital
investment. In FY23 this exceptional business delivered pre-tax margins of 69%. Dividend
payout ratio was more than 40% and dividend yield alone is more than 5%. And on top of all
this, one would also get to own a promising recycling business for nothing.

Interestingly, MSTC’s stock has no significant institutional ownership and has no significant
coverage in the investment analyst community. Perhaps the camouflaging of an emerging and
attractive platform business by the poor operating performance of a legacy business has
played a role in the relative lack of interest from the street.

**********

Sanjay Bakshi