STRATEGY...STRATEGY Research Analysts: When accounting predicted VinitPowle [email protected]...

STRATEGY

Research Analysts:

When accounting predicted

Vinit [email protected] Tel: +91 22 3043 3149

January 2020

Nitin [email protected]: +91 22 3043 3241

We’re in good shapeNobody understands our financial statement

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January 08, 2020 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

When accounting predicted…………………………………………………………..5

Accounting quality shapes investment returns! ……………………………………6

Ambit’s ‘forensic’ model: Methodology …………………………………………..14

Signs of a potential deceit; learnings of last decade ……………………………15

A few case studies from our model ……………………………………………….21

Link between accounting quality and investment returns ……………………..38

Accounting quality merits attention in a more normal market scenario …….42

How clients can use our forensic expertise ………………………………………44

Case study: Fooling by Pooling! ……………………………………………………47

Strategy


Strategy


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Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

When accounting predicted… Reverberations of IL&FS’ accounting shenanigans were felt by the Indian economy throughout CY19. This coincided with the 10-year anniversary of Satyam scandal and also led to stringent regulations on auditors! In this 10th edition of our accounting scorecard for nearly 1500 listed companies (ex BFSI), we reiterate that accounting quality is a pertinent first filter for stock selection. Of the key 16 accounting-related company/stock crashes of the past decade, our accounting screens had highlighted more than 80%, sometimes very early. Most of these cases fared very poorly on capital intensity, related-party transactions and working capital adjustments whilst raising pledges; a simple framework, voila! FF mcap of Zone of Darkness (ZOD) companies has decreased from FY17 by 10%, yet it is still higher than its lowest (19% at FY14); it’s not just the small-caps. Of the top 100 FF mcap companies, 29 are in ZOD. Ask us, have you avoided ZOD?

CY19: Many examples of accounting shenanigans exposed

Over the past 15 months since IL&FS unraveled, DHFL, Yes Bank were amongst the few whose questionable accounting/reporting practices were exposed, leading to massive decline in investor wealth. Apart from this, there were a few others (HDIL, CCD, Jain Irrigation, PC Jewelers) whose stock prices declined massively on concerns over accounting practices. Our analysts, either on bottom-up analysis or using our accounting screen, had been highlighting concerns in most barring IL&FS.

Add pledging to our accounting analysis, save yourself from deceit Out of key 16 companies which gained significant attention over the past decade owing to alleged financial irregularities, 14 featured in bottom quality deciles (D8-D10) either throughout the last 8-year period or at least once, thereby making a good case for further analysis. In many cases, Red Flags were raised 2-3 years before the concerns came to fore. Another unique thing common in most of these was rise in percentage of pledged shares. Most of the pledging was simultaneous to the rising capital intensity and related-party transactions. Some of the key examples were Manpasand Beverages and Arshiya.

Fool-proofing and expanding our framework whilst regulator tightens Over the past 2-3 years we not only added details of related-party transactions and advances but also moved to 11 ratios using financials of 6-7 years. Alongside, our analysts brought in an accounting-cum-business risk framework for banks and will soon release accounting screens for other BFSI segments. All this whilst MCA, SEBI and RBI are expanding accounting disclosures (including IND-AS), increasing liabilities on management and auditors, and increasing oversight on auditors (rotation, NFRA). Hopefully, next decade would be better!

Yes, in CY19 too ZOD/ZOP highlighted 12m back underperformed Accounting quality is important in shaping investment returns. Poor quality accounting stocks (D8-10) continued to underperform by ~10% on a median basis in CY19 compared to good quality accounting stocks (D1-D5). Needless to say, the same applies to even long-term periods. On a five-year CAGR (Nov 14-19) basis, D10 (last decile) stocks delivered ~1% median CAGR returns.

THEMATIC ACCOUNTING January 08, 2020

Strategy

5 key improved companies over last 5 years

Ashok Leyland 3M India

Godrej Consumers Balkrishna Ind

Jubilant Life Sciences

Source: Ambit Capital research

5 key deteriorated companies over last 5 years

Zee Entertainment Take Solutions

Glaxosmithkline Pharma

Sun Pharma Advanced

Quess Corp


The simple variables when overlaid with pledging predicted deceits awaiting disclosure

Source: Ambit Capital research THIS NOTE CANNOT BE USED BY THE MEDIA IN ANY SHAPE OR FORM WITHOUT PRIOR CONSENT FROM AMBIT CAPITAL. CASE STUDIES FEATURED IN THIS NOTE ARE FOR ILLUSTRATIVE PURPOSES ONLY AND MAY NOT NECESSARILY IMPLY ANY ILL-INTENT ON THE PART OF THE COMPANY IN QUESTION.

Research Analysts

Vinit Powle

+91 22 3043 3249

[email protected]

Nitin Bhasin

+91 22 3043 3241

[email protected]

Reach out to us for…

Accessing our HAWK platform for gauging accounting quality and capital allocation history of non-BFSI firms. HAWK currently is updated with FY18 scores, FY19 scores will be updated in next 30 days

Heatmap for your portfolio companies Detailed bespoke for a company on both

accounting and corporate governance

Training for your teams

Strategy


Accounting quality shapes investment returns! In CY19, India Inc. faced liquidity crisis post debacle of IL&FS. The liquidity crisis also surfaced the bitter part of financial reporting norms in India with regulators waking up to the call and making stringent decisions like setting up of NFRA (National Financial Reporting Authority) or seeking ban on faulty audit firms. The poor accounting quality stocks (D8-D10) continued to underperform by ~13% on average basis in CY19 as compared to top quality accounting companies (D1-D5). We, at Ambit, have always believed accounting quality plays a very instrumental role in long-term wealth creation and is a critical hygiene factor, lack of which is severely detrimental to portfolio returns. This is also evident in long-term (six years) share price outperformance of superior accounting quality deciles vis-à-vis poor quality deciles irrespective of them being large-caps, mid-caps or small-caps. With this note we launch our accounting model for CY19 extended to all companies (ex BFSI) with market-cap greater than `1,000mn.

IL&FS – Accounting lapses were indicative of the brewing issues; now India Inc. faces a liquidity crisis and set-up of NFRA

In CY18, IL & FS group entities reported inability to repay back certain loans to banks and other lenders. During the same time, its founder Mr. Ravi Parthasarathy reported his intent to leave the firm citing medical reasons. Whilst reasons for its debacle could be many, the investigations led by authorities like SFIO (Serious Fraud Investigation Office) very sharply brought out the ugly side of financial reporting practices in India. SFIO probe revealed major lapses in the audit done by two globally renowned and well-respected auditing firms.

Needless to say, several large investors lost significant wealth. We at Ambit have always believed poor accounting quality companies erode shareholders wealth over a longer period of time. Our observation that high accounting quality means higher investment returns over long term, while poor accounting quality means lower investment returns over same time frame has always stood the test of time.

Exhibit 1: Zone of Darkness (D8-D10) companies continued to underperform at several notches below Zone of Safety (D1-D5) companies

Source: Bloomberg, Ambit Capital research, Company. Universe for this company is BSE-500 companies (ex-BFSI) with market cap of above `1bn at Nov’18. Share price performance is calculated over 21 Dec’18 to 02 Dec-19. These are average returns of the deciles.

Investors could argue that average returns are not the right representative to gauge impact of accounting quality as one stock with large negative returns could distort the overall analysis. But the performance differential is equally evident using median returns instead of average returns. On median basis, the bottom decile (D8-D10) stocks declined by ~15% vs ~5% for the top five deciles (D1-D5) stocks.

(18.0)

(14.0)

(10.0)

(6.0)

(2.0)

2.0

6.0

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

Ave

rag

e r

etu

rn (

%)

Poor quality accounting companies(D8-D10) underperformed by ~13% (on average basis) between Dec-18 to Dec-19 as compared to top quality accounting companies (D1-D5)

Strategy


Exhibit 2: Even on a median basis, bottom quality accounting deciles have been underperformers

Source: Bloomberg, Ambit Capital research, Company. Universe for this company is BSE-500 companies (ex-BFSI) with market cap of above `1bn at Nov’18. Share price performance is calculated over 21 Dec-18 to 02 Dec-19. These are median returns of the deciles.

Accounting quality - A touchstone in defining long-term investment returns

Even an analysis over the previous six years (FY14 to FY19) suggests that accounting quality does play an active role in shaping investment returns over the long run. Superior accounting quality firms continue to outperform poor accounting quality firms in the long run as is evident in performance differential for ‘Zone of Safety’ over ‘Zone of Darkness’ in the exhibit below:

Exhibit 3: Performance of accounting deciles over long periods of time

Since… Decile

Median share price performance

2014 2015 2016 2017 2018

5 yr. CAGR 4 yr. CAGR 3 yr. CAGR 2 yr CAGR 1 yr Abs

Zone of Safety

D1 6% 7% 5% -5% -5%

D2 10% 2% 11% -5% 11%

D3 5% 11% 5% -3% -9%

D4 8% 1% -1% -15% -11%

D5 7% 6% 7% -14% -9%

Zone of Pain

D6 8% 3% 4% -14% -7%

D7 6% 5% 3% -17% -8%

Zone of Darkness

D8 1% 5% 3% -16% -9%

D9 6% 0% 9% -20% -13%

D10 1% 3% -7% -28% -19%

Source: Ambit Capital research, Company, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-FY18. For deciles constructed using FY14 scores we have plotted the stock price performance for five years i.e.27 November 2014 to 27 November 2019, for deciles constructed using FY15 scores we have plotted the stock price for four years i.e. from 27 November 2015 to 27 November 2019 and so on.

Analysis of deciles constructed on the basis of accounting quality (quantified using our model) brings out the following interesting observations:

Zone of Safety (D1 to D5): Over long periods, Zone of Safety has done reasonably well. Deciles constructed on the basis of FY14 accounting scores suggests that the Zone of Safety stocks have delivered median ~7% CAGR returns in the 5-year period from Nov’14 to Nov’19.

Zone of Pain (D6 and D7): The next two deciles on accounting quality, i.e. D6 and D7, constructed using FY14 accounting scores have delivered median ~7% CAGR returns in 5 years from November 2014 to November 2019, which is almost equal to Zone of Safety stocks.

(20.0)

(16.0)

(12.0)

(8.0)

(4.0)

-

4.0

8.0

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

Med

ian

retu

rn (

%)

Zone of Safety (D1 to D5) stocks have delivered median ~7% CAGR returns in five years period, as against Zone of Darkness (D8 to D10) have delivered median ~3% CAGR returns over same time frame.

Strategy


Zone of Darkness (D8-D10): The bottom three deciles. The worst quality stocks on accounting quality based on FY13 accounting scores have been massive underperformers with median ~3% CAGR returns from November 2014 to November 2019. It is pertinent to note that D10 stocks have delivered ~1% CAGR returns over same period.

This analysis clearly brings out the fact that accounting quality plays an important part in generating investment returns over the long term.

Zone of Darkness means ‘lower returns over long period’ holds true across large-caps, mid-cap or small-caps

In CY17, a year driven by excess liquidity, investors ignored accounting quality in large-caps; but post CY17 the ZOD companies under large-cap have only underperformed compared to ZOS and ZOP companies. Except CY17, Zone of Safety mid-cap companies have clearly outperformed the ‘Zone of Pain’ or ‘Zone of Darkness’ companies. Correction in poor accounting quality small-cap companies was the sharpest.

Exhibit 4: Large-caps: >25% comprises of Zone of Darkness (ZOD) companies; relative performance to Nifty of ZOD companies was higher in CY17 (driven by excess liquidity); however fall was steeper in CY18

Source: Ambit Capital research, Company, Bloomberg. We have used Nifty-50 index to workout relative returns. Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014 deciles and relative returns for same are average returns computed for next 1 year, i.e. Dec’14 to Dec-15 and so on. Large-cap companies are companies with market cap of above `280bn for each year at Dec. Universe is BSE-500 companies (ex-BFSI)@ 31st Dec of each year.

Exhibit 5: Mid-caps: >25% comprises of Zone of Darkness (ZOD) companies; Zone of Safety (ZOS) companies have only outperformed ZOD and ZOP companies post CY17

Source: Ambit Capital research, Company, Bloomberg. We have used NSE mid-cap index to workout relative returns. Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014 deciles and relative returns for same are average returns computed for next 1 year i.e. Dec’14 to Dec-15 and so on. Mid-cap companies are companies with market cap of `85bn to `280bn for each year at Dec. Universe is BSE-500 companies (ex-BFSI) @ 31st Dec of each year.

50% 66% 48% 55% 54%

26%

17%

18%15% 21%

24% 17% 33% 30% 25%

-25%

-15%

-5%

5%

15%

0%

20%

40%

60%

80%

100%

2014 2015 2016 2017 2018Zone of Safety Zone of PainZone of Darkness ZOS relative return (RHS)ZOP relative return (RHS) ZOD Relative returns (RHS)

61%50%

62% 54% 56%

15%22%

16%21% 17%

24% 28% 22% 25% 28%

-15%

-10%

-5%

0%

5%

10%

15%

0%

20%

40%

60%

80%

100%

2014 2015 2016 2017 2018

Mid-caps

Zone of Safety Zone of Pain Zone of DarknessZOS relative return (RHS) ZOP relative return (RHS) ZOD Relative returns (RHS)

Strategy


Exhibit 6: Small-caps:>30% comprises of Zone of Darkness companies; investors clearly ignored the accounting quality in CY17; correction in poor accounting quality small-caps was the sharpest

Source: Ambit Capital research, Company, Bloomberg. We have used NSE small-cap index to workout relative returns. Accounting scores are based on annual financials over FY09-FY18. For instance ‘2014’ indicates 2014 deciles and relative returns for same are average returns computed for next 1 year i.e. Dec’14 to Dec-15 and so on. Mid-cap companies are companies with market cap below `85bn. Universe is BSE-500 companies (ex-BFSI) @ 31st Dec of each year.

Considerable portion of large-cap companies is in ‘Zone of Darkness’

Basis FY15 financials, ~17% of total large-cap companies (lowest between FY14-19) comprised Zone of Darkness companies. In the very next year, basis FY16 financials, ~33% of total large-cap companies consisted of ZOD companies. Needless to say, it was during same period in which ZOD companies also gave highest returns. The number of ZOD companies is again high at 33% at Dec’19. For mid-caps and small- cap companies, the number of ZOD companies has always been around one-fourth and one-third respectively (between FY14-FY19) of total number of companies

Exhibit 7: Basis FY19 financials, 33% of large-cap companies are ‘ZOD’ companies;

Source: Ambit Capital research, Company, Bloomberg. Note- Large-cap companies (market cap: above `285bn), mid-cap companies (market cap: `85bn to `285bn and small-cap companies (market cap: Less than `85bn). Universe is ex-BFSI @ 31st Dec of each year.

Relationship between voluntary resignations of auditors, independent directors and ‘Zone of Darkness’ companies remains strong

CY19 was again characterized by a high number of auditor and independent director resignations. Our analysis of resignations (between Apr’19 to Jul’19) of leading listed companies suggests that over ~60% of companies with voluntary auditor resignation feature in the ‘Zone of Darkness’ (constructed last year on our accounting model for FY18-end financials). Meanwhile, ~50% of companies which faced ambiguous independent director resignations feature in ‘Zone of Darkness’ and ‘Zone of Pain’.

48% 49% 46% 48% 46%

21% 18% 22% 20% 21%

31% 33% 31% 32% 33%

-15%

-5%

5%

15%

25%

35%

45%

0%

20%

40%

60%

80%

100%

2014 2015 2016 2017 2018

Small-caps

Zone of Safety Zone of PainZone of Darkness ZOS relative return (RHS)ZOP relative return (RHS) ZOD Relative returns (RHS)

48% 54% 48%

21%22%

19%

31% 25% 33%

75

106

227

0

50

100

150

200

250

0%

20%

40%

60%

80%

100%

Large caps Mid-caps Small-caps

Zone of Safety Zone of PainZone of Darkness total number of companies (RHS)

Strategy


Exhibit 8: ~60% of auditor resignations have been in companies that feature in Zone of Darkness

Source: Company, Ambit Capital research. We have considered auditor resignations from 01 April 2019 to 24 July 2019. Accounting scores are based on 2018 framework. Universe is ex-BFSI.

Exhibit 9: 47% of total ambiguous independent director resignations relate to companies featuring in ‘Zone of Darkness’ or ‘Zone of Pain’

Source: Company, Ambit Capital research. Universe is BSE-500 companies (ex-BFSI) with market cap of more than `1bn at Dec’18. Accounting scores based on FY13-FY18 financials. We have considered resignations from Jan’19 to Nov’19. Universe is ex-BFSI

Is accounting quality appropriately factored in valuations?

Basis free float market cap, the contribution of ‘Zone of Darkness’ companies to total free float market cap has reduced since CY17. We believe the drop in contribution of ZOD companies is largely on account of significant correction in their stock prices rather than improvement in their accounting scores as we observe accounting scores have remained largely static since CY17.

Exhibit 10: Contribution of ‘Zone of Darkness’ companies to free float market cap has reduced post CY17

Source: Company, Ambit Capital research, Bloomberg. Universe is BSE-500 (ex-BFSI). Market cap is considered as at 31-Dec of each year except for 2019, where it is 13-Dec.

Satyam did trade at a valuation discount to Infosys and Wipro even before the promoter owned up to aggressive accounting. That said, its share price crashed by over 90% within two days of the fraud being made public. Thus, the market does not already know and properly discount firms that have poor accounting quality.

More recently, 8K Miles Software lost more than 90% of its value since hitting all-time high in Nov 2017. 8K Miles was trading at significant premium (on P/E multiples) to its peers Accelya Kale, MPS Ltd and eClerx Services until a chain of questionable (including resignation of auditors) events unfolded resulting in significant erosion in value.

1

0 0 0

2

1

0

1 1

4

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

Number of companies

61

2430

Zone of Safety Zone of Pain Zone of Darkness

Number of independent director resignations (CY19)

19% 21%30% 34% 23% 24%

28% 18%14% 13% 21% 16%

53%62% 55%

53% 56% 60%

0%10%20%30%40%50%60%70%80%90%

100%

2014 2015 2016 2017 2018 2019

Zone of Darkness Zone of Pain Zone of Safety

Strategy


To check if accounting quality is factored in stock valuations, we constructed four sector-agnostic buckets. ‘Bucket A’ comprises the first quartile of each sector with stock trading at most premium valuations; ’bucket B’ the second quartile of each sector; ‘bucket C’ the third quartile of each sector; and ‘bucket D’ the last quartile of each sector with stocks trading at most discounted valuations. Hence, every bucket has an equal number of stocks from each sector, implying the buckets are sector-agnostic.

Exhibit 11: 25%, 34% and 17% of total stocks featuring in D8, D9 and D10 respectively are trading at premium valuations; also significant numbers of ‘Zone of Safety’ stocks are trading at cheap valuations.

Accounting Deciles Number of

stocks Bucket A Bucket B Bucket C Bucket D

D1 41 10% 27% 34% 24%

D2 41 34% 24% 27% 12%

D3 40 38% 18% 20% 20%

D4 42 24% 24% 17% 33%

D5 40 13% 30% 30% 23%

D6 41 17% 20% 29% 24%

D7 40 23% 25% 25% 20%

D8 40 25% 20% 20% 25%

D9 41 34% 22% 20% 20%

D10 41 17% 24% 10% 32%

Source: Bloomberg, Ambit Capital research. Note: Accounting score is based on annual financials over FY14-19; we have considered 1-year trailing PE for our analysis purpose. Universe for this exhibit is the BSE-500 excluding BFSI.

Considerable proportions of the bottom three decile stocks are trading at significant premiums; so such stocks need to be diligently evaluated to ascertain investment suitability.

Link between changes in accounting scores and investment returns for long periods

We analysed the median share price returns of the portfolio of stocks based on a combination of beginning period accounting quality (i.e. 2014) and accounting quality based on the most recent year (i.e. 2019) over longer time periods; i.e. in this case over Nov’14-Nov19. Results from our analysis have been summarized in the exhibit below.

Exhibit 12: Median share price returns for a combination of stocks based on beginning (2014) and ending period (2019) accounting scores

Ending period accounting quality (2019)

Zone of Safety

Zone of Pain

Zone of Darkness

Beginning period accounting quality (2014)

Zone of Safety 6.9% 8.5% 0.0%

Zone of Pain 15.5% 9.7% 5.3%

Zone of Darkness 14.5% 0.1% 1.2%

Source: Ambit Capital research, Company, Bloomberg

Following are the key takeaways from the above exhibit:

Firms that moved from bottom three deciles (‘Zone of Darkness’) on accounting quality in 2014 to Zone of Safety in 2019 delivered ~15% returns on a median basis over Nov’14 to Nov19.

Firms that continued to stay in ‘Zone of Darkness’ delivered 1.2% CAGR returns (underperformance by 14% than firms which moved to ‘Zone of Safety’) on median basis over Nov’14 to Nov19. Firms that continued to stay in ‘Zone of Safety’ delivered ~7% CAGR on median basis over the same time.

Firms that remained in Zone of Pain delivered CAGR returns at ~10%, i.e. higher by 3% than firms that remained in Zone of Safety. however considering their accounting scores, companies in Zone of Pain need to be evaluated carefully.

Considerable percentages of three bottom decile (D10, D9 and D8) stocks are trading at premium valuations. Considering their poor accounting scores, these stocks should be carefully evaluated.

Strategy


Change in accounting scores over longer period of time: In the BSE-500 universe between FY14 and FY19, we observe around 50 companies switched either from Zone of Darkness (2014) to Zone of Safety (2019) or vice versa. We believe investors should be aware of sharp fluctuations in accounting scores in case of their portfolio companies. We plot below a few examples whose accounting scores have sharply deteriorated or improved between FY14 and FY19. Areas highlighted in pink denote the areas of improvement or deterioration in FY19.

Exhibit 13: Top 2 ratios (highlighted in pink) of 5 key companies where scores improved in FY19

Company name Rank-

CFO: EBITDA

Rank- Cont Liab

Rank-CWIP: Gross Block

Rank- chg in

depr rate

Rank-CAGR in auditors

remn/CAGR in consol

revs

Misc exps-% of Total

revs

Rank-Cash yield

Rank- PFD

as a % of Drs>

180 days

Cum. FCF/

median revs

Rank-Advance

to related parties /

CFO

Rank-Change in

Reserves (ex-Sec Prem)/

(PAT-Div)

Ashok Leyland Ltd. 368 206 301 267 292 397 15 204 314 273 204

Jubilant Life Sciences Ltd. 248 150 146 107 337 299 22 204 335 273 305

3M India Ltd. 220 89 382 218 206 143 112 204 247 273 305

Godrej Consumer Products 291 147 352 368 359 135 141 204 299 273 204

Balkrishna Industries Ltd. 369 104 90 312 378 204 208 204 294 273 305

Source: Ambit Capital research, Company. Accounting scores are based on financial statements for the year FY14-FY19. Numbers in the boxes indicate accounting scores relative to BSE-500 universe (ex-BFSI). Standalone financial statements are considered for Ashok Leyland.

Exhibit 14: Top 2 ratios (highlighted in pink) of 5 key companies where scores deteriorated in FY19

Company name Rank-

CFO: EBITDA

Rank- Cont Liab

Rank-CWIP: Gross Block

Rank- chg in

depr rate

Rank-CAGR in auditors

remn/CAGR in consol

revs

Misc exps-% of Total

revs

Rank-Cash yield

Rank- PFD

as a % of Drs>

180 days

Cum. FCF/

median revs

Rank-Advance

to related parties /

CFO

Rank-Change in

Reserves (ex-Sec Prem)/

(PAT-Div)

Zee Entertainment 53 79 144 115 372 295 50 102 344 134 204

Glaxosmithkline Pharma 296 88 3 262 179 31 241 204 375 273 305

Quess Corp Ltd. 39 354 384 28 312 376 28 204 54 1 305

Take Solutions Ltd. 32 335 326 7 257 390 65 102 34 273 204

Sun Pharma Advanced 8 42 344 139 145 101 349 204 5 273 305

Source: Ambit Capital research, Company. Accounting scores are based on financial statements for the year FY14-FY19. Numbers in the boxes indicate accounting scores relative to BSE-500 universe (ex-BFSI).

Dispersion of accounting scores exists within a sector

Given the nature of framework, it is possible that a particular sector may get penalised more as compared to others owing to its specific nature (e.g. E&C sectors where CWIP/gross block ratio can be considerably high for years); however, the dispersion of accounting scores within a sector highlight that there are differences in accounting quality of companies within the sectors. For instance, in case of FMCG sector within the BSE-500 universe (ex-BFSI), we observe that in the universe of 29 FMCG companies, the maximum and minimum accounting score is 297 and 132 respectively.

Strategy


Exhibit 15: Accounting scores of companies vary significantly within the sector; Pharma has highest dispersion while auto anc has lowest in our analysis

Source: Ambit Capital research, Company. The chart plots the difference between the maximum and minimum accounting score for each sector. We have excluded sectors with less than 15 companies. The figure within each column indicates the number of stocks in the respective sector

Launching our proprietary accounting model for CY19

Given the powerful bearing that accounting quality has in shaping investment returns, and with nearly all major listed companies having published their FY19 annual reports, in this note we bring to you this year’s edition of our annual accounting thematic extended to all companies with market-cap greater than `1,000mn.

In the next section, we discuss the methodology used to rank the entire universe of listed companies (excluding banks and financial services firms) with market-cap greater than `1,000mn on the basis of their accounting quality. All our accounting analysis is based on data sets taken from Ace Equity, Capitaline and Bloomberg. We triangulate our data across three data sets to ensure that we minimise data-driven errors in our analysis.

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190

240

290

340

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We launch our accounting model for FY19 for all companies (ex-BFSI) with market-cap greater than `1bn

Strategy


Ambit’s ‘forensic’ model: Methodology We use 11 objective, quantifiable ratios to rank the universe based on accounting quality in this year’s iteration. These ratios can be broadly categorised into four key areas of accounting checks as shown in the exhibit below.

Exhibit 16: Key categories of accounting checks - Universe (excluding Financials) Category Ratios Rationale Variables used Basis for scoring

P&L mis-statement checks

Cum. CFO/cum. EBITDA Check on a firm's revenue recognition policy; a low ratio may be indicative of aggressive revenue recognition practices

CFO, adjusted EBITDA Express cumulated previous six years CFO as a percentage of cumulated adjusted EBITDA for previous six years

Volatility in depreciation rate Penalise firms where volatility in depreciation rate is unusually high

Adjusted gross block of fixed assets, depreciation charge

Previous six year median of absolute depreciation rate changes

Provisioning for doubtful debts as a proportion of debtors more than six months

Check on a firm's debtor provisioning policy; a low ratio raises concerns regarding earnings being boosted through aggressive provisioning practices

Provision for doubtful debtors, debtors outstanding for a period of more than 180 days

Previous six year median of ratio

Balance sheet mis-statement checks

Cash yield A low cash yield may either imply balance sheet misstatement or that the cash is not being used in the best interests of the firm

Investment income, current investments, cash and bank balance


Change in reserves (excluding share premium) to net income excluding dividends

A ratio of less than 1 may denote direct knock-offs from equity

Profit after taxes, dividend amounts, reserves balances


Contingent liability as a proportion of net worth

Indicative of the extent of off-balance-sheet risk

Contingent liabilities, net-worth Previous six year median of ratio

Pilferage checks

Miscellaneous expenses as a proportion of total revenue

Check on a firm's expenditure policy; a high ratio raises concerns regarding the authenticity of such expenses

Miscellaneous expenses, CSR expenses, revenues


CWIP to Gross Block A high CWIP to gross block ratio could either indicate unsubstantiated capex or delay in commissioning

Capital work in progress, adjusted gross block of fixed assets


Cumulative CFO plus CFI to median revenue

Check on whether the firm has historically been able to generate positive cash flows after investing activities

Cash flow from operations, cash flow from investing activities, revenues

Cumulate balances of previous six years cash flow from operations and investing activities and express it as percentage of previous six years median revenue

Related-party advances as a proportion of cumulative CFO

Penalise firms where advances to related parties have been increasing

Long-term related party advances, cash flow from operations

We use buckets of 3 +3 years e.g. cumulate CFO of FY14-FY16 and express it as percentage of FY16 year-end advances and compare it with cumulated CFO of FY17-19 to FY19 advances ratio

Audit quality checks

CAGR in auditors remuneration to CAGR in consolidated revenue

Check on the audit quality; ideally growth in auditors remuneration should be consistent with growth in consolidated revenue

Standalone audit remuneration, revenues

Difference in audit fee CAGR less revenue CAGR for previous six years is expressed as percentage of revenue CAGR for previous six years

Source: Bloomberg, Ambit Capital research. Note: *Depreciation accounting has undergone significant changes in FY15 (due to the requirements of the Companies Act, 2013 that became applicable w.e.f. 01.04.2014). This has resulted in inherent volatility in the depreciation rate in FY15 across the universe. However, given that we are looking at a 6-year median in our model, this change in depreciation accounting does not materially impact the scores for companies in the universe.

A note on Ind-AS adoption

With effect from 01 April 2018, all listed Indian companies (excluding BFSI) have become compliant with Ind-AS (substantially converged Global IFRS). We discussed how Ind-AS is conceptually different from the erstwhile IGAAP extensively in our 20th October 2015 thematic: “Are you ready for Ind-AS? (click here)

Ind-AS is adopted with the intention to achieve more transparency through increased quality disclosures. In the subsequent section, we have provided a brief description of these accounting ratios along with illustrative case studies. We have also detailed how we tried to minimise the impact of Ind-AS adoption in our model.

We use 11 quantifiable ratios across four categories of accounting checks

Strategy


Signs of a potential deceit; learnings of last decade We, at Ambit, have believed in continuously developing our accounting framework to make it robust in assessing accounting quality. Interestingly, if we look at 16 cases which gained significant attention in the last decade owing to alleged accounting irregularities, almost all of them got penalised on our accounting framework at least once in previous 8 years. In the context of Indian companies, the simple connotation of accounting fraud is either siphoning of money or creating a rosy picture of business which is largely understood to be done through irrational capex spends, high related-party payments or working capital adjustments (three common parameters). Using a sectoral heatmap analysis, we explain through these 16 cases how these companies scored lowest on ratios relating to these three common parameters. Lastly, we observe, even a rise in percentage of pledged shares has some bearing on accounting fraud risk, with 50% of these 16 companies showing increase in percentage of shares pledged.

Evolution of Ambit’s forensic framework

Analysis of more than 10 years of financial statements of Indian listed companies is already with us. But we always believed in sharpening the existing framework plus making it easy for investors to do a quick first level check on accounting quality of their portfolio companies. Importance of accounting quality was never before been understood so well. India Inc. has made significant strides in recent past to come at par with other developed nations on accounting practices. The government/regulators have been taking serious steps over the past decade. The steps taken to enhance the quality of accounting practices in India can be broadly divided into 5 phases over last decade: 1) Post Satyam, 2) Adoption of Companies Act, 2013, 3) Adoption of Ind-AS (global IFRS), 4) Establishment of National Financial Reporting Authority (NFRA), and 5) Other actions (e.g. SEBI’s ban on Satyam auditors). Alongside, we also evolved on our ‘greatness’ framework to identify companies with sound capital allocation practices.

Exhibit 17: Continuously developing our checks on accounting issues around Indian companies


Strategy


Accounting risk was present in almost all blow-ups We look at accounting deciles of 16 companies across sectors which gained significant attention in last decade over alleged accounting irregularities. We consider the accounting deciles from FY12 as we started classifying the companies into deciles from that year. But, please note, even for FY12, we are looking at financial statements of previous six years to FY12 (till FY07) to determine the accounting decile. Accordingly, we cover a fairly long period. One could argue that some blow-ups from these 16 cases happened in early years of last decade (say FY10) and hence the accounting scores in later years just highlight the continuing state of already poor quality accounts. Hence, to reduce this ambiguity, we go till FY07. We believe featuring even once in Zone of Darkness in any of these eight years should have warranted attention. Needless to say the stock returns of these companies were either negative or significantly low than even risk free rates in India.

Exhibit 18: 14 out of 16 companies with alleged accounting irregularities featured in Zone of Darkness at least once; share price performance of these companies was negative or below the risk free rate of return in India

S.no Company name

Accounting Deciles over years* FY12-FY19

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 Revenue

CAGR

EBITDA growth

CAGR

Share price performance#

1 Conglomerate #1 D10 D10 D10 D10 D10 D8 D8 D6 -4% -20% -43%

2 Realty#1 D10 D10 D10 D10 D10 D10 D10 D10 -7% -37% -32%

3 Healthcare Services#1 D10 D9 D6 D8 D6 D3 D4 D9 6% -8% 2%

4 Heavy Engineering#1 D9 D9 D9 D4 D9 D9 D10 D8 -19% -42% -28%

5 E&C and Infra#1 D10 D10 D10 D10 D9 D9 D10 N/A -8% -189% -39%

6 Media#1 D2 D2 D1 D4 D3 D8 D6 D9 15% 18% 4%

7 Heavy Engineering#2 N/A N/A D8 D9 D10 D10 D7 D6 -5% -13% -17%

8 Heavy Engineering#3 N/A N/A D8 D7 D9 D9 D10 D9 13% 3% -37%

9 Logistics#1 D10 D10 D9 D10 D10 D10 D10 D8 -17% -22% -25%

10 Auto Anc#1 D9 D9 D7 D7 D7 D9 D8 N/A -6% -24% -41%

11 Consumer Discretionary#1 N/A D8 D7 D8 D9 D8 D6 N/A 23% 48% -39%

12 Retail#1 N/A D2 D4 D5 D4 D5 D5 D3 16% 1% -15%

13 Aviation#1 D6 D6 D5 D4 D4 D4 D6 D6 6% 14% -34%

14 FMCG#1 N/A N/A N/A D7 D8 D9 D9 N/A 33% -230% -44%

15 IT#1 N/A N/A D10 D10 D10 D10 D10 D10 69% 66% 7%

16 Consumer Discretionary#2 D9 D9 D10 D10 D9 D8 D8 N/A -11% -6% -43%

Source: Ambit Capital research, Company. *Deciles are shown from the financial year they are available or FY12 whichever is earlier. This largely depends on availability of financial information for previous six years. Revenue and EBITDA CAGR are calculated from FY12 to FY19 except for consumer discretionary#1, Aviation#1 and consumer discretionary#2 where it is calculated till FY18. Share price performance is calculated from 31 Dec-12 to 31 Dec-19, except for Heavy Engineering#3, Consumer discretionary#1 and FMCG#1 where it calculated from 08 Apr-15, 12 Apr-13 and 08 July-15 respectively to 31 Dec-19. Share price performance of Auto anc#1 is calculated from 31 Dec’12 to 13 Aug-19

Watch out for capital intensity, related-party transactions and working capital adjustments

In a very common parlance, accounting fraud is understood as siphoning of money out of business by trusted senior personnel of corporations. Most understood ways of doing that are: 1) unlawful loans, advances or payments to related parties and 2) unwarranted capital expenditures. Secondly, investors have always been wary of aggressive revenue recognition techniques. Volatility in working capital days (e.g. bloating of debtor days) is one of the outcomes of aggressive revenue recognition techniques.

Using sectoral heatmap analysis, we try to find peculiar characteristics of accounting gimmicks that surfaced in these 16 Indian companies. Interestingly, we observe from heatmap for previous three years (FY17, FY18 and FY19) that almost all of these 16 companies scored lowest on at least one of the accounting ratios that highlight high capital intensity, high related party payments or working capital adjustments

14 out of these 16 companies either continued to remain in Zone of Darkness (i.e. D8-D10) throughout these eight years (FY12-FY19) or they showcased significant volatility in their accounting scores thereby shifting sharply between the three quality zones.

Strategy


Exhibit 19: 3 key variables coupled with continuous increase in percentage of shares pledged can indicate amiss

Source: Ambit Capital research, Company

High capital intensity was prominent versus peers

A simple sectoral level heatmap shows several companies out of these 16 companies got penalised on low CFO+CFI/median revenue ratio or high CWIP to gross block ratio as compared to their peers. A low CFO+CFI/median indicate inability of a company to generate sufficient cash after investing activities. A high CWIP to gross block ratio could indicate unsubstantiated, delayed or unauthorized capex.

High related-party payments and outstanding balances over longer period

Simple check through our ratio ‘Related-party advances as a proportion of cumulative CFO’ reveals several companies carried significant amount of related-party advances year on year as compared to peers. The purpose and recoverability of these advances always seemed to be an issue.

Working capital adjustments were very noticeable

Volatility in working capital days is a common outcome of aggressive revenue recognition practices adopted by companies. Our framework captures red flags around revenue recognition techniques using these ratios: 1) low or volatile CFO/EBITDA ratio, 2) low provisioning of debtors outstanding for a period of more than 180 days, and 3) cash yield. For rationales explained in exhibit 14, all three ratios have direct links in identifying aggressive revenue recognition practices.

NOTE: How to read a heatmap shown below. For BSE-500 companies, the ranking is done at sector level. For instance, say healthcare sector has 25 companies. Rank 1 on ratio ‘cumulative CFO/cumulative EBITDA’ for a particular company denotes lowest score on the said ratio while rank 25 denotes the highest score. Hence, the lower the rank, the poorer it is. For sub-BSE 500 companies, ranking is done at the entire sub-BSE 500 level. There are 900-1000 companies in sub-BSE 500 segment for all three years FY17/FY18/FY19.

Working capital adjustments

Accounting fraud

Capital intensity

Related party advances

Continuous increase in % of

shares pledged

Ask us for sectoral level heatmap for your portfolio companies

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Strategy


Rise in percentage of shares pledged? Time to run a quick first-level check on accounting quality

Increase in percentage of shares pledged cannot be considered a blanket negative; however in case of 16 companies under our analysis, we observe that for ~50% of cases the percentage of shares pledged significantly increased between FY10 and FY19. Also, they remained at significantly higher level. Rise in percentage of shares pledged along with Red Flags on accounting can be a reason to worry for investors. We believe investors should run a quick first-level check on accounting quality using HAWK wherever there is constant increase in percentage of share pledged.

Exhibit 21: In 50% of cases, there was significant rise in % of shares pledged between FY10 and Sep-19

Company name % of shares pledged

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 Sep-19

Heavy Engineering#2 6 4 5 62 57 66 84 100 100 100 -

Logistics#1 13 29 59 20 67 84 100 100 100 100 100

Media#1 30 25 35 35 42 38 42 39 53 66 96

Aviation#1 - - - - - - - - - - DNA

Heavy Engineering#1 70 63 89 100 100 99 96 99 99 76 76

Conglomerate #1 0 0 0 0 1 1 20 20 20 20 20

Auto Anc#1 - - - - - - 5 5 - - -

Healthcare Services#1 68 45 71 64 70 75 78 86 17 0 -

Realty#1 37 66 64 81 81 85 78 70 72 62 69

Consumer Discretionary#2 - - - - - - - 12 37 75 75

IT#1 - - 89 54 54 - - 9 11 14 14

Retail#1 - - - - - - - - - - -

Consumer Discretionary#1 - - - - - - - 3 11 - -

Heavy Engineering#3 - - - - - - - - - - -

FMCG#1 - - - - - - - - - - 100

E&C and Infra#1 - - - - 50 - - - - - -

Source: Ambit Capital research, Company. Before Sep-19, percentage of pledged shares is noted at Mar-31 of each financial year presented in the table

Lessons from Satyam debacle are still not taken seriously by investors

We present one case study from FMCG where we compare two companies within these sector; a company with a good accounting quality versus a company with weaker accounting quality. In both the cases, we observe that stock market was not concerned about relatively poor accounting quality as long as the company was posting good headline and operating financials parameters. However, to a discerning investor, the signs of weak business model were visible through detailed accounting checks or even through some basic analysis. Until some event led to cash flow concerns and auditor resignations, the stock of the weaker accounting quality company held up and then suddenly plummeted. The two case studies also highlight prominence of high capital intensity in the financial statements of companies with alleged accounting irregularities.

Case Study: A tale of two FMCG companies

In this case study FMCG#1 is a relatively smaller but fast growing company, while FMCG#2 is fairly large and well established company. Over FY14-FY18, FMCG#1’s revenue grew at 34%CAGR (17X the pace of FMCG#2) with lower but stable EBITDA margin. Lead by strong improvement in headline financials, FMCG#1 always traded at premium to FMCG#2. What investors missed but could have been picked by discerning ones was drastically reducing fixed asset turnover (from 2.8X in FY14 to 1.3X in FY18), on other hand making continuously negative free cash flow (cumulative `10bn over FY14-19). All throughout the high growth phase, FMCG#1 fared very poorly on FCF and fixed asset turnover. Amid, FCF concerns becoming more evident followed by auditor resignation citing ‘lack of information’, valuation of FMCG#1 significantly plummeted post Mar-18.

Strategy


Exhibit 22: FMCG#1 was growing ahead of FMCG#2 and also posting lower but stable margins, before suddenly deteriorating in FY19


Exhibit 23: In spite of lower and decreasing gross block turnover of FMCG#1 vs FMCG#2…..

Net sales/gross block

FY14 FY15 FY16 FY17 FY18 FY19

FMCG#1 2.8 2.8 2.3 1.5 1.3 0.7

FMCG#2 3.1 3.2 3.0 2.5 2.4 2.5


Exhibit 24: …..FMCG#1’s free cash flow has been negative

Cum CFO plus CFI

Median revenues

Cum. CFO plus CFI to median

revenues

` mn FY14-19 FY14-19 FY14-FY19

FMCG#1 (10,547) 5,785 (1.8)

FMCG#2 50,082 76,677 0.6


Exhibit 25: FMCG#1 traded at premium to FMCG#2 until investors finally realized the issues in Mar’18. It sharply corrected post auditor resignations citing lack of information as reason for resignation


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FMCG#1 revenue growth FMCG#2 revenue growthFMCG#1 EBITDA margin (RHS) FMCG#2 EBITDA margin (RHS)

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Strategy


A few case studies from our model We discuss 11 case studies on how various leading listed Indian companies get penalised on our framework discussed above. These case studies are for illustrative purposes only. The objective is to demonstrate the working of our framework and not to imply any ill-intent on the part of any company in question.

I - P&L mis-statement checks

Companies can easily manage accounting profits or EBITDA while it is more difficult to manipulate actual cash flows. Companies can manipulate the accounting profit (or EBITDA) by resorting to 1) Aggressive revenue recognition policies; 2) Deferring booking of certain expenditures; or 3) Capitalising revenue expenditure etc. In other words, accounting profit or EBITDA could be subject to various accounting gimmicks. Hence it is imperative for investors to evaluate true cash generating abilities of a company. Thus we seek to penalise such firms in our model using the following ratios:

1 Cumulative CFO to cumulative EBITDA

This ratio is a check a company’s ability to convert EBITDA into operating cash flows.

A company’s accounting profits should ideally translate into cash flows. A low ratio (i.e. CFO/EBITDA that is significantly less than one) should raise concerns about the practices followed by company; these could include: 1) Adopting aggressive revenue recognition techniques like channel stuffing, booking revenue in advance (i.e. even before goods are actually delivered to customers) and 2) high credit period to customers in anticipation of booking higher revenues etc.

To arrive at the scores for the universe on this measure, we first cumulate CFO and EBITDA over the last six years. We then sort companies on this ratio and penalise firms where this ratio is abysmally low.

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we use FY14-15 cash flow from operations, EBITDA as per IGAAP and FY16-19 cash flow from operations and EBITDA as per Ind-AS. For companies which adopted Ind-AS in FY18, we use FY14-16 cash flow from operations, EBITDA as per IGAAP and FY17-19 cash flow from operations and EBITDA as per Ind-AS.

Case study: ZEE Entertainment (ZEEL IN, US$ 3.6bn, Not Rated)

Whilst Zee’s EBITDA increased, there was reduction in cash flow led by build-up of inventory, advances, receivables and deposits, the pre-tax CFO to EBITDA ratio declined sharply. ZEEL began showing issues with CFO/EBITDA ratio since FY17.

Exhibit 26: Sharp reduction of pre-tax CFO to EBITDA


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FY13 FY14 FY15 FY16 FY17 FY18 FY19

Pre-tax CFO EBITDA Pre tax CFO/EBITDA(RHS)` mn

We discuss 11 case studies on how leading Indian listed companies get penalised on our framework

Strategy


Given the large chunk of loans/advances/deposits given, we take that data into receivables for all periods presented for ZEEL. This data is not taken for other companies. ZEEL’s receivable days have continued to increase and are back to FY14 levels. Whilst peers like Sun TV have been able to reduce receivable days in the last year, ZEEL’s have remained flat

Exhibit 27: Receivable days have increased sharply

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19

Zee 240 227 204 230 197 215 170 203

Sun TV 93 104 100 106 113 107 117 109

TV18 104 104 88 81 161 98 180 90

Star 102 90 96 92 99 95 90 NA

Sony 181 138 186 64 56 61 68 NA

Peer Median 104 104 100 92 113 98 117 109

Source: Ambit Capital research, Company.

Interestingly, receivables from related parties (Dish and Siti) also increased significantly. There has been a sharp spike in receivables from Dish in FY19 (68% of the subscription revenue recognized in FY19 is receivable). Receivables from Siti are 167% of the subscription income recognized in FY19. This implies that revenue recognized from Siti in FY18 is also still not realized in cash. We believe that this would be a key metric to be tracked.

Exhibit 28: Receivables from Dish have shot up


Exhibit 29: The same for Siti are beyond FY19 revenues


Given continuing investments in content, inventory has risen nearly three-fold from FY16 to FY19. This has led to a sharp jump in inventory days; now it is nearly half a year of sales. Any stress in the inventory book or less than expected realization from the marquee properties lying in the inventory could be a material event for ZEEL. We believe inventory days would be a key metric going forward.

Exhibit 30: Inventory days have increased by over 2X from FY16 for ZEEL

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19

Zee 80 86 97 89 83 96 143 177

SunTV 325 331 293 229 219 230 211 166

TV18 100 179 168 139 415 NM NM NM

Star 194 142 112 62 77 131 140 NA

Sony NA NA NA 238 282 203 146 NA

Peer Median 147 160 140 139 219 167 145 247

Source: Ambit Capital research, Company, Ace-Equity

0%

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FY16 FY17 FY18 FY19

Dish SI* Dish TR* TR as a % of SI(RHS)

` mn

0%

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1,000

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FY16 FY17 FY18 FY19

Siti SI* Siti TR* TR as a % of SI(RHS)` mn

Strategy


Exhibit 31: ….and inventory as a % of pre-tax CFO continues to rise


Above challenges gets effectively captured on our framework and hence ZEEL gets penalised on our framework.

2 Volatility in depreciation rate

Companies Act 2013 prescribes rate of depreciation for different categories of assets but companies can differ from these prescribed rates on the basis of their own technical evaluations about the life of the asset. This leaves room for the companies to manipulate the amount of depreciation charge every year. So we believe undue volatility in the depreciation rate warrants further investigation.

We first calculate the depreciation rate for each of the past seven years (FY13-FY19). We then calculate the change in depreciation rate for each year (giving a set of six observations). We then calculate the median of absolute changes and then sort the companies on this ratio so that the company with the smallest change in depreciation rate receives the best score. The rationale is to penalise companies that have high volatility in their depreciation rate on a YoY basis.

Note: Depreciation accounting has undergone significant changes in FY15 owing to the requirements of the Companies Act, 2013 that became applicable with effect from 01 April 2014. This resulted in inherent volatility in the depreciation rate in FY15 across the universe.

However, for the purpose of our analysis, we use a six-year median of volatility in depreciation rate. So this change in depreciation accounting does not materially impact the accounting scores of companies covered in our forensic universe.

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we have calculated the depreciation rates for FY14-15 as per IGAAP. For FY16-19, we calculate the depreciation rate as per Ind-AS. Here we use depreciation expense as per FY16-FY19 accounts; for gross block we use FY16 gross block as per IGAAP and then make adjustments for changes in gross block in FY17- FY19. We then take a median of volatility in depreciation rate, using FY14-15 depreciation rate as per IGAAP and FY16-19 depreciation rate as per Ind-AS.

For companies which adopted Ind-AS in FY18, we calculate volatility in depreciation rate over FY14-16 as per IGAAP but for FY18-19 we calculate the depreciation rate as per Ind-AS (wherein we use the depreciation expense as per FY17-FY19 accounts; for gross block we use FY17 gross block as per IGAAP and then make suitable adjustments for changes in gross block in FY18 and FY19)

Case study: Vakrangee Ltd. (VAKRANGEE IN, US$ 0.8bn, Not Rated)

Vakrangee’s depreciation rate has historically been volatile vis-à-vis peers (see exhibit below):

0%

50%

100%

150%

200%

250%

300%

350%

400%

-

10,000

20,000

30,000

40,000

50,000


Pre-Tax CFO Inventory Inventory/Pre tax CFO(RHS)` mn

Our model penalises high volatility in depreciation rate

Strategy


Exhibit 32: Vakrangee has volatile depreciation rate as compared to its closest possible peers

Company/metric Depreciation rate

YoY change in depreciation rate (in bps)

FY14 FY15 FY16 FY17 FY18 FY19 FY15 FY16 FY17 FY18 FY19

Vakrangee Ltd 20.1% 16.2% 15.6% 13.1% 4.5% 5.6% 391 55 250 859 104

Firstsource Solutions 10.2% 9.2% 7.2% 6.1% 6.7% 8.2% 102 202 103 61 147

Hinduja Global Solutions 10.0% 10.6% 12.1% 11.2% 10.4% 12.9% 55 155 92 75 248

Source: Company, Ambit Capital research

One plausible reason for such volatility in depreciation rate could be the continuous changes to its gross block.

Exhibit 33: Vakrangee’s gross block breakup; company made significant sale of assets in FY19 largely of computer hardware

Gross block Composition


Land Improvement 0.0% 0.0% 0.0% 0.0% 0.0% 8.4% 7.1%

Buildings / Premises 1.2% 1.0% 1.0% 1.0% 24.5% 15.7% 10.7%

Plant& Machinery 0.9% 0.8% 1.0% 1.3% 29.4% 22.9% 44.1%

Furniture & Fixtures & Office Appliances

8.7% 7.0% 6.7% 6.6% 9.5% 8.7% 6.2%

Vehicles 0.1% 0.1% 0.1% 0.1% 2.5% 1.2% 0.8%

Leasehold Land 0.0% 0.0% 0.0% 0.0% 0.0% 25.0% 17.0%

Computer Hardware 89.1% 91.2% 91.3% 91.1% 34.1% 18.2% 14.2%

Other Fixed Assets 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: Company filings, Ambit Capital research

Sharp fluctuation in depreciation rate in FY18 compelled us to do a further analysis of block of assets. We observed Vakrangee made a significant sale of assets in FY17 of which a significant portion of gross block sold (~98%) consisted of computers. Accordingly, it was obvious for depreciation rate to come down, as the depreciation rate for computers is quite high as compared to other assets.

However, we need more information on how company managed to increase the revenues without any replacement (new additions) of computers. One possible reason could be change in the nature of business activities. In FY18, company’s e-governance project contributed mere 8%, while revenue from Vakrangee Kendra contributed 92% as against 36% and 64% in FY17 respectively. Nonetheless, reduction in computers gross block was as high as ~98% and hence more information is required on the same. Also, there was no corresponding increase in any item of other expenses like computer lease etc. which could have meant company started using computers through rent.

Exhibit 34: Company made significant sale of computers in FY17 without any major replacement in coming years…..

Gross block (` mn) FY15 FY16 FY17 FY18 FY19

Land Improvement - - - 105 132

Buildings / Premises 104 103 142 197 200

Plant& Machinery 100 134 170 288 828

Furniture & Fixtures & Office Appliances 696 697 55 110 116

Vehicles 5 6 15 15 15

Leasehold Land - - - 315 319

Computer Hardware 9,489 9,666 197 229 266

Other Fixed Assets - - - - 0.55

Total 10,394 10,605 580 1,260 1,878


Strategy


Exhibit 35: …however revenues only increased in FY17 and FY18; composition of revenue shifted more towards Vakrangee Kendras


Whilst Vakrangee fares well on our other accounting ratios, it gets penalised on volatility in depreciation metric. 3 Provision for doubtful debt as a proportion of debtors more than six

months

This ratio is a check on conservativeness of a company’s provisioning policy. Debtors more than six months have a greater probability of defaulting and, hence, best practices would require higher provisioning for such debtors.

A low ratio, on the other hand, raises the spectre of earnings being boosted through aggressive provisioning practices. We use a six-year median for this measure and penalise firms where this ratio is abysmally low.

Note: We agree that in case of several companies, given the nature of their business operations, debtors more than six months are not material (vis-à-vis the size of the business). Thus, in such cases, we assign an average score to the firm on this parameter to avoid unduly penalising firms where debtors more than six months are a small fraction of the consolidated revenue (our threshold for this is 0.2% of consolidated revenue).

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, in some cases we have calculated the scores on this parameter by using provisioning for old debtors over FY11-16 (as per IGAAP) given data pertaining to debtors outstanding for more than six months is not available under Ind-AS accounts. For companies which adopted Ind-AS in FY18, we have calculated the scores by using provisioning for old debtors over FY12-17 as per IGAAP.

Case study: VA-Tech Wabag (WABAG IN, US$ 0.2bn, Not Rated)

Receivable days for VA-Tech have been continuously increasing, particularly if we include all the receivable balances (trade receivables, retention money and due from customers). Due from customers are essentially ‘unbilled revenues’.

However, in spite of the higher share of debtors more than six months, provisioning for old debtors (i.e. provisioning for debtors as a percentage of debtors more than six months) is still far from 100% (see exhibit below). There is no separate provision on due from customers.

Exhibit 36: Provisioning for old debtors – VA-Tech’s provision for doubtful debt have picked up significantly each year, but still far from 100%

Company/metric

PFD as a % of Debtors more than Debtors more than six months

six months as a % of Gross Debtors

FY15 FY16 FY17 FY18 FY19 FY15 FY16 FY17 FY18 FY19

VA Tech Wabag 12% 39% 26% 40% 60% 22% 14% 15% 22% 19%

Source: Company filings, Ambit Capital research.

57%46%

36%

8%

43%54%

64%

92% 100%

28 32

40

64

15

-

10

20

30

40

50

60

70

0%

20%

40%

60%

80%

100%

FY15 FY16 FY17 FY18 FY19

e-governance projects Vakrangee kendra Revenues(Rs. bn)

Low provisioning raises the spectre of earnings being boosted through aggressive provisioning practices

Strategy


Provision for doubtful debts as % of debtors more than 6 months have grown almost 3X since FY17, sharp change in provisions at every balance sheet data indicates company has been aggressive in making provisions in earlier years only to realise later that higher provisions were required.

On considering all the receivables balances together, we observe the situation is more serious. We observe the data for receivables for FY17-19 from the FY19 annual report. Total receivable days at FY19 stand at 381 days.

Exhibit 37: Total receivable days have crossed 350-day mark and have been increasing since FY17

Source: Ambit Capital research, Company. Total receivable days include trade receivables, unbilled revenue and customer retention money. Receivable days are calculated on closing balances

So VA-tech Wabag gets penalised on this metric on our framework. II - Balance sheet mis-statement checks

Direct write-offs from equity without routing it through the P&L account, high levels of off-balance-sheet risks, low investment income (as a percentage of cash and marketable investments) etc. are some of the key areas that need to be scrutinised to assess the sanctity of a company’s balance sheet.

In that context, these are the ratios that we use to penalise such firms:

4 Cash yield

Cash yield denotes the yield that is being earned on cash and marketable investments.

A low cash yield may either imply balance sheet mis-statement or cash not being used for the firm’s best interests

With the risk free rate in India being 6-7%, one would expect idle cash and marketable investments to generate at least 5-6% returns. A low cash yield could thus be a cause for concern as it could mean that either the balance sheet has been mis-stated or cash is not being used in the best interests of the firm.

We calculate the cash yield for each of the last six years. We then sort the firms on this ratio using the last six-year median such that companies with relatively high cash yields get a high score while companies with lower cash yields get penalised the most.

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we have used FY14-15 investment income and cash and marketable investments (to compute the cash yield) as per IGAAP, while FY16-19 investment income and cash and marketable investments are as per Ind-AS. For companies which adopted Ind-AS in FY18, we have used FY14-16 investment income and cash and marketable investments as per IGAAP and FY17-19 investment income and cash and marketable investments as per Ind-AS.

12 12 13

4 5 5

10 12 12

286 303 381

-

50

100

150

200

250

300

350

400

-

10

20

30

FY17 FY18 FY19

Trade receivables (Rs.bn) Customer retention(Rs.bn)unbilled revenue(Rs.bn) Receivable days

Strategy


Case study: Eveready Industries (EVEREADY IN, US$ 0.05bn, Not Rated)

Eveready Industries caught attention in Jun’19 as its auditor resigned citing no proper reasons.

Low cash yield numbers basis our working draw our attention to make further analysis. Interest is earned on two assets: 1) bank balances in the form of deposits and 2) loans and advances made to others.

Exhibit 38: Eveready’s cash yield has been very volatile over the years

Company/metric Investment income yield

FY15 FY16 FY17 FY18 FY19 Average Interest income/average cash and bank balances

6% 3% 2% 3% 2% 3%

Interest income / average loans given balances 72% 31% 35% 26% 18% 36%

Source: Company, Ambit Capital Research. We have considered average cash & bank, loans given balances.

Lower interest income on cash and bank balances is primarily on account of higher balance (~90%) lying in current accounts at every balance sheet date.

However, interest earned on loans given balances looks very high. Simple calculation of interest income to closing or closing average loans and advances balances gives a very high ratio of interest earned. We observe that significant amount of loans is also given and recovered during the year and hence simple interest income to closing loans balances will not give right answer to interest rate earned.

Exhibit 39: Interest income on cash and bank balance is low as a significant portion of cash is held in current accounts


Cash in current account (%) 91% 89% 86% 87% 91%

Other bank balances (%) 9% 11% 14% 13% 9%

Total cash and bank balance(Rs.mn) 71 72 56 56 72

Interest income 2 2 1 2 1

Source: Ambit Capital research, company

While interest is charged on loans given, interest received as a percentage of interest income booked has been decreasing.

Exhibit 40: Several transactions of financial nature are taken during the year


Interest earned from others (` mn)

19 64 84 126 286

Closing loans given balances 27 381 90 893 2,308

Loans given to others (` mn) (430) (500) (650) (1,580) (4,625)

Loans realised from others (` Mn)

430 150 1,000 820 3,407

Source: Ambit Capital research, Company. Cash flow statement

Exhibit 41: Interest income received as % of interest income booked has been decreasing


We urge investors to ask for more information on the purpose of such transactions of financial nature.

19

6484

126

286120%

92%

32%

69%

30%

0%

20%

40%

60%

80%

100%

120%

140%

0

50

100

150

200

250

300

350


Interest earned on loansInterest received as % of interest earned

Strategy


5 Change in reserves (excluding share premium) to net income excluding dividends: Under IGAAP and in some specific situations under the current regime of Ind-AS (substantially converged global IFRS), certain provisions are allowed directly through write-offs to equity without reflecting these adjustments in the P&L. Further, through various court approvals, several companies have taken direct write-offs from reserves without routing it through the P&L.

In order to penalise firms that have historically taken direct knock-offs from equity, we calculate the change in reserves (excluding share premium) on a YoY basis and divide it by that year’s PAT excluding dividends. We then take a six-year median of this ratio. A ratio of less than one indicates direct write-offs to equity without routing these through the profit & loss (P&L) account and may indicate aggressive accounting policies.

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, the data related to reserves and net income from FY16 to FY19 is basis the Ind-AS financials. For companies which adopted Ind-AS in FY18, the data related to reserves and net income from FY17 to FY19 is basis the Ind-AS financials.

Case study: India Cements (ICEM IN, US$ 0.3bn, Not Rated)

We plot two instances in the consolidated financial statements of India Cements for FY15 and FY17 wherein the company took a direct hit to the reserves without routing it through the profit and loss statement.

After the Companies Act, 2013 became applicable, several companies were required to adjust the depreciation rates (basis the new schedule of depreciation rates) from the beginning of the life of asset and pass the impact from such change through the reserves as at 01 April 2015. India Cements charged the reserves and surplus balance on 01 Apr 2015 by `2.3bn with additional depreciation charge which meant India Cements has technically reduced the life of assets or increased the depreciation rates. While there is no issue with the said adjustment, we believe more information is required on why the depreciation rates were increased in FY15 only as increase in depreciation rate was even allowed under previous law (Companies Act, 1956)

Secondly, on adoption of Ind-AS in FY17, India Cements booked provisions/losses to the tune of `5.2bn (including deferred tax of `1.1bn) directly through reserves. The buffer created from fair valuation gain of ` 28.6bn from revaluation of certain fixed assets was used to absorb this provision. We believe, more information will be required on why these provisions were not made in IGAAP regime basis the principle of conservatism and prudence.

Exhibit 42: Several provisions and losses were booked on adoption of Ind-AS; fair valuation gain on certain fixed assets acted as buffer to absorb these losses (numbers are in lacs)

Source: Company, Ambit Capital research

A ratio of less than one on change in reserves, ex-share premium to net income, ex-dividends, may denote direct write-offs through the balance sheet

Strategy


6 Contingent liabilities as a proportion of net worth A significant contingent liability (‘off balance sheet risk’) is a potential liability which could lead to a significant cash outflow. A high ratio raises concerns regarding the strength of the company’s balance sheet in the event that these contingent liabilities materialise. Also, significant amount of contingent liabilities over years could highlight that the company is being very aggressive, thereby avoiding making provisions for these liabilities with intent to show higher profits.

Given that contingent liabilities also include genuine items such as letters of credit, bill discounting and capital commitments, we seek to eliminate as many of these items whilst computing the figure for contingent liabilities. We use a six-year median for this measure and penalise firms with a very high proportion of contingent liabilities.

Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we have used FY14-15 contingent liabilities and net worth as per IGAAP while FY16-19 contingent liabilities and net worth are as per Ind-AS. For companies which adopted Ind-AS in FY18, we use FY14-16 contingent liabilities and net worth as per IGAAP while FY17-19 contingent liabilities and net worth as per Ind-AS.

Case study: Gayatri Projects (GAYAPROJ IN, US$ 0.2bn, Not Rated) Gayatri’s contingent liabilities to net-worth ratio stood as high as 412% at FY19 year-end. Six-year median (FY14-FY19) for the same ratio is 828%. Contingent liabilities drastically reduced to `43bn in FY16 from `93bn in FY15 and then rose to `48bn in FY19. The sharp reduction in contingent liabilities followed by the rise again was largely led by corporate guarantees given by the company to banks/financial institution for loans availed by them.

Exhibit 43: Break-up of contingent liabilities; corporate guarantees given for loans availed by group companies is on rise

As per annual report (Rs.bn) FY15 FY16 FY17 FY18 FY19

Claims against the company * * - - -

Guarantees given by the banks towards performance and contractual commitments

8 12 13 13 15

Corporate guarantees given to group companies 84 30 31 36 33

Disputed liability of income tax, sales tax, service tax etc

1 1 1 1 0

Total contingent liabilities 93 43 45 49 48

Net-worth 7 5 5 10 12

Contingent liabilities/net-worth 1272% 783% 872% 487% 412%


A very high proportion of contingent liabilities to net worth indicate disproportionately high off-balance sheet risk

Gayatri’s contingent liabilities stand at ~412% of FY19 net worth…

Strategy


We delve into corporate guarantees given to group companies. We believe, since the group company wise (name of entities) break-up for corporate guarantees given by the company is not disclosed in the related-party disclosure, it is difficult to select any group company for determining its financial solvency position through other details available in the financial statements. But the ‘Emphasis of matter’ paragraph in the auditor’s report highlights some liquidity issue with one of the associate company.

Exhibit 44: ‘Emphasis of matter’ para in FY19 audit report highlights subsidiary of an associate to which corporate guarantee is given has defaulted in loan repayment

Source: Company filings, Ambit Capital research. Audit report on consolidated financial statements

Note no.31.17 of the consolidated financial statement suggests the company has given an irrevocable and unconditional guarantee of `18bn to the lenders of above subsidiary of an associate, yet the management believes no provision is required to be made in respect of the same.

Exhibit 45: Note no 31.17 of financial statement highlights not all is well at subsidiary…


Exhibit 46: …(note no 31.17 continued) but management continues to believe all is well


We believe investors should remain skeptical of rising contingent liabilities of Gayatri Projects and ask for more information wherever required

Strategy


III - Cash pilferage checks Cash pilferage is the third category of checks that we analyse. High miscellaneous expenditure (for which no further disclosures are available), unsubstantiated capex, negative free cash flows over long periods of time, and advances given to related parties are some of the key categories of checks that should raise eyebrows and, hence, need to be scrutinised.

We use the following ratios: 7 Miscellaneous expenses as a proportion of total revenue

This ratio is a check on a company’s expenditure policy. Miscellaneous expenses, by their very nature, do not require any further disclosure. A high ratio thus raises concerns regarding the authenticity of such expenses. Thus, in order to penalise firms with high miscellaneous expenses, we calculate miscellaneous expenses as a proportion of total revenue for the last six years and then use a six-year median for this measure. Ind-AS adjustment: For companies which adopted Ind-AS in FY17, we have used FY14-15 miscellaneous expenses and total revenue as per IGAAP while FY16-19 miscellaneous expenses and total revenue are as per Ind-AS. For companies which adopted Ind-AS in FY18, we have used FY14-17 miscellaneous expenses and total revenue as per IGAAP while FY18-19 miscellaneous expenses and total revenue are as per Ind-AS. Case study: DB Realty (DBRL IN, US$ 0.04bn, Not Rated)

An analysis of DB’s miscellaneous expenses (as a percentage of net sales) suggests miscellaneous expenses have been significantly higher than those of peers (see exhibit 21 below). Miscellaneous expenses is generally a residual head of expense; i.e. when a particular expense cannot get clubbed in specific head of expense owing to its nature, it is clubbed with miscellaneous expense. In an ideal case, where the number of specific heads of expenses is more, miscellaneous expense should be low. But despite having a higher number of heads for specific nature, the miscellaneous expenses are high for DB.

Exhibit 47: DB Realty’s miscellaneous expenditure as % of revenue has always been higher than its peers…

Company/metric

Miscellaneous expenditure as % of net sales


DB Realty 1% 1% 3% 8% 1%

Prestige Estates 0% 0% 0% 0% 1%

Godrej Properties 0% 0% 0% 0% 0%


Exhibit 48: ….despite having more specific expense heads under ‘other expenses’ schedule


Note that not only has this ratio been higher than that of peers, in FY18, the miscellaneous expenditure rose to as high as 8% of revenues. Also, miscellaneous expenses as % of revenue look very volatile.

32

2225

6

DB Realty Sobha Prestige Estate GodrejProperties

Specific expense h

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