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Analysis : BEL annual results

By Rohit Chauhan
In Investment ideas, Non-equity assets, Uncategorized
September 11, 2008
3 Min read
5 comments
A

Read my earlier analysis of BEL here

Results summary
The company had an average year in 2007-2008. The sales growth was around 7% and the profit growth was around the same. The net profit margin improved to around 20%. The company maintained the ROE numbers at the 25%+ levels and continues to be a zero debt- cash rich company
The open order book has now increased to 9586 Crs with around 3100 Crs executable in the current year. This provide visibility to around 80% of the annual revenue.
The business is skewed to the fourth quarter due to the projects nature of the business and hence the company accrues almost 60% of its profit in the last quarter.

The positives
The company maintained its ROE, margins and other key performance indicators such as order book, Fixed asset Turnover ratio, Raw material costs etc.

In addition the company is now spending almost 5.1% of revenue on R&D and plans to increase it to 8-9% of sales. This is a very positive development as R&D is crucial in this business . BEL is among the very few indian companies which spend on R&D and may have the highest spend in terms of sales. The company has been developing a lot of new products and now gets almost 83% of the turnover from indigenously developed products

The company has conservative accounting for foreign exchange (Company has no derivatives) and charges all changes to the Profit and loss statement.

Finally the company continues to be a debt free company with almost 2400 Crs in cash on the books. Net of cash, the ROE numbers of the company are fairly high, which reflects the strong competitive advantage of the company.

The negatives
The number that concerns for me is the high level of recievables. The recievables have shot up from around 1000 odd crores in 2005-06 to around 2080 Crs in 2007-08. As a result recievables have consumed almost 60% of the free cash for the last 2 years. This is very discomforting and will have to watched closely. The management has indicated that they are planning to bring it down, however I am still concerned about this number which is now a red flag.

The other concern is the very high skew for the fourth quarter. It is not very healthy to book so much business in a single quarter, especially the year end to make the numbers. Projects type business (for ex: blue star) have higher skews in Q4, however such skew results in poor recievables turns, bad debts and other issues (more on that later).

The valuation
The company now sells at around 6 times earnings (net of cash). So the market is clearly expecting the company to perform pretty badly. Now this is a company earning very high return on capital, growing in mid to low teens and in a business which is pretty immune to the economy (defence spending). In addition, though private companies are now being allowed in defence since 2001, BEL has been able to do well.
Other than the fact that the company is PSU, I cannot find a reason for almost a 50-60% drop in the stock price (other than that the market as a whole has declined).

Added note : I would not read too much into the Q1 results. As I said earlier in the post, if the company books too much revenue in Q4, the next years Q1 results get impacted.

I have loaded the a detailed analysis of the company in google groups.

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Replying to a comment, a correction and misc thoughts

By Rohit Chauhan
In General thoughts, Uncategorized
September 8, 2008
5 Min read
8 comments
R

I got the following comment recently

If I take u back to 1994, how would u have spotted Infosys. The only way one could spot it could be through the market opportunity, good results and good management.or u may enlighten if there was any other way. So it could have been a kind of recurring deposit wherein one wud have seen good results and put money in that company every quarter.

I agree there could have been companies where the growth wud have stopped, but then its like finding out 20 horses in a race of 5000 and then slowly and steadily identifying the best horse through results only. When I say results I mean higher EPS also and not just a company like Teledata or any other which diluted its equity too.

Thats what big companies like GE, Tatas do. Hire gud people and then thru performance weed out the non performers.

Agreed that Educomp is richly valued or investing in Infosys in 2000 wud have been burning fingers. What I am saying is that implmenting the value investing approach with growth companies.Take micro technologies for instance. It has been growing at CAGR of >50% for last 4 years. It has a book value of 206 approx. It trades at 220. EPS of around 50. Almost no debt. Mcap of 60% CAGR for last few years.

These companies are not richly valued at all.Thru Value Investing combined with Growth, I could see huge returns. Unfortunately I did not put a lot for money. e.g Rajesh Exports in a single year increased its sales from 200 to 2200 crore somewhere around 2003. That time the stock did not appreciate and had excellent value(128 book value, eps around 40, Price around 150. It gave 25 times returns since then), That was the time to enter and make huge money. and I did but with a small amount as I was learning then.

Following is my response :

Hi anonymous
There is a book, The gorrila game, which talks about an approach on how to invest in tech companies.

Approach is similar to the one you mention ..buy the whole basket ..and then follow the results of each. sell the poor performers and invest the cash into the good performers. That could have been a way to make money in infosys.

However it would have been diffcult to have the foresight in 1994 that infosys would do so well.even employees working in infosys did not recognise that (employees who were given options then thought the options were worthless).

I think growth is compatible with valueinvesting. Growth in the end, is a variable in the valuation process. As long as your are paying less than the growth implied intrinsic value, you will do well. So microtechnologies and Geodesic may fall in that bucket. They maybe insanely undervalued due to the excellent prospects. I have however not looked at these companies and hence cannot comment. However I would definitely look at them now.

Regarding your experience with rajesh exports, I can understand what happened as I have gone through similar experiences several times – namely how do you know beforehand that you are right on a company. I think as one gains experience, one learns to identify and benefit from such opporunities.

A correction
In the valuation of several companies I have used the following formulae to check the valuation

Mcap – cash on hand = Net Mcap
Net Mcap / Net profit = effective PE.

There is an error in the above approach. Typically the above cash earns 8-10% as part of the other income. The net profit should be adjusted with this non core income to arrive at the effective PE, otherwise you end up double counting the cash.

The error, lucklily has not changed most of the valuations I have done, but it is an error all the same and has a bigger impact if the cash as a % of market cap (mcap) is high. It is such an obvious error, but I have missed it till now. Well, better late than never.

A quote

I saw this quote from Keynes (A famous economist)

When the facts change, I change my mind. What do you do, sir?

Reply to a criticism during the Great Depression of having changed his position on monetary policy, as quoted in Lost Prophets: An Insider’s History of the Modern Eonomists (1994) by Alfred L. Malabre, p. 220

This quote is very apt in investing. One analyses companies based on present facts and a set of assumptions. Valuation is finally an exercise of projecting the future. By being conservative, you can reduce the possiblity of an error. However when facts change dramatically, I am reminded of the above quote and find it prudent to change my mind – nothing wrong with that. Even a 60-70% success rate in picking stocks (being right 6-7 times out of 10) can give very good results in the long run.

Misc thoughts
I am reading through the Annual reports of several companies which I follow. I will be posting my analysis on the same. The market seems to be going one step forward and one step back. There are problems developing in the US and the markets may start weakening in the US. In india, inflation seems to be high and somehow the policy response has still not been strong enough. I think the RBI thinks that this inflation is temporary and it will cool on its own.

I hope they are right for everyone’s sake. If however they are wrong and they forced to hike the rates further to kill inflation, then we could have nasty times ahead of us in the market.

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Analysis: NIIT tech Annual results

By Rohit Chauhan
In Company analysis, Uncategorized
September 2, 2008
6 Min read
7 comments
A

Warning: Parts of this post are boring as I would be discussing about Hedge accounting, reserve adjustments etc. However if you are invested in IT stocks, I would recommend you to get a good understanding of these concepts as they are now critical to understand how the company is doing.

Results summary
The company had an average performance for the year 2007-08. The ROE was maintained at 30% level. The sales growth was lower at around 6% (reduced partly by the rupee appreciation) and the net profit growth was around 3%. The net profit margins were maintained at 14.3%. The operating margins also held steady at 19%.

The key segments of BFSI, Insurance and travel now contribute to more than 80% of the revenue. Europe continues to the major geographic segment with the contribution to revenue at 50%. The other performance parameters such as % revenue from top customers, no. of new customers etc showed decent improvement.

The company completed the accquisition of ROOM solutions during the year. This business was not profitable during the year as it is in the investment mode as per the management. In addition the company made another small accquisition of Softec in the airline IT solution space. Thus the company is pursuing a strategy of both organic and inorganic growth in the focus verticals, especially in Insurance and transportation.

The positives
The company did not perform as well as the tier I vendors. However the company is now pursuing a strategy of focusing on key verticals. It is growing through accquisitions in these verticals and accquiring the required IP and customers via these accquisitions. This strategy makes sense for mid size companies such as NIIT tech, which cannot compete with the Tier I companies on scale alone.

The company maintained its margins and ROE inspite of the slowing markets and currency fluctuations. The company performed as expected and as the valuations are currently discounting a terrible performance, the stock price did not suffer.

The cash and equivalents for the company now stand at 220 Crs which is almost 30% of the mcap. The company continues to sell at around 2.5 times earnings (or slightly higher than book value), which means the market expects the company to be out of business pretty soon.

The negatives
The volume growth for the company was poor for the year 2007. The company is definitely not performing as well as some of the Top tier companies.

The accquisition for ROOM solutions was done at 100 Crs. The company is currently making losses. NIIT tech Management has paid quite a bit for the company and must have seen a lot of value. I hope they are right. Although subsequent poor performance of ROOM may not hurt the company a lot, it would definitely put the capital allocation skills of the management into question. I would personally rethink my entire thesis about the company if the accquisition turns out to be a dud

The performance of the accquisition is more critical than it seems on the face of it as the company has a large cash holding. This cash holding would grow further in the future and the management would be looking at new accquisitions with this cash. A poor track record would hurt the performance in the long run.

The accounting
The company accounted a forex loss of around 6.7 Crs in the P&L account with net impact of +.8 crs ( still trying to figure how they arrived at this number).

Now for the dry part,
The company maintains effective and non-effective hedges. The effective hedges are used to hedge the revenue and recievables. The company booked a loss of around 15.5 crs against reserves in the year 2008. These reserves have increased to around 65 Crs in Q12009. So if the rupee remains at the current levels, the company will close the hedges (which cover 27 months of revenue) over the next 27 months and take a loss of 65 Crs on the P&L account.

So the question is – Has the company already incurrend a loss of 65 Crs ? Yes and No. If the company were to close the contracts then it will have to account for the losses. However NIIT tech is not in the business of derivatives. These derivatives and contracts are used to hedge forex revenues. It is possible that the exchange rate could go in the opposite direction and the losses could worsen or they could go in the intended direction and the company could make profit and come out smelling roses.

The valuation impact
How should one account for forex gains/ losses? I think it would stupid to consider these losses as an ongoing one and capitalize it.

For ex: 2008 net proft was 137 Crs. So would you net the above loss of 15 Crs and say the Net profit is 122 crs and use this number for the final valuation ?

I would rather do the following

Say we take the appropriate PE as 15. The value of the company is 137*15= 2055. I would net off 15 crs from this value to arrive at the final value of 2040 Crs. I would apply the same logic if the company made a profit.

Over the long term, I think the forex gains or losses should be a wash (net impact should be minimal). Unless the treasury department is foolish (which doesn’t look likely) or very smart, the hedges should end up serving their purpose of reducing the impact of exhange losses or gains.

Ofcourse I am assuming the company will not start looking at Forex hedges and derivatives as a source of profit. That is a different ballgame completely. If the company gets in exchange speculation (and some companies have tried that stunt), I will take a very dim view of it.

The employee benefit (AS15) impact is not too high for the year and hence I would not concern myself too much about it.

Reading up

I am currently reading AS30 standard to get a better understanding of the new accouting standard for mark to market accounting. It is quite a dry read. However if you are interested in understanding the accounting and results of IT companies, then it is important to understand these standards. I would say, that if you are into fundamental analysis, the understanding all the AS standards is crucial.

Ofcourse reading AS standard is as entertaining as getting your dental work done. But investing is not always fun ..is it ? 🙂

I have still not changed my mind about the company. The market expects a far worse performance and as long as the company can do better than what is expected, the returns for an investor should be good.

The analysis for NIIT tech is uploaded here. Earlier posts on NIIT tech here, here and here

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Infosys accquisition of Axon group: My view point

By Rohit Chauhan
In Uncategorized, Views on news
August 29, 2008
3 Min read
7 comments
I

Infosys recently announced the accquisition of the Axon group. Most of the analysis I have seen is centred around whether the deal is EPS accretive or dilutive. I think this kind of analysis is superficial and misses the point. A deal can be EPS dilutive and still be adding value and vice versa (more on that in a later post).

In this specific case, Infosys is accquiring an ERP (SAP in this case) consulting firm with net margins of around 10%. ERP consulting is a high margin, high growth business for Infosys. The typical gross margins are sometimes in excess of 50%.

How do I know ? disclosure : I worked with infosys in their ERP practise in the past. The ERP business for Infosys has seen phenomenal growth in the last 8 years and has done exceedingly well. Their Oracle and SAP practises have done very well too (I have personally seen the practises grow in the last 6-7 years). Infosys has managed to constantly increase the offshore component of ERP projects and thus maintain high margins.

Axon has gross margins in the range of 25-30%. In addition they are based out of UK, US and Malaysia. I am not sure of how much offshoring Axon does, but any improvement in the onsite/ offshore component of their existing projects due to the backend infrastructure of Infosys will enhance their margins. This is a good deal where Infosys gain the front end part of the business ( clients, onsite consultants, relationships , Knowledge etc) and Axon (which will be now be a part of infosys) will see improvements in margins due to higher offshoring.

Is everything hunky dory then ? Not necessarily. Integration of Axon into infosys will be a challenge. Infosys has an ‘Indian’ company culture (I do not mean it in a negative way). They are very conservative on expenses and there are other typical ways of doing things. Axon (about which I do not have any special insight) must have a more European culture. Integrating two such diverse culture will be a challenge. The key asset for an consulting company are its people. If the integration is poor, then employees from Axon (or even from exisiting practise in Infosys) could leave. I think that may not be a major issue in the long term. The company will work on retaining the key employees.

So overall, there is more to this deal than just plain EPS numbers. The ERP practise (especially SAP) is doing well for the company. Addition of Axon will provide further scale to the SAP consulting business of infosys and will add value down the road.

Additional disclosure : I hold infosys stock

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