I was wrong about CFS business

I had written about CFS business profitability to head south? on March 16, 2009 but the latest results from Gateway Distriparks show that the reverse is happening. The ROCE earned by GDL at that time was 20.15% but for FY12 results, it is 174.17/639.50 = 27.24% compared to 113.03/586.10 = 19.28% for FY11. Although some numbers do not make sense to me. The result published on NSE website for FY10 shows capital employed in CFS business as INR 273.30 Crore while the latest results on BSE show the same at INR 586.10 Crore, even though the total in all segments in both the results add up to INR 687.94 Crore. The difference started in results between FY08 and FY09 when capital employed dropped in CFS business from INR 441.83 Crore to INR 325 Crore but the depreciation in FY09 was just INR 44.47 Crore. In the same year, the capital employed in Rail Transportation business grew from INR 153.83 Crore to INR 426.89 Crore. Even the last year result on BSE shows capital employed in CFS business at INR 273.31 Crore so this year's results can be considered incorrect it seems but still we can say that even with the results with lesser capital employed, ROCE would come much higher.

I had also mentioned about investment by LIC in the company at an average price of INR 153 in year 2007. The current price of INR 143 is still below the investment price of LIC. The company came out with IPO at INR 92 in 2005 and also bought back shares in January 2009 at an average price of INR 81.

Image(s): FreeDigitalPhotos.net

Why book value matters?

Most of the value investor understands the importance of book value in determining the intrinsic value of a company. Book value represents the hard assets including its inventory, fixed assets minus depreciation and its cash/receivables minus all the liabilities like provisions, accounts payable etc...Ben Graham suggests not to pay much higher than book value while buying shares of a company.

If this criterion is strictly followed, there might be some set of companies that an investor may not be able to invest in ever. These companies include FMCG firms like Nestle, HUL and GSK Consumer since they distribute most of their earnings as dividends and so the book value of the company does not increase much. These companies also work sometimes on negative working capital so their book value will be very less compared to their earning power and so their intrinsic value can only be calculated based on their earning power.

But in bull markets, like the one we are in, investor enthusiasm stops differentiation between these companies and average small/mid cap companies. See the following table for the examples:

* 2006 numbers
Company	Book Value March 2005	EPS March 2005	Share Price September 2005	P/B September 2005	P/E September 2005	Book Value March 2010	TTM EPS	Share Price Today	P/B Today	P/E today
Ador Welding	63.36	19.95	260	4.1	13	108.45	21.22	170	1.57	8
GMM Pfaudler	36.39	5.21	116.94	3.21	22.45	62.9	8.07	94	1.5	11.65
GM Breweries	25.63*	14.3*	117*	4.57*	8.18*	60.12	17.73	101.8	1.69	5.74
India Nippon	122.4	22.86	286.5	2.34	12.53	187.17	30.95	242	1.29	7.82
Gateway Distriparks	62.39*	7.88*	131.4*	2.1*	16.67*	61.91	7.4	120	1.94	16.22
TV Today	35.58	2.83	96.15	2.7	33.97	52.56	-7.17	62	1.18	NA
Voith Paper	141.15	17.22	200	1.42	11.61	217.81	21.44	200	0.92	9.33

Most of the companies were purely trading at that time based on their earning power and the importance of book value was completely ignored by Mr Market. After more than five years, they are trading at prices lower than what they were trading at in 2005. The loss is not even compensated from dividends since capital erosion is far more than the cash received by an investor from dividends. The story may not end here. In the bear market of 2001-2002, these vary companies were trading at a steep discount to their book value and the same may happen when the next bear market comes. This doesn't mean the investor should shy from buying these names since the loss would be a notional loss unlike the loss that has happened over the last five years which is real.

The typical experience of the speculator is one of temporary profit and ultimate loss. - Benjamin Graham

Image: jscreationzs / FreeDigitalPhotos.net

Some more pain

Extending my previous post, following are some more charts of stock prices of some companies over the last three years:





The first one is from Subex Systems and the second one is of Northgate Technologies.

Mismanagement of money?

I was looking at the list of companies trading at a market cap below the money they raised during their IPOs in the last five years provided in previous two articles, and found one of them, named Precision Pipes and Profiles, interesting. The company till March 2007 had investments of only INR 0.72 Crore, on their balance sheet which subsequently increased to INR 56.86 Crore at the end of March 2008 and declined to 21.24 Crore in March 2009. This made me curious and led me to read their annual reports of FY2008 and FY2009. I found that the company heavily invested in equity mutual fund schemes during April 2007 - March 2008. Some of the schemes were liquid, FMP schemes and were sold off during April 2008 - March 2009 but equity schemes still remained in the investments and that too at a very steep decline in NAVs.

Scheme	Units 2008	Value 2008	Units 2009	Value 2009	Value Today
Birla Special Situation Fund	9388753	80413731	9388753	48314523	86977407
Birla Sunlife Industries Fund	90113	3173975	90113	1647271	2706093
Fidelity Equity Fund	26715	429822	26715	289834	784111
HDFC Infrastructure Fund	2000000	18708000	2000000	10364000	21782000
JM Basic Fund	53860	1071603	198320	1238506	3572139
Kotak 30	61285	1918655
LICMF Equity Fund	44540	393953	44540	253927	1092031
LICMF Infrastructure Fund	5400000	50079600	5400000	30493800	49680000
Reliance Growth Fund	73730	3735910	69457	2041755	3661495
Reliance Natural Resources Fund	2962962	28511111
Tata Infrastructure Fund	203307	4586314	151163	1935036	4875006
AIG World Gold Fund			1955990	17545232	24404887

The value today for the investments mentioned in the annual report of 2009 stands at
INR 199535169 which is still below the actual invested amount of INR 205188460. The company clearly mismanaged money. At the end of March 2009 itself, the market value of schemes was 45% lower than the invested amount. Thanks to rise in stock market over the last 10 months, the market value of this schemes today is just 2.8% lower than the invested amount. But we don't know if the company has already sold them or not. Let's wait for the next annual report.

Is D-Street misinterpreting advance tax numbers?

Advance tax numbers for many companies are out and the D-street is seeing a sign of revival in the numbers. Let's see if the enthusiasm is overdone or not.

First of all, the D-street is forgetting about the big increase in taxes levied by the FM in budget of 2009, i.e. MAT has been increased from 15% to 20%. This change in policy itself increases the taxes by around 33%, 20/15=1.33, it is that simple. Secondly, many companies did not pay higher advance tax in first quarter since MAT recommendation came in budget only on 2nd July 2009, well after the first advance tax was already paid. So YoY comparison of taxes is not going to help.

Some articles are comparing QoQ advance numbers which is worse than comparing YoY numbers since first quarter advance tax paid by companies is 15% of the estimated taxes for the full year while the second quarter advance tax paid by companies is 30% of the estimated taxes for the full year. Read the article on the website of Income Tax Department. The companies have to pay not less than 15% taxes by June 15 and not less than 45% taxes by September 15.

With these two points in mind, it is clear that by adding the advance tax of June 15 with September 15, we can calculate the estimated taxes that the company expects to pay for FY2010. Here is the table:








AT=Advance Tax

Company	Q1 AT	Q2 AT	Total AT	Total AT/0.45 = Estimated FY10 Tax	Actual Tax for FY2009	Estimated FY10/Actual FY09 change
RIL	314	1157	1471	3269	3028	8%
SBI	1068	1832	2900	6445	5060	27.37%
L&T	110	210	320	711	1231	-42.23%
Tata Steel	230	400	630	1400	2113	-33.75%
TCS	53	220	273	606	444	36.5%

RIL and TCS already has to pay 33% higher tax due to higher MAT so RIL taxes will actually go down after MAT increase is considered. Tata Steel stock went up by 8% today with this news of higher QoQ advance tax. Nobody can stop bulls!!!!!

How wrong financial analysts can be?

I would bring to your notice one of the worst financial analysis, in my humble opinion, done by an analyst while comparing two companies. Read the report here. The report compares performance of Bharat Forge with that of Infosys at the peak of auto demand in June 2005. The share price of Bharat Forge at that time (adjusted for 5:1 split) was INR 286.78 and that of Infosys (adjusted for 1:1 bonus) was INR 1106.39. Today the share price of Bharat Forge is at INR 217.2 while that of Infosys is INR 2192.2. Thus during the last four years and three months since this article was written, Bharat Forge has given -24.27% returns while Infosys has generated 98.14% returns. Simply put, the analysts at that time was comparing apples with oranges. Although this seems easy in hindsight, the comparison itself was wrong in the first place. One is a manufacturing business while the other was a services business. As many great investors know, services can command higher EBITDA margin and have big entry barriers. Manufacturing has lower margins, higher competition and low entry barriers. The only conclusion is : take everything that is being said on Dalal Street with a pinch of salt.

Thumb-sucking s**ks

I wrote an article in March about investing in IT stocks. But I myself didn't take the plunge since I am a software engineer by profession and I cannot invest in the sector I am employed in. The reason? If there is a big slowdown in IT and I get laid off, I will lose my job as well as investments. Now most of the recommended stocks are up by 2-3 times. Geometric is up from INR 10 to INR 36, CMC is up from INR 280 to INR 800, Polaris is up from INR 35 to INR 110, KPIT is up from INR 25 to INR 53. The one that I missed during my analysis, Patni is up from INR 110 to INR 320 and still moving up. So much for the rules!!!!!!

How to identify Bubble?

What are the main characteristics of a bubble? How can an investor identify early and take advantage or avoid getting punished? Let me give you some examples which can be used to give a fair idea of a bubble in terms of P/E ratio.

All the gurus agree that 21,000 Sensex in January 2008 was nothing but a bubble. What did the valuation look like at that time? The five companies in the Sensex that led this bull market were trading at following valuations:

Company	P/E of TTM EPS	P/E of 10 year average EPS
Reliance	30	70
Larsen & Toubro	56	135
ICICI Bank	35	80
Bharti	32	150
NTPC	30	45

Companies were trading at 70-140 times ten year average EPS. When the markets corrected many good companies without any debt on their balance sheet giving good dividend in BSE500 were available at TTM P/E of 3-5 with a P/E of 10 year average EPS of less than 5. The examples were Patni and Maharashtra Seamless. Even Bharat Electronics and BEML were available at P/E of 10 of average EPS of 10 years.

The fact shows that investors were paying too much for the near term growth in profits and were not taking into the account the impact of business cycles. The period between 1999-2003 was such that corporates were earning less than their potential but between 2006-2007, most of the companies were earning above their potential.

Can I locate similar trends in some sectors today? Have a look at the following table to compare valuations of some companies:

Company	P/E of TTM EPS	P/E of 10 year average EPS
ABB	31	60
Bharti	19	70
BHEL	33	76
Colgate	29	63
Dabur	29	61
Educomp	50	260
GMR	87	267
GSPL	27	80
GVK Power	35	150
India Infoline	18	76
Jain Irrigation	33	89
JP Associates	55	84
KSK Energy	50	287
Mundra Port & SEZ	50	225
Nagarjuna Fertilizer	75	135
NMDC	31	97
RNRL	188	775
Titan	34	95

Many of the stocks seem to be related to Ports, Airports, Metals, Education and Power. Some overvaluation in FMCG has also started to appear. Manish Chokhani says that there might be companies in power sector that grows from small caps to be a part of Sensex one day replacing NTPC similar to what happened in Telecom. But isn't that hope priced in at this point of time?

The overvaluation of stocks can continue for a long period of time since the liquidity chasing the equities is in huge amount. Investors should stay cautious.

Impact of changes in Accounting Standards

RBI changed the accounting standards to report foreign exchange gain/loss directly to balance sheet instead of showing them in P&L account. This has resulted in many companies hiding their foreign exchange losses in balance sheets. There are prudent companies like Infosys, Bharti, TCS and Ranbaxy who, instead of following the new accounting standard, adhered to the old standard and showed the exchange losses in their P&L account. If all the companies in Sensex had followed this practice the Full Net Profit of Sensex companies would have been lower by around INR 10K Crore and Free Float Net Profit would have been lower by INR 5660 Crore resulting in Sensex EPS lower by INR 68 and instead of INR 752, it would have been INR 674 on 25 June 2009. The P/E for Sensex at 14345.62 would have been 21.28 instead of 19.06.

This is not just the case with companies in Sensex. When the going was good, aka there was foreign exchange gains, the companies didn't hesitate to report them as profits in their P&L account. As soon as the standard changed, most of the companies started taking advantage of it. I would suggest investors to keep reading the fine print.

How changes in Index constituents affect returns?

I will explain this by the example of Tata Power. As per the BSE website, Tata Power was replaced by RCOM on 12 June 2006. If we consider the market capitalization of both the companies at that time with their respective shareholding patterns of the previous quarter, Tata Power had a market cap of 8668.9 Crore with FF(Free Float) of .7 giving FF Market Cap of INR 6068.3 Crore while Reliance Communication had a market cap of 27018.95 Crore with a FF of .65 giving a FF Market Cap of 17562.32. Thus Sensex's FF Market Cap increased by 11494.02 Crore between 9 June and 12 June without giving any increase to the index (when a new company is introduced to Sensex, the FF market cap of the Sensex for the previous day is increased by difference in FF market cap of incoming and outgoing companies).

Now the same Tata Power entered the Sensex back on 28 July 2008 replacing Cipla but the scenario was different. Cipla had a market cap of 17535.69 Crore with a FF of .65 giving a FF market capitalization of 11398.2 Crore. Tata Power had a market cap of 22419.18 Crore with a FF of 0.7 giving FF market cap of 15693.42 Crore. Thus Sensex FF market cap increased by 4295.22 Crore between 25 July and 28 July without giving any increase to the index.

Thus, the increase in FF market cap of Tata Power company between 12 June 2006 and between 28 July 2008 amounting to 9625.12 Crore didn't contribute anything to the Sensex since it was moved out and then moved in again, which amounts to around 1% of 9 lakh Crore worth of FF market cap for Sensex. This is significant loss to the Sensex Index plan investors.

Standalone vs Consolidated

With the help of StatCounter, I have been able to find what people are looking for while investment. There was a search yesterday on Google by one investor which led to my blog and the search keyword was what the title of this post is. Many people want to know what is the difference between the two kinds of results published by the companies. Let me give you the definition:

Standalone Financial Results of a company includes only the revenue, expenditure and other items for the company.

When a company has some stake in another company, the other company is called subsidiary of the parent company.

Subsidiaries can be of many types:

1. Wholly owned subsidiary: The parent owns 100% shares of the subsidiary.
2. Majority owned subsidiary: The parent owns more than 50% shares of the subsidiary.
3. The rest is also divided in two types

• Company holding greater than or equal to 20% shares but less than 50% shares of a subsidiary.
• Company holding less than 20% shares of a subsidiary.

The GAAP says when a company publishes consolidated financial results, it should follow the following rules:

1. If a company holds more than 50% stake in a subsidiary company, the consolidated financial results of the company should add all the revenue, expenditure, profits and other items to its financial results in respective items but the profits; that does not belong to the company due to minority shareholders owning shares of subsidiary, should be shown as minority interest. Thus if a company owns 100% in a subsidiary company, minority interest is 0.
   
2. If a company holds more than 20% stake in a subsidiary company but less than 50%, the consolidated financial results of the company should add the proportionate revenue, expenditure, profits and other items to its financial results in respective items, i.e. If a company A owns 25% stake in company B, B's 25% revenue, 25% expenditure, 25% profits etc. should be added to the respective items of A's standalone results to get the consolidated results.
   
3. If a company holds less than 20% stake in a subsidiary company, the consolidated financial results of the company should not be any different from its standalone results.

Let's understand this by example. Look at L&T's Standalone results and Consolidated results for FY2008. L&T has many subsidiaries like L&T Infotech, L&T Finance and L&T has very different shareholding for each of its subsidiaries. When the L&T creates it's consolidated results, it follows the above three GAAP principles to add the revenue, expenditure, profits and other items to its standalone numbers to get the consolidated results.

Because of case 3, P/E of some company sometimes may not reflect the true picture of the company's valuations. There is one significant example of this in Indian stock market, HDFC holds 19.xx% in HDFC Bank, thus HDFC's consolidated results do not include the profits, revenue and other items from HDFC Bank. HDFC Bank is valued at around 50K Crore, 19.xx% of it is around 10K Crore. HDFC itself is valued at 60K Crore with a P/E of 26. But if you remove HDFC Bank's valuations from it, P/E comes down to 22. I am not sure if the market is adding HDFC Bank's valuations to HDFC.