Tuesday, June 14, 2011

Earnings Quality check - India Nifty stocks - Does your portfolio / mutual fund has the `next Satyam` ?

Earnings Quality check - on India Nifty stocks - Does your portfolio / mutual fund has the `next Satyam` ?
( this post is updated with additional comments in the end)

Introducing a new series on Earnings Quality check – also called as SSEXI – Saanp aur Seedi Earnings Xittiness Index.

So why name it as SSEXI not EQI ( Earnings Quality Index) ?
My  goal is to not to establish a hall of fame but a hall of shame. For the former, there are numerous ratings such as ET,BS,BT ( Economic Times, Business Standard and Business Today).
I was bit frustrated by the lack of availability of decent earnings quality analysis on Indian firms by the reputed big brokers equity research desks. So decided to do this research.

Please let me know your top pick for this rating ( i.e worst quality of earnings) by posting your comment. I have also enabled comments posting as “Anonymous” i.e one can post a comment without the need to log into your email account.
Also let me know , if you have any stock that you want this check to be done. I cant promise it will be done but within my time constraints, I will try my best to close it.  My next objective is to do this similar SSEXI rating on my potential list of multi-baggers ( ~ Top 40 stocks)
Approach  - is quite simple . It involves the past 4 years trend and ratios within same sector.The ratio would be reported P&L Net Income ( or PAT Profit After Tax) to cash based profit or CFO – Cash Flow from Operations. This can be nicknamed as NICFOR – Net Income to CFO Ratio. Similarly other ratio that could be compared is comparing reported EBITDA to cash EBITDA or CFO before cash interest and cash taxes paid.
The most used valuation metric is PE ratio. But `E` is heavily related to accounting standards adopted by the management and involves accrual component also. So my approach is to find out the cash based earnings (i.e CFO from the cash flow statement ) to arrive at the actual PE ratio ( based on cash earnings).
Here is the rationale of using CFO as better valuation indicator.  There are generally three reasons for which Net Income and CFO will differ.
  1. Non Cash charges such as depreciation -  reduces Net Income. This will result in CFO being higher than Net Income, other things remaining the same. Thus CFO will be a better metric to judge the cash flows available to a firm
  2. Working capital changes – such as increasing Account Receivable will reduce CFO as compared to Net Income. Thus CFO reflects better quality of revenues and working capital management of the firm. Some high working capital intensive business such as Infra/ real estate might have a negative CFO also. This combined with a reported positive Net Income will result in a negative NICFO ratio.
  3. Other  income -  such as investment income, sale of long term investments are added to the reported P&L Net Income. But in the cash flow statement,these items are added under CFI ( Cash flow from Investments) so the result is that CFO would be lesser than Net Income. Thus CFO would be a better indicator for  valuation. This is fair because business should be valued only on recurring `core` earnings of the business.
I had to make slight adjustments for Indian firms. Under Indian Accounting standards, interest paid is classified as CFF – Cash flow from Financing activities. So while comparing NICFOR for Indian firms, I have taken the interest paid from CFF and reduced it from CFO to arrive at an adjusted CFO that matches Net Income. (Under US GAAP interest paid is classified under CFO and under IFRS , firm has option to classify as under CFI or CFO)
Similarly I had to make some adjustments if there was a significant one-time other income added to the Net income.
This NICFOR trend can be very useful to identify
  1. Accounting aggressiveness /  conservativeness used by the management. This can also be compared over the years and within the same sector. 
  2. Arriving at truer and better valuation / PE ratio -Can be used as a discount / multiplying factor to arrive at true valuation ratio that can be used to give a better overweight/underweight rating. For Eg. if a firm has latest PE of 10x and NICFOR of 1.5x  this means that the actual PE is 15x ( reported PE x NICFOR) . Similarly if the same firm had a NICFOR of 0.7x that means actual PE is 7x and not 10x. 
  3.  Potential earnings manipulation by management. Management has various reasons for earnings manipulation. Some are
a.       High ESOPs / stock options owned by management.
b.      High peer pressure and street pressure. I.e To meet high expectations of the street / analysts / stakeholders
c.       To get a better valuation and raise more money for a FPO/IPO.
d.      To meet debt covenants and avoid lower debt rating. Also over $7 Bn of FCCB`s ( Foreign currency convertible bond) will be maturing in the next 2 years and firms that have issues these FCCB`s would like to see their share price goes up and above the conversion price so that the debt will get converted to equity.

From the past accounting scandals, the most reliable alarming signs are usually comparing CFO to Net Income. Other ratios such as debt to equity ratio have not at all shown any early signs. Enron ,for example had debt to equity ratio of 0.9 but its CFO was consistently negative as compared to its reported Net Income.( It showed actual negative CFO as positive by reporting `CFO before working capital charges` separately.)
I have done a study of ~ 25 NIFTY companies (comprising ~ 61% of Market cap of NIFTY or ~ $0.8 Trillion. ( See the chart below at the end. Click to zoom) .Some other points to note:
1.       All accounts are as per Indian Accounting Standards
2.       I have taken Consolidated Financial Statements only.
3.    These ratios only gives an indication of earnings quality or accounting aggressiveness and these ratios do not imply higher upsides in the stock, as the earnings /CFO growth is not compared here. Will come up with an update later .Stay tuned / subscribe to this blog to get latest update via email. ( click on the top right hand side)
4.       Most Indian firms have not yet released their FY11 Annual report. Will come up with an update later. Stay tuned / subscribe to this blog to get latest update via email. ( click on the top right hand side)
5.       * Only for Satyam – F.Y is FY`10 to FY`06.
6.       #  for L&T – in FY10 I have removed the one time income from Net Income to adjust for stake sale of Ultratech Cement and Bangalore airport.
These are the companies I have studied :
  • Oil and gas –RIL,GAIL,ONGC
  • Capital Goods -L&T# ,BHEL
  • Power -NTPC
  • Telecom - BHARTI AIRTEL
  • Cement - ACC
  • Real Estate – DLF ,JP ASSOCIATES
  Here is the table ( click to zoom)

Here is the same chart with a heatmap. If ratio is more than 1.1 or reported P&L number is 10% higher than indicated by the cash flow, then it is highlighted as RED. 

Brief Ending Comments on the chart
  1. Satyam was a clear outlier with reported P&L numbers double the cash flow numbers. ( i.e actual PE of Satyam was double / 20x  vs then reported PE of 10x. Similarly P&L EBITDA to Cash EBIDTA ratio was 3x-4x). Even even big players such as L&T, Aberdeen Fund, Fidelity,J P Morgan, Morgan Stanley,,LIC, ICICI Pru,Singapore Sovereign fund were caught in this value trap. Yes , it is hard to tell if outright fraud is committed or not just by this ratio but at least it flags off valuation concerns and a fundamental value driven investor would have avoided the Satyam `value trap`. As per the table, for Satyam , the xit was actually hitting the fan. And had R Raju  not sent the letter of acceptance of the fraud I doubt if this would have been unraveled. Cases such as Satyam only shows the weakness of the system in catching such manipulation. Also had the cash from Satyam been put into a more liquid asset ( say Gold ETF`s vs real estate Land) , Raju could have easily raised liquidity and announce a big buyback at a huge premium. Even many IT majors such as IBM  was also in the fray to acquire Satyam. And had such a deal been pulled off then many of us would never have known this.
  2. Big drawback in India is that Balance Sheet and Cash Flow Statement is not disclosed quarterly. And recently SEBI required firms to report Balance Sheet every 6 months. Maybe this drawback one characteristic of an emerging market. 
  3. Till date ,out of this study sample of 25 NIFTY firms that comprise of 61% of total market cap of NIFTY, just four firms have released their full FY 11 financial statements – INFY,TCS,ACC and RIL. Will update this again after a month or so.Stay tuned to this site.
  4.  IT Pack -Surprisingly for latest FY11 ending in Mar 2011,INFY and TCS have shown their NICFO ratios hitting the highest level in the last 4 years. This might indicate the pressure by management to meet the huge street expectations. CFO for TCS and INFY declined by -10%  and -23% respectively vs their reported earnings growth of +30% and +10% respectively. Thus as compared to the reported PE of 25x of both TCS and INFY, the actual PE ( based on CFO) is actually 35x. ( reported PE x NICFOR of 1.4x). If in FY11 this is the standard set by IT firms then I believe it would be very fair to assume that other sectors would be worse/ similar.
  5. These ratios should generally be stable over the years without big variations. Any big variations -both on higher or lower side need to be examined more closely. A negative ratio ( in most cases) would be a result of positive Net Income and Negative CFO.
  6. Again I repeat – These ratings / ratios are just indicative of P&L based earnings vs cash based and higher ratios cannot be assumed to imply a fraud. However, higher ratios would require closer examination. And most importantly , one should be extra careful of firms that have positive Net Income with Negative CFO ( i.e negative NICFOR).These kind of firms  would definitely deserve a lower valuation rating. Similarly a lower ratio does not imply higher upside as upside depends on fair value vs current price and future earnings growth and this study doesn’t cover cash flow / earnings growth.  I will explore it later. Stay in touch with this blog to be the first one to know.
  7. One could make a hypothesis that in general PSU stocks ( Public Sector) would have lower ratios as unlike private sector management doesn’t own significant stock in the firm. But again if a PSU is looking to raise equity via FPO/IPO the tendency to adopt aggressive accounting standards will increase. 
  8. Here is the sector wise summary of the findings ( the given tables)
    • IT – For FY`11 ,TCS and INFY both seem to be a race to the bottom in terms of earnings quality. From past 4 years record ,it seems Wipro earnings has been consistently of lower quality.
    •  Oil & Gas – RIL `s earnings quality has been consistently poor but the latest FY`11 shows a sharp drop in ratio – a 55% drop in NICFOR from 1.5 to 0.6. Effective tax rate ( based on Cash tax / CFO before Interest and taxes) has also been low at 11%.It again raises more questions than answers. PSU`s GAIL and ONGC score way higher.
    • Capital Goods – L&T earnings has been consistently poor and has been on a steady downhill since FY`07 when the NICFOR was 1.0. For two years, CFO was in fact negative. BHEL has been consistently better for last 4 years except for FY`10 where it took a change for the worse matching with L&T.
    • Auto – Maruti Suzuki and Hero Honda have clearly maintained their good earnings quality consistently.
    • Telecom – Bharti has very low ratios i.e actual PE is just 0.6x times reported PE. I.e  maintained good earnings quality throughout. For R Com could not find Annual reports on their website.
    • Steel & Mining- SAIL was doing well till FY`09 but FY`10 took a tumble. Maybe due to planned FPO in FY`12. JSPL and Sterlite have maintained quite low/medium ratios ( Good)
    • FMCG – HLL and ITC both are quite ok with ITC being more consistent.
    • Infra & Real Estate – DLF has consistently a negative CFO except FY`11. FY`12 remains to be seen. JP Associates again has been a consistent negative CFO firm.
    • Coal India – steady. Only slight increase in FY`10 most probably due to planned IPO. FY`09 ratios dipped ( to as low as 0.2) as P&L Net Income was abnormally down due to salary revision.
  • Banks are excluded for this study. But my view is that the earnings quality of banks would always be inferior to other businesses/sectors. Unlike other businesses, Banks first `loan` their product/ service ( loan) and then start recognizing revenue ( interest income) immediately as the customer starts paying EMI`s and loan defaults generally doesn’t happen within the first/second  year of the loan. It happens after the initial 20%-30% of the loan tenure. And NPA recognition standards in India are very subjective and not stringent. Loan collateral /security / personal guarantee also doesn’t have any meaning as even if the borrower defaults, in most cases the collateral is not easy to liquidate soon. Some Indian private banks also show their low default rates over the years but this doesn’t make sense with India macro of low per capita income of $ 1,000 and low transparency in many sectors. I.e not only ability to pay factor is important but one also need to factor in willingness to pay. Micro finance is a good case study.
  • This study throws up many other areas to explore and hope to do some in near future. Other areas to explore from here :
    • Effective tax rate based on Cash taxes paid.
    • Growth in FCFF / FCFE , Gross Cash and Net Cash levels
    • Comparing P&L based return ratios such as ROE,ROCE vs cash flow based return ratios
    • Use both SSEXI (Earnings Quality index) and growth in cash flow to arrive at fair valuation i.e upside / downside rating.


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Anonymous said...

good stuff!!