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Kirloskar Bros.: Too many cooks could spoil the broth - Outside View by Luke Verghese

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Kirloskar Bros.: Too many cooks could spoil the broth
Nov 1, 2010

Anointing of the Crown Prince

The year FY10 will be marked as a very important year in the life of Sanjay Kirloskar. For he has anointed himself as the de facto crown prince of Kirloskar Brothers, after seeing through a chain of mergers and demergers of group companies, and having a direct bearing on Kirloskar Brothers. As a result of the legal maneuverings, the company gained 4 direct subsidiaries and 3 subsidiaries of subsidiaries. It simultaneously divested its stake in a number of Kirloskar group companies. It also meant that Kirloskar Brothers ceased to be a subsidiary of Better Value Holdings, one of the promoter companies of the Kirloskar group. The icing in the cake was the stepping down of blood relative, Vikram Kirloskar, as executive director of the company 'due to other pre-occupations'. He will henceforth function as a 'naam ke vaaste' director of the company. But the company will sure as hell be saving a lot of money, with his demitting full time office. Between Sanjay (Rs 35 m) and Vikram (Rs 35 m) it is costing the company a cool Rs 70 m a year as 'pagaar' to the two. It is also a salary structure which appears totally at odds with what the other high functionaries of the company are earning. There are two other scions on the board bearing the Kirloskar label, Rahul, who is the brother of Sanjay, and MS Kirloskar. The latter, at the sprightly age of 89 must rank as one of the oldest serving director's in any listed company. For this alone he deserves to be awarded a medal. Rahul and M.S. appear to be silent witnesses to the company's progress, making do with their sitting fess and dividend accretions.

A performance to celebrate the homecoming

As if to celebrate Sanjay's home coming, the company declared the best results on tap in the last decade, and celebrated the event by proposing a record dividend payout of 275% against 100% in the preceding year. The ostensible reason being proffered for this largesse is that this dividend is to mark the centenary of the company's Kirloskarwadi factory. The company per se is 90 years young, and is one of the flag bears of the group. For the matter of record, on a 10.6% increase in gross revenues at Rs 20.7 bn, the company recorded a 76% jump in pretax profit of Rs 1.7 bn against Rs 982 m in the preceding year. The difficult trick of course is to continue this outperformance in the years to come.

How the profit works out

The substantial increase in the pretax profit on a marginal rise in turnover was due to two major factors. Materials consumption, the largest item of expenditure by far, rose a mere 7%, while employee payouts were actually lower by 5% over that of the preceding year. Operating expenses too grew only 9.4%. In other words the expenditure side of the equation fell neatly into place during the year. One important observation is that the company has to incur substantial working capital costs on its contracts, as the gross amount of dues owing the company from customers, and the debtors balances together at year end at Rs 8.6 bn is fairly sizeable, compared to the turnover recorded for the whole year - even if one nets off the advances that it received from customers. And despite of generating substantially more cash of Rs 1.2 bn (Rs 424 m) from operations, and spending considerably less on capital assets - Rs 441 m against Rs 1 bn, the company ended up borrowing more cash than it repaid, to its lenders! The surplus funds got added to its cash balances at year end!

How the business is driven

The company is basically in the business of making power driven pumps and its many accessories, but has fast forwarded the business to include turnkey contract jobs for industrial complexes. It services a wide variety of industries ranging from the irrigation sector, power, oil and gas, building and construction, marine and defense, and an omnibus sector classified as industry. Its footprint now extends across the seven seas to cover Africa (through its subsidiary in South Africa), the Middle East, South America, and the Far East. Through its two wholly owned subsidiaries, Kirloskar Brothers Thailand, and Kirloskar Brothers International B V and Kirloskar Brothers Europe, it addresses the markets in South East Asia and Europe. It also boasts of 2 subsidiaries based out of France, and three others, one a limited partnership (LP) and the other two being limited liability companies (LLC), probably based out of North America and England. Needless to add, there is a lot of intended complexity here in the way these subsidiaries along with the interlinkages and such like are panned out. Some of these subsidiaries also appear to be some sort of holding companies of the foreign operations. But one will never be able to get to the bottom of it given the way the laws are structured. The spread of operations also marks the very makings of an Indian MNC, perhaps. It currently also rides piggyback on 21 joint ventures in implementing its turnkey contracts.

The complex interlinkages

The way it goes about its business is complex, and must be giving is accountants the 'heebie jeebies'. The bigger issue that confronts turnkey contractors is in the timing for accounting of the work completed. To put it more precisely, the stage at which the contracts are booked as revenue along with the attendant expenses, and, the stage at which the profits, and or losses, on these contracts are factored in. That is only a part of the unfolding story.

Though the quantitative information in the annual report informs us that its manufactured sales and income from services, spare parts, and civil receipts toted up to Rs 15.1 bn, and that it realized Rs 5.3 bn from the resale of bought out items, the final accounting for revenues is quite different. The same revenues are bifurcated almost equally, under the heads of gross sales, and project related revenue.

It is a much bigger canvas in reality. It has ten strategically placed subsidiaries some of whom manufacture parts and components that the parent requires to execute the contracts that it tenders for. Then there are another 10 subsidiaries of subsidiaries or fellow subsidiaries as they are euphemistically called - making a total of 20 such entities. Besides the Rs 1. 9 bn that it has sunk into the equity capital of the direct siblings, it also provides them the necessary lubrication in the form of loans, depending on the needs perhaps of these entities. There is of course no repayment schedule for these pickings, and besides, no interest is charged on these large outstanding balances. There is no compulsion on any of them to declare any dividend either. This largesse, excludes the guarantees that the parent provides to banks for the contingent liabilities run up by the little sissies and so on. The subsidiaries however contribute to a turnover of Rs 6.4 bn in the consolidated turnover of Rs 26.9 bn. But their collective contribution to pretax profit is a mere Rs 188 m.

Leaning on its siblings

The parent has considerable operational linkages with several of the subsidiaries. In FY10 it bought goods and services worth Rs 1.3 bn from them and in turn sold goods and services to them. The parent in turn rendered services to them and vice versa. The parent bought shares in its subsidiaries and in turn paid royalty to two of the subsidiaries. There are several other transactions of such like, both on revenue and capital account, between the parent and the subsidiaries. As a matter of fact the list of such transactions runs into some 5 pages! The entries on these counts must be numerous and taxing to boot. Adding to the intrigues is the fact that it imported goods (large motors) worth Rs 5.1 bn and the picture that one gets is that of a humungous operation. Such large imports also imply having to traverse the treacherous path of forex fluctuations, and hedging on derivatives contracts, all of which adds to the business uncertainty.

The ten subsidiaries whose working results are presented in brief provide a very interesting mix. More importantly the second largest of these subsidiaries in terms of turnover, Kirlsokar Construction & Engineers, seems to be in some sort of a tight spot. The company recorded a turnover of a little over Rs 1 bn but netted a loss during the year. It had recorded an even larger loss in the previous year. The accounts of this company which were audited by another accounting firm has been peppered with qualifications on just about every count - on revenue and capital account and in terms of internal controls - et all. One could even hazard a guess that the auditor's qualifications even goes to the extent of questioning its very existence. Going by the auditor's qualifications, the loss disclosed of Rs 20 m, is only a poor shade of the actual loss incurred. Remarkably enough it even made a tax provision of Rs 17 m on a book loss of Rs 2 m.

The subsidiary pyramid

But the most interesting part is the manner in which the subsidiary pyramid has been partly restructured during the year. The parent sold its shareholding in its directly wholly owned subsidiary, SPP Pumps, to its directly wholly owned international subsidiary, Kirloskar Brothers International B.V. This restructuring appears to be deliberate. The point is that SPP (now a fellow subsidiary) is a very important cog in the wheel, as it controls seven subsidiaries on its own, including six overseas subsidiaries. (There appear to be nine overseas subsidiaries in all). The consolidated results of SPP with a recorded turnover of Rs 4 bn and a pretax profit of Rs 201 m makes it now the biggest of all the siblings (whose brief accounts are published separately) of Kirloskar Brothers. Apparently, under our disclosure laws, the results of 'fellow subsidiaries' and that of the subsidiaries of fellow subsidiaries, do not have to be disclosed separately, but merely clubbed with that of the direct subsidiary. At least this is the conclusion one derives from the manner in which Kirloskar Brothers has presented the accounts of its fellow subsidiaries - barring one that is. The results of SPP Pumps should logically have been clubbed with that of Kirloskar Brothers International BV. Why the company has chosen to so generously display the results of SPP Pumps, a fellow subsidiary, separately is not known, as the implied intention of the restructuring was to reveal less and not more.

It is a bizarre scenario on the whole. And, definitely not an example of a company that inspires much confidence in the minds of the investing public.

Please note that I am not a shareholder of this company

This column Cool Hand Luke is written by . Luke has been a business journalist, financial analyst and knowledge management head with a professional experience of more than 20 years. An avid watcher of the stock market, he has written extensively on stock market trends. His articles have featured in Business Standard, Financial Express and Fortune India amongst others. He has also been the Deputy Editor, Fortune India and the Financial Editor of The Business and Political Observer.

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