Analysis: Cyient Ltd

The current section of “Analysis” series covers Cyient Ltd, an information technology (IT) services company providing engineering services to industries like aerospace, defense, transportation, semiconductor etc.

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

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

Cyient Ltd Research Report by Reader

Hello Sir,

I attended your lecture in Delhi and got to learn many good things. Based on your lecture, the company evaluations that you shared with us, and my understanding, I have tried to do the assessment for one such company, Cyient Ltd.

I am looking forward to your reviews.

I have attached the research report and screener evaluation metric.

Thanks,

Manu Agarwal

The analysis of Cyient Ltd was submitted by the reader some time back and it was kept on hold, as we did not use to analyse information technology (IT) companies earlier. Therefore, readers may find that at places the data in the readers’ report is dated.

About Cyient Ltd (Source CRISIL):

Cyient (formerly known as Infotech Enterprises Ltd) was originally founded as a private limited company in 1991 by Mr. B V R Mohan Reddy, its executive chairman. The company commenced operations in September 1992. Cyient was reconstituted as a public limited company in April 1995 and made its initial public offering in March 1997. Operations are being managed by Mr. B G V Krishna, son of the founder and currently managing director and chief executive officer.

Cyient started operations by providing geographic information systems (GIS) services. In May 2000, the company diversified into engineering services. It currently operates through eight strategic business units: Aerospace & Defense; Transportation; Industrial, energy and natural resources; Semiconductor, Internet of things and Analytics; Medical and Healthcare; Utilities & Geospatial; Communications and Design-led-manufacturing (Cyient DLM). Cyient DLM (earlier Rangsons business, provides design integration and production facilities to the designs created in Engineering, thus enabling Cyient to provide design­to­production solutions to its clients.

Cyient has operations across the globe. It derives around 60% of its revenue from the Americas, 29% from Europe, the Middle East, Africa, and India, and around 11% from the Asia Pacific.

Metric Analysis of Cyient Ltd:

We have chosen to analyze the consolidated result for the company, as it will reflect the true picture of all the operations and cash utilization.

1) Sales Growth:

The company over a period from 2008-2017 has shown good revenue growth of CAGR: 20%, though the growth has been decreasing in the last few years.

2) Profit margins:

Operating margin has seen some constraints in the last 4 years decreasing from 18.5% to 12.5%. This could be explained by the investments done in the DLM business unit where a lot of capital is being stuck in inventory and the adverse currency movement, which owing to the export nature of the company has resulted in lower sales and margins.

The 70% hedging policy of the total expected inflows has proved useful in mitigating the margin losses.

Hence, the Net profit margin has only decreased from 12% to 9.5% over the same years and other income has increased drastically.

3) CFO vs PAT for Cyient Ltd:

Over the period of 2008-2017, the company has posted a total net profit of ₹2,170 cr while the total cash from operations is ₹2,000 cr. The lower cash from operations is explained by capital being stuck in working capital as inventory for DLM business. Over the same period, working capital has increased by ₹526 cr.

4) Free cash flow (FCF) analysis:

The free cash flow the company generated comes out to be ₹870 cr out of which ₹400 cr is paid as dividends and ₹50 cr as interest. Thus, the company is virtually debt-free and only a small amount of debt is taken on a short-term basis. High levels of cash and investments reaching a milestone figure of ₹1,000+ cr reflect the cash-rich position of the company.

5) Creation of wealth for shareholders:

The company has shown continuous good performance and created shareholder wealth as can be seen by continuous excess return. Retained earnings are approx. ₹1,770 cr and change in market cap is ₹4,000 cr, which indicates a wealth creation ratio of 2.25.

The company over the years has not raised any capital via equity dilution.

6) Tax rate:

The effective tax rate has deteriorated over the years putting a strain on net margins but will remain at this level (26-28%) going forward as indicated by the management.

7) Other income:

The increasing other income is due to the forward contract gains because of the hedging policy.

8) Quarterly results:

The quarterly section analysis reveals that the company is posting quarter on quarter (QoQ) growth since the last 6 quarters with margins being stabilized. With all the eight business verticals showing growth (as shown in the table below), it seems the worst for the company is over and the company is poised for a good growth trajectory.

Business Unit Performance of Cyient Ltd:

Company is forecasting double-digit growth. With margins more or less stable, the growth in earnings will come out to be the same. As per the commentary and data available, we can safely assume that the company will post a growth of around 14% with a little upside as all the business units have started showing growth.

The net fixed asset turnover ratio (NFAT) revolves around five, which seems a decent value for a service provider company. However, with the DLM business, the NFAT value might decrease.

The company carries a high value of goodwill on consolidated books as it has been making continuous acquisitions.

Fund Flow Analysis of Cyient Ltd:

• Inventory buildup started in the financial year 2014-2015.
• Rate of increase of trade payable is high.

Points of Concern for Cyient Ltd:

1) Trades payable:

Reason and parties concerned for trades payable are not clear.

2) Operating Leases:

Sudden rise in operating lease.

3) Goodwill:

CRISIL credit report published on Aug-1-2017 states the yearly amortization of goodwill being provided by the company. However, no such amortization is recognized in the financials contained in the annual reports.

4) Abrupt Margin Movements of Cyient Ltd:

In the year 2009-2011 and in the year 2014-2015

5) Inventory figures from 2015:

On consolidated figures, there was no inventory prior to the year 2015. The inventory might be after the acquisition of Rangsons, currently named Cyient DLM.

Management Commitments:

• Annual report FY2016-17: To become a major Tier-I supplier in select industries in the next ten years.
• FY2018 Q1 conference call: DLM business to start generating cash from Q2 onwards, Double-digit earnings growth by end of the year,
• The management is open to big acquisitions and is continuously evaluating the options. With cash getting collecting on the books and no major acquisition on the card we have to see how the management acts.

Management Analysis of Cyient Ltd:

1) Board Members:

• Mr. Krishna Bodanapu is the son of Mr. BVR Mohan Reddy. This arrangement provided easier succession.
• All the independent directors are reputed members in their respective field of work and unrelated to the promoters. Presence of Mr. MM Murugappan instills confidence in the board.

2) Remuneration:

• The total remuneration to all the directors is below the maximum limit.
• Even the promoters’ salary is not excessive and can be deemed reasonable with the experience they provide to the company.
• The stock option for the senior management personnel and not the promoters instills confidence in the remuneration scheme being followed by the company.
• This arrangement makes the senior management dedicated to the good performance of the company and does not provide promoter and promoter group entities any undue advantage.

3) Dividend history of Cyient Ltd:

• Continuous and increasing dividend with a healthy payout of 20-30%.over last 5 years.
• Dividend payout policy is revised to 40%.

4) Shareholding pattern analysis of Cyient Ltd:

The strong promoter and institution holding in the company (of 85%) shows confidence in the business by the experts. The number of shareholders also shows that the stock is not distributed in the market as of yet.

Valuation Analysis of Cyient Ltd:

• Currently, it is available at a P/E ratio of 16, which is lower than the long-term average of Indian index (17); the current valuations provide a margin of safety.
• In addition, the P/B value of 2.5 provides added safety.
• Historical P/E value chart for the last 10 quarters giving a median price target of 615.

Dr Vijay Malik’s Response

Hi Manu,

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

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

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

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

Let us analyse the financial and business performance of Cyient Ltd over FY2010-2019.

Financial and business analysis of Cyient Ltd:

While analyzing the financials of Cyient Ltd, an investor would note that in the past, the company has been able to grow its sales at a rate of 15%-20% year on year. Sales of the company increased from ₹953 cr. in FY2010 to ₹4,618 cr in FY2019. The sales of the company have witnessed a consistent increase year on year over the last 10 years. However, when an investor analyses the profitability of the company, then she notices that the operating profit margin (OPM) of the company has seen large fluctuations in the past.

The OPM of the company used to be 22% in FY2010 and it witnessed a sudden decline to 15% in FY2011. Later on, the OPM improved gradually to 19% in FY2014. However, since the FY2015, the OPM of Cyient Ltd has declined again to 13% in recent times.

Such fluctuations in the OPM lead an investor to a deeper analysis of the annual reports to understand the reasons behind them.

While reading the FY2010 annual report, an investor gets to know that the major reason for the increase in OPM in FY2010 was depreciation of India Rupee (INR) against US Dollar (USD).

FY2010 annual report, page 55:

The company registered a 16.66% growth in EBITDA. While EBITDA increased to Rs. 2,082.6 million as against Rs. 1,785.2 million, PAT increased to Rs. 1,708.30 millions as against Rs. 924.80 million in previous year due to increase in other income as a result of exchange fluctuation gain.

In FY2011, the operating profit margins of the company declined sharply from 22% in FY2010 to 15% in FY2011. Cyient Ltd highlighted in its FY2011 annual report that the decline in profitability is primarily a result of an increase in different operating expenses, which have increased the costs of providing services for the company.

FY2011 annual report, page 20:

Our Operating margins went down from 21.5% to 15.2%. Key reasons for the margin contraction were:

1. Salary increases for both offshore and onshore employees without equivalent rate increases from customers.

2. Hiring of far more laterals compared to freshers which again put burden on the cost of wages.

3. Acquisitions which operated at less than 10% margins took longer time to create offshore workload. The acquired entities’ revenues exerted pressure on margins on consolidated revenues.

4. Initiatives taken on improving productivity are taking longer time though in focus and right course.

5. Step up in our overhead burden with not so corresponding increase in revenues as some of these were investments in organisation and initiatives whose results will fruitify in the coming year.

While reading the above disclosure esp. point (1), an investor would notice that the company has acknowledged that it has to increase the salaries of its employees, which has increased its costs but it was not able to get a corresponding increase in prices from its customers. This situation indicates that Cyient Ltd does not have a strong negotiating position in comparison to its customers.

An investor would appreciate that the customers of Cyient Ltd are well established large players in the aviation and communications field like Prat & Whitney (UTC group), Boeing etc. These customers are very large companies who always have many IT suppliers chasing them in order to a share of their business. Moreover, these companies have their own in-house research & development centers in low-cost countries like India, which also act as competition to other IT services companies.

As a result, it is not possible for the IT service providers who rely on the outsourcing of business from large players to increase prices whenever there is an increase in costs. Moreover, there is a continuous pressure from the customers on IT service providers to reduce pricing in order to generate higher savings. Customers who are large established players in their industry frequently renegotiate contracts. In the light of intense competition, such renegotiations make it challenging for the IT service providers to retain business as well as profitability.

While explaining the reasons for low profitability margins in FY2019, Cyient Ltd highlighted such renegotiations by one of the large customers as one of the reasons.

Conference call, April 2019, page 6:

As you recall, this is another deal that contributed to the challenge in Q4. One of our large customers has gone through renegotiation. The good news is not only did we win most of the business we also have a much wider scope, but what we are seeing is the workflow is just starting.

As per the above discussion, an investor would appreciate that IT service providers usually do not have strong negotiating power with their customers. As a result, the IT service providers like Cyient Ltd, do not possess the ability to increase prices to their customers whenever their costs (like employee salaries) go up. This is because an increase in prices by an IT service provider may undermine the entire basis of outsourcing of business, which is to generate savings for the large customers. If a large customer is not able to see savings in outsourcing a part of its business to an IT service provider, then it may very well do that business in-house. Moreover, the IT service field is intensely competitive and if one IT service provider is not able to accept one business, then it is not very difficult for the customer to find another IT service provider to do the business at acceptable terms.

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

As a result, an investor would notice that many times an increase in the profit margins of IT service providers is due to the depreciation of INR against USD. The profitability of Cyient Ltd in 2010 increased due to INR depreciation and it was repeated in later years as well. E.g. in FY2014, the revenue, and profitability of Cyient Ltd increased despite a reduction in the price of contracts in USD terms. The increase was due to INR depreciation.

FY2014 annual report, page 124:

Therefore, an investor would notice that in FY2014, the customers who pay in USD had reduced the prices of the contracts. However, it was primarily the INR depreciation, which led to higher revenues and profits.

On similar lines, in July 2019, while discussing the results of Q1-FY2020, Cyient Ltd intimated the shareholders that it had witnessed a decline in both the pricing of contracts as well as the volume of the business it used to get from customers.

Conference call, July 2019, page 4:

If you look at our income statement, we have reported profit after tax of Rs. 905 million. Definitely the shortfall from Rs. 1,768 million of last quarter is significant, where we had other income impact, which was there as a one-off. Plus, we also have reduction in volumes and reduction in the margin that has taken place.

In light of intense competition, IT service providers continuously face the challenging task of managing their profitability. Their customers continuously put pressure on them to reduce prices whereas their employees continuously put pressure on them to increase salaries (employee costs are one of the largest expenses for IT service providers). The result of this continuous tussle is that the companies attempt to keep employee costs as low as possible.

IT service companies attempt to keep the salaries of employees at the minimum possible levels, which leads to a lot of churn in their employees who leave the companies soon to join higher-paying opportunities. This is one of the reasons for higher employee attrition levels for IT service companies including Cyient Ltd.

Investors’ presentation, April 2019, page 43:

An investor would notice that the attrition level of Cyient Ltd for FY2019 has been 22.7% indicating that almost one out of five employees left the company during the year. As a result, companies like Cyient Ltd have a continuous quest to find new employees and to keep the costs low.

In order to keep the employee costs low, Cyient Ltd focuses on hiring engineers who are fresh pass outs from the colleges. This is because otherwise if the company hires experienced engineers, then its employee costs go up, which in turn reduces the profitability of the company.

An investor would remember the disclosure by Cyient Ltd in FY2011 annual report, page 20:

Our Operating margins went down from 21.5% to 15.2%. Key reasons for the margin contraction were:

2. Hiring of far more laterals compared to freshers which again put burden on the cost of wages.

An investor would notice that the lack of the ability of the IT service companies to increase prices to their customers leads them to focus on continuously hiring engineers without any experience to maintain profit margins. The newly joined engineers gain some experience working at the firm and then leave soon to join other higher paying job opportunities and the company then again has to hire fresh engineering graduates.

An investor would appreciate that such high churn of employees and the focus of companies on hiring fresh engineering graduates can create a situation where the company does not have employees with relevant work experience to complete a customer’s project and in turn, the customer’s project suffers.

Cyient Ltd faced such a situation in FY2019 when it could not complete customers’ projects due to lack of employees to work on available projects.

Cyient Ltd, April 25, 2019 conference call, page 10-11:

Pankaj Kapoor: Krishna, during this year FY2019 we had at least a couple of quarters in which what we guided for versus what finally came in, there was a reasonable gap. So I am just trying to understand that how who have looked at this issue and have you made any changes to the way you try to forecast the business outlook….

Krishna Bodanapu: ……I think we are typically focused really on the demand side and if there was demand we thought that fine we will be able to achieve it, but I think the key challenge that we faced, which is what happened more or less in Q4 is the supply side did not really stood up. That is also the case of, say, the DLM. We had the demand we were not able to supply it because of various reasons. In the case of Aerospace & Defence, for the most part, the demand was there, and it was locked in. It was just the supply could not be made because of attrition challenges in some case, etc.

Pankaj Kapoor: So just one clarification on this. So basically you are saying it was more of a fulfillment challenge that you faced because of absence of the supply pool or the talent availability rather than anything on the client or demand side.

Krishna Bodanapu: I said 75% of it was on that, 25% was demand being pushed out.

Therefore, an investor would notice that IT services companies operate in a very tough business environment. There is continuous pressure from the customers to reduce costs, as the lower cost is the biggest basis of the business in outsourcing; otherwise, the customer will get the work done from its own employees. On the other hand, the employees of IT service companies expect a better salary and leave the company soon after gaining some experience.

The quest to satisfy the customer with lower prices and retain the employees by paying higher salaries, puts the IT services company in a difficult spot where many times, they are not able to fulfill customer orders due to lack of relevant employee resources or have to compromise with lower profit margins by hiring experienced employees at a higher salary.

Further advised reading: Analysis Framework for IT Services Companies

Apart from the above-mentioned tussle between customers vs. employee interests, the margins of Cyient Ltd were impacted by another 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 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.

Further advised reading: Understanding the Annual Report of a Company

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 is currently operating in a tough competitive business environment where it is not able to retain employees by providing them attractive remunerative salaries. As a result, it has faced situations of non-delivery of customers’ projects due to lack of relevant employee resources. On the other hand, the customers have continuously put pressure on the company to reduce prices. Such a tough business environment led to a decline in operating profit margins of the company. The situation of declining operating profit margins 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.

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

In such a situation, Cyient Ltd feels that the only way for the company to improve its profit margins is by taking further cost reductions. As a result, in FY2019, it has hired an external agency for cost optimization to increase profit margins.

Conference call, April 2019, page 11-12:

Gaurav Rateria: Couple of questions for Ajay, fiscal 2019, your margin was stable. It was helped by FX to the extent of 120 basis points. There was NBA investment, which you anticipated to be 100 basis points, but that turned out to be lower at around 50 basis points. So for fiscal 2020 how do you expect to manage margins given that FX tailwind may not be there and NBA investment may actually step up from current 50 basis points?

Ajay Aggarwal: Very fair point. I would say that there are two or three things that we are doing. One is that we have embarked on exercise for cost optimization where we are working with an external agency with a very focused program, which has started in December and which gets concluded by Q4 of the year. So that program is explicitly focusing on improving the margins through the cost optimization and some other initiatives.

It remains to be seen whether Cyient Ltd is able to improve its operating profit margins in the light of an intensely tough business environment faced by it.

The net profit margin (NPM) of the company has followed the trend of its operating profit margin except for the fact the relative decline in the NPM has been lower due to better management of tax payout by the company.

While analyzing the tax payout ratio of the company, an investor would notice that it has a tax payout ratio, which is lower than the standard corporate tax rate prevalent in India. When an investor reads the annual reports of the company, then she notices that in FY2012, Cyient Ltd had tax payout ratios of 36%, which is near the standard tax payout ratio.

In FY2013, the company intimated the shareholders that it is focusing on saving on tax payouts by completing customers’ projects from special economic zones (SEZs) and in future, it will add all the incremental capacity in SEZs only.

FY2013 annual report, page 28:

Our effective tax rate declined 479 bps to 30.5% during 2012-13 as a result of increased volumes being generated out of the SEZs. We are setting up all our incremental Indian operations in SEZs to take advantage of tax benefits, adding more than 1,000 people in the SEZs during 2012-13.

The strategy of the company seems to have worked well as the tax payout of the company declined from 36% in FY2012 to 31% in FY2013 and has further declined to 24% in FY2016 as the company added many new employees in its SEZ units.

FY2016 annual report, page 70:

Driven by Special Economic Zone (SEZ) deployment strategy, the company has realized substantial tax reduction in last 3 years. Effective tax rate for the organization has improved by 70 bps from 24.6% in FY’15 to 23.9% in FY’16. The company has added close to ~3,000 people in SEZ in last 3 years for new business.

In FY2018, the tax payout of the company increased moderately to 26%, which was a result of the maturity of the tax incentives of some of the SEZ units, where the tax exemption declined from 100% to 50%.

FY2018 annual report, page 47:

The effective tax rate for the organization has increased by 150 bps from 24.2% in FY’17 to 25.7% in FY’18, mainly due to phase-off of some units in Special Economic Zone (SEZ) from 100% to 50% tax bracket.

Going ahead, an investor may monitor whether the company is able to reduce its tax payout ratio of its Indian operations further by taking benefits of the tax incentives.

Further advised reading: How to do Financial Analysis of Companies

Operating Efficiency Analysis of Cyient Ltd:

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

Cyient Ltd is an IT services company, where the revenue primarily depends on the design/software work done by computer engineers. In such cases, the fixed assets of the company are not a key determinant of the revenue-generating ability of the company. This is because the revenue-generating unit of the company is an engineering professional working on a computer system. The value of the fixed asset (the computer) is hardly a determining factor for revenue that can be generated by the employee working on the computer. Moreover, other fixed assets like buildings etc. also do not have a direct relationship with revenue-generating ability because companies can easily fit in more employees within existing buildings by optimally utilizing the space.

Therefore, we believe that in IT services companies the net fixed asset turnover (NFAT) may not be the best parameter to determine the revenue-generating ability.

An investor would also appreciate that in February 2015, Cyient Ltd acquired the design-led-manufacturing (DLM) business (REPL, later renamed as Cyient DLM Pvt. Ltd), which is a capital-intensive business. However, currently, the DLM is currently a small portion of the overall company. In FY2019, it contributed about 10% of the total revenue. In FY2019, DLM contributed revenue of ₹480 cr out of total revenue of ₹4,618 cr of Cyient Ltd.

In case, going ahead, the DLM business improves and becomes a very significant contributor to the overall revenue of Cyient Ltd, then NFAT may become a more relevant parameter to analyse Cyient Ltd.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

b) Analysis of inventory turnover ratio of Cyient Ltd:

Cyient Ltd is an IT services company, which provides software solutions to its customers. In its services business, it does not need to keep any inventory. Therefore, the standalone balance sheet of the company does not contain any inventory for any of the last 10 years from FY2010-FY2019. The lack of inventory has been highlighted by the auditor in its report to the standalone financials of the company every year including FY2019.

FY2019 annual report, page 151:

The Company does not have any inventory and hence reporting under clause (ii) of the Order is not applicable.

During February 2015, the company acquired design-led-manufacturing (DLM) company REPL and as a result, from FY2016 onwards, the company started carrying inventory on its consolidated balance sheet. Therefore, an investor would appreciate that the inventory position of Cyient Ltd reflects the position of its DLM business.

While analysing the trend of inventory, an investor would notice that the inventory level of the company has continuously increased since FY2016. Inventory level has increased from ₹61 cr in FY2016 to ₹183 cr in FY2019.

To assess the efficiency of inventory utilization by the DLM business, an investor needs to find out the data of the financial performance of Cyient DLM Private Ltd from the annual reports of Cyient Ltd. When an investor gets this data from the annual reports, then she notices that the inventory turnover ratio (ITR) of DLM business has declined significantly from 3.9 in FY2017 to 2.6 in FY2019.

Looking at the above data, an investor also notices that even though the DLM business has grown in size (revenue) over the years, the business has been repeatedly making losses (FY2016, FY2018, and FY2019). In addition, the DLM business has continuously consumed more & more cash in the form of higher inventory requirements.

Going ahead, an investor should monitor whether Cyient Ltd has been able to improve the operations of DLM business in terms of both the profitability as well as operating efficiency aspects like inventory turnover ratio.

Advised reading: Inventory Turnover Ratio: A Complete Guide

c) Analysis of receivables days of Cyient Ltd:

Over the years, the receivables days of Cyient Ltd have improved from 74 days in FY2013 to 59 days in FY2019. It indicates that the company has been able to keep its receivables under control and as a result, it could save its money from being stuck in working capital.

Further Advised Reading: Receivable Days: A Complete Guide

When an investor looks at the working capital position of Cyient Ltd, then she realizes that the business of Cyient Ltd has consumed cash in its working capital in the form of inventory. However, its position seems comfortable on the front of receivables. Moreover, an investor would notice that the inventory of the company relates only to the design-led-manufacturing (DLM) business, which is currently a small portion (about 10%) of the company. As a result, it seems that Cyient Ltd has been able to keep its working capital position from deteriorating significantly.

However, when an investor compares the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of the company for FY2010-19, then she notices that the company has been not been able to convert its profits into cash flow from operations.

Over FY2010-19, Cyient Ltd has reported a total cumulative net profit after tax (cPAT) of ₹2,875 cr. whereas during the same period, it reported cumulative cash flow from operations (cCFO) of ₹2,447 cr.

When an investor analyses the reasons for the cCFO of the company being lower than cPAT for the last 10 years, then she notices that Cyient Ltd has reported a significant amount of other income during FY2010-2019, which forms a part of net profit (PAT); however, it is removed while calculating cash flow from operations (CFO). This is because, the other income is primarily related to the investments done by the company in financial instruments like mutual funds, fixed deposits etc.

Therefore, in the case of Cyient Ltd, even if the cCFO for FY2010-2019 is lower than cPAT, still it does not represent that the working capital position of the company has deteriorated significantly.

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

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

Margin of Safety in the Business of Cyient Ltd:

a) Self-Sustainable Growth Rate (SSGR):

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

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

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

While analysing the SSGR of Cyient Ltd, an investor would notice that the company has an SSGR ranging from 35% to 20% over the years.

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

SSGR = NFAT * NPM * (1-DPR) – Dep

Where,

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

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

An investor would notice that in recent years, the NPM of Cyient Ltd has been declining year on year and the dividend payout ratio has been increasing year on year. It indicates that the company is able to retain lesser funds for reinvestment. As a result, the SSGR of the company has come down over the years.

However, the SSGR of the company is still more than the sales growth of 15%-20% achieved by the company over the years. As a result, it seems that the core business of the company does not need debt for the growth achieved by the company. An investor may also note that Cyient Ltd was a debt-free company until FY2015 when it acquired the DLM business.

The DLM business seems a capital-intensive business due to both investment requirements in the manufacturing setup as well as the working capital requirements for inventory. Moreover, from the discussion above, an investor would recollect that the DLM business has hardly made any profits over the years despite an increase in sales. As a result, the DLM business of Cyient Ltd has relied on external capital for growth. Therefore, investors would notice that since FY2015 onwards, Cyient Ltd has reported debt levels on its balance sheet, which is primarily related to the debt of its manufacturing business in Cyient DLM Pvt. Ltd.

Moreover, the debt level of Cyient Ltd has increased from ₹147 cr in FY2015 when it acquired the DLM business to ₹368 cr in FY2019. The increase in debt is despite the presence of cash & investment of ₹1,025 cr available with the company on March 31, 2019.

Going ahead, an investor should keep a close watch on the debt levels of the company and monitor whether Cyient Ltd continues to meet the fund requirements of its DLM business by raising more debt or its uses its cash balance for the same.

b) Free Cash Flow Analysis of Cyient Ltd:

While looking at the cash flow performance of Cyient Ltd, an investor notices that during FY2010-19, the company had a cumulative cash flow from operations of ₹2,447 cr. However, during this period it did a capital expenditure (capex) of ₹1,472 cr. As a result, it had a free cash flow of ₹975 cr. (2,447 – 1,472).

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

Therefore, an investor would note that during FY2010-2019, the company had a free cash flow of ₹975 cr from its CFO after meeting all the capex. In addition, it also had other income of ₹737 (income from investments) and also raised funds by incremental debt of ₹364 cr (the total debt increased from ₹4 cr in FY2010 to ₹368 cr in FY2019). As a result, the company had a funds surplus of about ₹2,075 cr (=975 + 737 + 364) after meeting its capital expenditure during FY2010-2019.

The company seems to have used these funds to pay dividends of about ₹758 cr and a buyback of about ₹200 cr.

As a result, the company had a cash & investment balance of exceeding ₹1,000 cr after meeting all the capital expenditure, dividends and buyback needs over FY2010-2019.

In light of the above cash surplus position, it remains to be seen whether the company would prefer to use its cash balance to retire its debt and meet the cash needs of its DLM business or it will keep on raising more debt for this purpose.

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

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

Additional aspects of Cyient Ltd:

On analysing Cyient Ltd, an investor comes across certain other aspects of the company, which are essential to know for any investor.

1) Management Succession of Cyient Ltd:

While analysing Cyient Ltd, an investor notices that Mr. Krishna Bodanapu (aged 42 years), MD&CEO of the company is the son of its founder promoter, Mr. B.V.R. Mohan Reddy (aged 68 years), who is currently working as Executive Chairman of the company.

FY2019 annual report, page 123:

Mr. Krishna Bodanapu is the son of Mr. B.V.R. Mohan Reddy. None of the other directors are related to any other director on the Board.

It indicates that the company has put in place a management succession plan in which the new generation of leaders are being groomed in business while the senior members are still playing an active part in the day-to-day activities.

Moreover, the credit rating agency ICRA has highlighted the presence of management succession planning in its report on the corporate governance of Cyient Ltd in March 2019.

Robust governance structure; succession planning in place:……While the robust governance structure supports Cyient in efficient decision making, ICRA understands from its discussions that the company has also been proactive in succession planning for the Board and various management positions, the latter being through various leadership programmes.

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

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

2) Frequent acquisitions done by IT services companies including Cyient Ltd.

While reading about Cyient Ltd, an investor gets to know that, the company has relied upon acquisitions to further its business interests. It has acquired multiple companies to get certain technological capabilities to provide better solutions to its clients. It has acquired some of the companies in order to get access to their customers. Moreover, many times, Cyient Ltd has acquired companies from its existing customers in order to gain additional business from them.

In light of different purposes for acquisitions, an investor notices that both for Cyient Ltd as well as for other IT service providers, acquiring other companies is a routine activity.

Advised reading: Analysis: Quick Heal Technologies Ltd

Investors would note that in case of acquiring any company especially those in technology space, it becomes very difficult to assign an absolute value to them. Many times, technology companies are acquired for their future business potential in terms of integration of the newly acquired technology into existing products and solutions of the buying company. It is very difficult to assign an absolute value to such future business potential. As a result, most of the times ascertaining whether the payment done for any acquisition is a fair one becomes difficult.

It is this difficulty to ascertain an absolute value for an acquisition that opens up space for dubious business practices and decisions, which may not be in the best interests of shareholders of buyer companies. As a result, minority investors must be very cautious while examining the acquisitions done by the companies in which they hold shares.

When an investor analyses the recent acquisitions done by the Cyient Ltd, then she notices that the company has paid a lot of money in excess of the balance sheet value (net worth) of these companies.

a) Acquisition of Softential Inc.:

In April 2014, Cyient Ltd via its wholly-owned USA subsidiary, Cyient Inc. acquired a company in USA, Softential Inc.

While reading the FY2015 annual report, an investor gets to know that at the time of the acquisition, Softential Inc. had negative net assets of (₹3.1) cr, while Cyient Ltd paid a price of ₹150.3 cr to acquire it.

FY2015 annual report, page 235:

The above data suggest that Softential Inc. has been a loss-making company, which has been acquired by Cyient Ltd for ₹150 cr.

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

b) Acquisition of Rangsons Electronics Private Limited:

In February 2015, Cyient Ltd acquired 74% stake in Rangsons Electronics Private Limited (REPL) for ₹292 cr. At the time of the acquisition, REPL contributed net assets of ₹37 cr to Cyient Ltd.

FY2015 annual report, page 236:

Therefore, it seems that Cyient Ltd purchased assets worth ₹37 cr for a price of ₹292 cr.

As mentioned above, many of the acquisitions done by IT services companies are to gain access to newer technologies as well as new customers. Therefore, it is usually very difficult to ascertain the absolute value for any acquisition done by the IT services company. Nevertheless, the uncertainty in determining the fair value of the acquisitions leads to the possibility of overpayments by the management for acquisitions, which may not be in the best interest of other shareholders.

An investor would notice that in the recent past in the case of IT service companies, there have been cases where investors raised questions to the management over the valuations paid for acquiring companies. One such case, which led to the resignation of the CEO of a large Indian IT services company, was the acquisition of a small Israeli IT company, Panaya for ₹200 million by Infosys Ltd in 2015. (Source: Infosys).

At that time, Vishal Sikka, CEO of Infosys said:

“The acquisition of Panaya is a key step in renewing and differentiating our service lines. This will help amplify the potential of our people, freeing us from the drudgery of many repetitive tasks, so we may focus more on the important, strategic challenges faced by our clients. At the same time, Panaya’s proven technology helps dramatically simplify the costs and complexities faced by businesses in managing their enterprise application landscapes.”

• However, after some time, a whistle-blower raised questions on this acquisition stating that acquisition was overvalued. (Source: MoneyControl: Whistleblower questions Infosys board on accountability for Panaya acquisition)
• Mr Narayan Murthy, one of the founding promoters of Infosys Ltd., took up this issue by with the board of directors. This incidence created many issues for the company’s promoters, board, and management. Subsequently, Mr Vishal Sikka resigned from Infosys Ltd in 2017.
• In 2018, Infosys decided to sell off Panaya at a 59% discount to the purchase price (Source: Livemint: Infosys struggles to sell distressed asset Panaya)
• However, the company could not find a buyer for Panaya and it apparently shelved the plans to sell Panaya in 2019 (Source: Livemint: Infosys drops plan to sell Panaya, Skava)

Therefore, while analysing companies in the information technology (IT) sector, an investor should be prepared to witness a lot of mergers & acquisitions, which may prove valuable to the business in terms of new skills and customers. However, these mergers & acquisitions also bring with them the possibility of overpayments by the management for acquisitions, which need to be analysed very closely by the investors.

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

3) Cyient Ltd lagging behind on crucial technology front:

An investor would appreciate that Cyient Ltd has witnessed its profit margins decline over the last 5-6 years. One of the key reasons for the decline in profit margins is the lack of ability of Cyient Ltd to pass on the increasing cost of operations to its customers. An investor would appreciate that such a lack of ability represents the low negotiating power in the hands of the company.

In the case of IT services companies, the negotiating power of the service provider frequently depends upon the strength of technological advancements that it brings to its customers. IT service providers with most advanced technological solutions are able to push for higher prices in their contracts with customers and in turn, enjoy higher profitability margins.

An investor would appreciate that the declining profit margins of the Cyient Ltd from a perspective may indicate the inability of the company to achieve required technological advancement to add further value to its customers and to find new customers who can provide it with large orders at higher profitability.

The management of the company accepted that it is losing revenue from its biggest customers and that it is lagging behind its competitors on the front of new-age technologies.

Conference call, July 2019, page 10:

Abhishek S: Maybe a couple of questions, but let me start first with Krishna. So, Krishna, do you believe that strategy refresh is necessarily both in terms of account mining and sales? Because the way we have seen deceleration in our top accounts or top five, six to ten account?

Krishna Bodanapu: So, Abhishek, I think it is a constant process. I think we do strategies for the most part at an account level, from a mining new services, new offerings, new solutions, etc……

….. But we will continue to do that more pragmatically also, because I think there are some really good opportunities around the capabilities that we have built in, digital, like IoT or virtual reality, augmented reality, virtual reality, analytics. Those things, we are still a little bit on the early stage and I will confess that we’re a little bit behind the curve on that one, but we believe we are catching up. And that’s also one of the big growth drivers for the rest of the year.

The inability of Cyient Ltd to achieve technological breakthrough may be one of the reasons that it is not able to generate profitability from its design-led-manufacturing business even after four years of acquiring it.

Going ahead, investors should keep a close watch whether the company is able to gain incremental business from its existing customers or on the other hand, it loses business to its competitors.

4) Hedging by Cyient Ltd using derivatives:

While reading the annual reports of the company, an investor notices that Cyient Ltd uses derivative contracts to hedge its risk related to foreign currency (forex) and interest rate movements.

As per the accounting policies disclosed by the company in its annual report, when a derivative contract acts as an effective hedge (i.e. it controls risk effectively), then the company recognizes its fair value changes in the cash flow reserve. It means that if a hedging derivative contract does its job properly, then the company does not recognize profit or loss due to its fair value changes in the P&L statement. Instead, it recognizes these changes (profit or loss) in the other comprehensive income and then under cash flow hedge reserve i.e. they do not impact the net profit after tax (PAT) reported by the company in the P&L.

FY2019 annual report, page 189:

These derivative contracts are stated at the fair value at each reporting date.

The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recognised in other comprehensive income and accumulated under cash flow hedge reserve. The gain or loss relating to the ineffective portion is recognised immediately in consolidated statement of profit and loss.

Further advised reading: Understanding the Annual Report of a Company

The above disclosure on accounting policy of hedging derivatives indicate that whenever any hedging instrument is considered ineffective, i.e. it becomes speculative in nature, then the company recognizes changes in its fair value in the profit and loss statement. It means that the changes in the fair value of ineffective/speculative derivative contracts are recognized in the P&L as profit or loss under other income and these, in turn, affect the net profit after tax (PAT) reported by the company.

From the above discussion, an investor may understand that whenever a derivative contract purchased by the company for risk mitigation (hedging) does its job, then the yearly changes in its values do not affect P&L statement. On the contrary, if the derivative contract purchased by the company stops reducing risk of the company or the derivative contract is speculative in nature, then the yearly changes in its value affect the P&L statement as profits or losses on such contracts are added or reduced from the “Other Income” in the P&L.

Therefore, an investor may appreciate that if any company has a lot of profit or loss due to derivative contracts in its “Other Income” then it may be due either or both of the below cases:

1. First, the derivative contracts purchased by the company to reduce risk (hedging) are not structured properly. It means that the derivative contracts have stopped doing their job of risk reduction and instead, they are now increasing the risk of the company by exposing it to high fluctuations of derivatives values.
2. Second, the derivative contracts are not purchased by the company for reduction of risk (hedging) but are purchased by the company as speculative instruments in order to gain on its views of future foreign exchange or interest rate movements.

Both the above scenarios indicate that the company is either not able to purchase proper hedging derivatives or the company is speculating on forex movements. Either of these cases is not a desirable situation for any company because handling speculative derivatives positions is not an expertise of an IT services company.

In the case of Cyient Ltd, an investor notices that very frequently, the company has reported large profits as well as losses due to derivatives contracts.

In FY2010, the company reported large amounts of gains & losses on derivative contracts.

FY2010 annual report, page 100:

Other Income for the year includes Rs.450,829,601 towards reversal of provision for MTM losses on derivative contracts, Rs.187,073,883 towards loss on settlement of derivative contracts and Rs.90,481,526 towards restatement gain on derivative contracts taken during the year.

Similarly, in FY2015, Cyient Ltd reported that a significant part of other income was due to changes in values of derivative contracts.

FY2015 annual report, page 147:

Other income for the year was at ₹ 1,218 million as compared to ₹ 169 million last year. The increase was mainly due to higher realized gain on forward contracts and increase in treasury income.

While reading the FY2016 annual report, it seems that gains and losses on derivatives contracts have become a regular feature of the other income of the company.

FY2016 annual report, page 71:

Other income for the year was at ₹ 1,085 million as compared to ₹ 1,218 million last year. The decrease was mainly due to lower realized gain on forward contracts.

In FY2017, the company took a large loss on its derivatives contracts. Investors should understand that derivatives contracts are double-edged swords. If they can increase the profits during good times, they can generate a large amount of losses during bad times as well. Moreover, we believe that IT services companies usually do not have the required capabilities to manage speculative derivatives instruments.

FY2017 annual report, page 86:

Other income for the year was at INR 932 million, compared to INR 1,085 million in FY2016. While there was an increase in the treasury income, the overall decrease in other income was mainly due to an unrealized loss on forwarding contracts.

FY2018 annual report, page 78:

Other income for FY 18 was at ₹ 1,519 Mn as compared to ₹ 932 Mn in FY 17. Increase in other income is primarily on account of increase in treasury income and gains on foreign exchange forward contracts.

While reading the management discussion in the conference call of the company in July 2019, an investor realizes that the company considers gains on derivatives contracts, whose original purpose is hedging (risk reduction) as a means to increase profits. In the discussion on the conference call, the management seems to rely on the gains from derivatives contracts as a reliable source of profits.

Conference call, July 2019, page 4:

Coming to the hedge book, in terms of the current quarter you would have seen we have gained on the forward contrasts, that’s showing up in our other income. When you look at next four quarters where we have a coverage for our multiple currencies, we are covered up to next for quarters, that is quarter one of financial year 2020. And we continue to be consistent with the policy. And if you see, our total contracts in all the currencies are at $134 million. And the spot rate on average basis for all the currencies for the next 12 months is about Rs. 5 higher compared to the spot rate today. So, what it means is, at current spot rate, we have a gain of about Rs. 691 million, or $10 million based on the hedge book as of now.

….Also for the full year, if you look at these benefits, look at the forward cover positions, we are very sure that our other income is going to be much higher than the last year, especially at the current spot rates.

The management has also highlighted this point in its presentation to investors in July 2019, page 12:

On the current forward contracts, the company has following position for the next 12 months at current spot rates:

• Outstanding Forward Contract as on 30 th June’19 is ~ $134Mn
• If the spot rate remains at same level (as at 30 th Jun’19), forex gain on current forward contracts could be ~$10Mn (~₹ 691 Mn)

The company seems to project that the forward contracts entered by the company are a source of profit generation source for the company instead of risk reduction instruments for foreign currency movements.

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

While assessing the hedging accounting policy, an investor understands that effective hedges i.e. the derivatives that reduce risk do not lead to gains or losses in the P&L. The other income in the P&L gets gains or losses only on derivatives contracts, which are either ineffective hedges (i.e. do not reduce risk) or are speculative in nature.

Presence of frequent large gains or losses from derivatives contracts in the “Other Income” of Cyient Ltd indicates that the company is not able to hedge its foreign exchange exposure effectively or the company is entering into speculative derivatives contracts. In either of these cases, investors should understand that derivatives are double-edged swords. In good times, their gains may seem sweet to the investor; however, in troubled times, losses on derivatives have even led to the bankruptcy of companies.

As a result, it is advised that investors should closely track the derivatives exposures of Cyient Ltd and take their decisions accordingly.

5) Lack of proper focus on risk management by Cyient Ltd.

While reading the above discussion about the reliance on the management of Cyient Ltd to generate profits, an investor would appreciate that the company seems to underestimate the risk of derivatives. It seems that the company believes that the company thinks that it can regularly generate profits from its derivative trades. As a result, in July 2019 conference call, the management communicated the gains on its derivative trades at the current spot rates giving the message that it’s another source of regular profits.

An investor would appreciate that assuming derivatives as a regular source of profits is underestimating the inherent risk of derivatives. The company seems to ignore the risk in these decisions.

While reading the report of the credit rating agency, ICRA, on corporate governance of Cyient Ltd in March 2019, an investor gets to know that ICRA has also highlighted that the company does not put the required focus on risk management. As per ICRA, the risk evaluation by Cyient Ltd needs improvement.

Requirement for more focussed discussion on risks in the board/board committee meetings – Cyient currently has combined audit and risk board committee. Though there is an internal risk committee comprising of members from the senior management team, ICRA opines that Cyient’s board discussions on risk are currently limited, and that a more robust risk evaluation and policy framing at the board level is required.

ICRA has mentioned in its report on Cyient Ltd that the board of the company does limited discussions on risk management and it requires improvements in terms of better risk evaluation. ICRA has recommended that a dedicated risk committee of the board of directors is needed for Cyient Ltd.

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

In light of the above discussion, it does not come as a surprise to the investor that the company seems to underestimate the risk of derivative trades.

What does come as a surprise to the investor is that in Q4-FY2019, Cyient Ltd won an award for best risk management systems.

Investors’ presentation, April 2019, page 8:

Cyient Finance team won the “Best Risk Management Systems and Framework” award in the Treasury Risk and Compliance Excellence by Kamikaze B2B Media

However, we believe that while taking investment decisions, an investor should not pay a lot of focus on the awards won by companies. This is because Satyam Computers Services Ltd, which is one of the biggest corporate frauds in India, has won awards for best corporate governance.

Therefore, we advise that an investor should not rely on the awards won by companies in order to take their investment decisions. Instead, she should do her own analysis to arrive at conclusions even if her conclusions represent an opinion different from the message given by the awards.

6) Independent director who may not be truly independent:

ICRA in its report on corporate governance of Cyient Ltd in November 2017, highlighted that the company needs to improve the selection of independent directors.

ICRA highlighted that in case of one independent director, Cyient Ltd had a position of inter-linkage. ICRA mentioned that one of the executive directors (maybe one of the promoters) of Cyient Ltd is a part of board and audit committee of a company, which is promoted by one of the independent directors of Cyient Ltd.

Corporate governance report, ICRA, November 2017, page 3:

Avoidance of Interlinkage in Boards – One of the executive directors of Cyient is a member of a Board and audit committee of a company where an independent director of Cyient is a promoter. This could result in conflict of interest and prevent independent decision making; and thus, avoidance of the same is imperative.

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

An investor may appreciate that such a situation may be similar to a quid-pro-quo between two friends where each one of them becomes a director on the board of other’s company. Investors may appreciate that in such arrangements; it is difficult to rely on the independence of opinion of independent directors. Such situations have the potential of affecting the corporate governance level for companies.

Here again, an investor notes that Cyient Ltd had won an award on corporate governance in Oct. 2012. (Source: Company Website)

We suggest that an investor should not rely on the awards while taking her investment decision. Instead, she should do her own homework before putting her hard-earned money in the shares of any company.

7) Very high maintenance expense incurred by Cyient Ltd on machinery:

An investor would appreciate that the dominant business of Cyient Ltd is providing IT services. The standalone financials of the company represent primarily services business and no manufacturing activity. As a result, an investor would recollect that the standalone financials of the company do not contain any inventory.

Cyient Ltd entered into design-led-manufacturing segment by acquiring Rangsons Electronics Private Limited in February 2015, which until March 31, 2019, was a separate subsidiary of the company. It is only in July 2019 that Cyient Ltd has initiated the process to merge Rangsons Electronics Private Limited (later renamed as Cyient DLM Pvt. Ltd) with itself.

Therefore, an investor would appreciate that until March 31, 2019, the standalone financials of Cyient Ltd represent primarily asset-light IT services business and the capital-intensive manufacturing business is present in its subsidiary (Cyient DLM Pvt. Ltd).

As per the annual report of Cyient Ltd for FY2019, the company reported standalone fixed assets (property, plant & equipment and capital work in progress) of ₹274 cr. Cyient Ltd has not provided a detailed breakup of fixed assets in its standalone financials. Therefore, it is not possible to ascertain the values of different components of these fixed assets like buildings, plant & machinery, computers etc.

FY2019 annual report, page 153, standalone balance sheet:

While analysing the expenses of Cyient Ltd, an investor notices that in the standalone profit & loss statement, the company has disclosed an expense of repair & maintenance of machinery of about ₹86.8 cr in FY2019, which seems very high for a fixed asset base of ₹274 cr. (>30% of the total asset value).

FY2019 annual report, page 167:

Further advised reading: Understanding the Annual Report of a Company

An investor should keep the following things in mind while she interprets the expense of ₹86.8 cr incurred by Cyient Ltd on the repair of machinery in standalone financials of FY2019:

• The standalone financials contain the asset-light IT services business, whose primary role is to produce software solutions using IT engineers sitting in buildings. Therefore, the main fixed assets of the IT services business are expected to be buildings and not plant & machinery.
• The asset-heavy manufacturing business of the company is present in its subsidiary, Cyient DLM Pvt. Ltd., which is not included in its standalone financials. Therefore, the fixed assets of the standalone balance sheet of Cyient Ltd are not expected to contain a lot of plant & machinery.
• Therefore, the standalone fixed assets are primarily expected to contain buildings, whose maintenance/repair expense is shown separately in the above screenshot as ₹1 cr in FY2019.

In light of the above points, it is not clear to an investor what does the large expense of ₹86.8 cr under repair of machinery in standalone financials pertain to. An investor may note that Cyient Ltd has consistently shown such a large expense in its “Other Expenses” year on year. In FY2018, the same expense was ₹75.3 cr.

An investor may assume that this expense may pertain to the maintenance expense for the building that Cyient Ltd has leased for its employees and it may have misclassified it as repair of machinery. However, an investor would appreciate that the maintenance expense of any leased building is a fraction of the lease rental paid by the company. Normally, as a rough benchmark, the maintenance expense of a building maybe 10-20% of the lease rent paid by tenants.

In the above screenshot, an investor would note that Cyient Ltd has disclosed ₹54.8 cr as a rental expense for FY2019. Assuming that the company misclassified the maintenance expense on these buildings as repair of machinery, then the amount of maintenance expense for the buildings should be about ₹10 cr (assuming 20% of lease rental).

Investors may contact the company directly to understand the nature of this expense and the kind of machinery the company carries in its standalone balance sheet (outside its design-led-manufacturing business in its subsidiary, Cyient DLM Pvt. Ltd.), for which it needs to spend almost ₹75-85 cr on repair every year.

Further advised reading: How should investors contact Companies/Management for clarifications or additional information?

8) Delays in depositing undisputed statutory dues by Cyient Ltd to govt. authorities:

While analysing past annual reports of Cyient Ltd, an investor notices that repeatedly, the company failed to deposit undisputed statutory dues like Income Tax, Employees’ State Insurance, Provident Fund, Custom Duty, Works Contract Tax etc. with the govt. authorities.

FY2012 annual report, page 77:

Whilst the Company has generally been regular in depositing undisputed dues, including Provident Fund, Investor Education and Protection Fund, Sales Tax/VAT, Wealth Tax, Service Tax, Custom Duty, Excise Duty, Cess and other material statutory dues applicable to it with the appropriate authorities, there were some delays in depositing undisputed dues in respect of Income Tax, Employees’ State Insurance and Works Contract Tax.

FY2013 annual report, page 81:

Whilst the Company has generally been regular in depositing undisputed statutory dues, including Investor Education and Protection Fund, Sales Tax/VAT, Wealth Tax, Service Tax, Cess and other material statutory dues applicable to it with the appropriate authorities, there were some delays in depositing undisputed dues in respect of Income-tax, Employees’ State Insurance, Provident Fund, Custom Duty and Works Contract Tax. Excise Duty is not applicable to the Company.

FY2014 annual report, page 151:

Whilst the Company has generally been regular in depositing undisputed statutory dues, including Investor Education and Protection Fund, Employees’ State Insurance, Sales Tax/ VAT, Wealth Tax, Service Tax, Customs duty, Cess and other material statutory dues applicable to it with the appropriate authorities, there were some delays in depositing undisputed dues in respect of Provident Fund, Professional Tax, Income-tax and Works Contract Tax. Excise Duty is not applicable to the Company

An investor may note that when a company, which has surplus cash & investment frequently does not deposit undisputed statutory dues on time, then it may not indicate liquidity issues. Instead, it may indicate a lax approach of the employees towards compliance standards. Such repeated delays may indicate a lack of proper training of the employees responsible for such functions or may represent a lax culture overall.

Many times, such frequent delays in depositing undisputed statutory dues may represent inefficient internal control processes in the organizations. Moreover, an investor would appreciate that occasionally inefficient internal control processes may leave loopholes for frauds as well.

Therefore, it is advised that an investor should closely track the disclosures of the company, which may indicate inefficient internal control processes. If investors come across any such incidence that may indicate lax internal controls, then she may take a decision accordingly.

Margin of Safety in the market price of Cyient Ltd:

Currently (August 4, 2019), Cyient Ltd is available at a price to earnings (PE) ratio of about 9.8 based on consolidated earnings of the last four quarters from July 2018 –June 2019.

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

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

• Further advised reading: 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
• Read: How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
• Further advised reading: Hidden Risk of Investing in High P/E Stocks

Analysis Summary

Overall, Cyient Ltd seems like a company, which has been able to grow its sales at a growth rate of 15%-20% year on year in the past. However, the sales growth of the company has not witnessed similar growth in profitability. Cyient Ltd has witnessed its profit margins decline over the years from 22% in FY2010 to 13% in FY2019.

The declining profit margins of the company are primarily due to two reasons. The first reason is the intense competition in the IT services markets where the companies are not able to pass on increasing cost of their operations (primarily rising employee costs) to their customers. As a result, IT service providers see very high attrition among employees, which at times affects the completion of customers’ projects.

The second reason for the decline in profit margins of Cyient Ltd is the management’s decision to acquire design-led-manufacturing (DLM) business, Cyient DLM Pvt. Ltd. The DLM business has provided to be very low margin business, which at the same time is capital intensive that has consumed a lot of cash. Cyient Ltd has not been able to derive significant benefits from the DLM business after four years of its acquisition and the DLM business is still making losses. Going ahead, it remains to be seen whether the DLM business is able to live up to the expectations with which Cyient Ltd paid almost ₹300 cr for its assets of about ₹30 cr in February 2015 (74% stake). Until now, the DLM business has performed below expectations, which is also evident from the fact that for the remaining 26% stake, which Cyient Ltd acquired in FY2019, the company paid a lower amount than what was originally envisaged. As per April 2019 conference call, Cyient Ltd paid ₹42.6 cr for the remaining 26% stake of DLM business instead of original estimates of ₹56 cr.

Cyient Ltd has been able to save on tax payouts by focusing on delivering solutions to customers from its units located in special economic zones (SEZs). However, now the tax incentives of many of the SEZ units are phasing out as these units shift from 100% tax exemption stage to 50% tax exemption stage. Going ahead, investors should monitor the tax payout ratio of the company.

The core IT services business of Cyient Ltd is an asset-light business, which needs the creation of computer setups in leased buildings and does not need any inventory buildups. However, an investor notices that the company has been spending almost ₹75-85 cr every year on the repair of machinery in its standalone entity, which does not contain any manufacturing operations. Investors may seek clarifications from the company regarding this.

The company has had cash surplus in its operations in the past and as a result, it has cash & investments exceeding ₹1,000 cr on March 31, 2019. However, the company has relied on debt to meet its fund requirements in the DLM business of its subsidiary. It remains to be seen whether Cyient Ltd is able to make its DLM business free cash flow (FCF) generating business in the future. Moreover, investors may monitor whether Cyient Ltd relies on further debt to meet the investment requirements of DLM business or it uses its cash reserves to reduce the debt levels.

In its quest to access newer technologies and customers, Cyient Ltd has acquired many companies in the past. A few of these companies have been acquired at steep valuations when compared to their asset values. In light of issues related to such acquisitions in the IT industry in the past, it is advised that investors should pay deeper attention while analysing such acquisitions by the companies in which they hold shares.

An investor should note that despite these acquisitions, the management of Cyient Ltd has acknowledged that it is lagging behind its competitors on new-age technological fronts when compared to its competitors.

The risk assessment and management practices of the company seem to leave room for improvement despite it winning the award in this area. The hedging policy of the company does not seem to lead to effective hedging/risk management and as a result, many derivatives purchased by the company end up a non-effective hedge or speculative in nature. Therefore, investors witness a large amount of gains/losses on its derivative transactions in the profit & loss statement in “Other Income”. Investors notice that the company seems to consider gains on derivative transactions as a regular source of profits without recognizing that derivatives are a double-edged sword and many companies have burnt their fingers playing with them.

There seem to be certain challenges like the selection of independent directors out of people in whose companies promoters of the Cyient Ltd also hold board positions and frequent delays in depositing undisputed statutory dues to govt. authorities. These instances may indicate that the company can improve its corporate governance and compliance standards. Investors may keep a close watch on the decisions of the company and in case, they find any decision, which is not in favour of minority shareholders, then they may take a decision accordingly.

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

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

Hope it helps!

Regards,

Dr Vijay Malik

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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.