Analysis: Escorts Ltd

Modified: 11-Sep-20

The current section of the “Analysis” series covers Escorts Ltd, an Indian company involved in the manufacturing of tractors & agricultural machinery, construction equipment and railways equipment.

“Analysis” series is an attempt to share with all the readers, our inputs to the company analysis submitted by readers on the “Ask Your Queries” section of our website.

In order to benefit the maximum from this article, an investor should focus on the process of analysis instead of looking for good or bad aspects of the company. She should learn the interpretation of different types of data and transactions and pay attention to the parts of annual reports etc. used to get the information. This will help her in improving her stock analysis skills.

 

Escorts Ltd Research Report by Reader

 

Good day, Dr. Malik,

I know that you like looking for companies that are not identified, but I would like to post my analysis of Escorts Ltd. (EL), my first analysis. It will certainly contain many gaps due to my lack of knowledge, but I hope that I should be able to get better with time and more effort.

Presently, though the stock is trading at a PE ratio of 13.9, with any further fall in the price of the scrip, it is bound to become very attractive.

Going by the principles of maintaining our margin of safety, cumulative cash flow from operations (cCFO) of Rs. 2,014 cr compared to capital expenditure (capex) of Rs.1,313 cr and interest payments of Rs.625 cr results in free cash flow (FCF) of Rs.76 cr. Add to that the fact that the company is almost debt-free.

Escorts Ltd. does have a lower self-sustainable growth rate (SSGR) compared to its sales growth, but the cCFO of Rs. 2,014 is much higher than the cumulative profit after tax (cPAT) of Rs. 1,337 cr. Hence, I think that the company will be able to sustain its growth if the above metrics continue to sustain.

The present earnings yield of Escorts Ltd. stands at 10.9%, which again provides some margin of safety.

The net fixed asset turnover (NFAT) of Escorts Ltd. presently stands at 3.16, its highest ever-barring FY2014 when the company reported results for 18 months.

Its improved working capital management is also a healthy sign. Payable days stand at 90-100 days compared to receivable days 40-45 and inventory days of about 40.

Operating margins of Escorts Ltd. have continued to improve over the last 3 fiscals due to lower raw material costs and a continued focus on cost rationalisation.

Escorts Ltd. has also created a value of over Rs.5 per rupee of retained earnings.

Escorts Ltd. has also turned profitable in its construction equipment business; though, its presence in the segment continues to be limited by achieving operational level breakeven in fiscal 2018 and has shown positive margins in 6 months FY2019.

Escorts Ltd. is present in the railways segment where is supplies brake systems, couplers and shock absorbers to coaches. It is also the highest margin business for the company with margins standing at a very respectable 13.9%. In addition, the division has bagged an order of Rs.400 cr in September 2018 offering revenue visibility in the near term.

Going by the credit rating reports and following the trend as mentioned in your article, its credit ratings have been improving over the years.

The company is run by a third-generation entrepreneur, Mr. Nikhil Nanda. Hence, it is a family run business for over 7 decades. As a result, succession planning offers comfort.

Even though the scrip has a lot of institutional holding and interest, but it appears fundamentally very strong.

Though it presently seems expensive, I feel that the stock can be looked into if the PE ratio drops to a level where paying a premium as per your articles can be considered.

I still face a lot of difficulty in going through the annual report because of it being extremely sleep-inducing (pun intended). I hope that in the coming times I would be able to change that.

This was my analysis of Escorts Ltd. I hope to have your inputs regarding the same.

I would again like to commend you for the wonderful job that you are doing and hope that your flock of avid readers continues to grow.

Best regards,

Vikas Reddy

 

Dr Vijay Malik’s Response

 

Hi Vikas,

Thanks for sharing the analysis of Escorts Ltd (EL) with us! We appreciate the time & effort put in by you in the analysis.

While analyzing the past financial performance data of Escorts Ltd, an investor would notice that the company has created many subsidiaries and joint venture companies in India and abroad. As a result, Escorts Ltd provides both standalone financials as well as consolidated financials in its annual reports.

We believe that while analysing any company, the investor should always look at the company as a whole and focus on financials, which represent the business picture of the entire group. Consolidated financials of any company present such a picture. Therefore, while analysing Escorts Ltd, we have analysed its consolidated financials.

Further advised reading: Standalone vs Consolidated Financials: A Complete Guide

Let us analyse the financial and business performance of the company over the last 10 years.

Escorts FY2009 2019 Financials

 

Financial and business analysis of Escorts Ltd:

While analyzing the financials of Escorts Ltd, an investor would note that in the past, the company has been able to grow its sales at a rate of 10% year on year. Sales of the company increased from ₹2,598 cr. in FY2009 to ₹6,262 cr in FY2019. However, an investor will also notice that this growth in sales has not been a smooth journey for the company.

The sales of Escorts Ltd increased from ₹2,598 cr in FY2009 to all-time high of ₹6,502 cr in FY2014. Thereafter, the sales declined to a low of ₹3,402 cr in FY2016. Then once again, the sales started increasing and reached ₹6,262 cr in FY2019. However, the sales in FY2019 are still below the sales level of ₹6,502 cr reached in FY2014. Such a kind of fluctuating sales performance with regular periods of sales increased followed by periods of sales decline indicate to the investor that Escorts Ltd operates in a cyclical industry.

The cyclical performance of sales of Escorts Ltd is due to the high dependence of its business of tractor sales, which are in turn dependent on factors like seasonal rainfall (monsoon), farm income, available of loans/subsidies to farmers to buy tractors etc., most of which follow a cyclical pattern in their contribution. In addition, the other key business division, construction equipment also depends upon the infrastructure spending by govt. and the private sector, which is also cyclical in nature.

Various credit rating agencies in their reports for Escorts Ltd have over the years, highlighted the aspect of cyclical nature of the business of the company.

ICRA, July 2019:

Agri-machinery and construction equipment divisions remain exposed to cyclicality – The company’s leading business divisions, agri-machinery and construction equipment, remain inherently cyclical in nature. While the agri-machinery division remains exposed to fluctuations in the demand scenario with sensitivity to monsoon and farmer sentiments, the construction equipment business growth remains strongly correlated to the level of economic activity in the country

CRISIL, Nov. 2018

These strengths are partially offset by high dependence on the cyclical tractors industry with limited presence in west and south India, weak though improving performance of the construction equipment (CE) segment, and susceptibility to volatility in raw material prices.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

Escorts Ltd provides annual reports from FY2003 on its website. As a result, an investor is able to analyse the business performance of the company for the last 17 years. Analysis of long-term historical data of the company is essential to provide good insights to the investor about the trends and characteristics of the business of the company over the years.

The following table shows the number of tractors sold by Escorts Ltd in each of the financial years from FY2002 to FY2019.

Escorts Number Of Tractors Sold Every Year 2002 2019

An investor may note that the company changed its financial year from Sept to March in 2014. As a result, the company did not report its annual results in FY2013 and instead after the annual results of Sept 2012, Escorts Ltd reported 18-months results in March 2014.

In the FY2014 annual report, the company provided the number of tractors sold in 18-months ending March 2014 and compared it with the number of tractors sold in 18-months ending March 2013.

FY2014 annual report, page 27:

Tractor volumes were up 9 percent to 1,00,833 in the 18-months ended March 2014 as against 92,543 in 18-months ended March 2013.

*In the table above representing yearly sales of the number of tractors, we have used the 18-months sales ending March 2014 and March 2013 and converted them to 12-months sales by multiplying them 0.66 (i.e. 12/18). As a result, the above table contains sales of 12 months ending March 2013 as 61,695 (= 92,543*12/18) and sales for 12 months ending March 2014 as 67,222 (= 100,833*12/18).

Based on the data of the annual number of sales of tractors in each of the years from FY2002 to FY2019, the following chart represents the annual growth rate trend of the sales of tractors for Escorts Ltd.

Escorts Yearly Tractor Sales Growth Rate

While analyzing the growth rate of sales of tractors since FY2003, an investor clearly notices that the sales performance of Escorts Ltd is following a cyclical pattern. The cyclical trends indicate that the business of Escorts Ltd follows periods of fast growth, which are then followed by periods of slow growth and even negative growth (decline in the business performance, reduction in the number of tractors sold) as seen in the years 2003, 2005, 2008, 2009, 2012, 2015, and 2016.

However, after every phase of low/negative sales growth, the company has seen phases of high sales growth. As a result, an investor may visualize the alternate periods of sales increase and decrease as a normal business phenomenon for the company and its industry.

Further advised reading: How to do Business Analysis of a Company?

While looking at the operating profit margin (OPM) of the company, an investor would notice that the OPM of the company declined from 5.1% in FY2009 to 3.8% in FY2010. Subsequently, the OPM increased to 6% in FY2014 only to again decline to 1.8% in FY2015. Thereafter, the OPM has increased to 11.5% in FY2019. Therefore, an investor would appreciate that the profitability performance of Escorts Ltd has also followed a cyclical pattern of alternate periods of increase and decrease like its sales performance.

The cyclical nature of operating profit margins of the company are primarily linked to two parameters:

 

1) Inability to pass on the cost of increase of raw material in a timely manner to the customers:

Escorts Ltd operates in a tough industry characterized by intense competition. The key business divisions of the company, the tractors division as well as construction equipment division face very tough competition. As a result, the company is not able to increase prices whenever the raw material costs increase. Most of the time, the company has to absorb the increasing cost prices by taking a hit on its profit margins.

Various credit rating agencies have highlighted this aspect of Escorts’ business in their reports.

CRISIL, Nov. 2018:

Susceptibility of profitability to volatility in raw material prices: The price of the main input, steel (in the CE segment), is volatile. Profitability is also constrained by the limited ability to pass on any increase in raw material costs in full to customers in a timely manner, given the competitive nature of the industry.

It is not that the Escorts Ltd has faced intense competition in its industry only in recent years. Even in the past, the company has highlighted that it faces difficulties to pass on the increase in raw material costs to its customers.

2007 Annual report, page 6:

There has been sharp increase in input costs due to increase in the prices of base metals. The same could not be recovered fully due to the competitive market conditions, thereby, affecting margins. It is a matter of concern that this overhang of increase in input costs continued throughout the year.

In 2005 annual report, the company reported the cutthroat nature of the competition in the tractor industry.

2005 Annual report, page 7:

The growth of the industry over the last three decades resulted in entry of several new entrants including all the major tractor multinationals. Today, the industry consists of 14 manufacturers with an aggregate installed capacity of approx. 4.50 Lacs tractors. The additional capacity created and the decline in industry volumes from 2.70 Lacs tractors to 1.72 Lacs tractors from 2000-01 to 2002-03 resulted in below 50 percent utilisation of capacities leading to severe cutthroat competition.

In 2015, the company highlighted the state of intense competition from Indian as well as foreign manufacturers in the construction equipment division.

2015 annual report, page 28:

Twenty five players have manufacturing footprint in India and every construction equipment manufacturer is facing challenges in terms of imports from low-cost countries, especially from China, who are increasing their distribution centers and after-sales network in India. China, along with Korea, is expected to offer competition to Indian construction equipment exports to the developed markets.

Further advised reading: Understanding the Annual Report of a Company

An investor would appreciate that due to the intense competition from other players, Escorts Ltd is not able to pass on the increase in the cost of raw material to its customers in a timely manner. As a result, whenever raw material costs increase, then the profit margins of the company decline.

The primary raw materials used by the company in its products are steel and rubber, which are commodities and face alternate periods of price rise and fall. As a result, the profit margins of Escorts Ltd also rise and fall in alternate periods.

 

2) Operating leverage:

The key business divisions of Escorts Ltd, tractors, construction equipment as well as railways equipment are capital intensive. The company needs to invest a lot of money to create a manufacturing capacity by keeping in mind the peak demand of its products whereas the actual demand for the products faces cyclical phases.

Keeping a large manufacturing capacity in place has many fixed costs involved including the cost of creation of a large plant, maintaining a large workforce as well as maintenance and running costs of the large plant. The company needs to incur these costs every year irrespective of whether it utilizes the full capacity of the plant or only partial capacity.

In the periods when the company utilizes a high capacity of the plant, then these fixed costs are spread over a large number of tractors/products and as a result, per tractor cost reduces. This leads to high profit margin with an increase in sales revenue.

On the contrary, in the periods when the company produces only a small number of tractors, then the fixed cost is spread over only a small number of tractors and per tractor costs increases. This leads to a decline in profit margin with a decrease in revenue.

This is called operating leverage and the management of Escorts Ltd has highlighted this aspect of their business to stakeholders in the conference calls. As per the management, with a change in the production of about 10,000 tractors in a year, the profit margins change by 1% i.e. if production increases by 10,000 tractors, then the profit margins increase by 1%. On the contrary, if the production decreases by 10,000 tractors, then the profit margins decline by 1%.

July 2019 conference call, page 9:

Bharat Madan: So, margin outlook I think if you look at the Tractor business though this quarter, obviously, there will be some effect on the operating leverage which will play out depending on how much we see the drop happening in the industry volumes. So, roughly we said for every 10,000 tractors we see 1% movement happening in the margin plus or minus.

As a result, an investor would appreciate that the profit margins of Escorts are expected to follow a cyclical pattern with alternate periods of increase and decrease. However, nevertheless, an investor also notices overall the operating profit margins (OPM) of the company have witnessed a significant increase in the recent year from its historical levels. Historically, the OPM of the company used to be in the range of mid to low single digits (1%-7%). However, in recent years, the OPM of the company has increased to double digits (10-12%).

While analyzing the company, an investor notices that since last 3 years, the company embarked upon various cost reduction measures like price renegotiations with vendors, consolidation of vendors, redesigning products to use lower amount of raw materials as well as reducing the number of employees in its various business divisions etc., which seem to have shown results now.

The company highlighted the reduction in the raw material costs due to its efforts from earlier 71.7% to now 68.4%, in the May 2019 presentation to stakeholders.

May 2019 presentation, page 35:

Escorts 2019 Reduction Of Material Cost Over The Years

As per the ICRA credit rating report of July 2019, these efforts by the company have contributed significantly to improvement in profit margins in the last 3 years.

Sustainable improvement in cost structure driven by cost rationalisation initiatives across divisions – Escorts is focussed on improving its profitability and has implemented various cost rationalisation exercises over the last few years. Raw material costs have been reduced across divisions through vendor consolidation, price renegotiation, product re-designing and other value analysis/value engineering (VAVE) efforts. The company’s operating profit margins improved significantly over the three years, benefitting from economies of scale and savings on account of various cost reduction measures

Similarly, credit rating agency CRISIL in its report for Escorts Ltd in December 2019 has also highlighted that the cost reduction initiatives taken by Escorts Ltd have contributed to the improving operating margins of the company.

Healthy operating efficiency: Operating margin has consistently improved (to 11.58% in fiscal 2019 from 6.9% in fiscal 2017), driven by the cost reduction initiatives undertaken over the past three fiscals, benefits derived from operating leverage, and exit from the loss-making automotive (auto) component business. Reduction in raw material cost, due to value engineering and lowering employee cost, should help sustain the margin over the medium term.

Another credit rating agency, India Ratings, in its December 2018 report for Escorts Ltd, highlighted the role played by cost reduction initiatives of the company in improving profit margins.

Significant Improvement in EBITDA Margins: During FY18, EBITDA margins expanded to 11.2% (FY17: 7.9%; FY16: 5.3%) and improved further to 11.8% in 1HFY19 (1HFY18:10.1%), on account of numerous cost rationalisation measures undertaken by the company across various segments to reduce material consumption and labour costs, and improve supply chain efficiency.

When an investor analysis the past business performance of Escorts Ltd, then she notices that the company has frequently resorted to such cost reduction measures in its business operations after a gap of a few years.

Escorts Ltd had embarked upon cost reduction measures in 2008 as well.

2008 Annual report, page 3:

Of the many initiatives that were undertaken, the biggest contributor has certainly been the initiatives in revamping the economics of the business by focussing on cost compression. A slew of initiatives has resulted in a saving of over Rs. 100 crore by eliminating waste, working more effi ciently, right-sizing the work force, reduction of held stock and negotiating better prices from our suppliers.

Therefore, an investor would appreciate that frequently, the company takes initiatives to improve its business efficiency and reduces costs, which leads to margins improvements. However, over the years, the inefficiencies come again, which results in a reduction of profit margins. As a result, the company has to go for cost reduction initiatives again after a period.

It remains to be seen whether Escorts Ltd will be able to retain the benefits of recent cost reduction measures going ahead or it will again witness inefficiencies cropping up in its business processes, which result in a decline in profit margins. In any case, the profit margins of the company are expected to keep following the fluctuating pattern in line with the cyclical demand of its products.

Further advised reading: How to do Financial Analysis of Companies

To understand more about the impact of industry cycles on the companies, investors may read the analysis of following companies:

 

Operating Efficiency Analysis of Escorts Ltd:

a) Net fixed asset turnover (NFAT) of Escorts Ltd:

When an investor analyses the net fixed asset turnover (NFAT) of Escorts Ltd in the past years (FY2009-19), then she notices that the NFAT of the company has followed a similar fluctuating pattern like the cyclical nature of its sales revenue. The NFAT increased from 2.1 in FY2010 to 4.0 in FY2014 when the sales increased to the all-time high. Thereafter, the NFAT declined to 2.19 in FY2016 when the tractor sales hit a downturn. Since then, the NFAT has increased to 3.87 in FY2019 in line with the increase in sales revenue of the company.

While analyzing the past annual reports of the company, an investor would notice that Escorts Ltd did its last major capacity addition to manufacture tractors in FY2007 when it increased its production capacity from 72,000 tractors per annum to 98,940 tractors per annum.

FY2007 annual report, page 7:

Your company is now capable of producing 98,940 Tractors per annum on a 2 shift basis i.e. a 37% increase over the previous capacity of 72,000 Tractors per annum from the same assets.

Since FY2007, the production capacity of Escorts Ltd is nearly constant at 100,000 tractors per annum. The investor would appreciate that the company is using the same set of plants to produce goods for the last 12 years. As a result, in the periods when it sells a higher number of tractors, the NFAT increases and vice versa.

Read on: How to Assess Operating Efficiency of Companies

 

b) Inventory turnover ratio of Escorts Ltd:

While analyzing the inventory turnover ratios (ITR) of Escorts Ltd, an investor would note in FY2019 and FY2009, the ITR had been stable at about 8.7-8.8 indicating that the inventory utilization efficiency has remained largely the same over this period. There were periods in between when the business enjoyed an upcycle like in FY2014 and in FY2018 and the ITR witness significant improvement and reached levels exceeding 10. Whereas during the business down cycle, the ITR declined, like in FY2016 when the sales hit a bottom and the ITR reached 7.1.

While comparing the sales revenue trend and the amount of inventory trend, an investor would notice that during the periods when tractor sales decline due to cyclical down phase, then the company attempts to reduce the amount of inventory it holds in its factory, warehouses, and the dealer channel. Like in FY2016-2017, it brought down its inventory to about ₹450 cr from a high of ₹623 cr in FY2014 when the business enjoyed the upcycle.

These phases of reducing inventory in a down cycle and stocking on the inventory in the upcycle is a regular phenomenon for cyclical industries like tractor/automobile etc. Escorts Ltd has faced the periods of destocking/reducing inventory in the warehouses/dealer channel by reducing production & other means in the past.

The company has provided annual reports from FY2003 onwards at its website. Therefore, an investor can easily analyse the business situations faced by the company from 2003 onwards and understand the responses of the management.

The company resorted to reducing dealer inventory in 2003 when the business hit a downturn and the sales of tractors declined 45% from 38,016 tractors in FY2002 to 21,011 in FY2003.

FY2003 annual report, page 2:

Against the steep decline in the industry during the financial year 2002-03 Escorts consciously decided to aggressively reduce dealers’ pipeline inventories by approximately 8,500 tractors resulting in reduction in receivables by about Rs. 200 crores. Despite loss of some retail sales which would inevitably result from such a sharp reduction in dealer’s inventory, Escorts managed to increase its market share at the retail level in various states. However, at the wholesales level Escorts sold 21,011 tractors against last year’s 38,016 tractors.

Escorts Ltd once again took the exercise to reduce dealer/channel inventory in FY2005.

FY2005 annual report, page 7:

Despite the steep decline in the industry, Escorts consciously decided to aggressively reduce channel inventory further by approximately 1100 units in 2004-05 in addition to approximately 12,000 units inventory reduction carried out in the previous years. This no doubt impacted our revenue and profits adversely but has enabled the Company to optimize its working capital and thus put us on a strong foundation for the future to be built upon.

Further advised reading: Understanding the Annual Report of a Company

In light of the past instances of the company reducing channel inventory, when an investor comes across the instances of Escorts Ltd taking measures to reduce dealer/channel inventory in 2019 including shutting down production for some days in June 2019, then she should not be surprised. This is because, cyclical demand leading to excess inventory, which is followed by reduced demand and production cuts to reduce inventory are normal cyclical phases of automobile/tractor or any other cyclical industry.

July 2019 conference call, page 20:

Bharat Madan: I already explained at the beginning of the call. Probably you missed that portion. So, we said there are two reasons for the margin decline this time — one obviously is the volume decline in the sales side which is exactly because of the industry going down, and second was the conscious call for the company to cut down on inventory because of which we took a production cut in this quarter, and the production this time is down by 20% compared to the sales number.

 

c) Analysis of receivables days of Escorts Ltd:

An investor would notice that over the years, Escorts Ltd has kept its receivables days within the range of 40-48 days. Business upcycles have witnessed the receivables days decline, whereas the down cycle phases have witnessed the receivables days increase as the customers delay payments. However, largely, the receivables position of the company seems stable over the years.

When an investor looks at the inventory and receivables level of Escorts Ltd, then she realizes that the company has managed to keep its inventory and receivables efficiency under check. As a result, the working capital of the company has remained under control and not consumed a lot of cash.

This aspect of the business of Escorts Ltd gets established when an investor compares the cumulative net profit after tax (cPAT) of the company with the cumulative cash flow from operations (cCFO) for FY2009-19. She notices that the company has been able to convert almost all its profits (~96%) into cash flow from operations.

Over FY2009-19, Escorts Ltd has reported a total cumulative net profit after tax (cPAT) of ₹1,712 cr. whereas during the same period, it reported cumulative cash flow from operations (cCFO) of ₹1,639 cr. One of the reasons for cCFO being slightly lower than cPAT is the significant amount of other/non-operating income of ₹798 cr over the last 10 years (FY2009-19).

It is advised that investors should read the article on CFO calculation mentioned below, which would help them understand the situations in which companies tend to have the CFO lower than their PAT and the situations when the companies tend to have CFO higher than their PAT.

Further advised reading: Understanding Cash Flow from Operations (CFO)

 

Margin of Safety in the Business of Escorts Ltd:

a) Self-Sustainable Growth Rate (SSGR):

Further advised reading: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.

Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.

While analysing the SSGR of Escorts Ltd, an investor would notice that the company has consistently had a low SSGR (3% to 4%) over the years. Only in the latest year (FY2019), the SSGR has improved to 13%, which is primarily due to a recent increase in the profitability of the company.

While studying the formula for calculation of SSGR, an investor would understand that the SSGR directly depends on the NFAT and net profit margin (NPM) of a company.

SSGR = NFAT * NPM * (1-DPR) – Dep

Where,

  • SSGR = Self Sustainable Growth Rate in %
  • Dep = Depreciation rate as a % of net fixed assets
  • NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
  • NPM = Net profit margin as % of sales
  • DPR = Dividend paid as % of net profit after tax

(For systematic algebraic calculation of SSGR formula: Click Here)

An investor would notice that the NPM of Escorts Ltd has been consistently very low in the range of 2% to 4%. Therefore, the company consistently has a low SSGR over the years. In FY2019, the NPM has increased to 8% and as a result, the SSGR has increased to 13%.

An investor would appreciate that the company has been growing at a rate of 10% over the years. However, the low SSGR indicates that the company does not seem to have the inherent ability to grow at the rate of 10% from its business profits. As a result, investors would think that Escorts Ltd would have to raise money from additional sources like debt or equity to meet its investment requirements.

However, while analysing the growth history of the company, an investor notices that despite growing at 10%, the company has kept its debt levels under control. Over the last 10 years, the debt levels of the company have decreased from ₹403 cr in FY2009 to ₹281 cr in FY2019.

One of the reasons leading to the controlled debt levels of the company over the years is that the company has kept its manufacturing capacity at the same level since FY2007. The lack of significant capital expenditure to increase manufacturing capacity and the use of operating leverage (using previously unutilized capacity) has kept the funds requirement of the company under check.

 

b) Free Cash Flow Analysis of Escorts Ltd:

While looking at the cash flow performance of Escorts Ltd, an investor notices that during FY2009-19, the company had a cumulative cash flow from operations of ₹1,639 cr. However, during this period it did a capital expenditure (capex) of ₹738 cr. As a result, it had a free cash flow of ₹901 cr. (1,639-738).

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

The presence of free cash flow indicates that Escorts Ltd has been able to meet all its capital expenditure requirements from its cash flow from operations. As a result, the company could keep its debt level under check over the last 10 years.

Free cash flow (FCF) is one of the main pillars of assessing the margin of safety in the business model of any company.

Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

 

Additional aspects of Escorts Ltd:

On analysing Escorts Ltd and reading the annual reports since FY2003, an investor comes across certain other aspects of the company:

 

1) Management Succession of Escorts Ltd:

While analysing Escorts Ltd, an investor notices that the company is run by the Nanda family, which originally founded the business in 1944. Currently, the third generation of the family is running the business.

The benefit of family-run businesses where multiple generations take part in the management of the business is that the company enjoys continuity in the leadership. It also provides an opportunity where the new generation of leaders are groomed in business while the senior members are still playing an active part in the day-to-day activities.

We witnessed such an occasion of a smooth transition of leadership on the demise of Mr. Rajan Nanda. Mr. Nikhil Nanda, son of Mr. Rajan Nanda, had been playing an active role in the management of the company for the last many years. As a result, when Mr. Rajan Nanda expired in August 2018, there were no challenges with respect to the transition of leadership and Mr. Nikhil Nanda continued to lead the company.

Currently, it seems that apart from Mr. Nikhil Nanda (age 45 yrs.), Chairman & Managing Director, Ms. Nitasha Nanda (age 50 yrs.) is a part of the board of directors as a whole-time director. An investor may keep a track of developments whether anyone from the next generations joins the company in an executive position.

The presence of a well thought out management succession plan is essential in businesses as it provides for a smooth transition of leadership over the generations and provides continuity in the business operations of any company.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

 

2) Promoters’ Shareholding in Escorts Ltd:

As per Sept 30, 2019 shareholding pattern of the company, the promoters own 40.25% stake in the company by holding 4,93,33,680 shares of the company out of total 12,25,76,878 shares of the company.

Shareholding pattern, BSE as per Sept. 30, 2019 (Source BSE: Click here)

Escorts Sept 2019 Shareholding

However, when an investor analyses the details of the promoter shareholding, then she notices that 27.49% (3,37,00,031 shares) out of the above 40.25% (4,93,33,680 shares) are owned by Escorts Benefit and Welfare Trust.

Promoters shareholding pattern, BSE as per Sept. 30, 2019 (Source BSE: Click here)

Escorts Sept 2019 Shareholding Of Escorts Benefit And Welfare Trust

As per the disclosures in the annual reports, the company (Escorts Ltd) is the sole beneficiary of the trust.

FY2019 annual report, page 181:

A Scheme of Arrangement and Amalgamation under Section 391 to 394 of the Companies Act, 1956 for the amalgamation of Escorts Construction Equipment Limited (‘ECEL’), a subsidiary company and Escotrac Finance and Investments Private Limited (‘Escotrac’) and Escorts Finance Investments and Leasing Private Limited (‘EFILL’), joint ventures of the Company (together referred to as ‘transferor companies’), was sanctioned by the Hon’ble High Court of Punjab and Haryana at Chandigarh vide its order dated 9 August 2012 (hereinafter referred to as ‘the Scheme’). Upon necessary filings with the Registrar of Companies, NCT of Delhi and Haryana by the Transferor Companies and Transferee Company, the Scheme became effective on 12 October 2012. In accordance with the Scheme, 37,300,031 equity shares of the Company comprising (a) equity shares issued in consideration of amalgamation of ECEL and (b) investments held by two amalgamating entities in the Company were transferred to Escorts Benefit and Welfare Trust (‘EBWT’). The beneficiary interest of the Company in EBWT, has been accounted for as an Investment by the Company in the manner prescribed in the Scheme.

EBWT presently holds 33,700,031 (31 March 2018: 33,700,031) equity shares of the Company and 23,497,478 (31 March 2018: 23,497,478) equity shares of Escorts Finance Limited (subsidiary of the Company). The Company is the sole beneficiary of the Trust. The dividend received by the trust on the Company’s shares is credited directly in “Retained earnings” in note 17 – Other equity.

It indicates that the benefit of the shares held by the trust belongs to the company i.e. all the shareholders of the company in proportion to their shareholding.

There are many other aspects, which indicate that the shareholding of the Trust belongs to the company and not the promoters:

a) The company represents the shares held by the Trust as treasury stock in the annual report, which indicates that the company owns its own stocks via Escorts Benefit and Welfare Trust

FY2019 annual report, page 232:

Escorts Holding Of Escorts Benefit And Welfare Trust As Treasury Stock

b) The company declares dividends on all the shares excluding the shares held by Escorts Benefit and Welfare Trust.

FY2019 annual report, page 50-51:

Based on the Company’s performance, your Directors are pleased to recommend, for approval of the members, a Dividend of ₹ 2.50 per Equity Share (25%) on the face value of ₹ 10/- each, aggregating ₹ 22.22 crores (exclusive of tax on dividend) for the financial year ended March 31, 2019 except on the equity shares held by Escorts Benefit and Welfare Trust (EBWT).

c) Shares held by the Trust are excluded while calculating the earnings per share of the company for the year.

FY2019 annual report, page 243:

Escorts EPS Calculation Excluding Share Of Escorts Benefit And Welfare Trust

d) Whenever the shares held by the Trust are sold, then the money received from such sales is taken by the company as a cash inflow.

FY2019 annual report, page 119:

Escorts Cash Inflow From The Sale Of Shares Of Escorts Benefit And Welfare Trust

As a result, an investor will appreciate that effectively, the 27.49% shares held by the trust belong to the company (all shareholders) i.e. these 27.49% shares belong to the remaining 72.51% shareholders (including promoters) in the proportion of their shareholding.

This may indicate that if one nullifies the shares held by the trust, then the effective shareholding of the promoters in the company is 17.6% = (40.25-27.49) / (100-27.49)

Moreover, if the company keeps on selling the shares held by the Trust and the shares are bought by non-promoters/public, then the shareholding of the promoters will keep on declining below 17.6%.

In case, all the shares held by the Trust are sold in the market and bought by non-promoters/public, then in such a situation, the promoters’ shareholding will stand at 12.76% = (40.25-27.49) / 100

It seems that showing the entire shareholding of the Escorts Benefit and Welfare Trust in the shareholding of the promoters is creating an illusion that promoters own a much larger stake in the company. However, as per the disclosures by the company in the annual report, the beneficiary of the trust is the company and not the promoters alone. Therefore, it seems that the promoters’ effective current stake in the company is about 17.6% instead of the reported 40.25%.

Also read: How Promoters use Loopholes to Inflate their Shareholding

Investors may contact the company to know about the effective stake owned by the promoters in Escorts Ltd.

An investor may appreciate that in the case of the Trust, the shares owned by the company seem to be shown under promoter shareholding. In the past as well, there have been instances where the shares effectively owned by the company were shown under promoter shareholding.

 

a) Escotrac Finance & Investments Private Limited (ESCOTRAC) and Escorts Finance Investment & Leasing Private Limited (EFILL):

While analyzing the shareholding pattern of Escorts Ltd during FY2011, an investor notices that out of the total shareholding of the promoters in the company 27.57% at Sept 30, 2011, the majority is owned by two companies:

  • 12.83% by Escotrac Finance & Investments Private Limited (ESCOTRAC) and
  • 6.50% by Escorts Finance Investment & Leasing Private Limited (EFILL)

BSE shareholding pattern filing, Sept 2011 (Source BSE: Click Here)

Escorts 2011 Shareholding Of Promoters ESCOTRAC EFILL

Therefore, investors would note that 19.33% of the shares of Escorts Ltd were owned by ESCOTRAC and EFILL and classified under promoters’ shareholding.

While analyzing the FY2011 annual report an investor gets to know the ownership pattern of ESCOTRAC and EFILL and she finds that both of these companies are majorly owned by Escorts Ltd.

FY2011 annual report, page 114:

Escorts 2011 Ownership Of ESCOTRAC EFILL

An investor notes that Escorts Ltd owns 49.81% of each of ESCOTRAC and EFILL directly and more shares of these companies by their cross-holding i.e. 49.81% shares owned by ESCOTRAC and EFILL of each other.

Many times understanding the impact of such cross-holding becomes confusing. Therefore, to simplify, we see them in terms of end beneficiaries. In the case of ESCOTRAC and EFILL, we assume two owning parties:

  1. Escorts Ltd and
  2. Outside shareholders.

In both ESCOTRAC and EFILL, the outside shareholders own 0.38% shares directly. 0.38 = 100 – 49.81 (Escorts Ltd direct holding) – 49.81 (Crossholdings of ESCOTRAC & EFILL in each other)

In addition, outside shareholders own 0.38% of the cross-holding indirectly i.e. outside shareholders have rights to 0.38% of the stake owned by ESCOTRAC and EFILL in each other, which comes out to be 0.19% (= 49.81% * 0.38%)

Therefore, the total shareholding of outside shareholders in ESCOTRAC and EFILL each is the sum of direct shareholding of 0.38% and indirect shareholding of 0.19%, which sums to 0.57% (= 0.38 + 0.19)

Therefore, an investor would note that both ESCOTRAC and EFILL are owned 99.43% (= 100 – 0.57) by Escorts Ltd and 0.57% by outside shareholders.

In light of the same, when an investor analyses the 19.33% shares of Escorts Ltd held by ESCOTRAC and EFILL, then she realizes that these shares out of these shares about 19.21% are owned by Escorts Ltd itself (19.21% = 19.33% * 99.43%) and only 0.12% is owned by outside shareholders (0.12% = 19.33% * 0.57%).

Therefore, in Sept 2011, it seems that the 19.21% shares, which are effectively held by the Escorts Ltd via ESCOTRAC and EFILL, are shown under promoter shareholding.

Also read: How Promoters use Loopholes to Inflate their Shareholding

Moreover, when an investor tries to find the sources of the funds used by ESCOTRAC and EFILL to buy shares of Escorts Ltd, then she notices that these funds have been provided by Escorts Ltd by way of equity and other investments.

FY2011 annual report, page 78:

Escorts 2014 Equity Investments In ESCOTRAC EFILL

FY2011 annual report, page 79:

Escorts 2014 Redeemable Preference Shares Investments In ESCOTRAC EFILL

By analyzing the above disclosures, an investor notes that Escorts Ltd has made the following investments in ESCOTRAC and EFILL:

  • ESCOTRAC: ₹98.48 cr
  • EFILL: ₹83.82 cr
    • Equity: ₹40.00 cr and
    • Preference shares: ₹43.82 cr

Therefore, an investor realizes that it seems to be the investment of ₹182.30 cr (= 98.48 + 83.82) done by Escorts Ltd in ESCOTRAC and EFILL, which has been used by these companies to buy shares of Escorts Ltd.

While analyzing previous annual reports, an investor notices that in the previous years, whenever Escorts Ltd used to give loans to other companies/subsidiaries, then it used to disclose the utilization of the funds by those companies. E.g. in the FY2003 annual report, Escorts Ltd had disclosed that ESCOTRAC and EFILL have invested the money given by it to those companies in Escorts Ltd itself.

FY2003 annual report, page 49:

Escorts 2003 Investments Done By ESCOTRAC EFILL

Therefore, an investor notices that in the case of ESCOTRAC and EFILL, the money provided by Escorts Ltd to these companies was used to buy shares of Escorts Ltd and these shares were shown under promoter shareholding.

Also read: How Promoters use Loopholes to Inflate their Shareholding

It is advised that in the cases of such cross-holdings of shares of the companies, an investor should due deeper due diligence to find out the effective shareholding of different parties. In case of any ambiguity, it is advised to get in touch with the company to enhance the understanding.

 

3) Money withheld in the escrow account for sale of Escorts Heart Institute & Research Centre Limited:

While reading the annual report of FY2019, page 230, an investor notices that Escorts Ltd has ₹142.68 cr in the escrow account, which it cannot use.

Escorts 142 Cr In Escrow Not Usable

Upon further reading of the annual report, the investor notices that this money is related to the sale of Escorts Heart Institute & Research Centre Limited (EHIRCL) by the company in Sept 2005. An investor learns that the money is kept by the company in the escrow account to indemnify/protect the buyer from liabilities in case of any tax demands pending against EHIRCL at the time of sale.

FY2019 annual report, page 238:

During the year 2004-05, Group sold its entire shareholding in Escorts Heart Institute and Research Center Limited (EHIRCL) vide Share Purchase Agreement (SPA) dated 25 September 2005. At the time of sale, EHIRCL had certain pending income-tax demands. For this purpose and in terms of said SPA, an amount of ₹ 64.99 crores had been kept under Escrow as fixed deposit by the Group, which after renewal(s) along with interest cumulatively amounts to ₹ 142.68 crores as on 31 March 2019 (31 March 2018: ₹ 134.12 crores). In accordance with the terms of said SPA, the Group has undertaken to indemnify the purchaser against the aforesaid tax demands arising on EHIRCL upon final adjudication in law, to the maximum extent of funds lying in the Escrow Account plus one-third of the remaining tax demand in excess of the balance in the Escrow Account or as may be finally settled between the parties. Correspondingly, a provision was created earlier on prudent basis to meet this liability, if and when the same arises, whose carrying value is ₹ 65.00 crores on 31 March 2019 (31 March 2018: ₹ 65.00 crores). The disputed tax demands on EHIRCL are presently reduced to Nil after the first appellate authority decided the appeals in their favour. The income-tax department has filed second appeal(s) before the Appellate Tribunal where these are pending.

When an investor explores the details of the sale transaction of EHIRCL by reading the annual report for the period in which the sale transaction took place i.e. FY2005, then she notices that at the time of the sale Escorts Ltd held 80% stake in EHIRCL when it was sold to Fortis Healthcare Ltd. After the sale, ₹85 cr from the share of Escorts Ltd was kept in the escrow account.

FY2005 annual report, page 8-9:

Escorts 2005 85 Cr In Escrow Money Is For Hospital Sale

An investor would assume that if the 80% shareholder (Escorts Ltd) has kept money in the escrow account, then the other selling shareholders (20%) would also have kept some money in the escrow account.

While tracking the later developments related to the EHIRCL sale transaction and the associated litigation in the subsequent annual reports, an investor finds that the FY2008 annual report provides further updates.

The FY2008 annual report provides that other shareholders had kept ₹64.99 cr in the escrow account. (See the screenshot below).

  • A question comes to the mind of investor here: why did the 80% shareholder (Escorts Ltd) put only ₹85 cr in the escrow account whereas the 20% other shareholders had to keep ₹64.99 cr in the escrow account, which seems very large in comparison to their stake in EHIRCL?

In the FY2008 annual report, the investor also notices that during FY2008, the Delhi High Court lifted the stay on the ₹85 cr, which was placed in the escrow account in FY2005. However, the FY2008 annual report also states that the money put in the escrow account by the other shareholders (20%) could not be released. (See the screenshot below).

  • A question comes to the investor’s mind that what could be the reason that the money put in the escrow account by Escorts Ltd is released whereas the money put in the escrow account by other shareholders is not released.

Moreover, the investor also learns that the other shareholders went into arbitration against Escorts Ltd and got their money from Escorts Ltd including interest from Escorts Ltd. In addition, it seems that Escorts Ltd (80% shareholder) was stuck with providing entire money to be put in the escrow account to meet the contingent tax liability (₹64.99 cr).

FY2008 annual report, page 86:

a) During the period 2004-05, Escorts Limited (EL) sold its entire share holding in Escorts Heart Institute & Research Centre Limited (EHIRCL) for consideration of Rs. 520/- crores vide Sale Purchase Agreement dated 25th September, 2005. The sale proceeds have been received, excepting for Rs. 85.08 crores which were retained in an Escrow Account, awaiting fulfillment of certain conditions. The Hon’ble Delhi High Court had ordered status quo, on a petition fi led challenging the sale transaction.

During the year the said petition have been dismissed by the Hon’ble Court. The Company has paid an amount of Rs. 7.50 crores as settlement cost to the buyer and the amount held in the Escrow Account has been realised.

At the request of the Company, other stakeholders of EHIRCL, who were holding 5% each of the paid up share capital of EHIRCL, had also agreed to keep their share of the sale consideration amounting to Rs. 64.99 crores in an Escrow Account. Pursuant to the status quo order of the Hon’ble High Court the amount held in Escrow Account belonging to the aforesaid stakeholders could not be released even on demand by them. The matter was referred to arbitration. As per the award, EL was required to pay the money to the aforesaid stakeholders including interest accrued thereon. Consequently, during the year the Company has placed a sum of Rs. 64.99 crores in an Escrow Account by paying off the other stakeholders.

b) Escorts Heart Institute & Research Centre Limited (EHIRCL), the Subsidiary company that was sold in September 2005, has disputed the Income Tax demand of Rs. 52.33 crores and interest thereon amounting to Rs. 29.16 crores and the matter is pending in appeal. Escorts Limited has undertaken vide the sale agreement dated 25th September, 2005 to indemnify the purchaser to the extent of Rs. 65.00 crores plus one-third of any amount in excess of Rs. 65.00 crores, in case the appeal is decided against EHIRCL. In view of the above the Company has kept an amount of Rs. 64.99 crores in an Escrow Account.

Further advised reading: Understanding the Annual Report of a Company

From the above disclosures in the annual report, it seems that after the arbitration, Escorts Ltd had to pay off the other shareholders.

  • However, it is not clear whether the money originally kept in the escrow account by other shareholders in FY2005, which was not released even after the Delhi High Court lifted its stay in 2008, was finally released or not.

Moreover, it is not clear if this money was ever released. If this money was released then whether it was given to the Escorts Ltd because it had to pay off the other shareholders after arbitration or it was given to the other shareholders.

  • If the other shareholders received this money, then they would have received a double bonanza, once by payment from Escorts Ltd through arbitration and second by the money from the escrow account kept by them in FY2005. However, the possibility of this happening without further litigation is minimal.

On a fair judgment presumption, an investor can only assume that the money kept by other shareholders in an escrow account in FY2005 would have been released to Escorts Ltd, as after arbitration, it had to pay to those other shareholders. However, it is not clear from the disclosure.

An investor may contact the company to know about the details of the other shareholders who held the 20% stake in EHIRCL and went into arbitration against the company.

Regarding the new escrow deposit created for ₹64.99 cr in FY2008 (point b in the disclosure screenshot above) to meet the contingent tax liability, an investor may seek details from the company if it is the only party that has kept money in the escrow account for meeting the contingent tax liability or the other selling shareholders (20%) have also kept their share of money in the escrow account.

This is because, in case, the other shareholders (20%) have received their entire money without keeping any money in the escrow account, and Escorts Ltd is the only party that has kept money in the escrow account to bear the contingent tax liability, then it is unfair for the shareholders of Escorts Ltd. Alternatively, if there are some other aspects of this transaction, which is not clear by reading the annual reports.

 

4) Capital allocation by Escorts Ltd:

In FY2017, Escorts Ltd informed its shareholders that it had sold off its auto division, which was continuously making losses and required regular capital infusion from the parent.

FY2017 annual report, page 39:

In an important development, the business of auto products was divested in favour of Pune-based Badve Engineering Limited in 2016, to cut losses and vacate a business that required consistent capital infusion.

The auto division had been making losses every year. Moreover, at the time of sale, in addition to regular business losses, Escorts Ltd had to take a hit of ₹41.92 cr because of the write-off of inventories, trade receivables and other assets.

FY2017 annual report, page 122:

Escorts 2016 Write Off Losses Of The Auto Business

It seemed like a case of sub-optimal capital allocation, which the company set out to rectify now by selling the business.

When an investor analyses the past performance of Escorts Ltd, then she notices that there have been many instances where the company decided to allocate capital to a new business division/geography but it could not run it successfully. As a result, the company had to face losses on such investments.

 

a) Escorts Finance Ltd (EFL):

In FY2006, Escorts Finance Ltd (EFL), a group company of Escorts Ltd wrote off loans, receivables and advances of about ₹230 cr and as a result, the entire net worth of EFL was wiped out. (Source: Economic Times Aug 02, 2006)

As per the disclosures in the FY2005 annual report of Escorts Ltd, EFL was not a subsidiary of the company indicating that it held less than 50% stake in the EFL. An analysis of the shareholding of EFL on June 30, 2006, indicated that Escorts Ltd held a 9.49% stake in the company. Most of the remaining stake (64.38%) was held by Escotrac Finance & Investments Private Limited (ESCOTRAC) (26.71%) and Escorts Finance Investment & Leasing Private Limited (EFILL) (37.67%).

BSE shareholding filing by EFL, June 30, 2006 (Source BSE, Click here)

Escorts June 2006 Shareholding Of Escorts Finance Ltd

In the discussion above about ESCOTRAC and EFILL, an investor would remember that both these companies are directly/indirectly 99.43% owned by Escorts Ltd by way of direct shareholding and cross-holdings.

Therefore, in essence, an investor would appreciate that EFL has been majorly owned by Escorts Ltd by direct/indirect shareholding, but it was not technically classified as a subsidiary of the company. As a result, the board of directors of Escorts Ltd may not have had complete direct control on the operations of EFL by way of passing of resolutions to control its day to day functioning and lending decisions. These decisions may have been in the hands of senior management of EFL, which probably was not answerable to the board of Escorts Ltd for their decisions.

In addition, FY2005 annual report of Escorts Ltd disclosed that it had invested a total of ₹13.51 cr in EFL in the following manner:

  • ₹4.01 cr in the equity shares of EFL and
  • ₹9.50 cr in the Cumulative Redeemable Preference Shares of EFL

FY2005 annual report, page 36:

Escorts 2005 Investments In Escorts Finance Ltd

In FY2006 after the significant write-offs of loans and receivables by EFL, Escorts Ltd moved a proposal to bail out the fixed depositors and lenders of EFL in order to protect its value, reputation and image.

FY2006 annual report, page 48:

The Company has proposed a scheme of Compromise & Arrangement with the Fixed Deposit holders and Secured Creditors of Escorts Finance Ltd (EFL). an Escorts Group Company under the provisions of Section 391 of the Companies Act, 1956. With a view to preserve its present value, reputation and image and on request of Board of Directors of EFL. Escorts Ltd (EL) proposes to grant under the Scheme liquidity options to all the fixed deposit holders in the form of either Equity Shares or Fully Convertible Unsecured Debentures of EL equivalent to 75% of the Fixed Deposit value. as described In the Scheme. EL may also assume liabilities of EFL towards Secured Creditors as a part of the Scheme such that EL shall realise the assets pledged by EFL to its secured creditors and settle their outstanding against EFL on effective date from the amount so realised to the extent of the amount so realised. EFL shall treat EL as Secured Creditors for 75% ofFixed Deposit Value and assign part of its Loans &Advances and part of Stock on hire in consideration for assuming liabilities of EFL

Later on, as a part of the attempt of Escorts Ltd to compensate fixed depositors and lenders of Escorts Finance Ltd (EFL), in FY2008, the company had to issue 3,404,256 shares of Escorts Ltd to the Hardship Committee set up by the Court to pay-off fixed deposit holders.

FY2008 annual report, page 12:

Your Company has allotted 34,04,256 fully paid up Equity Shares of Rs. 10/- each at a price of Rs. 94/- per share equivalent to Rs. 32 crores to Hardship Committee (“Committee”) as per directions of Hon’ble High Court, Delhi to provide relief to certain depositors of Escorts Finance Ltd. who have been identifi ed as hardship cases by the Committee pending approval of the Scheme of Compromise and Arrangement.

By FY2011, the hardship committee had paid off ₹130 cr to the fixed deposit holders. In FY2011, the remaining shares of the company were transferred to Escorts Benefit Trust for settlement of remaining fixed deposit holders and the hardship committee was dissolved.

FY2011 annual report, page 37:

The Scheme of compromise and arrangement pending before the Hon’ble Delhi High Court (High Court) to bail out the Fixed Deposit Holders of Escorts Finance Limited stand disposed off vide order dated 4 th March, 2011. On the interim direction of the High Court, fixed deposit liability of ₹ 130.32 crores has already been discharged by the Hardship Committee constituted under the direction of the High Court. For discharging the liability of unclaimed deposit holders, balance 2,401,050 Equity Shares of Escorts Limited, have been transferred to Escorts Benefit Trust (Trust) and the Hardship Committee has been dissolved. The Trust in due course and in terms of the direction of the High Court is discharging the unclaimed deposit holders as and when claimed by the deposit holders.

Finally, in FY2015, the Honorable High Court confirmed that Escorts Ltd has no more liability towards the fixed deposit holders of Escorts Finance Ltd (EFL).

FY2015 annual report, page 142:

The Hon’ble High Court has confirmed that Escorts Limited has no outstanding liability towards payment to Escorts Finance Limited deposit holders.

Thereafter, in FY2017, the company intimate its shareholders that Escorts Benefit Trust has sold all the shares held by it and that it had retained sufficient money to repay the remaining depositors of EFL. As a result, the trust has paid back excess funds of ₹15 cr to Escorts Ltd.

FY2017 annual report, page 132:

Escorts Benefit Trust has realised the investments held by it and remitted the surplus of ₹15.00 crores to the Company (beneficiary) after retaining sufficient funds for meeting its liability towards Escorts Finance Limited deposits.

In the case of Escorts Finance Ltd, an investor would note that the manner of corporate structuring of its shareholding avoided it being a direct subsidiary of Escorts Ltd. As a result, the board of directors of Escorts Ltd may not have had complete direct control on the operations of EFL by way of passing of resolutions to control its day to day functioning and lending decisions. The lending decisions may have been in the hands of senior management of EFL, which probably was not answerable to the board of Escorts Ltd for their decisions.

Nevertheless, Escorts Ltd moved to accept the liabilities of EFL, which seems a kind gesture for the fixed depositors of EFL but simultaneously seems a helpful gesture to the senior management of EFL and might have been responsible for the erroneous decisions of particular loans, which turned bad and in turn bankrupted EFL.

In the end, it seemed that after more than 10 years of the origination of the problem at EFL (FY2006), in FY2017, the issue was resolved. The shareholders of Escorts limited saved the fixed depositors of EFL as well as the other majority shareholders of EFL and there should not be any further payout from the shareholders of Escorts Ltd towards saving EFL.

However, an analysis of subsequent annual reports of Escorts Ltd indicates that the entire trouble may not be over yet. This is because as per the FY2019 annual report of Escorts Ltd, EFL has not deposited ₹10.85 cr of dues to the Investor Education and Protection Fund.

FY2019 annual report, page 191:

Escorts Finance Limited, subsidiary of the Company has not deposited sum of ₹ 10.85 crores against various due dates upto 7 May 2019 to the Investor Education and Protection Fund;

An investor may keep a track of the developments at the end of EFL to monitor additional financial support that may be done by Escorts Ltd.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

 

b) Escorts Mahle Ltd (EML):

An article in the Business Standard, first published on June 08, 2001 and last updated at January 28, 2013 (click here), indicated that the Escorts group is looking to sell its 50% stake in the Escorts Mahle Ltd (EML) to its joint venture partner Mahle GmbH of Germany for ₹10.92 cr. The article quoted the then Chairman of Escorts Ltd, Mr. Rajan Nanda.

However, when contacted, Rajan Nanda, chairman, Escorts group, denied that the group has sold off its stake in Escorts Mahle to the foreign partner.

“We are still negotiating with Mahle for selling off our stake. Talks are still on and we have not sought FIPB nod,” Nanda said.

While reading the past annual reports of Escorts Ltd, an investor notices that in FY2003 annual report, the company communicated its shareholders that it had sold its entire stake in Escorts Mahle Ltd for a loss of ₹32.46 cr. In addition, the company sold the preference shares of EML at a loss of ₹32.05 cr.

FY2003 annual report, page 44-45:

13. Escorts Mahle Limited a joint venture of the Company with 50% holding has been incurring losses for the past few years and had accumulated losses of Rs. 95.92 crores as on 31st March, 2002. The Company has during the year sold the entire holding of 2,17,58,908 equity shares of Escorts Mahle Limited at a loss of Rs. 32.46 crores.

14. The Company acquired 26,25,000 14% Cumulative Redeemable Preference shares of Escorts Mahle Limited as stipulated under the terms of the agreement of the Company dated 25th April, 2000 with Infrastructure Leasing & Financial Services Limited (IL&FS). These Preference shares, which were due for redemption on 11th June, 2007 have been sold by the Company during the year at a loss of Rs. 32.05 crores.

₹64.51 cr of losses (= 32.46 + 32.05) on the investments in Escorts Mahle Ltd represent a case where the decision of the company to allocate capital did not produce desired results.

 

c) Telecom business of Escorts Ltd:

In the past, Escorts Ltd invested capital into the telecom business, which did not provide profitable returns to the shareholders.

As per the FY2003 annual report, the telecom business had accumulated losses of more than ₹850 cr.

FY2003 annual report, page 44:

At the year end, Escotel’s accumulated loss and miscellaneous expenditure (to the extent not written off/adjusted) amounting to Rs. 859.01 crores and Rs. 19.23 crores respectively has exceeded its Net Worth. However, the management is of the view that erosion of the equity is not unusual in a sizeable infrastructure project during its initial years.

As a result, the company sold the telecom business in FY2004 to Idea Cellular Limited for a total sum of ₹380.74 cr, which included ₹205 cr immediate payment and a bond of ₹175.74 cr as deferred payment.

FY2004 annual report, page 10:

Escorts 2004 Value Of Sale Of Escotel To Idea Cellular Limited

During FY2004, the company recognized a loss of ₹185 cr on the sale of the telecom business.

FY2004 annual report, page 8:

Escorts 2004 Losses In Sale Of Escotel To Idea Cellular

However, the losses in the telecom business did not end in FY2004. Escorts Ltd could not realize the full consideration of ₹175.74 cr of the bond (deferred payment). In FY2009, the company received ₹96.69 cr from Idea Cellular Ltd for the final settlement of the said bond.

FY2009 annual report, page 97:

As a part of consideration for sole of its Telecom Business during the period 2003-04 the Company was issued an Unsecured Subordinoted Bond of Rs. 175.74 crores by Idea Cellular Limited (Idea). Idea had a call option for early redemption of the Bond of a discount rate of 10.50% per annum exercisable at any time and the Company had a put option in January, 2010. Accordingly during 2004.05, the Company had provided a sum of Rs. 57.86 crores to reflect the discounted value of the Bond as of January, 2010 at Rs. 117.88 crores. During the year the Company requested Idea for prepayment of the above amount and received an amount of Rs. 96.69 crores in final settlement.

Further advised reading: How to Identify if Management is Misallocating Capital

 

d) Hughes Communication India Limited (earlier name Hughes Escorts Communication Limited):

While reading the FY2019 annual report, an investor finds that Escorts Ltd has sold its investment in Hughes Communications India Limited for ₹50.08 cr.

Investment in equity shares of Hughes Communications India Limited was sold during the year for a consideration of ₹ 50.08 crores to HNS-India VSAT, Inc. Monies received on account of this transaction has been included under note 13.

Upon further analysis, the investor notes that Hughes Communication India Limited was earlier named as Hughes Escorts Communication Limited (HECL) (Source: CDSL)

Escorts 2019 Hughes Communications India Limited Name Change From Hughes Escorts Communications Limited

While reading the past annual reports of Escorts Ltd, in the FY2003 annual report, an investor finds that Escorts Ltd owned 37,64,992 shares of Hughes Escorts Communication Limited (HECL).

FY2003 annual report, page 32:

Escorts 2003 Stake In Hughes Escorts Communications Limited

As per further disclosure in the FY2003 annual report, Escorts Ltd intimated its shareholders that according to an agreement between the company, its joint venture partner in HECL Hughes Network Systems and ICICI (probably the lender to HECL, Escorts Ltd has transferred 34,00,000 shares of HECL to another company called Escorts Motors Limited. And, currently, Hughes Network Systems and ICICI own 98% of Escorts Motors Limited.

Moreover, Escorts Ltd has given assurance of a minimum return to Hughes Network Systems and ICICI over the next four years.

FY2003 annual report, page 44:

Consequent to an agreement dated 31st March, 2000 between the Company and Hughes Network Systems (HNS), the joint venture partner of the company in Hughes Escorts Communication Limited (HECL), and ICICI Bank Limited (ICICI), the company sold 34,50,000 equity shares of HECL to Escorts Motors Limited (EML).

HNS and ICICI thereafter subscribed to the equity share capital of EML equally to hold 98% of its total equity share capital. Under the terms of the agreement, the Company has given an assurance to HNS and ICICI of a minimum return compounded annually for a period of four years. On the other hand, the company has been assured by both HNS and ICICI severally that gain on disinvestment of the said HECL equity shares over the assured minimum return will be shared by them equally with the Company.

When an investor looks at the term of a minimum guarantee of the returns to the counterparties given by Escorts Ltd, then she would appreciate that it seems like compensation for their investment in HECL, which does not seem to perform well.

In the FY2005 annual report, the company disclosed that it has purchased 49% shareholding of Escorts Motors Limited (which held shares of Hughes Escorts Communication Limited) from ICICI by paying ₹68 cr. It probably meant that ICICI has taken ₹68 cr and moved out of the transactions of Hughes Escorts Communication Limited.

The company also disclosed that out of the payment of ₹68 cr, it has recognized ₹31.25 cr as a loss/diminution of value because it is the excess amount over the original investment done by ICICI. It indicates that ICICI invested ₹36.75 cr (= 68 – 31.25) in HECL and in 2004 took ₹68 cr for its investment making a gain of ₹31.25 cr.

The gain of ₹31.25 cr to ICICI has come at the cost of shareholders of Escorts Ltd apparently because the business of HECL had not done well. Therefore, Escorts Ltd recognized the gain of ₹31.25 cr earned by ICICI as a loss in its financial statements.

FY2005 annual report, page 49:

Subsequent to 31st March 2004, the Company has in terms of earlier agreement agreed to purchase the 49% holding in EML from ICICI and had advanced Rs. 68 crores out of which Rs. 31.25 crores has been provided as diminution in the value of proposed investment, being the differential in excess of the original investment made by ICICI.

Additionally, in FY2006, Escorts Ltd had to pay ₹10.60 cr in cash and shares to Hughes Network Systems (HNS) as a settlement for their investment in Hughes Escorts Communication Limited.

FY2006 annual report, page 49:

Pursuant to Settlement Agreement dated 14th September. 2006 between HNS and Escorts Limited, the Company agreed to pay a settlement amount of Rs.10.60 crores. During the year Company has paid Rs. 2.40 crores in cash and the balance of Rs. 8.20 crores by transfer of 16,90.500 Equity Shares of HECL (now Hughes Communications India Limited) of face value Rs. 10.00 each amounting to Rs.1.69crores (Estimated Market Value of Rs. 8.20 crores). The amountof Rs. 4.09 acres has been shown as Settlement Cost in Schedule 17′ Exceptional Items’.

It seems that the current sale of stake by Escorts Ltd in Hughes Communication India Limited is the culmination of its investment in Hughes Escorts Communication Limited almost 2 decades back. Escorts Ltd had to make initial investments, bear the operational losses, give exit to ICICI at ₹68 cr in 2004 at a significant premium from the original investment and then settle with HNS for cash & share payments. Now, after almost 2 decades, Escorts Ltd seems to have realized ₹53.33 cr out of its investments in the company.

Investment in Hughes Communication India Limited does not seem to have created a lot of value for the shareholders of Escorts Ltd.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

 

e) Farmtrac Tractors Europe Spolka Zo.o:

While reading the details of subsidiaries in the FY2015 annual report, an investor notices the financial performance of one of wholly-owned (100%) subsidiary of the company in Poland, Farmtrac Tractors Europe Spolka Zo.o.

The investor notices that Escorts Ltd has made significant investments in the subsidiary as the company has a share capital of ₹8.3 cr and assets of ₹59.5 cr. However, when an investor notices the sales & profitability of the company, then she notices that this subsidiary has made a net loss of about ₹1 cr despite having sales of about ₹150 cr during 15 months of January 2014 to March 2015.

FY2015 annual report, page 145:

Escorts 2015 Performance Of Subsidiaries

Looking at the above performance, an investor may think that the investments done by Escorts Ltd in the Poland subsidiary are not generating a lot of return for the shareholders of Escorts Ltd.

While reading the past annual reports of the company, an investor would notice that Escorts Ltd has attempted to venture into many related and unrelated businesses to its core activities including software, telecom, automobiles, animation, ERP implementation, wireless IT & internet solutions, mutual funds, finance & credit, securities, healthcare etc. However, it seems that out of these diversifications, except healthcare and Carraro India Ltd, no other major business could create value for the shareholders of the company and in many cases, the company had to do write-off of the investments.

FY2006 annual report, page 5:

Includes Loss on Sale/Provision for Diminution in the value of Investments, Loans to Telecom and Other Businesses amounting to Rs. 185.02 Crores.

Includes profit on divestment of healthcare business amounting to Rs. 505.51 Crores.

Includes profit on divestment of Carraro India Limited shareholidng amounting to Rs. 94.92 Crores

Moreover, one of the major business divisions of the company, Construction Equipment, is not making steady profits for the company despite being in existence since 1971. This division routinely makes operating level losses. In FY2017, the construction division of the company reported EBITDA level profits after being in EBITDA losses consecutively for 22 quarters.

FY2017 annual report, page 39:

Transformed the business into EBITDA-positive in the fourth quarter after almost 22 quarters of EBITDA being negative. One of the reasons for this was market outperformance – while the industry grew in the range of 10-12%, Escorts’ construction equipment business grew at about 20%

It remains to be seen whether, in the future, the construction equipment division is able to generate sufficient cash flow to the company in order to justify the deployment of shareholders’ capital.

Further advised reading: How to Identify if Management is Misallocating Capital

 

5) Write-offs done by Escorts Ltd:

While analyzing the annual reports of Escorts Ltd, an investor notices that over the years, the company has undertaken many write-offs of its assets. Most significant amount of these write-offs had been because of Escorts Agri Machinery Inc. (USA) (EAMI) adjusted against the business reconstruction reserve (BRR) in the balance sheet during FY2009-2012.

 

a) Escorts Agri Machinery Inc. (USA) (EAMI):

In the past, one of the wholly-owned subsidiary (100% owned) of Escorts Ltd in the USA, EAMI, could not perform as per expectations and as a result, the company merged EAMI in itself in FY2009. After this merger was over, then Escorts Ltd disclosed that it had to absorb losses/write-offs to the extent of ₹641.82 cr (= 156.53 + 485.29) in FY2009. Moreover, there were additional losses in subsequent years on account of EAMI.

FY2009 annual report, page 98:

EAMI has been amalgamated with the Company with effect from the appointed date. EAMI is an investing company holding other overseas operational companies. On amalgamation, all the subsidiaries of EAMI have become direct subsidiaries of the Company. The amalgamation has been accounted for under the ‘Pooling of Interest Method” in accordance with AS-14 Accounting for Amalgamations. Accordingly, all the assets and the liabilities of EAMI have been taken at their book value as appearing in the books of EAMI on the appointed date, based on their unaudited financial statements. The entire share capital of EAMI and investment in the equity share capital of EAMI as appearing in the books of EL stands cancelled and inter se amount of loans, advances and other current account balances of EAMI with the Company also stand cancelled. EAMI being the wholly owned subsidiary of the Company no consideration is required to be paid.

As envisaged by the aforesaid Scheme, a separate reserve account titled “Business Reconstruction Reserve” (BRR) has been created by transferring amounts lying to the credit of Revaluation Reserve, Amalgamation Reserve, Capital Redemption Reserve and Shore Forfeiture Reserve with effect from the appointed date. The Compony has got its immovable properties in the form of Land & Buildings valued by a reputed independent valuer resulting in net addition of Rs. 672.72 crores to their book value as on the appointed dote. The corresponding credit has been given to the BRR.

Business Reconstruction Reserve has been utilised to adjust profit and loss account debit balance of Rs.156.73 crores brought forward from earlier years. An amount of Rs. 485.29 crores has also been utilized from BRR to adjust the difference between the value of assets and liabilities taken over upon amalgamation, provision/write down/write off in the valve of the fixed assets, investments, current assets, loans and advances, excess depreciation on the account of revaluation of the fixed assets and all the expenses incurred in carrying out and implementing the Scheme as detailed in Schedule-2 “Reserves &Surplus” and Schedule- 17 “Exceptional Items”.

Investors would note that in FY2009, Escorts Ltd recognized a total diminution in the value of ₹641.82 cr out of which ₹156.53 cr was accumulated losses and another ₹485.29 cr was on account of impairment of assets, investments, excess liabilities etc. An investor would note that the deterioration of the value of ₹485.29 cr was already there on the ground in the USA; however, it was recognized in the financials at the time of the merger.

Moreover, by way of creation of business reconstruction reserve (BRR) and adjusting these losses directly to BRR in the balance sheet by bypassing the profit and loss statement, the company could report higher profits. The auditor of the company highlighted this aspect in its report in the annual report where the auditor mentioned that such a treatment of the write-offs directly to the balance sheet bypassing profit & loss statement, though approved by the Honorable High Court, is not as per the accounting standards.

FY2009 annual report, page 77:

In our opinion, the Balance Sheet, Profit & Loss Account ond Cash Flow Statement dealt with by this report comply with the Accounting Standards referred to in subsection (3C) of Section 211 of the Companies Act, 1956, except accounting treatment as described above regarding creation and utilization of Business Reconstruction Reserve pursuant to a scheme of arrangement as duly sanctioned by the High Court of jurisdiction.

It seems that the amount of loss recognized in FY2009 (₹641.82 cr) did not reflect the entire loss of value as in FY2012; the company had to recognize another value erosion of ₹369.79 cr. In FY2012 as well, Escorts Ltd adjusted the value erosion/write-off directly to the balance sheet in BRR bypassing the profit and loss statement.

FY2012 annual report, page 74:

Pursuant to the Scheme of Arrangement (Scheme) under Sections 391 to 394 which has been approved by the Hon’ble High Court of Punjab & Haryana vide its Order dated 17th September 2009, an amount of ₹ 369.79 crores on account of, receivables, fixed assets, inventories, loans & advances which is doubtful of recovery/realization has been provided for/written off and adjusted through Business Reconstruction Reserve.

Had the Scheme not prescribed for the aforesaid accounting treatment as approved by the Hon’ble High Court, the balance sheet (including reserves & surplus) and the statement of profit and loss would have been impacted to that extent.

Therefore, an investor would notice that in the case of EAMI, Escorts Ltd suffered losses to the extent of ₹1,000 cr, which were directly adjusted in the balance sheet bypassing the profit & loss statement. Had the Honorable High Court not permitted this adjustment, then the profit performance of the company as represented by the P&L would have looked very different. Moreover, while assessing the overall cumulative profitability of the company over the years, investors may make adjustments accordingly at their end.

This aspect of significant write-offs adjusted to the balance sheet has been highlighted by credit rating agencies as well.

ICRA in its report of March 2016 for the company stated that any balance sheet adjustment of write-offs like the one done in the past via BRR is an event risk for assessment of Escorts Ltd.

ICRA March 2016 report, page 1:

Going forward, EL’s ability to divest the loss-making auto components segment without any substantial write-off or any major debt-funded inorganic expansion would remain key rating sensitivities. Further, any balance sheet adjustment, similar to write-offs from BRR in the past, is an event risk.

Further advised reading: How Companies Inflate their Profits

Apart from the write-offs because of EAMI, Escorts Ltd has written off assets under inventory, receivables, investments etc.

 

b) Write-off of inventory & receivables by Escorts Ltd:

While analyzing past annual reports of Escorts Ltd, an investor notices that the company has had significant write-offs under inventory & receivables in the past.

In FY2011, the company wrote off ₹115 cr, in FY2012, it wrote off ₹50 cr.

FY2012 annual report, page 70:

Escorts 2011 2012 Bad Debts Written Off

In FY2016, the company wrote off ₹61 cr, in FY2017, it wrote off ₹27 cr.

FY2017 annual report, page 159:

Escorts 2016 2017 Bad Debts And Inventory Written Off

In FY2019, the company wrote off ₹19 cr. (FY2019 annual report, page 157):

Escorts 2018 2019 Bad Debts And Inventory Written Off

In FY2011, Escorts Ltd wrote off receivables of ₹32.53 cr from Farmtrac Tractors Europe Sp. Z.o.o., Poland. However, the company chose to adjust these losses directly in the Business Reconstruction Reserve (BRR) instead of recognizing these losses in the profit and loss statement. The auditor has highlighted that if the Honorable High Court had not allowed it, then the profits for the year would have been lower by this amount.

FY2011 annual report, page 91:

Pursuant to the order of the Hon’ble High Court of Punjab & Haryana dated 17 th September, 2009 an amount of ₹ 32.53 crores on account of exports receivables from Farmtrac Tractors Europe Sp. Z.o.o., Poland, which is doubtful of recovery and exports incentives availed thereon to be refunded, has been provided for and adjusted through Business Reconstruction Reserve. Had the Scheme not prescribed for the aforesaid accounting treatment as approved by the Hon’ble High Court, the balance sheet (including reserve & surplus) and the profit and loss account would have been impacted to that extent.

 

3) Write-off of advances given to related parties and inter-corporate deposits by Escorts Ltd:

In one instance, in FY2017, Escorts Ltd disclosed that it fears that it would not be able to recover an advance given to one of the related parties.

FY2018 annual report, page 140:

Escorts 2018 Advance To Related Party Written Off

In FY2009, Escorts Ltd provided ₹25 cr for inter-corporate deposits given by it to other companies indicating that it might be difficult to recover this money.

FY2009 annual report, page 117:

Escorts 2009 Doubtful Inter Corporate Deposits

In the FY2005 annual report, the auditor of the company highlighted that Escorts Ltd has given loans of about ₹11.55 cr to related party companies from which it is not able to get the money back. As per the audit report, in FY2005, Escorts Ltd has stated that ₹6.91 cr is doubtful for recovery.

FY2005 annual report, page 29:

The Company has granted unsecured loans to three companies covered in the register maintained under Section 301 of the Companies Act, 1956. The maximum amount involved during the period was Rs.12.51 crores and balance of the loans granted to such companies was Rs.11.55 crores as at September 30, 2005.

As explained to us, in respect of outstanding loans including interest accrued up to June 30, 2004 the repayments are not forthcoming due to financial constraints of these companies. In view of the aforesaid, no interest has been charged during the period under review. A provision amounting to Rs. 6.91 crores has been made for the amount considered doubtful of recovery.

Further advised reading: How Promoters benefit themselves using Related Party Transactions

In the past annual reports, the company has disclosed that it had given an inter-corporate deposit of ₹0.60 cr to MS Shoes East Ltd in FY1995, which it could not recover.

FY2003 annual report, page 35:

The Company had given Inter-Corporate deposit of Rs. 0.60 crore to M.S. Shoes East Limited which is outstanding for recovery since February, 1995. Interest accrued on this deposit has not been accounted for. Adequate provision amounting to Rs. 0.60 crore has been made.

In respect of Inter-Corporate deposits earlier placed with third parties though the principal amounts have been received, the interest accrued and due on these deposits amounting to Rs.1.14 crores is still pending recovery. Adequate provision amounting to Rs. 1.14 crores has been made

Investors would remember that MS Shoes group was accused of rigging in the stock market in 1995 and it had led to the closure of BSE for 3 days when its promoter, Pavan Sachdeva, defaulted on payment to his broker. There were concerns about a public issue of fully-convertible debentures, which had failed. And there were allegations of investors not getting their money back as both the promoter and the underwriters refused to pay. BSE, Delhi Stock Exchange and SEBI issued show-cause notices to MS Shoes for having misled investors. (Source: India Today, April 15, 1995)

Later in May 2014, Central Bureau of Investigations (CBI) proposed to charge sheet officials of Securities and Exchange Board of India (Sebi), SBI Capital Markets, MS Shoes promoter Pawan Sachdeva and the company, MS Shoes East Ltd. (Source: Business Standard, May 29, 2014)

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

 

6) Default by the subsidiary of Escorts Ltd in the USA:

While reading the annual reports of Escorts Ltd, an investor notices that in FY2009 a subsidiary of the company in the USA, Farmtrac North America LLC is currently in liquidation under the Supreme Court of North Carolina.

FY2009 annual report, page 121:

At the behest of the creditors of Farmtrac North America LIC (FNA) (a subsidiary of the Company) the Superior Court Division of Country of Edgeconbe, North Carolina, USA have appointed a Receiver for FNA, who has taken over all the assets, book & records of FNA accordingly the financial statement of FNAwas not considered for consolidation.

An investor gets more details about the bankruptcy of Farmtrac North America LLC in the annual report of FY2017 of Escorts Ltd. In the disclosures in the FY2017 annual report, the investor learns that Farmtrac North America had received tractors from M/s L S Mtron for sale in the USA; however, it did not pay for these tractors to M/s L S Mtron. As a result, M/s L S Mtron initiated arbitration proceedings against Farmtrac North America.

The court-appointed receiver sold all the assets of Farmtrac North America and distributed them to the creditors. In addition, Escorts Ltd had to pay ₹47.67 cr to M/s L S Mtron.

FY2017 annual report, page 80:

Farmtrac North America, LLC (FNA), previously subsidiary of the Company had entered into a distribution agreement for distribution of tractors manufactured by M/s L S Mtron (LSC). FNA however defaulted in making payments to LSC for the tractors supplied to them. LSC initiated International Arbitration conducted by ICC against the Company. FNA is currently under receivership and its assets had been disposed off by the Receiver and proceeds were distributed to secured creditors. A settlement agreement was executed between EL and LSC during FY 2015-16 and according to such settlement agreement, out of the total amount payable ₹47.67 crores, 50% was paid during FY 2015-16 and balance is payable in three equal yearly installments, there after.

 

Margin of Safety in the market price of Escorts Ltd:

Currently (Dec 17, 2019), Escorts Ltd is available at a price to earnings (PE) ratio of about 16.86 based on the last four quarters consolidated earnings from Oct. 2018 to Sept 2019. The PE ratio of 16.86 does not provide any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.

However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, takes into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.

In the absence of any strength in the business model of the company, even a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.

 

Analysis Summary

Overall, Escorts Ltd seems like a company, which has been able to grow its sales at a growth rate of 10% per annum over the last 10 years (FY2009-19). However, the journey of the company over this growth path has not been smooth. The company witnessed its growth rates fluctuate during this period in cycles and it even witnessed a decline in sales in three out of these last 10 years. The company has faced similar fluctuations in its profitability where its profit margins improved during business upcycle and declined during the down cycles. The main reason for the cyclical nature of the business performance of Escorts Ltd is its high dependence on monsoon, farm income, and general economic activity in the country. Moreover, the company faces intense competition in all its business segments and is not able to pass on the increases in its raw material prices to its customers in a timely manner, which leads to declining profit margins when its input costs increase.

Escorts Ltd has undertaken cost reduction measures over the last 3 years, which have led to significant improvement in its operating margins. However, it seems that the company is not able to retain the benefits of such initiatives for a very long time. Over time, the inefficiencies again creep up into the business processes and the company has to repeatedly take cost reduction measures. In the past, Escorts Ltd had taken significant cost reduction measures in FY2008. It remains to be seen whether the company will be able to hold on to the profit margins improvement of recent years.

Escorts Ltd has been operating with a near-constant manufacturing capacity of tractors since FY2007. The lack of significant capital expenditure over the last decade has ensured that the company could report free cash flow and keep its debt levels under check.

Escorts Ltd is a family-led business with the third generation of the company founders currently leading the company. In the past, the management succession of the company has been smooth. However, it seems that none of the members of the next generation has joined the company as of now. It is advised that investors should monitor whether the fourth generation of founder promoters join the company management.

An investor notices that in the past the company has shown the shares held by entities where the company is the ultimate beneficiary, as the shareholding of the promoters. Currently, it is the shares held by Escorts Benefit and Welfare Trust whereas, in the past, it was the shares held by Escotrac Finance & Investments Private Limited (ESCOTRAC) and Escorts Finance Investment & Leasing Private Limited (EFILL). It is advised that while assessing the net promoter shareholding of the company, investors may make the necessary changes on their own.

An investor notices that Escorts Ltd has kept a large amount (₹142 cr) in the escrow account to indemnify Fortis Healthcare Ltd from contingent tax liability on Escorts Heart Institute & Research Centre Limited (EHIRCL). Escorts Ltd held an 80% stake of EHIRCL at the time of its sale to Fortis in 2005. It is not clear whether the remaining 20% shareholders have kept their share of money in the escrow account for the said contingent tax liability.

In the past, there have been many instances where the capital allocation decisions of the management of the company have failed to generate significant wealth for the shareholders of Escorts Ltd. There have been recent instances of sale of the Auto division of the company at a loss. In the past, the company had sold telecom business at a loss, had to pay a lot of money to compensate fixed depositors of Escorts Finance Ltd, sold Escorts Mahle Ltd at a loss, and lost money on its investments in Hughes Escorts Communications Ltd. The company has made profits on some of the initiatives like healthcare business and its stake in Carraro India Ltd. Otherwise, the result of diversifications in the different fields has not been a pleasant experience for the investors.

The company has written off a large amount of money on account of its USA subsidiary, Escorts Ltd in the USA, (EAMI) as well as default by Farmtrac North America LLC. The company had multiple instances of write-offs on account of inventory, receivables, advances, inter-corporate deposits, advances to related parties etc.

Currently, one of the major business divisions of the company, the construction equipment division, has been producing low returns in comparison to the capital deployed by the company. The construction equipment division has been in existence since 1971; however, it was revived from a continuous streak of losses of 22 quarters in FY2017. It remains to be seen whether the company will continue to report profits in the construction equipment division.

The core business of Escorts Ltd is cyclical in nature and the periods of good performance have always been followed by poor performance, which again has been followed by periods of good performance. The years of good profitability have resulted in poor profitability and vice versa. Therefore, while analyzing the performance of Escorts Ltd, an investor needs to keep this cyclicity of performance in mind. In addition, the investor should keep a close watch on the capital allocation decisions of the company going ahead.

Further advised reading: How to Monitor Stocks in your Portfolio

These are our views on Escorts Ltd. However, investors should do their own analysis before making any investment-related decisions about the company.

You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

I hope it helps!

Regards,

Dr Vijay Malik

P.S:

 

DISCLAIMER

Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of the companies mentioned above in my portfolio.

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