Decoding the mind of ‘sell’-side analyst

By Hrishikesh Dubey

What is an equity research report?

An equity research report is a document prepared by an analyst or a strategist. Such Analysts are part of the investment research team in stock brokerage firms or investment banks. When you research or investigate something, it has some motto behind it. Your motto is to come to a conclusion with the help of your findings and give recommendations.

Let’s understand how this segment works.

I think it’s important to understand the intentions of “sell-side” analysts, which is the industry term for equity analysts who work for the brokerage houses. These analysts don’t write their reports for the public. They write reports to serve the institutional investment community who are their clients. These institutions, such as mutual funds, pension funds and hedge funds, pay for stock analysis through commissions. They direct more trading rupees to firms who employ analysts they like. So, the job of a sell side analyst is to be well-liked by clients, and one way to do this is to publish reports that clients find interesting. The reports mostly serve as marketing pieces for the analyst because they initiate direct conversations with the clients.

When you realize research reports are really marketing pieces, it’s easy to see why several smart analysts can have widely different opinions on the same stock. It’s easier to get attention from clients if your story on a stock has a different angle. So, while analysts certainly have positive intentions and try to be right all of the time, the real motivating factor behind their work is to form a differentiated view and market that as a report with a stock target price and recommendation (usually buy, hold or sell) on the front page.

Unfortunately, the investment community is designed to focus on short-term performance, so analysts tend to present analysis to support a short-term recommendation.

So, should you bother to read analyst reports or think about the details of these reports as written about in the financial media? Yes and no. I think it would be unfair to judge a stock based on short term analysis and not taking into account it’s past performances and long term potential. Spend your time looking at the more interesting discussions that actually matter to the long-term performance of a business.

Now let’s “analyze” a research report from a prominent Institutional Equity Fund on Manpasand Beverages Ltd (MBL) dated 5th July 2018.

From first reading, it appears that this stock should be a no-no for an investor.

Let’s see the recommendation given by the same entity on MBL in a research report dated 14th September 2015.

The interval between both the reports is of 1025 days (2 years, 9 months & 21 days). So what exactly happened during this interval that they went from a “BUY” recommendation at Rs. 500 to a “SELL” recommendation at Rs. 132. Certainly the research team might have come across concerns to support their recommendations. Prima facie it would seem that the research team must have come across deviations and abnormalities that didn’t exist when the 2015 report was issued.

So let’s try to evaluate the concerns and deviations to understand the basis of the “SELL” recommendation.

CONCERN NO.1:-

The two questions to be addressed here are

Q.i. Why is the FCF negative?

Q.ii. What does this mean/how to read this?

Below is the forecast given by institutional investment fund in its 2015 report with respect to the FCF:

The forecast of the 2015 report gave a negative FCF forecast till 2018. So the negative aspect doesn’t look like a concern.

The plant capacity mentioned in the 2015 report was as follows:

Going by the forecast given above, in 2018, if all the production lines in all the plants ran for 24×7, then the turnover mentioned below would have been the maximum possible turnover:

195,000 cases per day x 30 days per month x 12 months = 7,02,00,000 cases per year x Rs. 200 per case = Rs. 14,04,00,00,000

However, practically the plant cannot function based on the logic given above. There is always some loss in capacity utilization. How much is the loss then?

Certainly for a company, which deals in seasonal items, the demand is not evenly spread over the year. Nearly 2/3rd of the sales happen during the 5-6 months of season. Thus, the average utilization of the plant cannot be above 80% in this industry, as high inventory levels cannot be maintained. 1-month inventory can be held on any given day.

To achieve the forecasted revenue of FY 2021, MBL required further capacity expansion.

FCF = Cash Flow From Operating Activities – Capital Expenditures

MBL has been generating cash, which is visible by its constant trend of net income after taxes. Below are the present as well forecasted figures pertaining to net income provided in the report:

Certainly the company is generating cash from operations.

Hence, it can be said that the FCF is negative due to the capital expenditures incurred. The amount of the FCF is more than the forecasted value because MBL is now incurring capital expenditures for 4 new plants as well, which were not planned when the 2015 report was issued. These investments will be adding value in the long run.

Although the companies and investors usually want to see positive cash flow from all of a company’s operations, having negative cash flow from investing activities is not always bad and needs further evaluation before decisions are made on a company’s investing activities.

It’s entirely possible and not uncommon for a growing company to have a negative cash flow from investing activities. For example, if a growing company decides to invest in long-term fixed assets, it will appear as a decrease in cash within that company’s cash flow from investing activities.

Even well-established companies make investments in long-term assets such as properties and equipments from time to time which might cause investing activities to go negative. If these investments earn high returns, the strategy has the potential to add value in the long run.

CONCERN NO.2:-

 

Cash Conversion cycle: The cash conversion cycle (CCC) is a metric that expresses the length of time, in days, which it takes for a company to convert resource inputs into cash flows.

Cash Conversion Cycle (CCC)	DIO + DSO – DPO
Days Inventory Outstanding (DIO)	Average Inventory / Cost of Goods Sold Per Day
Days Sales Outstanding (DSO)	Average Accounts Receivable / Sales Per Day
Days Payable Outstanding (DPO)	Average Accounts Payable / Cost of Goods Sold Per Day

Rs. In lacs

	Manpasand Beverages Ltd			Varun Beverages Ltd
	end-FY2018	end-FY2017		end-CY2017
COGS	59,086	45,920		2,32,289
COGS Per Day (A)	162	126		636
Sales	95,517	71,711		4,51,624
Sales Per Day (B)	262	196		1,237
Inventory	9,570	6,160		43,889
Average Inventory (C)	7,865	6,601		46,441
Accounts Receivable	13,927	7,519		15,025
Average Accounts Receivable (D)	10,723	7,147		14,080
Accounts Payable	5,060	6,723		19,095
Average Accounts Payable (E)	5,892	5,599		23,277
1) DIO (C) / (A)	48.58	52.47		72.97
2) DSO (D) / (B)	40.98	36.38		11.38
3) DPO (E) / (A)	36.40	44.51		36.58
CCC (1) + (2) – (3)	53.17	44.34		47.78

It can be observed above that CCC mentioned in the report is incorrect. What the report mentioned as 71 days is actually 53.17 days. And what the report mentioned as 36 days for Varun Beverages is actually 47.78 days. There is not much deviation when compared with Varun Beverages either.

The basis for calculation by the Institutional Equity Fund is not available, as the figures do not match with the actual ones derived above.

CONCERN NO.3:-

Average requirement per plant is mentioned below from the 2015 report-

It takes on an average Rs. 150 crores for setting up 1 plant. The amount has subsequently increased on account of better quality equipments and rise in material costs.

In the Annual report of FY2017, following was mentioned-

Four new plants were going to be commissioned. These plans didn’t exist during the 2015 report and hence were never a part of that report. To set up these 4 plants, the Company required an additional Rs. 600-800 crores.

As per the Annual Report for FY 2016-17, the funds of IPO were utilized as follows-

The four new plants were never part of the IPO plan.

Thus, funds were raised through QIP amounting to Rs. 500 crores. This partially covers the fund requirement of Rs. 600-800 crores for all 4 new plants. Working capital requirements are not even addressed yet.

Hence, it makes sense that Company had to opt for borrowings.

Also, the said borrowings are the overdraft limit on existing fixed deposits at an incremental cost of 0.5% only as against pre-maturing the deposits and losing interest of 2% to 3%. Company has not taken any facility of Working capital or Term Loan from the Bank.

CONCERN NO.4:-

The Company got listed in July-2015. Pre-IPO ROE was high due to lower value of equity capital (which includes securities premium as well). In FY17, there was QIP. The equity has drastically increased since IPO. The drop in ROE is due to this increasing trend of equity base. Apart from this, it can be observed that EPS and NET worth has always been on an upward trend, which highlights the constant growth in shareholder’s value.

The Net Profit Margin of the company has shown an upward trend on yearly basis since 2015-16. Further taking into consideration the expansion plans of the company, the revenue of the company is prospected to witness a considerable rise which ultimately will lead to increase in the Net profit of the company which insights the good health of the financials of the company.

Return on Equity is arrived at dividing the Net Profit by Equity Shareholders fund. The company’s ROE is showing a downward graph since 2015-16. This is due to expansion in equity funding. The increase in equity funding is for the purpose of planned expansion of the company. Thus, ROE is prospected to rise in coming years when the expansion plan of the company is completed and will participate in generation of additional revenues in future. Thus, the downward graph should not be considered as worry for the investors, taking into consideration the expansion plans of the company.

Further, the company’s financials is showing an increasing trend of Earnings per Share (EPS) since 2015-16. EPS is a fundamental measure used in valuing any company, based on its earnings, as it breaks down the profits on a per share basis. Earnings of the company are mainly dependent on the ‘Revenue from Operations’, which is rising on a yearly basis, leading to an increase in earnings and ultimately the EPS. The current scenario of the company depicts increase in revenue of the company, which is prospected to rise in coming years.

The company has maintained a steady payout of 10% dividend (Re. 1/ share) every year since 2015-16. Hence, the company is moving on the growth model by ploughing back of the profits. Bonus shares in ratio of 1:1 were also issued in FY 2017-18.

CONCERN NO.5:-

Below was the detailed breakup provided for above concern-

Before jumping to MBL’s YoY and QoQ movement, it is important to see these numbers compared with its competitors. In this case, we’ll take Varun beverages as it has already been used by KIE in their report for comparison.

When compared with the industry, MBL is better in all the variables. Hence, any deviation YoY or QoQ should not be a cause of concern when seen with the complete picture about how other companies are doing in the industry.

With respect to MBL’s drop in EBIDTA level compared with expectations, it looks primarily on account of increased value of other expenses. These increase can be attributed to the increase in branding activities done by MBL and increase in freight and fuel cost.

 

---

It can be observed that all the concerns mentioned are not that severe to give a “SELL” recommendation with a target price of Rs. 132.

So Why did the institutional equity fund give such an adverse recommendation?

 Let’s understand a few facts first. MBL came up with its IPO in July, 2015. The fund was one of the investment bankers in IPO of MBL. So it makes sense why they gave a “BUY” recommendation with target price of Rs. 500 in their 2015 report. It was a post-IPO report.

So what is the credibility of any recommendation of such an entity?

Analysts who make sell recommendations increase their credibility and therefore exhibit a higher impact on prices in their subsequent earnings forecasts of other firms.

The amount of scrutiny, given to information is not constant but rather depends on whether the information is seen in a favorable light or not, given the decision maker’s preferences. When people are presented with information that is counter to their directional preferences, they are motivated to interpret it skeptically.

Investors are motivated to agree intuitively with information that suggests they might make/save money on their investments but disagree with information that suggests that they may lose money.

Some stock analysts work for firms that do more than just analyze stocks. Sometimes, the other objectives of the firm are, or appear to be, in conflict with the objectives of the analyst to give an unbiased recommendation. This causes some investors to have less confidence in the recommendations from some analysts.

Why did the investment banker of MBL’s IPO give an adverse recommendation now after giving a highly favorable post-IPO recommendation?

 If the analyst is not on good terms with company management, it doesn’t take a genius to see that the fastest way for an analyst to sour a relationship with company management is to slap a “sell” rating on the company’s stock.

Investors place a lot of trust in market analysts because of their intimate knowledge of particular stocks and the companies behind them. That level of expertise can certainly be helpful to an investor when learning about a company and making investing decisions. But there may be a lot more behind those recommendations than meets the eye.

Big and small investors rely on analysts’ written reports to make decisions about buying and selling individual stocks. Analysts polish their reputations and earn raises, bonuses and partnerships by making accurate predictions and winning top rankings

Conclusion

Based on the above points, the basis of the “SELL” recommendation and true motive of this “SELL” recommendation is unclear. There definitely is a lot more behind these recommendations then meets the eye.

---

Hrishikesh Dubey is an analyst at Qrius