How using earnings power box lets you ask right questions ?

Over my limited experience in equity markets, I have come to conclusion that earnings power box is a powerful tool to analyse authenticity of corporate earnings. While I am not going to repeat much of much I have written earlier, you can go through it here and here

One of first things I do after getting annual reports of the companies I hold is to update their earnings power box (EPB)

Updating it sets me in right frame of mind to query annual reports, let me run through an example to elucidate my point

In 2014 this is how Kitex ‘s  EPB looked like

kitex-14

A company in wealth maximizing quadrant 2, the more number of years it continues its advance in this quadrant the more it will continue to create value for owners

2015 EPB will blow your mind away

kitex-15

The company made a significant advance in quadrant 2, no wonder stock market rewarded the stock in the bull market

Kitex-3

This is where we start our investigation

First let’s look at raw data for per share earnings

Kitex-4

The accrual EPS (one which is reported as diluted EPS in Profit and loss account) had a significant jump from INR 12.08 /Share to INR 20.74 / Share however what was even more staggering was a fourfold jump in defensive EPS from INR 6.37 /Share to INR 22.61 / Share

What led to this ?

On opening annual report this is what you find

Reduction in working capital to the tune of ~INR 17 Crores (Note the company already is a negative working capital company and continues to improve this situation)

Let’s look at component by component

Current assets excluding cash increased by ~24 Crores

Loans and advances increased by INR ~13.25 Crores largely on account on advance taxes paid (No surprises here)

Inventory increase of ~INR 1 Crores

Trade Receivables increased by INR ~9 crores, (expected as sales increased)

Current Liabilities increased by ~41 Crores
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Provisions increased by ~18 Crores (Due to higher profitability)

Short term borrowing increased by ~23 Crores (Packaging credit – This is favourable rate loan available to exporters, key tracking item to see if an exporter is doing well)

Trade payable reduced by ~5.5 Crores (Was large inventory bought at discount for cash as ideally this should have increased with increase in sales ?)

Other liabilities increased by ~5 Crores

The company continues to be smart in managing working capital prudently funding it via huge packaging credit

Steep reduction in Fixed investment to depreciation ratio – There was no huge capex spend this year, Also in Annual report company claimed

– New sewing machines have been installed to increase from 7000 stitches per hour to 9000 per hour

– A bow making automated machine that reduces manual effort by 1/50th , yes you read it right 1/50th

See this

Revenue increased by 16%

Kitex-5

Assets increased by 3% only

Kitex-6

Kitex-7

Is plant running at full capacity can sales be increased with limited capex in future as well? Nothing in annual reports to come to a conclusion however management has indicated that they can double capacity in same campus

One thing is clear increase in defensive profits indicates that capex is internally funded

Now turning my attention to enterprising profits

Like last year again a 100% jump from INR 6.59/ Share to INR 12.18 / Share, indicating that company is expanding its ROIC and earning greater economic profits.

In simple terms additional capital retained in business is getting put to good use

My conclusion – Like last year Kitex Ltd has authentic earnings power and now it’s no longer a secret as the stock has become darling of markets !

Do you want to use EPB analysis to evaluate how your portfolio companies are doing ? Buy an easy to use ready-made template which can be used for any company – here

16 comments

  1. Ravi says:

    Hi Vivek,

    Good Article, May i know at which rate you considered WACC for Debt and Share holders equity for calculating interest expense?

    Thanks
    Ravi

      • Ravi says:

        My bad that i did not explain my question fully. while calculating Enterprise income statement, one should not consider the share holders equity as free. So we should calculate the share holders equity as rate to arrive the cost of capital. So i am referring to the cost of capital that you considered ( 20 or 30% etc) for the share holders equity.

        Infact, i have calculated Defensive EPS and Enterprise EPS, they are different from yours. so wondering about the rate.

        I have followed the points mentioned in the “Its Earnings that count” book and prepared the Defensive and Enterprise EPS for Kitex but the values yours is a bit different. If you would like to check my file, i can share it with you.

        Thanks
        Ravi

  2. Krishan says:

    To calculate whether Workin cap. is negative or not, we should also exclude short term borrowings from calculation as they are interst bearing. If we do so, Kitex is not a negative working cap. co.

    • Vivek Bothra says:

      Krishan,

      By principle short term borrowings are used to fund day to day operations so whether they are interest bearing or not have no relevance for working capital calcs

      • Krishan says:

        If a Co. is having negative WC, the general implication is that it is having some sort of moat and that can be implied only when the current liabilities consist of OPM “OTHER PEOPLES MONEY ” which is free of cost. Kitex is a good co. but cannot be termed as having negative WC. Colgate whose results are published in today’s papers has real neagitive WC and also has a MOAT. This is my understandin of negative WC.

        • Vivek Bothra says:

          Unfortunately we would not be able to build a model on general implications we need to put in a set standard which can be used across companies

          • Ravi says:

            I concur with Krishnan thoughts here, we cannot consider it as negative working capital as we exclude cash and equivalents for calculation purpose. Negative working capital when company receives advances in the case of DFM foods etc.

          • Vivek Bothra says:

            You may disagree with me 🙂 My theory is investment in WC is use of cash so I can’t use cash as use of cash

  3. avind says:

    Working Cap for fy 15 = Current asst – Cirrent Liability
    =341.19-218.7 = 122.71
    How come wc came negative(Note the company already is a negative working capital company and continues to improve this situation)
    wc for fy 14 =217.33-176.72=40.61

    Kindly explain Formula for Defensive Earnings

    • Vivek Bothra says:

      Hi Arvind,

      I always take Current Assets – Cash ( as cash is not operating asset) = Current assets

      Thanks

      • Avind says:

        Thnak you Vivek…
        Kindly give Formula for Defensive Earnings
        On Internet also lot of people write about it.
        But no one explains it by taking real company examples form India
        If you write one blog on Defensive and Entrprise Value .It will be useful for retail investors……

Have your say