Stocks of companies that are big on debt and weak on profitability have zoomed in this bull-run. Now’s the time to sell these stocks and get your portfolio in shape

A rising tide lifts all boats, they say, and this stock market rally has been no different. As the markets soared, it is not just those members of India Inc that boast of good fundamentals and squeaky clean balance sheets that moved up.

Plenty of their peers in a more shaky position have been re-rated too. With companies filing their latest balance sheets, we delved into the debt position of Indian companies to identify opportunities for investors to cash out. Analysing the latest (2013-14) balance sheet of 878 companies filed so far reveals three interesting trends.

Back to the balance sheet

The recent market rally has been all about rebounding profits for India Inc; but what about balance sheet risks?

Well, nearly half the companies in the universe saw their debt-equity ratio (total borrowings as a proportion of equity shareholders’ funds) rise in March 2014, compared with the previous year.

Yet, the stock prices of 9 out of 10 such companies witnessed a healthy rally between August 2013 and now. In this list, there were companies which not only saw their debt-equity swell but also their profits shrink; yet their stocks completely ignored their business fundamentals.

We think these are ideal candidates for investors to cash out.

The stock of construction company Gayatri Projects is a classic example. The company slipped into losses in FY14 — ₹78 crore in 2013-14, compared with a profit of about ₹10 crore in 2012-13. During this period, its total borrowings also rose from about ₹6,380 crore to about ₹6,655 crore. As a result, the total debt to equity ratio rose from 9.5 times as of March 2013 to over 10.4 times by end of March 2014.

Even as the company’s fundamentals continued to weaken, the stock price has trebled since August 2013. The euphoria around improvement in economic prospects, hopes of a strong Government and a policy push drove this rally, completely ignoring the deterioration in financial health.

Cable manufacturer Sterlite Technologies is another example. In 2013-14, the company slipped into a loss of ₹36 crore as against a profit of over ₹25 crore the year before. Not just this, the company’s debt-equity rose to over 3.7 times. Yet the stock price has more than trebled in the last 10 months.

Cement maker Prism Cements and steel maker Welspun Corporation also feature in this list. In some cases, even marginal improvement in profitability was given a big thumbs-up by the market. Interestingly, even stocks of companies that had seen significant erosion in shareholders’ wealth joined the party. The market remained completely oblivious to the fact that it may be long before these companies return to good health.

The stock of renewable energy company Suzlon Energy has jumped five-fold since August 2013. But the company’s financial health continues to remain weak. Its total shareholders’ funds slipped into the red; negative ₹376 crore at the end of March 2014 from a positive ₹908 crore by end-March last year. The company’s borrowings saw a sharp rise from ₹13,693 crore to over ₹15,164 crore. As a result the debt-equity ratio further worsened in 2013-14 from a massive 15 times in the previous year.

The stock of mid-tier IT company Ramco Systems is a good example. The company’s stock price soared 2.5 times in the last 10 months. This is despite deterioration in the company’s debt-equity position; from 2.2 times at the end of March 2013, it rose to 3.4 times as of March 2014. Ramco’s equity shareholders’ funds declined from ₹129 crore at the close of fiscal 2013 to almost ₹108 crore by the end of fiscal year 2014. The total borrowings stood at ₹365 crore as of March 2014, higher than the ₹287 crore at the end of March 2013.

Takeaway: Be wary of putting your money in such stocks as the catch-up with fundamentals is bound to happen.

Not so ‘defensive’

Defensive sectors such as IT and pharma, the market darlings for over five years now, have also seen meaningful increase in leverage; profits for some of these companies have even declined in the last one year. IT, in fact, topped the list of companies that saw a jump in debt-equity ratio in FY14, compared with the year-ago period.

While borrowings as a proportion of equity for large-cap IT companies such as Infosys and TCS remained stable, it was the smaller companies such as Virtualsoft Systems, Northgate Communication, 3i Infotech, Ramco Systems and Subex that actually saw a big jump in leverage ratio.

This was on two counts, the first being the most obvious one — increase in borrowings ahead of the growth in profit and equity. The second one was erosion in shareholders’ funds on the back of accumulated losses, even as some of these companies managed to either maintain actual borrowings or even repay a small portion of it, which led to a sharp rise in the debt-equity ratio. But these stocks continued to be favoured by the market.

IP-based software solutions provider 3i Infotech faced a double whammy. Its borrowings spiked even as the equity reserves fell sharply due to losses.

Thanks to the net loss of ₹358 crore in 2013-14, 3i Infotech’s shareholders’ reserves declined from ₹915 crore in 2012-13 to ₹596 crore in 2013-14. But the company’s borrowings increased from ₹2,084 crore to ₹2,345 crore, leading to a surge in the debt-equity ratio from 2.3 times to almost four times. Yet, cheering the reduction in losses to ₹358 crore in FY14 from ₹421 crore reported in the year-ago period, the stock of 3i Infotech gained almost 150 per cent in the last one year.

Or consider Allsec Technologies which made a loss in the latest financial year; from a profit the year before. This led to a contraction in the funds available to equity shareholders from ₹101 crore in 2012-13 to about ₹80 crore as of March 2014.

Even as fundamentals weakened, the stock has gained over 40 per cent since August 2013.

Quite a few pharma companies also saw their debt-equity ratio surge in FY14.

The increase for smaller companies such as Parabolic Drugs, Sequent Scientific, Ind-Swift Labs, Parenteral Drugs and Panacea Biotech was largely on account of either losses or decline in profits, which led to erosion in reserves. Yet again, the stock prices soared high.

The stock of active pharma ingredient maker Ind-Swift Labs is a fitting example. The company’s adjusted loss widened from ₹87 crore in 2012-13 to about ₹125 crore last fiscal.

On account of this, the funds available to equity shareholders fell from about ₹853 crore at the end of March 2013 to ₹725 crore by end of March this year.

Parabolic Drugs also borrowed more during this period; total debt increased to ₹1,332 crore as of March 2014 from ₹1,212 crore. Yet the stock price has more than doubled since last August.

Markets cheered even the slightest improvement in profitability for some companies, unmindful of the slippage in debt-equity ratios into precarious territory. For instance, markets gave a thumbs-up to the Sequent Scientific stock, which jumped 2.5 times since August 2013, following a reduction in loss from about ₹65 crore in 2012-13 to nearly ₹52 crore in 2013-14. But the jump in leverage from three times as of March 2013 to 6.6 times by March 2014 was completely ignored by the market.

While the smaller companies saw their debt-equity ratio decline largely due to weakness in business fundamentals, those of quality large-cap companies also increased in FY14, for different reasons, though.

The debt-equity ratio of companies such as Torrent Pharma, Cipla and Glenmark rose in 2013-14 as these companies borrowed more, predominantly to fund their expansion projects and inorganic acquisitions. Revenue flows from these projects will lead to a moderation in leverage over the next two to three years.

Despite the increase in leverage, the debt-equity ratio for the large-cap drug makers and select small players remained well within the threshold level of two times.

Takeaway: Increase in debt-equity ratio may not be a bad thing, but it is a worry if the borrowings don’t create assets.

Vanishing cover

The stocks of companies with precariously low interest coverage ratio (profit before interest, depreciation and tax available to meet interest payment obligation) also rallied in the last 10 months. A good number of companies in the cyclical sectors such as construction, realty, capital goods and metals space had coverage ratio of just about one.

This means that the profits were barely enough to meet interest cost obligations.

Power and telecom infra company Sujana Towers is a standing example. The profit available to meet its interest obligation was just ₹225 crore while its interest cost was ₹209 crore, translating into an interest coverage ratio of a little over one time.

Remember, an interest coverage ratio of less than two times is cutting it quite fine.

Strangely, the stock price has jumped from just about a rupee in August 2013 to over ₹27 now, despite deterioration in the company’s finances.

Sujana incurred loss of about ₹3 crore in FY14, compared with a profit of ₹1.4 crore in the previous year.

Similarly, interest coverage ratio for construction company Welspun Projects saw a sharp slide from about 2.5 times in 2012-13 to about 0.2 times in 2013-14. This means that the company did not have enough profit to pay interest on its borrowings.

Though the company’s debt-equity ratio (0.6 times) was well within the comfort zone, prolonged low interest coverage could mean higher risk of slippage on interest payments.

But the stock price has zoomed nearly 240 per cent since August 2013.

Takeaway: With interest rates unlikely to be cut in the near term, avoid companies with abysmally low coverage ratio.

Any further hike in interest rates in the near term to curtail inflation may have a negative impact on stock prices — landing you in trouble.

Also read: Bet on the fittest

(This article was published on June 22, 2014)
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