Why We cannot always Trust What Management Claims

Modified on May 22, 2020

Management of any company is its best spokesperson. One of the responsibilities of the management is to create an environment conducive for the business of the company. Therefore, the management does its best to create the best possible positive impression about the company in front of all the stakeholders; be it lenders, equity shareholders, employees, customers, or its suppliers.

Only when the stakeholders feel positive about the company, they offer better terms to the company in their transactions. Lenders give it a lower interest rate. Suppliers give it a cheaper price and a higher credit period. Customers give it a higher price and early payments. In addition, when the company creates a positive perception, then the equity markets reward the company with a higher share price.

Moreover, many of the companies now award employee stock options (ESOPs) to their senior management. It associates the compensation of the management with the rising stock price. This, in turn, makes the management go overboard to indicate to the stock markets that the company is doing great almost all the time irrespective of the fact the actual business position of the company may not be very promising.

While reading the annual reports, an investor would have noticed that the communications of the management are invariably very positive and promising even during the years when the company made losses. Many times, despite very poor financial performance during any year, the positive language in the annual report might give the impression that nothing bad happened to the company.

There have been instances when the positive commentary of the management did not stop even right before when the company became bankrupt.

Therefore, an investor should recognize that it is the job of the management of the company to always give positive communications about the company and its business. It is in their personal and professional interest that they always portray very positive outlooks about the company’s prospects. At the very least, during tough business times, it might be an attempt to lift the stock price or sustain the stock price at higher levels, which might not be justified by the business performance.

An investor should not be surprised when she notices that the owners/managers of the company have come in media channels and say very positive things about the prospects of the company but in private, at the very same time, they sold their personal stock holding in the company. This might be an attempt by them to get as much value out of the company & its share price before the probable poor performance of the company come out and the stock price suffers.

Therefore, an investor would acknowledge that the owners/management of the company would always try to portray a very positive impression of the current position and the future prospects of the company. Even when they acknowledge a poor business position of the company, then it is usually a small mention. However, such acknowledgment comes with long caveats that the future is going to be extremely bright just a few months down the line.

Such permanent positive communications from the management may be due to their permanent optimistic personality or due to their personal monetary interests tied up with the higher stock price.

However, an investor would notice that she might burn her fingers and lose her wealth if she takes her investing decisions based on the positive communications by the management of the company. This is because if the positive picture portrayed by the company is not backed by sound financial performance, then ultimately the market realizes the hidden truth and in turn, the stock price of the company falls.

Therefore, it is in the investor’s own interest that she ignores the overly positive vibes/optimism in the management’s communications and in turn, focuses on the evidence/financial performance to find out the truth to make up her mind about the company.

In our investing journey, we have analysed hundreds of companies for our website as well as for our personal investments. During our analysis, we have come across multiple instances where the claims of the management did not corroborate with the actual financial performance of the company.

Moreover, we also came across situations where the owners/managements made tall promises to the shareholders but such promises never come true. At times, in the hindsight, the investor realises that the management was aware at the time of making those claims that it would not be able to fulfill them. Therefore, many times, an investor may even feel that the management led her into believing something that the management knew was not. So effectively, it may seem that the management misled the investor.

Therefore, an investor would realise that it is only and only her own analysis that can help her make good and informed investment decisions. She has to ignore all the overly positive vibes generated by the company and find out the truth backed by evidence/on-ground financial performance.

The current article is an attempt to present to the investors some of the instances that we came across in our analysis where the claims made by the management did not match with the actual on-ground financial position. In some cases, the management did not meet their stated commitments to the shareholder. At times, in the hindsight, it looked like the management was aware while making the commitment that it would not be able to meet it.

An investor should be specially cautious before relying on management claims because the corporate world contains numerous examples where:

  1. Management is not able to meet its stated commitments/promises to shareholders
  2. Management’s claims about their competitive strength do not match with the financial performance
  3. Management’s explanations of its poor financial performance do not seem logical
  4. Management’s claims about its business performance/practices do not seem logical

These examples should serve as real-life cases stressing that an investor should not trust management’s claims but instead, she should always do and trust her own analysis.

Let us see some such examples.

 

1) Management is not able to meet its stated commitments / promises to shareholders

 

A) Omkar Speciality Chemicals Ltd:

Omkar Speciality Chemicals Ltd is an Indian manufacturer dealing in specialty chemicals and pharma intermediates ranging from organic, inorganic and organo-inorganic intermediates products.

While analysing the company, an investor notices that in FY2017, the promoters of the company had pledged a significant portion of their shareholding to the lenders. During this period, many investors and analysts questioned the high level of pledge of promoters’ stake and repeatedly asked the promoters about their plans to reduce the pledge levels.

However, when an investor analyses the responses of the promoters and the subsequent developments of events, then she realises that at times, the management knew that the promises they were making were not likely to be fulfilled.

 

i) Management of Omkar Speciality Chemicals Ltd not able to meet its stated commitment to shareholders:

The promoters/management of the company has made numerous commitments to stakeholders about the timelines for getting the pledge on promoters’ stake released from the NBFCs:

  • First, in July 2016, during a conference call, the management assured the stakeholders that they would be able to release entire pledge within 4-5 months.

Omkar Speciality Chemicals Ltd Promoter Said Entire Depledging In 4 5 Months 2016 07

  • Second time in August 2016, the management said that it will get the pledge on its shares released by October 2016.

Omkar Speciality Chemicals Ltd 2016 08 Depledging Deferred Prepayment Penalty

  • Third time in November 2016, during another conference call, when the management could not meet the earlier stated timeline, it stated that it would release entire pledge by end of FY2017:

Omkar Speciality Chemicals Ltd 2016 11 08 Depledging To Happen By FY17 End

However, the management could not meet even this deadline as at March 31, 2017, more than 21 lakh shares of promoters were still pledged with lenders.

When an investor reads through the reasons cited by the management for its inability to meet the stated deadlines for the release of the pledge, then she finds the explanation that the loans against shares have a prepayment penalty. Therefore, repaying these loans ahead of schedule would lead to additional cost for the company in the form of the prepayment penalty

Now, an investor is left confused about:

  • whether the management had read the loan agreements that it had signed with the lenders before taking loans against shares
  • if the management knew that these loans against shares had a prepayment penalty, then whether it took the concurrence of lenders about waiving the prepayment penalty before it started assuring the stakeholders that it would soon get the pledge on the shares released.

Whatever be the reason about the prepayment penalty being the road block for the pledged shares to be released, it shows that the management needs to do a bit more homework before it prepares its strategies and communicating it to stakeholders.

 

ii) Management of Omkar Speciality Chemicals Ltd not able to meet its stated commitment to shareholders again:

As mentioned above, we believe that the management of Omkar Speciality Chemicals Ltd has led the company into a liquidity crunch situation by commencing a capital expenditure program, which needed funds far in excess of what the company could produce from operations. Moreover, the deteriorating working capital position further complicated the tight liquidity position of the company.

As a result, the promoters of the company had to resort to selling their personal stake in the company to raise funds to ease out the liquidity position of the company.

However, like in previous cases of assessing the funds requirement for the started capital expansion plan and assessing the feasibility of getting the pledge of shares released, the management has again erred while assessing the exact amount of stake that it might need to sell before the liquidity situation is brought under control.

  • In July 2016, when promoters had a conference call about their stake sale, they communicated to stakeholders that they would not sell any further stake. The promoter stake was at 58% at that time:

Omkar Speciality Chemicals Ltd Promoter Said He Wont Sell More Shares 2016 07

  • The promoter reiterated their resolve of not needing to sell a further stake in the company during the conference all in August 2016:

Omkar Speciality Chemicals Ltd 2016 08 Again No More Selling Plan

  • However, the promoters sold more shares later on and then during the conference call on November 8, 2016, the promoters said that their stake will not go down below the majority mark:

Omkar Speciality Chemicals Ltd 2016 11 08 Promoter Stake Wont Go Down Below Majority

The promoters have resorted to further sale of shares and as per the shareholding pattern of Omkar Speciality Chemicals Ltd at March 31, 2017, available on BSE website, the promoter’s shareholding stands at 41.01%.

The company has been mentioning in its shareholding pattern disclosures that certain shares which are encumbered are not shown by depositories in the name of promoters and these shares though owned by promoters and pledged by the company to lenders, are reflected in the name of the financiers/lenders in the disclosed shareholding patterns.

Such a manner of disclosing shareholding patterns makes it difficult to assess the exact amount of shares, which the promoters own at any point in time, which is not a desirable practice to be followed. For ease of understanding by investors, the disclosures should state clearly about the total number of shares, which are owned by the promoters and out of which the stated number of shares are pledged with lenders so that the interpretations and conclusion are straightforward for the investors.

At March 31, 2017, the BSE website shows that promoters own 84.4 lakh shares out of total 205.8 lakh total shares of the company, which is 41.01% stake. It also mentions that 21 lakh shares of the promoters are pledged, which is 10.2% stake in the company. So if we assume that the disclosed 41.01% stake of the promoters does not include any pledged share, then the total promoter shareholding might get shored up to 51.21% (41.01+10.2).

It is to be noted that this is a mere guess given that the company is not providing the total number of shares actually owned by promoters in its shareholding filings. Therefore, if the stated promoter stake of 41.01% stake includes the pledged shares as well, then it might have happened that the promoter’s stake has already gone below majority mark.

An investor may read the complete analysis of Omkar Speciality Chemicals Ltd in the following article: Analysis: Omkar Speciality Chemicals Ltd

 

2) Management’s claims about their competitive strength do not match with the financial performance

 

A) HEG Ltd:

HEG Ltd is one of the leading graphite electrode manufacturers in India. This case study of HEG Ltd provides good insights into cyclical industries.

While reading the past annual reports of HEG Ltd., an investor notices that year after year, the company has claimed itself as one of the lowest cost producers of graphite electrodes in the world.

FY2009 annual report, page 7:

HEG Ltd FY2009 Lowest Cost Producer Of Graphite Electrodes

FY2011 annual report, page 10:

HEG Ltd FY2011 Lowest Cost Producer Of Graphite Electrodes

Investors expect that when an industry is faced with tough times, then the lowest cost producers in the industry are able to perform better than their competitors do. Investors expect such manufacturers to keep generating profits while their competitors make losses as the sales volumes and sales prices decline because of their lowest costs of production.

However, when an investor observes the performance of HEG Ltd during the downturn phase of graphite electrode industry FY2016 and FY2017 and compares HEG Ltd.’s performance with its Indian competitor, Graphite India Ltd, then she expects that HEG Ltd would report profits and Graphite India Ltd would have reported losses. This is because HEG Ltd is supposed to be one of the lowest cost producers in the world. However, the performance of HEG Ltd and Graphite India Ltd during FY2016 and FY2017 indicates that during this industry downturn, Graphite India Ltd reported profits and it was HEG Ltd, which reported losses in its graphite electrodes business.

HEG Ltd FY2017 annual report, page 115:

HEG Ltd FY2016 FY2017 Graphite Electrode Segment Losses

Graphite India Ltd FY2017 annual report, page 157:

Graphite India Ltd FY2016 FY2017 Graphite Electrode Segment Profits

Looking at the above comparative performance of the two Indian graphite electrode manufacturers, an investor notices that during the business downturn of the industry in FY2016 and FY2017, the claims of HEG Ltd of being one of the lowest cost producers did not reflect in the comparative business performance.

An investor may read the complete analysis of HEG Ltd in the following article: Analysis: HEG Ltd

 

B) Maithan Alloys Ltd:

Maithan Alloys Ltd is an Indian manufacturer of Ferro alloys focusing on the production of Ferro- manganese, Silico- manganese and Ferro- silicon primarily catering the demand of steel manufacturing industry.

While analysing the FY2017 annual report, an investor notices that as per the management, Maithan Alloys Ltd. has a noncyclical business model in a cyclical industry. The management claimed that the company has insulated itself from the sector realities.

FY2017 annual report, page 11, management Q&A section:

Maithan Alloys Ltd Non Cyclical Performance In Cyclical Sector

Moreover, the management claimed in FY2017 that the improvement of EBITDA margins of the company from 7.75% in FY2012 to 22.13% in FY2017 is due to “the culture” of the company.

FY2017 annual report, page 9:

Maithan Alloys Ltd Attributing Ebitda Margin To Culture

However, when an investor observes the financial performance of the company over the years, then she notices that the business performance of the company is cyclical where the operating profit margin (OPM) of the company increased from 12% to 18% over FY2010-FY2011 and then declined sharply to 6% in FY2014. Thereafter, the business witnessed an upcycle and the operating margins increased to 21% in FY2018. However, since last 2 years, the business is in the downcycle and the OPM has again declined to 13% in the last 12 months (Jan-Dec 2019). (Source: Screener)

Maithan Alloys Ltd Financial Performance Operating Profit Margin FY2010 FY2019

Therefore, an investor notices that the claims of the management in FY2017 about the business being non-cyclical or the improvement in the profit margins due to “the culture” of the company were merely exuberance during the up-cycle phase of the industry.

Ferro-alloys industry is dependent on the steel sector for its business and the cyclicity of the steel sector percolates down to its suppliers including ferro-alloy players like Maithan Alloys Ltd.

An investor may read the complete analysis of Maithan Alloys Ltd in the following article: Analysis: Maithan Alloys Ltd

 

3) Management’s explanations of its poor financial performance do not seem logical

 

A) Omkar Speciality Chemicals Ltd:

While analysing the company an investor noticed that the working captial position of Omkar Speciality Chemicals Ltd was deteriorating. The management of the company stated that the delay in the payments by the customers is one of the key reasons for deterioration of working capital. The receivables days of Omkar Speciality Chemicals Ltd had increased from 72 days in FY2012 to 122 days in FY2014.

However, if one notices the list of clients that Omkar Speciality Chemicals Ltd has displayed to investors as part of its April 11, 2016, presentation to investors, then the investor would find that they are all the names of large established companies in pharmaceuticals and chemicals industry in India and across the world.

Omkar Speciality Chemicals Ltd List Of Customers

The investor would appreciate that these companies are a few of the best credit rated companies across the world and we find it difficult to believe that such companies would have delayed payments to their vendors in recent years.

The investor might expect that the Eurozone crisis in last few years (FY2014) might have led the customers based out of Europe to delay the payments to some extent. However, Omkar Speciality Chemicals Ltd is primarily a domestic focused company with sales in India constituting more than 75-80% of its sales and more so Europe is only about 4-5% of its total sales revenue. Therefore, it seems difficult that the delay in payment that too from large well-known customers based out of Europe would have led to such deterioration of receivables.

Therefore, we believe that an investor should explore further the reasons for such significant deterioration of receivables days of the company before she commits her hard earned money to investment.

Moreover, we have always believed that the trinity of “Rising Sales, Rising Receivables and Rising Debt” when grows out of proportion, then it many times indicates cases of aggressive accounting practices.

In the case of Omkar Speciality Chemicals Ltd, the receivables and debt have definitely gone out of proportion of normally expected business levels.

The investor should also explore further about the sudden remarkable improvement of receivables days for the company.

An investor may read the complete analysis of Omkar Speciality Chemicals Ltd in the following article: Analysis: Omkar Speciality Chemicals Ltd

 

4) Management’s claims about its business performance/practices do not seem logical

 

A) Ruchira Papers Ltd:

Ruchira Papers Ltd is a north India based paper manufacturing company dealing in writing & printing paper and kraft paper (packaging paper).

While analysing Ruchira Papers Ltd, when an investor reads the FY2016 annual report, then she notices that the company had proudly communicated to the shareholders that they have been able to maintain their operating margins in the tough paper business. The company claimed that in the paper industry, it is extremely difficult to pass on the increase in raw material costs to the customers. However, as per the company, it had been able to do exactly the opposite indicating that it has been able to pass on the increases in raw material costs to the customers and in turn, maintain its profitability margins.

See pg. no. 4 of the FY2016 annual report:

Ruchira Papers Ltd Profitability Claim

If an investor analyses the comparative performance of Ruchira Papers Ltd with its peers (JK Paper, Tamil Nadu Newsprint, Emami Paper and West Coast Paper), then the investor realizes that neither Ruchira Papers Ltd seems to have been able to maintain its profitability margins nor it is the most cost competitive player in the industry:

Ruchira Papers Ltd Peer Comparison OPM

The above chart clearly depicts that the operating margins of Ruchira Papers Ltd have been fluctuating more or less in the same manner as the margins of most of its peers like JK Paper, West Coast Paper, Emami Paper etc. The only paper manufacturer to stand out in terms of stable margin out of the five players is Tamil Nadu Newsprint & Paper Ltd, which without doubt has the most stable as well as the highest operating profitability margins out of the five key players.

The above comparative analysis also indicates that the Ruchira Papers Ltd is not the most competitive paper producer in the country. Many other players e.g. Tamil Nadu Newsprint & Paper Ltd are more cost competitive than Ruchira Papers Ltd.

An investor may read the complete analysis of Ruchira Papers Ltd in the following article: Analysis: Ruchira Papers Ltd

 

B) Maithan Alloys Ltd:

Maithan Alloys Ltd is an Indian manufacturer of Ferro alloys focusing on the production of Ferro- manganese, Silico- manganese and Ferro- silicon primarily catering the demand of steel manufacturing industry.

While reading the FY2017 annual report of the company, an investor comes a strange management claim that the company does not believe in passing on the increases in its costs (including raw material costs) to the customers.

FY2017 annual report, page 8:

Maithan Alloys Ltd Do Not Pass On Cost Increase To Customers

When companies state that they do not pass on the cost increases to end customers as a strategy, then they imply that they have the ability to do so. However, they indicate that despite having the ability to pass on the increase in costs to their customers, they choose not to do it and, in turn, voluntarily take a hit on their profits.

To assess the truthfulness of this claim, when an investor does further analysis to find out the details of the customers of Maithan Alloys Ltd. In the investor presentation of August 2017, Maithan Alloys Ltd had disclosed the names of its customers.

Maithan Alloys Ltd Customers List

An investor notices that the customers of Maithan Alloys Ltd are large steel companies, which are much bigger in size and have a lot more negotiating power than Maithan Alloys Ltd.

The large steel manufacturers would always have a lot of competing suppliers willing to sell them their products, which limits the ability to Maithan Alloys Ltd to increase prices of its products at its will.

Moreover, the fact that steel manufacturers produce commodity products and therefore, in turn, face stress on their profitability in different phases of commodity cycles. Therefore, it seems obvious that one of the main means for steel producers to keep their profitability intact would be to lower the cost of their raw material purchases as much as possible.

This attempt of steel producers to keep their input costs as low as possible precludes any possibility of vendors like Maithan Alloys Ltd, which supplies a commodity input (Ferro-alloys), to steel producers to get price hike at their own will.

Moreover, India is currently facing an oversupply of Ferro-alloy production. In the management discussion and analysis section of FY2017 annual report, page 27, Maithan Alloys Ltd has mentioned this situation to the shareholders.

Maithan Alloys Ltd Ferro Alloys Overcapacity. Players Shut Shop

Maithan Alloys Ltd has clearly communicated to the shareholders that currently, India has 3.5 MTPA of production capacity of Ferro-alloys whereas the domestic consumption is only 2.3 MTPA. It does not come as a surprise that in such a tough competitive scenario, some of the Ferro alloy manufacturers have closed their operations.

An investor would appreciate that in such tough competitive situation, a supplier (Maithan Alloys Ltd) of a commodity product (Ferro alloys) to very large customers (steel producers), who themselves produce commodity output (steel), would find it difficult to get favourable pricing terms from its customers.

These industry dynamics are clearly visible in the profitability performance of Maithan Alloys Ltd over the years, where its operating profit margin (OPM) has been varying from 3% to 21%.

A look at the credit rating rationale for Maithan Alloys Ltd prepared by CARE Ltd in Oct. 2015 has also highlighted these issues being faced by the company:

Maithan Alloys Ltd Care 2015 Raw Material Fluctations, Dependence On Steel Industry

In light of the above discussion, we do not agree with the disclosure by Maithan Alloys Ltd in its FY2017 annual report that it does not pass on the increases in costs to its customers as a business strategy.

We believe that every business wants to protect its profitability margins and given the capitalistic nature of the private business, the key aim of the companies is to maximize the returns to the shareholders. Sustained profit margins help companies to plan their future capacity additions efficiently whereas fluctuating profit margins make it difficult for providers of capital including lenders and equity investors to gain confidence in the business model of the company, thereby leading to higher cost of capital for the company.

Therefore, when companies state that they do not pass on the cost increases to end customers as a strategy while implying that they have the ability to do so but choose not to do it and in turn take a hit on their profits, we do not believe them.

The inability of the company to pass on the increase in inputs costs to its customers in normal course of business also becomes evident when an investor reads the FY2017 annual report of the company, page 12, management Q&A and gets to know that the company had to shut one of its furnaces in Q2 for one month, as it was not able to make any money on the prices offered by its customers due to increasing costs.

Maithan Alloys Ltd Furnace Shut Due To Ore Prices Increase

Therefore, we believe that the operations of Maithan Alloys Ltd in a commodity business which faces over-capacity is leading to fluctuating profit margins and there is no certainty that the OPM might not decline in future. OPM has declined from the levels of 18% to 3% in FY2008-09 and from 17% to 6% in FY2011-14 in the past and it remains to be seen whether Maithan Alloys Ltd will be able to maintain its profitability margins going ahead.

An investor may read the complete analysis of Maithan Alloys Ltd in the following article: Analysis: Maithan Alloys Ltd

 

C) MBL Infrastructure Ltd:

MBL Infrastructure Limited (MBL Infra) is an Indian infrastructure player focusing on the construction of roads in both build operate & transfer (BOT) as well as engineering, procurement and construction (EPC) segments.

An investor would appreciate that during the initial periods of the first National Democratic Alliance (NDA) government (2014-2019), the economy was growing at a reasonably good speed and there was a significant amount of govt. spending in the infrastructure sector.

As a result, all the companies operating in the infrastructure sector were reporting significant growth in their sales with high profitability.

During this period of the industry upcycle (2014-2016), MBL Infrastructure Ltd had also reported good business performance. In FY2016, the company reported an all-time high revenue of ₹2,343 cr, which was nearly 4-times the revenue the company had in FY2010 (₹637 cr).

While analysing the financial history of MBL Infrastructure Ltd, in FY2016 annual report, the investor notices that the management of the company was effusing with optimism and claimed that by 2020, the company would grow its revenue to ₹5,000 cr.

FY2016 annual report, page 5:

MBL Infrastructure Ltd 5000 Cr Sales By 2020

During the industry upcycle of FY2016, if an investor would have believed the management and taken their claims on the face value, then she would be looking forward to a revenue of ₹5,000 cr by 2020.

However, now in May 2020, when an investor assess the financial performance of MBL Infrastructure Ltd , then she notices that in the last 12 months (Jan-Dec 2019), the company has reported a revenue of ₹141 cr, which is lower than the claimed revenue of ₹5,000 cr by 2020. In FY2019, the company had reported a revenue of ₹154 cr. (Source: Screener)

MBL Infrastructure Ltd Financial Performance FY2010 FY2019

In fact, an investor would notice that the time (FY2016) when the chairman of MBL Infrastructure Ltd had made the claim to reach ₹5,000 cr revenue by 2020, was the peak of the industry cycle. After FY2016, the business of the company is on a continuous downhill.

In the very next year, FY2017, the company reported a decline of operating profit margin (OPM) from 11% in FY2016 to 1% in FY2017.

Therefore, an investor would notice that making financial projections in business is a difficult (many times, futile) attempt where the people like the chairman of an infrastructure company who is well verse with all the sectoral dynamics with a lot of highly relevant industry experience, is not able to forecast the future.

An investor may read the complete analysis of MBL Infrastructure Ltd in the following article: Analysis: MBL Infrastructure Ltd

Looking at the above examples, an investor would appreciate that the management of different companies tends to always project a very optimistic perception of the company in the minds of all the stakeholders. This is their job.

However, an investor should be very cautious before she takes the claims of the management at its face value. She should always question the statements of the management and test their veracity/truthfulness/feasibility/logicalness by doing her own analysis.

It is only by doing her own analysis that the investor would be able to take an independent & informed investment decision.

An investor should always remember that it is her hard-earned money, which is at the stake. She should always keep in mind that the biggest responsibility to safeguard her money lies with herself.

Therefore, she should not rely on statements/claims of the owners and the management without verifying these claims herself and testing those claims at the soundness of logic.

What has been your experience in relying on managements’ claims? Do you take their claims at their face value or you verify each of such claims independently? It would be great if you could share your experiences with the author and the other readers in the comments section below.

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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