Amara Raja Batteries: First Principles Thinking and Operating Cash Flow

I am still in process of finding that one company I can wholly back. In the meantime, I might use this blog to store my thoughts on certain matters.

Amara Raja Batteries(ARBL) has become a household name thanks to its Amaron batteries line. As a teenager I loved their stop motion funny ads:

In years past the company has been a “multi-bagger” with stock going from being a penny stock to 1000+ at its peak. The company also boasts of investors like Nalanda Capital.

The company had two promoters – Galla Family and Johnson Controls (through their subsidiary Johnson Controls (Mauritius) Private Limited). Last year JC sold it’s power division to the PE firm – Brookefield Asset Management and remade it into a new company called Clarios. This news added uncertainty to ARBL’s Future so the stock started to drop. The drop precipitated when it was announced JC and Amara Raja were ending their partnership.

While news like these add lot of fear it also provides a great opportunity to enterprising investors, especially the ones who are able to put in time to unravel the uncertainty. Thinking on similar lines, Nalanda Capital increased their holdings by ~ 1% in the last quarter. So, I looked into the stock.

After a detailed analysis my answer was that I shouldn’t invest in the company. While I am not going to elaborate all the metrics in this post there were two things which I noticed:

Messaging Around Ending of Partnership

One thing I have come to appreciate a lot while going through my journey has been that rating reports add some real value to the analysis. So, I was surprised to see CRISIL’s report:

CRISIL believes that the termination of technology transfer with JCI will not have a material impact on ARBL’s business risk profile as the technology has been internalized over the 22-year long partnership and later customized as per ARBL’s business requirements. With respect to the recent PowerFrame Technology License Agreement, ARBL has already received the technology for manufacturing batteries using stamped grid plate making process and will also receive technical assistance from JCI for a mutually agreed additional time period.

This sounds eerily similar to ARBL’s messaging around ending of partnership. So, it’s seems CRISIL is simply parroting ARBL’s narrative.

Nowadays I have been listening to Shane Parrish’s (writer at book called The Great Mental Models: General Thinking Concepts. One of the chapter is about “First Principles” Thinking. The idea here is to break down a statement to its most basic tenant. One of the easiest way is – 5 Whys.

So, when we put ARBL’s narrative through the 5 Whys grinder here’s what happens:

termination of technology transfer with JCI will not have a material impact on ARBL’s business risk profile

Why is there no material impact? (1)

as the technology has been internalized

Why has the technology been internalized? (2)

22-year long partnership and later customized as per ARBL’s business requirements

Why does 22 year long partnership and customization cause no impact? (3)


The logic cycle does not complete.

We all know that technologies are often patented. Unless the patent expire, no one can use the technology willy-nilly. No one can use it even if they add customization on top. They need to have an agreement with the company owning those patents. These agreements can be in form of licensing fees or a shareholder agreements.

Looking at ARBL- JC partnership from this lens, there are three possibilities where ending the agreement has no impact :

  1. There are no patents held by Johnson Controls in lead battery manufacturing
  2. There were patents held by Johnson Controls but have expired. So now ARBL is free to use them.
  3. Patents are still valid but JC or Brookefield Asset Management has decided to allow Amaraja to use it for free.

The PR statement makes neither of these three points rather focuses on technology being “internalized” whatever that is supposed to mean.

I can be wrong but ARBL might end up paying technology licensing fee and that will change their business risk profile.

Cash Flow from Operations

Amaraja has been continuously adding capacity and hence hemorrhaging cash for last 6 years. So, when I looked at Cash Flow from operations certain entry seem odd to me:

I cannot figure out why is “Gain on sale of investments in mutual funds” is considered part of normal operations.


ARBL had been growing a fair clip (10+%) but demontization put some hard brakes on their growth. I expect them to get their mojo back slowly and grow at a good rate.

They have a great ROCE (25%) but they are struggling to convert it to cash (FCFROCE at 0%). I really don’t want to buy a company which is not generating cash, so I skipped ARBL.


Aavas Financiers – My first reading of an IPO Document

Another post, another recommendation from the Outlook 2019 picks – Aavas Financiers. It is often hailed as another Gruh Finance – a company with returns so high that it might be the barometer other NBFC, especially housing, are tested against for a long time.

It is also a well-known fact that the valuations for the company aren’t exactly cheap. So, spoiler alert: The conclusion is mostly going to be that Aavas Financiers is costly. Let’s see how it stacks up:

Do I understand it?

My first read was of the initial recommendation. Things which I noted were:

  1. The company was initially promoted by AU Small Finance and then sold to two PE companies – Kedaara Capital and Partners Group
  2. The senior leadership owns 7.5% of the company
  3. The company’s presence is mostly in the lower and middle income group in semi-urban and rural areas.
  4. A third of customers are new loan buyers
  5. “It caters to customers in the segment of sub -1 million average ticket size along with good asset quality.” I am unsure if it means that the average loan size is less than 1 million or the company max loan size is less than 1 million
  6. Operates in 10 states with 83,000 homes built and total gross loan size of INR 70 billion
  7. Gross NPA are 0.58% and Net NPA at 0.49%
  8. The company doesn’t use any direct sales agent or monthly targets – Though you have to wonder how long before they feel the pressure to grow
  9. Customers have to come to the bank to sign the papers
  10. There are no asset-liability mismatch. “Aavas’ average borrowing tenure is 11 years, while its average loan tenure is 15 years at origination and 7.5 years after prepayment.”
  11. The company is under leveraged
  12. The PE funds might sell out their holdings once their term is over
  13. Currently it trades at a premium
  14. The target market is under served and there is room to grow
  15. Good Indian companies tend to be costly and remain costly.

This was much easier read than other Outlook recommendations.

One of things I disagree with is the discussion about good companies being costly and remaining costly. Just a decade ago, we had one of the worst recession, stocks were down. HDFC for example was trading at very cheap valuation of MCAP (Adjusted)/Net Income of 8. But the parable gets often repeated in a bull run and becomes a self-fulfilling prophecy. Every time it is repeated, people’s FOMO (fear of missing out) kicks-in and they buy an already expensive stock pushing the prices even further.

Sure, today finding a good and cheap stock is difficult. But nothing lasts forever.

Sidebar: Asset Liability Mismatch

Financial Institutions make money on interest difference. They borrow money from one person and lend it to another. Ideally, until the borrowed interest rate is lower than the lending rate, they make money and everything is fine. But, there is an additional caveat.

Every business needs to manage its cash flow by ensuring money going out matches the money coming in. If there is a mismatch company can get in trouble.

When it comes to banks, they need to ensure that the payment for their borrowings match their income from loans. If there is a mismatch they can get into trouble.

To understand, let us take a simple example – Let’s say a bank borrows INR 100k at 8% for 10 years. They turn around and loan the money at 12% for 20 years.

Even though the loan rate is higher there is a difference in EMI. Bank’s EMI is INR 1213 while the loan’s EMI is INR 1101. The bank has to pay the difference from its own pocket. This situation gets worse when the loan turns into non-performing asset.

In a time of huge credit expansion, this is not a problem. Someone will always step in to provide another short term impetus.

When there is a liquidity crunch or a market crash, this backfires really badly. So, we need to be aware of a bank’s borrowing terms (or any company for that matter).

Coming back to our discussion on Aavas Financiers, I read up on credit reports of Aavas to understand the business better.

Aavas’ main business is loans and even in there 75% is in housing loan. Their target is to increase it to 80% of loan portfolio.

99% of total loans are retail loans. Out of which 65% loans have been given to self-employed customers.

On the supply side, the break seems to be:

NCD – 13%

Loan assignment/securitisation – 25%

Borrowing/Share Capital – 52%

Because of the nature of their business they get better rates under “priority sector lending”.

Has it been good?

Yes it was been really good:

ROE 19.67%
Debt to Equity 455.15%

If we compare it to HDFC, we discussed earlier the ROA is superior. The ROE is way less but it comes with a moderate debt. As Gautam Trivedi points out above Aavas might actually under leveraged. The question though is how much leverage should they take on, especially given their average loan size seems to be less than 1 million or INR 10 lakhs. 2x-3x more leverage or D/E around 1000-1500% is something I feel should be comfortable. Above that I think they should run start running into trouble.

Will it remain good?

Information about customer demographics made this consideration easier.

  1. Customers – Customers are mostly retail, semi-urban and self-employed.
  2. Supplier – Main supply is money. The priority sector lending means they shouldn’t have any supply side issues.

So, there are no concerns on customer or supplier concentration.

Porter’s Modified 4 Forces Analysis:

  1. Customers – Weak – There is no dependency on a single customer and there aren’t many companies providing loans to economically weak section (EWS).
  2. Supplier – Weak – This is mostly driven by their status under priority lending and India’s push towards housing under many government schemes.
  3. Threat of Substitutes – Medium – We tend to hear a lot about how India’s rural population is under-banked and underserved. But not many people talk about Gramin banks. These are small government banks created specifically for catering to the rural population and provide loans/credits to SMEs on similar terms. While they might not focus entirely on housing loans like Aavas or handle loans better, I am still inclined to see them as a threat.
  4. Threat of New Competitors – Medium – Government for past couple of years has pushed for housing reforms. If they believe in it strongly and push for even more reforms then we might see more housing finance companies coming up.

Though the score is 2 weak and 2 medium, I am still inclined towards Aavas.

Moat – None.

Growth Assessment – Rural housing has been one of the ignored aspects in Indian growth story. So, I believe the company should grow.

Shareholder Friendliness

Compensation – Sushil Kumar Agarwal is the highest paid board member at INR 2 crores. He has also been granted some ESOPs. So, the figure might be understated. We might need to re-visit this figure after latest annual report is released.

Most of the directors are paid INR 6 lakhs. So, compensation is fine.

Shareholding – Currently, the promoter group holds 58% of the company. Additionally, the senior management owns ~ 8% of the company, which is the highest among all the companies I have looked at.

Related Party Transaction– No concerning transactions were found.

Share Repurchase/Dividends – This is again something we might have to revisit once the first annual report is out.


Just as Gautam Trivedi pointed out the company is trading at a huge valuation:

MCAP/NI 74.42

This is costlier than even HDFC, and that is saying something.

One of often repeated stories in value investing circle has been about Buffet buying Coco-Cola at mid-teen price to earnings. This happened at a time when anything with P/E above 10 was thought to be costly. When asked about this, Buffet famously said – “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

While buying companies like Aavas many people remember the wonderful company part but forget the fair price part. Currently, the company’s valuation cannot be termed fair to say the least.

Accounting Note: Provisions

The nature of a credit business is such that you inevitably run into customers who won’t pay you back. In a normal course of business, it is known as bad debt expense and for bank it is the NPA (non-performing asset) write-off.

The issue with laggard customers doesn’t stop there, companies also need to estimate the amount of debt that might go bad and provision for it. This ensures company is safe from any future shocks emanating from non-paying customers. Non-financial companies call it “provision for doubtful debts and advances” and financial companies call it “Provision for non performing asset”.

These provisions appear on the balance sheet as liabilities and recorded as expense on profit and loss statements. So, if the company assess that a large number of debt might go bad and records a high provision then their bottom line takes a hit. In which case, companies might be tempted to reduce their estimation and expenses.

Let’s take a look at couple of charts to understand what I am getting at.
Profit Before Tax

Aavas’ PBT has grown exponentially. The same trend can be seen for other data too. Here’s the growth in NPA:
Gross NPA

In this graph, the green highlight is the Gross NPA for FY 2019 first quarter (period ending 30-June-2018) mentioned in the IPO document. I have made a crude extrapolation by multiplying the quarter figure into 4. The actual figure might be less or more.

The red highlight, which stands out a lot, is the Gross NPA for FY 2018.

Similarly, when we look at provisioning for NPA:

Provision for NPA

Again, the green highlight is a crude extrapolation by multiplying first quarter figure into 4 to arrive at the yearly figure.

Once again, 2018’s data is an aberration. It is way less than the provision for FY2017 which I find odd.

One way to look at it is that Gross NPA has halved between FY2017 and FY2018 hence lowered provision. Then the company says:

26.1 During the FY 2017, the Company had revised its estimates of provisioning for non-performing loan assets. As a result of such change, the profit before tax for the year ended March 31, 2017 lowered by Rs.12.20 millions.

My reading of this statement is that their new estimation in FY2017 was much harsher. But in FY2018 with gross loans increasing by over 50%, the provision is still lower than FY2017?

NHB has recently issued its inspection report for Fiscal 2017, identifying certain deficiencies and observations, including non-classification of rescheduled loan accounts, where interest rates were renegotiated during Fiscal 2017, as sub-standard assets; higher provisioning required based on the foregoing, and on account of incorrect classification of multiple loans given for housing purpose to same borrower as housing loans, instead of as commercial real estate (“CRE”); incorrect inclusion of off-balance item of credit enhancement through liens over fixed deposits under on-balance sheet items instead of as off-balance sheet items; non-disclosure of a percentage of outstanding loans granted against the collateral of gold jewellery, although no loans were granted against the collateral of gold jewellery in Fiscal 2017;

NHB had asked them to raise the provisions owing to re-negotiated loans and multiple housing loans given to same borrower. There is not much info on what corrective actions was taken. But, in light of this information gross/net NPA was still lower for the next fiscal year?

I might be missing something and don’t have enough information to understand Aavas’ provision estimation correctly.

Some might note that, I didn’t cover this aspect in my HDFC analysis. The reason is simple – I looked at HDFC Bank financials for last 6 years. Their Net NPA kept increasing and so did the provision for NPA.


Back in 2006, my father was searching for a business loan. All the national banks in my small town – ICICI, SBI, Bank of Baroda etc. refused him owing to the non-salaried status. Finally he got a loan from Gramin bank for some amount. Rest of the amount had to be borrowed from a money lender who charged 3% per month!!

So, I really love the fact that there is now renewed focus on banking inclusion for rural and semi urban population. But, I also fail to understand the hype surrounding these companies. Sure, they are great earners and they deserve our support but not at such high valuation.

Starting next post I will not be looking any more of the Outlook 2019 recommendations. Additionally, I will try and post an idea which I can firmly stand-by. So, it might be a while before next post shows up. I’d encourage everyone to start following the blog.

Note: This is not an investment advice.

GreenPly Industries or What happens when you follow free “professional” advice

In my search for ideas, I picked up another Outlook 2019 recommendation – Greenply Industries.

I made some crucial mistakes while researching Greenply. I will try to explain those mistakes in detail.

Do I understand it?

First, let us go through the initial recommendation to understand the case being made:

  1. The thesis is to find good companies in bad phase which is a sane idea.
  2. Greenply makes plywood and MDF boards
  3. “For a company like Greenply, which has a strong track record of operating performance, and considering other factors, the correction offers a good opportunity to invest from a three- to four-year perspective.”
  4. Company has commissioned new plants to increase their MDF capacities.
  5. With GST in place Greenply is hopeful of capturing the unorganized market share of plywood
  6. They have started getting into lower end plywood products as well
  7. Plywood utilization has been hitting 100% and other requirements is fulfilled by outsourcing.
  8. New plants to produce veneer in Gabon and Myanmar
  9. There is a case made for MDF using a comparison with China.
  10. The company has set up new plants to manufacture MDF
  11. There is a glut of MDF capacity
  12. Plywood growth has been steady
  13. The company should do well, once the MDF market starts to grow

Sidebar – Capacity Utilization and Orderbook

One odd thing I have been noticing with Indian investors is the focus on capacity utilization and order books. It seems to me that both these measures are used as proxy to determine how much a company can grow. I mean you can’t have a company growing with a factory which is hardly utilized or even with zero orders to work on. Though I see two problems with such approaches.

When a measure becomes a target, it ceases to be a good measure.

Goodhart’s law

Goodhart’s law is the first problem with such an approach. A good example of this law is earnings per share or EPS. Once everyone started to target an EPS growth as a measure, companies took notice and started to doggedly pursue the same. This meant they started taking steps like commingling huge non-operating income, just so that they appear to be growing.

As the companies realize that they need to target a 100% utilization or a full orderbook, they will start taking every step possible to bloat those measures too.

This is also one of the reasons we shouldn’t take every ratio or measure on blind faith. If those ratios becomes are target then people will try to bloat that measure as much as possible.

The 2nd problem is that orderbook tells me only one aspect of business. Even if a company has a huge orderbook without margins it is not going to make money. To take it one step further, even if they have good margins companies can take up some low margin orders just to show a full orderbook.

Coming back to our analysis, I normally pride myself on catching logical fallacies easily but I failed to look into this article clearly. Instead I went on to read the annual report.

Annual Report (AR) 2018

Greenply’s 2018 annual report gives you a fair reading of their business. Here’s how business stacks up:

Plywood and Allied Products 69.50%
MDF 28.60%
Others 1.90%

Another story emerges when you look at net profit contribution:

Plywood and Allied Products 47%
MDF 55.8%
Others -2.8%

So, plywood while the most selling product isn’t exactly the most profitable of the lot. Looking at the country segment – 96% of the revenue came from India.

In this case, the raw material was clear – wood. And because wood is a commodity there aren’t many supply side constraints. This also meant the end product is mostly commodity too.

On the customers front, Greenply is mainly a B2B shop.

Sidebar: Enabling Business

When a company’s sales sag they often provide customer financing and other payment options. But, there are ways a company can enable it’s business.

To give you a example, think of Google. Their main revenue source is selling ads. They had a good search engine and they could have sat and collected revenue from search ads.

Would that help them become a revenue generating machine? No. So, they enabled their own business via free products. Free mail, free video stream etc. All to sell more ads.

Many businesses take part in their respective industry trade shows, demos etc. Not many actively enable their own business.

So, when I learned of three initiatives from Greenply I was really happy:

First one is called Ask Greenply where people could go to their site and ask them quotes for different furniture and fixing. They also had tons of information about plywood and MDF.

Second one is called Green Access which is a loyalty program for interior designers. They were providing a lead generation tool to designers to manage and track leads.

Third one is called Green Samriddhi where they were offering points to carpenters and contractors using their products.

Put together Greenply had covered most of their selling points and using these tools effectively should enable their business.

In the report there are no pages depicting board of directors. I found the info on their site. 4 out 9 directors were family members.

This made me look up the compensation committee. I normally want only outside directors to be responsible for deciding the remuneration. In this case I found one of the family member was actually part of the compensation committee. This was not a good sign.

Has it been good?

Simple answer – No. Long answer – They have actually been FCF negative for 2017 and 2018.

FCFROCE -12% -13% 17% 11%

Operating Income hasn’t grown as well. Though BV and TBV growth is good, those are measures used mostly to uncover dead companies. Figures for last 4 years:

∆OI/FDS 2%
∆FCF/FDS #NUM! (two years negative growth meant excel couldn’t take it)
∆BV/FDS 15%
∆TBV/FDS 15%

I wanted to recheck my FCF calculation. In the process I found something which cast doubt over the credibility of Katalyst Wealth (founder had made this recommendation).

What I had missed earlier?

I found most of the information in the article and annual report. So, it was late in the analysis that I read the credit rating document:

Ind-Ra has maintained Greenply’s rating on RWE due to its continued inability to assess the rating impact of the pending demerger of Greenply (demerged company) and Greenpanel Industries Limited (resultant company). Greenply is awaiting final approval for a composite scheme of arrangement for the demerger from National Company Law Tribunal and Securities and Exchange Board of India. The company has obtained approval from creditors and shareholders on 4 February 2019. 

A quick search revealed that Greenply has been looking to demerge its MDF to another company way back in March 20, 2018!

You’d think this kind of material information should be highlighted in a recommendation made a year later on April 29, 2019. This information can make or break the share’s price.

I was also guilty of skimping this in annual report. They mentioned the demerger in passing and I should have read that.


This whole experience reinforced two lesson I should have learned earlier:

  1. Do not allow other’s analysis to cloud my judgement
  2. Read the Credit Ratings Report

Looking at the quarterly reports, it seems that Greenply’s operating results have improved. But the pending demerger and capex spending add lot of uncertainty to the future. So, I am skipping the stock.

The last idea from Outlook 2019 list is going to be – Aavas Finance because I want to challenge myself to read an IPO document correctly. After that I will move on to finding some better ideas and hopefully a stock which I can wholeheartedly support and buy.

Note: This is not an investment advice.

Foods & Inns: A very short analysis

Radhakishan Damani is a legend in the Indian stock market. He is right up there with Rakesh Jhunjhunwala and people tend to follow him religiously.

So, it was no surprise that when it was announced that his company “Derive Investments” had acquired a 4% stake in an unknown small cap company called “Food & Inns” the market went into a tizzy. The price jumped by 38% and everyone was interested in knowing about this company. The CFO was interviewed by Bloomberg Quint too:

Bloomberg Quint Interview of Foods & Inns CFO

While I normally stay away from hyped companies, I said why not try one and see how good is the company.

Do I understand it?

I got the company’s Annual Report and just like our earlier company Grauer & Weil, I found the report to be light on details. It told us what we already knew – the company was into processing fruits into pulps etc. The only detail is India vs foreign revenue split which was not enough.

So, I ended up looking at Credit Rating documents. If prepared properly there are some real gems in those documents.

The first rating document was from CRISIL which had actually reaffirmed and then withdrawn it’s rating. They noted in the document that CARE had also withdrawn the rating citing that the company was not cooperating. This is never a good sign.

Ideally, we should end the analysis here. But I am a big believer in everyone getting a second chance. So I read one more recent document from another rating agency called Acuite (previously SMERA). This agency is partially owned by Dun and Bradstreet India.

The document, dated 7th Jan 2019, tells us more about the business. Some of the excerpts which I found interesting were:

Around 35 percent of the total sales in FY2018 are to Pepsi and Coke (Domestic & Export) and the remaining is distributed amongst some of the reputed players including Sumitomo Corporation (Japan), Agrana Fruit, Dohler Group, A.G. Barr, Lacnor (UAE), Haldirams and Heinz India Private Limited, among others.

The company in its 2018 Annual Report says that no customer accounted for 10% of revenue. That is interesting because 35% between Pepsi and Coke cut either ways means at least 17% for one client, which points to a customer concentration. Though the company might say they treat domestic and export(of Pepsi and Coke) as two different customers, so effectively they don’t constitute 10% of revenue.

The group’s revenues remained stagnant during the period FY2015 to FY2018. Revenues stood at Rs.335.48 crore in FY2018 as against Rs.354.88 crore in FY2017 and Rs. 338.12 crore in FY2016. On a standalone basis, there has been a decline in the operating account from Rs. 338.03 crore in FY2017 to Rs. 315.70 crore in FY2018. In FY2017, Excise duty of Rs. 7.35 crore has been included in the revenues against which Rs. 1.60 crore has been included for FY2018 (prior to GST implementation)

Interestingly, this was one of the questions in the above interview. The CFO first misinterpreted the question and then later refused to comment on the growth, which we can see has been stagnant. Not a good sign I’d say.

In FY2018, the fruit price of mango was largely suppressed due to excess fruit supply in the market and no substantial growth in demand. Operating in a seasonal industry, raw materials are prone to price fluctuations. The group remains vulnerable to agro climatic risks as it deals with fruits and vegetables. Being seasonal, the prices of fruit pulp are vulnerable to the vagaries of nature. Sale of mango pulp accounts for ~75 percent of total sales. On account of the above, the company’s operating margins declined to 10.56 percent in FY2018 from 11.66 percent in FY2017

75% from a single product can be a good thing if you are the sole provider and/or your products are specialized. Mango pulp sounds like a commodity product which a bigger player can get into if there is a huge growth potential.

Around 65 percent of the group’s sales are through export to Europe Africa and China.

The CFO clearly answered on this aspect during the interview. Though surprisingly, unlike Vaibhav Global there are no constant currency growth figures . That is the third red flag for me. So, I quit the analysis.


Radhakishan Damani is a great investor. He must be seeing something in this company which I have failed to notice. So, all I can say is good luck to everyone who is buying this company.

Note: This is not an investment advice.

HDFC Bank -Great and Expensive?

This week’s company is HDFC. There are two reasons I chose this company:

  1. In an earlier post, I said that financial companies and value investing don’t really go hand in hand.
  2. I have heard many Indian value investors use HDFC as an example of “a great company which might never be available at a fair price”.

I wanted to test both these hypothesis.

Do I understand it?

This was my first time looking at an Indian bank and the income split felt both useful and useless at the same time. Here’s how HDFC stacks up:

Interest from Advances65.60%
Interest from Investment18%
Commission, Exchange and Brokerage11.90%
FX and Derivative Income1.60%
Other Interest Income1.40%

The “advances” in this case can be a loan – personal, credit card, housing, business etc , current accounts etc.

The split on business segments:

Retail 50%
Wholesale 28%

Two thing of note here – One, HDFC regards anything less than 2 crores as retail. If you think in terms of a middle class income Indian, the bar of 2 crores is very high.

Second, each segment all income generated in that segment for example retail includes loan + fees from selling mutual funds + brokerage charges etc. So, we cannot simply use this split to create further granular detail of the topline income. For example, we cannot say that say that 50% of “Interest from advances” because of this split.

Additionally, HDFC Bank holds 6.7% of Total Domestic Deposits and gives out 7.4% of total Domestic loans.

Retail plays a big part in the portfolio:

Retail Deposits73% of total deposits
Retail Advances57% of total Advances

Further granularity on retail is unclear as the data is provided only for personal and housing loans:

Personal Loans19% of retail advances11% of total advances
Housing Loans6% of retail advances~4% of total advances
Auto Loans/Credit Cards75% of retail loans49.3% of total advances

The bank also distributes mutual funds (HDFC ones, I guess) and collects fees for the distribution. This constituted ~2% of the total income (18% of fees income which stands at 11.9% of total income).

Wholesale (or corporate) banking advances was 43% of total advances. There is no mention of wholesale deposits.

They also specify the amount of advances given to MSME, agriculture, gold loans etc.

Let’s pause here for a second. Imagine a Company XYZ with INR 100 Crores in revenue. The company says it sold 1000 units worth of product . The Unit wise division is: 105 units of Product A, and 895 units of Product B. Ratio-wise, that is 10.5% of Product A, and 89.5% of Product B. Using this information can you tell me which product generated most revenue?

Looking at just the volume one might come to conclusion that Product B was the fastest moving product. It should have the largest revenue.

Here’s the twist. If you go back to basics: Profit = Revenue – Cost. So, it is entirely possible for Product B to be making INR 0 and still the company to make 100 crores in profit. This might happen if the revenue from Product A is INR 105 crores while the cost are 5 crores. Hence, it is always important to know either the margin or the revenue split at product level.

HDFC, in spite of it’s all the numbers about loan books and advances tells me neither the margins nor the revenue split at product level. Loan book growth might be used as a proxy by many others but I see it as smokes and mirrors. Without looking at other banks it is difficult to assess whether this kind of reporting is correct or not. For me personally, these numbers feel overwhelming and useless to an extent.

The only thing data we can reliable use is the 2nd table – the revenue split by segment.

Sidebar: Mortage Derivatives

For me personally, one of great things about this investing journey is about learning something new about how companies work. It was interesting to see diagnostic industry workings in an earlier post.

This time I learned about how home loans work in HDFC:

In addition to this, the Bank operates in the Home Loan
business in conjunction with HDFC Limited. As per this
arrangement, the Bank sells HDFC Home Loans while
HDFC Ltd approves and disburses them. The Bank receives
sourcing fee for these loans and has the option to purchase
up to 70 per cent of the fully disbursed loans either through
the issue of mortgage backed Pass Through Certificates
or by a direct assignment of loans.

Annual Report 2018

So, the bank is not underwriting these loans. It is instead HDFC Limited, a separate company which underwrites this loan. These loans are then packaged as a fixed income product called Pass Through Certificates. Here, I was like a frog in a well thinking securitization of risks hasn’t arrived in India.

Has it been good?

The first metric we use to analyze historical operations of a company is ROCE. We could calculate ROCE for banks. The problem is capital in banks is not the same as capital in other companies. So, the ROCE metric doesn’t work. Instead we will use ROA (Return on Assets) and ROE (Return of Equity) to measure banks.

We will also use Debt to Equity ratio to see how much debt the bank is taking on to achieve its ROA and ROE.

Here’s how HDFC has fared on these metrics:

Debt to Equity 2483.89%
Δ NI/FDS (Net Income Growth per
Full Diluted Share)
Δ BV/FDS (Book Value Growth per
Full Diluted Share)
Δ TBV/FDS (Tangible Book Value per
Full Diluted Share)


ROA is near 2% which is good. ROE is amazing at 51%. Though lot of it seems to have been driven by high debt to equity ratio. Net Income also clears my hurdle of 15% year on year.

Will it remain good?

This was a tough nut to crack. First, let’s look at customers and suppliers:

  1. Customers – Revenue split is in favor of retail customers. And, the largest 4 loans amount for less than 10% of total loans. So, we can safely say no customer concentration issue.
  2. Supplier – Main supply is money. There shouldn’t have any supply side issues.

Porter’s Modified 4 Forces Analysis:

  1. Customers – Weak – As explained above, I believe there are lots of customers. We also don’t have a fear of forward integration because customers can’t become banks. Though with so many banks and similar banking products, there shouldn’t be any switching cost. Still I believe this force to be weak.
  2. Supplier – Weak – The raw material is money. The only way an issue might crop up is if the bank’s loan go bad and they have trouble raising funds. Still I consider this a weak force.
  3. Threat of Substitutes – Unclear – There are tons and tons of other banks in India and now with NBFC there are other ways to get loans too. On the other hand, HDFC is one of the largest banks so they have good physical presence which should outweigh the NBFC substitutes. But, I am still conflicted if this force is weak or strong.
  4. Threat of New Competitors – Strong – Even though banking license are hard to get in India, there are already tons of banks. HDFC doesn’t exactly has a core demographic. Both of which makes me conclude that this force is strong.

So, 2 weak, 1 unclear and 1 strong.

Moat – None.

Growth Assessment – This is a no brainer. In a growing economy, banks are the points for access of credit, so they should grow irrespective.

Shareholder Friendliness

Compensation – One other thing I am learning from this exercise is the propensity of Indian companies to understate huge executive compensation. Routinely, I am seeing stuff like “vested other years but exercise last year” kind of explanations to try and exclude ESOP/RSU from reported compensation. I really don’t care for such explanations because every stock which comes into existence is a cost to me as a shareholder. It doesn’t matter if the vesting happened during in the 1800s or 3 years ago.

Don’t get me wrong, executives play a huge role in company’s growth and they deserve to be compensated fairly for their effort. But, if everything is above board why is there a need to hide compensation in legalese or “condition applied” bracket. The only explanation is that there is something wrong and the company in full realization tries to underplay that aspect.

If that is not enough, HDFC invokes an arcane rule to escape the need for 10% Net Profit cap:

^ Section 198 of the Companies Act, 1956 (which corresponds to the now applicable section 197 of the Companies Act, 2013) does not by virtue of section 35B (2A) of the Banking Regulation Act, 1949, apply to Banking companies

So, they are using every trick in the book to justify fat paychecks to executives. How can you not be suspicious of this?

If we talk numbers, Aditya Puri earns 9.6 crores in salary + whopping 32 crores in options = 41 crores last year. Though the number huge it is still above my bottom line.

This prompted me to look at salaries of other directors. They have routinely taken home approximately 15-20% hikes each year for last 3 years. Their compensation has outpaced HDFC’s growth which I don’t think is a good sign.

Another sticking point for me is that HDFC paid board chairperson a salary above and beyond the sitting and commission fees.

During the year, Mrs. Shyamala Gopinath was paid remuneration of ` 3,123,662. The remuneration of the Chairperson has been approved by the Reserve Bank of India

Shareholding – The only golden lining of the huge compensation is that Aditya Puri now holds 0.13% of the company and he hasn’t been trimming his portfolio. This is a good sign.

Related Party Transaction – There is one transaction of note. A 76 lakh charge for service rendered by executives or their relatives. There is clarification on the 66 lakh part:

During the year ended March 31, 2018, the Bank paid rent of ` 0.66 crore (previous year: ` 0.66 crore) to party related to the Bank’s key management personnel in relation to residential accommodation

There is no information on the executive’s name or rented location. Still, this plan sounds like something my colleague used to do. He used to pay 20k rent to his own father to save on taxes on HRA. Here HDFC is making shareholders pay for accommodation.

There are no clues about the other 10 lakh was spent for.

Dividends – HDFC paid INR 13 as dividends last year which is good. They also say:

It has a consistent track record of steady increase in dividend distribution, with the Dividend Payout Ratio ranging between 20 per cent and 25 per cent – a range that the Board endeavours to maintain.

Commitments of this kind have a tendency to back fire. If there is a slowdown, HDFC might be tempted to do some financial engineering to keep the payout at 20-25%.

So, there are some issues with HDFC which needs to be weighed against Aditya Puri’s commitment and shareholding.


This was a forgone conclusion even before we analyzed the company. It is costly by a long shot:

Adjusted MCAP/NI35.40
Adjusted MCAP/TBV20.50

The Adjusted Market Cap = Market Cap + Minority Interest + Share Premium Account with HDFC.


HDFC has some amazing characteristics – ROA is good and ROE is freaking amazing. Though my future assessment fails to give them full marks, they probably should grow well in a growing economy. That being said, the company is neither cheap nor shareholder friendly. I might consider some shares at a lower price but I don’t see that happening anytime soon.

Note: I am not a SEBI registered advisor and this is not an investment advice.

Engineers India Ltd: A story about Boards, Cash, Disinvestment, Book Value and Revenue Concentration

This week’s company is Engineer’s India and it comes from our old list – the Outlook Picks for 2019 . You can find the master list here . I have covered other recommendation Grauer & Weil, Vaibhav Global and Dr. Lal Pathlabs too.

To be honest, I was hesitant to analyze a PSU. I have been told that they are bad investments. Accepting that on face value means that I have an authority bias acting on me. I haven’t looked at any PSUs, so how do I even know if it is worth it? So, with that in mind I went ahead with this analysis.

Do I understand it?

I first started with the initial thesis presented in Outlook to see what makes this company compelling from a seasoned investor’s POV.

Initial Thesis

Couple of things I noted from the article:

  1. Engineer India has played a large role in our country’s petrochemical refineries.
  2. Health Earnings Growth and Consistently paying Dividends
  3. Stability of Oil prices prompting spending from Middle East and Africa
  4. “Further, in a boost to EIL, there has been a consolidation in the international project management consultancy market (PMC) with the number of players halving from 12 to six. ” I am not clear if we are talking about all PMCs or specifically hydrocarbon PMC.
  5. EIL is diversifying into projects like water treatment, airports etc. outside their hydrocarbon base.
  6. Revenue growth has been good, especially from turnkey segment which now contributes a large portion of revenue.
  7. “We expect EIL to compound its operating and net profit at 14.25% and 9.62%, respectively, with increasing contribution from the turnkey segment.”

Before I read up on last year’s Annual Report (AR), I wanted to understand what exactly turnkey meant:

Engineeringprocurement, and construction (EPC) contracts, sometimes called turnkey contracts are similar to design and build contracts, in that there is a single contract for the design and construction of the project, but generally with an EPC contract, the client has less say over the design of the project and the contractor takes more risk

So, with turnkey projects EIL needs to design, source, build and deliver hydrocarbon projects. To me that sounds like a risky and low margin proposition. But, we will look at the annual report to see if that is true.

Annual Report

The company starts off by laying out its progress – 2,141 crores in new projects – 63% in consulting, 22% from turnkey and 14% from overseas (consulting and turnkey combined, I guess). The largest win on consulting side being Guru Gobind Singh Polymer Addition project of HMEL and in Turnkey segment from brown-field expansion projects of ONGC.

One of things I can say about EIL is that they pull no punches when it comes to laying out their projects. Maybe it is because they are a PSU, which would be a happy thing – taxes put to good use.

Revenue grew at 17.6%, PBT at 13.5% and PAT at 16.2%, which is also good.

Story Part 1: Boards

As I look at the Board of Directors, I can’t help but weep for my tax rupees. What is the exact need for such a humongous board? What can 13 members achieve which 6-7 member board can’t?

It doesn’t really help that most of them are government servants and then there is Shazia Ilmi Malik. With all due to respect to her work, if this was a media/entertainment company I’d welcome her nomination. Her nomination in this company concerns me.

The Director’s Report gives us detailed information about the revenue split and growth:

Consulting and Engineering Contracts: 70% (+18% growth)

Turnkey: 21% (+44% growth)

Other Income: 9%

Turnkey was the fastest growing segment for the company. But the profit growth in turnkey was terrible:

Consulting and Engineering Contracts: +20% growth

Turnkey: -27% down

So, my guess about turnkey being low margin is somewhat correct.

After reading all the discussions in the AR, there was only question remaining – What were the raw materials and who were the vendors?

I had to reverse engineer the answer by looking at the listed projects. Most projects were PMC, DFR (design for reliability) type of projects. So, I guessed that EIL was more of an engineering consultancy organisation. The only way to confirm was to look at expenses.

The soul and blood of a consultancy organisation is its employees. So, the employee expenses should be huge while stuff like COGS should be either absent or minimal.

As per the consolidated P&L statement employee expenses was 54% of total expenses. There were other notable expenses:

  1. Technical assistance/sub-contracts – This sounds like expense towards hiring third party contractors or getting outside technical expertise. This is 15% of the total expense.
  2. Construction materials and equipment – This sounds like expense towards buying stuff from vendors – stuff which I assume goes into turnkey projects. This is 7% of the total expense.

So, my summary understanding was: EIL is a consulting focused PSU working primarily on Indian hydrocarbon projects (though things are changing this year with focus moving towards turnkey projects).

Has it been good?

There was lot of learning while doing this particular section. Some of which I have highlighted below.

Story Part 2 – Cash Balance

The first quantitative calculation we do is the ROCE (Return on Capital Employed). The denominator, Capital Employed, is calculated as (from the book):

Capital Employed = Total Asset – All non-interest bearing Current Liabilities and treatment of cash

It is difficult to know exactly how much cash a business needs. So, we always calculate two capital employed numbers – one with cash and one without cash. Most of the time, the difference between both numbers is minuscule.

When it came to EIL both numbers diverged by a large amount. You see, the new India Accounting standards (AS) says the cash balance has to be broken down to two different components:

  1. Cash and cash equivalents
  2. Other Bank Balance

Other Bank Balances has some payables sounding entries:

  1. Amount held on behalf of clients
  2. Unpaid dividend account

In the older AS, the combined value of cash + other bank balances was referred to as “cash”. I used the older AS assessment to calculate capital employed.

The problem with my approach became apparent with EIL. The divergence between cash and non-cash numbers are huge. The ROCE for 2017-2018 was:

ROCE with cash16%
ROCE without cash1282%

A difference of 1000%!!!

One way to handle this would be to calculate using only the cash and cash equivalent values:

ROCE with cash16%
ROCE without cash16%

As, you can see difference is negligible.

The third approach is to stick to the definition of cash i.e. anything which can be converted to cash within a year. In this case, we include “Balances with Banks in deposits account” to calculate ROCE:

ROCE with cash16%
ROCE without cash272%

There is a still a big difference but not as bad as the first one.

After much deliberation I decided to stick the 3rd approach.

Story Part 3 – Disinvestment

GOI has been trying to divest it’s holding in EIL. To achieve this, EIL first made an offer for sale in Jan 2016, which diluted the government holdings from 69% to 59%. Then there was a share buyback where GOI offloaded a chunk of it’s holding. GOI also gave some shares to Bharat 22 ETF.

Story Part 4 – Book Value

The reason I brought up disinvestment is because it affected my other quantitative measures – Book Value (BV) and Tangible Book Value (TBV).

Due to offer for sale and share repurchase, the BV/TBV growth has been negative. It is expected because both actions affect the equity portion of the balance sheet.

It was my first time seeing a negative BV so, I re-confirmed from another source:


Putting it everything together, EIL’s performance for past 4 years:

ROCE (with cash)8%
ROCE (without cash)52%

My assessment based purely on these numbers is that the company has decent, not great, but decent. But the fact that they are moving towards turnkey has me worried.

Will it remain Good?

Other than turnkey there were other things which might affect EIL’s future.

Story Part 5 – Revenue Concentration

Customers: The concentration of customers in EIL is big sticking point.

Segment revenue with major customers During the year 31 March 2018, 42,387.44 Lakhs (previous year 31 March 2017: ` 38,754.01 Lakhs) of the Company’s revenues, each individually exceeding 10% in the consultancy and engineering projects segment was generated from two (previous year 31 March 2017: two) customers.

During the year 31 March 2018, ` 37,959.27 Lakhs (previous year 31 March 2017: ` 28,109.56 Lakhs) of the Company’s revenues, each individually exceeding 10% in the turnkey projects segment was generated from three (previous year 31 March 2017: four) customers.

Annual Report 2017-2018

Top 2 consulting customers contribute nearly 30% of segment revenue. And top 3 turnkey customers contribute nearly 93% of segment revenue.

It is possible that there is an overlap between consulting and turnkey customers. Without combined figures it is difficult to reach a conclusion. So, for now I can only say this – A minimum of 20% of total revenue came from top 2 customers. From the looks of it, these customers are HPCL and ONGC.

I am not entirely sure if this concentration is a bad thing. As a PSU working with other PSUs should give EIL an upper hand.

Suppliers: As I noted above EIL seems to be more of a consulting company and their key “supply” is their talent and know-how.

Initiatives like setting up Skill Development Institutes at Bhubaneswar, Kochi, Visakhapatnam, Rae Bareli and Guwahati and contributing towards setting up of Hydrocarbon Sector Skill Council, New Delhi etc. augurs well for the company.

Though if they end up doing more turnkey projects, we will need to revisit this section.

Porter’s Modified 4 forces:

  1. Customers – Unclear – As I noted above the effect of concentration is unclear.
  2. Suppliers – Weak – This force is weak for now. But if they truly go towards turnkey projects we might have to re-visit this conclusion.
  3. Threat of Substitutes – Unclear – If being a PSU gives them an upper hand in the bidding process there might be no threats to speak of.
  4. Threat of new competitors – Weak – EIL work is highly specialized so I believe the threat of competitors should be low.

Conclusion – Unclear on 2 parameters. Ideally we should skip the company.

Moats: EIL might have a moat due to the PSU status but without a thorough understanding of the PSU bidding process this a difficult call to make.

Growth Assessment: I think EIL will have a slow single digit growth.

Shareholder Friendliness

I have talked about one aspect above – the size of the board and its members. The other aspects are:

Compensation: Salaries paid are fair. Due to the large board I was concerned about the 10% net profit barrier. As I noted in an earlier post about diagnostic companies, I consider this to be a serious issue. Thankfully, even with a huge board the salaries are not that high.

Shareholding: GOI is the largest shareholder and they have been trying to trim it down owing to their disinvestment targets. I am conflicted about this part.

Related Party Transaction: Looks okay but then again my understanding of this law is pretty shallow so take it with grain of salt.

Repurchases: The repurchase last year seemed to have helped GOI but not many minority shareholders.

Dividends: The company is paying consistent dividends.

Frankly, I am conflicted about calling EIL a strictly shareholder friendly company. Actions like the share purchase haven’t exactly helped minority shareholders.


This is the most inexpensive company I have analysed till date:

EV/OI (with cash)17.89
EV/OI (without cash)11.89

I considered two versions of Enterprise Value because of the huge cash position.


Honestly, EIL feels like a missed opportunity. Another day, another time, it would have been a great buy. I mean how can you not love a company doing mostly consulting work in hydrocarbon with little capex overheads? No vendor/raw material headaches and their unique PSU status might have helped too.

But, the changing revenue mix towards turnkey projects and the disinvestment steps make me wary of the company.

Note: This is not an investment advice.

Indian Diagnostic Industry, Dividends and Shareholder Friendliness

This week I decided to look at another company from the Outlook Business’ Stock Picks for 2019, compiled from interviews with famous investors. A summarized list can be found here.

This company name we are analyzing is – Dr. Lal Pathlabs. Before I started the blog I had looked at Thyrocare, another diagnostic chain. So, it was interesting to look at another diagnostic chain. Now I can safely say that I understand diagnostic business better than an average investor. The following information should work well for recent IPO Metropolis Healthcare and other diagnostic chains as well.

Do I understand it?

Indian diagnostic chains call themselves “Asset Light”, a term I discussed in my last post. As I explained in that post, it is normally used by companies which offload their heavy capex commitments to someone else. It applies slightly differently to diagnostic chains. There are three different aspects to it:

Hub and Spoke Model

Diagnostic chains run on what they call a “hub and spoke” model. This model/paradigm consists of a single large hub with smaller inter-connected hubs. For diagnostic chain it looks something like this:

Source: Metropolis DRHP

The reference labs or the “Hubs” are the labs equipped with the heavy diagnostic machinery. These labs are used to various diagnostic tests. These are located in metro cities like Mumbai, New Delhi etc.

The hubs are connected via spoke to the satellite labs which are one step down from reference labs. The labs act mainly as feeders to the reference labs and manage the workloads.

The satellite labs are further connected to collection centers. As the name suggests, these centers are used to collect samples from the patients.

So, when a patient needs a sample analyzed they approach the collection centers which take samples and send to satellite/reference labs for processing. This way diagnostic centers can avoid buying machinery for every collection center/regional hub, thereby lowering capex.

Lab Machines

Furthermore, the machines at the national/regional labs are leased. This reduces any upfront capex as the only expense is lease payments, to be paid over time.

Diagnostic chains have further optimized their costs by committing to reagent purchase in lieu of lease payments. As, these reagents are anyways required to run tests this serves dual purpose – reduce expense and get raw materials for their machines.


Interesting look at Collection Center Setup (Source: Metropolis DRHP )

As you can imagine setting up collection centers will require another round of capital expenditure. So, diagnostic chains have been trying to optimize this cost by franchising out the collection center. These centers operate on a revenue sharing scheme.

When all three – Hub and Spoke, Machine Lease and Franchisee are combined, it leads to lowered upfront Capex for diagnostic chains.

Now that we understand how the business is setup let’s look at how business is conducted. There are two major ways to drive patient volumes:

  1. B2C – Customers directly approaching one of the collection centers for tests
  2. B2B – Collection centers in hospitals being managed by the diagnostic chain

Thyrocare’s 2017-2018 Annual Report (AR) says, 77% of their revenue comes from B2B arrangements as opposed to 23% from B2C. Dr. Lal Pathlabs on the other hand doesn’t provide this information. But interesting, they make another point which we will cover later.

We normally do not have a very accurate estimation of this because some of our B2C business is also B2B led, but our internal estimate shows that about 60% of our business is walk-ins and B2C and balance approximately 40% is B2B.

Dr. Lal Pathlabs Analyst ConCall Q2H1-FY17.pdf

Another major business theme in diagnostic industry has been about market share. Diagnostics is ruled mainly by unorganized players with 70-85% of the market share. As per Dr. Lal Pathlabs a diagnostic chain might control 40% of the organised market or 3-6% of the total market. So, there is room for chains to grow.

The 2nd theme is government regulation. There are no proper government regulation for diagnostic tests. Though there are accreditation like NABL but those are not mandatory. If tomorrow there are government regulations, it might actually help the diagnostic chains.

The 2nd business theme is per patient revenue. My understanding from reading both company’s AR is that diagnostics is a price competitive market. Test prices haven’t increased in last couple of years. The focus for these companies has been to increase samples per patient, thereby increasing revenue per patient. This I find concerning.

In India, over the years we all have heard stories of doctors having “tie-ups” with certain diagnostic centers. Doctors getting kickbacks for each test performed so they tend to write up more tests than necessary. That is illegal.

Diagnostic chains say that their focus is on selling bundled tests at a lower costs, which to me sound similar to writing up more tests to collect more money.

Lastly, a note on demographics. Currently, Dr. Lal Pathlab operates mainly in North India region. Metropolis and Thyrocare operate in nearly the same market – West and South India. So, things will get interesting once these guys start to expand in other areas.

Have they been good?

Oh, absolutely. Diagnostics chains have actually killed it in the past.

Thyrocare(last 4 years):

ROCE(Return on Capital Employed)34%
FCFROCE(Free Cash Return on Capital)26%
∆OI/FDS(Growth in Operating Income)14%
∆FCF/FDS(Growth in Free Cash Flow)15%
∆BV/FDS(Growth in Book Value)24%
∆TBV/FDS(Growth in Tangible Book Value)28%

Dr. Lal Pathlabs (last 4 years):


Both companies have cleared the hurdle of ROCE/FCFROCE greater than 20% and operating income/FCF growth of at least 15%.

Will they remain good?

While diagnostic chains have been good, I am not so sure about their future.

Customers: Both the companies have a standard disclaimer that no customer contributes more than 10% of their revenue. Though I wonder if that is true. See, if a hospital (B2B channel) asks for diagnostic test, who exactly is the customer? From a revenue point of view, billing is in the name of the customer. But, in reality it was the hospital who was providing them the case. And Dr. Pathlab’s statement above about B2B and B2C split says as much. They are also unsure how the division will work due to overlap.

In any case, if there is a particular hospital chain adding lot of revenue, maybe more than 10%, then I’d consider that a problem.

For now, unfortunately, I don’t have enough info to make this conclusion.

Suppliers: Medical instrumentation is a highly specialized field. So, there can be only so many suppliers. Though the saving grace is that diagnostic chains have long term contracts with suppliers. So, they should be fine from supplier end.

Porter’s Modified 4 forces:

  1. Customers – Strong – There is no clarity on customer concentration. There doesn’t seem to be any pricing power. And customers can always approach another, cheaper diagnostic center. Due to lack of regulation there are no switching costs as well. So, I believe this force to be strong.
  2. Suppliers – Weak – I think the long term lease of instrument contracts should provide diagnostic chains with some bargaining power.
  3. Threat of Substitutes – Strong – Direct substitutes i.e. competitor products are a big problem for these guys. Additionally, there are online aggregators like Practo, Medplus etc which help steal customers away. There is no loss of value or switching costs for customers to switch away to substitutes.
  4. Threat of new competitors – Strong – Without regulation, it is an open field. The barrier of entry is low and anyone can come-in and set up shop. With low switching costs, customers can shop around too. This might be mitigated if diagnostic companies capture the “supply” market i.e. hospitals but then that will increase their dependency on such customers.

Conclusion – 3 out 4 strong forces is bad. So, we should ideally skip both these companies.

But, I promised a full analysis. So, let’s continue.

Moat– None.

Let me add something here. Diagnostic companies talk a lot about how GST has opened this field up. Everything is about the name brand recognition. Especially today in a world where people can’t differentiate between diagnostic centers. They are all the same. As, the great marketer Don Draper put it – This might be the greatest marketing opportunity. They can take a simple quote like “X Labs, Its accurate” and run with it.

Greatest Marketing Opportunity

Growth Assessment – Population is growing and spending power is growing. So, it is not a stretch to say diagnostics will grow too.

Shareholder Friendliness

This is where we come to the meat of the topic. Do note – The following information is reflection of Thyrocare and Dr. Lal Pathlabs only. I have not read Metropolis’ DRHP to draw a conclusion about their shareholder friendliness.


Compensation – Highest paid manager is Mr. A. Sundararaju at 60 lakhs. Dr. Velumani takes only Re.1 as compensation which is awesome.

Though while looking for director compensation I found that Mr. Sundaraju and Dr. Velumani are brothers and Dr. Velumani’s daughter is also a director. Total 3 family members on company’s board breaks the “rule of 2”.

Shareholding – Promoters hold 64% of the company which is good.

Related Party – There were no concerns. I still don’t understand the related party disclosure so take this with a grain of salt.

Dividends – Total dividends last year was Rs. 15 . Dividends were 55% of standalone profit.

Capital Allocation (Dividends)

Dr. Velumani in his note said this:

We recorded a 17% growth in our revenues to ` 356.31 Crores in 2017-18. However, this growth was slower than what we have achieved historically. A key reason behind it was our lower spending on advertising this year. During the IPO-phase, we undertook significant advertising [..] led to stronger growth. We expected its lingering impact to continue driving growth. And so, we stopped advertising this year

Thyrocare AR 2018 Page 10

In spite of the clarification given, there is an assertion that advertising is tied to revenue. If that is true then why not spend more on ads. Why give away 55% of the revenue as dividends? Additionally, diagnostics is already a competitive field, why wouldn’t you want to retain earning and have a bigger chest to expand and grow?

My take on dividends is simple – A company should pay dividends only after it has exhausted all of its available growth opportunities.

This company has 34% ROCE and 14% growth so, dividend actually look shareholder – unfriendly.

Dr. Lal Pathlabs

Compensation – Company’s CEO Dr. Manchanda earned about INR 20 crores from stock options alone. Salaries in India are capped at 10% of the company’s net profit. In Dr. Lal’s case 10% of profit is INR 16.8 crores. So, that cap was breached and the company had to take government approval. This for me was shareholder-unfriendly.

If that was not enough the company tried to downplay this aspect:

2016-2017 Remuneration Table
2017-2018 Remuneration Table

Shareholding – Dr. Manchanda has been routinely trimming his holdings which I don’t see as a good sign.

Related Party – They mention rents being paid to “Central Clinical Laboratory” which can be as generic as a name can be. They don’t specify who has interest in the company or where it is located. This was another red flag for me.

Dividends – The company paid 22% of the net profit as dividends. Just like Thyrocare I find this to be problematic.

So, in conclusion neither of these companies are shareholder friendly.


Both the companies are too expensive for what they offer:



Dr. Lal Pathlabs



Couple of things I noticed about the accounting as well.

Operating Lease and Reagent

Both these companies have reagent buying arrangements instead of machine lease payments. The interesting thing is how both companies handle it in their books.

Here’s Thyrocare:

Thyrocare AR 2018 Page 142

So, it is legally not a lease but Thyrocare considered it as one?

While Dr. Lal Pathlab’s said:

Dr. Lal AR 2018 Page 94

In my opinion, Dr. Lal’s accounting treatment is the correct one.


Neither of the diagnostic chains provide information about the franchisee vs own collection center split. Without this information it is difficult to gauge – one, how much dependency is there on franchisee network and two, the revenue booking process.

Interestingly, Dr. Lal has an expense account called “Fees to collection centers/channel partners” which is around 12% of total revenue. We don’t have any explanation about the exact nature of the account. But, if the account represents the amount paid to franchisee locations, there is a chance Dr. Lal is might be reporting gross revenue.

Ideally, we want companies to quote net revenue earned by the company. For example, let’s say you book an Uber cab for INR 100. Uber’s gross revenue is the total trip amount i.e. INR 100. Let’s say they charge 20% of the ride as commissions which is their revenue. So, their top line revenue should be INR 20. If instead they report INR 100 then they are over reporting their revenue.

Comparatively, Thyrocare doesn’t even have any such expense account. So, it is anyone’s guess as to what is going on.


There is no doubt that diagnostic industry is set to grow but the current landscape is too competitive. As a wise man once said – If you are in an industry with more than 5 players, forget about pricing power. And that seems to be true for diagnostics due to local/regional players.

There are also concerns on shareholder-friendliness and valuations. So, I say – Pass to both the companies.

Note: This is not stock advice.