Many companies reported better earnings in the September quarter not because of better operations but other income, concludes a research report by Kotak Institutional Equities. Also, many companies are facing stressful times due to poor cash flows
According to a research report by Kotak Institutional Equities (Kotak), the quality of earnings this season has largely been ‘suspect’ even though it beat their expectations. Most market participants obsess over profits (net profit, to be more precise). Stock prices are primarily based on this. This year, it would seem that the results met market expectations. “2QFY13 results were largely in line with our expectations with BSE-30 Index’s net profits growing 6.8% year-on-year (y-o-y),” says a Kotak report. This is 1.6% higher than expectations. This would be good news for investors, right? Not if you peer into the numbers more closely and notice that EBITDA and cash flow matter too. This is what Moneylife analyses when we write earnings results. Apart from net profit, we look at operating profit (which is EBITDA plus depreciation minus other income) for the last three successive quarters, on a year-on-year basis, to gauge performance more closely and check for consistency.
In its coverage of 161 stocks, 61 beat expectations—reported net profit was more than 5% of their estimates; 43 companies reported between -5% and 5%, and 57 companies reported lower than their estimates by more than 5%. Some of the sectors that surprised positively were automobiles, energy (largely due to government-owned downstream companies), pharmaceuticals and utilities. The sectors which disappointed were industrials, metals & mining and telecom.
While overall net profits have indeed risen, it doesn’t mean companies’ core businesses are doing well. This is determined by EBITDA (we at Moneylife use operating profit instead in our analysis). In fact, according to the Kotak report, EBITDA declined 0.5% y-o-y which was 3.3% below their expectations. Thus net profit was actually boosted by higher “other income” component. For instance, Larsen & Toubro has reported good orders which met expectations, but largely due to an exceptional income of Rs210 crore which arose from gains on divestment of stake in a subsidiary. While this certainly adds to value of business, it isn’t exactly ‘core’ business. Likewise, one must look at every balance sheet to note the EBIDTA component and see whether it has increased y-o-y, which is how we analyse results.
While net profit is an important component of companies, nothing is ever more important than cash flows, which can give us clues about a company’s future performance. A strong cash flow trend will imply that the company will stay, even if net profit is subdued. After all, cash flow is result of operations and what keeps the business going while profit can go down because of higher interest, taxes or lower other income. Kotak remarked in its report, “the quality of earnings was a tad suspect with cash flows being weak in several companies”. Furthermore, it stated, “Almost all other industrial companies reported a steep increase in working capital (net working capital) quarter-on-quarter, which shows the stress on cash flows of customers”. In other words, companies are taking more time to get cash after a product is sold, or having trouble recovering from debtors. The table below illustrates this concept.
Another aspect is the dollar-rupee exchange variable. If the rupee depreciates, IT companies (or anybody exporting) will stand to gain, and vice versa. In this quarter, several IT companies reported higher growth in rupee income but lower growth in dollar income. This shows fundamentals have not changed much other than currency rates. The table in Kotak report is shown below to illustrate this concept also.