Quality of Earnings: A Sound Filter Board to Avoid Permanent Loss of Capital

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Investors invest in the stock market based on the odds of reward and risk, but the odds are not always easy to calculate. Multi-Act’s Quality of Earnings analysis is utilized to judge the congruence between the economic earnings of the firm and the integrity of its balance sheet.

At Multi-Act, instead of looking at volatility (or volatility derived measures) as proxies for risk, we define risk in terms of:

  1. Balance Sheet Risk
  2. Business Risk
  3. Market Risk

Thus, Quality of Earnings analysis (QoE) is used as a key element of identifying business risk:

Does the accounting earnings of a firm reflect the economic earnings and does this in turn reflect a sound business model?

Having the correct measure of economic earnings also reflects on the integrity of the ‘balance sheet’ and is an important tool to filter investible companies and processing clean numbers for valuation purposes.

Often, markets have seen enough instances of companies with distorted reported earnings taken at face value and hiding both business and balance sheet risk resulting in a near permanent loss of capital to investors when this gets exposed.

At this juncture it might be relevant to highlight a few cases which Multi-Act has published in the public domain (through its blog ‘Praxeology’) and can be good reference points where diligent analysis of the Quality of Earnings of a company resulted in warnings signs well in advance of the potential risk which emanated from the QoE analysis of such companies.

1. Canadian specialty pharmaceutical company: ‘High’ on high yield

First on the list is a large Canadian specialty pharmaceutical company which was a market darling wherein its debt funded acquisition led growth was cheered and rewarded by the market. Our QoE analysis in April 2015 focused on:

  1. Aggressive B/S: Alarming Debt to Equity ratio, poor AZS 1, poor debt servicing ratios etc.
  2. Change in revenue recognition policy (at one acquired company): From ‘at the time of shipments to ultimate customer’ earlier to ‘at the time of shipments to wholesalers’.
  3. High Intangibles on B/S: ~ 4 times its Net Worth; potential w/off in offing. Suggestive of aggressive capital allocation policy.
  4. Deterioration in M-Score 2 from mid 2000s.
  5. Recurring and large restructuring charges.
  6. Hard to decipher sustainable/applicable tax rate.
  7. Aggressive acquisition bid of another US based specialty pharmaceutical company, with similar QoE and Corporate Governance issues.

Grade assigned by Multi-Act Research Report:    B-

(Ranges from A, B+, B, B- and C; wherein A is best and C is worst).

Ultimately the issues exploded upon some adverse news flows on its pricing practices followed by some damning reports on its accounting practices and corporate governance matters.

**Read the full report here

2. Steel company melting down

Second one to refer is a prominent steel maker in India (amongst the top 5). On a client’s request, we had initiated research coverage on this company in Sep 2012 with a specific focus on its balance sheet. The stock was the market’s darling till mid-2014, as was reflected in its out performance against the steel sector pack. So while market focused on its top-line growth, aggressive capacity expansion and better than peers’ margins, our analytical conclusions revolved around following points:

  1. Leverage driven growth and whether the growth capex was well spent.
  2. Significant amount of un-hedged foreign currency loans.
  3. Aggressive expense capitalization (boosting margins!).
  4. Other parameters like M-Score, AZS and Cash Conversion Cycle also reflected the balance sheet strain.

Grade assigned by Multi-Act Research Report:    B-

(Ranges from A, B+, B, B- and C; wherein A is best and C is worst).
Again, the high flying stock crashed significantly, owing to the weight of the debt on the B/S and fact that debt rolling-over the same beyond a limit became difficult and lenders became wary. Weak macro/industry environment added to the weakness emanating from the B/S.

**Read the full report here
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3. Curious case of INR 13,000 m write-Off!

Third on the list is a mid-size Indian Pharmaceutical company. Towards the mid-2014, it sold significant part of its operating ‘formulations’ business in India to a leading industry player.

While looking deep into its balance sheet, cash flow statement and schedules in notes to accounts, what caught our attention was that the full sale proceeds never reached the minority shareholders or the lenders of the company. Instead it appeared that the company made certain ‘advances’ thereafter, which were also written-off subsequently during the same quarter itself. Similarly there were some write-offs of certain ‘trade debtors’ as well.

The same then was indirectly confirmed by way of auditor’s qualifications in that regard.

On the top of that, the said company also defaulted on repayment of principal and interest on certain deposits and sought time extension from CLB for repayments. That, for a company, supposedly aflush with sale proceeds of its substantial business segment is well, hard to understand.

Our questionnaire to the company management in August 2015 on these issues went unanswered.

Grade assigned by Multi-Act Research Report:    B-

(Ranges from A, B+, B, B- and C; wherein A is best and C is worst).

Subsequently there have been more adverse developments in form of absconding directors; arrest of some directors for alleged fraud etc. and stock price continues to remain under pressure.

**Read the full report here
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Statutory Details: Multi-Act Equity Consultancy Private Limited (MAECL).

SEBI Registered Portfolio Manager – Registration No. INP000002965

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The views expressed in this article are for educational and reading purpose only. MAECL does not solicit any course of action based on these views and the reader is advised to exercise independent judgment and act upon the same based on its/his/her sole discretion, their own investigations and risk-reward preferences. The article is prepared on the basis of publicly available information, internally developed data and from sources believed to be reliable. Due care has been taken to ensure that the facts are accurate and the views are fair. MAECL, its associates or any of their respective directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such views and consequently are not liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way for decisions taken based on the said article.

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Notes:

  1. AZScore: Score based criteria for predicting balance sheet stress. Used as follows:
    Greater Than 2.6 Safe Zone
    1.1 – 2.6 Grey Zone
    Below 1.1 Distress Zone
  2. M-Score: In his out of sample tests, Prof. Dr. Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.

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