This article provides an in-depth fundamental analysis of KNR Constructions Ltd, an Indian infrastructure player focused on EPC (engineering, procurement and construction) activities in the road and irrigation sector.
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.
KNR Constructions Ltd Research Report by the Reader
Dear Vijay Sir,
I was going through Screener using some criteria and came across this company KNR Constructions Ltd engaged in EPC construction of highways and recently getting involved with irrigation projects.
The stock is held by many marquee mutual funds and this is what I am surprised at when I tried to analyze the quality of management. Here I might be completely wrong and thus need your expert comments on my understanding of management
Regards
Sunny Bhardwaj
Financial Analysis of KNR Constructions Ltd:
- Good CAGR, PAT, OPM and PAT. Consistent Margins.
- Working capital ratios improving. NFAT improved from 3.37 to 7.05 (2008-17)
- Receivable days decreased from 53 to 35
- Inventory turnover ratio (ITR) stable
Industry and Business Analysis of KNR Constructions Ltd:
KNR Constructions Ltd is a dominant player in south India in the construction of highways. It gets a rebate on taxation to consider profit as non-taxable under section 80IA.
80-IA. (1) Where the gross total income of an assessee includes any profits and gains derived by an undertaking or an enterprise from any business referred to in sub-section (4) (such business being hereinafter referred to as the eligible business), there shall, in accordance with and subject to the provisions of this section, be allowed, in computing the total income of the assessee, a deduction of an amount equal to hundred percent of the profits and gains derived from such business for ten consecutive assessment years.
It has backward integration enabled with quarries in South India and thus enjoys sustainable margins of nearly 14-15%. The current order book stands at ₹33 bn ~ 1.9x TTM sales value. It is expecting an order inflow of ₹25-30 bn in 2018. Regular BOT revenue of around ₹2.76 mn daily from two toll projects.
Valuation Analysis of KNR Constructions Ltd:
- PE of ~15 against inverse govt bond yield of 16+
- 56% FCF/CFO
- 36% SSGR gives a cushion of safety.
- Cash per share of ₹44 for CMP ₹316 gives a cushion
- SSGR of 36% against sales growth of 20 odd percent does not warrants any dilution or capital infusion
Management Analysis of KNR Constructions Ltd:
The stock is held by many marquee mutual funds and this is what I am surprised at when I tried to analyze the quality of management. Here I might be completely wrong and thus need your expert comments on my understanding of management.
Doubt 1:
Regular equity dilution in huge chunks – in just 3 years they have diluted almost 17% of equity. However, the compensation ratios appear to be decent with a decent avg. employee salaries. What is the need for such aggressive dilution? Why not just raise the debt and repay it as growth is there? In addition, CSR adherence is not appropriate with no logical explanation for the unspent amount.
2. Doubtful related/3rd party transactions
The promoter whose salary is ₹3.6 Cr/₹2.4 Cr in the previous year, takes an unsecured loan of ₹80 Cr. from the company and pays 3.54 Cr. as interest @ 4% while the bank charges individual loan rates of nearly upside of 12-13%. What is this loan for? What interest this serves the company.
Then for another promoter, there are charges like land leasing and locker charges which seem to be unexplained. Why will you lease land if you are already staying in a guesthouse at the company’s expense? What benefit does this land lease bring to the company?
Then there are other transactions leading to huge receivables from related parties, which seem not to be explained and then there are inter-corporate loans to subsidiaries without any interest shown.
Dr Vijay Malik’s Response
Hi Sunny,
Thanks for sharing the analysis of KNR Constructions Ltd with us! We appreciate the time & effort put in by you in the analysis.
As highlighted by us in the analysis of PNC Infratech Ltd and MBL Infrastructure Ltd, the analysis of an infrastructure/EPC player (Engineering, Procurement and Construction) is different from other companies due to the following factors and we need to keep these points in mind whenever we put interpretations to the financial results of any infrastructure/EPC player:
- The EPC contractor’s business is nothing but an accumulation of all its projects under execution. Unless each of these projects is assessed individually, the complete business position of the EPC player cannot be understood. From the publically available information, we find it difficult to assess whether these projects have key factors like land acquisition, govt. approvals etc. in place. We have always been sceptical about the cost estimates shared in the publically available information whether these are the real ones or there have been escalations, which companies usually hide from stakeholders.
- The revenue of the EPC players is derived from the cost incurred by them as these companies use a percentage of completion method (POCM) for revenue recognition. The revenue declaration has no linkage to the actual cash that an EPC player might or might not receive. Many times, using the percentage of completion method (POCM), EPC companies show even that part of the project work in revenue whose bills are not sent to the customers, which gives rise to “Unbilled Revenue” in the balance sheet. Many times, there are disputes between the stage of the project claimed by the EPC player and the Govt Departments/project allottees who have to release the payments etc. It cannot be assessed from the publically available information how the situations are on this front.
- The EPC players usually have many subsidiaries and the assimilation of subsidiary financials into the main company leads to many areas of accounting manipulations, which always raise an alarm in business assessment.
We would analyse the financial performance of KNR Constructions Ltd while keeping these aspects in mind. Moreover, as mentioned above, the EPC players usually create many subsidiaries/joint ventures to bid for projects and execute them. Therefore, it is advised to focus on the consolidated financials of EPC players so that an investor may assess the financial position of the complete group in her analysis.
In light of these points, let us now assess the performance of KNR Constructions Ltd over the last 10 years (FY2008-17).
Financial Analysis of KNR Constructions Ltd:
Looking at the financial data of KNR Constructions Ltd for the past 10 years (FY2008-17), an investor would notice that the company has grown its sales at a moderate pace of 10-12% year on year from ₹551 cr in FY2008 to ₹1,680 cr in FY2017 with stable operating profitability (OPM) of 14-15% year on year.
While reading the FY2017 annual report of KNR Constructions Ltd, page 155, an investor notices that the company follows the percentage of completion method (POCM) for revenue recognition:
The Group follows the percentage completion method, based on the proportion that contract cost incurred as on reporting date to the total estimated contract cost including escalations/ variations as per Ind AS 11, Construction Contracts.
As mentioned above, in POCM, EPC players recognize revenue based on their assessment of the cost incurred in the project as a proportion of the total estimated cost of the project. Many times, the EPC players end up showing that part of the project work as revenue, which is yet to be billed to the customer/accepted by the customer as completed, which gives rise to “Unbilled Revenue”.
As per the FY2017 annual report, page 172, has about ₹80-85 cr of revenue, which it has shown as its operating revenue in the profit & loss statement, but which is yet to be billed to the client:
Further advised reading: Understanding the Annual Report of a Company
An investor would appreciate that in such instances, many times, later on, the customer may dispute the bill raised by the EPC player citing that it does not agree that the construction stage as per the agreed contract has been achieved. On the other hand, the customer may dispute the quality of the work and in turn, show its dissent on the bill raised by the EPC player.
Such a situation leads to disputes and claims between the customers and EPC players, which many times lead to the customer denying payment of bills raised by the EPC player, which leads to the reversal of revenue earlier recognized. Many times, customers ask for a refund of the money paid earlier in case they are not satisfied with the work. As a result, we notice that EPC players including KNR Constructions Ltd many times show items like “Due to customers” in their balance sheet.
The FY2017 annual report, page 179 shows that on March 31, 2017, KNR Constructions Ltd has about ₹158 cr due to customers, an amount that has increased over the years:
An investor would note that the item “Due to customers” is different from “Advance received from clients”. The advance received from clients may represent the money provided by the clients to kick-start the work of any project by mobilizing the construction machinery/acquiring land on behalf of the customer etc.
Therefore, it is advised that investors may seek clarifications from the company about the reasons for the significant amount of dues to the customers.
Therefore, in light of the above observations related to:
- Recognition of revenue at a stage where the customer has still not approved it (unbilled revenue).
- The constant scope of disagreement in the total amount of estimated cost of the project, the amount of cost actually incurred on the project as well as the percentage of the stage completed. Moreover, the person auditing/certifying the financials being chartered accountants, who are not experts in matters related to civil engineering works, also brings in chances of errors in the cost/percentage stage assessment.
- Frequent disputes between the customers and EPC players in the stage of the project achieved until date, which directly affects the revenue to be recognized by the EPC player
- These disputes lead to claims on EPC players, where EPC players may resort to deferring the reversal of revenue recognition from profit and loss statement but instead carry a liability on the balance sheet under “Due to customers”
Therefore, an investor would appreciate that the amount of the revenue disclosed by the company in any year predominantly highlights the company’s assessment of its project execution instead of its ability to bill and collect money from its customers.
Therefore, it is advised that investors should always be cautious while assessing the revenues reported by the infrastructure/EPC players and should seek clarifications from the companies as and when needed.
Further advised reading: How to do Business Analysis of Construction Companies
Moreover, an investor would need to keep a few things in mind while assessing the expenses of the company as well.
Apart from the regular operational expenses on the construction of the projects shown in the profit & loss statement (FY2017 annual report, page 144) an infrastructure/EPC player like KNR Constructions Ltd, every year, spends a significant amount of money on the construction of projects, which is not reflected in the profit and loss statement for that year. These projects and the expenses on these projects, which are over and above the P&L, are shown under “intangible assets under development” in the balance sheet under “intangible assets under development” in the non-current assets section. (FY2017 annual report, page 143):
These projects are usually the BOT (Build, Operate and Transfer) or HAM (Hybrid Annuity Mode) projects. After the completion of the projects, which are capitalized under “intangible assets under development”, the projects are shifted to “other intangible assets”. This shift is visible in the non-current assets section shown above for KNR Constructions Ltd, where the other intangible assets are increasing year on year.
An investor would observe that the other intangible assets and intangible assets under development are shown differently from the normal capital expenditure under “Property, plant and equipment” and “Capital work-in-progress”. The normal capital expenditure under “Property, plant and equipment” and “Capital work-in-progress” may represent the spending done by the company on construction machinery, trucks, dumpers, crushing plants, mixing plants etc.
Looking at the significant amount of assets accumulated under “Other Intangible Assets” and “Intangible assets under development” (about ₹1,000 cr at March 31, 2017), an investor would appreciate that to assess the real economic value generated by the company to its shareholders, an investor needs to take into account the returns on these assets. An investor would appreciate that a normal look at the P&L statement would not be sufficient to assess the true outcome of such financial decisions.
Additionally, an investor would appreciate that a company will show only those projects in its balance sheet, which are either owned by it or are owned by its subsidiaries in which it has more than 50% stake.
For the joint ventures, where the company has less than 50% stake, it would not show those projects in its balance sheet under “Other Intangible Assets” or “Intangible assets under development”. In such cases, the company will show the amount invested by it under the non-current investments and the economic benefit from such projects will be shown as dividends/interest received in the P&L. An investor would appreciate that without looking at the detailed project dynamics of such investments, only information of dividend/interest received may not be sufficient to assess the true profitability of these projects.
If an investor analyses the FY2017 annual report, then she notices that KNR Constructions Ltd had decided to sell its stake in two operational BOT annuity projects, which it had developed in collaboration with Patel Engineering Ltd. The FY2017 annual report, page 7:
Key Developments: As part of our strategy, Company along with Patel Engineering Limited (PEL) signed a share purchase agreement to sell entire equity stake in two Road BOT (annuity) assets viz. Patel KNR Infrastructures Limited and Patel KNR Heavy Infrastructures Limited. Both the assets are operational annuity based BOT assets awarded by NHAI.
However, when an investor analyses the annual report further, then she notices that at the sale price of these assets, the company has to incur a loss of about ₹10 cr and the company had made a provision of impairment in the value of assets in the annual report (FY2017 annual report, page 15):
During the year the Company has entered a Share Purchase Agreement for sale of its equity in two BOT annuity projects and correspondingly impairment in value of investment to the tune of ₹ 108.6 million has been provided. In percentage it accounts for 0.70% of revenue.
Further advised reading: Understanding the Annual Report of a Company
An investor would notice that the projects on whose sale price, the company has to take a loss were operational annuity projects. Therefore, the reported financial numbers in the profit & loss statement of an infrastructure/EPC player may not communicate its true financial position/money-making ability for its shareholders.
On an update, as communicated in the February 2018 conference call, page 18: it seems that the sale of these two projects has not been completed and the issue is currently under arbitration:
Ravi Naredi: So, our two projects, toll project sale has been suspended with Patel Joint venture, so are you planned to again sell it?
S. Vaikuntanathan: See, now we are planning to expedite that the arbitrations is going in a faster manner, so we are trying to expedite that. Till such time the clients and other things are received, we may try to hold it on for some more time.
An investor would appreciate that the operating profit margin (OPM) shown by the company in the P&L may represent only the nature of those projects, which are being factored in the P&L for the year by way of incremental costs being incurred on those projects during the year. An investor should keep in mind that this assumes that the auditor despite being a chartered accountant and not a civil engineering expert, has correctly estimated the cost/project estimates provided by the company.
The management has communicated to its shareholders in the February 2018 conference call that the variations in the prices of cement and steel are a major risk to the profitability of the company as the EPC contracts do not provide for a full pass-on of increase in these raw material costs. (February 2018 conference call, pages 18-19):
Sourabh Jain: Sir, second and last question can you throw some light on challenges that you foresee in business and say immediate and mid-term, medium term?
K. Jalandhar Reddy: Challenges really would be the cement, steel prices because you would have seen last 3 months there has been steep price in the steel and cement. Going forward how they would be that is only major constraint because in any of the EPC projects also the cement and steel is not properly covered in the escalations.
Sourabh Jain: So, when you say not properly covered do you mean that there is no pass through or there is some pass through but which may not be sufficient?
K. Jalandhar Reddy: Yes, but that is not sufficient.
In light of the fact that the EPC contracts do not fully cover escalations in the key raw materials of cement and steel, it comes as a positive surprise to the investors that the company has been able to generate a stable OPM of 14-15% over entire last decade (FY2008-17). It is advised that investors may seek clarifications from the company to understand in detail the parameters that influence their profit margins and the steps taken by the company in the past, which could lead to sustained profitability over the last 10 years when the cement and steel prices had witnessed significant fluctuations.
In order to understand the cement industry better including the working of a cartel of manufacturers in the cement industry, an investor can read the analysis of one of the cement companies, Heidelberg Cement India Ltd, on our website: Analysis: Heidelberg Cement India Ltd
The assessment of the true profitability of the company would require an estimation of the profits generated by the company on the projects, which are capitalized on the balance sheet under “Other Intangible Assets” as well.
For illustration, an investor may look at the BOT project “Walayar –Vadakkancherry Project” which is completed by KNR Walayar Tollways Private Ltd, which is 100% owned by KNR Constructions Ltd and is likely to be present in the “Other Intangible Assets” in the balance sheet. Details of this project are provided on page 22 of Feb 2018 investor’s presentation of the company:
An investor would notice that the company has spent about ₹900 cr on this project as the total cost. In 9M-FY2018, the project generated a toll income of about ₹38 cr, which can be extrapolated to about ₹50 cr per annum (37.87*12/9 = 50.36). An investor would appreciate that a toll income of ₹50 cr on a project cost of ₹900 cr provides a yield of about 5.55%. This yield is very low on investment as ₹900 cr invested in any bank fixed deposit may provide a higher return/yield.
Additionally, the company needs to spend further money to operate the toll road in terms of employee salaries, regular maintenance of the road, the lighting of the road etc., which needs to be spent from the toll revenue. Therefore, the net profit from the project will provide even a lesser yield than 5.55% on the total project cost.
Further advised reading: When a company should sell all assets and invest money in FDs?
You may read about some of the other companies, which have such low returns on their assets that the company might be better off selling all its assets and investing the money in bank fixed deposits:
- Analysis: Globus Spirits Ltd
- Analysis: Meghmani Organics Ltd
- Analysis: Navkar Corporation Ltd
- Analysis: Castex Technologies Ltd / Amtek India Ltd
In light of the lower toll yield on the project cost for the Walayar –Vadakkancherry project coupled with other expenses and debt-servicing requirements, the project does not seem to be able to sustain itself on its own. As a result, the parent company KNR Constructions Ltd has to put in additional capital in KWTPL to make it sustainable.
As per the FY2017 annual report, page 91, during FY2017, a year that was a period of the full year of toll operations, KNR Constructions Ltd had to infuse an amount of ₹130 cr (396.51 – 266.51 = 130.00) in KWTPL to help it meet its expenses and debt servicing requirements.
The requirement for infusion of funds by the parent company indicates that the project is not profitable and until now has not been able to add economic value to the shareholders of KNR Constructions Ltd. Instead, it is draining the resources of the parent company.
If an investor looks at the performance of the subsidiaries of KNR Constructions Ltd on page 201 of the FY2017 annual report, then she realizes that most of the subsidiaries & joint ventures (JV) of the company are making losses:
Moreover, an investor would notice that for FY2017, the profit shown by the parent is 152.39% of the total consolidated profit. This indicates that all the other subsidiaries and JVs have contributed to a loss of 52.39% to the overall consolidated financials of KNR Constructions Ltd. The company running the Walayar –Vadakkancherry project, KNR Walayar Tollways Private Ltd (KWTPL) has reported a net loss of ₹23.5 cr for FY2017.
An investor may also note that in the case of KNR Walayar Tollways Private Ltd (KWTPL), the subsidiary had reported a loss of ₹23.5 cr for the full year of operations in FY2017 whereas as discussed above, the parent company KNR Constructions Ltd had to infuse ₹130 cr in FY2017 to sustain it.
Therefore, we believe that the assessment of the profitability of any infrastructure/EPC player only based on the profitability shown in the P&L might not represent the true picture of the company. In the details of the subsidiaries/JVs shown above, an investor would notice that many of the JVs of the company are currently not making profits. As a result, the company may need to infuse additional funds into such subsidiaries/JVs.
KNR Constructions Ltd has been communicating that in the case of JVs it is only liable to fund only its proportionate share of expenses/cash flow shortfalls etc. This position may seem right from a logical argument perspective. However, we believe that in such cases, it becomes important that investors take note of the financial health of the JV partner as well.
In the case of KNR Constructions Ltd, many JVs have been formed with the Patel Engineering Group. While doing a preliminary analysis of Patel Engineering group, an investor notices that currently, the group is not doing good financially and has been defaulting to meet its debt servicing requirements. (Livemint.com: Banks invoke S4A to recast Patel Engineering’s Rs 2,963.5 crore debt)
An investor would appreciate that if a JV faces financial difficulties and the JV partner of KNR Constructions Ltd refuses to bring in its proportionate share of money to meet the cash shortfall of the JV, then KNR Constructions Ltd would face two options:
- Let the JV project be stuck and let the JV become a defaulter/NPA with lenders. In such an outcome, the parent company (KNR Constructions Ltd) will also face the consequences of restricted lending from its lenders, as banks would be extremely cautious while lending to the entire KNR group in future. In such a situation, the loss of economic value to the parent company is most likely to exceed its original investment in the JV project.
- The second option would be to infuse funds in the JV project over and above its proportionate share to meet the cash flow shortfall so that the JV project may survive and keeps on paying its lenders.
In cases of joint ventures, most of the time, the JV partner who can afford to put in additional money in the JV ends up infusing a share higher than its proportionate stake to avoid the ramifications, which otherwise would hit the parent company as well.
Therefore, it looks like that once a JV project has started and has raised debt from the lenders, then a company cannot simply conclude that its responsibility is only to the extent of its stake in the JV. A financially weak JV partner is bound to put pressure on the parent company and in turn, reduce the economic value that it may derive from the JV project.
Therefore, the consolidated financials of the infrastructure/EPC player that has many JV projects and includes only the liabilities to the extent of its proportionate share might not reflect the true profitability/economic value that the shareholders of the parent company may derive from the company.
Further advised reading: How to do Business & Industry Analysis of a Company
Therefore, in light of the above argument, we believe that investors should be cautious while assessing parameters like OPM shown in the P&L by infrastructure/EPC players as a representative of the true economic value added by the company to its shareholders in any year.
KNR Constructions Ltd has been availing tax benefits under section 80IA of the income tax act, which provides a 100% deduction on profits for companies, which carry business of road/highway projects etc. for a period of 10 years. (Ref: caclubindia.com). Therefore, investors would notice that the tax payout of the company is significantly lower than the standard corporate tax rate applicable to Indian companies.
As communicated by the company, going ahead, the tax payout of the company is expected to stay lower than the standard corporate tax rate. February 2018 conference call, page 8:
Shravan Shah: And sir tax rate for this year and next year?
K. Venkatram Rao: This year will be around 10%, sir and next year it will go up to 15%
To understand more about the infrastructure (roads/EPC) sector, an investor may read the analysis of PNC Infratech Ltd:
Analysis: PNC Infrastructure Ltd
Operating Efficiency Analysis of KNR Constructions Ltd:
The fixed assets of the company include the assets like construction machinery, crushing and mixing plants that are used to construct the road projects as well as the BOT/HAM projects, which the company plans to keep on its books and operate during the concession period.
An investor would note that the recent reduction in the net fixed asset turnover (NFAT) during the recent years from 3.67 in FY2015 to 1.77 in FY2017 is because of the completion of the BOT projects Muzaffarpur Barauni Tollway and Walayar Tollways where the significant investment in the Walayar Tollways is not resulting in significant returns.
The parameter of inventory turnover does not seem highly relevant for a player like KNR Constructions Ltd who apart from putting the inventory under the current assets also has such material classified under “intangible assets under development” under non-current assets. Therefore, it becomes challenging to ascertain the true efficiency of the inventory utilization of any EPC player.
Further advised reading: How to Analyse Operating Performance of Companies
The receivables days is a relevant parameter for an EPC player as it represents the ease with which it is able to bill and collect money from its customers. Moreover, the release of funds by the customers also indicates that the customer agrees with the amount and quality of work performed by the EPC player.
Therefore, a delay in the collection of receivables from the customers indicates that either the customers are under financial stress and may default in making the payments or that the customers do not agree with the bills raised by the EPC player. Such disagreement may be related to the achievement of payment milestones in the project progress or the quality of the work done by the EPC player.
In the case of KNR Constructions Ltd, an investor notices that the receivables days have declined from 67 days in FY2009 to 34 days in FY2017, which is a good improvement.
Further Advised Reading: Receivable Days: A Complete Guide
Keeping the receivables under control while growing the size of the EPC business is a good sign for a company that has to primarily deal with govt departments for releasing payments. It indicates that the company has been doing its job in a satisfactory manner, which is also visible from the claims made by the company that it has completed most of its projects before time.
February 2018 investor’s presentation, page 14:
The company has been able to convert its profits reported in the P&L in the form of cash flow from operations. Over FY2008-17, KNR Constructions Ltd reported a total cumulative net profit after tax (cPAT) of ₹652 cr. whereas during the same period, it reported a cumulative cash flow from operations (cCFO) of ₹1,261 cr. An investor may refer to the following article to understand more about the situations in which a company may be able to report a lower cCFO when compared to its cPAT and vice versa:
Further advised reading: Understanding Cash Flow from Operations (CFO)
Margin of Safety in the Business of KNR Constructions Ltd:
i) 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 was attempting 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.
An investor would notice that over the years, KNR Constructions Ltd has witnessed an SSGR of -3% to +5% whereas the company has been growing at a rate of 10-12% over the years. As a result, it seems that the company is attempting to grow at a pace, which is higher than what the internal business cash generation is able to sustain. As a result, the company has resorted to raising debt to meet its growth requirements as the debt has increased from ₹191 cr in FY2008 to ₹722 cr in FY2017.
ii) Free Cash Flow Analysis:
While analysing the free cash flow (FCF) position of the company, an investor notices that over FY2008-17, KNR Constructions Ltd generated a total cash flow from operations (CFO) of ₹1,261 cr and it did a capex of ₹1,565 cr over the years to grow its revenues from ₹551 cr in FY2008 to ₹1,680 cr in FY2017. However, as mentioned above, the company had a sustained high level of debt during the last decade and as a result, it had an interest expense of ₹249 cr over FY2008-17.
Therefore, post the capital expenditure and the interest payment, the company had a cash deficit of ₹553 cr (1261 – 1565 – 249). Moreover, the company has paid dividends over these years and has also made investments in various JV projects.
The company has met the cash shortfall by raising debt from different lenders and promoters and as a result, the total debt of the company has increased from ₹191 cr in FY2008 to ₹722 cr in FY2017.
An investor would notice that in the case of companies having negative free cash flow (FCF) where the entire CFO is used to meet the capital expenditure, the dividends are usually funded by raising debt. We believe that investors should not take any comfort from the dividend payouts of such companies as the dividend declarations might represent merely the act of transferring money from lenders to equity shareholders.
Free cash flow (FCF) and SSGR are 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 KNR Constructions Ltd:
On analysing KNR Constructions Ltd, an investor comes across certain other aspects of the company, which are essential for making any final opinion about the company:
1) Management Succession:
KNR Constructions Ltd was set up in 1995 by Mr. K. N. Reddy. Currently, Mr. K. N. Reddy is about 70 years of age and his son Mr. K. Jalandhar Reddy who is about 48 years of age has started playing an active role in the management and leadership of the company.
As per the communications from the company, until now, it seems that Mr. K.N. Reddy has put in place a succession plan where he is able to guide the new generation of leadership while still being at the helm of the company. February 2018 conference call, page 17:
Faisal Hawa: And another question is that within the family are our issues of who takes over the leadership or who is what I mean to say is that the promoter holding and are goes really addressed between the family going forward like say 3 years, 4 years, 5 years down the line? See, ownership that you feel that there could be any change? That been the management like says 5 years down the line or 10 years down the line?
K. Jalandhar Reddy: May be 10 years down the line I may not be able to tell you right now what will be the situation but 4-5 years in the line there is no big change that can happen but we are getting up the new, second management line, so that well the main promoters are well assisted and the many issues are taken care of our approval.
Faisal Hawa: My pointed question is that I hope there is no difference of opinion between brothers or brother-in-law this thing between so far Mr. KN Reddy has been like the great captain as the pioneer and even though legendary leader. So I hope there are no issues between the next families?
K. Jalandhar Reddy: No issues there are no issues.
Going ahead, investors may need to keep monitoring the developments on the front of promoter family members.
Further advised reading: Steps to Assess Management Quality before Buying Stocks (Part 3)
2) Project Execution:
As mentioned above, it seems that KNR Constructions Ltd has been able to show good project execution skills, as it has been able to complete a lot of projects ahead of their scheduled completion period.
Further advised reading: Steps to Assess Management Quality before Buying Stocks (Part 3)
3) Declining promoter shareholding over time with an increase in the share price of the company:
If an investor analyses the trend in promoters’ shareholding over the past few years, then she would realize that the promoters have been continuously selling shares of the company and have significantly reduced their shareholding from 74% on March 31, 2014, to 55.38% at March 31, 2018.
A simultaneous look at the reduction in the promoters’ shareholding along with the movement of the share price over the past few years might lead to the conclusion that the promoters are cashing out their stake as the share price of the company is increasing.
As detailed below, it might be that the promoters prefer to give the money raised by the sale of their shares as loans to the company and earn interest on it. It might be akin to a situation where a promoter prefers to have debt exposure on her company rather than equity exposure.
It is advised that investors should keep a close watch on the change in promoters’ shareholding going ahead.
Further advised reading: How to know if Promoters are Losing Commitment to the Company
4) A large amount of loans provided by promoters to the company:
On March 31, 2017, promoters provided loans of about ₹121 cr to the company out of which the founder promoter Mr. K.N. Reddy provided loans of ₹117 cr. During FY2017, the promoters’ loans increased by about ₹40 cr.
The FY2017 annual report, page 199:
Usually, the argument that is provided for such loans from promoters to the companies is that the company is facing difficulties in raising debt from independent sources like banks. Therefore, the promoters are helping the company by infusing funds by way of loans. KNR Constructions Ltd has put forward the same reason while describing the loans in its FY2017 annual report on page 15:
The total secured loans by way of working capital, cash credit, hire purchase loans for fixed assets and unsecured loans at the end of the year March 31, 2017 was ₹ 1,440.5 million compared to ₹ 1,167.5 million as on March 31, 2016. The net increase of ₹ 273 million is basically due to infusion of additional fund by the Promoter to pay off the debt of the one of the Project Company and finance of the hire purchase loans for fixed assets needs, necessitated by a rapid growth in the revenue during the year.
Such reasoning of the promoters helping the company to repay the debt by putting in money from their personal pockets does not corroborate with the high credit rating of A+ being enjoyed by the company from credit rating agency CRISIL. Investors should also note that in the past few years CRISIL has upgraded the credit rating of the company twice to reflect its strong financial position of the company.
As per December 2017 credit rating rationale of CRISIL, it first upgraded the rating of the company from A- to A in 2016 and then further upgraded the rating from A to A+ in 2017.
Further advised reading: 7 Important Reasons Why Every Stock Investor Should Read Credit Rating Reports
Therefore, at one end it seems that the credit strength of the company is improving as reflected by upgrades in the credit rating and on the other hand, the company has to rely on promoters’ money to pay off the debt of its subsidiaries. These contrasting signs raise questions and investors should think further about it.
Infusion of money by promoters for debt repayment in a company with a high credit rating may represent any of the following two scenarios:
A) The first interpretation may be that the credit rating assigned by the rating agencies does not reflect the true financial position of the company. As a result, the company may not be in a fundamentally sound position, which is represented by a credit rating of A+.
B) The second interpretation may be that the company is fundamentally sound and the promoters are using the company as an avenue to get the interest rate on their money, which is more than the interest rate available to them from outside sources like fixed deposits of banks.
An investor may find the amount of interest paid by the company to the promoters on the loans provided by them in the FY2017 annual report at page 195:
Using the above-shared data of the interest payment and the loans outstanding from promoters, an investor may calculate the interest rate being paid by the company to the promoters for their loans. An investor may calculate that the interest rate is about 10.3% for the loans provided by Mr. K. Narasimha Reddy and 9.7% for the loans provided by Mr. K. Jalandhar Reddy.
The interest rate available for bulk deposits in the banking system currently ranges from 6.25% to 7.50% (May 09, 2018) for senior citizens like Mr. K. Narasimha Reddy (Source: SBI Website)
Therefore, the loans from promoters to the company might be an attempt to get a higher interest rate on their funds than the interest rate provided by banks on the fixed deposits as the promoters are getting an interest rate of about 10% from the company whereas the banks may provide an interest of 6-7% on the fixed deposits.
Further advised reading: How Promoters benefit themselves using Related Party Transactions
Therefore, an investor would notice that the infusion of funds by promoters in a company with a high credit rating might:
- raise questions on the strength of the credit rating or
- may reflect an attempt by the promoters to benefit from the company by obtaining a higher interest rate on their money than the interest rates provided by the banks on fixed deposits.
Moreover, an investor would note from the discussion on the free cash flow position of the company above that KNR Constructions Ltd has negative free cash flows where its investment requirements are higher than its cash-generating abilities. As a result, the company has been meeting its cash flow needs by raising loans. Such a situation indicates that the dividends paid by the company to its equity shareholders are also funded by debt.
Extending this argument, an investor would also appreciate that the major source of funds for promoters is the dividend from the company, which in the case of KNR Constructions Ltd seems to be funded by debt. Therefore, this situation may be akin to a vicious cycle where the company is raising loans to pay dividends to the promoters and then the promoters are giving the same funds that they received from the company, back to the company and are earning higher interest rates on it.
Moreover, as discussed above, the promoters are continuously selling their shares over the last few years while the share price of the company is increasing. Therefore, these loans may be partly funded by the proceeds of the sale of the promoters’ stake in the company, which indicates that the promoters might prefer to put their money as debt in the company in place of equity shares.
We would suggest that the investors should arrive at their own conclusion regarding it by doing their analysis.
This is a situation similar to the position of promoter loans in another company Bharat Rasayan Ltd. Investors may read the following article to read the analysis of Bharat Rasayan Ltd.
Further advised reading: Analysis: Bharat Rasayan Ltd
Additionally, the investors may also seek clarifications from the company about a property owned by the promoters, which is rented by the company. It becomes significant to ascertain whether the promoters are exclusively using the guesthouse for their personal use because it might be akin to using company resources for personal benefits.
5) Demonetization: dealing in non-permitted receipts and payments in currency notes:
As per the FY2017 annual report, page 171, the company received about ₹12 lac in demonetized currency notes which were not permitted during the demonetization period. Additionally, it made payments for about ₹77 lac in the demonetized currency notes, which was not permitted:
The auditor of the company has also highlighted these non-permitted dealings of the company in demonetized currency notes in its report for the year in the FY2017 annual report, page 140:
However, as stated in Note 11.3 to the financial statements and as represented to us by the Management during the aforesaid period ₹ 77.63 lakhs has been utilized for other than permitted transactions and ₹ 12.08 lakhs has been received from other than permitted transactions.
Investors may seek clarification from the company about the nature of these non-permitted dealings in the demonetized currency notes.
Further advised reading: Understanding the Annual Report of a Company
6) Investments in closed-ended mutual funds and equity mutual funds:
While analysing the mutual fund investments made by KNR Constructions Ltd, an investor notices that the company has invested funds in SBI Equity Opportunities Fund – Series I, which is a closed-ended mutual fund indicating that the company will not be able to get its money back when it needs until the fund period gets over.
An investor would appreciate that investing money in mutual funds, which lock the money for a certain period might not be the best option for a company, which has to rely on loans from promoters to repay the debt of its subsidiaries. Any surplus money should be invested in such assets, which may be liquidated as and when the company needs money.
Moreover, the investor would also notice that the company has invested money in equity mutual funds like SBI Infrastructure Fund, SBI PSU Fund and SBI Equity Opportunities Fund, which invest money in equities. It is usually advised that companies should focus on taking the risk of their core business operations and not take unrelated risks like investment in the stock markets.
Further advised reading: How to Identify if Management is Misallocating Capital
7) Subsidiary/JV financial results not audited by their auditors:
As per the qualified opinion put in by the auditor in the FY2017 annual report of KNR Constructions Ltd, the company does not get the financial results of two subsidiaries, six joint operations and one joint controlled entity audited from their respective auditors. Instead, the management has prepared their financials and without any check by any auditor, these management-prepared financials have been included in the consolidated financials of KNR Constructions Ltd.
The FY2017 annual report, page 138:
Basis for Qualified Opinion: The Consolidated financial statements include:
a) The unaudited financial statements of two (2) subsidiaries, whose financial statements reflect total assets of ₹ 147.62 Lakhs as at March 31, 2017, total revenue of ₹ Nil, total net profit after tax of ₹ Nil and total comprehensive income of ₹ Nil for the year ended March 31, 2017, and six (6) joint operations, whose financial statements reflect total assets of ₹ 5,673.28 Lakhs as at March 31, 2017, total revenue of ₹ 3,920.50 Lakhs, total net (loss) after tax of ₹ 563.25 Lakhs and total comprehensive loss of ₹ 563.25 Lakhs as considered in the consolidated financial results, in respect of one (1) joint controlled entity is based on financial results prepared by the management and not audited by their auditors.
b) The comparative financial information for the year ended March 31, 2016 and the transition date opening balance sheet as at April 01, 2015 in respect of two (2) subsidiaries, six (6) joint operations and one (1) joint controlled entity included in this statement are prepared in accordance with the Ind AS have not been audited by their auditors.
It is advised that investors may seek clarification from the company about the reasons for the non-audit of these entities. Moreover, the investors should also ask whether any auditor has ever audited the financial results of these entities.
8) Apparently, surplus funds lying with subsidiaries:
An analysis of the subsidiaries of KNR Constructions Ltd indicates that one of the subsidiaries, KNR Agrotech & Beverages Pvt Ltd (KABPL), is apparently involved in an unrelated business of mango plantations. CRISIL in its January 2014 credit rating report of the company has indicated that KABPL is involved in mango plantations:
KABPL’s operations are restricted to mango plantations near Hyderabad (Andhra Pradesh).
Further advised reading: 7 Important Reasons Why Every StockInvestor Should Read Credit Rating Reports
The company has disclosed that in FY2017 KABPL has profits that are higher than the turnover.
The FY2017 annual report, page 209:
The most probable reason for profits being higher than the turnover might be the non-operating income of the subsidiary, which can be due to surplus funds lying with the subsidiary. Investors would appreciate that any company should call back the surplus funds from its subsidiary companies before taking loans from outside parties like promoters.
Investors may contact the company to know if the subsidiary KABPL has surplus funds available with it. Additionally, what are the company’s plans for the utilization of these surplus funds, if any?
Advised reading: How should investors contact Companies/Management for clarifications or additional information?
9) High dependence of company’s revenues & business on govt policies and activity:
The business of KNR Constructions Ltd is highly dependent on the tenders/projects being floated by central and state governments and various other departments. Any decline in the tender activity due to any issue related to elections, or political uncertainties will have a direct impact on the revenues of the company.
In the current financial year, despite the seemingly strong focus of the current central govt. on roads and infrastructure projects, as per the company, the tender allocation activity was low, which affected the entire sector.
February 2018 conference call, page 11:
Alok Deora: Just couple of questions, if we look at the order inflow in the third quarter and even in the 9 months, so they have been actually quite muted especially from the road segment. So, while we understand that the industry order flow has been weak but still some of the players have got couple of orders here and there. So, any particular reason are we like very much sticking to our profitability and then bidding which is why we are losing on some of the orders, if you can just throw some light on that? Because one year back we had slightly more order book than what we currently have. So, just some light if you can throw on the order book part?
K. Jalandhar Reddy: Yes sir, we were also trying in the year beginning to bid. From April to this December there has been very less tenders in from NHAI. So, due to that actually not happened and right now the market is in a very aggressive state because there was a gap of 6 months.
Moreover, the business of the company involves a lot of land acquisition activity, which is a highly politically sensitive matter. There is a high possibility of projects being delayed due to land acquisition issues.
February 2018 conference call, page 15:
Rita Tahilramani: Sir, I wanted to know the land acquisition status on the Pollachi project and how much revenue have we booked in from this project in 9-month 2018?
K. Jalandhar Reddy: Actually around 55% of the land has been done and the land problem is due to the toll plaza area and they have not handed over so around 20% to 25% of the project size of the land need to be acquired right now.
In addition, the majority of the customers of the company are govt. entities, therefore, the company needs to deal with govt. departments to get its payments released in order to fund its operations. It seems that the company has faced multiple periods where the receivables of the company were stuck with counterparties, where the company also resorted to delaying the payments to its vendors and other counterparties to increase the payables.
The cash flow statement of the company for FY2016 and FY2017 indicates a situation where a significant amount of money was stuck in the trade and other receivables, where the company resorted to delaying the payables in order to protect its liquidity.
The FY2017 annual report, page 146:
Further advised reading: Understanding Cash Flow from Operations (CFO)
All these aspects of the company’s business make it highly vulnerable to the vagaries of the political environment.
Margin of Safety in the market price of KNR Constructions Ltd:
Currently (May 8, 2018), KNR Constructions Ltd is available at a price-to-earnings (P/E) ratio of about 18.5, which does not offer any margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.
However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, taking 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 sign 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.
- 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
- How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
- Hidden Risk of Investing in High P/E Stocks
Analysis Summary
Overall, KNR Constructions Ltd seems to be a company, which has been growing at a moderate pace of 10-12% over the last decade while reporting stable operating profit margins in the profit and loss statement. However, upon deeper analysis, it seems that the reported profitability of the company in the P&L may not represent the complete profitability of the business of the company, which is spread across various different entities like joint ventures/subsidiaries etc.
There have been instances where the parent company has to infuse funds into the subsidiary having a full year of operations of a toll road, in order to help it sustain its expenses and debt repayments. Similarly, the company had to resort to selling two of its operational BOT annuity joint ventures at a loss and make provisions for impairment in the FY2017 annual report. Therefore, we believe that the nature of the structuring of the business in various entities along with the accounting method of the percentage of completion method (POCM) makes it difficult to assess the true business position of an infrastructure/EPC player.
The company seems to be growing faster than its internal resources can sustain. It is reflected by a lower self-sustainable growth rate (SSGR) and the negative free cash flow position of the company. As a result, the company has to resort to taking loans to fund its cash flow shortfalls as well as dividend payments to equity shareholders.
The promoters have demonstrated very good project execution skills by way of completing a number of projects ahead of their scheduled deadlines. Moreover, the promoters seem to have a management succession plan in place where the son of the founder promoter is playing an active role in the management of the company.
However, it comes to the notice of the investors that the promoters have significantly reduced their shareholding in the company over the past years when the share price of the company has increased significantly. It might look like the promoters are cashing out their gains resulting from the increase in the share price of the company.
The promoters have provided a significant amount of loans to the company, which seem to have been used to repay the debt raised by the subsidiaries of the company. Such instances of loans from promoters to companies, which have a strong credit rating of A+ may put doubts on the credit strength represented by such credit ratings. Moreover, such loans may also represent opportunities by promoters to gain higher interest rates from the company than what they can get from fixed deposits from banks. Analyzing these aspects becomes important for investors as such loans represent a situation where the company takes loans to pay dividends to equity shareholders including promoters and then the promoters plough back the same funds in the company as interest-bearing loans to meet the cash flow shortfalls of the company.
Certain actions of the company require further clarifications like a large amount of money due to the customers, non-auditing of the financials of some of the entities that are included in the consolidated financials and dealing in non-permitted receipts & payments in the demonetized currency notes. Investors may contact the company directly to know more about these aspects including the investments in seemingly unsuitable mutual funds including equity mutual funds and closed-ended mutual funds etc. renting out the guesthouse owned by the promoters and the land parcel taken on lease by the company from the promoters.
Advised reading: How should investors contact Companies/Management for clarifications or additional information?
We believe that going ahead; investors should monitor the shareholding of the promoters in the company, loans given by the promoters to the company, debt levels of the company, and signs of receivables being stuck with the customers as well as the dues to the customers. Investors may request the company to disclose consolidated financial results each quarter as the consolidated results would help the investors understand the business position of the company in a better manner than the standalone financials.
Further advised reading: How to Monitor Stocks in your Portfolio
These are our views about KNR Constructions 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
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.
