22 December 2014 note

December 2014

STRATEGY

Gaurav Mehta, [email protected]: +91 22 3043 3255

Saurabh Mukherjea, [email protected]: +91 99877 85848

Karan [email protected]: +91 22 3043 3251

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Forensic Accounting: Identifying the Zone of Trouble

Speculator

Ambit Client

Analysts:

Strategy

December 22, 2014 Ambit Capital Pvt. Ltd.

CONTENTS

Forensic accounting: Identifying the ‘Zone of Trouble’…………………………..3

Methodology…………………………..…………………………..………………….. 4

Accounting quality and investment returns……………………………………… 13

Change in accounting quality and investment returns………………………… 18

Accounting quality in practice…………………………..…………………………. 21

What does our model not capture? …………………………..…………………..23

Sample bespoke - World Cargo…………………………………………………... 27

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

Strategy

THEMATIC December 22, 2014

Sector-neutral accounting buckets show a strong link between accounting quality and investment returns Accounting bucket

Accounting score

Share price performance

Bucket A 223.7 19.2%

Bucket B 199.0 14.3%

Bucket C 177.1 11.8%

Bucket D 144.2 2.0%

Source: Bloomberg, Ambit Capital research

Weakest ten sectors on accounting quality

Sector Average

accounting score

Average share price

performance

Realty 152.0 -11.6%

Conglomerate 158.0 1.9%

E&C 159.2 -1.7%

Telecom 165.7 -8.1%

Infrastructure 168.2 -1.8%

Miscellaneous 169.6 12.2%

Capital Goods 170.0 2.3%

Textiles 172.0 10.7%

Utilities 175.7 -2.1%

Media 183.7 4.9%

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is sector CAGR from April 2008 to October 2014.

THIS NOTE CANNOT BE USED BY THE MEDIA IN ANY SHAPE OR FORM WITHOUT PRIOR CONSENT FROM AMBIT CAPITAL.

Analyst Details

Gaurav Mehta, CFA +91 22 3043 3255 [email protected]

Karan Khanna +91 22 3043 3251 [email protected]

Saurabh Mukherjea, CFA +91 22 3043 3174 [email protected]

Forensic accounting: Identifying the ‘Zone of Trouble’ Forensic accounting is a key component of our research, as we have time and again shown that accounting quality is not just one of the many factors affecting investment returns but rather a critical hygiene factor, the lack of which can be detrimental to portfolio returns. Moreover, contrary to popular belief, accounting quality has stayed relevant even in the recent recovery, with stocks with weak accounting quality still underperforming. Through our well-established proprietary model, we seek to help investors avoid this accounting ‘Zone of Trouble’ which is profoundly damaging for investment performance.

Quantifying accounting quality Our model looks at the following key categories of accounting irregularities: balance sheet misstatement, profit & loss misstatement, cash pilferage and audit quality. We use 11 ratios across these categories to quantify accounting quality for stocks with a market-cap of more than Rs 1,000mn (excluding banks and financial services firms). The caveat is that whilst these aggressive accounting policies raise red flags, they may not necessarily imply accounting fraud.

The ‘Zone of Trouble’ Accounting quality is not just one of the many factors affecting investment returns but rather a critical hygiene factor, the lack of which can be detrimental to portfolio returns. An assessment of historical returns suggests that whilst the top 6 deciles on accounting do not seem to be materially different from each other on investment performance, the performance slumps beyond D6. Therefore, D7-D10 is the zone of trouble to be avoided at all costs.

Accounting quality drives investment performance

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from Apr’08 to Oct’14 (on a CAGR basis). Universe for this exhibit is BSE500.

Furthermore, accounting quality has remained relevant even in the market recovery, with the last four deciles on accounting continuing to underperform significantly (in terms of investment returns). However, it is interesting to note that the biggest improvements in performance in the uptrend have come for D5 and D6 and not for firms with superior accounting quality (see pg 21).

Are you in the ‘Zone of Trouble’? Our forensic accounting model allows us to conduct a first-level health check of portfolios and helps identify whether any holdings belongs to the ‘Zone of Trouble’. Further, on a bespoke basis for clients, we also supplement these screen-driven red flags with bottom-up investigative research on individual companies. Please contact your Ambit sales representative in case your portfolio has not been screened yet by our forensic accounting model.

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Methodology We use 11 ratios to score our universe (excluding, banks and financial services firms) based on their accounting qualities. These ratios can broadly be categorised into four buckets.

Exhibit 1: Key categories of accounting checks

Category Ratios

P&L misstatement checks (1) CFO/EBITDA, (2) change in depreciation rate, and (3) volatility in Non-operating income (as a percentage of net revenues)

Balance sheet misstatement checks

(1) Cash yield, (2) change in reserves (excluding share premium) to net income excluding dividends, (3) provisions for doubtful debts as a proportion of debtors more than six months, and (4) contingent liability as a proportion of net worth

Cash pilferage checks (1) Non-operating expenses as a proportion of total revenues, (2) CWIP to gross block, and (3) cumulative CFO plus CFI to median revenues

Audit quality checks (1) CAGR in auditor’s remuneration to CAGR in consol. revenues

Source: Ambit Capital research

Here is a brief description of the accounting ratios with illustrative case studies:

Note: These examples are just illustrative case studies. The objective is to demonstrate the working of our framework and not to imply any ill-intent on the part of the company in question.

I - P&L misstatement checks 1 CFO/EBITDA: This ratio checks a company’s ability to convert EBITDA (which can

be relatively easily manipulated) into operating cash flow (which is more difficult to manipulate). A low ratio raises concerns about the company’s revenue recognition policy (because this may imply aggressive revenue recognition through methods such as channel stuffing). We use a six-year median for this measure.

Case study: Aurobindo Pharma

Aurobindo’s pre-tax CFO/EBITDA has consistently been significantly below the median for its peers. The company’s CFO/EBITDA has deteriorated from 70% in FY10 to 46% in FY14 even whilst the CFO/EBITDA for its peer group has improved from 88% to 100% over the same period.

This deterioration in its CFO/EBITDA is mainly on account of the deterioration in its working capital days (from 186 days in FY10 to 217 days in FY14). Given its lack of material exposure to branded generic markets, where terms of trade are more benign, its working capital days have remained at elevated levels throughout.

We also note that in years when Aurobindo’s EBITDA has posted healthy growth, CFO/EBITDA seems to have deteriorated, as working capital needs have expanded. For instance, whilst EBITDA improved by 17% in FY11, CFO/EBITDA deteriorated to 55% in FY11 vs 70% in FY10 owing to higher working capital requirements (204 days in FY11 vs 186 days in FY10). Note that inventories and debtors increased significantly during the year as well (32% and 29% respectively).

We focus on four categories of accounting checks: P&L misstatement, balance sheet misstatement, cash pilferage and audit quality

A low CFO/EBITDA may be indicative of aggressive revenue recognition policies

Strategy


Exhibit 2: Revenue recognition - Aurobindo Pharma vs its peers

Company/Metric Pre-tax CFO as a % of EBITDA

FY10 FY11 FY12 FY13 FY14 Average

Aurobindo Pharma 70% 55% 65% 46% 46% 57%

Cadila 88% 85% 64% 82% 98% 83%

Glenmark N/A 60% 131% 80% 102% 93%

IPCA 71% 74% 85% 77% 82% 78%

Biocon 101% 150% 123% 104% 103% 116%

Median (ex-Aurobindo) 88% 80% 104% 81% 100% 88%

Divergence (Aurobindo) -18% -25% -39% -35% -54% -32%

Source: Company, Ambit Capital research

2 Change in depreciation rate: We calculate change in depreciation rates for each of the past six years (FY09-14). We then calculate the median of absolute changes and then sort the companies on this ratio such that the company with the smallest change in its depreciation rate receives the best score. The rationale is to penalise companies that have high volatility in their depreciation rate on a YoY basis.

Case study: Amtek Auto

For the period under study, Amtek Auto uses the ‘Straight Line Method’ to provide depreciation on its fixed assets in the manner and at the rates specified in Schedule XIV to the Companies Act 1956. This method and rate of providing depreciation are in line with that followed by most of the Indian companies.

However, note that there was a significant YoY change in consolidated and standalone average depreciation rates in FY13. Whilst the acquisition of JMT Auto and Neumayer Tekfor Group (NT Group) in June 2013 could partially explain the volatility in depreciation rates for the year-ending September 2013 in the consolidated accounts, we do not understand why the YoY depreciation rates have declined even at the standalone level. Further, plant and machinery (subject to higher depreciation rates) constitute ~90% of Amtek Auto’s gross block (vs ~78% for its peers). In spite of the higher share of plant and machinery in Amtek Auto’s gross block, its depreciation rates have historically remained lower than its peers.

Overall, Amtek Auto’s lower depreciation rate vs its peers and the volatility in its depreciation rate suggest that further analysis would be warranted.

Exhibit 3: Depreciation analysis - Amtek Auto vs its peers

Company/metric Average depreciation rate

YoY change in depreciation rate (bps)

FY11 FY12 FY13 FY12 FY13

Amtek Auto (consolidated) 4.4% 5.0% 3.7% 66 (131)

Amtek Auto (standalone) 4.7% 4.8% 3.7% 4 (103)

Bharat Forge 6.7% 7.0% 6.6% 26 (41)

Mahindra CIE 7.8% 7.6% 8.0% (12) 34

Nelcast 4.6% 4.6% 4.3% (3) (27)

Median (ex-Amtek) 6.7% 7.0% 6.6% (3) (27)

Divergence (Amtek consolidated) -2.4% -2.0% -2.9% 69 (104)

Divergence (Amtek standalone) -2.0% -2.2% -2.8% 7 (76)

Source: Company, Ambit Capital research. Notes: (1) FY11 and FY12 figures for Amtek Auto are June year-end whilst FY13 is 15 months ended September 30, 2013 which has been annualised for a like-to-like comparison with peers. March year-end for all the other companies; (2) Standalone accounts for all the peer companies.

3 Volatility in non-operating income: We calculate change in non-operating income (as a percentage of net revenues) for each of the past six years (FY09-14). We then calculate the median of absolute changes and then sort firms on this ratio such that the company with the least volatility receives the best score. The

Our model penalises high volatility in depreciation rate

High volatility in non-operating income is a cause of concern!

Strategy


rationale is to penalise firms where volatility in non-operating income is unusually high as this could imply intent to inflate profitability in years of low profits by resorting to such means as sale of assets, investments, and so on.

Case study: Akzo Nobel

Akzo Nobel’s non-operating income (as a percentage of net revenues) has historically been higher vs its peers (see Exhibit 4 below). Akzo Nobel’s NoI has averaged ~7% of net revenues over the last five years (vs ~1% for its paint sector peers). Further, this has also remained quite volatile over the period. For instance, NoI (as a % of net revenues) was 2.3% in FY14 v/s 6.3% in FY13 implying a ~394 bps YoY change. The high volatility in FY14 (~394bps) could be attributed to lower gains on redemption of long-term investments (in FY14 vs FY13) and interest on income tax refund in FY13.

Exhibit 4: Akzo Nobel - Volatility in other income vs its peers

Company/metric NoI as a % of net revenues Volatility in NoI (as a % of net revenues)

FY10 FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14

Akzo Nobel 10.1% 9.1% 5.7% 6.3% 2.3% 98 344 60 394

Asian Paints 2.0% 0.8% 1.1% 1.0% 1.1% 113 28 7 1

Berger Paints 1.0% 1.3% 1.0% 0.9% 0.9% 29 25 14 2

Kansai Nerolac 1.2% 2.1% 0.9% 0.6% 0.3% 96 125 33 26 Median (ex-Akzo Nobel) 1.2% 1.3% 1.0% 0.9% 0.9% 96 28 14 2

Divergence (Akzo Nobel) 8.9% 7.8% 4.6% 5.4% 1.4% 2 316 46 392


II - Balance sheet misstatement checks 4 Cash yield: This ratio is calculated as the yield earned on cash, investments and

deposits. A low ratio could be a cause for concern, as it could mean that either the balance sheet has been misstated or that the cash is not being used in the best interests of the firm. We use a six-year median for this measure.

Case study: Arshiya

Historically, Arshiya appears to have earned a significantly lower yield on its cash and marketable investments as compared to its peers. Whilst its peers such as Gateway Distriparks have earned cash yields of 5-8%, Arshiya International’s yields have been much lower.

Exhibit 5: Arshiya - Cash yield vs its peers

Company Name Investment income as a % of cash and marketable investments


Arshiya International 4.2 4.8 1.4 1.9 0.4

Gateway Distriparks 7.8 8.1 4.0 5.4 7.2

Allcargo Logistics 5.9 4.7 11.4 5.5 7.0


Whilst the company’s cash yield did improve in FY13 (2.3%) and FY14 (3.2%), it is worth noting that in January 2013, several Arshiya employees made allegations of financial irregularities and claimed that the company had not paid salaries to its staff since September 2012.

(Source: http://articles.economictimes.indiatimes.com/2013-01-09/news/36237462_1_lakh-shares-cent-promoters)

A low cash yield may either imply balance sheet misstatement or that the cash is not being used in the firm’s best interest

Strategy


5 Change in reserves (excluding share premium) to net income excluding dividends: This ratio is calculated by dividing the change in reserves (excluding share premium) on a YoY basis and dividing it by that year’s PAT excluding dividends. We then take a six-year median of this ratio. A ratio of less than one indicates direct write-offs to equity without routing these through the Profit & Loss account and may indicate aggressive accounting policies.

Case study: Tata Steel

Tata Steel acquired Corus (now Tata Steel Europe) in 2007. In FY08, the first year after consolidation, the defined benefit pension plan operated by Corus (British Steel Pension Scheme) had actuarial gains. These gains were recognised in the P&L (consistent with the Indian accounting standards) in the consolidated accounts of Tata Steel.

From FY09, the company has changed its policy. Since then the pension liability of Tata Steel Europe Ltd has been computed and accounted for in accordance with IFRS and there have been actuarial losses from this defined benefit pension plan that do not hit the consolidated P&L. Instead, IFRS allows Tata Steel to take the actuarial losses through ‘Reserves & Surplus’.

The justification provided by the company is that given the large share of Tata Steel Europe Ltd in the consolidated P&L, periodic changes in the assumptions underlying the computation of the pension liability would cause undue volatility in the stated consolidated profits.

That said, we would like to highlight that the company has always made appropriate disclosures in its notes to accounts. This disclosure is also made by the company in its quarterly filings with the stock exchanges. We are highlighting Tata Steel as an example primarily to show how a few changes in accounting policies may cause a significant change to the reported bottom-line.

In fact, the auditors of Tata Steel too have, since 2009, highlighted this in the audit report. For example, in the FY14 Annual Report, the auditors have made the following comments:

“Attention is invited to Note 42 to the financial statements regarding accounting policy for recognition of actuarial valuation change of Rs. 628.23 crores (net of taxes) [Gross: Rs. 917.66 crores] in the pension and other post retirement benefit plans of Tata Steel Europe Limited, a subsidiary for the reasons specified therein. Had the Company recognized actuarial valuation changes in the Consolidated Statement of Profit and Loss, the deferred tax expenses would have been lower by Rs. 289.43 crores and the Profit after taxes, minority interest and share of profits of associates would have been lower by Rs. 628.23 crores. Our opinion is not qualified in respect of this matter.”

If Tata Steel had followed the previous policy of recording actuarial valuation changes in the consolidated P&L, its restated earnings would have been different (as shown in the exhibit below). Especially interesting is the impact in FY09, the year in which Tata Steel Europe switched to the new method for estimating its pension liability.

Exhibit 6: Tata Steel - Restated earnings if the previous policy had been followed

(Fig in INR mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14

Consolidated Profit after taxes [A] 123,500 49,509 (20,092) 89,827 53,898 (70,576) 35,949

Actuarial gain/ (loss) [B] 59070* (54,966) (35,412) (4,028) (23,723) (3,173) (6,282) Net profit (had the actuarial gains/(losses) been charged to the P&L) [C=A-B] 123,500 (5,457) (55,505) 85,799 30,175 (73,749) 29,667

Impact on net profit (as a % of stated profit) [(C-A)/A)] 0% -111% -176% -4% -44% -4% -17%

Source: Company, Ambit Capital research, Note: * has already been reflected in the P&L.

A ratio of less than one on change in reserves ex-share premium to net income ex-dividends may denote direct write-offs through the balance sheet

Strategy


6 Provision for doubtful debts as a proportion of debtors more than six months: This ratio checks the conservativeness of a company’s provisioning policy. A low ratio raises the spectre of earnings being boosted through aggressive provisioning practices. We use a six-year median for this measure.

Case study: Jindal Steel and Power

Historically, JSPL’s standalone debtors outstanding for more than 6 months (as a percentage of gross debtors) have been 5-13%, slightly more than its steel peers. However, note that JSPL has provided for less than 1% of its debtors more than six months as of FY14. This is materially below the 60% figure for its steel peers.

Even on a consolidated basis, JSPL’s debtors outstanding for more than six months (as a percentage of gross debtors) have been 8-12%, slightly more than its power sector peers. In spite of a higher share of debtors outstanding for more than six months, on a consolidated basis, JSPL has provided for less than 1% of its debtors more than six months (vs ~60% by Tata Power in FY13 and FY14). Had the company’s provisioning for debts more than six months been in line with its peers (i.e. 60%), consolidated PBT for FY14 would have been lower by ~5%.

Exhibit 7: Jindal Steel and Power - Provision for old debtors lower than its peers

Company/metric Provision for doubtful debts as a % of debtors over six months

Debtors over six months as a % of gross debtors

FY11 FY12 FY13 FY14 FY11 FY12 FY13 FY14

JSPL (standalone) 4.3% 2.9% 1.4% 0.7% 3.9% 5.0% 6.7% 12.7%

JSPL (consolidated) 4.3% 1.0% 0.8% 0.6% 2.5% 10.1% 8.4% 11.8%

Steel players Tata Steel (standalone) 34.4% 32.9% 43.5% 63.0% 9.6% 3.8% 4.1% 3.2%

SAIL (standalone) 59.3% 35.4% 27.4% 23.1% 5.6% 7.0% 10.0% 10.1%

JSW Steel (standalone) 82.2% 39.8% 5.3% 61.1% 1.3% 1.5% 5.6% 21.1%

Median (steel players) 59.3% 35.4% 27.4% 61.1% 5.6% 3.8% 5.6% 10.1%

Divergence -55.0% -32.5% -26.1% -60.4% -1.7% 1.3% 1.1% 2.6%

Power players NTPC (consolidated) 92.8% 88.7% 0.0% 0.0% 35.0% 12.6% 3.3% 6.8%

Tata Power (consolidated) 75.9% 71.5% 56.5% 61.1% 9.0% 9.1% 10.4% 6.8%

Median (Power sector players) 84.3% 80.1% 28.2% 30.6% 22.0% 10.9% 6.9% 6.8%

Divergence (JSPL Consolidated vs Power peers) -80.0% -79.1% -27.4% -29.9% -19.5% -0.7% 1.5% 5.0%


7 Contingent liabilities as a proportion of net worth: This is a check on a company’s off-balance-sheet liabilities. If this ratio is high, it raises concerns regarding the strength of the company’s balance sheet in the event that the contingent liabilities materialise. Given that contingent liabilities also include genuine items such as letters of credit, bill discounting and capital commitments, we seek to eliminate as many of these items whilst computing the figure for contingent liabilities. We use a six-year median for this measure.

Case study: Gillette India

An example of a firm that gets penalized in our framework due to relatively high contingent liabilities as a proportion of net worth is Gillette India.

FMCG companies in general have an asset-light model (implying relatively low networth) and hence this ratio might appear unusually high for some of these names. However, Gillette India has seen a meaningful rise in contingent liabilities over the last few years led by disputes around direct and indirect taxation matters, for which the company has chosen to appeal to the appropriate authorities. Contingent liabilities as a percentage of net worth have historically averaged ~45% for Gillette India (see Exhibit 8 below). Whilst contingent liabilities have historically remained high owing to disputes with respect to excise, service tax and customs matters, note that contingent liabilities in FY14 have increased

A low provisioning raises the spectre of earnings being boosted through aggressive provisioning practices

A very high proportion of contingent liabilities to net worth indicates disproportionately high off-balance-sheet risk

Strategy


significantly on account of income tax disputes. This is with respect to matters related to income tax disputes on inventory write-off, allowability of losses carried forward from merged entities and others.

Exhibit 8: Gillette India - Contingent liabilities analysis

Company/metric Contingent liability as a % of net worth

FY11 FY12 FY13 FY14

Gillette 26.4% 37.8% 43.8% 70.3%

Dabur* 6.8% 7.5% 6.5% 8.9%

Emami 17.1% 2.3% 8.8% 7.8%

HUL 29.0% 21.7% 28.6% 28.0%

Median (ex-Gillette) 17.1% 7.5% 8.8% 8.9%

Divergence (Gillette) 9.3% 30.3% 35.0% 61.4%

Source: Company, Ambit Capital research. Note: *this does not include LCs, bills discounted.

III - Cash pilferage checks 8 Non-operating expenses as a proportion of total revenues: This ratio checks

a company’s expenditure policy. A high ratio raises concerns regarding the authenticity of such expenses. We use a six-year median for this measure.

Case study: Unity Infra

Historically, Unity Infra’s miscellaneous expenses (as a percentage of net sales) have been higher than its peers. Whilst this ratio has declined from ~1.5% in FY10 to ~0.9% in FY14, this is still well above the sector median of 0.14%. Higher miscellaneous expenses indicate less-than-ideal financial reporting practices and hence raise concerns regarding the authenticity of such expenses.

Exhibit 9: Miscellaneous expenditure analysis - Unity Infra vs its peers

Company/metric Miscellaneous expenses as a % of sales

FY-11 FY-12 FY-13 FY-14 Average

Unity Infra 1.49% 1.60% 1.01% 0.94% 1.26%

Supreme Infra 0.21% 0.30% 0.42% 0.73% 0.41%

MBL 0.83% 0.74% 0.89% 0.48% 0.73%

JMC 0.14% 0.16% 0.06% 0.13% 0.12%

Pratibha 0.21% 0.32% 0.11% 0.22% 0.22%

KNR 0.07% 0.07% 0.11% 0.14% 0.10%

J Kumar 0.19% 0.28% 0.51% 0.08% 0.27%

Ahluwalia 0.06% 0.06% 0.04% 0.04% 0.05%

Median (ex-Unity Infra) 0.19% 0.28% 0.11% 0.14% 0.22%

Divergence (Unity Infra) 1.30% 1.32% 0.90% 0.80% 1.04%


9 CWIP to gross block: The idea here is to penalise firms that show consistently high CWIP relative to the gross block, as this may either indicate unsubstantiated capital expenditure or a delay in commissioning (which may in turn be motivated by a delay in the recognition of the related depreciation expense). We calculate the proportion of capital work in progress to gross block for each of the last six years and then take the 25th percentile observation (instead of a simple six-year median like in most other ratios).

The reason for using the 25th percentile over the last six years for this measure as opposed to the median (which would be the 50th percentile observation) is to allow the benefit of doubt to firms that have invested wisely during the recent downturn. Hence we are penalising companies only if the ratio has been consistently high over most of the last six-year period.

A high proportion of non-operating expenses raises concerns regarding the genuineness of such expenses

A high CWIP to gross block ratio may either indicate unsubstantiated capex or delay in commissioning

Strategy


Case study: Balkrishna Industries

Balkrishna Industries is an example of a firm that gets penalised on this measure in our accounting model compared to its Auto Ancillary peers. Whilst the company’s CWIP relative to its gross block was in line with its peers in FY11, the ratio has remained at elevated levels over the last three years. This seems to be on account of the capex incurred in connection with its green-field tyre project at Bhuj in Gujarat which has only been partly commissioned so far. As per the company, this plant will be fully commissioned by end-FY15. Hence, we believe CWIP (and thereby the CWIP/gross block ratio) should decline significantly in FY15.

On bottom up coverage, we are BUYERs of the stock with a target price of Rs760 (27% upside).

Exhibit 10: Balkrishna Industries - Capex analysis

Company/metric CWIP/Gross Block

FY11 FY12 FY13 FY14

Balkrishna Industries 0.05 0.37 0.54 0.18

Apollo Tyres 0.05 0.04 0.04 0.00

MRF 0.27 0.08 0.07 N/A *

JK Tyre 0.06 0.22 0.02 0.04

Ceat 0.06 0.01 0.01 0.04

Median (ex-Balkrishna) 0.06 0.06 0.03 0.04

Divergence (Balkrishna) (0.00) 0.31 0.52 0.15

Source: Company, Ambit Capital research. Note: *N/A since MRF is a September ending company.

10 Cumulative CFO plus CFI to median revenues: We calculate the cumulative CFO (cash flow from operations) plus cumulative CFI (cash flow from investing activities) over the last six years and divide this by the last six-year median revenues for the company. The higher the ratio, the better our perception of the company’s accounts. The idea is to penalise firms which over such large periods have been unable to either generate positive cash flows from operations or alternatively where cash flow from investments have consistently eaten away cash generated from operations.

Case study: Amtek Auto

Amtek Auto’s standalone and consolidated gross block turnover has historically remained significantly below its peers. Plant and machinery have historically averaged ~90% of Amtek Auto’s gross block (vs ~78% for its peers). Even with a higher share of Plant and machinery in overall gross block (which would imply a greater share of productive assets in its gross block versus its peers), Amtek Auto’s gross block turnover hasn’t picked up.

Further, in spite of the lower gross block turnover, Amtek Auto’s cumulative CFI over the last three years has consistently eaten away the cash generated from operations raising questions regarding the reasonability of its capex.

Our model penalises firms that have not generated positive cash flows even on a six-year basis

Strategy


Exhibit 11: In spite of the lowest gross block turnover vs its peers…

Company/metric Gross Block Turnover

FY11 FY12 FY13

Amtek Auto (consol) 0.6 0.7 0.5

Amtek Auto (stan) 0.5 0.6 0.4

Bharat Forge 1.0 1.2 0.9

Mahindra CIE 1.3 1.4 1.3

Nelcast 2.5 2.7 2.0

Median (ex-Amtek) 1.3 1.4 1.3 Divergence (Amtek consolidated) (0.6) (0.7) (0.8)

Divergence (Amtek standalone) (0.8) (0.8) (0.9)


Exhibit 12: …Amtek Auto’s free cash flows have been negative(Rs mn)

Company/metric Cumulative CFO plus CFI

Median revenues

Cumulative CFO plus CFI to median

revenues

(FY11-13) (FY11-13) (FY11-13)

Amtek Auto (consol) (85,847) 76,222 (1.1)

Amtek Auto (stan) (19,601) 24,539 (0.8)

Bharat Forge 3,841 31,512 0.1

Mahindra CIE 999 4,325 0.2

Nelcast 1,924 5,076 0.4

Median (ex-Amtek) 0.2 Divergence (Amtek consolidated) (1.36)

Divergence (Amtek standalone) (1.03)


IV - Audit quality checks 11 CAGR in auditor’s remuneration to CAGR in consolidated revenues: We

calculate CAGR in standalone auditor’s remuneration and consolidated revenues over FY08-14. A lower ratio of CAGR in auditor’s remuneration relative to CAGR in consolidated revenues receives a high score. The rationale is to penalise companies whose growth in auditor’s remuneration has exceeded the growth in the firm’s revenues.

Case study: Crompton Greaves

Crompton’s consolidated auditor’s remuneration of Rs63.2mn in FY11 was far higher than the consolidated auditor’s remuneration of Rs20mn paid by Infosys and standalone auditor’s remuneration of Rs28.1mn paid by Larsen & Turbo in FY11. Further, whilst the company has stopped reporting consolidated audit fees since FY12 (as this was not required under the revised Schedule VI), Crompton’s auditor’s remuneration was significantly ahead of its peers whilst these numbers were still being reported.

Exhibit 13: Crompton Greaves - Auditor’s remuneration vis-à-vis peers

FY11 FY12 FY13 Crompton (consolidated) Net Sales (Rs mn) 100,051 112,486 120,944 Auditor’s remuneration (Rs mn) 63.2 93.4 Not disclosed Auditor’s remuneration as a % of Total revenues (%) 0.06 0.08 Not available Siemens (standalone) Net Sales (Rs mn) 120,289 129,199 113,526 Auditor’s remuneration (Rs mn) 23.0 33.0 39.0 Auditor’s remuneration as a % of Total revenues (%) 0.02 0.03 0.03 ABB India (consolidated) Net Sales (Rs mn) 62,871 74,518 76,105 Auditor’s remuneration (Rs mn) 21.7 24.4 23.8 Auditor’s remuneration as a % of Total revenues (%) 0.03 0.03 0.01 Alstom T&D India* (consolidated) Net Sales (Rs mn) 40,200 33,113 31,519 Auditor’s remuneration (Rs mn) 10.0 11.8 14.8 Auditor’s remuneration as a % of Total revenues (%) 0.02 0.04 0.01 Thermax (standalone) Net Sales (Rs mn) 48,524 53,041 46,909 Auditor’s remuneration (Rs mn) 9.2 11.6 10.4 Auditor’s remuneration as a % of Total revenues (%) 0.02 0.02 0.01

Source: Company, Ambit Capital research; Note: * FY12 numbers have been annualised.

We penalise firms where growth in auditor’s remuneration has been higher than the growth in the firm’s revenues

Strategy


Cumulating scores: We cumulate scores across these 11 parameters to arrive at the final accounting score for each firm. Based on these parameters, we rank 370 BSE500 firms and 767 sub-BSE500 firms on accounting quality in this year’s forensic exercise. From the BSE500 universe, we have excluded 85 banks and financial services firms. Further, 8 firms were excluded because their FY14 annual reports had not been published at the time of running this exercise (see the table on the right). A further 37 firms have been excluded due to sketchy data availability/corporate restructuring/year-end change/limited listed history.

Whilst we have extended this year’s forensic accounting exercise to include all firms with mcap above Rs 1,000mn, the exhibits and discussion that you find in the subsequent sections are only for the BSE500 universe (excluding Financial Services firms).

Data sources: We have used Ace Equity and Capitaline as data sources for the underlying financial data whilst stock price data has been sourced from Bloomberg. We had to use Ace Equity for some data items and Capitaline for some others in order to minimise data errors. Unfortunately, neither of these databases (nor any other database in India) is entirely reliable by itself.

Please note, however, that several adjustments need to be made to each of the individual variables which we have not detailed here. For further details on these adjustments, kindly email the authors of this note.

List of firms whose FY14 data is not available (cut-off date is 31 October)

Company name Financial Year end

Trinity Tradeli. March

India Cements March

Sunrise Asian March

Alok Inds. September

Ballarpur Inds. June

Kappac Pharma March

Orchid Chemicals September

Luminaire Tech. March

Source: Ace Equity, Ambit Capital research Note: For the purpose of this exercise, we have included Essar Oil (March-ending), MRF, Siemens, Amtek Auto, Amtek India and BF Utilities (September-ending) based on their FY08-13 financials.

Strategy


Accounting quality and investment returns Absolute scores In this section, we seek to answer the following question: ‘Does accounting quality, as quantified by our model, impact stockmarket performance?’ For this we assess the link between the blended forensic accounting scores for the BSE500 universe of firms, derived based on the methodology explained above using the last six years’ data, and the stock price performance for these stocks from April 2008 to October 2014.

1. Universe level: We find that for the BSE500 universe as a whole, stock-specific accounting scores and stock price returns do not have a significant relationship (see the exhibit below). Such a lack of correlation is not surprising given the multitude of other factors (such as the underlying fundamental performance) which influence stock price returns.

Exhibit 14: Scatter plot of accounting scores vs stock price performance for all BSE500 stocks does not bring out any significant relationship

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.

2. Decile level: To control for noise around individual stocks, we arrange these stocks into deciles based on their accounting scores. We then find a strong relationship between the average accounting scores of these deciles and the average stock price performance of their constituent stocks, suggesting that accounting quality is a significant driver of stock returns.

Exhibit 15: Decile-level analysis points to a strong link between accounting scores and stock price performance

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accouting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.

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Stock-level noise leads to a weak relationship between accounting scores and stock returns at the universe level (370 firms)…

…however, deciles constructed on accounting scores demonstrate the power of accounting quality in shaping stock returns

Strategy


In terms of individual decile performances, the first decile (D1) has delivered stock price returns of 24.2% CAGR since April 2008. In contrast, the last decile (D10) has delivered returns of -9.7% CAGR over this period, thus implying a close to 34% CAGR outperformance for D1 vs D10. The performance differential across deciles becomes more evident from the exhibit below.

Exhibit 16: Decile-level analysis suggests accounting quality is important

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accouting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014. Shaded area denotes ‘Zone of Trouble’. Universe for this exhibit is BSE500.

The most crucial takeaway from the above exhibit is that whilst the top 6 deciles on accounting do not seem to be materially different from each other on investment performance, the performance just slumps beyond D6. Therefore, thinking about accounting quality as just one of the many factors affecting investment returns isn’t appropriate. It is in fact a critical hygiene factor, the lack of which can be seriously detrimental to portfolio returns; D7-D10 is the zone of trouble to be avoided at all costs.

3. Sector-agnostic buckets: One may argue that in the decile construction above, sector effects have not been nullified and some sectors may do better than others on our accounting model by virtue of the nature of their businesses. The decile performances thus might reflect serendipitous sector effects. To control for the sector effects, we now construct four sector-agnostic buckets such that ‘bucket A’ comprises the first quartile of each sector on accounting scores, ’bucket B’ comprises the second quartile of each sector, ‘bucket C’ comprises the third quartile of each sector and ‘bucket D’ comprises the last quartile of each sector. Hence, every bucket has an equal number of stocks from each sector, implying that the buckets are sector-agnostic.

Each bucket in this case will have similar sectoral compositions and hence a performance assessment of these buckets should enable one to assess the impact of accounting quality on stock price performance in a sector-agnostic manner. Exhibit 17 below displays these four buckets with their respective stock price performances. Clearly, the performance differential points to a strong link between accounting quality and stock price performances even after controlling for sector effects.

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Top accounting decile outperforms the bottom decile by 34% on a CAGR basis

Strategy


Exhibit 17: Strong link between accounting quality and stock performance even after controlling for sector effects (the first entry is the accounting score over FY09-14, the second entry is the median CAGR stock returns in that bucket from April 2008 to October 2014)

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014. Universe for this exhibit is BSE500.

The above exhibit yet again highlights the vitality of avoiding the lowest rung firms on accounting for a healthy portfolio performance.

4. Sector level: Next, arranging the BSE500 firms into sectors and assessing the link between the average accounting scores of these sectors and the average stock price performance of their constituent stocks suggests that accounting quality makes a difference at the sector level as well (i.e. sectors with higher accounting quality, such as FMCG, Auto Anc and Consumer Durables, perform better than sectors with poor accounting quality such as Realty, Engineering & Construction and Infrastructure).

Exhibit 18: Link between accounting quality and stock price performance at the sector level is relatively high

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014. Universe for this exhibit is BSE500.

With an average score of 213, FMCG is amongst the best sectors in our accounting model. The sector has generated average stock price returns of 25% CAGR over the last six-year period since April 2008. On the other hand, Realty is the worst sector on accounting on our model with an average score of 152. The average stock price performance in the sector has been -12% CAGR over the last six-year period.

Also, stocks within the same sector exhibit a significant link between accounting scores and stock price returns in many cases. Three sectors which show strong links are Utilities, Auto and Industrials.

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Consumer Durable

FMCG

Cement

LogisticsAuto Anc

Oil & Gas

Agri inputs

Shipping

IT

Auto

Chemicals

RetailIndustrials

Metals & Mining

Pharma

Media

Utilities

TextilesCapital goods

Infra.Telecom

Misc.

E&CConglomerate

Realty

Sector-agnostic buckets constructed with homogenous sectoral make and differentiated only on accounting quality show accounting quality drives investment performance even after controlling for sector effects

Link between accounting scores and price performance is relatively high at the sector level…

Strategy


Exhibit 19: Within the sector, the link between accounting and price performance for Utilities

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe for this exhibit is stocks from the Utilities sector in the BSE500 index.

Exhibit 20: Within the sector, the link between accounting and price performance for Auto

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe for this exhibit is stocks from the Auto sector in the BSE500 index.

Exhibit 21: Within the sector, link between accounting and price performance for Industrials

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 on a CAGR basis. Universe for this exhibit is stocks from the Industrials sector in the BSE500 index.

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…Even within a sector, stock returns show significant dependence on accounting scores

Strategy


5. Size buckets: Finally to address the size dimension, we split our universe of stocks into four size buckets, as shown below. Bucket 1 comprises the largest 50 stocks on market cap, Bucket 2 of the next 100, Bucket 3 of the next 100 and Bucket 4 of the lowest 120 stocks on market cap (thus, taking the total to 370 firms).

Exhibit 22: Larger capitalisation firms have better accounting scores on average Size Bucket

Number of firms in the bucket

Market cap range (Rs bn)

Market cap range (US$ bn)

Average accounting score

Average share price performance

% stocks in 'Zone of Trouble'

Bucket 1 top 50 Rs331bn-5,108bn US$5.4bn-83bn 202 17.1% 24%

Bucket 2 next 100 Rs68bn-330bn US$1.1bn-5.4bn 190 17.2% 31%

Bucket 3 next 100 Rs28.4bn-66.8bn US$0.5bn-1.1bn 189 17.1% 37%

Bucket 4 bottom 120 Rs4.4bn-28.3bn US$0.07bn-0.5bn 173 4.9% 56%

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY09-14; stock price performance is from April 2008 to October 2014 (on a CAGR basis). Universe for this exhibit is BSE500.

As one would expect, we find that the average accounting score as well as the stock price performance varies directly with market cap, i.e. the larger market-cap buckets have better accounting scores as well as better stock price performance whilst the smallest market-cap bucket has the worst accounting score as well as the worst stock price performance.

Further, the proportion of stocks in the ‘Zone of Trouble’ (i.e. stocks that fall in D7 and below) too varies directly with market-cap. Whilst 24% of firms belonging to the largest market-cap bucket fall in the ‘Zone of Trouble’, ~56% of the firms belonging to the smallest market-cap bucket fall in this zone.

Delving further into the stocks that fall in Bucket 4 of market-cap, we note that ~38% of these names also fall in Bucket ‘D’ discussed earlier (i.e. the bottom quartile stocks from each sector). In contrast, the remaining ~62% stocks are evenly distributed amongst Buckets ‘A’ to ‘C’ (see Exhibit 23 below).

Exhibit 23: Distribution of the smallest market-cap firms across the four accounting quality buckets Accounting quality bucket Number of firms As a % of total number of firms in Bucket '4'

(i.e. the smallest 120 firms in the BSE500)

Bucket A (best quality) 24 20%

Bucket B 25 21%

Bucket C 26 22%

Bucket D (worst quality) 45 38%

Total 120 100%

Source: Company, Ambit Capital research. Universe for this exhibit is BSE500.

Accounting quality is better for larger-caps on average

Strategy


Change in accounting quality and investment returns Change in scores The decile level and sector-agnostic buckets from the previous section suggest that accounting quality is a significant driver of stock prices and that this holds true even after controlling for sector effects. In this section, we seek to answer the question: ‘Does a change in accounting score impact stockmarket performance?’

To calculate the change in accounting score, we break the six-year period (from FY09 to FY14) that we have used so far to calculate absolute accounting scores into two sub-periods—FY09-11 and FY12-14. We then use the 11 parameters to quantify accounting scores for each of the two sub-periods separately using the same methodology as earlier (but for a three-year period now vs a six-year period earlier). Change in accounting score is calculated as the change in the FY12-14 sub-period’s score over the FY09-11 sub-period’s score. Finally, we assess the link between this change in accounting score for the BSE500 universe of firms and the stock price performance for these stocks from April 2011 to October 2014.

1. Universe level: We find that for the BSE500 universe as a whole, the change in accounting scores and individual stock prices does not have a meaningful relationship (see the exhibit below). Such a lack of correlation is not surprising given the multitude of other factors (such as the underlying fundamental performance) which influence stock price returns.

Exhibit 24: Scatter plot of change in accounting scores vs stock price performance for all BSE500 stocks does not bring out any significant relationship

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the FY12-14 subperiod over FY09-11; stock price performance is from April 2011 to October 2014. Universe for this exhibit is BSE500.

2. Decile level: Similar to the methodology used in the preceding section to control for noise around individual stocks, we arrange these stocks into deciles based on their accounting scores. Arranging these stocks into deciles based on the change in accounting scores points to a moderate relationship between the change in accounting scores of these deciles and the average stock price performance of their constituent stocks.

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With accounting quality showing a strong link with stock price performance, change in accounting quality is another dimension meriting attention

Again stock-level noise prevents any strong link between change in accounting scores and stock performance

Decile-level analysis points to a moderate link between change in accounting scores and stock performance

Strategy


Exhibit 25: Decile-level analysis points to some link between the change in accounting scores and stock price performance but only a moderate one

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the FY12-14 subperiod over FY09-11; stock price performance is from April 2011 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.

3. Market and sector level: When looking at changes in accounting scores over time, one is keen to know: (1) At the market level, are accounting ratios improving or worsening over time? (2) At the sector level, are accounting ratios improving or worsening over time?

In the exhibit below, we highlight the proportion of ratios that are improving over time (i.e. in the FY12-14 period vs the FY09-11 period). It is heartening to see that on aggregate 80% of ratios have improved for India Inc.

Exhibit 26: Improvement in accounting ratios at the overall market and sector level

Sector Proportion of ratios improving (FY12-14 over FY09-11)

Average stock price performance

Aggregate 80% 15.5%

Oil & Gas 90% 4.3%

Pharma 90% 25.9%

Auto Anc 90% 35.7%

IT 80% 25.2%

Logistics 80% 36.2%

Realty 80% -2.1%

Utilities 80% -3.5%

Retail 80% 19.3%

Infrastructure 70% 1.3%

Cement 70% 28.3%

Metals & Mining 70% -11.6%

Conglomerate 70% 6.6%

Industrials 60% 21.6%

FMCG 60% 22.6%

Auto 60% 33.0%

Engineering & Construction 60% 1.4%

Shipping 60% -0.8%

Telecom 60% 3.7%

Textiles 60% 10.0%

Consumer Durable 60% 33.0%

Agri Inputs 50% 29.9%

Media 50% 17.8%

Chemicals 50% 25.6%

Capital Goods 50% 4.0%

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the FY12-14 subperiod overt FY09-11; stock price performance is from April 2011 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.

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Oil & Gas, Pharma and Auto Anc are amongst the most-improved sectors on accounting quality…

…whilst improvements are more modest for Agri inputs, Media, Chemicals and Capital Goods

Strategy


At the sector level, the ratios of Oil & Gas, Pharma and Auto Anc have improved the most. Agri inputs, Media, Chemicals and Capital Goods bring up the rear of this table even with half of the parameters improving for these sectors.

4. Size buckets: Finally, we split our universe of stocks into four size buckets exactly in accordance with the method described in the preceding section. We find that the improvement in accounting scores is the most for the lower market-cap buckets.

Exhibit 27: There does not appear to be link between capitalisation and change in accounting scores Number of firms in the bucket

Size Bucket Market cap range (INR bn) Market cap range (USD bn) Proportion of ratios improving (FY12-14

over FY09-11)

Average stock price

performance

top 50 Bucket 1 Rs 331bn-Rs 5,108bn US$ 5.4bn-US$83bn 40% 16.8%

next 100 Bucket 2 Rs 68bn-Rs 330bn US$ 1.1bn-US$5.4bn 70% 17.9%

next 100 Bucket 3 Rs 28.4bn-Rs 66.8n US$ 0.5bn-US$1.1bn 70% 24.3%

bottom 120 Bucket 4 Rs 4.4bn-Rs 28.3bn US$ 0.07bn-US$0.5bn 90% 5.7%

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score change is for the FY12-14 subperiod overt FY09-11; stock price performance is from April 2011 to October 2014 on a CAGR basis. Universe for this exhibit is BSE500.

Overall, here are some of the key findings from our analysis of accounting quality change over time:

At the universe level, the accounting quality of India Inc seems to be improving.

At the sector level, Oil & Gas, Pharma and Auto Anc have improved the most.

On the other hand, improvements have been more modest for Agri inputs, Media, Chemicals and Capital Goods

Improvement in accounting ratios is more prominent for lower market-cap stocks.

Improvement in accounting is the most for lower capitalisation stocks, helped by a lower base to start with

Strategy


Accounting quality in practice In this section of the note, we now turn to some practical observations on accounting quality based on our experience over the last few years.

Accounting quality matters, even in a bull run

That accounting quality drove alpha in the bear phase of 2008-13 is a point we have observed over the past few years. However, contrary to popular belief, accounting quality has remained relevant even in the recent uptrend, with the last four deciles on accounting continuing to underperform over the past 12 months.

Exhibit 28: Lower deciles on accounting quality have underperformed even in the uptrend

Source: Bloomberg, Ambit Capital research. Note: Price performance has been measured over the period 21 November 2013 to 15 December 2014.

However, it is interesting to note that in the uptrend the biggest improvements in performance have come for D5 and D6 and not for firms with champion accounting quality.

Exhibit 29: Middle deciles have shown the best share price performance in the uptrend

Stock price performance

last 12 months* 12 months prior to that** Delta

D1 48% 3% 45%

D2 59% -4% 63%

D3 44% 1% 44%

D4 59% -7% 66%

D5 64% -8% 72%

D6 70% -10% 80%

D7 44% -15% 59%

D8 56% -19% 74%

D9 31% -30% 61%

D10 19% -33% 52%

Average 49% -12% 62%

Source: Bloomberg, Ambit Capital research. Note: * Defined as price performance over the period 21 November 2013 to 15 December 2014 ** Defined as price performance over the period 21 November 2012 to 21 November 2013.

Accounting quality not priced in

Satyam traded at a P/E discount to Infosys and Wipro even before the promoter owned up to aggressive accounting. Yet Satyam’s share price crashed by over 90% within two days of the fraud being made public. Thus, the market does not already know and properly discount firms that have poor accounting quality.

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The ‘Zone of Trouble’ on accounting quality has stayed an underperformer in the uptrend of the past 12 months

Accounting quality is not properly discounted by the markets

Strategy


We also find no correlation between P/E and accounting scores at the market level nor do we find anything significant at an intra-sector level. Accounting quality is not already priced in (and that is why it is worth investigating and assessing)!

Exhibit 30: No correlation between accounting quality and P/E at the market level

Source: Company, Ambit Capital research; Note: Trailing P/E has been restricted to 100. Universe for this exhibit is BSE500.

Exhibit 31: No correlation between accounting quality and P/E for FMCG stocks

Source: Company, Ambit Capital research; Note: Trailing P/E has been restricted to 100. Universe for this exhibit is stocks from the FMCG sector in BSE500 index.

Not all Nifty firms have good-quality accounts

Whilst the top size bucket, bucket 1 (Exhibit 22 on page 18), has the best accounting score, this overall average hides a great deal of variation even within the large caps. For example as many as 45% of Nifty firms have accounting scores below the universe (BSE500) average. Further, for the weakest nine of these firms, the accounting scores are actually so low that these firms fall in bottom four deciles of accounting quality for the BSE500. In other words, nine Nifty firms are in the ‘Zone of Trouble’.

Avoiding the ‘Zone of Trouble’

We can give interested clients an accounting heatmap of their portfolio within five working days of receiving it if the constituent stocks are in our accounting model. This will enable clients to identify if any of their holdings are in the ‘Zone of Trouble’. A sample screenshot of what such a diagnostic looks like is presented below.

Exhibit 32: Indicative portfolio heatmap

Scores

Companies Ambit sector CFO EBITDA

Cont Liab-% of NW

Change in depr rate

Vol. in NoI (as a % of

sales)

CAGR in auditor’s remn

to CAGR in consol revs

Non-oper exps-% of total revs

Cash yield

PFD-% of debtors

more than six months

Cum. FCF/ median

revs

Change in reserves/(PAT

ex dividend)

Overall Score

ABC Industrials 11 12 13 8 2 13 6 13 11 3 8.5

XYZ Utilities 13 8 12 9 5 12 2 7 7 3 7.3

PPP Utilities 1 5 8 10 8 8 11 11 6 3 7.4

DEF Metals 12 10 4 5 6 3 3 6 13 3 7.1

GHI Metals 10 6 7 6 1 2 12 5 12 3 6.6

RRR IT 3 2 10 12 7 10 8 10 5 3 6.7

TTT Oil & Gas 6 11 5 4 4 7 1 1 10 2 5.3

PQR Oil & Gas 7 13 3 2 3 1 4 1 2 3 4.3

Note: ORANGE denotes sub-par accounting quality relative to the sector average; Red denotes that the stock falls in the ‘Zone of Trouble’

For a more detailed analysis, we also do extensive bottom-up company-specific bespoke research for clients. A sample bespoke has been attached towards the end of this note (page 27 onwards) as an example of our past work on this front.

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Not all firms from the Nifty have clean accounting

Strategy


What does our model not capture? Whilst our accounting model uses 11 objective, quantifiable parameters to assess the overall quality of a firm’s accounts, it has certain limitations too. For example, there are certain subjective assessments on governance standards that one can make only after going through the annual reports and which cannot be quantified. Our bottom-up analysis therefore plays a vital role in helping our clients identify these parameters. Some such examples are discussed below.

Subjective checks- Related party transactions Investors should lookout for suspicious related party transactions undertaken by listed entities. At its simplest, the extent of related party transactions and the trend in these transactions are important; a sudden increase can be bad news. However, it is often trickier than this, as shown in instances illustrated here.

Parties would be considered ‘related’ if at any time during the financial year, one party is able to either control the other party or can exercise significant influence over the other. Thus, related parties would include subsidiaries, associates, joint ventures, key management personnel and their relatives, etc. Ideally, transactions between related parties should be at arm’s length. An arm’s length transaction would mean that both the parties seek to execute the transaction in their best interests. However, in several cases, related party transactions are conducted in a manner that is not in the best interests of one party. Overpaying for an asset purchased from a related party, sale of goods or other assets to related parties at a significant discount to their fair market values, loans given to related parties at exceptionally concessional rates or loans taken from related parties at exorbitant interest rates are just a few examples of how these transactions might not be in the best interests of the minority shareholders. Likewise, unwarranted transactions with related parties should raise a red flag.

This point can be better understood by analysing certain related party transactions that Crompton Greaves has undertaken over the last 5-6 years.

(Note: Crompton Greaves falls in the second quartile in its sector on our accounting model).

Case study: Crompton Greaves

During FY08, Crompton Greaves purchased co-ownership rights in an aircraft from a related party, M/s Asia Aviation Ltd, for `562.5mn. Mr. Gautam Thapar, MD & CEO of Crompton Greaves, was also a director of M/s Asia Aviation Ltd, a company in the business of providing air charter services.

Whilst it is arguable that the aircraft purchase was unwarranted, the fact that it had been executed with a related party in the business of providing aircrafts on a lease basis also raises concerns regarding the appropriateness of such a transaction, given that Crompton Greaves could have simply hired the aircraft.

This transaction was followed by the purchase of another aircraft during FY11 for `2700mn. However, no disclosures were made by the company in its annual report for FY11 as to whether or not this was a related party transaction. When these issues were raised by investors with the management in 2QFY12, the management transferred the entire block of aircrafts at book value to its unlisted related parties, M/s Asia Aviation Ltd (`411.7mn) and M/s Avantha Holdings Ltd (`2,405mn). This last point can be detected from the FY12 Annual Report.

Subjective checks - Issues raised by the auditor Amongst the first things to look for whilst analysing an auditor’s report is to keep an eye out for any qualifications made by the statutory auditor. Whilst there are several reasons why an auditor may qualify his reports, one common reason is when the accounts have not been drawn up according to the generally accepted accounting principles.

Suspicious related party transactions would merit further attention

Investors should keep an eye out for any qualifications made by the statutory auditor

Strategy


This can be better understood by looking at the issues raised by Lanco Infratech’s auditors, PwC, in the auditor’s report in FY07 and FY08.

(Note: Lanco Infratech falls in the bottom quartile in its sector on our accounting model).

Case study: Lanco Infratech

In FY07, the auditors of Lanco Infra had raised the following issues with respect to the consolidated financial statements:

Profits were higher by `169.29mn (or 9% of consolidated profits for FY07) due to non-elimination of intra-group transactions and unrealised profits pending clarification from ICAI.

The consolidated financial statements were presented considering M/s Lanco Kondapalli Power Private Limited (LKPPL) as a subsidiary with effect from 1 April 2006 when in fact, LKPPL became a subsidiary of the company with effect from 15 November 2006. As a result, profits were higher by `242.94mn (or 13% of consolidated profits in FY07).

Not only did the company not meet the requirements of AS-21 on the consolidated financial statements (given that according to AS-21 issued by the ICAI, consolidation should have been carried out from 15 November 2006, the date on which holding subsidiary relationship came into existence), the above treatment resulted in the profits for FY07 being higher by `412.23mn (or 22% of consolidated profits for that year).

The excess profit of `412.23mn, which was recognised in the P&L account of Lanco Infra in FY07, had to be reversed in FY08. According to the generally accepted accounting principles, such a reversal should have been made against current-year profits (i.e. FY08 profits in this case) as a prior-period adjustment. Lanco Infra instead chose to adjust these excess profits against the balance of profit brought forward from the previous year. Consequently, the correction to FY08 profits was not made as required. The auditors too had raised their issues on such a treatment in their report on the consolidated financial statements for FY08.

Issues raised by Lanco’s auditors in FY07 Annual Report (on Page 63)

“Attention is drawn to the following:

As detailed in note 4(xvi) of Schedule 19, pending clarification from the ICAI on non-elimination of intra group transactions and unrealized profits arising out of construction of projects under Build Operate Own and Transfer basis, the Company has not eliminated revenues and unrealized profits in the consolidated financial statements. As a result the consolidated revenue and net profit after minority interest are higher by `1692.97 millions and `169.29 millions respectively.

M/s Lanco Kondapalli Power Private Limited (LKPPL) has become a subsidiary of the Company with effect from November 15, 2006. However the consolidated financial statements have been presented considering LKPPL as a subsidiary with effect from April 01, 2006. As a result the consolidated revenues and net profit after minority interest are higher by `3270.90 and `242.94 millions respectively.”

Issues raised by Lanco’s auditors in FY08 Annual Report (on Page 71)

“Attention is drawn to Note 4.viii on Schedule 19 to the consolidated financial statements regarding the adjustment of excess profits recognised in the previous year aggregating to `412.23 million against the balance of profit brought forward from the previous year, which in our opinion and according to the generally accepted accounting principles in India should have been adjusted against the current year’s profit as a prior period adjustment. Consequently the net profit after tax and minority interest for the current year has been overstated by the above amount.”

Strategy


Subjective checks - Cash repatriation to foreign parent Ideally, cash held by the subsidiary belongs as much to the minority shareholders as it does to the controlling shareholder. However, in recent times, we have seen how the parent can abuse its position as the dominant shareholder to pull out cash from the subsidiary without the minority shareholders having any say in this decision.

In order to protect the interests of minority shareholders, SEBI came out with a Circular in early February (which was later amended in May), wherein it directed that listed entities would need the support of majority of the minority shareholders in case of M&A transactions. Ambuja Cement is a recent example of a firm that has seen repatriation of cash to the foreign parent.

(Note: Ambuja Cement falls in the top quartile in its sector on our accounting model).

Case study: Ambuja Cement

What was proposed?

In July 2013, the Board of Directors of Ambuja Cement unanimously approved the proposal to amalgamate Holcim (India) Private Limited (HIPL) with the company. HIPL is a wholly owned subsidiary of Holderind Investments Ltd, Mauritius. As a result of the scheme, Ambuja acquired a 50.01% stake in ACC and paid `35bn in cash and issued incremental 433.7mn shares worth `83bn for the same to Holcim (see Exhibits 33 and 34).

Exhibit 33: From a complicated structure earlier…


Exhibit 34: …Holcim transfers all its holdings to Ambuja


Issues with the proposal As highlighted by our Cement analyst and Head of Research, Nitin Bhasin, in his 25 July 2013 note (click here for the detailed note), the rearrangement would not result in any value creation for Ambuja’s shareholders because: The controlling shareholders stood to benefit at the expense of the minority

shareholders. The rearrangement offered a relatively raw deal for minority shareholders, as it would result in an indirect holding in ACC.

It is difficult to decipher how the transaction in which the cash is taken from Ambuja and replaced with investment in ACC made the capital structure of the standalone Ambuja entity any better.

Holcim took out `35bn cash giving in return only the promise of some future synergies. The synergy potential of `9bn do not seem likely to accrue in the near future (see Exhibit 35).

Exhibit 35: Expected synergies and benefits highlighted by Ambuja Cement’s management to be extracted over the next two years

Source Synergy/ cost benefits Through Our view

Supply Chain Optimisation `3.6bn-4.2bn Clinker swaps, cement swaps This is a likely source of immediate benefit and with the change in the management

structure, these benefits could accrue soon; we expect benefits of this in CY14 itself

Shared services / Fixed Costs `4.2bn-4.8bn

Procurement; fixed cost reduction through shared services in back-end processes; financial optimisation

Our primary data sources suggest that both the companies are already working on most of these together especially procurement and hence we do not expect such large benefits immediately

Total `7.8bn-9bn We model total benefits of `4.5bn in CY14, equally for ACC and Ambuja and then increasing marginally every year


Cash repatriation to foreign parent is another aspect that investors should watch out for

http://webambit.ambit.co/reports/Ambit_Strategy_Thematic_Good&Clean8_25Jul2014.pdf

Strategy


The eventual outcome

As discussed earlier, under the new norms proposed by SEBI, issuance of new shares to the promoter or promoter group in deals involving acquisitions, mergers and demergers would require a simple majority (i.e. 51%) of non-promoter shareholding for passing such a resolution.

The results of the postal ballot conducted were as under:

~87% of the institutional shareholders had voted, out of which ~68% had voted in favour of the resolution whilst just over 32% had voted against the resolution.

Only ~10% of the remaining public shareholders had voted, out of which ~88% had voted in favour of the resolution whilst less than 12% had voted against the resolution.

Thus, in spite of widespread criticism of the deal and opposition from minority shareholders, Ambuja could get 68.5% of public shareholder votes in favour of the deal. Post that, Ambuja had also received the EGM approval for a reduction in its share capital. As a result of this scheme, Holcim’s stake in Ambuja will go up by 10% whilst the minority shareholders’ stake will be diluted by over 20%.

Incorrect penalisation? - Volatile depreciation as a means to improved cash flow generation Whilst a company with a volatile depreciation rate gets penalised in our accounting model, note that there could be certain instances where this volatility in depreciation could stem from a management’s strategy around improving its cash flow generation. One such example of a company where a focus on cash profits over book profits has resulted in the management following an aggressive depreciation policy is Shree Cement.

(Note: Shree Cement falls in the top quartile in its sector on our accounting model).

Case study: Shree Cement

Shree Cement follows the written-down value method of depreciation due to which its depreciation is volatile and increases materially in the years of capacity addition (due to accelerated depreciation in the first year of operation). Front-loading depreciation in the initial years reduces the NPV of taxes although the book profits are lower in that year. The management highlights that the company is focussed on increasing cash profits and not book profits and hence its follows an aggressive depreciation policy.

Thus, whilst the company gets penalised on our accounting model because of a volatile depreciation rate, we like the stock from a bottom-up perspective, as the company has displayed the best capital discipline (low cost capacity additions, high CE turnover) and cost efficiencies which will ensure superlative EBITDA growth and RoCEs in the cement demand upcycle.

Exhibit 36: Volatile depreciation rate - Shree Cement vs its peers

Company/metric Depreciation rate Volatility in Depreciation rate (bps)

FY11 FY12 FY13 FY14 FY12 FY13 FY14

Shree Cement 19.3% 18.8% 7.8% 8.6% 52 1,101 77

UltraTech 5.9% 4.9% 4.7% 4.5% 100 16 20

ACC 5.3% 5.4% 5.4% 5.3% 9 6 12

Ambuja 5.2% 4.8% 5.7% 4.7% 34 87 102

Ramco 4.4% 4.6% 4.5% 4.6% 18 6 11

Median (ex-Shree Cement) 5.2% 4.9% 5.1% 4.6% 26 11 16

Divergence 14.1% 14.0% 2.7% 3.9% 26 1,090 61


A volatile depreciation rate may sometimes be a result of management’s cashflow optimisation strategy

Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.

World Cargo Sample Bespoke Analysis – World Cargo

SAMPLE BESPOKE ANALYSIS

Analyst Details

Nitin Bhasin +91 22 3043 3241 [email protected]

High hopes but poor accounts Whilst the Real Estate and Metals background of the promoter couple may not provide relevant industry experience, they do provide them with capital and relationships. Using these advantages the promoters have built World Cargo into a force to be reckoned with in the logistics industry. Whilst primary data and peers highlight the long-term potential of the business being created by World Cargo through superstar employees, a marquee advisory board and the “right regulatory reach”, the company’s accounts raise lots of questions.

Plenty of RED FLAGS

Revenue booking seems aggressive

World Cargo’s industry leading debtor days rose at a much faster pace than its peers (Gateway, Allcargo and Concor) in FY10 whilst its revenues increased marginally by 4%. Despite the highest receivable days in the industry, provisions for doubtful debts remain very low at 0.3% compared to 2-20% for its peers. Concerns on revenue booking are accentuated by the appallingly low investment income return rates for FY09 (4.8%) and FY10 (1.4%) on cash holdings whilst peers have posted 3-5% investment returns on cash.

Understated depreciation expenses boosting earnings?

Significantly low depreciation rates vis-à-vis peers on buildings and the Rail License Fee appear to be inflating the net earnings of the company. Despite peers amortising the Rail License Fees on a straight line method over the 20 years of concession period, World Cargo’s choice of amortising it using management estimates of revenues and operational usage over 20 years appears to be aggressive (given that investments and operations may not pan out as expected by the management).

Auditor certification for not even half of the income and balance sheet!

World Cargo changed its auditors at the beginning of FY10 to ABC & Co. from Big4 as Big4 expressed its unwillingness to continue (source: BSE). Whilst we do not consider the accounts of other companies audited by ABC & Co. (Zee Group and Welspun) as topnotch, what worries us the most that neither Big4 nor ABC has audited ~50% of revenues and Balance Sheet for the last 2-3 years. Whilst international revenues dominance does explain the gap on account of audited revenues, we fail to understand that why the main auditor does not audit the nearly 10% of consolidated revenues and 30% of the consolidated assets of the Indian subsidiary World Cargo Rail Infrastructure (audited by LMN & Associates).

Snapshot

Section Notable findings

Accounting analysis RED FLAG in respect of CFO/EBITDA and debtor days

Expense manipulation RED FLAG in respect of depreciation

Cash manipulation RED FLAG in respect of unclassified loans and advances

Fictitious revenues booking RED FLAG in respect of investment income returns

Debtors provision RED FLAG

Auditors RED FLAG

Source: Ambit Capital research

Sample Bespoke Analysis – World Cargo

Ambit Capital Pvt. Ltd.

Accounting analysis Exhibit 1: Revenue Recognition

Company\Metric CFO as a % of EBITDA Debtor days

FY08 FY09 FY10 FY08 FY09 FY10

Gateway Distriparks (Gateway) 85% 75% 132% 38 38 46

Allcargo Global Logistics*(Allcargo) 88% 37% 86% 47 41 47

World Cargo 18% 44% 24% 59 83 143

Container Corporation of India (Concor) 78% 86% 65% 1 2 2

Average (A) 67% 60% 77% 36 41 60

Average (ex-Concor) (B) 64% 52% 81% 48 54 79 World Cargo divergence from peer group average (A) -49% -16% -53% 23 42 83

World Cargo divergence from peer group (excl Concor) average (B) -45% -8% -57% 11 29 64

Source: Company, Ambit Capital research, Note: (a)* Dec year end, year end for other companies is March; (b) We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies; (c)CFO/EBITDA for Allcargo is calculated after adjusting for the exceptional items of Rs-26.3mn and Rs5.6mn in CY08 and CY09, respectively and World Cargo’s EBITDA for FY08, FY09and FY10 is adjusted for the forex losses and loss on sale of asset included under other expenses

World Cargo’s CFO/EBITDA declined significantly in FY10 as CFO declined by 35% due to increased working capital investments while EBITDA increased 21% on a YOY basis. However, after detailed analysis of the CFO and EBITDA for World Cargo for FY09 and FY10, we find the following “unexplained anomalies”, which raise a RED FLAG:

1 In FY10, World Cargo reported “Loss on foreign exchange fluctuations (net)” of Rs31.3mn under “Administrative and Other Expenses” in its P&L while reporting a GAIN under “Exchange Adjustments” of Rs167.3mn in the cashflow statement, and

2 In FY09, World Cargo reported “Gains on foreign exchange fluctuations (net)” of Rs37.7mn under “Other Income “in its P&L while reporting a LOSS under “Exchange Adjustments” of Rs161mn in the cashflow statement.

If the above amounts were to be adjusted from CFO and EBITDA (considering that such foreign exchange investments were on account of operations) then the CFO/EBITDA for FY09 and FY10 would be 18% and 52%, thus trending in line with its peers. Non-disclosure of the nature of these foreign exchange adjustments needs explanation by the company.

World Cargo’s debtor days have always been ahead of its peers and have shot up significantly in FY10. Debtor days for Gateway and Allcargo have been considerably lower and more stable compared to World Cargo. Whilst World Cargo’s debtors increased nearly 100% on a YOY basis (Rs2.7bn in FY10 from Rs1.47bn in FY09), revenues grew by a nominal 4%. Part of the increase in debtors can be explained by a substantial increase in revenues from the rail freight business (FY10 revenues of Rs482 mn from Rs20 mn in FY09). But such a high jump in debtor days (when the industry has not witnessed such a trend) and a low and declining provision for doubtful debts (see exhibit 6) raise a RED FLAG.



Exhibit 2: Depreciation rate comparison

Company\Metric Depreciation rate (%) YoY change in depreciation rate (bps)


Gateway 5.1% 5.4% 4.7% 33 (69)

Allcargo* 5.6% 7.1% 6.7% 145 (39)

World Cargo 17.1% 8.7% 4.9% (838) (376)

Concor 5.0% 4.7% 4.8% (25) 6

Average 8.2% 6.5% 5.3% (171) (120) World Cargo divergence from peer group average 8.9% 2.2% -0.3% (666) (257)

Source: Company, Ambit Capital research , Note: (a)* Dec year end, year end for other companies is March.(b) We have used Annual report of CY07, CY08 and CY09 Allcargo and Annual report of FY08, FY09 and FY10 for other companies

The depreciation rate for World Cargo has sharply declined over FY08-10 because World Cargo has added nearly Rs2.3bn of gross block in its logistics business over last two years on the Rs301mn of gross block of its erstwhile technology business. Moreover, a high proportion of land in the gross block (FY10: 22%, FY09: 14%, FY08: NIL) and a significant decline in the software gross block (FY10:0.3%, FY09: 21%, FY08:71%) has led to a sharp decline in the depreciation rate. Freehold land accounts for 3% and 17% of the gross block of Allcargo and Gateway, respectively.

Despite a lower proportion of land in gross block, Allcargo’s high depreciation rate is on account of high depreciation rates (9-13%) on Plant & Machineries, heavy equipment and furniture (which account for 42% of gross block).

Whilst World Cargo’s FY10 depreciation rate is closer to the peer , we highlight that World Cargo’s depreciation policy should be read taking note of the following:

1 World Cargo depreciates “Rail License fees” after considering the matching concept of revenue, on a weighted of the agreement period, projected numbers of rakes to be utilized over the said period and annual usage period of the operational rakes since put to use. The Rail License agreement period is 20 years from the date of commencement of commercial operations in 2007. This depreciation policy is materially different to Gateway’s policy of amortising Rail License Fees on a straight line method over the life of the agreement i.e., 20 years. Effective Rail License Fee amortisation rate for World Cargo in FY10 was 0.8% as against 5% for Gateway. Underreporting of depreciation forms the basis of management’s comment “Our unique model has resulted in World Cargo Rail being the most profitable private container rail operator in India” in FY10 annual report (see pg27).

2 Depreciation rate on buildings (2% of FY10 gross block) for FY10 is 2.6%, which is lower than the 3.3% and 4% provided by Allcargo and Gateway, respectively.

3 World Cargo provides depreciation on its “logistics operations and related services’” tangible assets on a written down value (WDV) method whereas others depreciate it on a straight line method. However, adoption of WDV policy is not visible in the reported low depreciation charges.

4 The depreciation rate for World Cargo would have been higher at 5.5% in FY10 had it not capitalized pre-operative depreciation of Rs12mn.

Considering the above points, the company’s reported depreciation charge seems low to us. RED FLAG



Exhibit 3: Cash Manipulation?

Company\Metric Unclassified loans and

adv as a % of net assets

Loans and adv to related parties as a %

of total loans and advances

Loans and adv to related parties as a %

of net assets

FY08 FY09 FY10 FY08 FY09 FY10 FY08 FY09 FY10

Gateway 1.2% 1.8% 1.9% 3.1% 2.0% 1.0% 0.1% 0.1% 0.1%

Allcargo* 14.5% 23.2% 19.3% 0.5% 11.8% 7.0% 0.1% 3.6% 1.6%

World Cargo 3.4% 3.7% 6.5% 6.9% 4.8% 6.6% 0.3% 0.2% 0.6%

Concor 2.7% 2.3% 2.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Average 5.5% 7.8% 7.4% 2.6% 4.7% 3.7% 0.1% 1.0% 0.6% World Cargo divergence from peer group -2.0% -4.0% -1.0% 4.3% 0.2% 3.0% 0.2% -0.7% 0.0%

Source: Company, Ambit Capital research Note: (a)* Dec year end, year end for other companies is March.(b) We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies (c) Employees, directors, promoters, promoter group companies and associates form part of related parties (d) Loans and advances to related parties include receivables as well

Whilst World Cargo’s “unclassified loans and advances” as % of net assets are lower than its peer , the concerning fact is that the ratio nearly doubled in FY10 when the peer numbers either declined or remained stable. World Cargo’s ratio doubled as the unclassified loans rose by 94% to Rs434mn, whilst net assets and revenues grew by a nominal 12% and 4%, respectively. Such a sudden increase without adequate disclosure and a proportionate increase in revenues is concerning. RED FLAG

World Cargo’s loans and advances to related parties mainly comprise of receivables from “Enterprise owned or significantly influenced by Key Management Personnel or their relatives.” Whilst revenues from these entities have declined by 31% YoY in FY10 to Rs371mn, the receivables from these entities increased by 178% to Rs39mn (31 receivable days on these revenues in FY10 as against 9 days in FY09). Revenues from these entities account for 7% of consolidated revenues but receivables from these entities account for just 1% of receivables.

Exhibit 4: Fictitious Revenue Booking?

Company\Metric Investment income as a % of cash and marketable investments

FY08 FY09 FY10

Gateway 7.8% 8.1% 4.0%

Allcargo * 6.1% 6.1% 14.9%

World Cargo 4.2% 4.8% 1.4%

Concor 9.8% 10.3% 7.8%

Average 7.0% 7.3% 7.0%

World Cargo divergence from peer group -2.8% -2.5% -5.6%

Source: Company, Ambit Capital research Notes: (a)* Dec year end, year end for other companies is March.(b) We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies. (c) Investment income comprises of interest income, dividend income, profit/loss on sale of (current and not strategic) investments (d) Investments comprise of marketable/current investments and exclude investments in associates.

Whilst high holdings of cash can be the reason for low level of investment income returns for World Cargo in FY09 (cash accounted for 100% of “cash and marketable investments”), the significant drop in investment return rate in FY10 despite cash levels rising raises a RED FLAG. Cash accounted for 99% of “cash and marketable investments” and grew by 10% in FY10 to Rs723mn. However, cash also accounts for 84% and 100% of “cash and marketable investments” for Gateway and Concor, respectively, and yet those firms post higher investments return rates.

Whilst Concor’s cash holding is relatively very high (Rs16 bn), World Cargo’s cash holding (Rs688mn) is very close to Allcargo’s (Rs964mn) and Gateway’s (Rs775mn).



Hence prima facie there should not be much of a difference between the cash returns posted by the latter three.

Concor’s high investment return rates can be explained by the interest income that the company may be booking on its loans to employees that does not form part of the cash and marketable investments and high cash holdings parked in high return fixed deposits. Allcargo’s high investment return in FY10 was on account of “unexplained” “profit from sale of shares” of Rs204mn (81% of the investment income) from untraceable and undisclosed shares in the balance sheet. Adjusting for all other investment incomes, Allcargo and Gateway posted 4% and 4.4% income on cash holdings as against 1.4% reported by World Cargo. Could it be the case that the company has under-reported investment income?

Detailed analysis of World Cargo’s investment income return is more concerning as it shows that despite cash and marketable securities remaining nearly stable in FY10 (see exhibit 6), investment income has shown a sharp dip. Further analysis highlights that the interest income includes interest received on loans and advances and cash deposits. As highlighted in exhibit 4 loans and advances have doubled in FY10, which means that interest income should increase in FY10 compared to FY09, but there is a sharp decline in interest income of Rs31mn in FY10. This inconsistency supports our earlier ascribed RED FLAG on this front.

Exhibit 5: Interest and Dividend Income for World Cargo as % of Loans and Advances, Investments and Cash

Rs mn, unless otherwise stated FY08 FY09 FY10

Interest income on loans, deposits etc. 25 41 10

Dividend on Investments in liquid mutual funds 35 31 0.4

Total Interest and other income 60 71 10

Loans and Advances 186 273 547

Cash and Marketable Investments 2,313 657 723

Total Loans +Investments+ Cash 2,500 930 1,270 Other Income as % of loans, investment and cash (%) 3.9% 4.1% 0.9%


Exhibit 6: Debtors Provisions

Company\Metric Provision for bad debts as % of Debtors

FY08 FY09 FY10

Gateway 20.6% 17.4% 20.0%

Allcargo* 0.4% 1.8% 1.7%

World Cargo 0.3% 0.7% 0.3%

Concor 6.4% 9.0% 12.0%

Average 6.9% 7.2% 8.5%

World Cargo divergence from peer group -6.6% -6.6% -8.2%

Source: Company, Ambit Capital research Note: (a)* Dec year end, year end for other companies is March.(b) We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies.

Despite World Cargo having the highest debtor days (see exhibit 2) amongst its peer set, World Cargo has maintained the lowest provisioning for its doubtful debtors. Given such a low number and given that it is early days for World Cargo’s logistics business, we assign a RED FLAG on this front.



Exhibit 7: Contingent Liabilities for World Cargo

Particulars FY09 FY10 Contingent Liability

as a % of Networth Contingent Liability as a % of Networth (Rsmn) (Rsmn)

Disputed Income -tax demands 22 7 0.40% 0.10% Claims against the company not acknowledged as debts 16 30 0.30% 0.40%

Guarantees issued by bank on behalf of the group 18 58 0.30% 0.90%

Guarantees and counter guarantees given by the company 609 4,359 10.20% 65.10%

Amount outstanding towards Letters of credit given to bank 544 644 9.10% 9.60%

Custom duty on pending export obligation against import of capital goods

60 138 1.00% 2.10%

Total Contingent Liabilities 1,268 5,236 21.20% 78.20%


Contingent liabilities as a % of networth has increased by 2.7X because the guarantees and counter guarantees given by the company have increased by 6.2X in FY10. These guarantees are given to the banks in respect of secured loan facilities granted to wholly owned subsidiaries of the company for Rs2.1bn in FY10 (Rs495mn in FY09); these numbers for guarantees and counter guarantees remain same as in the stand-alone accounts.

Auditors World Cargo International changed its auditors in FY10 (Aug-09) from Big4 to ABC & Co., a firm engaged in business consultancy, tax regulation, advisory services, internal audit and risk consultancy.

ABC & Co also audits the accounts of Zee Group and Welspun Corp (flagship company of Welspun Group) neither of whom are corporates whose accounts would be rated first rate by us.

We assign a RED FLAG for World Cargo’s audit quality:

1. Big4’s unwillingness to audit the accounts of World Cargo at the end of FY09; and

2. Continuing non-disclosure of the auditors auditing nearly 50% of revenues and now 58% of the group’s assets. What is more concerning is the fact that nearly 29% of these assets are from an Indian subsidiary “World Cargo Rail Infrastructure.” Accounts of World Cargo Rail Infrastructure are audited by a Mumbai based firm, LMN & Co for the last two years.

Exhibit 8: Rising share of unaudited balance sheet by the main auditor

Sales Assets In mn, unless otherwise stated FY08 FY09 FY10 FY08 FY09 FY10 Consolidated (A) 4,012 5,034 5,259 5,061 7,291 12,431 Amounts not audited by the main auditor (B) 2,018 2,499 2,530 929 3,364 7,182 B as % of A 50.3% 49.6% 48.1% 18.4% 46.1% 57.8%




Exhibit 9: Audit Fees comparison with peers

Company\Metric Audit fees as % of sales FY08 FY09 FY10 Gateway 0.10% 0.07% 0.06% Allcargo * 0.18% 0.11% 0.19% World Cargo 0.16% 0.17% 0.18% Concor 0.01% 0.01% 0.01% Average 0.11% 0.09% 0.11% World Cargo divergence from peer group 0.05% 0.08% 0.07%

Source: Company, Ambit Capital Research: Notes: (a)* Dec year end, year end for other companies is March.(b) We have used Annual report of CY07, CY08 and CY09 for Allcargo and Annual report of FY08, FY09 and FY10 for other companies. (c) Audit Fees includes - Statutory fees, Out of pocket expenses and other audit expenses

Whilst the audit fees as % of sales has marginally increased over the years for World Cargo, it is significantly higher compared to the Gateway and Concor on account of higher out of pocket expenses and other audit expenses. These expenses have doubled in FY10 compared to FY09. Hence we attach a RED FLAG.

Exhibit 10: Break-up of Audit fees of World Cargo International

Auditors' Remuneration FY09 (Rs mn)

FY10 (Rs mn)

% of total audit fees

% of total audit fees

Statutory audit 7.9 7.0 91.3% 73.2%

Other Services 0.6 1.6 7.3% 16.4%

Out of Pocket Expense 0.1 1.0 1.4% 10.4%

Total 8.7 9.5 100.0% 100.0%


Strategy


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Achint Bhagat Cement / Infrastructure (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Dayanand Mittal, CFA Oil & Gas / Metals & Mining (022) 30433202 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Krishnan ASV Real Estate (022) 30433205 [email protected]

Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar Metals & Mining / Oil & Gas (022) 30433223 [email protected]

Rakshit Ranjan, CFA Consumer / Retail (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Midcaps – Chemical / Retail (022) 30433242 [email protected]

Ritesh Vaidya Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Sandeep Gupta Media / Midcaps (022) 30433211 [email protected]

Tanuj Mukhija, CFA E&C / Infra / Industrials (022) 30433203 [email protected]

Utsav Mehta Technology (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Deepak Sawhney India / Asia (022) 30433295 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction

Strategy


Aurobindo Pharma (ARBP IN, SELL) - Stock price performance


Amtek Auto (AMTK IN, NOT RATED) - Stock price performance


Akzo Nobel (AKZO IN, NOT RATED) - Stock price performance


Arshiya (ARSL IN, NOT RATED) - Stock price performance


0

500

1,000

1,500

Dec

-11

Feb-

12

Apr

-12

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-12

Oct

-12

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-12

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13

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-13

Feb-

14

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-14

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14

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AUROBINDO PHARMA LTD

050

100150200250300

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-11

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AMTEK AUTO LTD

0

500

1,000

1,500

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-14

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-14

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-14

AKZO NOBEL INDIA LTD

0

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100

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200

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-12

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-12

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-13

Feb-

14

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-14

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14

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-14

ARSHIYA LTD

Strategy


Tata Steel (TATA IN, BUY) - Stock price performance


Jindal Steel & Power (JSPL IN, NOT RATED) - Stock price performance


Gillette India (GILL IN, NOT RATED) - Stock price performance


Unity Infra (UIP IN, NOT RATED) - Stock price performance


0100200300400500600700

Dec

-11

Feb-

12

Apr

-12

Jun-

12

Aug

-12

Oct

-12

Dec

-12

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13

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-13

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-13

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-13

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-13

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14

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-14

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14

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-14

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-14

TATA STEEL LTD

0

200

400

600

800

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-11

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-13

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-14

Jun-

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-14

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-14

JINDAL STEEL & POWER LTD

0

1,000

2,000

3,000

4,000

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-11

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GILLETTE INDIA LTD

0102030405060

Dec

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UNITY INFRAPROJECTS LTD

Strategy


Balkrishna Inds (BIL IN, BUY) - Stock price performance


Crompton Greaves (CRG IN, SELL) - Stock price performance


Lanco Infratech (LANCI IN, NOT RATED) - Stock price performance


Ambuja Cement (ACEM IN, SELL) - Stock price performance


0200400600800

1,000

Dec

-11

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BALKRISHNA INDUSTRIES LTD

050

100150200250

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CROMPTON GREAVES LTD

05

10152025

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-11

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-12

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-12

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LANCO INFRATECH LTD

050

100150200250

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-11

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-12

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-12

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-12

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-12

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14

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AMBUJA CEMENTS LTD

Strategy


Shree Cement (SRCM IN, BUY) - Stock price performance


02,0004,0006,0008,000

10,000

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-11

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SHREE CEMENT LTD

Strategy


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >5%

SELL <5%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock

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22 December 2014 note

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