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Company that flew high on broken wings

Mar 13, 2012

In our previous article, we gave you some red flags which you could watch out for when making an investment decision. In this article, we will take you through the example of one such company where red flags were visible for quite some time. If one had seen them or knew where to look and paid attention, an investor could have avoided investing in the stock and hence saved considerable losses to the portfolio.

To avoid any bias in opinion, we will disclose the name of the company only at the end of the article.

So lets get started.

We will first start with looking at the cash flows of this company. For our analysis, we will refer to it as Company A till we finally get to the name.

Cash flows do not match the income from operations:

Since 2007, company A has been consistently in losses at the bottom line level.

Losses in cash flows larger than that in income statement
Net income (Rs m)(4,196)(1,881) (21,397) (16,472) (10,274)
Operating cash flows (Rs m)(5,526)(5,196) (17,074) (16,651)22

At the same time, its cash flows from operations too have remained negative. In fact in FY07 as well as FY08, the company’s cash losses from operations were much higher than its net losses at the bottom line level. A closer look into this reveals that this was largely due to a huge acquisition made by the company in 2007.

As seen, this acquisition increased the losses for the company. But did it help in improving its other fundamentals? We will get to that in a bit but let us first take a look at the company’s ratios.

Unhealthy ratios

The cash conversion cycle is measured as inventory days + receivable days- number of payable days. It indicates the amount of time that lapses between the outlay of cash and the collection of cash. Longer conversion cycles indicate lower liquidity and vice versa. As seem in the table below, the cash conversion cycle for Company A has been increasing since 2007. It is true that a negative cash conversion cycle is good for a company as this means that it has more time to pay back its creditors. But if this elongates over time, then it starts creating doubts on the company’s ability to pay back its creditors.

Ratios did not indicate a healthy trend
Revenues (Rs m)16,221 14,414 52,390 50,899 63,596
Debtor days (Days)8 7 19 23 25
Inventory days (Days)12 14 14 21 21
Payable days (Days)62 98 162 186 201
Cash conversion cycle (Days)(42)(77)(129)(142)(155)

And this is what happened with company A. It started to look at short term debt to fund its working capital.

And debt it did take

Its debt to equity ratio has been going up and up and up. At the same time, its ability to service this debt (interest coverage ratio) has been coming down over the years.

Debt ratios
Debt to equity ratio (x)0.8 0.8 12.6 17.6 2.9
EBIT (Rs m)(7,215)(7,607)(19,782)(10,886)(2,367)
Interest charges (Rs m)624 504 7,786 11,026 13,129

The company has been piling on debt which is implied from its high debt to equity ratio. The trend started after 2008 when the company merged its acquisition (mentioned earlier) with itself. Its debt to equity ratio jumped from 0.8 levels to 12.6 in 2009. Since then it had to continually take on short term debt to fund its ailing operations.

Short term debt on the rise
Short term debt (Rs m)5,193 4,226 26,907 48,508 45,633
Total debt (Rs m)9,167 9,344 56,656 79,226 70,571
Short term debt as % of total debt57%45%47%61%65%
Debt to equity ratio (x)0.8 0.8 12.6 17.6 2.9

In 2011, the debt to equity ratio appears to have come down. But this is largely due to additional equity issued by the company in the form of preference shares. Moreover, the company has had a negative EBIT (Earnings before Interest & Tax) and a growing interest burden.

These ratios clearly indicate that the company was headed for troubled waters.

Unfortunately that is exactly what happened.

From its IPO (initial public offer) till the end of 2007, all investors were gung ho about Company A. The share price appreciated by nearly 220% in this period.

Source: ACE Equity

But since then, share prices have been on the decline. Investors who had held on to the stock in the hopes that its past performance would be replicated were in for a rude shock. Over the next four years, the stock crashed by nearly 92%.

Source: ACE Equity

The company A that we have just discussed is none other than Kingfisher Airlines. After dishing out a blockbuster performance post its IPO, the stock has come under pressure. It has been trying to shore up funds to pay back its debt and continue running its operations. But banks and creditors have stepped away saying that they do not wish to help out the company. At this rate, it seems to be headed the Lehman Brothers way with no one wanting to bail it out. But the point is not its current troubles. As a prudent investor one could have seen the brewing signs of trouble long before the events actually unfolded themselves.

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