Electrosteel Steels: An observation on the disparity in company’s actual value (~Rs. 10) and market price (~Rs 50)

I came across Electrosteel through an article which pointed out disparity in share price of this company on two Indian exchanges – Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). While the company was trading at 52 on BSE, it was 10 on NSE. It surely looked like a great arbitrage opportunity to buy on NSE and sell on BSE. Only a handful of people would have been able to make use of this opportunity due to very low trading volume on NSE.

Case was basically about a bankruptcy situation for Electrosteel. Trading was suspended on the stock and it resumed after Vedanta bought stake in the company and paid off some debtors. Now that company was seemingly out of the woods, seemed like the stock would reach the highs it was trading at a year ago.

ElectroSteel Steels, value investing, distressed equity

I tried to work out the asset value of this company’s equity based on the notes they published along with 1st quarter P&L statement. Following observations:

  • The company didn’t recreate the balance sheet for Jun 30, 2018 while there was lot going on with the liabilities.
    • Vedanta paid off a chunk of debt and bought out 90% equity stake in the company.
    • A lot of equity transformation was done as part of Vedanta’s deal to buy out the company as will be shown in this article soon.

Back of the envelope calculations suggest that the share price should be around Rs 10 per share. Vedanta paid Rs 53bn to company’s creditors. Of this amount, Vedanta got 90% stake in the company for Rs. 17.6bn worth face value of equity. Which means that approximate equity value of the company will be Rs 19.6bn. Divide this number by the total outstanding shares (1.96bn outstanding shares), it comes to Rs 10. Getting to the 1.96bn outstanding shares is the interesting bit.

Transformation in equity can be seen in the table below.

Electrosteel Steels, Value investing, distressed equity

Here Step 2 and Step 3 are most important steps as these show the reduction in face value and number of shares for existing shareholders. What the table above effectively shows is that if you held 100shs in the company before this equity transformation, you would be left with only 2 shares after the process. And Vedanta owns 18 shares for every 2 shares you hold now.

This can be a perfect example for investors to stay away from over leveraged companies in a cyclical industry. Electrosteel Steels could not repay its debt, hence had to be bought out by Vedanta, in turn creating massive value destruction for existing shareholders.

Greenblatt applied to India stocks, July 2018

Just applied Greenblatt criteria to India listed stocks above USD 50mm of market cap, here are the top 50 ranked by the Return on Invested Capital rank, which is a combination of:

  • Earnings yield: EBIT/ Market cap + Book value of debt
  • Return on capital: EBIT/ Working capital + Net fixed assets

Please do your due diligence before selecting the companies you invest in. This list is only the starting point. All the best!

Greenblatt, value investing, top 50, investingclass
(List of Indian stocks in no particular order)

Chapter 13 – Current ratio

Now I will introduce a concept to gauge the liquidity of a business. It deals with the company’s ability to pay its creditors on time. Typically we want to see a company with Current assets greater than Current liabilities. This ensures that it can pay off all its short term obligations, else the creditors may impose liquidation of the business to get their dues back, which is not a very rosy scenario.

To check this, a common ratio that is used is called CURRENT RATIO calculated as below:

Current assets/Current liabilities

As you would have rightly guessed by now, a current ratio greater than 1 shows a decent liquidity position. If this ratio is greater than 2, it provides an even better safety buffer from liquidation perspective.

It is important though to view this ratio with respect to the industry or company’s business as well. Sometimes a company has a strong bargaining position over its suppliers and uses the credit from suppliers to finance its own operations. In that case the company can run a current ratio under 1.

Let’s take the example of Proctor & Gamble, the famous FMCG company. Looking at their current assets and current liabilities as of June 2017, we can see that the company is effectively financing its inventory and receivables using the credit from its suppliers:

Current Assets, Current Liabilities, Current Ratio, Financial Analysis, investing-class.com, P&G, Proctor and Gamble

(All numbers in USD mm)

Chapter 14: Long term debt and other liabilities

Chapter 12: Current liabilities

Chapter 12 – Current liabilities

As discussed in the Balance Sheet basics, liabilities refer to the obligations of a business. Current liabilities are the obligations due within one year timeframe. Major items under current liabilities are as follows:

  • Payables: This is when a business buys some goods or services on credit. Let’s say our hot dog business owner buys the ingredients from a grocery store with a promise to bill to pay within 30 days. In this case, hot dog owner will record this transaction as a Payable on the company’s balance sheet while the grocery store will record it in Accounts receivables.
  • Accrued expenses: These are the expenses incurred by the business but not yet paid out. Typically staff salaries, marketing expenses, which are billed, say monthly/quarterly etc. come under this category.
  • Short term debt/loan: This is the loan taken by the company to meet its short term cash requirements, i.e. to buy the inventory for production of goods. As the inventory is sold, the company pays back the loan and repeats the cycle. Other uses of this cash could be payment of bills or anything which is required to keep the business running.
  • Long term debt due in 12 months: As the name suggests, the company borrowed money for a tenor greater than 1 year at some point in past, but as of the reporting date the company has to pay it back within 12 months.

For the short term debt, I would also check whether it is used to finance long term assets. If it is doing so, that is red flag as it can potentially pose problems when the liquidity dries up in the market, in other words, when the banks stop lending due to worsening business conditions or other factors. It can also negatively impact the P&L if the interest rates are going up – more the interest rates for rolling over the debt, lesser is the profit left for the business owners.

Other current liabilities, if any, would ideally not be significant enough to worry about.

Chapter 13: Current ratio

Chapter 11: Non-current assets

Chapter 10 – Current assets

In any balance sheet, Assets are mostly shown in the order of their liquidity i.e. the time it takes to convert the asset into cash.

Current assets indicate the assets which can be liquidated within a year. These typically contain cash, cash equivalents (liquid securities like government bonds), receivables, inventory, and other miscellaneous items that can be converted to cash within one year.

  • Cash: Without any doubt, this is the most liquid item on the balance sheet.
  • Cash equivalents: These are investments in liquid securities such as government bonds or treasury bills.

To understand the receivables and inventory, we should spend some time on the cash cycle for a business. For simplicity, putting it in a picture below:

Financial analysis, Current assets, Cash conversion, value investing, accounting frauds

A business starts with cash, uses the cash to produce goods (captured as inventory on balance sheet), then sells these goods to the customer, for which the customer pays cash. When the customer does not pay cash instantly, it can be said that the company sold goods on an agreement to receive cash later. These payments are captured as receivables on a balance sheet.

An investor should always keep an eye on the inventory and receivables. There have been instances in the past where the companies reported these numbers higher than they were. Typical ways to inflate/misreport these numbers are:

  • Company might assign a high value to the inventory. So say the hot dog business owner has 1,000 readymade hot dogs in refrigerator on the reporting day. While valuing his inventory, he assigns a value of $20 to each hot dog which takes his inventory value to $20,000. If he is able to sell the hot dogs for only $15 per piece, that is clear misrepresentation of inventory.
  • Other times, we should be careful of increasing value of inventory if the firm is just ramping up production whilst the corresponding demand is not increasing. So, an investor is advised to compare if the increase in inventory is actually corresponding to increasing revenues.
  • Most of the businesses can not expect to get cash payment upfront, it is reasonable to expect receivables on the balance sheet. But we should keep an eye on the receivables as a proportion of revenues. If this number changes materially, it could mean that customers are consuming the product but aren’t paying for it. Sounds very fishy, no?

To keep the above factors in mind, it is advised to check the following ratio over the years:

(Inventory + Receivables)/ Revenues

If this ratio changes materially in any given year, it is a red flag and should be investigated more.

Chapter 11 – Non-current assets

Chapter 9 – Balance Sheet basics

Chapter 7 – Other items

Gain/loss on sale of assets: There are times when a company decides to sell its assets which could be investments in securities or land or a part of business to a competitor who is willing to pay a good price. Since these do not form a part of major operating activities of most businesses (except financial institutions and real estate companies), these should be excluded from ascertaining the earnings power of the business.

It is worth mentioning that some companies might window-dress their income statements by not putting the Gain on sale of assets separately from the operating income section. Value investors would be careful not to get fooled by such practices.

Other items: Other sources of income other than the ones mentioned above are not directly contributing to the earning power of the business, so should be excluded.

Investors should be very careful if these items form a major part of profits, year after year.

Chapter 8: Income before tax, Tax expense and Net Profit

Chapter 6 – Interest Expense


Chapter 6 – Interest Expense

Many owners borrow money to setup the business. Sometimes it is due to the lack of capital with the owner. Other times, the owners have the capital to start but they believe in the higher potential for the business, so they borrow additional money to increase the returns (I will cover this more while introducing the concept of Leverage in Balance Sheet section).

For our hot dog business example, let’s say that the hot dog business owner did not have much capital to start his business, i.e. enough money buy the stalls, rent a shop, buy the ingredients for hot dogs, etc. So he goes to either a bank or friends for a loan and promises them to return the money in certain period of time with an interest. Borrowing money mostly creates two obligations for the business:

  • Paying a timely interest until maturity of the loan, although some loans can also be agreed with payment on the end date of the loan
  • Paying back the principal borrowed in the first place

When evaluating the earning power of the business, it is advised that the investor looks at the interest expense in relation to the operating profit. If the operating profit is not able to fulfil the interest obligations, it is not really a business one should invest in.

To see how the company has performed in relation to its interest obligations, we should look at the Interest Coverage Ratio that is defined as below:

Interest Coverage Ratio = Operating Income/ Interest Expense

Higher the ratio over the years, the better it is from investing perspective.

We will talk more about Debt (money borrowed) in Balance Sheet segment to see if too much debt is an issue for the company.

Chapter 7 – Other items

Chapter 5 – Operating Profit/Operating Margin


Chapter 5 – Operating Profit/Operating Margin

Operating profit is simply defined as below:

Operating profit = Gross Profit – Operating Expense

Since the absolute numbers can seem pretty, they make more sense when seen in relation to total revenues. Value of a company can be judged by checking the proportion of Revenues left after paying for Cost of Goods Sold and Operating Expenses, expressed as Operating Margin (%):

Operating margin (%) = Operating profit/ Revenue

Operating margin provides the earnings power of a company. It gives an indication of the cushion that the company has after paying for its bills. Needless to say, higher this cushion, better are the chances that the company can survive tough times better than the companies with thinner operating margin.

If the operating margin is improving or has been consistent over the years, I would be more comfortable in investing in such a company.

Chapter 6 – Interest Expense

Chapter 4 – Operating expenses (SG&A; R&D; Depreciation)


Chapter 3: Revenues, Cost of Goods Sold and Gross Margins

Revenues – this is value of total sales done by the company during the period under consideration. For a value investor, one must understand the real business – what is the company actually selling? Based on this, one can make some simple assumptions about the future prospects of the business.

Revenues can be simply put as:

Number of units sold * Price per unit

So effectively, the number of units sold or price per unit or both factors can be the growth drivers for a company’s revenues. A new hot dog stall will probably have to sell more hot dogs as there is not much scope to depend on the price per hot dog. When a company reaches a stage where the number of items sold starts to stagnate, it needs to be seen if the company can increase the price per unit. If the answer is yes, then the company has a recognized product for which people are willing to pay more. If the price of Coke increases from $1 to $1.1 per can, would you still buy it? Of course!

Cost of Goods Sold – This shows the cost of making the product being sold. So for a hot dog business, it would involve cost of getting the meat trimmings, fat, salt, pepper, sauce etc.

Gross Profit – It is the difference between Revenues and Cost of Goods Sold. It shows how much value is added to the product. A particular ratio which is very insightful for a value investor is Gross Margin, defined as below:

Gross Margin (%) = Gross Profit/ Revenues

If we have a trend of Gross Margin for a company, several things can be inferred from it:

  • Competitive position of the company: If the company has been able to maintain it’s margins in the trend, chances are that the customers value the products/services. Ideally we want to select companies that have upward trending or stable margins. Anything above 40%-45% indicates that the company may have a strong position in the market.
  • Nature of the business: For example, a company making a product vs a company which only sells someone else’s product. A company only selling someone else’s product is not adding a lot of value to the process, so most likely it’s margins will be low. This will be more clear with the example I am going to show below.
Gross margin, Value investing, Financial Analysis, GILD, MCK
Gross Margin Comparison for GILD and MCK

Here we are comparing the Gross Margins of Gilead Sciences (GILD) and McKesson Corp (MCK). Observations from the comparison above:

  • GILD has margins in the range of 75% – 85% for the last 10 years
  • MCK has very tiny Gross margins in the range of 5%-6%

Gilead (GILD) is a specialty pharmaceutical company with products targeting diseases like HIV, liver diseases, Hepatitis C etc. Clearly the company is adding a lot of value and hence has been able to mark up the price with healthy margins.

McKesson (MCK), on the other hand, is one of the largest medical distributor companies in the US. But it is the nature of its business that doesn’t allow higher margins. So to earn more, MCK depends on more sales i.e. number of units sold.

Hope this has made it a bit clear as to why understanding of the business is so important before investing.

Chapter 4: Operating expenses (SG&A; R&D; Depreciation)

Chapter 2: Income Statement basics

Chapter 2 – Income Statement basics

There are two main things that I will focus on in this section:

  • Main items in an Income Statement
  • Caution against drawing conclusions purely from Income Statement

I’ll touch upon the cautionary stance first. We should always see the Earnings along with the sources available to the firm, and that can be seen in the Balance sheet. A firm can be earning $100, but we need to understand what amount of assets is dedicated to generate that income. A firm using $100 to generate $100 is more preferable to a firm using $10,000 to generate the same income. This measure is called the Return on Invested Capital (ROIC). What consists of Invested Capital will be covered when we touch upon the Balance Sheet.

What does the income statement consist of?

A typical income statement will cover the following headings:

REVENUES Total value of sales during the period in consideration
COST OF GOODS SOLD Total cost of making the goods, raw material, processing etc
SELLING, GENERAL & ADMIN Mostly consist of marketing costs and operational costs in general
R&D Research and development for improving products
DEPRECIATION Entry used to capture the expense of acquiring an asset in the past
INTEREST EXPENSE Interest on borrowed capital
GAIN/(LOSS) ON SALE OF ASSETS Profit/loss on sale of existing asset/business line/patents etc
OTHERS Any other non-operating income

In a nutshell, we need to understand what the company is selling, what are costs of making the product, what are the operating expenses to keep the business running and what are the interest expenses on the money borrowed by company. Taxes are pretty much standard for most of the companies, but some tax subsidies might be applicable for industries that the government wants to promote going forward. Keeping these factors in mind, we will be in a better position to evaluate the underlying business.

In the chapters ahead, I will discuss how to read into these numbers.

Enjoy reading!

Chapter 3: Revenues Cost of Goods Sold and Gross Margins

Chapter 1: Types of Financial Statements