>ACCOUNTING THEMATIC: Accounting quality drives investment returns

Along with everything else, accounting quality in India seems to have stagnated at a low level. Our analysis of the last four years of consolidated accounts of the BSE500 (excl Financials) points to continuing divergence in accounting quality within the stock market. The silver lining is that the relationship between good accounting and positive investment performance seems to be tightening over time.


As one would expect, accounting quality varies by sector (see table on the right) with the usual suspects like Realty, Conglomerates and Construction bringing up the rear. More importantly, the change in a sector’s accounting scores over time seem to have a bearing on investment returns (see exhibit 6 on page 5). Ironically, this puts Realty companies in a nice position as, inspite of being the bottom of the class on a blended basis over FY08-11, Realty is one of the most improved sectors when it comes to change in accounting score across FY08-11. Media companies are also in a similar position.


Similarly, accounting scores vary across market cap buckets (see table below right & Section 3). Whilst the “top 50” stocks have the best blended scores across FY08-11, the improvement in accounting scores over FY08-11 has been the greatest in the midcap bucket (bucket 3: the 100 stocks with mkt cap between $0.2-0.6bn).


Most importantly, from an investors’ perspective accounting scores have a clear impact on stock level returns. Whilst this is not apparent when you look at the BSE500 as a whole, when you drill down to the sector level the relationship is clear (see Exhibits below and Section 5). In fact, if you drill down further into a specific market cap segment in a sector (see Exhibit on the right), the link between good accounting and positive investment performance becomes even clearer.


Whilst our analysis uses on an array of accounting ratios to detect financial manipulation by listed companies, the most powerful ratios are:

• CFO/EBITDA or the “cash conversion ratio” fluctuates widely across time and across companies. It appears that whenever promoters want to boost profits (and do a QIP), working capital deteriorates and cash conversion suffers.
• “Other Loans & Advances as a % of Networth” seems to be the most widely favoured route when it comes to pulling cash out of the company (to fund whatever else has caught the promoters’ fancy outside the listed entity).
• “Provisioning for doubtful debtors as a % of gross debtors” also fluctuates significantly across time and widely across sectors and companies. A low score on this metric combined with poor cash conversion is arguably the defining signature of a dodgy set of accounts.

To read the full report: ACCOUNTING THEMATIC
RISH TRADER

>BASEL III: Global regulatory standard on bank capital adequacy, stress testing and market liquidity risk

Highlights of Basel III:

• Core equity tier-1 of 5.5% as against 4.5% for international banks
• Capital conservation buffer of 2.5% by way of common equity
• Leverage ratio introduced at a minimum 5% (without risk weighting) as against 3% for international banks
• Early transition by March 2017, as compared to January 2019 as per international norms
• Core equity fulcrum of CAR
• Charges to core equity tier -1 as against total CAR
• Dividend payout ratios relaxed, allowed upto 100%

For most private sector banks Basel III transition is likely to be smooth. High core-equity tier-1 capital along with room for increase in capital conservation ratios augur well for private sector banks. Select public sector banks are likely to face hiccups. Lesser room for capital conservation as PSU already operate on low dividend payout and low core equity are amongst the concerns for these PSU banks. For every 1% increase in core equity, RoEs are likely to moderate by about 200 bps on an average for the Indian banking industry.


■ Indian Private Sector banks well placed
Indian Private Sector banks are comfortably positioned to move towards Basel III guidelines. Banks would need to keep 11.5% as overall CAR with tier-1 capital at 9.5% (including capital conservation buffer of 2.5%). Core equity tier- 1 capital is the fulcrum of Basel III, and its impact extends into dividend payouts and computation of additional tier-1 capital and tier-2 capital. Leverage ratio has been introduced with core-equity as the capital base. Higher core-equity and CAR requirements are likely to moderate banks’ RoEs from current levels.


■ Select public sector banks, however, are on a sticky wicket
This list includes Bank of India, Central Bank of India, IDBI Bank, UCO Bank, United Bank of India and Vijaya Bank. Conversion of perpetual non-cumulative preference shares, however, may see UCO Bank, United Bank of India and Vijaya Bank sail through. With the Government of India holds bulk of the preference shares of these banks, such a conversion could be on the cards. Others in the list are likely to relook at their growth strategy, resort to dividend cuts or tap equity funding sources.


■ Higher core equity likely to moderate ROEs
Higher core equity are likely to curtail ROEs. Banks on average deliver about 15% ROE, and our estimates indicate that for every additional 100 bps of increase in core equity, ROEs are likely to dip ~200bps. An increase of 1% in tier-1 ratio would need an additional capital of ~Rs 470 bn (~US$10 bn) with the total RWA in the banking system at ~Rs 47 trillion. We believe private banks are well placed to strengthen their core equity through internal accruals.


To read the full report: BASEL III
RISH TRADER

>RELIANCE INDUSTRIES LIMITED: Comparison of RIL’s 3QFY12 results with 2QFY12 and 3QFY11 results

Financial highlights
■ EBITDA and net income. RIL’s 3QFY12 EBITDA declined 26% qoq and 23.7% yoy to `72.9 bn led by (1) lower refining margins, (2) lower production from KG D-6 block and (3) weaker performance of the chemical segment. 3QFY12 net income declined 22.1% qoq and 13.6% yoy to `44.4 bn.


■ Other income. Other income increased 55.8% qoq to `17.2 bn reflecting higher cash balance in 3QFY12. RIL had cash and cash equivalents of `754 bn at end- December 2011 versus `615 bn at end-September 2011.


■ Interest expense. 3QFY12 interest expense increased to `6.9 bn compared to `6.6 bn in 2QFY12; gross interest expense including interest capitalized of `1.1 bn was `8.1 bn. RIL’s implied interest rate was 4.3% in 9MFY12 and 4.3% in FY2011.




■ DD&A charges. 3QFY12 DD&A declined 13.4% qoq and 23.5% yoy to `25.7 bn reflecting (1) the first full-quarter impact on depreciation from reduction in gross block by the amount received from BP and (2) lower depletion due to lower production from KG D-6 block. RIL has not provided breakdown of depreciation and depletion separately.


■ Taxation. RIL’s 3QFY12 effective tax rate was 22.6% compared to 22.1% in 2QFY12 and 19.5% in 3QFY11. We note that RIL continues to provide for tax at the MAT rate of 20% for gas produced from its KG D-6 block.


■ Net debt. RIL’s end-3QFY12 net debt stood at –`0.4 bn against `99 bn at end- 2QFY12 reflecting `72 bn of gross cash flow generation (net profit + DDA + deferred taxation) and receipt of `147 bn of cash received from BP in October 2011. Net capex (adjusted for foreign currency gains or losses on foreign currency loans) was `58 bn in the quarter. We note that net capex includes (1) actual cash capex (not disclosed for 3QFY12) and (2) increase in gross block due to capitalization of increase in foreign currency loans due to depreciation in the value of the Indian Rupee against the US Dollar. The company has disclosed cash capex of `48.4 bn for 9MFY12, significantly lower than reported net capex of `124.6 bn. However, we would note that the net debt figure would capture the movement in foreign currency loans also due to movement in currencies of foreign currency loans relative to the reporting currency. Exhibit 3 gives details of movement in net debt over the past few quarters and years.


To read the full report: RIL
RISH TRADER

>Impact: Third Quarter Review of the Monetary Policy(January 2012): Impact on Liquidity

The Reserve Bank of India in its Q3 Monetary Policy Review retained key interest rates at the existing levels and reduced Cash Reserve Ratio (CRR) by 50 bps in order to ease the prolonged tight liquidity conditions in the banking system.


CRR, the proportion of the net demand and time liabilities (NDTL) that banks have to hold with the RBI, has been reduced by 50 bps to 5.5% effective from 28th January 2012. The 50 bps cut in the CRR would infuse approximately Rs. 320 bn into the banking system. With this change the RBI intends to permanently address the structural liquidity shortage in the banking system caused mainly due to the infusion of Dollar by the RBI since November.


On account of the increased government borrowings and the slowdown in private credit demand, the RBI has retained M3 growth projection for 2011-12 at 15.5%, while non-food credit growth has been scaled down to 16.0%.



Key Take-away:
1. Cut in Cash Reserve Ratio
In reducing the CRR by 50 bps the RBI wishes to address the liquidity pressure prevalent in the banking system since early November 2011.

Table 3 illustrates very clearly that the banks have been borrowing over the Rs. 600 bn comfort level of the RBI. Further, a CRR cut will end up giving money to even those banks that have surplus liquidity. Therefore, an infusion of Rs. 320 bn as induced by the 50 bps CRR cut would benefit the liquidity conditions to some extent. However to the extent that the liquidity crunch is due to bank investments in GSecs, these CRR released funds could flow mainly into government paper and support borrowing programme of government as commercial credit growth is sluggish due to demand and interest rate conditions.


2. Impact on Liquidity
Based on the RBI’s projections for growth in deposits (16% = Rs. 8,328 bn) and credit (16% = Rs. 6,301 bn) for FY12 along with the enlarged borrowing programme of the government (Rs. 5,099 bn), the following is the pattern of liquidity flows in the system.

Taking a closer look at the growth achieved so far in the financial year (Apr-Dec 2011-12), Table 3 shows that based on the RBI’s assumptions, there will be a net gap of Rs 1,324 bn in the system, of which Rs 320 bn would be addressed through the present CRR cut. Assuming that there are another Rs 200 bn of OMOs, there would be a gap of Rs 800 bn which will have to financed by other subscribers like PFs, Insurance companies, PDs, repos or CRR cut.


The mitigating factors would be:
- Deposits grow at a faster rate
- Credit growth slows down further


3. Inflation
Headline inflation, which averaged 9.7% for the Apr-Oct period of 2011-12 moderated to 9.1% in November and further to 7.5% in December. However, it is critical to note that the slowdown in inflation has been driven by the moderation in the prices of primary articles, especially vegetables while inflation continues to be high for the core sector. Further, the decline in food inflation is likely to reverse ahead with the base effect waning and seasonality factors sneaking in. Fuel inflation has also remained elevated at 14.9% in December 2011-12 on account of high Global crude prices and rupee depreciation.

RBI has maintained that the inflation target of 7% by the end of March would be attainable despite the slow improvement in core sector inflation and uncertainties in the global economies. This target appears to be reasonable. More importantly, core inflation should move down for any RBI action on this front.


4. Rate reduction
Further, speculation that CRR cut is guidance for interest reduction in the future, it is more likely that the RBI would be more cautious before reducing interest rates as it would be premature to begin reducing policy rates before a substantial and sustainable dip in overall inflation. We do not expect this before early FY13.

RISH TRADER