The idea for this post started with a Tweet which claims Laurus Labs’ cash levels are too low for comfort. How can Laurus have just 2-4 Crs of cash at the end of each financial year, despite a healthy TTM topline of 3682 Crs?
|Laurus Labs||Mar 2014||Mar 2015||Mar 2016||Mar 2017||Mar 2018||Mar 2019||Mar 2020||Sep 2020|
I think there was room for more deep diving. This analyst from Twitter had more room for giving more weight to other data points that disconfirmed his notion about low cash levels. I have tried to cover those data points below.
Let’s start with the assumption that the guy’s hunch is true. If a business is running low on cash, what are the things you’d typically see?
- The co’s suppliers would be squeezed for credit, leading to lower operating margins, because suppliers would charge the co. more, for raw materials supplied. In turn, the co’s margins would shrink due to an inability to pass on the increased cost unless they have huge pricing power, which is scarce in the Pharma industry. But surprise, surprise. Instead of margins declining, the co’s margins expanded.
- Given the co’s high sales growth, inventories would have reduced, due to an inability to fund incremental raw material demand. Did inventories decrease? No.
- Assuming the management was cooking it’s books in order to inflate it’s stock price, what would you see? They would try to maximize profits now, and try to push the expenses to a later date. But here the co. is doing just the opposite. It is taking a hit on current year’s P&L and expensing 100 Crs of R&D before hand. This tells you the accounting practices are not too aggressive. Whereas a stock price focused promoter would do all the things in the world to inflate his profits. This promoter didn’t.
- Did the co. inflate it’s capex? Did auditors miss to check something important? No, lease agreements were verified by Deloitte. This is in addition to other basic checks and balances on the auditor’s side.
- Sales would not have grown at this pace, without an increase in debt. It would have still grown, but not at the scorching pace it has. That the co. grew it’s sales at a rapid pace without taking debt in the same proportion tells us something. No?
- One of the things about most of the crooked managers is they take on a lot of debt. If you are a crooked manager, why would you have an all equity capital structure? Wouldn’t you want to maximize funding the business from others money than your very own? You would want gullible banks to lend you all the money they can and put up very little of your own money into the co. If I was a crooked promoter, why would I screw just shareholders and NOT cheat banks too? Higher debt would lead to an increase in debt to equity. In my view, debt free co’s are more likely to be honest than not. If debt to equity is decreasing, it is possibly a step in that very direction. That being said, being just debt free does not guarantee a totally honest promoter. There are no guarantees in equity investing.
- If we were to look at past patterns of fraudulent companies, one thing that stands out usually is CFO stays low in comparison to PAT. Again, this co. clears that hurdle without doubt.
- Auditors would have flagged concerns about cash. After all, bank balances at the end of the year, are one of the easiest things to check, even for an untrained eye. And here we are talking about Deloitte, one of the reputed “big four” and not some mysterious unknown auditor.
- Without cash balances there would be bounced cheques in the company’s current account. Any evidence of that? No.
- There are smaller things like employees not getting paid on time, not getting increments, etc. I can’t get into those because I can’t find evidence on either side. And, absence of evidence does not necessarily mean evidence of absence. We’ll just have to wait for more evidence to come by.
All of the above points prove low cash levels are not a valid data point to look at, unless additional red flags show up in the future, that confirm the opposite view.
What could the plausible reasons for low cash in bank possibly be?
Imagine you own the only store selling daily necessities in a small town. Every year, your next door auditor sees more and more customers in your store. He decides to investigate if you are doing some hanky panky. He sees there is no cash in the cash box at the end of every year. There is no cash because you have paid salaries to your employees, paid back your suppliers / distributors for stuff you bought from them, paid the tax man, bought more merchandise so you can sell more next year, perhaps added another floor on top to accommodate all that extra merchandise, besides paying dividends to your partners.
Now, you have this next door banker friend who offers, hey Laurus, you can use my credit card (Cash Credit facility in Laurus’ case) whenever you are falling short of funds to repay any of your stakeholders. Laurus happily obliges, because his sales is growing at 26% whereas his return on equity is only about 15%. So he has to fund the scorching growth somehow.
The overdraft facility has been validated by the rating agency. I found this, thanks to a superb post on Valuepickr by somebody who worked in credit on banking side and has a better handle on this aspect. Here’s what he says.
Another thing to note is that this Valuepickr member is not invested and hence his opinion is more likely to be unbiased than not.
Instead of looking at one data point, one should look at the holistic picture because vested interests (perhaps) will torture numbers and get those numbers to confess anything. Why did the guy choose cash on the balance sheet instead of something like CFO to PAT or debt to equity, which is a much better indicator than actual cash itself? Because low cash was perhaps the only data point that confirmed his notion.
For those of you who already understand how Cash Credit facilities work, you may choose to skip the below video. In simple terms cash credit is a revolving credit facility given to companies by putting up inventories, receivables or assets as collateral. Co’s can use this to meet their working capital requirements whenever they are falling short of cash. Why is there no cash? Because all of it is being invested, back into the business.
With working capital loans, it doesn’t make sense to keep funds in your bank ac. Who in his right mind would keep cash in his bank ac and not pay back his lender asap, given the huge difference in interest rates between a loan and a bank ac?
In the quest to find red flags, sometimes we forget to see the green flags, thereby missing the forest for the trees. We also need to get on the other side of the fence sometimes and back up managements of companies that are executing well, and try to put in a good word and keep them motivated. A promoter who could have been relaxing in his farm house, chose not to do so and took most of his life’s savings and put them into his firm. He took risks and pursued growth. I don’t see why he would put so much at stake if he simply wanted to cook books. We should appreciate the fact that doing business in India is challenging indeed and despite all hiccups, and despite being called bogus, here’s a management team that just keeps executing.
Show me one multibagger out there which did not have a single red flag. Pharma co’s by their very nature (sometimes rightly so) keep investors worried all the time that they stay invested. Take Ajanta Pharma’s 120 bagger journey for example. Elsewhere, I have written about the gut wrenching roller coaster ride it’s investors had through their journey while experiencing the joy of a 120 bagger.
Does that mean we close our eyes? No. But we do need to separate the signal from the noise. Personally, I have a neutral view and would look out for more red flags, if any. Meanwhile I continue to stay invested.
PS: Ideas in this post have been collated from Twitter / Valuepickr / Whatsapp and based on my own personal investing experience. I have tried to put everything in one place to try and get a holistic picture. I sincerely thank everybody’s contributions / ideas.
I could be wrong on one or more ideas articulated above. I rank myself as moderate when it comes to doing forensic accounting and acknowledge there are much better forensics guys out there. I may change stance on this business as and when new facts present themselves or whenever I start looking at old facts in new light. And hence, I reserve the right to be wrong. The best thing to do for you would be to do your own due diligence and build your own conviction.