HP, Autonomy, Unearned Revenues and Indian IT Industry

March 8, 2013 Leave a comment

Pretty complicated post title really, and I am not sure if anyone can make out anything from the title on what would follow 🙂

I have been recently reading on HP and Autonomy, described by some as amongst the worst corporate deals ever.  I happened to go through this post on Bronte Capital and John Hemton’s analysis of the deal.


In the accounting part, he seems to explain that software companies should have very little receivables and a lot of deferred revenues (also called unearned revenues). Unearned revenues basically represent the cash which the company has received upfront and the service is yet to be delivered. This is something like a float in Insurance Industry – you receive cash upfront, can play with it (invest rather) and provide services later. hmmm, signs of moat in the IT Industry.


After going through this article, I went through the financials of some of the IT companies in India, and to my surprise, hardly found any companies which have unearned revenues. On the contrary, Indian companies seem to have something completely opposite – unbilled revenues, which is revenue booked but no invoice yet raised. Now, there can be a trick used by any project based company (not just in the IT sector) to boost the revenues:


How to boost your revenues:

The trick is quite simple. Say, you are working on an ongoing project and expect to do some 50 cr of this project work in January 2014. Now if you have to boost your revenues in 2013, you may recognize this 50 cr today. And put an entry called “Unbilled Revenues” in balance sheet. Its very difficult for the auditors to detect whether any part of this project work was done in 2013 or not !

And once you raise the invoice for this work and the client certifies the invoice, this entry moves from unbilled revenues to receivables.

With this background, I believe that while looking at project based companies, once should pay close attention to unbilled revenues, apart from receivables. I have tried to analyze some data in the IT sector in India.


*All amounts are for 2102 and in INR Cr.

As can be seen, there is hardly much unearned revenue for Indian IT companies, nothing close to Autonomy’s unearned revenue.

Instead, there is a decent amount of unbilled revenue. A high amount of unbilled revenues can be a danger sign. I can think of only 2 reasons why unbilled revenues should be abnormally high for certain companies:

  1. Aggressive accounting policies, whereby companies try to boost their revenues by recognizing revenues from project work they are yet to accomplish.
  2. Payment terms are defined in such a way that companies raise invoices after some part of the work is already done.


The second reason has to be the case for the likes of Infosys and TCS. No one doubts their integrity.  But for some of the lesser known players, one can never know. So, beware. 


Categories: Company Analysis

ROE – Does it really matter!

September 21, 2012 2 comments

I have sometimes wondered why return of equity is not paid as much significance as it should be while investing. You will find people investing in all sorts of businesses no matter how much they earn on their equity. Even some of the well respected funds with intelligent teams of analysts invest in businesses not earning that high ROE. And the short answer for this behaviour is – it doesn’t matter what the business earns, what matters is what I earn on my investment!

Simple, but hasn’t some genius told that owners of a business can’t earn more than what the underlying business earns.

Let’s say I start a new venture and put in Rs 100 of my capital into the business – all equity. This business earns 20% return on equity and there is no debt. So, I get Rs 20 each year as profits. Assume also that the business doesn’t grow and all the profits are cash profits which are duly given back to me by the business. In such a case, my IRR on the investment over a long period would be 20% – same as return on equity.

Ok, that was a pretty basic example of the fact that an owner can’t earn more than what the underlying business earns. But, hey, what if there is a creature called Mr. Market. Then, I as an owner can earn more than what the underlying business earns if someone pays me a high price for the business.

Let’s say I am able to sell this same business for Rs 150 in year 5. Then my return on this investment becomes a whopping 38%. Getting 38% by investing in a business earning 20% is a pretty big deal really. But then, I need a buyer who is willing to pay me that Rs 150 for this business. And in a manic depressive Mr. Market, I can sometimes find such a buyer.

What this new buyer will earn on his investment for next, say 30 to 40 years – a lousy 13%!


Now I can draw 2 main conclusions from this story – one positive, other negative:

Positive side of the story:

Now, you might wonder why someone paid Rs 150 to acquire this business in year 5. Because in year 5, most likely the business would be a stable business, a proven business model and there is high degree of certainty about the future cash flows. So, a more conservative investor might just be happy to come in year 5 and earn a certain 13% returns on his investment. On the valuation side, if the cash flows are more certain, the discount rate would be lower thus justifying the high value of Rs 150.

This in essence is a basic model behind venture capital funds. They invest in businesses in early stage, take on the initial risk when future cash flows are uncertain, and then sell at a high price because someone is willing to pay a higher price for a stable business. In effect, this ensures that the VC fund gets a better return and the new investor earns a mediocre return. And both are perfectly happy doing this trade as both have different risk appetite. Over the long term, both players combined together will earn what the underlying business earns.

After all there is some truth to the principle that – High risk implies high returns – no matter how much some value investors disagree with the same.

Negative side of story:

Now I come to the sad part. A lot of Investors play on the valuation front. They are worried about the entry price and the exit price and subsequent IRR. This tends them to pay little heed to what the underlying business earns. There are fancy excel models implying higher and higher returns but in reality, the returns fall way short of expectations.

 This attitude according to me is a key factor why lot of funds don’t earn what they expect to earn. I know I should not be generalizing this as the main reason for failure, but atleast in my brief experience in Investing, this has been a major factor for poor performance. There is too much emphasis on playing the valuation game, I enter at this price and I exit at that price (in between there is some EPS expansion and PE rerating taking place). But people don’t pay due respect to what the business earns on its capital.

 When you bring in the price factor and combine it with a potent tool called “Excel” – well that’s one deadly combo and range of possibilities and scenarios is only a figment of man’s imagination!




Trying to benefit from news and events: Short analysis on Whirlpool

July 7, 2012 Leave a comment

What better way to understand the wonderful money making mechanisms driven by events and news than to demonstrate it through superior analytical skills and a practical example 🙂


ET reported on 4th July – “Shares of major air conditioner manufacturers rally after weaker-than-expected rain falls so far during the monsoon season spark hopes of increased sales.”


Now, let me try to work out how much this event would benefit the investors by taking the example of Whirlpool of India.

Some analysis on Whirlpool

As per my analysis, this shortfall in rains is a onetime phenomenon and that bump in sales won’t last year after year (unless we are predicting bad rains perpetually). Now if my analysis is correct (that’s a big if) and its only a onetime event, then only sales and profits for this year would be affected. Let’s say previously markets were factoring in profits of 148 cr for FY 2013. And with this news, let’s assume the forecast is revised up by 10%, to 163 cr. That’s a pretty generous increase considering ACs only constitute ~ 13% of sales of whirlpool.

  • So, delta change in PAT for FY 2013 = 15 cr (for simplicity, let’s assume this to be the delta change in cash flows available to equity holders as well).
  • Whirlpool’s cost of equity = 17% (another assumption using the famous beta !)
  • Delta change in Equity Value = 12.8 cr (Discounting 15 cr by 17%)
  • Delta change in per share Value = Rs 1.01
  • Previous share price = Rs 200
  • Implied new share price = Rs ~201

Well, as per my calculations, if there is an upward revision of 10% in this year’s sales estimates, that should result in a whopping share price increase of 0.5%.

Let’s see how far I am correct on this:

Whirlpool of India stock price went up from Rs 200 to Rs 220 on the day of the news (4th July 2012) – that’s a gain of ~10%, which is way off the target 0.5% I had calculated 😦 😦

Damn, I have to figure out a better way to figure out how these news traders operate.

Categories: Random

Understanding risk in dynamic business environment

June 18, 2012 Leave a comment

For most of the companies and businesses, some improved product or service has to be launched at some point of time in order to survive. The improvement can be in terms of better technology or better design or better quality or more user friendly version, etc, etc.  You can’t just keep on providing the same goods or services forever and hope to do well and prosper. Change is the only constant.

What determines the riskiness in such a scenario is how quickly you have to change. There might be industries in which you have to come up with new innovations rapidly, every year or so. And then there might be Industries where a new breathtaking innovation can wait for 10 or 20 years and still business won’t be impacted that much.

Consider a field such as smart phones and gadgets; let’s assume a hypothetical scenario that for a company like Nokia, it has to come up with a new model/ product/ version every year; this is the only way the company can survive else it fails (the scenario isn’t that hypothetical actually and there might be some truth to it !)

  • Let’s say the probability that Nokia can successfully release the new product each year: P(S) = 95%
  • Thus, probability of failure: P(F) = 5%

Now, the probability that Nokia will fail in the next 5, 10 or 20 years is:

  • P(Failure in next 5 years) = 22.6%
  • P(Failure in next 10 years) = 40.1%
  • P(Failure in next 20 years) = 64.2%


The same rules apply to Apple and other high tech companies which have to innovate rapidly. And maybe that’s why long term value investors (is there a short term value investor?) are advised to stay away from technologically advanced fields. Even a small probability of failure in one year can translate to a big chance that the firm would go down in the next 10 or 20 years.

Making sense of cost of equity

June 14, 2012 Leave a comment

Any business would have requirement for capital which might come in the form of debt or equity. While cost of debt is easily understood, most of us have trouble exactly defining and measuring the cost of equity. Although there are fancy theoretical frameworks like CAPM model which define cost of equity as risk free rate plus beta times market risk premium, such formulae hardly make any common sense. Why don’t we consider and define cost of equity in same terms as we define cost of debt!


Consider a hypothetical case of a company having 100 cr of equity and no debt currently. Further assume that this company requires another 100 cr of capital to expand. There are 2 options which we can consider for this new capital:

1. Debt: Let’s say the company takes the entire expansion through a debt of 100 cr, which is given at an interest rate of 10% per annum. Hence, the company has to shell out 10 cr next year in debt charges and 10% would be its cost of debt. This seems quite simple, but I wonder why the same principle is not employed while evaluating the cost of equity.

2. Equity:  Let’s say the company takes the entire expansion through new equity infusion of 100 cr. For this equity infusion, let’s assume the new investor gets 30% stake in the company. Hence the original promoter’s stake gets reduced to 70%. Now when this company generates profits, part of it (70%) will go to the promoter and part of it (30%) will go to the new investor. The amount which goes to the new investor represents the actual cost of equity to the promoters. This is the amount they will have to pay to the new investor for its investment of 100 cr in the company.


Calculating the cost of equity:

Having explained this simple construct, the cost of equity isn’t that difficult to measure. Let’s say the company earns 20% on its equity and would continue to earn the same returns even after new capital infusion and expansion. Now, the total equity of the company is 200 cr (100 original + 100 by the new investor) and with 20% return, the profits would be 40 cr. 30% of it will go to the new investor, that is, 12 cr.

Hence, cost of equity = 12/100 = 12%


It seems like such a simple exercise but I don’t think anyone considers computing cost of equity this way. Most often than not, the text book definition of risk free rate plus beta times market risk premium would be used to compute the cost of equity. And this CAPM formula may or may not have any relevance to the actual cost that the promoters would have to pay for new equity funding.


Why cost of equity is not calcualted this way:

There is a big flaw in here. One is the assumption built in here about the future ROE for the company(which is a bit of guesswork). And cost of equity is heavily dependent on the ROE.

But the major drawback is that cost of equity is also dependent upon the % stake which the new investor gets in the company. And to calculate this % stake, we first need to know the valuation of the company, which is further dependent on the cost of equity (if we are using DCF method to calculate valuation). Hence, the argument becomes circular.

Some thoughts on rating agencies – CRISIL and ICRA

June 7, 2012 Leave a comment

CRISIL is amongst the most popular companies these days – it has a track record of wonderful performance and superior returns (ROE in excess of 40% over the last 3 years). But the story is well discovered and there are plenty of funds already invested in CRISIL. Rakesh Jhunjhulwala holds 7.85% stake in CRISIL and that’s a big enough endorsement of the capabilities of the company. Combine all this together and we have CRISIL today trading at a crazy valuation of ~ 37 P/E.

Since CRISIL is way too expensive, I thought may be I can settle for the other not so profitable companies in rating domain, and so happened to look at ICRA’s financials. Just some basic numbers below and it seems like a decent business, but nowhere close to matching CRISIL.


ICRA’s financials (INR Cr)







Total Income





















Net Worth














Capital Turnover







ICRA’s ROE is roughly half of what CRISIL earns on its equity. Even though both ICRA and CRISIL have same profit margins, capital turnover for CRISIL is almost twice that of ICRA; and that’s why ROE for CRISIL is also almost twice that of ICRA.  Both are 0 debt companies and generate huge amounts of free cash flows.

But if I delve into the balance sheet of ICRA, some very interesting aspects emerge regarding its profitability.


As on March 2012, ICRA had cash and investments of 277 cr on its books. This represents 91.8% of the total net worth of ICRA. As such, the net operating assets of ICRA are only 25 cr! And on this asset base, ICRA is generating huge amounts of profits. Crazy and insane, how can a company be so profitable? Have a look at operating profitability of the company over the years:

 (INR Cr)







Operating Assets







Operating Income




























Operating Assets Turnover







Return on Operating Assets







*NOPBT – Net operating profit before tax

*NOPAT – Net operating profit after tax = NOPBT * (1-Tax Rate)


As we can see, the company is able to generate more and more revenues while hardly deploying any assets in the business. The margins have remained steady over the years, though there is a slight decline over the last 3 years. But the margins are bound to decline, when the company is so profitable, others ought to notice and competition should come in. And that’s where the catch is, the Industry is highly regulated with few players competing and each of them earning very good returns.



Operating profitability of ICRA looks out of this world. Compare this to CRISIL; ICRA earns far more returns on its operating assets than CRISIL. CRISIL earned only 98% on its operating assets in 2011. Well, 98% is not small, but compared to ICRA, its far far behind.

And why is it so? Annual reports of these companies give details on revenues and profits per employee. See some data below:



Revenue per employee



Expenses per employee



Profits per employee



* Values in INR lakhs from the latest available annual report

ICRA pays more per employee and charges more to clients and generates much more profits per employee than CRISIL. That’s because CRISIL offers advisory and research services as well, besides rating services. And CRISIL may not be able to charge very high amounts for these other services (Rating is a regulated business and hence there is significant pricing power enjoyed by few players in this domain). Whereas in ICRA’s case, 90% of the profits are from rating services.


And despite all these high returns enjoyed by ICRA, it trades at (only) 22 P/E while CRISIL trades at 37 P/E !



Does that mean that one should buy ICRA at these levels; well I won’t suggest that because its still pretty expensive and besides, there are a few concerns:

1. ICRA is a cash machine, no doubt about it. The company hardly needs to invest anything in the business to grow and it will always keep on generating huge amounts of cash. But what it will do with so much cash. Already its balance sheet is filled with cash and investments; and there hardly are any related avenues for ICRA to invest in. I am not sure even if the management has a clue on what to do with all this cash.

One thing they can do is acquire some businesses and do some transactions here and there. And that’s what ICRA seems to have done actually. ICRA arm picks up majority stake in US tech firm

Talk about synergies 🙂

CRISIL seems to have managed diversification much better whereas ICRA looks more on the diworsification side.

2. ICRA senior management doesn’t seem to be too excited about its prospects. There has been heavy selling by some of the top brass in the company. See the announcement page on BSE and it’s full of disclosures regarding insiders buying and selling, though it’s all selling and no buying. This year alone, the senior management has sold ~ 26,000 shares of ICRA in the open market – representing 0.26% of the company.

Ofcourse, the senior management can be bullish on the company but perceives that the stock is highly over valued and maybe that’s why they are selling. The senior management did get some stock options in Nov 2011, exercised at Rs 330 per share and they could also be selling because there is a huge instant profit to be made.

There could be many reasons for insiders selling and so shouldn’t be taken as a signal, but still this insider selling doesn’t instill confidence.


 Some concluding thoughts on Rating Companies:

  • Ratings have been made mandatory in India for most of the debt instruments since 1992. In 2003, SEBI made ratings mandatory for debt instruments placed under private placement basis. A host of other regulations have meant that there has been a huge surge in demand for rating services.
  • Increasing demand and limited competition means that rating agencies can earn abnormal returns on their capital. There are only 6 players providing rating services in India – CRISIL, ICRA, CARE, Fitch, Brickworks and SMERA.
  • In my view, if the ratings business is regulated, then the returns these companies earn should also be regulated. Its just crazy to allow companies like CRISIL and ICRA to earn such excessive returns on their capital.
  • Anyways, the Industry is becoming more competitive and there is a proposal that Banks may be given approvals for starting their internal rating divisions. RBI has pursuant to a circular dated July 7, 2009 advised banks that they may apply for migration to an “internal rating based” approach for measuring credit risk.
  • This can bring in some sanity in the market and may not be such good news for existing players. And that’s another big factor why CRISIL’s more diversified model is valued so highly.
Categories: Company Analysis

Evaluating performance while Investing

June 4, 2012 Leave a comment

Many of us have seen various performance indicators used by funds. Consider a mutual fund investing only in equities; the fund would most likely determine its performance with respect to an equity index. A sector agnostic fund might consider Nifty as a benchmark and if its returns exceed the returns in Nifty over a period, this implies fantastic results. Basically, the fund would have generated an alpha, which every fund manager desires to seek.

Similarly, a mid cap focused fund would benchmark its results against a mid cap index. A sector focused fund would benchmark its returns against the sector index.

While all this seems to be the norm, I am not too convinced with the approach.

Consider some scenarios below:

1. If I had started to invest in stocks, say at the start of 2008 and I have managed to achieve annual returns of minus (1) % over a 4 year period. During the same period (from Jan 2008 to Jan 2012), the Nifty has given annual returns of minus (3.4) %. Now should I be happy that I have beaten the index by 2.4% – that’s my alpha BTW 😉

No, I won’t be happy as I could have just kept the cash as it is and it would still have given me returns of 0%, better than I achieved by putting all the efforts and time in investing in stocks.

2. Now if only I had started a year earlier, say at the start of 2007 and I have managed to achieve annual returns of 7% over a 5 year period. During the same period (from Jan 2007 to Jan 2012), the Nifty has given annual returns of 5.4%. Now should I be happy that I have beaten the index by 1.6%.

Again my answer would be no, as I could have fared better if I had invested in Central Government Securities (and what could be safer than that). The yields back in 2007 on securities maturing in 2012 were better than 7% I had managed by investing in stocks (Link)


So how should I approach evaluating my performance?

Why should I benchmark only against the broader Index or mid cap Index or small cap index or some sector index when I have a choice to invest in so many different instruments. I have considered 2 criteria below and would like to satisfy both these 2 criteria to consider myself successful:

1. If I am investing my money in stocks, what matters to me is that I should basically do better than the safest possible option. The safest option could be investing in fixed deposits or investing in central Government securities. In current markets, that would mean achieving more than ~ 10% annually over a time period; let’s say 5 years or 10 years. That should be the minimum aim. If Nifty drops by 10% during this period and my portfolio shrinks by only 5%, I should still be terribly disappointed.


2. The ultimate goal of investing is to have more purchasing power than currently. As mentioned by Warren Buffet in his last annual letter – investing is defined as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date. Now if I achieve above 10% returns over the next 5 years, then I would have taken care of inflation and purchasing power as well (assuming inflation stays below 10%, which is a reasonable expectation).


In case the Nifty gives an annual return of 30% over the next 5 years (I think I am highly optimistic here) and I achieve only 20%, should I then be disappointed. I would still be happy as I have fared better than the safest option and would have earned more purchasing power than I had in 2012.