How to Identify if Management is Misallocating Capital

It is said the primary aim of a company is to maximise the wealth of its shareholders. Therefore, whenever an investor puts money in any company, then she expects that the management of the company will utilize the money to generate significant profits for its shareholders.

Many times, companies generate good returns for investors. However, some times, companies fail to meet these expectations and as a result, end up wasting the money of shareholders.

Investors need to be very cautious before putting money in companies that have a history of losing shareholders’ money. In business language, it is called as poor capital allocation.

Investors should always study all the available annual reports of the company in detail to understand its history of financial management. The annual reports contain all the details about the various investment decisions taken by the company and its management. Annual reports also contain the data to assess the outcomes of these investment decisions.

Therefore, a careful analysis of annual reports by an investor can help her identify whether a company has made good use of shareholders’ money or it has wasted this precious resource.

Our experience of analysing hundreds of companies both for the website and for our personal investments has brought forward many instances where companies did not make good use of shareholders’ money. The management of many companies made investments where they could not recover even the investment value. As a result, the shareholders had to pay a price.

The current article is an attempt to highlight a few of the cases that we have come across where companies could not utilize shareholders’ money efficiently. These examples also aim to highlight the sections in the annual report from where investors can get the relevant information to assess the capital allocation decisions of the companies.

In our analyses of companies, we have come across instances of poor capital allocation in different forms:

• Many companies could not generate returns for their shareholders even in their main business of operations
• Many other companies ventured into unrelated business areas and then lost money
• Frequently, companies entered into derivative transactions where the management did not understand the true risk and as a result, lost huge money of shareholders
• Some other companies generated surplus cash from their main business but invested it in financial instruments where they lost money
• A few companies did acquisitions when the main business was doing good and then these acquired divisions consumed significant cash without giving any profits

Therefore, investors would notice that there are more than one way in which companies can waste shareholders’ money. The investor needs to read the annual report and analyse every decision where the management of the company decides to invest shareholders’ money.

Investors need to analyse each decision of the company like capacity expansion (capital expenditure), acquisitions of new businesses, investment in subsidiaries and joint ventures, investment of surplus money in financial instruments etc.

Now, let us see some examples and understand how an investor can identify instances of poor capital allocation by the companies.

Companies generate poor returns in their main line of business

Many times, companies are not able to run their core business efficiently. As a result, investors notice that the money invested by the company in its business is not able to create returns for their shareholders. Investors need to be very careful in their analysis and investment decisions related to such companies where the main business is producing poor returns.

Let us see some examples.

1) Globus Spirits Ltd:

Globus Spirits Ltd is a manufacturer of country liquor (IMIL) and bottler for Indian made foreign liquor (IMFL) having a presence in multiple states with distilleries in Rajasthan, Haryana, West Bengal, and Bihar. The company owns IMIL brands like Nimboo, Narangi, Heer Ranjha, and Ghoomar.

When an investor analyses the returns generated by Globus Spirits Ltd on its assets, then she notices that currently, Globus Spirits Ltd is able to generate a profit before tax (PBT) of ₹33 cr. from its net fixed assets (NFA) of ₹574 cr. in FY2019.

This amounts to a pre-tax return of 5.6% on the money invested in plants & machinery. In the past, the pre-tax return generated by the company on its assets was even lower at 1.64% (FY2018), 2.68% (FY2017) and 2.73% (FY2016).

Investors would note that the pretax returns of 1.64% to 5.6% are less than the risk-free pre-tax return of 6.2% available on the Government of India Securities 10-Years (2029) (Source: RBI Website on April 20, 2020).

An investor would note that a pretax (PBT) return earned by Globus Spirits Ltd on its assets is very low when compared to other hassle-free and risk-free avenues like govt. securities.

An investor would appreciate that Globus Spirits Ltd will have to improve its business efficiency to generate profits to meet the minimum benchmark of the risk-free return offered by Govt. of India securities.

Alternatively, an investor may consider that unless an investment in the business is able to generate returns higher than the risk-free returns provided by Govt. Securities, there is no point in taking the business risk of investing money in creating large plants & machinery and taking the added stress of selling the produce in the market. In such situations, an investor may simply sell all its plant & machinery and invest the money in govt. securities or fixed deposits and earn a higher return.

An investor would note that the other listed player in the country liquor segment, GM Breweries Ltd has a pretax business return on its net fixed assets of about 100%. In FY2018, GM Breweries Ltd had a profit before tax of ₹111 cr. whereas it has net fixed assets of ₹111 cr. This is in sharp contrast to Globus Spirits Ltd., which in FY2018 has a profit before tax of ₹10 cr. on net fixed assets of ₹609 cr.

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

2) Navkar Corporation Ltd:

Navkar Corporation Ltd is an Indian container freight station (CFS) player with operations at Jawaharlal Nehru Port Trust (JNPT) and Vapi.

When an investor analyses the returns generated by Navkar Corporation Ltd on its assets, then she notices that currently, Navkar Corporation Ltd is able to generate a profit before tax (PBT) of ₹69 cr. from its net fixed assets (NFA) of ₹1,958 cr. in FY2019. This amounts to a pre-tax return of 3.5% on the money invested in net fixed assets.

An investor would notice that a pretax return of 3.5% is low when compared to a risk-free pre-tax return of 6.2% provided by Government of India Securities 10-Years (2029) (Source: RBI Website on April 20, 2020).

An investor would note that a pretax (PBT) return of 3.5% earned by Navkar Corporation Ltd on its assets is very low when compared to other hassle-free and risk-free avenues like govt. securities.

As mentioned above, an investor may think that unless investment in the business is able to generate returns higher than the risk-free returns provided by Govt. Securities, there is no point in taking the risks of running a business. In such situations, an investor may simply sell all its plant & machinery and invest the money in govt. securities or fixed deposits and earn a higher return.

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

3) Ion Exchange (India) Ltd:

Ion Exchange (India) Ltd is an Indian company involved in water treatment plants, wastewater processing, sewage treatment, packaged drinking water, and seawater desalination etc.

While analysing Ion Exchange (India) Ltd, in FY2011, the investor gets to know that the company is planning to conduct a corporate restructuring in which it would transfer its project division involved in executing domestic turnkey projects to a wholly-owned subsidiary, Ion Exchange Projects and Engineering Limited (IEPEL).

FY2011 annual report, page 10:

RESTRUCTURING OF BUSINESS: The Board of Directors at their meeting held on 22nd February 2011, accorded their approval for the proposal to sell its Project Division (covering domestic turnkey projects) on a going concern basis to Ion Exchange Projects and Engineering Limited, a wholly owned subsidiary company.

The restructuring exercise was completed in the next financial year.

As the domestic projects division is now present in a separate subsidiary, Ion Exchange (India) Ltd started to report its financial performance in each of its subsequent annual reports.

A) Performance of domestic turnkey projects division of Ion Exchange (India) Ltd:

While analysing this financial performance, an investor notices that Ion Exchange Projects and Engineering Limited (IEPEL) has never made any profits at least since FY2011 until FY2018.

• FY2011: loss of ₹5.6 cr.
• FY2012: loss of ₹8.5 cr.

FY2012 annual report, page 71:

• FY2013: loss of ₹0.6 cr.
• FY2014: loss of ₹5.5 cr.

FY2014 annual report, page 71:

• FY2015: loss of ₹4.5 cr. (FY2015 annual report, page 147)
• FY2016: loss of ₹9.1 cr. (FY2016 annual report, page 148)
• FY2017: loss of ₹6.9 cr. (FY2017 annual report, page 149)
• FY2018: loss of ₹0.6 cr. (FY2018 annual report, page 190)

The company reported a minuscule profit of ₹0.3 cr in FY2019.

FY2019 annual report, page 190:

Until now, Ion Exchange (India) Ltd has made a total investment of about ₹39 cr in the company in the form of equity ₹14.2 cr and loans of ₹24.8 cr.

FY2019 annual report, page 110:

FY2019 annual report, page 112:

In addition, Ion Exchange (India) Ltd has given guarantees of about ₹27.8 cr of loans taken by the company.

FY2019 annual report, page 112:

Therefore, an investor may notice that the domestic turnkey projects business of the company under Ion Exchange Projects and Engineering Limited has almost never made any profits on the business done by it despite a direct investment of about 39 cr and indirect investment (guarantee) of ₹28 cr.

Such business performance of the water treatment turnkey projects division of the company, which has been specializing in the water treatment business for more than 5 decades, indicates that there seem to be fundamental issues with this business division.

B) Performance of consumer products division of Ion Exchange (India) Ltd:

While analysing the segmental performance of the company, an investor notices that Ion Exchange (India) Ltd has a business division dealing in water purification products for retail/institutional customers under its consumer products division.

In the FY2019 annual report, the investor notes that this division has made losses in the last two years.

• FY2019: loss of ₹2.68 cr
• FY2018: loss of ₹3.00 cr

FY2019 annual report, page 168:

Similarly, when the investor reads the history of the financial performance of this division in the available annual reports since FY2011, then the consumer notes that the division has only rarely reported profits and that too very low amount of profits in comparison to the large losses in other years.

• FY2017: loss of ₹3.49 cr
• FY2016: loss of ₹3.67 cr
• FY2015: loss of ₹1.57 cr
• FY2014: loss of ₹0.25 cr
• FY2013: profit of ₹2.75 cr
• FY2012: loss of ₹1.96 cr
• FY2011: profit of ₹0.66 cr
• FY2010: loss of ₹0.12 cr

An investor would note that in the last 10 years (FY2010-2019), the consumer products division has reported losses in 8 out of 10 years. An investor may look at this performance in the light that the consumer brand of the company “Zero B” is in existence since 1986 and the company is making consumer products since 1998.

June 2019 presentation of the company, page 10:

1986: Zero-B Launched with Suraksha tap attachment.

1998: Consumer products manufacturing started at Goa.

Therefore, an investor may note that despite creating the consumer brand Zero B more than 30 years back and working towards creating a sustainably profitable business out of it for the last 20 years, the company is not able to generate profits out of the same.

Moreover, while answering a query of an analyst on the consumer products division, the management of the company disclosed that is still uncertain when the consumer products division will turn profitable.

Conference call, Nov. 2019, page 8:

Arun Kumar: And do we expect profits next year then or the year after?

Management: It’s a difficult guess to make, we are hoping we will be close to achieving that sooner. But on a conservative basis, I would say that probably next year.

Going ahead, an investor needs to monitor the performance of the consumer products division closely whether it starts generating profits and in turn returns on the capital invested in this business. Otherwise, it may be a case of poor capital allocation by the company.

An investor may read the complete analysis of Ion Exchange (India) Ltd in the following article: Analysis: Ion Exchange (India) Ltd

Therefore, looking at the above cases, an investor would notice that there have many instances where companies are not able to generate a good return for their investors in their main lines of business in which they might be operating for many decades.

As a result, investors need to assess capital allocation ability of the management of companies carefully before making an investment decision.

Companies invest in subsidiaries that generate poor returns

Frequently, companies start new projects and business divisions in their subsidiaries. Many times, the subsidiaries consume a lot of money in terms of equity investments, and loans & advances etc., and in return, are not able to generate good profits from the business.

However, it becomes difficult for the investors to quickly assess the performance of individual subsidiaries when they only look at the summary standalone and consolidated financials. This is because, in both the standalone and consolidated financials, the profits of the main business of the company mask the poor performance by subsidiaries, if any.

Therefore, to understand the outcome of investments in each of the subsidiaries, an investor has to study the annual report in detail to understand the financial performance of each of the subsidiaries, individually.

Reading the annual report, in-depth, becomes essential because, many times, companies disclose critical information about the subsidiaries in the detailed notes & paragraphs to the financial statements, which are not captured in the summary financials provided by various online sources.

Let us see some examples where the companies invested money in subsidiaries and subsequently reported losses in the subsidiaries.

In the examples shared below, investors should focus on the sections of the annual reports from where she would be able to gain the relevant information to assess the performance of subsidiaries.

1) Escorts Ltd:

Escorts Ltd is an Indian company involved in the manufacturing of tractors & agricultural machinery, construction equipment and railways equipment.

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:

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)

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:

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 prevented it from 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;

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:

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

FY2004 annual report, page 8:

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.

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)

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:

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.

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:

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.

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

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. The 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.

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.

Therefore, an investor would notice that Escorts Ltd has over the years created many subsidiaries and ventures in which it invested shareholders’ capital. However, in many of these cases, the company could not generate returns for its shareholders.

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

2) Quick Heal Technologies Ltd:

Quick Heal Technologies Ltd is an Indian company providing security software solutions like antivirus, antispyware, antimalware etc. to retail consumers under brand Quick Heal and to enterprise & govt. segment under brand Seqrite.

While analysing Quick Heal Technologies Ltd, an investor notices that over time, the company has done many investments in subsidiaries as well as investments in other companies like start-ups in order to generate value for its shareholders.

However, when an investor analyses the current state of these investments, then she notices that almost all of these investments have lost value in recent years. Some of the investments have led to complete loss whereas others have led to a partial loss of the investments.

FY2019 annual report, page 177:

Further advised reading: Understanding the Annual Report of a Company

As per the above data, Quick Heal Technologies Ltd has suffered a complete loss of its investments in startups:

• Smartalyse Technologies Private Limited and
• Wegilant Net Solutions Private Limited.

Moreover, it has suffered a significant loss in the value of its investments in almost all of its subsidiaries:

• Quick Heal Technologies Japan K.K., Japan
• Quick Heal Technologies America Inc., USA
• Quick Heal Technologies (MENA) FZE, UAE
• Quick Heal Technologies Africa Limited, Kenya

Over the years, Quick Heal Technologies Ltd has recognized losses due to these decisions as exceptional items in the profit and loss statement.

FY2018 annual report, page 193:

Exceptional items includes impairment of investment in wholly owned subsidiaries amounting to INR 75.09 Million (March 31, 2017: INR 6.33 Million). It also included INR Nil (March 31, 2017: INR 37.80 Million) towards impairment of financial assets being loan to and interest receivable from Wegilant Net Solutions Private Limited.

In light of such frequent losses in the investment decisions made by the company, an investor should keep a close watch on the future investments to be done by the company. An investor would appreciate that ideally investment decisions/capital allocation decisions should generate positive value for shareholders and not losses on almost all the investment decisions.

An investor may read the complete analysis of Quick Heal Technologies Ltd in the following article: Analysis: Quick Heal Technologies Ltd

3) Finolex Cables Ltd:

Finolex Cables Ltd is a manufacturer of cables, fans, switches etc. The company specializes in electrical, power distribution and communication optical fibre cables.

While analysing the company, an investor notices that Finolex Cables Ltd has been generating a lot of cash from its core business of cables manufacturing. As a result, the company has a significant position of cash & investments even after it has repaid almost all of its borrowings.

The presence of surplus funds has led the company to make investments in many new business segments either within the company or by way of ventures with other partners. Such initiatives include:

• the venture to manufacture high voltage cables power cables (Finolex J-Power Systems Private Ltd (FLPS) with J-Power Systems Corporation of Sumitomo Electric Industries of Japan)
• the venture to manufacture optical cables (Corning Finolex Optic Fibre Pvt. Ltd with Corning Inc., USA)

However, these ventures have not led to any significant value addition for the equity shareholders of Finolex Cables Ltd. FJPS has been loss-making ever since its incorporation and as a result, Finolex Cables Ltd has to invest more & more capital to keep the company afloat. As highlighted by company management, FJPS is facing very severe competition in tendering & other business aspects.

Similarly, Corning Finolex Optic Fibre Pvt. Ltd has also not led to any significant value addition to the shareholders of Finolex Cables Ltd.

As per FY2017 annual report of Finolex Cables Ltd, page 52, FJPS has contributed a loss of ₹12.4 cr. to the consolidated financials of the company and Corning Finolex Optic Fibre Pvt. Ltd has been a no-profit-no-loss position for the year.

Finolex Cables Ltd has been writing off its past investments in FJPS and is continuously making additional investments in the company. The FY2017 annual report, page 84:

An investor needs to assess whether these ventures are a result of the trial & errors attempted by the management of Finolex Cables Ltd only because of the availability of surplus funds with the company. An investor also needs to assess whether continued equity contribution to FJPS by the company is akin to throwing good money after bad.

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

In the above discussion, an investor noticed that many times, companies invest shareholders’ capital in various business initiatives by way of subsidiaries and joint ventures. However, some times, companies lose money in these ventures. However, to assess the true financial performance of these ventures and to ascertain the capital allocation efficiency of the management of the companies, an investor needs to read annual reports in detail.

Companies make acquisitions that perform poorly and lose shareholders’ money

Many times, when the main business of companies is doing well and they generate surplus cash, then they acquire other companies. Frequently, investors observe that such acquisitions end up consuming a lot of cash and resources of the company and the time of the management but do not produce commensurate profits in return.

An investor should assess companies, which do many acquisitions on a regular basis, very carefully before they make any investment decision.

Let us see examples.

1) Ashok Leyland Ltd:

Ashok Leyland Ltd, a part of the Hinduja Group, is one of the leading manufacturers of commercial vehicles in India. Ashok Leyland Ltd specializes in medium & heavy commercial vehicles and buses. The example of an acquisition by the company in Optare Ltd, a UK based bus manufacturer, where it initially bought 26% stake in FY2011 and then increased it to 99.08% by FY2018, is a classic example where the management kept putting good money after bad money.

In the FY2011 annual report, the chairman of Ashok Leyland Ltd intimated its shareholders that the company has bought out a 26% stake in Optare Plc. UK.

FY2011 annual report, page 2:

Your Company acquired a 26% controlling stake in Optare plc, U.K. a reputed bus manufacturer with a proven experience in hybrid and electric vehicles. They manufacture a range of urban buses with integral architecture including the iconic Solo midi bus range. The acquisition will further strengthen the leadership position of your Company in the domestic market and is also expected to open up new frontiers in the developed markets.

The management of the company seemed very optimistic about the acquisition and expected that it would help them in both Indian and overseas markets.

Ashok Leyland invested about ₹50 cr to acquire 26% of Optare Plc in FY2011.

FY2011 annual report, page 66:

The next year, in FY2012, Ashok Leyland Ltd increased its stake in Optare Plc from 26% to 75.1%.

FY2012 annual report, page 45:

During the year, your Company along with the investment arms have increased their stake to 75.1% (from earlier 26%) in Optare plc UK.

Upon further analysis, an investor finds that by FY2012, Ashok Leyland Ltd had invested ₹58 cr in equity, ₹37 cr in loan to Optare, and given an additional guarantee of ₹97 cr to Optare.

The FY2014 annual report indicated that until then, Ashok Leyland Ltd had invested a total amount of ₹329 cr in its equity shares and ₹50 cr as loans.

FY2014 annual report, page 66:

FY2014 is also an important year in the history of Ashok Leyland Ltd because, from FY2014, the company started reporting consolidated financials. As a result, the investors could now assess the performance of subsidiaries of the company. (Please note that the website of Ashok Leyland Ltd provides the annual reports of its subsidiaries only from FY2015 onwards. Until FY2014, only the annual report of Ashok Leyland Ltd is provided).

Investors noticed that in FY2014, the three Optare group companies disclosed in the annual report has reported net losses. FY2014 annual report, page 118 (₹ Lac):

• Optare plc* (183.57)
• Optare UK Limited (303.64)
• Optare Group Limited (3,589.95)

Put together, the three Optare companies had reported a loss of about ₹40 cr in FY2014.

In FY2015, Optare Plc and its subsidiaries reported a net loss of ₹30 cr (FY2015 annual report, page 144).

An investor realizes that despite high hopes on the acquisition in FY2011 and subsequent additional investments in Optare via equity and loans as well as guarantees, the Optare group companies were reporting losses until FY2015.

In FY2016, Optare Plc along with its subsidiaries reported a loss of ₹92 cr (FY2016 annual report, page 147).

As a result, it does not come as a surprise to the investor that when she notices that in FY2016, Ashok Leyland Ltd acknowledged the poor fate of this investment and in turn, provided about ₹150 cr for impairment/loss on its investments in Optare.

FY2016 annual report, page 42:

Your Company, after studying its intrinsic value of investments in Joint Ventures (JV)/Associates/Subsidiaries has made an impairment provision of ₹ 107 Crores towards Albonair Germany, ₹ 150 Crores towards Optare Plc, UK and ₹ 5 Crores towards Albonair India.

The impairment provision done by Ashok Leyland Ltd serves as an acknowledgement that the investment in Optare has turned bad and it is not working out as planned. This seems normal as businesses need to invest in growth opportunities and many times, these decisions may not work as expected. Whether the acknowledgement of impairment would have taken 5 years (from FY2011 to FY2016) or it should have come earlier all the while when Optare was making losses, can be a subject of debate. However, it is better late than never.

However, what comes as a surprise to the investor that despite acknowledging that the investment in Optare has turned bad, Ashok Leyland Ltd put an additional ₹169 cr in Optare in FY2016 in the form of loans.

FY2016 annual report, page 106:

This looks like a situation of throwing good money after bad money, which is not good capital allocation.

In FY2017, Optare Plc along with its subsidiaries reported another loss of ₹100 cr. (FY2017 annual report, page 201).

As a result, Ashok Leyland Ltd had to make provisions/acknowledgement of loss of additional ₹526 cr for its investments/loans/obligations for Optare Plc.

FY2017 annual report, page 50:

Your Company, after studying its intrinsic value of investments in Joint Ventures (JV)/Associates/Subsidiaries has made an impairment provision of ₹121 Crores towards Albonair GmbH and Albonair India, in addition, ₹526 Crores has been provided towards Optare Plc. for the loans and obligation.

In FY2018, Optare Plc along with its subsidiaries reported another loss of ₹90 cr. (FY2018 annual report, page 179.

By this time, an investor would acknowledge that the losses in Optare year after year, stop looking surprising to the investor now. However, what comes as a surprise that in FY2018, Ashok Leyland Ltd further invested ₹248 cr in Optare Plc.

FY2018 annual report, page 44:

Your Company has invested in cash ₹ 248 Crores in Optare Plc., ₹ 494 Crores in Hinduja Leyland Finance and ₹ 4 Crores in Ashok Leyland Defence Systems. Thus, in all your Company had invested ₹ 746 Crore in cash in Joint Venture (JV) / Associates / Subsidiaries during the year.

This again seems like a situation of throwing good money after bad money. Despite a continuous streak of losses of Optare Plc, in FY2018, Ashok Leyland Ltd instead of attempting to recover its investments had put in additional commitment in Optare and increased its stake in the company from 75.11% to 99.08%.

FY2018 annual report, page 16:

During the year under review, the Company has increased its stake in Hinduja Leyland Finance Limited from 57.20% to 61.85% and in Optare PLC from 75.11% to 99.08%.

The increase in the stake of Ashok Leyland in Optare Plc in FY2018 seems to be due to the conversion of the loan worth ₹263 cr into equity.

FY2018 annual report, page 127:

In FY2019, Optare Plc along with its subsidiaries reported another loss of ₹85 cr. (FY2019 annual report, page 246).

However, an investor notices that in FY2019, Ashok Leyland Ltd invested an additional ₹18 cr in Optare Plc.

FY2019 annual report, page 52:

Your Company has invested ₹124 Crores in Hinduja Leyland Finance Limited, ₹43 Crores in Ashok Leyland (UAE) LLC, ₹18 Crores in Optare Plc, ₹10 Crores in Albonair (India) Private Limited, ₹6 Crores in Ashley Aviation Limited, ₹1 Crore in Ashley Alteams India Limited and ₹1 Crore in other Companies. Thus, your Company has invested ₹203 Crores in cash in Joint Venture/Associates/Subsidiaries during the year.

By now, an investor realizes that what started in FY2011 as a small investment of ₹50 cr in Optare Plc for taking 26% stake has by FY2019, ballooned into losses of about ₹1,000 cr for the shareholders of by Ashok Leyland Ltd. The shareholders have lost almost all the money put by Ashok Leyland Ltd in Optare Plc by way of equity or loans and are now holding 99.08% of the company.

Despite a significant amount of investment of money and management time, Optare Plc has never reported profits at least since FY2014 when Ashok Leyland Ltd started reporting consolidated financials and the shareholders started to know the performance of its subsidiaries.

However, instead of cutting down their losses and attempting to recover whatever little can be done from Optare; the management is continuously putting in more money in Optare year after year. It seems like a case of continuously throwing good money after bad money.

Moreover, when the investor analyses the February 2020 conference call of Ashok Leyland Ltd to discuss the results of Q3-FY2020, then she notices that the management of the company is looking to throw an additional ₹80-90 cr. after Optare. The management of Ashok Leyland Ltd is still trying to turnaround the company.

Q3-FY2020 results conference call, February 2020, page 9:

Gopal Mahadevan: Yes. The investments in subsidiaries is the main subsidiary where we have a challenge is in Optare, and there, we spent about £10 million per annum approximately. So, that is about 80 Crores, 90 Crores. Now we are trying to turn around the company.

To an investor, Optare Plc seems like a case where the previous shareholders of Optare have handed over the bag to the shareholders of Ashok Leyland Ltd and exited the company.

It remains to be seen whether the management of Ashok Leyland Ltd is now able to turnaround Optare Plc despite spending & losing hundreds of crores of rupees and about a decade of management’s time. Or how much more time and investment, the management of Ashok Leyland Ltd throws behind Optare Plc before they realize that sometimes, it is better to cut your losses and move ahead.

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

2) Cyient Ltd:

Cyient Ltd is an information technology (IT) services company providing engineering services to industries like aerospace, defence, transportation, semiconductor etc.

While analysing the business performance of the company over the years, an investor notices that profitability margins of the company are on a decline in recent years. While assessing the reasons for the declining profit margins, an investor gets to know about the management decision of entering design-led-manufacturing business by acquiring a company, Rangsons Electronics Private Limited (REPL).

Cyient Ltd acquired REPL in February 2015 with an aim to provide an additional value-added solution to its customers to gain a higher share of the revenue from them. However, ever since, it acquired REPL (later renamed as Cyient DLM Pvt. Ltd); Cyient Ltd has witnessed a decline of its profit margins.

The key reason for the reduced profitability of Cyient Ltd after the acquisition of REPL has been the very low-profit margins of its design-led manufacturing (DLM) business. The services business of Cyient Ltd makes an operating profit margin of about 15% whereas the DLM business made an operating profit margin of about 2-4%.

Cyient Ltd has been suffering from the DLM business ever since it acquired it in 2015. The management has year after year communicated to shareholders that the DLM business has not performed as per their original expectations.

FY2016 annual report, page 21:

Our newly acquired Manufacturing business did not perform to expectation given the cyclical nature of that part of the business

Credit rating agency CRISIL, also highlighted in its report of the company in 2016 that the profit margins of Cyient Ltd have declined due to the integration of low-profit margin business of design-led manufacturing of REPL.

Though operating margin has moderated during 2015-16 (refers to financial year, April 1 to March 31) due to integration of the comparatively less profitable business of Rangsons Electronics Pvt Ltd (Rangsons), CRISIL believes this will not have a significant impact on cash flows from operations considering healthy revenue growth during the year driven by acquisitions

Crisil repeated this observation in its credit rating report for Cyient DLM Pvt. Ltd in August 2017.

Profitability of Cyient has declined to about 13% during fiscal 2017 from 14% during fiscal 2018 but is largely due to cross currency fluctuations and lower profitability of Cyient DLM.

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

In FY2018, the management of Cyient Ltd accepted that the satisfaction level of customers of DLM business is not good and it needs improvement.

FY2018 annual report, page 22:

For FY18, our Customer Satisfaction score was 58.1 against the industry average of 55.2. While we fared well on the services side, we have an opportunity to improve the score for the DLM business.

Despite running the business for about four years even in FY2019, Cyient could not make a meaning profit contribution from its DLM business, which is a continuous drag on its profit margins. In FY2019, the DLM business reported operating profit margins of 4%.

Investors’ presentation, April 2019, page 9:

Operating Profit Margin @ 14.0%

• Services Margin @ 15.3%
• DLM Margin @ 4.0%

Investors may note that the DLM business is able to report profits only at the operating margin level. When an investor analyses the DLM business at net profit level, then she notices that it made losses in FY2019.

FY2019 annual report, page 240:

The DLM business has made losses in FY2018 as well.

FY2018 annual report, page 199:

Even in the Q1-FY2020, DLM has reported losses at EBIT (earnings before interest and taxes) level.

Conference call, July 2019, page 1:

The DLM EBITDA margin was at 1.9%, down to 260 basis points year-on-year. DLM EBIT margin stood at a negative 0.3% for the quarter, which translates to 10 basis points margin expansion on a year-on-year basis, and a 250-basis points margin contraction on a quarter on quarter basis.

Therefore, an investor would notice that Cyient Ltd operates in the tough competitive information technology business where the customers continuously put pressure on the company to reduce prices. In such a tough business environment, maintaining operating profit margins is difficult. The situation has been compounded by the poor performance of its newly acquired design-led-manufacturing business, which is making net losses even after four years of acquisition.

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

Therefore, investors would appreciate that many times, acquisitions done during good times do not perform on expected lines and become a drag on the business performance of the company.

An investor should be very cautious while analysing companies that keep doing frequent acquisitions.

Companies diversify in unrelated business areas and lose shareholders’ money

Similar to acquisitions, many times, when the main business of companies is doing well, then they utilize their surplus cash to venture into unrelated business areas. Most of the time, the management of the company is not able to successfully handle the unrelated business activity. As a result, they end up losing the money of the shareholders.

Let us see some examples.

1) Bodal Chemicals Ltd:

Bodal Chemicals Ltd is an Indian manufacturer and exporter of dyestuff, dye intermediates and basic chemicals.

While analysing the history of the company by reading past annual reports, an investor would notice that the Bodal Chemicals Ltd has taken multiple attempts to diversify into other businesses. However, until now most of their diversification attempts have not seen good results.

While analysing the past investment decisions of the company, an investor comes across multiple instances where the promoters/management decided to implement a business strategy but it had to reverse the decision after failing to implement the strategy.

Let us see a few such decisions:

A) Agriculture based businesses/ Agro-products:

In FY2010, the company disclosed its plans to set up a wholly-owned subsidiary company as Bodal Agrotech Ltd. (BAL) to focus on technology-based agriculture businesses. The management disclosed its plans to start a fertilizer plant of Single Super Phosphate (SSP) as the first project of BAL.

The FY2010 annual report, page 5 & 6:

Considering the future growth planning and as a part of diversification strategy of the company, your company has identified the Technology based Agricultural Business for exploiting the opportunities for diversification……The Agriculture business covers area of contract farming, fertilisers like SSP, plant development, agriculture equipments etc…..To exploit said business, “Bodal Agrotech Ltd” the wholly owned subsidiary company has been floated.

The Company expects that SSP plant will generate Rs. 240 crore Turnover and having 20 to 25% operating profitability margin. The construction work of SSP plant will be started after necessary formalities/approvals. Once the construction work of SSP plant start, it will take a time of 15-18 months for commencement of production.

The management projected that BAL will be able to generate revenue of ₹240 cr. once the SSP fertilizer plant is functional.

In FY2011, the management informed the shareholders that the SSP plant is still under process; however, BAL has started the business of trading in vegetables, fruits, and food grains.

The FY2011 annual report, page 9:

Bodal Agrotech Ltd.(BAL): This company has been incorporated in the month of August, 2010, as wholly owned subsidiary company. The company has started its business in the area of trading of vegetables, fruits, and foodgrains initially. BAL has also acquired business of one retail store, in Ahmedabad, for direct selling of vegetables and fruits to retail customers and BAL also plans to open more retail stores, with same line of business, in the name of “Bodal Agro” in Ahmedabad city.

BAL plans to manufacture Single Super Phosphate (SSP)-Fertilizer with 3.5 lacs MTPA capacity near by our existing manufacturing facility of Sulphuric Acid, Dye Intermediates and Dyes, located at our Padra unit, Vadodara. During the year, BAL has applied to government authorities/agencies for licenses/approvals of SSP project..

In FY2013, the company intimated the shareholders that after looking at the losses incurred by it in the agro-products business, the management has decided to stop all the business activities of BAL including the trading/retailing of vegetables, fruits etc. as well as the SSP plant.

By reviewing losses and comparatively small turnover, your company has, at present, discontinued all the activities of Bodal Agrotech ltd. for the time being. This will also enable the management to concentrate more on the main company i.e. Bodal Chemicals Ltd.

The management cited that closing the operations of BAL would allow it to focus on the main company i.e. Bodal Chemicals Ltd. Investors would appreciate that venturing into trading and retailing of vegetables & fruits may be a case of moving out of the area of expertise.

B) Tissue culture, contract research, microbial bio-fertilizers, genetic research:

Bodal Chemicals Ltd entered into the business of culture plants, microbial bio-fertilizers, genetic improvement of crops and contract research in FY2011 by acquiring a 51% stake in Sun Agrigenetics Pvt. Ltd (SAPL) through its subsidiary Bodal Agrotech Ltd. (BAL).

The FY2011 annual report, page 17-18:

BAL has acquired 51% equity stake in Sun Agrigenetics Pvt. Ltd.(SAPL) during January, 2011. Hence, SAPL becomes subsidiary of BAL.

SAPL is in business of production of tissue culture plants, Microbial bio-fertilizers, Genetic Improvement of crops, contract research etc. SAPL has tissue culture laboratory with production capacity of 2 million plants p.a. Green House and Nursery complex spread over an area of 70,000 sq.ft. R&D centre recognized by Department of Science and Industrial Research (DSIR), Gov. of India, New Delhi. SAPL plans to expand its capacities and also launch new products through R&D.

We expect that these two companies will not contribute much in consolidated top line and bottom line for the financial year 2011-12 but it will contribute significantly for the financial year 2012-13.

In FY2013, the company said that it plans to conduct research & development in SAPL and launch new products.

The FY2013 annual report, page 5:

Sun Agrigenetics (SAPL): SAPL is fellow subsidiary of BCL. SAPL is in business of production of Tissue Culture plants, Microbial. bio-fertilizers, Genetic Improvement of crops, contract research etc. SAPL has tissue culture laboratory with production capacity of 2 million plants p.a. Green House and Nursery complex spread over an area of 70,000 sq.ft. R&D centre recognized by Department of Science and Industrial. Research (DSIR), Gov. of India, New Delhi. SAPL plans to launch new products through R&D.

However, an investor would notice that within the next two years, Bodal Chemicals Ltd sold off its stake in SAPL. It sold a part of the stake in FY2014 and some part in FY2015.

The FY2014 annual report, page 13:

Sun Agrigenetics (SAPL): Bodal Agrotech Ltd. had sold some of its holding from Sun Agrigenetics Pvt. Ltd. and due to this transfer of holding; Sun Agrigenetics Pvt. Ltd. is no more subsidiary of Bodal Agrotech Ltd. and fellow subsidiary of Bodal Chemicals Ltd as on 31-03-2014. So, SAPL is only the associate company of the Bodal Agrotech Ltd.

SAPL is in business of production of Tissue Culture plants, Microbial bio-fertilizers, Genetic Improvement of crops, contract research etc. SAPL has tissue culture laboratory with production capacity of 2 million plants p.a. Green House and Nursery complex spread over an area of 70,000 sq.ft. R&D centre recognized by Department of Science and Industrial Research (DSIR), Gov. of India, New Delhi. SAPL plans to launch new products through R&D.

The FY2015 annual report, page 13:

Sun Agrigenetics (SAPL): Bodal Agrotech Ltd. had sold some of its holding from Sun Agrigenetics Pvt. Ltd. and due to this transfer of holding; Sun Agrigenetics Pvt. Ltd. is no more subsidiary or associates company of Bodal Agrotech Ltd. and fellow subsidiary of Bodal Chemicals Ltd as on 31-03-2015.

Investors would note that Bodal Chemicals Ltd entered the business of culture plants, microbial bio-fertilizers, genetic improvement of crops and contract research in FY2011 and exited it in FY2015. However, the business could not do any meaningful contribution to Bodal Chemicals Ltd.

Advised reading: How to do Business Analysis of Fertilizer Companies

C) LABSA (a chemical used in detergents):

In FY2015, Bodal Chemicals Ltd decided to make investments in Bodal Agrotech Ltd to manufacture LABSA, which is a chemical used in the detergent industry. The company said that it would be able to generate a revenue of ₹100 cr from LABSA.

The FY2015 annual report, page 36:

NEW PROJECTS: Bodal Agrotech Ltd.: It is 100% owned subsidiary company of Bodal Chemicals Ltd.It had applied for environment clearance from Ministry of Environment and forest, New Delhi for several products. We are pleased to inform our shareholders that we have already received the said clearance. Out of the several products company has finalized to start project for the product named LABSA which is further used in detergent industry. On of the raw material for producing the product is Sulphuric Adic and for the same ample production is there in Bodal Chemicals Ltd. It may take about 10 months to start commercial production and at optimum capacity it will do about Rs. 100 Cr. Turnover at investments cost of upto Rs.15 crores.

In FY2016, the company communicated its shareholders that it has started commercial production of LABSA and that the product has received a very encouraging response from the market.

The FY2016 annual report, page 9:

During the latter part of the financial year, we also started commercial production of LABSA. The market feedback for the product has been absolutely encouraging so far and it gives us great confidence to enhance production of the same.

However, in May 2018 conference call, the company intimates its shareholders that it is exiting the LABSA business (page 7):

Now when we decided to put LABSA business, that was actually for sulphuric acid before not realizing even up to the cost amount from the market at that point. So we just tried to add some value addition into that and convert into different products and sell it in the market. So we tried to do that but meanwhile while we are exiting the LABSA business, the sulphuric industry has been transformed and changed completely. Now sulphuric acid is sold in the market at a very good premium. So now we do not need to convert much into the LABSA, anyhow try to sell as LABSA. So that is one of the reasons why we are not very keen on LABSA business or do not produce too much of LABSA.

Investors would note that over last a few years, Bodal Chemicals Ltd initiated multiple new businesses as a part of its wholly-owned subsidiary, Bodal Agrotech Ltd (BAL). After initiating and then closing these businesses, finally, the company merged BAL in itself.

When an investor analyses the financial position of BAL disclosed in the FY2017 annual report of Bodal Chemicals Ltd, then, she would notice that BAL has accumulated negative reserves & surplus in its balance sheet. The negative reserves are usually due to the losses accumulated by the companies over the years.

The FY2017 annual report, page 115:

Therefore, it might seem that Bodal Chemicals Ltd formed a subsidiary, BAL, to start new businesses. However, after experimenting with multiple businesses for over 5 years, the company accumulated losses and then merged it into the main company.

D) Trichloro Isocynuric Acid (TCCA) by investment in Trion Chemicals Pvt. Ltd. (TCPL)

In FY2015 annual report, Bodal Chemicals Ltd intimated its shareholders that diversification is a key part of its business strategy and as a result, it plans to invest ₹15 cr in Trion Chemicals Pvt. Ltd. (TCPL). In FY2017 Bodal Chemicals Ltd acquired 42% stake of TCPL that it increased further to 59% in May 2018.

The FY2015 annual report, page 36:

Trion Chemicals Pvt. Ltd.(TCPL): Your Company has always considered diversification strategy for the future growth of the company. Your Company has identified the business space for exploiting the opportunities for diversification by making investments in other chemical Company, namely TRION CHEMICALS PRIVATE LIMITED. To exploit said business, Your Company is making investment of about Rs.15 crores for taking stake in Trion Chemicals Pvt. Ltd. (TCPL) and will become the single majority stake holder.

TCPL was incorporated in the year 2013 and ready with various required approvals for a project falling under the head of specialty chemicals having good export potential and better profit margin then the existing product line of Bodal Chemicals Ltd. Project construction work has just started and expected to start commercial production by July 2016. At the optimum capacity utilization level it will be able to generate turnover of about Rs. 240 Crore. It will add wealth to the business of the company as well as wealth of the shareholders of the company. It will be kind of first project in India.

As per FY2015 management communications, TCPL was to start commercial production in July 2016 and generate potential revenues of ₹240 cr. However, as per the management comments in the August 2018 conference call (hh:mm:ss = 12:00:00 to 14:00:00), the company has not yet started production in the TCPL plant even after a delay of more than two years from the initial expected date of July 2016. (Please note that the transcript of the August 2018 conference call is not yet available publicly).

As per FY2018 annual report, page 54, TCPL is facing many issues related to price increases in its raw materials.

Trion and SPS: In case of Trion, the company is facing issues related to the price hike of raw materials.

An investor would appreciate that the new business segment entered by Bodal Chemicals Ltd by acquiring TCPL, also faces similar intense competition like its core business. As a result, the company is finding it difficult to charge higher prices to its customers and has not been able to start production of TCCA despite significant delays from original plans.

Therefore, it remains to be seen whether the company can successfully execute its plans to generate significant revenue from TCPL.

Moreover, the company disclosed in its QIP document, Oct. 2017 that in TCPL, it is completely dependent on others for generating any benefits from TCPL:

We are entirely dependent on our Associate for TCCA, which is used in water treatment and textile industry. In the event of any major disagreement with promoters of our Associate, the production of TCCA will be affected which could in turn have an adverse impact on our financial performance..

In Fiscal 2017, we acquired 41.51% stake in our Associate, engaged in production of a speciality chemical, TCCA. TCCA’s production is export oriented and specifically targets the US market. We cannot unilaterally control the actions in respect of our Associate, including any non-performance, default or bankruptcy of its promoters. In the event the promoters do not observe their obligations, it is possible that our Associate would not be able to operate in accordance with our business plans and strategy. Differences in views with the promoters of our Associate may also result in delayed decisions or in failures to agree on major matters may adversely affect the business and operations of our Associate. This could in turn adversely affect our operations with respect to TCCA which is supplied to the water treatment and textile industry. Our Associate had no turnover in Fiscal 2016 and 2015. Thus, any disruptions in our Associate will affect our financial performance and growth prospects

As per the Dec 2017 conference call, the other promoters of TCPL, three individuals, had brought the project to Bodal Chemicals Ltd. As a result, Bodal decided to invest in TCPL and acquired about a 42% stake. However, in the light of continued delays in the production of TCCA by TCPL and the sale of stake by other promoters (17%) to Bodal in May 2018, an investor may need to explore the possibility of whether the prospects of TCCA remain good. This is because the other promoters may be selling out if they are not seeing bright prospects of TCCA/TCPL.

Therefore, an investor would notice that over last a few years, Bodal Chemicals Ltd has attempted to diversify its business stream by entering various kinds of businesses. However, it is yet to achieve any significant success from these ventures. We believe that investors should keep this past record in mind when they appraise future ventures of the company.

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

2) Balaji Amines Limited:

Balaji Amines Ltd, an Indian manufacturer of Amines and its derivatives (methylamine, ethylamine, DMF etc.). The company, later on, diversified its business to run a five-star hotel.

Balaji Amines Ltd had invested in the five-star hotel in Solapur, Maharashtra, which was completed in FY2014 with a total investment of ₹107 cr. (FY2017 annual report, page 95, tangible assets schedule, gross block):

The hotel is operational for the last three full financial years i.e. FY2015, FY2016 and FY2017. Therefore, an investor would appreciate that the initial period required to ramp up the utilization is over and the hotel business should have reached its steady state of operations by now.

As per FY2017 annual report, the hotel division has contributed revenue of ₹15.9 cr. in FY2017.

The section on segmental information on page 87 of the FY2017 annual report of Balaji Amines Ltd indicates that the hotel division has reported a profit before tax of negative ₹3 cr. i.e. the hotel division has recorded a loss of ₹3 cr. before tax adjustments.

The investment in the hotel business has been a capital allocation outside the core business of the company by Balaji Amines Ltd, which has led to revenue of ₹15.9 cr. on investment of ₹107 cr. representing a fixed asset turnover of 0.15 (=15.9/107).

An investor would notice that the net fixed asset turnover of the core amines business of the company is about 2. Therefore, the expectations of investors are that a capital allocation of ₹107 cr. by the company should lead to a revenue of about ₹214 cr. per annum (= 107*2) with some net profit margin every year.

Assuming an NPM of 5-10% for any investment, it is expected that the capital allocation of ₹107 cr. should contribute a net profit of about ₹21.4 cr. (=214*10%) every year. However, the hotel investment done by the company is not able to report the revenue equal to the expected profit contribution levels.

We believe that on a revenue & profit contribution perspective, the capital allocation decision of Balaji Amines Ltd of investment of ₹107 cr. in the hotel business, leaves scope for improvement.

Advised reading: How to do Business Analysis of Hotels

Moreover, as per the above discussion, an investor would notice that ₹107 cr. invested in Govt. of India securities can easily provide a return of 6.2% before tax amounting to about ₹6.6 cr. per year, which is better than the losses currently being suffered by the Hotel. (Source: RBI Website on April 20, 2020).

However, if the company has made this investment by taking a view on the estate prices in future and it aims to recover its investment by assuming to get higher property prices in future, then we believe that companies should avoid speculating in areas outside their expertise like real estate prices because there have been many cases where investments, which were done by investors solely to benefit from higher property prices in future have gone wrong.

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

3) India Nippon Electricals Ltd:

India Nippon Electricals Ltd is a TVS group company, manufacturing electrical ignition systems for automobiles (two-wheelers, three-wheelers), and gensets (portable generators).

In the FY2010 annual report, India Nippon Electricals Ltd intimated its shareholders that it had invested ₹6 cr in Synergy Shakthi Renewable Energy Private Limited (SSREPL) for a 40% stake in the company and that the project of SSREPL to generate energy from biomass has started operations.

FY2010 annual report, page 11:

Synergy Shakthi Renewable Energy Ltd., in which your Company has invested Rs.6 crores, being 40% of its share capital, has commenced commercial production during the year.

While searching for additional details about the project of SSREPL, an investor find from online sources that it had created a power project for ₹49 cr out of which ₹15 cr was equity contribution and remaining ₹34 cr was debt. (Source: http://power.industry-report.net/synergy-shakti-renewable-energy-pvt-ltd/)

SSREL is a part of Lucas TVS group. Pursuant to obtaining clearance from Government of Tamil Nadu to put up a 10 MW biomass based power plant, SSREL started construction at Ollaipatti Village, Krishnagiri District, Tamil Nadu (TN) in 2007. The total project cost was around Rs 49 crore, of which promoters contributed Rs. 15 crore as equity. The construction of plant has been completed and its commissioning was done in Feb 2010.

From the above description, it looks that out of the ₹15 cr equity contribution, ₹6 cr (40%) was contributed by India Nippon Electricals Ltd whereas balance equity contribution of ₹9 cr (60%) was invested by Lucas TVS.

Over time, the biomass power project faced severe troubles. First, the company faced challenges in procuring raw material, biomass, for producing power.

FY2011 annual report, page 12:

SSREL is, however, facing acute shortage of biomass availability. As a result of overall economic growth, a number of industries are competing to procure biomass not only for power generation but also for other industrial purposes.

Later on, in the FY2016 annual report, India Nippon Electricals Ltd intimated its shareholders that since June 2015, the SSREPL project is non-operational because of adverse conditions. The state electricity utility, Tamil Nadu Electricity Board (TNEB) is not providing it remunerative tariffs for the power. Moreover, as per regulations, SSREPL cannot sell power to any other third party.

FY2016 annual report, page 16:

Synergy Shakthi Renewable Energy Private Limited (SSREPL) was not in operation since June 2015 due to restrictions on sale of power to third parties, unviable tariff offered by TNEB and adverse changes in regulatory policies. As a result, the associate company incurred a loss of ₹389.46 lakhs as against a profit of ₹70.52 lakhs during the previous year.

As of FY2019, the SSREPL plant remains closed and is continuously incurring losses.

FY2019 annual report, page 18-19:

Synergy Shakthi Renewable Energy Private Limited (SSREPL) was not in operation from 2017-18 onwards due to unviable tariff and adverse regulatory policies. SSREPL had made many attempts to liaise and represent Government and various authorities to make changes in regulations but the efforts had not yielded favourable results. SSREPL has incurred loss of Rs 257.34 lacs during the year against Rs 98.45 lacs in previous year.

SSREPL seems a case of suboptimal capital allocation where the project started facing troubles in procuring the most important input of raw material soon after it became functional. Moreover, even if the company was not finding it viable to supply power to TNEB contracted prices, it was a very strict regulatory condition not to have the authority to sell power to third parties. It seems that the project assessment leaves a lot of scope for improvement.

While reading the FY2017 annual report, when the SSREPL project was closed for some time, an investor notices that India Nippon Electricals Ltd put in additional money of ₹12 cr in the project.

FY2017 annual report, page 10:

to enable SSREPL restart its operations on a viable mode, SSREPL has come up ‘rights issue’ in the ratio of 2 shares for every one share held by its existing shareholders at the face value of ₹ 10/- each to revive the company repay the borrowings from banks and also to meet the working capital requirements. Your Company subscribed ₹12 Crores for the ‘rights issue’ proportionate to its existing holding of ₹ 6 Crores.

Putting additional money in a failed project may represent throwing good money after bad money.

In FY2019, the value of total investment of ₹18 cr done by India Nippon Electricals Ltd is currently valued at ₹3.62 cr, which represents a significant amount of value erosion.

FY2019 annual report, page 150:

Therefore, investors would note that the decision of the company to invest into a field that is completed different than its main business did not prove remunerative for the shareholders.

An investor may read the complete analysis of India Nippon Electricals Ltd in the following article: Analysis: India Nippon Electricals Ltd

4) Fineotex Chemical Ltd:

Fineotex Chemical Ltd is an Indian company manufacturing speciality chemicals primarily for the textile industry.

While reading the annual reports of Fineotex Chemical Ltd, an investor notices that in the past when the company got the surplus money with itself, then it also invested money to venture into real estate stating that real estate business has better potential and profitability.

FY2013 annual report, page 8:

During the year, FCL Landmarc Private Limited was incorporated as a wholly owned subsidiary to pursue Company’s activities in the realty sector as approved by the shareholders at the Ninth Annual General Meeting without affecting the activities of the chemical business. It will carry on the realty business as joint ventures in the initial stages. Realty business has better potential & profitability.

However, in FY2017, the company realized that it may not make much headway in real estate and as a result, sold its subsidiary FCL Landmarc Private Limited at a loss to the company.

FY2017 annual report, page 87:

During the year under consideration, the Company has sold its 100% stake in erstwhile Indian subsidiary FCL Landmarc Private Limited at loss of Rs. 38,289/- which has been given effect to in Profit & Loss Account.

It may seem to an investor that when a company had surplus funds, which it keeps with itself without investing in the core business or returning it to shareholders, then there is a high probability that the company will invest it into unrelated areas. In many such cases, the companies may invest the money at suboptimal returns to the shareholders.

As a result, an investor should be cautious while analysing companies, which have surplus cash but are hesitant to give it back to the shareholders.

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

Losing shareholders’ money in derivative transactions:

Derivatives transactions carry a lot of risks and if not used cautiously, they can result in severe losses. This is true for both individual investors as well as companies.

During our analyses, we have come across instances where companies lost money heavily in derivatives. These include both types of cases where either the companies were speculating in derivatives markets for higher gain as well as companies that entered into derivatives transactions to hedge risks like foreign exchange fluctuations.

In both types of transactions, speculative as well as hedging, we noticed that many companies ended up losing a significant amount of shareholders’ money. As a result, many times, companies had to file for bankruptcy/debt restructuring. In many cases, companies filed cases against the financial institutions that had sold them these derivative transactions.

Irrespective of the outcomes, an investor should always be cautious while investing in companies that show a large amount of gains as well as losses in their financial statements because of derivative transactions.

Investors would notice that many times, enthused by their recent gains in derivatives transactions, the management of the companies start including it in their financial projections as if they will keep earning these gains on derivative transactions with certainty in future as well.

However, investors should always be aware that there have been numerous instances where companies became bankrupt due to derivatives transactions that went wrong.

Let us see some of the examples where companies suffered losses due to derivative transactions.

1) India Glycols Ltd:

India Glycols Ltd is an Indian company manufacturing glycols, ethylene oxide derivatives using renewable raw material (alcohol, molasses), guar gum derivatives, alcohol & spirits, industrial gases, and nutraceuticals.

Over the years, India Glycols Ltd invested about ₹150 cr in one of its subsidiaries, IGL Finance Ltd (IFL) by way of equity and inter-corporate deposits. IFL primarily invested this money in the short-term commodity derivative contracts offered by National Spot Exchange Ltd (NSEL).

In 2013, the govt. sensed a fraud in NSEL and shut down the exchange. NSEL defaulted on its obligations and as a result, the investors in its contracts are yet to recover their money. Therefore, the investments done by India Glycols Ltd in NSEL via IGL Finance Ltd represent a loss of the money of the shareholders.

FY2019 annual report, page 101:

In earlier year the company had given (included in current Loan) Inter Corporate Deposit (ICD) of ₹14,649.64 Lakhs (Previous Year ₹14,649.64 Lakhs) to its subsidiary IGL Finance Ltd. (IGLFL) (A 100% subsidiary). IGLFL in earlier year had invested funds for short term in commodity financing contracts offered by National Spot Exchange Ltd. (NSEL). NSEL had defaulted in settling the contracts on due dates, for which IGLFL has initiated legal and other action and in turn IGLFL did not pay back due amount to the company. Accordingly considering the prudence no interest on above ICD has been accrued for the period from 01-09-2013 onwards.

An investor may note that the NSEL fraud took place in 2013 and the company could make the recovery of only about ₹10 cr in FY2015.

FY2015 annual report, page 11:

Company has so far recovered ₹10.31 Crores from NSEL.

Since then, it seems the company did not receive any money from NSEL.

Therefore, investors would note that the decision of the management to invest shareholders money in a completed unrelated area of short-term commodity derivatives to generate higher returns backfired. As a result, the company lost a significant amount of shareholders’ money.

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

2) Indo Count Industries Limited:

Indo Count Industries Ltd is an Indian textile player, which has a significant share in the home textile segment of USA and has marquee clients like Walmart, JC Penney, Target, etc. as customers.

While analysing the company, an investor notices that it went through a very rough phase during FY2008-10. The global financial slowdown along with some specific decisions of the company worked against it and resulted in the company facing deep losses.

One of the decisions of Indo Count Industries Ltd, which hurt it badly was the decision to enter into a derivative contract that led to losses of ₹150 cr and pushed the company into corporate debt restructuring (CDR).

An excerpt from the interview given by the company promoters to Forbes in August 2016, clearly tells the situation faced by the company:

“The company had an unfortunate experience in June 2008, when their erstwhile CFO signed a zero-cost derivative contract. This was a time when the rupee was quoting at 40 to the dollar and consensus was that it was expected to strengthen further. In order to lock in their dollar receivables, the company got into a contract that stipulated they would have to pay double the amount if the rupee depreciated. That is exactly what happened and Indo Count was saddled with a Rs 150 crore loss. “We just didn’t know what to do,” says Anil. They could have sued the banks that sold them the contracts as they were sold without being signed by two signatories. Instead, the company decided to repay what they owed. The decision resulted in Indo Count going for corporate debt restructuring, which set them back by at least three years.”

It took the company until 2014 to pay off its bankers for the loss of income that they had on account of restricting (recompense). It could come out of the debt restructuring only in April 2014.

An investor may read the complete analysis of Indo Count Industries Ltd in the following article: Analysis: Indo Count Industries Ltd

Therefore, an investor would appreciate that derivative contracts are very risky in nature. In case, the management of a company is not able to understand the inherent risk of derivatives, then it may lose a significant amount of shareholders’ money.

3) Finolex Industries Ltd:

Finolex Industries Ltd is a leading Indian manufacturer of PVC pipes & fittings and PVC resin.

While analysing FY2010 annual report for the company, page 49, an investor notices that the company has disclosed “Premium, Loss on Exchange fluctuation/derivatives” of about ₹187 cr. in FY2009 and ₹93 cr. in FY2010.

While analysing the FY2017 annual report, page 170, for Finolex Industries Ltd, an investor would notice that the company did not settle the derivatives losses immediately and was carrying an amount of $20.8 million (₹135 cr at March 31, 2017) as contingent liabilities, which it said that are under dispute with the counterparties.

The company finally settled these derivatives transactions in FY2019 when it disclosed in its annual report at page 250:

Exceptional item represents settlement of derivative claims against the Company disclosed as contingent liability as at March 31, 2018. There are no more claims or liabilities on account of derivatives.

Therefore, investors should note that they should increase their depth of analysis for companies when they come across large gains or losses on account of derivative transactions. This is because derivatives are a double-edged sword. In case, the management of the company is not able to accurately understand the risk of derivatives transactions, then it can lose a significant amount of shareholders’ money.

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

Losing money in exotic financial instruments like real estate funds

Many times, investors would notice that companies make decisions like investing in exotic financial instruments like real estate funds even though the company may not have any business interests or experience related to real estate

At times, such investment decisions lead to losses where the ultimate burden has to be borne by the shareholders.

Let us see an example.

1) Dynemic Products Ltd:

Dynemic Products Ltd is an Indian manufacturer of food colours, dye intermediates being used in industries like food, cosmetics, pharmaceutical etc.

An analysis of the annual reports of Dynemic Products Ltd would indicate to an investor that the company has invested in HDFC PMS (Real Estate Portfolio) and IndiaReit Fund Scheme IV, which invest in real estate. The company exited its investment in HDFC PMS in FY2016 whereas the investment in IndiaReit contined.

FY2016 annual report, page 72:

The company seems to have had the peak investment level of about ₹59 lac in HDFC PMS (Real Estate Portfolio) in FY2011. (Annual report FY2011, page 50).

An investor would appreciate that investment in avenues like real estate funds is non-core to the business of the company. The fact that the company witnessed its debt levels increase from ₹9 cr. in FY2008 to ₹25 cr. in FY2017, indicates that the company could have used the funds, which it invested in real estate funds to reduce debt.

Real estate fund investments are specialised investment vehicles carrying higher risks, which might not be compatible with the risk profile of the shareholders of the company, which might lead to unexpected unfavourable outcomes.

An analysis of the performance (income & expenses) of HDFC PMS (Real Estate Portfolio) in FY2016 presents such a picture.

FY2017 annual report, page 73:

In FY2016, the company earned ₹5.38 lac from HDFC PMS (Real Estate Portfolio) as income whereas it had to bear costs of ₹18.79 lac (10.46 + 8.33) as expenses for the scheme. It seems that in FY2016, the company had to bear losses on its investment in this fund.

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

Therefore, investors would notice that many times, the investment decisions of the management do not work in favour of shareholders.

The capital allocation decisions of the management take multiple forms like managing the main business line of the company with frequent capacity additions (capital expenditure) plans, investments in new business divisions, subsidiaries, and joint ventures etc.

If the company generates surplus cash, the management of companies takes decisions with respect to the utilization of these funds. It may decide to give it back to shareholders by way of dividends or share buybacks. Alternatively, it may invest it in financial instruments that may include speculative derivative transactions or real estate funds.

To summarise, an investor needs to assess all these aspects of capital allocation by the companies to understand whether the company has made good capital allocation decisions or it has lost money of shareholders. The key aspects to look for are:

• Whether the company is making good returns in its main line of business?
• If the company has formed subsidiaries/joint ventures, then whether these ventures are making good returns?
• Whether the company is doing frequent acquisitions and if yes, then are these acquisitions making good returns?
• Whether the company is diversifying into unrelated business areas?
• Whether the company is able to manage its derivatives exposure efficiently? Any large gain, as well as loss due to derivatives, is a red flag that the hedging policy of the company is not efficient.
• Whether the company has invested surplus cash in exotic financial instruments like portfolio management services, real estate funds etc.

Further, whenever, an investor attempts to analyse the capital allocation decisions of the management, then it is advised to read the annual reports in detail. This is because many times, the important information related to such decisions like the performance of important subsidiaries, state of investments in joint ventures, derivative transactions etc. is present only in detailed notes and schedules to the financial statements.

We believe that comprehensive ratios like the return of equity (ROE) and return on capital employed (ROCE) etc. may not capture the true essence of capital allocation decisions by the management of the companies. This is because of two main reasons:

• The data used in the calculation of these financial ratios is open to various assumptions, the impact of various cash & non-cash transactions, discretion of management to consider many items as expenses or non-expenses, capitalization of many expenses etc. As a result, only looking at a ratio computed from a few data points from the financial statements may not provide the complete picture of the financial management of companies.
• Moreover, the management of the companies also knows that investors focus on ratios like ROE and ROCE. As a result, many times, the companies attempt to present a rosy picture in their financials using aggressive assumptions so that investors using simplistic ratios may assume that the company is doing a good job of capital allocation.

Therefore, we believe that a comprehensive analysis of the annual report focusing on different investment decisions is needed to understand the true picture of capital allocation by any company.

How do you assess the capital allocation efficiency of the management of any company? What parameters do you use for your interpretations? What has been your experience of analysing capital allocation decision of any company? Has it proved a helpful parameter to differentiate good management from the poor one? It would be great if you could share your experiences with the author and the other readers in the comments section below.

Investors’ Queries about Capital Allocation

Deployment of Surplus Funds

For other income, we are supposed to compare with cash + investment. Do you mean we have to do other income/cash+ investment * 100 to check whether its return is less than or equal Bank’s FD?

Author’s Response:

Hi,

Thanks for writing to me!

Using the figure of other income/(cash + investments) and comparing it with bank FD return might not be very accurate as the investments in the data provided by the screener clubs current investments (mutual funds etc.) as well as the equity investments in the JVs etc. (from where the company might receive only dividends).

We use the bank FD returns to compare it with the PBT/Net Fixed Assets to assess whether it makes sense to have all the assets and take the pains of running a company. In case PBT/NFA is not more than bank FD return, then it seems like selling the entire assets and investing in FD would be beneficial for shareholders.

Hope it clarifies your queries!

Regards,

Vijay

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.