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December 2016

STRATEGY

Forensic Accounting: Beware of the 'Zone of Darkness'!

Research Analysts:

RevenueManipulation

CashPilferage

Karan Khanna, [email protected]: +91 22 3043 3251

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Ambit Client

ExpenseManipulation

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Nitin [email protected]: +91 22 3043 3241

Nikhil [email protected]: +91 22 3043 3265

Strategy

December 16, 2016 Ambit Capital Pvt. Ltd. Page 2

CONTENTS

Beware the ‘Zone of Darkness’! …………………………………………………….3

Executive summary ……………………………………………………………………4

Our ‘forensic’ model: Methodology ………………………………………………..8

Link between accounting quality and investment returns ……………………..20

Why we think accounting quality especially merits ……………………………26 attention at this critical juncture

Debunking myths about accounting quality …………………………………….29

How can clients access our forensic model? …………………........................31

Subjective checks: Can be gauged only with a careful ………………………..33 reading of the annual report

Sample bespoke: Analysing top Indian auditors ……………………………….37

Sample bespoke: Thousands of Miles …………………………………………...38

Analysing top Indian auditors ………………………………………………..37

Thousands of Miles (NOT RATED): Too good to be true! ………………..38

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.

Beware of the ‘Zone of Darkness’!

The accounting quality of India Inc. remains lower than its global peers. Instances of alleged accounting malpractices have only increased over the last couple of decades. GTB, Satyam and Reebok India are associated with some of the biggest accounting malpractices that have shaken the Indian markets from time to time. Given that sub-par accounting quality is profoundly damaging for investment returns, forensic accounting has played a pivotal role in shaping our investment philosophy over the past few years. With all major listed Indian companies having published their FY16 annual reports, we present this year’s edition of our annual accounting thematic. We reiterate that for meaningful investment returns, the ‘Zone of Darkness’, the bottom three deciles of our accounting framework, should be avoided at all costs.

Quantifying accounting quality We use 11 financial ratios across four categories of accounting checks – P&L mis-statement, balance sheet mis-statement, cash pilferage and audit quality – to rank the largest 1300 listed companies (ex BFSI; with market-cap greater than Rs1bn) on their accounting quality. Note, however, that whilst these aggressive accounting policies raise red flags, they may not necessarily imply fraud. Avoiding the ‘Zone of Darkness’ Analysis of long-term (i.e. six years) as well as short-term (last 12 months) share price returns of deciles constructed on the basis of accounting quality suggests accounting quality is a critical hygiene factor, the lack of which is severely detrimental to portfolio returns. The bottom three deciles, D8, D9 and D10, have been massive underperformers and are to be avoided at all costs. The three zones on accounting quality

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-16; stock price performance is from November 2010 to November 2016 Accounting quality especially merits attention at this critical juncture As ‘business as usual’ gets severely hampered by the ongoing demonetisation-driven disruption, we believe several promoters would resort to more and more creative ways to flatter their books. At this critical juncture, investors need to be much more vigilant whilst investigating the quality of accounts of any company and, hence, our accounting model should be helpful in this regard. How can clients access our forensic model? Clients can now use our ‘HAWK’ platform (click here) to screen the entire listed universe on the basis of accounting quality. For clients interested in their portfolio heatmaps, we can also provide an accounting heatmaps of their portfolio within five working days of receiving requests if the constituent stocks are in our accounting model. Finally, for a more detailed analysis, we also conduct extensive bottom-up company-specific bespoke research for clients.

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THEMATIC ACCOUNTING December 16, 2016

Strategy

Case studies featured in this report Company name Pg. no.

Examples of companies getting penalised on our model

8K Miles 9

Omkar Speciality Chemicals 10

Biocon 11

Tata Chemicals 12

Linde India 12

Tanla Solutions 13

Godrej Consumer 13

UPL 14

Wockhardt 15

Balkrishna Inds. 16

Sequent Scientific 16

Unitech 17

Other subjective checks

Glenmark Pharma 33

Arshiya 34

Lanco Infra. 34

Crompton Greaves 35

In-depth case studies

Emerging IT Solutions provider 38

Top Indian auditors 37

Source: Ambit Capital research

THIS NOTE CANNOT BE USED BY THE MEDIA IN ANY SHAPE OR FORM WITHOUT PRIOR CONSENT FROM AMBIT CAPITAL. CASE STUDIES FEATURED IN THIS NOTE ARE FOR ILLUSTRATIVE PURPOSES ONLY AND MAY NOT NECESSARILY IMPLY ANY ILL-INTENT ON THE PART OF THE COMPANY IN QUESTION.

Research Analysts

Karan Khanna, CFA +91 22 3043 3251

[email protected]

Nitin Bhasin

+91 22 3043 3241

[email protected]

hawk.ambit.co

Strategy

16 December, 2016 Ambit Capital Pvt. Ltd. Page 4

Executive summary Over the past couple of decades, instances of alleged accounting malpractices have become widely prevalent in India. Global Trust Bank, Satyam and Reebok India remind one of some of the biggest accounting malpractices that shook corporate India in recent times. Given poor accounting quality is profoundly damaging for investment returns, forensic accounting has become the cornerstone of Ambit’s investment philosophy over the past several years. With FY16 annual reports out for nearly all the major listed Indian companies, we bring to you this year’s edition of our annual accounting thematic.

The accounting quality for India Inc. remains lower than the accounting quality for most of its global peers. Global Trust Bank (2004; for more details click here for an interesting article online), Satyam (2009; for more details click here for an interesting article online) and, more recently, Reebok India (2012; for more details click here for an interesting article online) are just a few examples of how accounting frauds have shaken the Indian markets from time to time. Further, with nearly 80% of listed Indian companies having failed to beat inflation over the last 20 years, the importance of accounting quality cannot be overemphasised, although this is an area that is often overlooked.

Before we continue with our discussion on why accounting quality matters, especially in the Indian context, a look at some of the biggest accounting and financial malpractices associated with India Inc. over the past two decades would be worthwhile (see exhibit 1 below).

Exhibit 1: Key accounting and financial malpractices in India over the past two decades

Name of company Year and month Brief description

Alleged falsification of accounts/misappropriation of funds

Global Trust Bank 2004

At the core of Global Trust Bank appears to be the issue of ’inappropriate‘ exposure to capital market activities, which resulted in huge NPAs, which in turn were significantly under-provisioned for by the bank. As a result, the bank’s reported net worth of Rs4,004mn (as on 31 March 2002) eventually turned out to be negative when inspected by the RBI.

Satyam Computers Jan-09 Ramalinga Raju, Chairman of Satyam Computers, confessed to manipulating the books of accounts of the company to the tune of more than Rs70bn.

DSQ Software 1998

DSQ and its promoter Mr. Dalmia allegedly made misleading statements "which had the effect of inducing purchase of securities by public which in turn increased the market price of the shares of the company". Also, Lovelock & Lewes- one of the member firms of PwC, and the auditors of DSQ Software, was found guilty of manipulating share prices and falsification of accounts by SFIO.

Reebok India Nov-12

Not only were sales allegedly exaggerated through ‘parallel accounting’ and were never passed on to the company, incidents of goods invoiced merely to inflate sales (but not dispatched), suspicious third party transactions, circular trading, and retrospective increases in the price of good already sold, are all believed to have been present in some form or the other.

United Spirits Sep-14

In its annual report for 2013-14, United Spirit's auditors (M/s BSR & Co. belonging to the KPMG group) alleged that the company had advanced certain amounts (amounting to Rs21bn) to a few UB group entities between 2010 to 2013 where there was no clarity on recovery. Both the previous auditors - PwC and Walker Chandiok & Co. – did not make note of this fund diversion in their auditors report.

Air India 2006-07

Citing one of the issues red flagged by the airline's statutory auditors in the 2006-07 annual report; one of the former employees alleged that the Air India management dressed up the airline’s balance sheet with “accounting loopholes” and “deception” to inflate receivable rents (to the extent of Rs0.8bn) to make its losses look smaller.

Ricoh India May-16 KPMG, who was appointed as the statutory auditors of Ricoh India in Sep ’15, identified several accounting irregularities in its books; said it is difficult to form an opinion.

Accounting quality for India Inc. remains lower than its global peers

GTB, Satyam and Reebok India are amongst the biggest accounting malpractices that shook corporate India over the past two decades

http://articles.economictimes.indiatimes.com/2010-05-31/news/27615568_1_ramesh-gelli-gtb-sridhar-subasri

http://qz.com/379877/the-satyam-scandal-how-indias-biggest-corporate-fraud-unfolded/

http://www.livemint.com/Companies/vkpTgJ1M39TbRHvG1nZGsK/Reebok-Indiafake-sales-and-secret-depots.html

Strategy


Name of company Year and month Brief description

Cases of auditors resigning/refusing to sign the accounts/'withdrawing' the auditor's report

Arshiya Aug-09 In August 2009 (FY10), based on the company filings, PriceWaterhouseCoopers (PwC) expressed their unwillingness to be reappointed as the auditors of Arshiya. Consequently, Arshiya changed its auditor in FY10 (August 2009) from PwC to MGB & Co.

Prithvi Information Dec-11

VK Asthana & Co, auditors of Hyderabad based software outsourcer Prithvi Information Solutions Prithvi Information Solutions (PISL) refused to sign the financial accounts of the company for 2010-11. VK Asthana was also the fifth auditing firm the company had in the last three years after Patwari & Co, Ernst & Young, PriceWaterhouseCoopers and Walker Chandiok & Co.

Financial Technologies (now 63 Moons Technologies)

Sep-13 In Sep ’13, Deloitte took the unprecedented step to ‘withdraw’ its audit report on Financial Technologies for the year ending 31 March 2013, stating that the company’s standalone and consolidated results are not to be relied upon.

Lanco Infra. Sep-12 Whilst E&Y replaced PwC in FY11, E&Y and Brahmayya & Co were appointed as joint auditors. In FY12, E&Y refused to be reappointed and highlighted several qualifications in the audit report.

Alstom T&D and Alstom India 2010/2013

Deloitte indicated unwillingness to audit Alstom in FY10 and PwC was appointed. However PwC too did not seek re-appointment in FY13 and were subsequently replaced by a mid-sized accounting firm SN Dhawan & Co.

Cases involving private equity investors

Fourcee Infra. Oct-13

In Oct '13, private equity investors General Atlantic (GA) and India Equity Partners (IEP) had dragged their investee company Fourcee Infrastructure to court over charges of fraud and embezzlement and willful deceit running into several hundreds of crores. These allegations surfaced after an audit of the books of accounts for year ended March 2013 by BSR & Company, an affiliate of KPMG.

Lilliput Kidswear Jun-14 In 2014, global private equity firm Bain Capital Partners LLC sued EY in a US court, claiming that the auditing firm cost it roughly $60 million by advising it to invest in Lilliput Kidswear, the children's clothing company. EY was also the statutory auditor of Lilliput.

Catmoss Jan-13 In 2012-13, private equity investors SAIF Partners alleged that the company had mishandled funds to the tune of Rs2bn (US$ 36.2mn) - half of which were investments secured from SAIF and the remaining raised as bank loans.

Ponzi Schemes

Sahara Aug-12

In Apr '08, Sahara India Real Estate Corporation (SIREC) and Sahara Housing Investment Corporation (SHIC) began the process of inviting and collecting subscriptions from the general public. Over a span of 3 years these companies collected ~Rs177bn from 30mn investors. The invitation to subscribe was in the form of “Optionally Fully Convertible Debentures”. On investigation by SEBI, it concluded that SIREC and SHIC violated the Companies Act by collecting money through optionally fully convertible unsecured debentures (OFCDs) and ordered the company not to raise any further funds using these instruments. Further, in Aug '12, the SC ordered the Sahara Group to return ~Rs240bn, plus 15% interest, to millions of investors, within three months.

Vishwapriya Sep-15 R Subramaniam, also the founder of defunct store chain Subhiksha, was arrested in Sep '15 for allegedly duping over 4,000 depositors in the Vishwapriya group of companies to the tune of Rs1.5bn

PACL Jan-16 Earlier this year, the promoters of PACL were arrested by the CBI over allegations that the property company cheated investors of Rs450bn (US$6.8 bn).

Source: Various press articles, Ambit Capital research

Given how widely prevalent instances of alleged accounting malpractices have been, for an investor contemplating whether or not to invest funds in India, it only becomes imperative to gauge the accounting quality of any company before investing.

Against that backdrop, five years ago we started out building our proprietary forensic accounting model with the sole objective of helping investors navigate camouflaged annual reports. Over the years, we have built from scratch and refined our now well-established forensic accounting model to help provide investors with a first-level assessment of their portfolio’s health. In addition to this, through a plethora of bespoke accounting projects, we helped several clients dig deeper into corporates with glaring accounting issues that were masked using various accounting gimmicks.

Note that our bespoke projects are not just restricted to an analysis of the reported annual accounts for the company, but also on extensive primary data checks, analysis of relevant press articles on the firm and/or its promoters, comparison with peers, and analysis of various statutory filings of the firm. To illustrate this, towards the end of this note (see page 38) we have provided a forensic bespoke that we did on an emerging IT Solutions provider earlier this year.

Further, we have always believed that the degree of conservativeness exercised by the auditor/audit firm auditing the books of accounts is as much important as the accounting quality of the underlying listed company itself. In that context, a sample bespoke that we did on the top Indian auditors too has been attached towards the end of the note (see page 37).

Instances of alleged accounting malpractices are aplenty in India…

…and hence at Ambit we have built our proprietary forensic model to help investors navigate through camouflaged annual reports

Strategy


Accounting quality matters! (over long periods of time)

That accounting quality matters is a point we have often highlighted over the past few years. Exhibit 2 below plots the long-term (six years to be precise; measured over Nov ’10 - Nov ‘16) share price performance of the ten deciles created on the basis of our accounting model.

Exhibit 2: Performance of accounting deciles over long periods of time

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016. Shaded areas denote the three zones on accounting quality. Universe for this exhibit is BSE500 (ex-financials).

From exhibit 2 above, we note that an analysis of deciles constructed on the basis of accounting quality (quantified using our model) brings out the following interesting observations: The top 5 deciles on accounting do not seem to be materially different from each

other on investment performance (we label these deciles the ‘Zone of Safety’); The next two deciles - D6 and D7 have been slight underperformers (and hence

we categorise them as the ‘Zone of Pain’); but The bottom three deciles have been massive underperformers (and hence we

categorise this as the ‘Zone of Darkness’).

The key takeaway from exhibit 2 above is that beyond D7, i.e. in the ‘Zone of Darkness’, the performance slumps dramatically, suggesting that this is the zone that has to be avoided at all costs.

Accounting quality matters! (on a live basis too)

Even on a live basis, accounting quality has remained relevant over the past year. An analysis of the performance of accounting deciles created on the basis of last year’s iteration of this note suggests that whilst the top 5 deciles on accounting quality (and within these deciles, ‘D3’ and ‘D4’) have done reasonably well, the bottom three deciles on accounting quality (especially ‘D10’) have been massive underperformers.

Exhibit 3: Performance of the accounting deciles over the last 12 months (for the BSE500 universe)

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Universe for this exhibit is the BSE500 (ex-financials) as of 31 October 2015. Price performance has been measured over the period 16 December 2015 to 14 December 2016.

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Bottom three deciles on accounting have been massive underperformers over long periods of time…

…as they have been over the last twelve months

Strategy


In exhibit 4 below, we illustrate the performance over the same period for the sub-BSE500 universe. Note the sharp underperformance for the bottom three deciles on accounting.

Exhibit 4: Performance of the accounting deciles over the last 12 months (for the sub-BSE500 universe)

Source: Bloomberg, Capitaline, Ambit Capital research. Note: Universe for this exhibit is the sub-BSE500 (ex-financials) as of 31 October 2015. Price performance has been measured over the period 16 December 2015 to 14 December 2016.

Exhibits 2, 3 and 4 above bring out a very interesting observation about accounting quality in India. 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.

Launching our proprietary accounting model for FY16

With FY16 annual reports out for nearly all the major listed Indian companies, this note brings to you this year’s edition of our annual accounting thematic extended to all companies with market-cap greater than Rs1,000mn.

In the next section, we will discuss the methodology used to rank the entire universe of listed companies (excluding banks and financial services firms) with market-cap greater than Rs1,000mn on the basis of their accounting quality. All our accounting analysis is based on data sets taken from Ace Equity, Capitaline and Bloomberg. We triangulate our data across three data sets to ensure that we minimise data-driven errors in our analysis.

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Gauging accounting quality especially becomes crucial for the less discovered space

With this note we bring to you this year’s edition of our annual accounting thematic

Strategy


Our ‘forensic’ model: Methodology We use 11 objective, quantifiable ratios to rank the universe based on accounting quality in this year’s iteration. These ratios can be broadly categorised into four key areas of accounting checks as shown in Exhibit 5 below:

Exhibit 5: Key categories of accounting checks - Universe (excluding Financials)

Category Ratios Rationale

P&L mis-statement checks

Cum. CFO/cum. EBITDA Check on a firm's revenue recognition policy; a low ratio may be indicative of aggressive revenue recognition practices

Volatility in depreciation rate* Penalise firms where volatility in depreciation rate is unusually high

Volatility in non-operating income (NoI) (as a percentage of net revenues)

Penalise firms where volatility in NoI 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

Provisioning for doubtful debts as a proportion of debtors more than six months

Check on a firm's debtor provisioning policy; a low ratio raises concerns regarding earnings being boosted through aggressive provisioning practices

Balance sheet mis-statement checks

Cash yield A low cash yield may either imply balance sheet misstatement or that the cash is not being used in the best interests of the firm

Change in reserves (excluding share premium) to net income excluding dividends A ratio of less than 1 may denote direct knock-offs from equity

Contingent liability as a proportion of net worth Indicative of the extent of off-balance-sheet risk

Pilferage checks

Miscellaneous expenses as a proportion of total revenues

Check on a firm's expenditure policy; a high ratio raises concerns regarding the authenticity of such expenses

CWIP to Gross Block A high CWIP to Gross Block ratio could either indicate unsubstantiated capex or delay in commissioning

Cumulative CFO plus CFI to median revenues Check on whether the firm has historically been able to generate positive cash flows after investing activities

Audit quality checks CAGR in auditors remuneration to CAGR in consolidated revenues

Check on the audit quality; ideally growth in auditors remuneration should be consistent with growth in consolidated revenues

Source: Bloomberg, Ambit Capital research. Note: *Depreciation accounting has undergone significant changes in FY15 (due to the requirements of the Companies Act, 2013 that became applicable w.e.f. 01.04.2014). This has resulted in inherent volatility in the depreciation rate in FY15 across the universe. However, given that we are looking at a 6-year median in our model, this change in depreciation accounting does not materially impact the scores for companies in the universe.

In the subsequent sections, we provide a brief description of these accounting ratios along with illustrative case studies.

Note: These case studies are for illustrative purposes only. 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.

We use 11 quantifiable ratios across four categories of accounting checks

Strategy


I - P&L mis-statement checks Several companies use aggressive revenue recognition policies to boost their book profits. Often, however, these book profits do not necessarily translate into cash profits for the firm. Further, in several cases, these book profits often appear higher due to use of less conservative policies such as lower provisioning for doubtful debtors, use of several one-offs such as sale of investments, assets etc. to artificially inflate profitability and so on.

We thus seek to penalise such firms in our model using the following ratios:

1 Cumulative CFO/cumulative EBITDA: This ratio is a check on a company’s ability to convert EBITDA (which can be relatively easily manipulated) into operating cash flows (which is relatively difficult to manipulate). Over long periods of time, a company’s book profits should ideally translate into cash profits. A low ratio (i.e. CFO/EBITDA that is significantly less than one) thus raises concerns about the company’s revenue recognition policy (as this may imply aggressive revenue recognition through methods such as channel stuffing, elevated credit period offered to customers etc.). To arrive at the scores for the universe on this measure, we first cumulate CFO and EBITDA over the last six years. We then sort companies on this ratio and penalise firms where this ratio is abysmally low. Case study: 8K Miles (KMSS IN, US$ 0.3bn, Not Rated) 8K Miles has had a stellar run over the last few years. The company’s revenues have compounded at an impressive 90% CAGR over the last four years. As a result, the company has been reporting healthy book profits. That said, a closer look at 8K Miles’ annual accounts suggests not all of these profits are getting translated into cash profits for the firm (see exhibit 6 below):

Exhibit 6: 8K Miles - rising investment in working capital has led to a low score on cumulative CFO/cumulative EBITDA Particulars (Rs mn) FY12 FY13 FY14 FY15 FY16 Cumulative

CFO (before changes in W/C) (A) 50 52 138 386 887 1,513

W/C investment (B) (84) (120) 1 (66) (548) (817)

CFO (after changes in W/C) (A-B) (34) (69) 139 320 339 696

EBITDA* 50 54 138 383 885 1,510

CFO/EBITDA -67% -126% 101% 84% 38% 46%

Revenue 211 262 441 1,249 2,719 Revenue growth 24% 68% 183% 118% Source: Company filings, Ambit Capital research. Note: *EBITDA excludes other income. CFO is pre-tax.

Exhibit 6 above also suggests the company’s cash flows have been fairly volatile over the years. This could partly be explained by its unstable working capital cycle (see exhibit 7 below). Whilst 8K Miles’ has historically had a much longer working capital cycle than its peers, it seems to have improved in FY15 (when the cash conversion cycle improved to 55 days from 103 days in FY14). However, in FY16, the company’s working capital cycle again seems to have deteriorated (to 110 days). Further, even in FY15, when the working capital scenario appeared to be improving, the company still lagged its peers.

Exhibit 7: 8K Miles’ cash conversion cycle is the highest among its peers FY12 FY13 FY14 FY15 FY16

8K Miles 84 145 103 55 110

Take Solutions 30 51 65 85 68

Accelya Kale 59 46 33 40 49

MPS 8 3 28 43 47

Persistent Systems 21 28 23 24 16

eClerx 55 55 68 72 34

Peer Median 30 46 33 43 47

Source: Company, Ambit Capital research; Note: Following reclassification of reporting structure, 8K Miles has been reporting zero payables since FY13.

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

Strategy


Given the rising investment in its working capital and the volatile nature of its cash flows, 8K Miles fares poorly on our accounting model on cumulative CFO/cumulative EBITDA.

2 Volatility in depreciation rate: Rather than looking at the absolute depreciation rate (i.e. whether it is high or low), we believe undue volatility in the depreciation rate warrants further investigation and, hence, we first calculate the depreciation rate for each of the last seven years (FY10-FY16). We then calculate the change in depreciation rate for each year (giving us a set of six observations). 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.

Note: Depreciation accounting has undergone significant changes in FY15 owing to the requirements of the Companies Act, 2013 that became applicable with effect from 1 April 2014. This has resulted in inherent volatility in the depreciation rate in FY15 across the universe.

However, for the purpose of our analysis, we use a six-year median of the volatility in the depreciation rate. Consequently, this change in depreciation accounting does not materially impact the accounting scores for companies in the universe.

Case study: Omkar Speciality Chemicals (OSCL IN, US$ 0.1bn, Not Rated)

Omkar Speciality Chemical’s depreciation rate has historically been fairly volatile vis-à-vis its peers (see exhibit 8 below):

Exhibit 8: Depreciation rate analysis - Omkar Speciality Chemicals vs peers

Company/metric Depreciation rate YoY change in depreciation rate (in bps)

FY12 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16

Omkar Spl.Chem. 15.6% 8.8% 10.9% 6.6% 4.4% 680 212 433 214

Navin Fluo.Intl. 6.0% 5.7% 5.8% 5.2% 5.3% 25 7 58 7

Sequent Scien. 8.6% 9.5% 8.9% 7.7% 8.8% 92 65 119 108

Aarti Inds. 6.7% 8.0% 6.6% 5.2% 5.3% 125 139 135 5

Vinati Organics 4.2% 3.8% 4.3% 4.5% 4.1% 41 55 21 38

Atul 4.4% 4.6% 4.8% 4.7% 4.6% 24 16 4 10

Peer group median (ex Omkar) 41 55 58 10

Divergence with median 639 157 375 204

Source: Company, Ambit Capital research

One plausible reason for such major volatility in depreciation rate could be the continuous additions to its gross block. However, if we see the gross block breakup directionally, the depreciation rates should move up as the share of buildings/premises (which attract a lower depreciation rate) has come down whilst the share of plants and machinery (which attract a higher depreciation rate) has moved up (see exhibit 9 below:)

Exhibit 9: Omkar Specialty Chemicals’ gross block breakup

Gross block Gross block breakup

FY12 FY13 FY14 FY15 FY16

Goodwill 6% 4% 4% 2% 0%

Freehold Land 0% 0% 0% 0% 0%

Buildings / Premises 22% 22% 20% 20% 20%

Plant& Machinery 59% 60% 60% 66% 68%

Leasehold Land 10% 12% 13% 8% 8%

Furniture & Equipment 3% 2% 2% 2% 2%

Patents, trademarks and designs 0% 0% 0% 2% 3%

Other Assets 0% 1% 1% 0% 0%

Source: Company filings, Ambit Capital research

Our model penalises high volatility in depreciation rate

Strategy


In Omkar’s case, the blended average depreciation rate has gone down from ~15.6% in FY12 to ~4.6% in FY16. Overall, given the volatility in its depreciation rate as well as the directional trend in its depreciation rate; Omkar Speciality Chemicals gets a low score on volatility in depreciation rate on our model.

3 Volatility in non-operating income: Just like the previous measure, high volatility in non-operating income (NoI) is a cause for concern as this could imply intent to inflate profitability in years of low profits by resorting to such means as sale of assets and investments and booking exceptional items.

We thus calculate the non-operating income (as a percentage of net revenues) for each of the last seven years (FY10-FY16). Next, we calculate the change in the non-operating income (as a percentage of revenues) for each year (giving us a set of six observations). We then calculate the median of absolute changes and finally sort the firms on this ratio such that the company with the least volatility receives the best score. The rationale is to penalise firms where volatility in non-operating income is unusually high.

Case study: Biocon (BIOS IN, US$ 2.7bn, Not Rated)

Biocon’s non-operating income (as a percentage of net revenues) has historically been fairly high versus its peers (see Exhibit 10 below). Whilst Biocon’s non-operating income has averaged at ~7% of its revenues over the last few years, the same stood at ~1% for its peers.

Further, not only has it been fairly high, it has also remained quite volatile over the period. For instance, NoI (as a percentage of net revenues) was 5.8% in FY15 vs 1.9% in FY14, implying a ~388bps YoY change. The high volatility in FY15 (as well as in FY16) could be attributed to gains on sale of shares in subsidiary. Similarly, Biocon’s non-operating income saw significant volatility in FY13 (and more recently in FY16) primarily due to exceptional income recognised in its books pertaining to deferred revenues allocated to Biosimilar Insulin Analogs.

Exhibit 10: Volatility in non-operating income - Biocon vs peers

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

FY12 FY13 FY14 FY15 FY16 FY13 FY14 FY15 FY16

Biocon 2.6% 10.8% 1.9% 5.8% 22.0% 818 883 388 1,620

Glenmark Pharma 0.5% 0.2% 0.2% 0.3% 0.5% 24 2 14 14

Dr Reddy's Labs 0.6% 1.0% 1.0% 1.2% 1.4% 36 1 20 23

Cadila Health. 1.0% 0.6% 0.5% 0.5% 0.9% 39 12 6 41

Median (ex-Biocon) 0.6% 0.6% 0.5% 0.5% 0.9% 36 2 14 23

Divergence 2.0% 10.2% 1.5% 5.3% 21.1% 783 881 374 1,597

Source: Company filings, Ambit Capital research. Note: *This includes exceptional items

4 Provision for doubtful debts as a proportion of debtors more than six months: This ratio is a check on the conservativeness of a company’s provisioning policy. Debtors more than six months have a greater probability of defaulting and, hence, best practices would require higher provisioning for such debtors.

A low ratio, on the other hand, raises the spectre of earnings being boosted through aggressive provisioning practices. We use a six-year median for this measure and penalise firms where this ratio is abysmally low.

Note: We agree that in case of several companies, given their nature of business operations, debtors more than six months are not material (vis-à-vis the size of the business). Thus, in such cases, to avoid unduly penalising firms where debtors more than six months are a small fraction of the consolidated revenues (our threshold for this is 0.20% of consolidated revenues), we assign an average score to the firm on this parameter.

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

Low provisioning raises the spectre of earnings being boosted through aggressive provisioning practices

Strategy


Case study: Tata Chemicals (TTCH IN, US$ 1.8bn, Not Rated); Linde India (LIIL IN, US$ 0.5bn, Not Rated)

Historically, Tata Chemicals’ debtors outstanding for more than six months (as a percentage of gross debtors) have ranged from 15% to 25%, which is substantially higher than that of its chemicals sector peers.

Further, for Linde India, the proportion of debtors outstanding for more than six months has been much higher (having ranged from 45% to 60%).

However, in spite of the higher share of debtors more than six months, as a percentage of gross debtors, the provisioning for old debtors (i.e. provisioning for debtors as a percentage of debtors more than six months) is materially below that of its peers for both these companies (see Exhibit 11 below):

Exhibit 11: Provisioning for old debtors - Tata Chemicals and Linde India vs peers

Company/metric PFD as a % of Debtors more than

six months Debtors more than six months as a % of Gross

Debtors FY12 FY13 FY14 FY15 FY16 FY12 FY13 FY14 FY15 FY16

Tata Chemicals 9% 4% 5% 6% 12% 16% 25% 21% 18% 15%

Guj Alkalies 69% 67% 64% 73% 78% 7% 7% 7% 6% 5%

BASF India 87% 73% 74% 76% 83% 4% 4% 4% 4% 4%

Coromandel Inter 44% 30% 11% 26% 52% 2% 5% 20% 12% 8%

Atul 16% 32% 27% 47% 45% 2% 2% 2% 1% 2%

Linde India 9% 10% 13% 7% 9% 44% 60% 60% 59% 60%

Median(ex-Tata Chemicals) 44% 32% 27% 47% 52% 4% 5% 7% 6% 5%

Divergence (Tata Chemicals vs peers) -35% -28% -23% -41% -41% 12% 20% 14% 12% 10%

Median(ex-Linde India) 44% 32% 27% 47% 52% 4% 5% 7% 6% 5%

Divergence (Linde India vs peers) -35% -22% -15% -40% -43% 41% 55% 53% 53% 54%


A study of Tata Chemicals’ annual accounts for FY16 suggests provisioning for old debtors has, in fact, increased from ~6% in FY15 to ~12% in FY16. Note, however, that a look at the provisioning policies followed by its peers suggests Tata Chemicals’ peers’ provisioning for old debtors stood at ~52% in FY16 and, hence, Tata Chemicals’ FY16 provisioning is still quite low versus peers.

Had the company’s provisioning for debts more than six months been in line with that of its peers (i.e. 52%), consolidated PBT for FY16 would have been lower by ~17%.

In Linde India’s case, had the company’s provisioning for debtors more than six months been in line with that of its peers (i.e. 52%), the excess provisioning required translates into ~9.1x FY16 profit before exceptional items and taxes.

II - Balance sheet mis-statement checks Direct write-offs from equity without routing it through the P&L account, high levels of off-balance sheet risks, low investment income (as a percentage of cash and marketable investments) etc. are some of the key areas that need to be scrutinised further in order to assess the sanctity of a company’s balance sheet.

In that context, following are the ratios that we use to penalise such firms:

5 Cash yield: Cash yield denotes the yield that is being earned on cash and marketable investments.

With the risk free rate in India being closer to 6-8%, one would expect idle cash and marketable investments to generate at least 5-6% returns. A low cash yield could thus be a cause for concern as it could mean that either the balance sheet has been mis-stated or cash is not being used in the best interests of the firm.

We calculate the cash yield for each of the last six years. We then sort the firms on this ratio using the last six-year median such that companies with relatively high cash yields get a high score while companies with lower cash yields get penalised the most.

A low cash yield may either imply balance sheet mis-statement or that the cash is not being used for the firm’s best interests

Strategy


Case study: Tanla Solutions (TANS IN, US$ 0.1bn, Not Rated)

Historically, Tanla Solutions has been earning a significantly lower yield on cash and marketable investments as compared to its peers.

Whilst its competitors such as Info Edge have been earning cash yields in the range of 6-9%, Tanla Solutions has been earning much lower returns. In fact, in FY16, the cash yield was as low as 1.1% (see exhibit 12 below):

Exhibit 12: Tanla Solutions’ investment income yield vs Info Edge

Company/metric Investment income yield

FY13 FY14 FY15 FY16 Average

Tanla Solutions 2.6% 3.4% 0.1% 1.1% 1.8%

Info Edge* 9.0% 6.4% 7.5% 6.8% 7.4%

Source: Company filings, Ambit Capital research. Note: *In FY13, detailed break up of proceeds from sale of investments (current and non-current) is not available. Hence we have considered the total proceeds from sale of investments in FY13.

As noted earlier, with risk free rate in India being closer to 7-8%, cash and liquid investments would be expected to generate at least 5-6% yield. In Tanla Solutions’ case, however, the cash yield has averaged a dismal 1.8% over the last few years and, hence, raises red flags.

6 Change in reserves (excluding share premium) to net income excluding dividends: Under the erstwhile accounting practices that were prevalent in India until FY16, there were several provisions that allowed direct write-offs to equity without reflecting these adjustments in the P&L account. Further, through various Court Schemes, several companies (such as the company discussed in the case study below) have taken direct write-offs from the reserves without routing it through the P&L account.

In order to penalise such firms that have historically taken direct knock-offs from equity, we calculate the change in reserves (excluding share premium) on a YoY basis and divide 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 (P&L) account and may indicate aggressive accounting policies.

Case study: Godrej Consumer (GCPL IN, US$ 7.3bn, SELL)

Godrej Consumer is an example of a firm that has historically taken direct write-offs from equity. Whilst these direct write-offs were in accordance with the accounting treatment prescribed under various Court Schemes, they were not in accordance with the generally accepted accounting practices in India.

For example, according to the Scheme of Amalgamation of the erstwhile GHPL with the company sanctioned by the Bombay High Court, GCPL directly routes the amortisation expense (of ~Rs527.50mn) pertaining to the Goodknight and HIT brands through its General Reserve (instead of the P&L account). Similarly, in accordance with various other Court Schemes, Godrej Consumer has taken several other write-offs directly from its equity.

Had Godrej Consumer routed these expenses through the P&L, its restated earnings would have been very different (as shown in the exhibit below).

Exhibit 13: Godrej Consumer - restated earnings if amortisation of Goodwill and Hit Brands as well as other direct write-offs from equity were routed through the P&L

(Rs mn) FY12 FY13 FY14 FY15 FY16

Profit before taxes [A] 9,773 10,246 10,297 12,487 14,760 Amortisation of Goodknight and Hit Brands directly debited to General reserve/other direct write-offs from equity [B] 904 528 923 777 528

Profit before taxes (had these direct write-offs been charged to the P&L) [C=A-B] 8,869 9,719 9,374 11,711 14,232

Impact on profit before taxes (as a % of stated profit) [(C-A)/A)] -9% -5% -9% -6% -4%


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


Note that the company has always made appropriate disclosures in its notes to accounts. We are highlighting Godrej Consumer as an example primarily to show how a few changes in accounting policies as well as a few court approvals may cause a significant change to the reported bottom-line.

In fact, the auditors of Godrej Consumer too have been highlighting this in the audit report. For example, in the FY16 annual report, the auditors have made the following comments:

“We draw attention to Note 13(b) to the Consolidated Financial Statements regarding the Scheme of Amalgamation of the erstwhile Godrej Household Products Limited with the Company approved by The Hon’ble High Court of Judicature at Bombay, whereby an amount of Rs52.75 crore, for the year ended on March 31, 2016, equivalent to the amortisation of the Goodknight and Hit Brands is directly debited to the General Reserve Account instead of debiting the same to the Statement of Profit and Loss as per the provisions of AS 26. The said accounting treatment is in accordance with the accounting treatment prescribed in the Order of the High Court of Mumbai dated February 28, 2011 under section 394 of the Companies Act, 1956. Had this amount been charged to the Statement of Profit and Loss, the profit for the year ended March 31, 2016 would have been lower by Rs52.75 crore and the General Reserve would have been higher by Rs52.75 crore.

Our opinion is not modified in respect of this matter.”

7 Contingent liabilities as a proportion of net worth: This is indicative of the extent of off-balance-sheet risk. A high ratio raises concerns regarding the strength of the company’s balance sheet in the event that these 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 and penalise firms with a very high proportion of contingent liabilities.

Case study: UPL (UPLL IN, US$ 4.9bn, Not Rated)

UPL is an example of a firm that gets penalised in our framework due to relatively high contingent liabilities as a proportion of net worth.

Contingent liabilities accounted for 18% and 14% of UPL’s net worth in FY15 and FY16 (see exhibit 14 below):

Exhibit 14: Contingent liabilities - UPL vs its peers

Company/metric Contingent Liabilities* as a % of net worth


UPL 17% 13% 17% 18% 14%

P I Inds. 3% 2% 2% 2% 1%

Rallis India 18% 16% 14% 14% 11%

Dhanuka Agritech 1% 2% 2% 3% 2%

Bayer Crop Sci. 17% 8% 8% 6% 7%

Median (ex-UPL) 10% 5% 5% 4% 4%

Divergence with median 7% 8% 12% 13% 10%

Source: Company filings, Ambit Capital research. Note: *Contingent Liabilities excluding LCs, Bills discounted and capital commitments.

These contingent liabilities mainly relate to tax payables, penalty claim on cartelisation claim by CCI, and claims related to associates (see exhibit 15 below). The cartelisation penalty was imposed by CCI in April 2012 for an anticompetitive agreement among the manufacturers of ALP (material used for preserving food grains in the central pool).

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

Strategy


Exhibit 15: UPL’s contingent liabilities breakup (Rs mn)

Nature of contingent liability FY12 FY13 FY14 FY15 FY16

Statutory payable (Direct & Indirect taxes) 2,111 2,345 2,252 2,281 2,679

Penalty on cancellation of licenses 335 335 335 335 335

Penalty on cartelisation 2,524 2,524 2,524 2,524 2,524

Guarantees (incl guarantees by bankers) 428 13 3,024 4,727 3,356

Claims not acknowledged as debt 361 416 469 220 244

For associates 1,215 533 212 142 456

Others - - - 67 68

Total 6,975 6,167 8,816 10,298 9,662


Overall, given the relatively high proportion of contingent liabilities and the nature of these liabilities, UPL gets penalised on contingent liabilities (as a proportion of net worth) on our model.

III - Cash pilferage checks Cash pilferage is the third category of checks that we analyse. High amount of miscellaneous expenditure (for which no further disclosures are available), unsubstantiated capex and negative free cash flows over long periods of time are some of the key categories of checks that should raise eyebrows and, hence, need to be scrutinised further. We use the following ratios: 8 Miscellaneous expenses as a proportion of total revenues: This ratio is a

check on a company’s expenditure policy. Miscellaneous expenses, by their very nature, do not require any further disclosure. A high ratio thus raises concerns regarding the authenticity of such expenses. Thus, in order to penalise firms with high miscellaneous expenses, we calculate miscellaneous expenses as a proportion of total revenues for the last six years and then use a six-year median for this measure.

Case study: Wockhardt (WPL IN, US$ 1.1bn, Not Rated) An analysis of Wockhardt’s miscellaneous expenses (as a percentage of net sales) suggests the company’s miscellaneous expenses have historically been significantly higher than those of peers (see exhibit 16 below):

Exhibit 16: Miscellaneous expenditure analysis - Wockhardt vs peers

Company/metric Misc. expenses* as a % of total revenues

FY12 FY13 FY14 FY15 FY16 Median

Wockhardt 4.1% 5.3% 6.2% 8.2% 8.2% 6.2%

Dr Lal Pathlabs 2.2% 2.2% 2.1% 2.0% 2.3% 2.2%

Fortis Health. 0.2% 0.5% 0.7% 0.6% 0.4% 0.5%

Apollo Hospitals 0.2% 0.2% 0.2% 0.2% 0.2% 0.2%

Median (ex-Wockhardt) 0.2% 0.5% 0.7% 0.6% 0.4% 0.5%

Divergence 3.9% 4.9% 5.5% 7.6% 7.8% 5.7%

Source: Company filings, Ambit Capital research. Note: *Misc. expenses include Donation and CSR expenses.

Note that not only has this ratio been fairly high versus its peers, it has also been increasing over time. Whilst sales for the company have only compounded at less than 1% over the last four years, miscellaneous expenses have compounded at a staggering 20% over the period.

Note further that this ratio was ~570bps higher versus its peers in FY16. In terms of magnitude, it is worth highlighting that miscellaneous expenses were nearly the same as Wockhardt’s PBT in FY15, and hence raises red flags.

A high proportion of miscellaneous expenses raises concerns regarding the genuineness of such expenses

Strategy


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 ensuing downturn. Hence, we are penalising companies only if the ratio has been consistently high over most of the last six-year period. Case study: Balkrishna Industries (BIL IN, US$ 1.7bn, SELL)

One firm that gets penalised on CWIP-gross block versus its peers is Balkrishna Industries.

Whilst the company’s CWIP relative to its gross block was broadly in line with that of its peers in FY11, the ratio had remained at elevated levels over the last few years until FY15. This seems to be on account of the capex incurred in connection with its greenfield tyre project at Bhuj in Gujarat, which had only been partly commissioned so far.

In its FY14 annual report, the company highlighted that this plant will be fully commissioned by end-FY15. However, as can be seen in exhibit 17 below, this does not appear to be the case (given its CWIP-gross block ratio still remained at elevated levels in FY15). Note that in FY16 the company appears to have fully commissioned the plant and, hence, the FY16 CWIP-gross block ratio is in-line with its peers.

Exhibit 17: Balkrishna Industries – capex analysis vs peers

Company/metric CWIP*-Gross Block

FY-11 FY-12 FY-13 FY-14 FY-15 FY-16

Balkrishna Inds 0.15 0.55 0.67 0.23 0.21 0.08

Apollo Tyres 0.07 0.05 0.05 0.01 0.03 0.16

MRF# 0.30 0.09 0.08 0.12 N/A 0.14

JK Tyre 0.06 0.22 0.02 0.04 0.17 0.02

Ceat 0.07 0.01 0.01 0.04 0.11 0.11

Median (ex-Balkrishna) 0.07 0.07 0.03 0.04 0.11 0.13

Divergence (Balkrishna) 0.08 0.48 0.64 0.19 0.10 (0.05)

Source: Company, Ambit Capital research; Note: Note: *CWIP includes Capital Advances. #N/A since MRF has changes its year end.

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. Next, we divide this by the last six-year median revenues for the company to normalise it for the size of a company. The higher the ratio, the better our perception of the company’s accounts.

The idea is to penalise firms which over such long periods have been unable to either generate positive cash flows from operations or alternatively where cash flow from investments have consistently eaten away the cash generated from operations.

Case study: Sequent Scientific (SEQ IN, US$ 0.4bn, Not Rated)

An analysis of Sequent Scientific’s asset turns suggests the company’s gross block turnover has historically remained significantly below its peers. In spite of the lower gross block turnover (suggesting inefficiencies in sweating the assets), Sequent Scientific’s cumulative CFI over the last five years has consistently eaten away the cash generated from operations, raising questions regarding the wisdom of the capex (see exhibits 18 and 19 below).

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

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

Strategy


Exhibit 18: In spite of the lowest gross block turnover vs its peers…

Company/metric Gross Block Turnover

FY14 FY15 FY16

Sequent Scien. 1.2 1.0 1.1

Omkar Spl.Chem. 2.1 1.6 2.0

Navin Fluo.Intl. 1.2 1.4 1.4

Aarti Inds. 1.9 1.8 1.5

Vinati Organics 2.0 2.0 1.4

Atul 2.0 2.1 1.8

Median (ex-Sequent) 2.0 1.8 1.5

Divergence (0.8) (0.8) (0.4)


Exhibit 19: …Sequent Scientific’s free cash flows have been negative (Rs mn)

Company/metric Cum. CFO plus

CFI Median

revenues

Cum. CFO plus CFI to median

revenues

(FY14-FY16) (FY14-FY16) (FY14-FY16)

Sequent Scien. (6,189) 4,432 (1.40)

Omkar Spl.Chem. (233) 2,651 (0.09)

Navin Fluo.Intl. 755 5,915 0.13

Aarti Inds. 1,876 27,796 0.07

Atul 2,421 26,014 0.09

Vinati Organics 2,768 6,961 0.40

Median (ex-Sequent) 0.09

Divergence (1.49)


Given the negative free cash flows on a cumulative basis over the past few years, Sequent Scientific gets a low score on free cash flows to median revenues on our model.

IV - Audit quality checks Having looked at the reported financial statements, the auditor and the auditor’s report are the next most important sections of the annual report that need attention.

Any qualifications made or issues raised by the auditor imply that something is amiss and that the books of accounts, as presented by the management, do not reflect the actual state of the firm’s business. Likewise, investors should watch out for frequent changes in the statutory auditor as this would imply frequent disagreements between the auditor and the management, which eventually resulted in the auditor leaving. On the other hand, a disproportionate increase in audit fees versus the increase in top-line calls for caution as well.

We use the following ratio to evaluate the quality of the audit and the auditors:

11 CAGR in auditor’s remuneration to CAGR in consolidated revenues: We

calculate the CAGR in standalone auditor’s remuneration and the CAGR in consolidated revenues over FY10-FY16. 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 where the growth in auditor’s remuneration has exceeded the growth in the firm’s revenues.

Case study: Unitech (UT IN, US$ 0.2bn, Not Rated)

Unitech’s standalone auditor’s remuneration (Rs27.3mn) in FY16 and consolidated auditor’s remuneration (Rs42.7mn) were far higher than the auditor’s remuneration paid by peers. Even as a proportion of consolidated revenues, remuneration paid to the auditors was significantly higher than its peers (see exhibit 20 below). Furthermore, whilst the company’s consolidated revenues have witnessed a decline over the last six years (on a CAGR basis revenues have declined by 6% over FY10-16); the auditor’s remuneration (on a standalone basis) has grown at 10% over the same period.

We penalise firms where growth in auditor’s remuneration has been exorbitantly high vis-à-vis growth in the firm’s revenues

Strategy


Exhibit 20: Unitech - auditor’s remuneration vis-à-vis peers

FY13 FY14 FY15 FY16

Unitech

Consolidated Net Sales (Rs mn) 24,405 29,534 34,312 20,075

Consolidated auditor’s remuneration (Rs mn) 38.5 46.2 44.7 42.7

Standalone auditor’s remuneration (Rs mn) 24.3 27.7 27.2 27.3

Consolidated auditor’s remuneration as a % of Total revenues (%) 0.16 0.16 0.13 0.21

Standalone auditor’s remuneration as a % of Total revenues (%) 0.10 0.09 0.08 0.14

Sobha






Oberoi Realty






Omaxe







Overall, given the high proportion of auditor’s remuneration vs the consolidated revenues and given that growth in auditor’s remuneration has exceeded growth in overall revenues for the firm, Unitech is an example of a company that gets penalised on our model on this measure.

Strategy


Cumulating scores: We first assign scores to all the firms in the universe on each of the 11 parameters discussed above. Next, we cumulate the scores across the 11 parameters to arrive at the final blended accounting score for each firm.

Based on these parameters, we rank 411 BSE500 firms and 893 sub-BSE500 firms on accounting quality in this year’s forensic exercise. Note that from the sub-BSE500 universe, four firms have been included in the BSE500 screen given the sheer size of these companies (see Table 1 on the right). As with all our forensic checks, from the BSE500 universe, we have excluded 72 banks and financial services firms. A further 17 firms have been excluded due to sketchy data availability, corporate restructuring and limited listed history.

Note that five firms have been included based on their financials over FY10-FY15 as their FY16 annual reports had not been published at the time of running this exercise (see Table 2 on the right). Further, six firms have been included based on their standalone financials as their consolidated financials would include the results of their financial arm and hence would not have been comparable with the rest of the universe (see Table 3 on the right).

Just like last year, we have extended this year’s forensic accounting exercise to include all firms with a market-cap above Rs1,000mn. The exhibits and discussion that you find in the subsequent sections, however, 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.

Table 2: Firms included based on FY10-FY15 financials Company Name Ticker Fiscal Year

End

Siemens SIEM IN Sept.

Jet Airways JETIN IN Mar.

SpiceJet SJET IN Mar.

HMT HMT IN Mar.

Lycos Internet LYIL IN Mar.


Table 3: Firms included based on standalone financials Company Name Ticker

Aditya Bir. Nuv. ABNL IN

Ashok Leyland AL IN

Larsen & Toubro LT IN

M & M MM IN

PTC India PTCIN IN

Tube Investments TI IN


Table 1: Sub-BSE500 firms that have been included in the BSE500 screen Company Name Ticker

Cairn India CAIR IN

L & T Infotech LTI IN

Mahanagar Gas MAHGL IN

Sundaram Clayton SDC IN


Strategy


Link between accounting quality and investment returns In this section of the note, we seek to answer the following question: ‘Does accounting quality, as measured by our model, have any link with stock market performance?’ To answer this, we assess the link between the blended accounting score for the BE500 ex-financials universe, derived using the methodology discussed above (i.e. using six years of consolidated financials), and the share price performance over the last six years (i.e. Nov 2010 to Nov 2016). We note the following key takeaways from our analysis:

Decile-level analysis points to a strong link between accounting quality and investment returns;

There is a strong link between accounting quality and investment performance even after controlling for sector effects; and

Large-cap firms have better accounting quality vis-à-vis mid/small-cap firms.

Universe level

At the universe level (i.e. BSE500), we do not find any significant relationship between accounting quality and share price performance. This could partly be explained by the fact that at the stock level, there are several other factors that influence share price returns (such as the underlying fundamental performance of the company, company-specific and industry-specific factors and so on).

Exhibit 21: Scatter plot does not reflect any significant relationship between accounting scores and share price performance for the BSE500 stocks

Source: Bloomberg, Ace Equity, Capitaline, Ambit Capital research. Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is BSE500 (ex-financials).

Decile level

To control the noise around individual stocks, we now construct deciles on the basis of accounting scores for the companies. A decile-level analysis is revealing and demonstrates the power of accounting quality in shaping investment returns.

An R-squared of ~84% suggests that accounting quality is a significant driver of stock returns.

R² = 9%

-60%-40%-20%

0%20%40%60%80%

100%120%140%

50 100 150 200 250 300

Sha

re p

rice

pe

rfo

rma

nce

(Nov

'10 to N

ov

'16)

Accounting score

We explore the link between accounting quality and stock returns

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

Strategy


Exhibit 22: Decile-level analysis, however, reveals the strong link between accounting quality and share price performance

Source: Bloomberg, Ace Equity, Capitaline, Ambit Capital research. Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is BSE500 (ex-financials).

In terms of individual decile performances, the first decile (D1) has delivered stock price returns of 24% CAGR since November 2010. In contrast, the last decile (D10) has delivered returns of -4% CAGR over this period, thus implying a 28% CAGR outperformance for D1 vs D10. The performance differential across deciles becomes more evident from the exhibit below.

Exhibit 23: 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 FY11-16; stock price performance is from November 2010 to November 2016. Shaded areas denote the three zones on accounting quality. Universe for this exhibit is BSE500 (ex-financials).

The most crucial takeaway from the above exhibit is that the market can be divided into three different ‘Zones’ on accounting quality on the basis of investment performance – the ‘Zone of Safety’, the ‘Zone of Pain’ and the ‘Zone of Darkness’. The top 5 deciles on accounting do not seem to be materially different from each other on investment performance and hence we label it the ‘Zone of Safety’. The performance drops in the next two deciles (D6 and D7), suggesting that such stocks need to be scrutinised carefully to deliver investment performance and hence such stocks can be categorised as the ‘Zone of Pain’. Beyond D7, however, the performance slumps significantly, suggesting that this is the ‘Zone of Darkness’, one to be avoided at all costs.

Exhibit 23 above therefore suggests that 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.

D1

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'Zone of Darkness'

'Zone of Pain'

'Zone of Safety'

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

Top accounting decile outperforms the bottom decile by 28% on a CAGR basis

Strategy


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 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 24 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.

Exhibit 24: Strong link between accounting quality and stock performance even after controlling for sector effects

Source: Bloomberg, Ace Equity, Capitaline, Ambit Capital research. Note: Accounting score is based on annual financials over FY11-16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is BSE500 (ex-financials). The first entry is the accounting score over FY11-FY16; the second entry is the median CAGR stock returns in that bucket from November 2010 to November 2016.

The above exhibit again highlights the importance of avoiding the lowest quality firms on accounting quality regardless of how cheap they are.

252, 15.4%

222, 12.8%

202, 10.5%

175, 6.4%

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Sector-agnostic accounting buckets

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

Strategy


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 suggest that accounting quality makes a difference at the sector level as well (i.e. sectors with higher accounting quality, such as Consumer Discretionary, Home Building and Consumer Durable perform better than sectors with poor accounting quality such as E&C, Utilities and Realty).

Exhibit 25: At a sector level, link between accounting quality and stock price performance is relatively modest

Source: Bloomberg, Ace Equity, Capitaline, Ambit Capital research. Note: Accounting score is based on annual financials over FY11-16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is BSE500 (ex-financials).

With a median score of 247, the ‘Home Buildings’ sector is amongst the best sectors in our accounting model. The sector has generated median stock price returns of 27% CAGR over the last six-year period (Nov ’10 to Nov’ 16). On the other hand, Utilities is amongst the worst sectors on accounting on our model with a median score of 184. The median stock price performance in the sector has been -8% 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 Media, Heavy Engineering and Infrastructure.

Exhibit 26: Within the sector, the link between accounting and price performance for the Media sector

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is stocks from the Media sector in the BSE500 index.

Home Building

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FMCGMisc.

Auto Anc

Light Engg.

Textiles

Shipping

AutoIT

Media

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Cement

Telecom

Agri Inputs

Infra.

Healthcare Srvcs.

Retail

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Sugar

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At a sector level, link between accounting scores and price performance is relatively modest…

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

Strategy


Exhibit 27: Within the sector, the link between accounting and price performance for the Heavy Engineering sector

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is stocks from the Heavy Engineering sector in the BSE500 index.

Exhibit 28: Within the sector, link between accounting and price performance for the Infrastructure sector

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-FY16; stock price performance is from November 2010 to November 2016 on a CAGR basis. Universe for this exhibit is stocks from the Infrastructure sector in the BSE500 index.

R² = 42%

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Strategy


Size buckets

Finally, to address the size dimension, we split our universe of stocks into four sizes of buckets as shown below. Bucket 1 comprises the largest 50 stocks in terms of market-cap, Bucket 2, the next 100, Bucket 3, the next 100 and Bucket 4, the lowest 161 stocks in terms of market-cap (thus, taking the total to 411 firms).

Exhibit 29: Larger capitalisation firms have better accounting scores on average Number of firms in the bucket

Bucket Market cap range (Rs bn) Market cap range (USD bn)

Average accounting score

Average share price

performance

% stocks in 'Zone of darkness'

top 50 Bucket 1 Rs 360bn- Rs 4187bn US$ 5.3bn-US$62bn 216 13.2% 28%

next 100 Bucket 2 Rs 82bn- Rs 348bn US$ 1.2bn-US$5.1bn 221 18.8% 21%

next 100 Bucket 3 Rs 37bn- Rs 82bn US$ 0.55bn-US$1.2bn 212 15.5% 26%

bottom 161 Bucket 4 Rs 3.7bn- Rs 36.9bn US$ 0.05bn-US$0.55bn 204 11.7% 39%

Source: Ace Equity, Capitaline, Bloomberg, Ambit Capital research; Note: Accounting score is based on annual financials over FY11-16; stock price performance is from November 2010 to November 2016 (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 (i.e. Buckets 1 and 2) 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 Darkness’ (i.e. stocks that fall in D8, D9 and D10) too varies with market cap. Whilst 28% of firms belonging to the largest market cap bucket fall in the ‘Zone of Darkness’, ~39% 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 ~35% of these names also fall in Bucket ‘D’ discussed earlier (i.e. the bottom quartile stocks from each sector). In contrast, the remaining ~65% stocks are evenly distributed amongst Buckets ‘A’ to ‘C’ (see Exhibit 30 below). This suggests that a significant proportion of firms from Bucket 4 on market cap, also fall in the bottom quartile on accounting quality in their respective sectors.

Exhibit 30: 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 161 firms in the BSE500)

Bucket A (best quality) 36 22%

Bucket B 36 22%

Bucket C 33 20%

Bucket D (worst quality) 56 35%

Total 161 100%

Source: Company, Ambit Capital research. Universe for this exhibit is BSE500 (ex-financials).

Accounting quality is better for larger caps on an average

Strategy


Why we think accounting quality especially merits attention at this critical juncture As ‘business as usual’ gets severely hampered owing to the ongoing demonetisation-driven disruption, we believe several promoters are likely to resort to more and more creative ways to flatter their books. So, we believe at such a critical juncture investors need to be much more vigilant whilst investigating the quality of accounts of any company. Our forensic model should be helpful to investors in this regard. We highlight two instances below where our forensic model helped investors discover accounting irregularities well in advance.

Case study: Amtek Auto

In our 22 December 2014 thematic: “Forensic accounting: Identifying the ‘Zone of Trouble’”, we had highlighted certain accounting issues in Amtek Auto. Amtek Auto’s stock had rallied by ~156% in the year before. In Aug 2015, however, the company had failed to honour its debenture obligations. Since its Aug 2015 highs, the stock is now down nearly 74% (see Exhibit 31 below):

Exhibit 31: Amtek Auto’s share price performance vs Sensex

Source: Company, Press articles, Bloomberg, Ambit Capital research; Note: Amtek Auto’ share price as well as Sensex have been rebased to 100 at the beginning of 2014

The following exhibit provides a brief snapshot of Amtek Auto on our ‘HAWK’ platform:

Exhibit 32: Amtek Auto’s forensic and greatness score evolution using ‘HAWK’

Source: Ambit ‘HAWK’, Ambit Capital research

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Amtek Auto Sensex

Amtek Auto fails to honour its debt obligations

Ambit's annual forensic thematic highlighting certain accounting issues in the company

Given the demonetization-driven disruption, accounting quality especially merits attention at this critical juncture

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_Forensicaccounting_22Dec2014.pdf

Strategy


Case study: Arshiya

Arshiya is another example of a company where our research team had highlighted several accounting irregularities. Exhibit 33 below provides a snapshot of the key accounting concerns raised by our Head of Research Nitin Bhasin (see our 25 February 2014 report: “How Accounting, Politics and Capital Allocation Drive Alpha in India”).

Exhibit 33: Arshiya’s accounting practices vs peers

Source: Company, Ambit Capital research. Note: This exhibit has been reproduced without any changes from our 25 February 2014 report: “How Accounting, Politics and Capital Allocation Drive Alpha in India”

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_HowAccountingPolitics_25Feb2014.pdf

http://reports.ambitcapital.com/reports/Ambit_Strategy_Thematic_HowAccountingPolitics_25Feb2014.pdf

Strategy


In Jan 2013, certain employees of the company alleged financial irregularities in the company and non-payment of salaries to the staff since Sep 2014. Since then, Arshiya’s shares have corrected by ~75% (see Exhibit 34 below):

Exhibit 34: Arshiya’s share price performance vs peers and Sensex

Source: Company, Press articles, Bloomberg, Ambit Capital research; Note: Arshiya and Gateway Distriparks’ share price as well as Sensex have been rebased to 100 at the beginning of 2009

The following exhibit provides a brief snapshot of Arshiya on our ‘HAWK’ platform:

Exhibit 35: Arshiya’s forensic and greatness score evolution using ‘HAWK’

Source: Ambit ‘HAWK’, Ambit Capital research

Whilst we agree that it requires a lot of time for these accounting issues to materialise, when they do, the events tend to be a binary event for the stock price.

Having discussed the crucial role that accounting quality plays in shaping investment returns, we now move to a discussion on popular myths about accounting quality.

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Arshiya Gateway Distriparks Sensex

Ambit's forensic bespoke on the company Employees allege

financial irregularities; non-payment of salaries to staff since Sep

Strategy


Debunking myths about accounting quality That the market knows and properly discounts firms with poor accounting is one of the popular myths around accounting quality that we have encountered over the years. Similarly, accounting quality does not matter in an uptrend is another popular myth about accounting. In this section of the note, we refute these (and some other) popular myths about accounting quality. Myth #1: Accounting quality is already priced in

Satyam did trade at a valuation discount to Infosys and Wipro even before the promoter owned up to aggressive accounting. That said, its 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. Similarly, more recently, Ricoh India is another firm where its auditors, KPMG, alleged certain financial irregularities in the company’s books. On the day the announcement was made public (in May ’16), the stock crashed by 5% and is down 38% since then. Even our analysis of trailing/forward P/E for the BSE500 firms and their accounting scores points to a zero correlation between the two variables. This further augments the argument that accounting quality is not already priced in (making it even worthwhile to investigate and assess further!).

Exhibit 36: At the market level, we find no correlation between accounting quality and trailing P/E…

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

Exhibit 37: …nor between accounting quality and forward P/E

Source: Company, Ambit Capital research; Note: Forward P/E has been restricted to 100. Universe for this exhibit is BSE500 (ex-financials).

Myth #2: Accounting quality does not matter in an uptrend

That accounting quality matters during bear markets is a point we have observed as well as often highlighted over the past few years.

Further, contrary to popular belief, accounting quality had remained relevant even during the most recent uptrend (i.e. in CY14), with the bottom two deciles (i.e. D9 and D10) on accounting massively underperforming the rest of the deciles.

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Accounting quality is not already priced in!

Accounting quality remained relevant even in the most recent uptrend

Strategy


Exhibit 38: Accounting quality stayed relevant even in the most recent uptrend (CY14)

Source: Bloomberg, Ambit Capital research. Note: Price performance has been measured over the period 21 November 2013 to 19 December 2014.

Myth #3: All Nifty firms have good quality accounts From our discussions in the preceding sections (see exhibit 29 on page 25 above), we note that the top size bucket (i.e. Bucket 1) has the best accounting quality. Whilst we agree that large caps on an average have superior accounting quality vis-à-vis small/mid-caps, this overall average hides a great deal of variations.

A look at the Nifty (ex-financials) universe suggests as many as 46% of Nifty firms (i.e. 19 firms) have accounting scores below the universe (BSE500) average. Further, for the weakest 19 of these firms, the accounting scores are actually so low that these firms fall in the bottom three deciles of accounting quality for the BSE500. In other words, 12 Nifty firms feature in the ‘Zone of Darkness’ on our model. Myth #4: In sectors such as E&C, Utilities and Heavy Engineering, weak accounting quality is a certainty Exhibit 25 on page 23 above suggests that for sectors such as E&C, Utilities and Heavy Engineering, weak accounting quality is a given. Within these sectors, however, several firms such as Bharat Electronics, Techno Electric and Thermax have accounting scores that are far superior to the market average.

Myth #5: It takes too much time and effort to assess accounting quality for a firm Contrary to popular belief, it does not take too much time and effort to assess accounting quality for a firm. As we will discuss in the next section, there are several ways in which interested clients can use our forensic model, not just to assess the first-level health of their portfolio but also to screen the entire spectrum of listed companies ex-financials (with market-cap greater than Rs1,000mn) on the basis of their accounting quality.

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Not all firms from the Nifty have clean accounting

Not all firms in sectors such as E&C, Utilities and Heavy Engg. have weak accounting

It is now easy for clients to access our models to assess the accounting quality for any firm

Strategy


How can clients access our forensic model? We discuss three distinct ways in which clients can access our forensic model. Clients can now use our ‘HAWK’ platform to screen the entire listed universe (~1,300 firms) on the basis of their accounting quality. For clients interested in their portfolio heatmaps, we can also provide an accounting heatmap of their portfolio within five working days of receiving it if the constituent stocks are in our accounting model. Finally, for a more detailed analysis, we also conduct extensive bottom-up company-specific bespoke research for clients. Access our ‘HAWK’ platform In the wake of several clients requesting access to both our ‘forensic’ and ‘greatness’ models, in July this year, we launched our ‘HAWK’ platform giving clients access to Ambit’s proprietary ‘forensic’ and ‘greatness’ models in an easy to use and intuitive format (click here for the User Guide).

Our ‘HAWK’ platform allows clients to screen the entire universe ex-financials (~1,300 listed Indian companies) on the basis of their accounting quality (quantified using our ‘forensic’ model) and capital allocation track record (quantified using our ‘greatness’ framework’) over the last ten years. Whilst the platform currently has the accounting scores for all the companies updated until FY15, in a couple of weeks from now, we will refresh our platform to incorporate FY16 financials as well.

As an example, the following exhibit illustrates how clients can use our ‘HAWK’ platform to identify the more conservative or the more aggressive sectors – both on capital allocation as well as the quality of financial reporting.

Exhibit 39: Sector level heatmap analysis using ‘HAWK’

Source: Ambit ‘HAWK’, Ambit Capital research. Note: Each block represents a sector – block size represents either free float or market cap, block color represents either forensic score or greatness score. Clients can use the toggle buttons to switch the representations. Click on any sector to see the constituent stocks – this also changes current selection to all stocks in that sector. The other charts update automatically. Data for the above exhibit pertains to FY10-15.

Please contact your relevant sales representatives at Ambit if you have not yet received the login credentials for ‘HAWK’ or if you would like a demo on how to use the product.

Clients can access our ‘HAWK’ platform to screen ~1,300 firms on their accounting quality

http://hawk.ambit.co/

http://hawk.ambit.co/

Strategy


Portfolio heatmaps 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 Darkness’. A sample screenshot of what such a diagnostic looks like is presented below.

Exhibit 40: Indicative portfolio heatmap

Companies Ambit sector

Scores

CFO-EBITDA

Cont |Liab-% of NW

Change in depr

rate

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% of sales)

CAGR in auditor’s remn

to CAGR in consol revs

Misc. 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 9.2

XYZ Utilities 13 8 12 9 5 12 2 7 7 3 7.8

PPP Utilities 1 5 8 10 8 8 11 11 6 3 7.1

RRR IT 3 2 10 12 7 10 8 10 5 3 7.0

DEF Metals 12 10 4 5 6 3 3 6 13 3 6.5

GHI Metals 10 6 7 6 1 2 12 5 12 3 6.4

TTT Oil & Gas 6 11 5 4 4 7 1 1 10 2 5.1

PQR Oil & Gas 7 13 3 2 3 1 4 1 2 3 3.9

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

In-depth bespoke analysis

From our discussions above, we note that our accounting model uses 11 objective, quantifiable parameters to assess the overall quality of a firm’s accounts. That said, it has certain limitations too. For example, as we will see in the next section of the note, certain subjective assessments on governance standards cannot be quantified and can only be made after going through the annual reports. Our bottom-up analysis, therefore, plays a vital role in helping our clients identify these parameters.

Thus, for clients interested in a more detailed analysis, we also conduct extensive bottom-up company-specific bespoke research. A couple of our sample bespoke reports have been attached towards the end of the note in this regards.

Clients can also request accounting heatmaps for their portfolio

For interested clients we also conduct in-depth bespoke research

Strategy


Subjective checks: Can be gauged only with a careful reading of the annual report Our discussions above suggest that whilst our accounting model uses 11 objective, quantifiable ratios to assess the accounting quality for a firm, it has certain inherent limitations too. Certain subjective assessments regarding corporate governance can only be made through a detailed analysis of the annual report. We discuss some of these subjective checks that investors should be on the lookout for whilst analysing annual reports.

Subjective check #1 – Proportion of assets not audited by the statutory auditor

An important parameter that cannot be captured on our forensic screen, but which needs to be scrutinised carefully is the proportion of assets not audited by the statutory auditor.

In several cases in his auditor report, the statutory auditor clearly gives a disclaimer that a certain proportion of assets have not been audited by it but have been audited by another auditor and that it has relied on the reports (of the other auditor) furnished to it by the management.

Thus, the higher the proportion of assets not audited by the statutory auditor, the weaker is the audit framework given to the extent to which these numbers fall outside the ambit of the audited consolidated numbers.

Glenmark Pharma is an example of a firm where the proportion of assets not audited by the statutory auditor is fairly high.

(Note: Glenmark Pharma falls in the ‘D7’ in the BSE500 universe on our accounting model).

Case study: Glenmark Pharma (GNP IN, US$ US$ 3.8bn, Not Rated)

A relevant extract from Glenmark Pharma’s FY16 auditor’s report has been presented in Exhibit 41 below:

Exhibit 41: Glenmark Pharma - extract from its FY16 auditor’s report (Pgs. 195 and 196 of the annual report)

Source: Company filings

Exhibit 41 above suggests that the auditors have not audited total assets to the tune of ~Rs53bn but have relied on the statement furnished by the other auditors. In percentage terms, this translates into ~53% of Glenmark Pharma’s FY16 consolidated assets.

Investors should keep an eye out to note the proportion of assets not audited by the statutory auditor …

Strategy


Subjective check #2 – Frequent changes in the auditor

Investors should keep an eye out for frequent changes in the statutory auditor as this could imply frequent disagreements between the auditor and the management, which eventually results in the auditor leaving.

This can be better understood by looking at the changes in Arshiya’s auditor in FY10.

(Note: Arshiya falls in ‘D10’ of the sub-BSE500 universe on our accounting model).

Case study: Arshiya (ARSL IN, US$ 0.1bn, Not Rated) In August 2009 (FY10), based on company filings, PwC expressed unwillingness to be reappointed as auditors of Arshiya (see Exhibit 42 below).

Exhibit 42: Extract of Arshiya’s BSE filings (from Aug ’09)

Source: BSE filings

Consequently, Arshiya changed its auditor in FY10 (August 2009) from PwC to MGB & Co. MGB & Co. in India is a member firm of MGI International, which is headquartered in London, UK, since 1947. MGB & Co. also audits the accounts of Zee Group and Welspun Corp (a flagship company of the Welspun Group).

Subjective check #3 - 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.

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 ‘D9’ of the sub-BSE500 universe on our accounting model).

Case study: Lanco Infratech (LANCI IN, US$ 0.1bn, Not Rated)

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

Profits were higher by Rs169.29mn (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 Rs242.94mn (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 Rs412.23mn (or 22% of consolidated profits for that year).

The excess profit of Rs412.23mn, 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

… as also any qualifications made by the statutory auditor

Strategy


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 unrealised profits arising out of construction of projects under Build Operate Own and Transfer basis, the Company has not eliminated revenues and unrealised profits in the consolidated financial statements. As a result the consolidated revenue and net profit after minority interest are higher by Rs1692.97 millions and Rs169.29 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 Rs3270.90 and Rs242.94 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 Rs412.23 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.”

Subjective check #4 - Related party transactions

Investors should look out 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 few years.

(Note: Crompton Greaves does not feature in our accounting model due to corporate actions).

Suspicious related party transactions would merit further attention

Strategy


Case study: Crompton Greaves (CRG IN, US$ 0.6bn, Not Rated)

In FY08, Crompton Greaves purchased co-ownership rights in an aircraft from a related party, M/s Asia Aviation Ltd, for Rs562.5mn. 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 Rs2700mn. 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 (Rs411.7mn) and M/s Avantha Holdings Ltd (Rs2,405mn). This last point can be detected from the FY12 annual report.

The nature of these subjective checks further augments the need for an in-depth bespoke analysis

Given the nature of the subjective assessments on corporate governance discussed above, the need for a detailed investigative bottom-up company-specific bespoke analysis only becomes much more imperative for an investor.

Against that backdrop, in the final section of the note, we look into our forensic bespoke knowledge bank and dig out two of the most interesting bespokes that we did during the year. Whilst one of the bespokes pertains to an emerging IT Solutions provider the other bespoke pertains to the top audit firms in India where we have evaluated these firms on the basis of the accounting quality of their auditee firms.


Analysing top Indian auditors

The accounting quality of India Inc. remains lower than its global peers. Our analysis of the top 13 auditors in India suggests that the “Big Four” (Deloitte, KPMG, E&Y and PwC) are more conservative than the mid-sized Indian audit firms. Even within the “Big Four” there is a wide level of disparity; KPMG and E&Y are the more conservative firms. Amongst the mid-sized Indian audit firms, V Sankar Aiyar & Co and Kalyaniwalla & Mistry are the more conservative auditors. The most unexpected observation, however, is that versus last year, the median accounting quality (basis our model) of top-10 auditee firms for the top 5-6 auditors has witnessed a decline. This could be in light of the auditor rotation which has gained momentum in the last one year.

Mapping accounting quality of the top audit engagements of the top Indian auditors

Name of the firm

Free float mcap of the auditee firms (as a % of overall

market’s free float mcap)*

Median Forensic deciles for the top

10 auditee firms# (2016)

Median Forensic deciles for the top 10 auditee firms# (2015)

Deloitte group 37% D6 D6

KPMG group 12% D6 D4

EY group 12% D6 D3

Price Waterhouse group 7% D8 D8

Chaturvedi & Shah 4% D8 D6

V Sankar Aiyar & Co 3% D7 D7

Sharp & Tannan 3% D9 D6

Lodha & Co 2% D7 D7

Haribhakti & Co 1% D10 D9

Walker Chandiok & Co LLP 1% D8 D10

Kalyaniwalla & Mistry 1% D8 D5

Brahmayya & Co 0% D4 D5

B K Khare & Co 0% D5 D5

Total 84% Source: Prime database, Bloomberg, Capitaline, Ambit Capital research. Note: *Free float market-cap as of Nov ’16. There is some degree of overlap in this calculation given some of the audit assignments are jointly audited by one or more auditors. That said, given these overlaps are more of an exception than the rule, the above exhibit should give a fair indication of the free float market cap audited by these firms. # Using six years of consolidated financials for BSE500 and sub-BSE500 companies (ex-financials), we assign accounting scores to the companies. We perceive firms with a high score on our model to have superior quality of accounts and vice-versa.

December 16, 2016

Research Analysts

Nitin Bhasin

+91 22 3043 3241

[email protected]

Karan Khanna, CFA

+91 22 3043 3251

[email protected]


Too good to be true!

“If something sounds too good to be true, it probably is” – Thousands of Miles is a classic fit for this adage with a supernormal revenue/PAT CAGR of 90%/83% over FY12-16. While most of the early stage growth companies have high growth rates, Thousands of Miles differs from them in its aggressive accounting policies (amortization rate of 2.1% vs normative of 10%/unbilled revenues of 36 days vs 13 days for peers), frequent reclassification of line items (sometimes resulting in a difference up to 30% of PAT) without adequate disclosures, sketchy cash flows and irreconcilable line items. Issue of preferential warrants to promoters at a discount (~Rs399 vs Rs419, calculated as per SEBI norms), inadequate disclosures on management remuneration (Rs0 as per annual report) and related party transactions, and non-rotation of auditors for 9 years are key corporate governance concerns. Our bespoke analysis of the company raise more questions than answers!

Highly aggressive and inconsistent accounting Key examples of aggressive accounting: (1) Receivables (including unbilled revenue) have increased to 144 days in FY16 vs 80 days in FY15, group median of 77 days, likely indicating an aggressive revenue recognition policy, and (2) certain intangible assets have an assumed life of 47 years.

Further, several actions appear to be undertaken just to obfuscate analysis. Key examples: (1) frequent re-classification of expense buckets so that a time-series analysis is not possible, (2) intangible assets clubbed with goodwill, (3) reserves and surplus (~42% of net-worth, FY16) in cash flow statement does not tally with that in the balance sheet.

Lower than peer median tax rates (22% vs 25% peer group median) despite lower proportion of other income in PBT (0.3% vs 8.5% for peers), volatile working capital cycle (103 to 55 to 110 days over FY14-16), discrepancies and errors in annual reports are relatively minor concerns for us.

Poor corporate governance practices The salaries of the key management personnel are not disclosed. The company secretary earns Rs300,000 lower than even a fresher at TCS. Inadequate disclosures regarding related party transactions, issue of warrants to promoters ahead of 4x jump in stock price, discrepancies in pricing of warrants, non-rotation of auditors for an extended period of time remain key corporate governance issues.

September 26, 2016

Thousands of MilesNOT RATED

Research Analysts

Sagar Rastogi

+9122 3043 3291

[email protected]

Sudheer Guntupalli +9122 3043 3203

[email protected]

Summary of flags

Checks on FLAGS

Accounting RED FLAG for ad hoc and often aggressive depreciation policy, unconventional cash flow accounting, numbers not tallying across statements.

Corporate governance

RED FLAG for low proportion of independent directors, lack of disclosure on management compensation, the appointment of the same auditor until FY21, issue of warrants ahead of 4x jump in stock price and discrepancy in pricing of warrants.


Thousands of Miles

September 26, 2016 Ambit Capital Pvt. Ltd. Page 39

DuPont analysis Thousands of Miles’ RoE has been lower than its peers due to lower PAT margin (15% vs 24% peer group median, FY16) and asset turnover vs its peers. Consummation of acquisitions like SERJ (acquired at an EV/sales =0.35), Cintel systems (acquired at an EV/sales = 0.5), NexAge (acquired at an EV/Sales = 0.6) and Mind print (acquired at approximate EV/sales = 0.8) resulted in an improvement in Asset Turnover ratio in FY15-16.

The company’s RoEs improved significantly to 26% in FY16 vs 14% two years ago (FY14). As seen in the DuPont analysis exhibit below, the improvement in RoE was mainly explained by improvement in asset turnover as the company grew its sales by 118% in FY16. PAT margin, however, remained flat in FY16.

Exhibit 1: Lower ROE compared to peers


Thousands of Miles 15% 15% 14% 23% 26%

Peers Take Solutions 32% 23% 14% 16% 22%

Accelya Kale 29% 70% 82% 60% 73%

MPS 16% 42% 48% 35% 27%

Persistent Systems 18% 20% 22% 22% 20%

eClerx 55% 44% 50% 35% 40%

Peer group median 29% 42% 48% 35% 27%

Source: Company, Ambit Capital research; Note: MPS had reported a loss in FY11 and has been excluded from the ROE exhibit

Exhibit 2: DuPont analysis PAT margin Asset Turnover Leverage

FY11 FY12 FY13 FY14 FY15 FY16 FY11 FY12 FY13 FY14 FY15 FY16 FY11 FY12 FY13 FY14 FY15 FY16

Thousands of Miles 13% 17% 15% 14% 15% 15% 1.1 0.6 0.7 0.7 1.1 1.3 0.7 1.4 1.4 1.5 1.4 1.4

Peers Take Solutions 15% 13% 11% 8% 11% 12% 1.1 1.3 1.3 1.1 0.9 1.1 1.4 1.8 1.7 1.6 1.6 1.6

Accelya Kale 9% 19% 28% 27% 22% 24% 2.8 1.4 2.4 2.9 2.6 2.9 0.6 1.1 1.1 1.0 1.0 1.0

MPS -65% 5% 19% 21% 26% 26% 1.7 2.5 2.1 2.3 1.3 1.0 1.2 1.1 1.1 1.0 1.0 1.0 Persistent Systems 18% 14% 14% 15% 15% 13% 1.1 1.3 1.3 1.4 1.4 1.5 1.0 1.0 1.0 1.0 1.0 1.0

eClerx 36% 34% 26% 30% 24% 28% 1.6 1.6 1.7 1.6 1.4 1.4 1.0 1.0 1.0 1.0 1.0 1.0 Peer group median 15% 14% 19% 21% 22% 24% 1.6 1.4 1.7 1.6 1.4 1.4 1.0 1.1 1.1 1.0 1.0 1.0


http://articles.economictimes.indiatimes.com/2014-11-27/news/56515611_1_september-quarter-rs-45-crore-providers

http://www.moneycontrol.com/news/business/cintel-to-push-bottomline-by-10-1512-18-mths-8k-miles_1364488.html

http://articles.economictimes.indiatimes.com/2015-09-18/news/66677366_1_8k-miles-miles-software-services-sciences

http://www.moneycontrol.com/news/business/canadian-acquisition-to-boost-clinical-research-focus-8k_1323667.html

Thousands of Miles


Inconsistent accounting policies In the exhibit below, we present a common-size income statement of the company for a better understanding of the drivers behind the company’s profit margins. We notice that the company’s employee expense (as a percentage of revenue) has come down significantly over the years (from 62% in FY12 to 47% in FY16). However, the drop in employee expense was somewhat offset by the rise in other expenses (14% in FY12 to 21% in FY16).

Whilst the company’s EBITDA margin has improved significantly (24% in FY12 to 33% in FY16), we observe that this has not led to an improvement in the company’s net profit margins (net profit margin declined from 17% in FY12 to 15% in FY16). This is explained by four factors: (1) Increase in depreciation as a percentage of revenue (discussed in detail in later parts of the report), (2) higher tax expense as a percentage of revenue due to higher PBT margins, (3) increase in the share of minority income, (4) acquisition of companies like Cintel (~10% net profit margin vs 15% net profit margin of Thousands of Miles) and Mind print (negative net profit margin vs 15% net profit margin of Thousands of Miles) with lower net profit margin profile.

Exhibit 3: Excerpt from common size income statement

Mar-12 Mar-13 Mar-14 Mar-15 Mar-16

Total Revenue 100% 100% 100% 100% 100%

Employee benefit expenses 62% 60% 53% 45% 47%

Other expenses 14% 19% 16% 24% 21%

EBITDA 24% 21% 31% 31% 33%

Finance costs 0% 1% 1% 0% 0%

Depreciation and amortisation expenses 4% 3% 10% 7% 7%

Profit before tax 20% 17% 21% 23% 25%

Tax expenses 3% 2% 4% 5% 6%

Profit from continuing operations 17% 15% 17% 18% 20%

Minority Interest - - 3% 3% 5%

Net profit attributable to shareholders 17% 15% 14% 15% 15%


Frequent reclassifications Other expenses

In the exhibit below, we benchmark the other expenses reported by Thousands of Miles with non-operating expense reported by peers. We find that Thousands of Miles’ other expenses were below peers in FY12 but increased over the years, peaked in FY15 and remained in line with peer group median in FY16.

Exhibit 4: Thousands of Miles’ other expenses as compared to peers

as % of revenue FY12 FY13 FY14 FY15 FY16


Take Solutions 19% 22% 23% 24% 23%

Accelya Kale 30% 21% 20% 20% 21%

MPS 32% 26% 24% 21% 21%


eClerx 17% 17% 17% 20% 19%

Peer group median 19% 21% 20% 20% 21%

Source: Company, Ambit Capital research; Note that different companies have different ways of reporting other income, this comparison is meant for a broad check

In the exhibit below we dig deeper into why the ‘other expenses’ reported by the company have increased in recent years (FY15-16) as a percentage of revenues. We notice that the company’s spending on ‘travelling and business promotion expenses’

http://www.moneycontrol.com/news/business/cintel-to-push-bottomline-by-10-1512-18-mths-8k-miles_1364488.html

http://www.moneycontrol.com/news/business/canadian-acquisition-to-boost-clinical-research-focus-8k_1323667.html

Thousands of Miles


has gone up substantially and peaked out during FY14-15 (14-16% of revenues for FY14 and FY15). Though this has come down sharply in FY16, we are of the view that this decrease may be because of the change in classification of other expenses rather than the actual decrease in such expenses.

The classification of other expenses reporting has changed considerably over time, rendering it difficult to compare time series data on a like to like basis. For instance, in FY15 annual report, ‘travelling and business promotion expenses’, for FY15 are reported as single line item (Rs195mn) while in FY16 annual report they seem to be reported as three different line items - travelling & logistics (FY15-Rs27.4mn), business promotion related (FY15-19.6mn), immigration expenses (FY15-Rs25.6mn). Surprisingly summation of these three line items (Rs72.6mn) would not result in reconciliation of numbers reported in the two annual reports. The difference amounts to 30% of FY16 PAT. There are similar discrepancies even in other line items like Rent, Rates & Taxes. While companies change/reclassify their line items, appropriate and adequate disclosures and reconciliations regarding the same are expected by the investors for making comparisons across time and across peer group.

Exhibit 5: Breakup of ‘other expenses’ expressed as % of revenue FY12 FY13 FY14 FY15 FY16

Auditors Remuneration 0.1% 0.1% 0.0% 0.4% 0.3%

Professional and Consultancy Fee 1.4% 0.1% 0.0% 2.1% 2.4%

Travelling and Business Promotion Expenses 0.2% 0.0% 14.5% 15.6% 4.0%

Communication 0.2% 0.1% 0.1% 0.8% 1.7%

Rent 0.7% 0.5% 0.3% 1.1% 1.6% Non-classified expenses (mainly other general and administration expenses) 11.3% 18.5% 0.7% 4.0% 10.6%

Total Other Expenses 13.9% 19.4% 15.6% 23.9% 20.6%


Exhibit 6: Other expenses as reported in FY16 AR

Source: company

Exhibit 7: Other expenses as reported in FY15 AR

Source: company

Depreciation & Amortization Discrepancies in reporting

We noticed the following discrepancies in the company’s reporting related to fixed assets and depreciation:

In the FY14 annual report, the company has reported its FY13 intangible assets as Rs14,354 on the balance sheet (page 78). However in the financial schedule for breakup of fixed assets, the total of intangible assets is shown as Rs57.4mn (page 88).

In its FY13 annual report, the company reported Rs54.5mn as goodwill on consolidation on the balance sheet for FY12 and FY13. However this goodwill

The classification of other expenses reporting has changed considerably over time rendering it difficult to compare time series data on a like to like basis.

Thousands of Miles


amount for FY13 does not appear in balance sheet and financial schedules of FY14 annual report.

In the FY12 annual report, the company’s total gross fixed assets increased from Rs0.3mn to Rs9.5mn (page 70) due to consolidation of Mentorminds. The numbers for net fixed assets were re-stated accordingly but the number for gross fixed assets were not re-stated.

In the FY13 annual report, the company added some new entries to FY13 gross block (page 67) related to consolidation and re-stated net fixed assets for FY12 but not the gross fixed assets. The table of breakup of fixed assets in the FY13 annual report is not easily readable because the table is probably a scanned image. For one of the consolidation entries (item 6 in the table) the company added Rs8.2mn to the gross block but depreciated it by Rs7.0mn in the same year.

Depreciation rate analysis

Given the nature of the business, the company invests in lot of intangible assets (like software products) on an ongoing basis. Certain assets that are not yet ready for intended use are recognized as ‘intangible assets under development’ and are not depreciated. These assets as a percentage of total net assets have come down over the years and in FY16 accounted for 11% of total net block.

The company’s overall depreciation rates look more or less stable over the past three years. We divided the depreciation rates into two sections, one for tangible assets (as a percentage of net block as the company uses WDV method) and other for intangible assets. Due to discrepancies in reporting discussed above, we get outlier values for depreciation rates for FY12 and FY13. We find the reporting for FY14-16 to be more reliable and put higher weight on depreciation rates for these two years for further analysis.

Exhibit 8: Thousands of Miles’ depreciation rate overview

FY12** FY13 FY14 FY15 FY16

Income statement depreciation as % of total gross block 13.5% 9.8% 13.7% 13.9% 15.3%

Depreciation rate based on footnotes

for tangible Assets* (as % of net block) 2.5% 130.7% 26.4% 22.9% 25.3%

for intangible Assets 26.3% 0.2% 11.4% 9.1% 17.4% Intangible assets under development as % of total net block 73.3% 96.0% 27.3% 20.1% 11.0%

Source: Company, Ambit Capital research; Note: depreciation rate is calculated as depreciation expense for the year divided by average gross block at the beginning and end of that year; *depreciation rate for tangibles is calculated on WDV basis, hence depreciation rate is considered as % of net block;** the gross block for FY12 includes Rs54.5mn of goodwill disclosed on the balance sheet

We point out that prior to FY16 there are some differences in total depreciation expense disclosed in the income statement and the breakup of tangible asset depreciation and intangible asset depreciation given in financial schedules.

Exhibit 9: Breakup of depreciation expense

Rs mn FY13 FY14 FY15 FY16

Total Depreciation (from income statement) 8.1 43.1 91.2 202.3

Tangible assets depreciation (from footnotes) 8.1 2.1 4.3 17.4

Intangible assets depreciation (from footnotes) 0.1 35.7 62.4 184.8

Total tangible and intangible 8.2 37.7 66.7 202.3

% difference 1% -12% -27% 0%


In the exhibit below, we compare Thousands of Miles’ intangible assets depreciation rates with peers (not comparable for tangible assets of peers as the company uses WDV method). We notice that intangible asset depreciation rate is also volatile for peers.

Thousands of Miles


Exhibit 10: Intangible assets depreciation rate comparison

Intangibles Depreciation as % of gross block


Thousands of Miles 26.3% 0.2% 11.4% 9.1% 15.0%

Take Solutions 14.7% 19.4% 21.7% 15.0% 15.3%

Accelya Kale 9.7% 10.0% 8.7% 9.0% 9.4%

MPS 28.0% 16.9% 10.6% 6.6% 1.9%

Persistent Systems 11.0% 20.5% 17.4% 7.6% 14.7%

eClerx 19.1% 19.6% 13.9% 12.7% 4.1%

Peer Median 14.7% 19.4% 13.9% 9.0% 9.4%


Thousands of Miles


Aggressive accounting - amortization rate

We take a closer look at the breakup of depreciation data provided by the company for intangible assets to understand the policy better. We notice that the company records depreciation (not impairment) on the goodwill on its balance sheet without specifying the reason behind it. We also notice that for intangible assets under its ~63% held subsidiary “Thousands of Miles Software Services Inc (USA)” the company has recorded a very aggressive 2.1% amortization rate. The company has a policy of amortizing intangible assets on a straight line basis based on the useful lives determined by the management. A 2.1% amortization rate (or 2.6% on taking FY14 gross assets) implies that the assumed life of the intangible asset is ~47 years (39 years using FY14 gross assets) which seems aggressive.

We note that intangible assets related to Thousands of Miles Software Services Inc (USA) are of substantial size and had the depreciation for them been 10% for FY15 (still lower than depreciation rate for other reported intangible assets) the reported depreciation would have increased by Rs.41mn and led to a reduction in reported FY15 net profit of Rs.190mn by ~21%.

There are discrepancies in reported numbers of Gross Carrying Value (GCV), Accumulated amortization, Net Carrying Value (NCV) as on 31st March 2015. Reported numbers in FY16 annual report do not tally with those in FY15 annual report. On further analysis, we discover that the company clubbed intangible assets of Thousands of Miles software services Inc (USA) (~63% held subsidiary) with the goodwill on balance sheet starting from FY16. Intangible assets of another 100% held subsidiary, Thousands of Miles software services Inc (FZE) are clubbed with internally generated intangible assets. We are highly critical of the accounting treatment of goodwill recognition/transfer during consolidation of subsidiary’s intangible assets without adequate disclosures. This accounting treatment will only mask the aggressive amortization rate that the company has adopted on the intangible assets of the subsidiary by making the FY16 numbers incomparable to those of previous years on a like to like basis.

We find many discrepancies in the company’s reporting of depreciation and also the depreciation policy looks ad hoc to us in the absence of sufficient disclosures. We highlight this as a RED FLAG.

Exhibit 11: Intangible Assets Depreciation Rate for FY15

Rs mn FY14 end gross intangible assets*

FY15 end gross intangible assets*

FY15 depreciation expense

FY15 depreciation as % of gross block**

Computer Software (Acquired) 0.04 0.04 0.01 15.2%

Computer Software (Internally Generated) 30.9 79.4 9.5 17.2%

Goodwill 74.0 74.0 29.6 40.0%

Thousands of Miles Software Services Inc (USA) 426.5 604.4 10.9 2.1%

Thousands of Miles Software Services Inc (FZE) 0.0 84.4 12.4 29.4%

Total 531.4 842.3 62.4 9.1%

Source: Company, Ambit Capital research; Note: *The gross intangible assets data given here excludes intangible assets under development; ** depreciation as % of gross block is calculated by dividing depreciation expense for FY15 by average of gross block for FY14 and FY15.

Thousands of Miles’ Depreciation and Amortisation Policy

Depreciation is provided on tangible fixed assets on the written down value (WDV) method over useful life of the assets as estimated by the management.

Intangible assets are amortised on a straight line basis over their respective individual estimated useful lives as determined by the management.

Thousands of Miles


Exhibit 12: Intangible gross block classification in FY16 annual report

Source: company

Exhibit 13: Intangible gross block classification in FY15 annual report

Source: company

Thousands of Miles


Unclear items – Lower Tax rates The company’s tax expenses as a percentage of revenues increased partially due to improvement in PBT margins. In the exhibit below, we take a closer look at the company’s effective tax rate. We find that Thousands of Miles’ tax rate is volatile and has climbed since FY13. The disclosure on taxes is not detailed enough to make sense of why the tax rate is volatile. For the recent years (FY14-16), the effective tax rate is lower than peers. We raise an AMBER FLAG for the tax rate being lower than peers despite lower proportion of other income and also for being volatile.

Exhibit 14: Effective tax rate of Thousands of Miles is lower than pees despite…

Effective Tax Rate (%) FY12 FY13 FY14 FY15 FY16


Take Solutions 18% 17% 2% 6% 14%

Accelya Kale 32% 31% 33% 37% 35%

MPS 26% 22% 34% 34% 32%


eClerx 20% 19% 23% 23% 24%

Peer Median 26% 22% 27% 25% 25%


Exhibit 15: …other income as percentage of PBT is lower for Thousands of Miles

Other income as % of PBT FY12 FY13 FY14 FY15 FY16


Take solutions 0.0% 0.0% 0.0% 0.0% 1.9%

Accelya Kale 3.8% -2.4% 3.4% 5.4% 7.2%

MPS 46.0% 12.5% 10.1% 11.6% 17.5%

Persistent Systems 13.0% 2.3% 4.4% 23.9% 19.0%

eClerx 11.2% -8.6% 3.3% 10.9% 8.5%

Peer group median 11.2% 0.0% 3.4% 10.9% 8.5%

Source: Ambit Capital research, company

Thousands of Miles


Volatile cash flows As shown in the exhibit below, Thousands of Miles’ cash conversion ratio is highly volatile. In FY12 and FY13, the company generated healthy EBITDA but reported negative CFO mainly due to allocation of cash towards working capital. In FY14 and FY15, the company’s cash generation has been healthy as compared to its peers before deteriorating again in FY16.

Exhibit 16: Thousands of Miles’ cash generation has been volatile

Pre Tax CFO/ EBITDA (%)

FY11 FY12 FY13 FY14 FY15 FY16

Thousands of Miles 367% -52% -124% 97% 83% 24%

Take Solutions 60% 83% 76% 71% 55% 71%

Accelya Kale 73% 110% 110% 105% 82% 96%

MPS - 33% 84% 82% 77% 59%

Persistent Systems 121% 78% 83% 88% 106% 99%

eClerx 88% 111% 76% 77% 98% 79%

Peer Median 80% 83% 83% 82% 82% 79%

Source: Company, Ambit Capital research Note: MPS had reported a loss in FY11 and has been excluded from the above exhibit

Unstable working capital cycle Thousands of Miles’ working capital cycle has improved over FY14-15 before deteriorating again in FY16. The company started reporting unbilled revenues in FY16 which resulted in almost a 100% jump in working capital days. Even during FY14-15 when working capital scenario appeared to be improving, the company still lagged the peer group with longer working capital cycle. We assign an AMBER FLAG due to volatility in the cash conversion cycle

Exhibit 17: Net working capital cycle days


Thousands of Miles 84 145 103 55 110

Take Solutions 30 51 65 85 68

Accelya Kale 59 46 33 40 49

MPS 8 3 28 43 47

Persistent Systems 21 28 23 24 16

eClerx 55 55 68 72 34

Peer Median 30 46 33 43 47

Source: Company, Ambit Capital research; Note: Following reclassification of reporting structure, Thousands of Miles has reporting been zero payables since FY13.

In the exhibit below, we break down the components of Thousands of Miles’ working capital cycle and compare it with peers. The biggest driver of the increase in the company’s working capital cycle in FY16 has been in unbilled revenue (increased to 36 days from zero days in FY15). While fixed price contracts contributed 40% of FY16 revenues, unbilled revenue days of 36 days are much higher than peer group median of 13 days. Here, we are concerned that the company might have switched to more aggressive revenue recognition policies. Improvement in creditor days (33 days from 25 days in FY15) scenario is more than offset by worsening of receivable days (108 days from 80 days in FY15) and unbilled revenue days.

Thousands of Miles


Exhibit 18: Breakup of cash conversion cycle as compared to peers

Receivable days Unbilled revenue days Creditor days Cash conversion cycle

FY14 FY15 FY16 FY14 FY15 FY16 FY14 FY15 FY16 FY14 FY15 FY16

Thousands of Miles 112 80 108 - - 36 9 25 33 103 55 110

Peers Take Solutions 101 117 107 13 17 20 49 50 58 65 85 68

Accelya Kale 45 44 42 21 23 28 33 26 21 33 40 49

MPS 58 61 64 14 14 13 43 32 30 28 43 47

Persistent Systems 66 69 67 7 8 - 18 17 52 56 60 16

eClerx 43 48 52 36 38 - 11 14 18 68 72 34

Peer group median 58 61 64 14 17 13 33 26 30 56 60 47

Source: Company, Ambit Capital Research

Weak free cash flow conversion In the exhibit below, we compare free cash flow (CFO+CFI) yield generated by the company over the last five years vs peers. The company has generated high negative free cash flow during this period whilst its peers have fared better. Thousands of Miles has been making many acquisitions in the past and this has contributed to cash outflow (CFI) whilst its benefits (CFO) will accrue over time. In the later parts of this report, we highlight that Thousands of Miles has been using an unconventional accounting practice for its cash flow statement. We believe this could have also led outflows related to investments (CFI) reported by the company to be overstated. We assign an AMBER FLAG.

Exhibit 19: Free cash flow conversion of the company has been week and volatile as well

Company name Cumulative

CFO Cumulative

CFI Cumulative (CFO+CFI)

Median revenues Cum (CFO+CFI)/median rev

FY12-FY16 FY12-FY16 FY12-FY16 FY12-FY16

Thousands of Miles 464 (1,857) (1,394) 441 (3.2)

Take Solutions 5,918 (5,179) 740 8,155 0.1

Accelya Kale 4,272 (660) 3,612 3,038 1.2

MPS 1,749 (1,784) (35) 2,040 (0.0)

Persistent Systems 12,635 (8,139) 4,496 16,692 0.3

eClerx 11,333 (7,110) 4,223 8,410 0.5

Peer group median 5,918 (5,179) 3,612 8,155 0.3


Sketchy cash flow accounting Thousands of Miles is following an unconventional accounting practice with respect to its cash flow from financing activities. It is difficult to understand how the company is funding its financing needs by looking at the cash flow statement. In FY14, the company reported Rs481mn (78% of FY14 net worth) as cash inflow related to ‘Reserves and Surplus’ although the company did not issue any new shares during that period. In FY15/16, the company reported Rs185mn/Rs859mn (19%/42% of FY15/16 net worth) as cash inflows related to ‘Reserves and surplus’ (proceeds from preferential share allotment out of conversion of 0.3mn/0.55mn warrants during FY15/FY16 could not be reconciled with cash inflows related to ‘Reserves and Surplus’). We notice the following other issues with the cash flow reporting:

The cash flow item in ‘Reserves and Surplus’ item does not tally (for FY14 & FY16) with the breakup of reserves and surplus given by the company in its financial schedules for consolidated balance sheet. Based on FY15 data, we ‘assume’ that this cash flow entry mainly pertains to two things shown in the breakup of reserves and surplus: 1) addition to capital reserves (including to securities premium account) during the year; 2) foreign currency translation effects.

Thousands of Miles


Pages 96 and 97 of FY15 annual report shows that the company has reported Rs418m as addition and Rs54m as deduction from capital reserves for FY14 and FY15 respectively. There is no disclosure on how these numbers were arrived at or what the underlying reasons behind it were. Surprisingly, page 120 of FY16 annual report paints a different picture. Opening and closing balances for FY15 capital reserves and securities premium account do not reconcile with each other (based on FY15 and FY16 annual reports). We expect further clarity and disclosures regarding this from the management.

Given that the company reported Rs859mn in FY16 cash flow statement related to reserves and surplus there ‘might’ also be an offsetting entry in investing cash flow section so that there is no impact on change in cash for the year. This ‘could’ lead to overstatement of cash outflow related to investments made by the company.

We also noticed that the individual line items for FY15 financing cash flow do not add up to the total financing cash flow of Rs436mn disclosed by the company. This is likely a typographical error and the correct number should have been Rs205mn. This way the individual line items add up to the total financing cash flow and total change in cash equals sum of operating, investing and financing cash flows.

Due to above issues, we assign a RED FLAG.

Exhibit 20: Cash flow statement of the company is a black box

Cash used in financing activities Mar-14 Mar-15 Mar-16

Share Capital - 3.0 5.5

Application money pending allotment - 115.0 (57.5)

In Reserves & Surplus 481.1 185.1 859.6

Deferred Tax liabilities 4.3 1.2 Interest Paid (3.7) (4.5) (2.1)

Increase in Non-Current Liabilities 5.6 (94.7) 0.4

Net Cash Used In Financing Activities (3) 487.3 436.1 805.9

Net Increase in Cash and Cash Equivalents (1+2+3) 33.9 99.5 137.7

Cash and Cash Equivalents at the beginning of the year 14.5 48.3 147.8

Cash and Cash Equivalents at the end of the year 48.3 147.8 285.5

Reserves and surplus as % of net worth 78% 19% 42%

Source: Annual report

Exhibit 21: FY16 annual report of the company…

Source: company

Exhibit 22: …contradicts data present in FY15 annual report

Source: company

Capital allocation Getting insights on Thousands of Miles’ capital allocation is challenging given that we don’t fully understand where the financing cash flow is coming from and there is no granular breakup on where the investing cash flow is being spent. In the exhibit below we take a deeper look at how the company has allocated its capital from FY12-FY16.

Out of total inflows of Rs2.9bn, 57% have come from financing cash flows and the rest came from operating cash flows (before working capital adjustments). Out of

Thousands of Miles


total cash outflows of Rs2.6bn, 69% was used towards investment activities while the rest was used for investing in working capital.

Exhibit 23: Getting insights into capital allocation is challenging

Source: Company, Ambit Capital research; Note: For Financing cash flow we have used RS205m as the number for FY15 instead of Rs436m due to a typo in the company’s annual report

Financing cash flow

57%

Operating Cash Flow

(before WC

changes)43%

Inflows: FY12-16: Rs2.9bn

Investing cash flow

69%

Working Capital

31%

Outflows: FY12-16: Rs2.6bn

Thousands of Miles


Corporate governance Company’s CEO serves on nomination and remuneration committee Thousands of Miles had a close-knit Board comprising only five people till FY15. However, the strength of the board has expanded to seven members by the close of FY16. The Board includes four independent directors (only two till FY15) whilst the other three Board members are promoters/part of the management team (CEO, CFO and COO). The company’s Nomination and Remuneration committee consists of three non-independent directors and only one independent director. Thus, we have a situation where a company’s top management is a part of the committee that oversees policies related to its own compensation. Hence, we assign an AMBER FLAG.

Exhibit 24: Board of directors

Name Background

Suresh Venkatachari

CEO , Chairman and Promoter of the company (held 55.25% stake as of September 2015) Has more than 26+ years of experience in the IT solutions & consulting industry Has founded four IT companies over the past 14 years Previously served as Head of Electronic Banking at Deutsche Bank, Singapore Other Directorship: SolutionNet (Asia Pacific) Pte Ltd; Mentor Minds Solutions and Services Pvt. Ltd.;

Imogo Tech Solutions Pvt Ltd Gurumurthi Jayaraman (Independent) Other Directorships: Nova Human Resources Outsourcing Pvt. Ltd.

Ramani RS

Serving as CFO of the company Owns 6.14% shares of the company (as of March 2015) 27+ years of experience in finance roles; key areas of focus for Mr. Ramani is Finance, Accounting,

Auditing and operations in IT, Education and Trading Industries Other Directorships: Mentor Minds Solutions and Services Pvt. Ltd.; Imogo Tech Solutions Pvt Ltd

Padmini Ravichandran (Independent) Other Directorships: Sreyes Communetwork Pvt. Ltd; Sudesi Infomedia Pvt. Ltd.

Lakshmanan Kannappan

COO and Head of Cloud IAM business for 8KMiles Founder of FuGen Solutions which was acquired by 8KMiles One of the original founders of SAML 2.0 protocol and Federated Identity Management model for the

industry while at Orange-France Telecom, which changed the way Identity Information is shared between Service Providers and enabled the huge success of SaaS, Cloud and Social Networking

Dinesh R Punniamurthy (Independent) Over 14 years of experience in service industry predominantly in India and a few years in Australia

Babita Singaram (Independent) Ardent marketing professional with a Post Graduate in Business Administration from SRM university

Source: Company, Media Sources; Note that Mr. Dinesh R Punniamurthy and Ms. Babita Singaram were appointed as additional directors under independent and non-executive category w.e.f 31st March 2016

Attendance of the members (especially independent) in the Board meetings in FY16 has been satisfactory.

Exhibit 25: Attendance and joining date details of the board members FY16 Attendance Appointment Date

Suresh Venkatachari 5/7 Aug-2010

Gurumurthi Jayaraman 7/7 Feb-2014

RS Ramani 7/7 Aug-2011

Padmini Ravichandran 7/7 Aug-2010

Lakshmanan Kannappan* 4/7 Mar-2015

Dinesh R Punniamurthy 1/7 Mar-2016

Babita Singaram 1/7 Mar-2016

Source: Company, Media Sources; Note that Dinesh RP and Babita S are appointed as independent directors w.e.f 31st March 2016 and hence their attendance does not reflect full year meetings

Thousands of Miles


Inadequate disclosures on management compensation In its FY16 annual report (pages 63, 64), the company has left the sections on remuneration for CEO, CFO and independent directors blank, suggesting that they are not getting any compensation from the company. We believe that the company’s disclosure regarding its compensation for top leadership is incomplete and assign an AMBER FLAG.

Strategic Advisory Board

On 9th October 2015, the company announced that it has appointed a strategic advisory board consisting of people with domain expertise in cloud, digital transformation, mobile and security. The aim of this initiative is to strengthen Thousands of Miles’ offerings and provide access to previously untapped business opportunities. This is an encouraging initiative by the company.

Exhibit 26: Composition of the strategic advisory board Name Background

John Cuny Senior health system developer & manager with 30 years of managed care experience in hospitals & major health plans Previously served as advisor / manager to select healthcare organizations in US, Britain, Argentina, Saudi Arabia etc

Reza Nazleman A global IT executive with 20+ years of proven leadership in professional services and operational end-to-end

accountability with EUnet, France Telecom, McKinsey & Co., KPMG, BearingPoint, Bank of Scotland, and Microsoft. Former Head of Global IT Transformation, Microsoft

Jason Rouault Senior Director of Engineering at Time Warner Cable; responsible for the ongoing development, operation, and support

of the TWC OpenStack Cloud Previously worked as CTO of the Hewlett-Packard’s Identity Management business

Jeff Nigriny Founder and President of CertiPath, a trust framework provider that certifies authentication and access control devices with a focus on high assurance for aerospace and defense industries and government agencies

Dinesh Yadav Responsible for sales, channel and go-to-market for IBM’s security solutions

Suja Chandrasekaran CIO of Kimberly-Clark corporation, Suja leads all technology, digital, data and application capabilities globally

Rajan Natarajan President of TechnoGen Inc. and serving on the Maryland cybersecurity council, board of directors of Maryland chamber of commerce

Source: Company

Company secretary’s remuneration is extremely low

The company secretary, Ms. Jayashree Jagannathan earns just Rs300,000 p.a., which we note is lower than even a fresher at TCS. At best, this indicates poor importance given to the role of a company secretary.

Inadequate disclosures on related party transactions As per the annual reports of the company, there were no materially significant transactions with related parties during FY16/FY15 but there were some in FY14. We find the company’s disclosures related to RPTs to be inadequate and flag it as a cause of concern.

The company reports RPTs for only the standalone entity whereas the RPTs for consolidated entity are not disclosed. In FY14, the company reported following related party transactions in the schedules to financial statements without disclosing the same in the RPT schedule.

Exhibit 27: Thousands of Miles’ notable related party transactions in FY14

FY14 Related party transactions Amount (Rs mn) % of net worth

Standalone Short term loans and advances from related party 10.2 1.3%

Long term loans and advances from related party 4.9 0.6%

Consolidated Loans and advances from directors 11.6 1.4%

Long term loans and advances to related parties (asset) 1.7 0.2%

Source: FY14 annual report

Thousands of Miles


Issues around warrant pricing On 20th December 2014, the company allotted 1.4mn warrants (equivalent to ~14% of shares outstanding) on a preferential basis to promoters and other non-promoter investors. The relevant shareholder resolution was passed at an extraordinary general meeting held on 28th Oct 2014. The warrants were allotted at a price of Rs398.6 per share.

In a BSE release dated 6th Oct 2015, Thousands of Miles disclosed the policy it was following for calculation of warrant price.

On 25th Aug 2014, the SEBI had released an amendment following which the warrant price calculation was to be based on volume weighted average price (VWAP) vs THE old rule of using closing price. The stock prices are to be considered for the exchange where higher number of shares of the company trade. In the exhibit below, we calculate the SEBI mandated floor price for the warrant using old and amended rules and using both BSE and NSE stock prices. Note that we are not including the previous 26 week average because it is much lower than the previous 2 week average and is inconsequential given that higher of the two prices is considered as the floor price.

Exhibit 28: Calculation of warrant floor price as per SEBI rules

Date

NSE BSE

Closing Price VWAP Closing Price VWAP

Week 1

26-Sep-14 469.9 465.5 468.8 465.9

25-Sep-14 447.6 452.4 446.5 452.9

24-Sep-14 452.4 447.2 449.4 443.3

23-Sep-14 452.2 454.2 448.4 452.4

22-Sep-14 451.0 445.8 449.5 443.6

Week 2

19-Sep-14 429.6 423.6 428.1 420.7

18-Sep-14 390.5 381.1 389.2 382.6

17-Sep-14 355.0 345.9 353.9 336.0

16-Sep-14 326.0 338.3 327.2 337.3

15-Sep-14 347.6 347.0 347.3 346.9

Week 1 min 447.6 445.8 446.5 443.3

Week 1 max 469.9 465.5 468.8 465.9

Week 2 min 326.0 338.3 327.2 336.0

Week 2 max 429.6 423.6 428.1 420.7

Average Price 418.2 418.3 417.7 416.5

Source: Company, BSE, NSE, SEBI

Our calculations suggest that the SEBI mandated warrant floor price should have been in Rs416-419 range compared to the price of Rs398.6 at which the company allotted warrants. The management stated in a TV interview that there was no discount in the price at which these warrants were allotted without giving further information. We assign a RED FLAG.

Calculation of Warrant Price

The price of the Securities to be issued is being calculated in accordance with the provisions for preferential issue as laid under Chapter VII of the SEBI ICDR Regulations which inter alia provides that the equity shares and Warrants shall be allotted at a price not less than higher of the following:-

(a) The average of the weekly high and low of the closing prices of the Company’s equity shares quoted on the Stock Exchange(s) during the twenty six (26) weeks preceding the relevant date; or

(b) The average of the weekly high and low of the closing prices of the Company’s equity shares quoted on the Stock Exchange(s) during the two (2) weeks preceding the relevant date.

http://corporates.bseindia.com/xml-data/corpfiling/AttachHis/8K_Miles_Software_Services_Ltd_061014.pdf

http://www.sebi.gov.in/cms/sebi_data/attachdocs/1409120871432.pdf

http://www.moneycontrol.com/news/business/warrant-size-is-rs-55cr-will-use-fund-for-buys-8k-miles_1258380.html

Thousands of Miles


This issuance came ahead of a 4x jump in stock price. Minority shareholders were worse off because the company preferred issuing warrants instead of common equity. The company does not have a usual practice of issuing warrants and the issuance in Dec-14 was one-off. We assign an additional AMBER FLAG for this reason.

Exhibit 29: List of shareholders to whom warrants were issued

Name of the allottee Category No of securities

Suresh Venkatachari Promoter 450,000

Ramani Rama Subramani Promoter 150,000

Sandeep Tandon - HUF Non-Promoter 400,000

Sarojini Tandon Non-Promoter 300,000

Karthik Ramakrishnan - HUF Non-Promoter 100,000

Total 1,400,000

Source: Company, BSE

During FY16, holders of 0.55mn (0.3mn during FY15) warrants have exercised their rights and converted their warrants to shares.

Exhibit 30: Conversion of warrants to shares

Date Name of the Allottee Category No of securities

8 Oct 2015 Ramani Rama Subramani Promoter 150,000

20 Apr 2015 Sandeep Tandon - HUF Non-Promoter 400,000

28 Jan, 30 Mar 2015 Sarojini Tandon Non-Promoter 300,000

Total 850,000

Source: Company, BSE

Thousands of Miles


Auditor checks Auditor’s Remuneration

Higher growth in auditor’s remuneration relative to company’s consolidated revenues remains a cause of concern for us.

Exhibit 31: Growth in company’s revenues vs auditor’s remuneration

CAGR in auditor's remuneration CAGR in consolidated revenues

FY12-FY16 FY12-FY16

Thousands of Miles 162% 90%


Exhibit 32: However, auditor’s remuneration as % of cons. revenues remained low



Source: Company

Auditor rotation

The company had last changed its auditor in FY12 to GHG Associates. The Board has recently passed a resolution that seeks to appoint GHG Associates as auditors of the company until FY21 (subject to ratification of their appointment at every AGM). We view this as a lack of intent towards rotating the auditors and raise a RED FLAG.

Insider trading As per Bloomberg, there were only two major transactions in Thousands of Miles’ shares and none of them involved insiders.

Exhibit 33: Insider trading grab from Bloomberg

Source: Bloomberg, Ambit Capital research

Pledging of shares by promoters From Mar-2012 to Mar-2014, the company had disclosed that its promoters had pledged 3.56mn of company’s shares (representing 33.1% of shares outstanding as of Sep-2015). However, from Jun-2014, the company disclosed that none of its promoters had pledged their shares. We see no signs of concern here.


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected] Pramod Gubbi, CFA Head of Equities (022) 30433124 [email protected]

Research Analysts

Name 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] Abhishek Ranganathan, CFA Retail (022) 30433085 [email protected] Anuj Bansal Mid-caps (022) 30433122 [email protected] Aditi Singh Economy / Strategy (022) 30433284 [email protected] Ashvin Shetty, CFA Automobile (022) 30433285 [email protected] Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected] Deepesh Agarwal, CFA Power Utilities / Capital Goods (022) 30433275 [email protected] Dhiraj Mistry, CFA Consumer (022) 30433264 [email protected] Gaurav Khandelwal, CFA Automobile (022) 30433132 [email protected] Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected] Karan Khanna, CFA Strategy (022) 30433251 [email protected] Mayank Porwal Retail (022) 30433214 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected] Paresh Dave, CFA Healthcare (022) 30433212 [email protected] Parita Ashar, CFA Metals & Mining / Aviation (022) 30433223 [email protected] Prashant Mittal, CFA Strategy / Derivatives (022) 30433218 [email protected] Rahil Shah Banking / Financial Services (022) 30433217 [email protected] Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected] Ravi Singh Banking / Financial Services (022) 30433181 [email protected] Ritesh Gupta, CFA Oil & Gas / Chemicals / Agri Inputs (022) 30433242 [email protected] Ritesh Vaidya, CFA 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] Sudheer Guntupalli Technology (022) 30433203 [email protected] Sumit Shekhar Economy / Strategy (022) 30433229 [email protected] Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected] Vivekanand Subbaraman, CFA Media (022) 30433261 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7886 2740 [email protected] Dharmen Shah India / Asia (022) 30433289 [email protected] Dipti Mehta India (022) 30433053 [email protected] Krishnan V India / Asia (022) 30433295 [email protected] Nityam Shah, CFA Europe (022) 30433259 [email protected] Parees Purohit, CFA UK (022) 30433169 [email protected] Punitraj Mehra, CFA India / Asia (022) 30433198 [email protected] Shaleen Silori India (022) 30433256 [email protected]

Singapore

Praveena Pattabiraman Singapore +65 6536 0481 [email protected] Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola – CEO Americas +1(646) 793 6001 [email protected] Hitakshi Mehra Americas +1(646) 793 6002 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected] Sharoz G Hussain Production (022) 30433183 [email protected] Jestin George Editor (022) 30433272 [email protected] Richard Mugutmal Editor (022) 30433273 [email protected] Nikhil Pillai Database (022) 30433265 [email protected]


Biocon Ltd (BIOS IN, NOT RATED)


8K Miles Software Services Ltd (KMSS IN, NOT RATED)


Omkar Speciality Chemicals Ltd (OSCL IN, NOT RATED)


Tata Chemicals Ltd (TTCH IN, NOT RATED)


0100200300400500600

Dec

-12

Feb-

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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BIOCON LTD

0200400600800

1,000

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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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8K Miles Software Services Ltd

050

100150200250300

Dec

-13

Feb-

14

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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

Feb-

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-15

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-15

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-15

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16

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-16

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16

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-16

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Omkar Speciality Chemicals Ltd

0100200300400500600700

Dec

-13

Feb-

14

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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

Feb-

15

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-15

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-15

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-15

Feb-

16

Apr

-16

Jun-

16

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-16

Oct

-16

Tata Chemicals Ltd


Linde India Ltd (LIIL IN, NOT RATED)


Tanla Solutions Ltd (TANS IN, NOT RATED)


UPL Ltd (UPLL IN, NOT RATED)


Sequent Scientific Ltd (SEQ IN, NOT RATED)


0

100

200

300

400

500

Dec

-13

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-14

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16

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Linde India Ltd

010203040506070

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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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16

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-16

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Tanla Solutions Ltd

0100200300400500600700800

Dec

-13

Feb-

14

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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

Feb-

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-15

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-15

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-15

Feb-

16

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-16

Jun-

16

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-16

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-16

UPL Ltd

050

100150200250300

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

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-15

Jun-

15

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-15

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-15

Dec

-15

Feb-

16

Apr

-16

Jun-

16

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-16

Oct

-16

Sequent Scientific Ltd


Unitech Ltd (UT IN, NOT RATED)


Arshiya Ltd (ARSL IN IN, NOT RATED)


Lanco Infratech Ltd (LANCI IN, NOT RATED)


Crompton Greaves Ltd (CRG IN, NOT RATED)


0

10

20

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-13

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Unitech Ltd

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Arshiya Ltd

02468

10121416

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-15

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-15

Feb-

16

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-16

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16

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-16

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-16

Lanco Infratech Ltd

020406080

100

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

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-14

Jan-

15

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16

Crompton Greaves Ltd


Glenmark Pharmaceuticals Ltd (GNP IN, NOT RATED)


Balkrishna Industries Ltd (BIL IN, SELL)


Wockhardt Ltd (WPL IN, NOT RATED)


Godrej Consumer Products Ltd (GCPL IN, SELL)


0200400600800

1,0001,2001,400

Dec

-13

Feb-

14

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-14

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Glenmark Pharmaceuticals Ltd

0200400600800

1,0001,2001,400

Nov

-13

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14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-

15

Sep-

15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Balkrishna Industries Ltd

0500

1,0001,5002,0002,500

Dec

-13

Feb-

14

Apr

-14

Jun-

14

Aug

-14

Oct

-14

Dec

-14

Feb-

15

Apr

-15

Jun-

15

Aug

-15

Oct

-15

Dec

-15

Feb-

16

Apr

-16

Jun-

16

Aug

-16

Oct

-16

Wockhardt Ltd

0

500

1,000

1,500

2,000

Nov

-13

Jan-

14

Mar

-14

May

-14

Jul-

14

Sep-

14

Nov

-14

Jan-

15

Mar

-15

May

-15

Jul-

15

Sep-

15

Nov

-15

Jan-

16

Mar

-16

May

-16

Jul-

16

Sep-

16

Godrej Consumer Products Ltd


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

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

POSITIVE We have a positive view on the sector and most of stocks under our coverage in the sector are BUYs

NEGATIVE We have a negative view on the sector and most of stocks under our coverage in the sector are SELLs

Disclaimer This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Ambit Capital. AMBIT Capital Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities is available on request.

Disclaimer

1. AMBIT Capital Private Limited (“AMBIT Capital”) and its affiliates are a full service, integrated investment banking, investment advisory and brokerage group. AMBIT Capital is a Stock Broker, Portfolio Manager and Depository Participant registered with Securities and Exchange Board of India Limited (SEBI) and is regulated by SEBI.

2. AMBIT Capital makes best endeavours to ensure that the research analyst(s) use current, reliable, comprehensive information and obtain such information from sources which the analyst(s) believesto be reliable. However, such information has not been independently verified by AMBIT Capital and/or the analyst(s) and no representation or warranty, express or implied, is made as to theaccuracy or completeness of any information obtained from third parties. The information, opinions, views expressed in this Research Report are those of the research analyst as at the date of thisResearch Report which are subject to change and do not represent to be an authority on the subject. AMBIT Capital may or may not subscribe to any and/ or all the views expressed herein.

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Additional Disclaimer for UK Persons

18. All of the recommendations and views about the securities and companies in this report accurately reflect the personal views of the research analyst named on the cover. No part of this researchanalyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst in this research report. This report may not bereproduced, redistributed or copied in whole or in part for any purpose.

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24. The information or opinions are provided as at the date of this report and are subject to change without notice. The information and opinions provided in this report take no account of the investors’ individual circumstances and should not be taken as specific advice on the merits of any investment decision. Investors should consider this report as only a single factor in making any investment decisions. Further information is available upon request. No member or employee of Ambit or ACUK accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of this report or its contents.


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Disclosures

29. The analyst (s) has/have not served as an officer, director or employee of the subject company. 30. There is no material disciplinary action that has been taken by any regulatory authority impacting equity research analysis activities.31. All market data included in this report are dated as at the previous stock market closing day from the date of this report.32. Take Solutions is in restricted list. Ambit and/or its associates have received compensation for investment banking/merchant banking/brokering services from Take Solutions Ltd and Omkar Speciality

Chemicals Ltd in the past 12 months.

Analyst Certification

Each of the analysts identified in this report certifies, with respect to the companies or securities that the individual analyses, that (1) the views expressed in this report reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly dependent on the specific recommendations or views expressed in this report.

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