My first point of analysis of any stock is the Cashflow statement. (Well, I don’t choose to evaluate stocks whose debt is very high and hence technically, you can say Balance Sheet is my first point). I don’t do an in-depth analysis right away, but I just glance through different items of the Cashflow statement to see if anything is largely amiss (if it is, then I dump the stock analysis, and move on to the next – there are soo many to evaluate!). In this blogpost, I will elaborate on one such cash flow statement which I thought looked very dicy (The reason I came to evaluate the stock was because some other investor had suggested I look into it). I shall name the stock later in the analysis, just so that revealing the name doesn’t put you off (oh, I don’t track that industry!, you know 🙂 ).
Anyway, here is a snapshot of the cashflow statement (from their Annual Report 2010-11).
Just glance through the statement. I found three items which were quite alarming to say the least.
a) Provision for doubtful debts have shot up more than 90% in one year. Of course, provision doesn’t mean actual loss, but then again, why have the provisions shot up by such a significant percentage?
b) The customers don’t seem to pay this company at all (look at the increase in sundry debtors) (I don’t want to calculate percentage increase here) and
c) Nobody seems to be buying (well, not technically) if you look at the increase in inventories (300% increase!).
This by itself, of course, should not put you off on the stock. Let’s dig a little deeper into the Annual Report. Here’s another snapshot which is relevant to the points mentioned above.
Two points again –
a) Finished goods have gone up by 80%. Either the customers are not buying this company’s products, or the company has grossly overestimated their product demand. Finished goods seem to be sitting in the warehouse.
b) Sundry debtors have increased dramatically, and so with Sundry debtors increase the doubtful debts. Why did Sundry debtors go up so dramatically? Has the company relaxed its collection norms or have the sales increased dramatically?
Let’s look at a snapshot of its P&L and Balance Sheet items (to see if the sales have increased dramatically).
|Debt Growth (%)||45.80||7.32||-23.73||28.83||18.07|
|Sales Growth (%)||12.19||7.56||31.32||22.11||17.15|
|Op.Profit Growth (%)||-5.82||10.51||80.96||75.35||42.93|
|Net Profit Growth (%)||-6.79||26.31||113.77||170.49||70.04|
|EPS Growth (%)||-8.64||-19.55||63.19||152.71||27.27|
Reading off this snapshot, we realise that Sales growth has only been 12%, while Sundry debtors growth has been…
The name of the company is Orient Abrasives. Abrasives are usually used in a wide variety of industries and Orient is one of the four listed players on the market (the other three being Carborundum Universal, Wendt India and Grindwell Norton). In brief, Orient Abrasives is into two categories of abrasives – Electrominerals (which are actually grains mined from mines and has different uses like making machine tools, SPV cells, abrasive) and Refractories (used in lining of different industries to protect from heat). They have the lowest P/E across the 4 listed players. Orient Abrasives P/E is 9 while others vary from 16 to 23.
Let’s put up some important figures for Orient Abrasives and its competition (all the return ratios are the medians of the company’s performance over the past 5 years)
|Sales Growth||3 yr CAGR||18.06%||9.85%||25.42%||24.81%|
|5 yr CAGR||18.69%||17.94%||12.26%||20.53%|
|Op. Profit Growth||3 yr CAGR||23.34%||2.02%||34.70%||26.70%|
|5 yr CAGR||17.81%||34.08%||13.20%||17.00%|
|Net Profit Growth||3 yr CAGR||44.18%||8.50%||44.96%||26.36%|
|5 yr CAGR||17.93%||61.53%||17.14%||17.21%|
|EPS Growth||3 yr CAGR||44.10%||-14.27%||34.31%||24.75%|
|5 yr CAGR||20.61%||31.95%||16.32%||16.80%|
(Figures in Blue are the highest across the competition for that category. Figures in Red basically means ‘it sucks’).
The table gives a clear picture of why Orient Abrasives has been beaten down by the market. Its past 3 year history has been close to pathetic, while its competition has grown by leaps and bounds. And with no new initiatives from the management, I don’t see why the market would re-rate it. 5 year record is pretty stellar though – anybody trying for the logic of ‘reversion to mean’ here?
Having said that, look at the table again at other investing contenders. We can easily see that Wendt has been an outperformer in this category, while Grindwell Norton comes a close second (and both are debt-free). Compare these two companies (forget Orient Abrasives for a moment) with Carborundum Universal and you’d see that Wendt and GN are much better performers than CUMI.
But what does the market say? The market says that CUMI is worth 25 times PE multiple, while Wendt is worth only 18.5 times PE multiple and GN is much lesser. In fact, as recently as March 2011, Wendt was quoting at 11 PE multiple, while CUMI was quoting at a 19 multiple even though performance of Wendt was much better than CUMI. Delisting mania took over, and Wendt shot up promptly to what I thought was still slightly undervalued figure of 1500 (CMP: 1700) and a 17 PE multiple (currently 18.5).
What does that indicate? It indicates that I should do this industry analysis more often that I do so that we could have had a 60% gain in Wendt, compared to a paltry 25% gain in CUMI off March 2011 figures 🙂 Also, that tells you that Mutual Funds are somehow fascinated with CUMI (most mutual funds have this stock) rather than other improved plays like Wendt (probably, they don’t want to get entangled in this delisting mania).
Would I invest in this company?
a) There is something awry in their collection process through which debtors and doubtful debts are increasing at an alarming rate.
b) There seems to be an unusual buildup in their finished goods – which leads me to believe that the company is not really efficient in managing customer demand.
c) If you look at their Jun 11 quarterly results (Q2 results have not yet been declared), there has been an increase of 17% in sales, but a degrowth in profit (and if you look at the table above, it is evident for the entire year 2010-11).
d) Debt has increased considerably over the past year. Although interest is easily covered by its earnings for now, we need to keep a watch on this figure. If it jumps again, we have a cause for concern.
e) Let’s try to estimate FY12 EPS. The median NPM over the past 5 years is 12.48%. Assume a 15% increase in sales (3yr CAGR is just 10%, but let’s be a little optimistic here). We end up with 420cr sales, which translates into 52cr net profit. EPS will be around Rs. 4.4. Let’s take a PE band of 8-12 (I don’t expect a PE rating higher than 12 for the simple reason that there is no kicker in sales/profits/new ventures etc over the past 3 years and recent quarters). That gives us an optimistic PE range of Rs. 35-Rs. 52. Not too much margin of safety, is there?
Therefore, I shall pass.
Where can I go wrong in this analysis?
a) Sentiments in markets, terrific bull market etc.
b) Probably the management is coming up with lots of new things, and I haven’t dug deep enough into their business.
Haven’t done Competitor analysis. If anybody has already done this, please share. Done now
d) My basic reading of these accounting statements is wrong.
e) I have taken only 5 yr data (which doesn’t cover an entire business cycle), while I should have taken 10.
Disc: Haven’t invested in this stock. Will not invest unless I am offered a convincing alternative explanation. I am bullish on this sector though and am reading through a few things. Please do poke holes in my argument.
P.S: If anybody is interested in DCF, the median FCF over the past 5 yrs is 8.41. So plug it into a two stage growth model and let me know what comes out as intrinsic value per share.
P.P.S: The biggest grouse I have is most companies don’t release their balance sheets and cash flow statement quarter on quarter. I hope they do. But then again, I also hope for winning KBC panch koti maha muni. So yeah. That’s that.