Investing Basics

Investment Basics Investing in stocks is like owning the company. What exactly does owning the company mean. We will take an example of a company called Arvind Mills. We will take a step by step approach to what Arvind Mills is all about and whether it is worth putting your money for buying Arvind Mills. History: If we look at the history of Arvind Mills, it was formed in 1931, was basically involved in spinning cloth out of raw cotton. The first phase of modernization was completed in late 80s along with the production of denim, and after a couple of mergers and acquisitions got listed. It also started venturing into the video cassette business and the readymade garments business. By 1994, it had three major operating units – Textiles, telecom and garments. The garments division started marketing Flying Machine and Newport jeans, and later introduced the Ruf n Tuf brand of jeans. It started floating all kinds of jeans brands – on its own and in parternship with the world leaders and by 1998 emerged as the third largest manufacturer of denim. It implemented the SAP R/3 system and launched the Arrow and Lee premium brands. It recorded a 280% growth in profits in 2003. Source: http://content.icicidirect.com/research/HistoryCompany.asp?icicicode=arvmil Operating input and output break-up: Now that we understand the business, let’s look at what the company uses to make what it makes: As of March 2006, the raw materials used by the company along with some more facts like quantity and value are given in the following table: Product Name Unit Quantity Value (Rs. Cr) % of Total Cotton Kg 75,800,000 393.69 63.51 Yarn Kg 10,500,000 181.92 29.34 Grey Cloth Mtr 1,500,000 14.09 2.27 Garments (cr) No 200,000 5.66 0.9 Trunk Radio (cr) No 348 0.58 0 Delta (cr) Lin 6,880 0.57 0 Other NA NA 23.36 3.76 Source: http://www.moneycontrol.com/india/stockpricequote/textilescottonblended/arvindmill s/11/58/rawmaterials/marketprice/AM A similar snapshot of the outputs (products of the company) and the installed vs used capacity taken in Mar 2006 shows as: Product Name Production Sales Sales Value % of Total Cloth 115,900,000 120,500,000 1252.07 77.13 EPBAX 100,000 100,000 1.82 0.11 Grey (Cr) 100,000 100,000 0.57 0.04 Grey Cloth 700,000 700,000 4.29 0.26 Jeans – Garments 6,300,000 6,400,000 180.50 11.12 Knitted Fabrics 1,300,000 32.98 2.03 Yarn 3,400,000 3,800,000 42.79 2.64 Misc + Utility 65.18 4.02 http://investmentinfoline.blogspot.com/ [email protected]

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Investment Basics

Production Unit Looms Rotors Spindles

Capacity 3878 2748 222068

Installed capacity 1042 7824 106776

Source: http://www.indiainfoline.com/company/product.asp?ltnum=25&lmn=4&co_code=&f dcd=&shcd= After looking at the product, products and output break-up, the company’s main operations can be classified as procuring cotton and yarn, using looms, rotors and spindles to produce cloth and jeans (garments). We can hence conclude that the expenditure will be hit by price of cotton and yarn. Cotton being the primary commodity with variable price in the market should have the most impact. Raw Material Impact: The recent demand and supply figures (Source: http://www.commoditiescontrol.com/eagritrader/index.php?userid=&cid=3&varid=0 #) of cotton indicate that domestic demand is a little more than the domestic supply and the same goes for the global market also. Yet, the cotton industry has some carryforward stock which would useful as a cushion. Hence, we do not foresee a major shift in cotton prices, hence not hitting the bottom line of Arvind Mills. However, India which was once a net exporter of cotton has now turned into a net importer of the same. This could result in a net increase in the cotton prices. However, we can peg the increase in cotton prices correlated to inflation and keep 6% as price increase in cotton over the year. Cash Flow Analysis: 1. Operating cash flow If we look at the cash flow, the Net Cash from Operating activities for year ending March 2006 (the cash generated out of producing cloth and garments) is +221.79 as compared to -37.06, +137.66, 222.35 and 230.64 for the previous years. This shows that the net cash from operating activities declined gradually till March 2005 and has had a drastic improvement in March 2006. We need to see a reason for this. If we look at the break up given for operating activities cash flow break-up, the Net profit before Tax and Extraordinary items has remained almost constant through the years. Same is the case with Depreciation and Interest (Net). Hence, Operating profit before working capital changes has either remained constant or increased, which is a good sign. If we look at the Trade and Other receivables row, we see a drastic reduction and this is one factor as to why the Mar’05 values are out of the trend. Also, the inventories row shows a trend from negative to positive which means that the inventories have increased in Mar’06 as compared to Mar’05. Also, the trend in inventories of drastic changes in values shows inefficient inventory management by Arvind Mills. 2. Investing activities cash flow: http://investmentinfoline.blogspot.com/ [email protected]

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Investment Basics Cash flow break-up of investing activities shows that lot of money was poured into purchase of fixed assets in Mar’05 column while that sum is halved in Mar’06, though a lot of fixed assets were sold in Mar’06. The cash flow into purchase of investments has increased ten-fold and shows management focus on investing and not putting the earned money in Mar’05 into operations. A heavy change of value from -143.52 in March’05 to -345.74 in March’06 is shown owing to above. 3. Finance activities cash flow: The cash flow from financing activities shows other long term borrowings column being used after Mar’04 after a major long term borrowing was paid off in Mar’03. This should have happened because of lower interest rate being charged on new loans and the management could have decided to pay off older higher interest debts to take new lower interest debt. This fact is also strengthened by the Interest (Net) paid column in the cash flow from operations area. Looking at the overall cash flow: 1. The proceeds from the operating cash are being used to make new investments. We need to look at what kind of investments are being sought and made. 2. The company has shifted its loans from a higher interest rate to a lower interest rate. 3. Inefficient inventory management. Source: http://www.indiainfoline.com/company/cashflow.asp?ltnum=24&lmn=4&co_code=& fdcd=&shcd= Free Cash Flow = 127.16 + 155.10 – (74.52 – 30.88) + (39.63 – 46.04) – 24.75 = 207.46, Per share = 14.81 Price / Free cash flow = 3, which is a little lower when compared to other manufacturing type companies which typically have ratio of 10-15. Results watch: Look at the sales, net sales, operating profit, net profit and EPS (Earnings per share) figures in the annual results of last 5 years for consistency. The figures should show a constant growth combined with the constant rate of growth. Look at the latest quarterly results for the same as above. These figures are derived from the company operations and reflect the company strength and the management efficiency to drive the profits. In particular: 1. Read the auditor’s report on the profit/loss report and the cash flow report. Arvind mills can be found here http://www.indiainfoline.com/company/auditreport.asp?ltnum=31&lmn=4&co _code=&fdcd=&shcd= 2. Look at the footnotes of each of the results, its called reading the fine print. 3. Read the director’s and chairman’s report/speech for any forward looking estimates, the business direction and the major decisions which the http://investmentinfoline.blogspot.com/ [email protected]

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Investment Basics management is considering. You may also want to consider reading the previous year’s speeches/reports to reflect upon how the management has performed on the past commitments made. 4. Insider trading – Exchange site for insider trades made, particularly insider sells. 5. You should also go behind the scenes to look at the management discussion and analysis to gather more data about the operations of the company and the decisions it made or is considering to make. I am leaving this section here as this is a very comprehensive analysis which itself requires much knowledge of the financial terms used in a balance sheet and profit/loss report. However, common sense states that sales, operating profit and net profit should increase for a company to sustain itself, as should EPS (which is shareholder’s wealth generated by running the company). Arvind Mills directors’ report and chairman speech can be found at http://www.indiainfoline.com/company/directorreport.asp?lmn=4<num=32 and http://www.indiainfoline.com/company/chairmanreport.asp?ltnum=33&lmn=4&co_c ode=&fdcd=&shcd= Source: http://www.bseindia.com/qresann/result.asp?scripcd=500101&scripname=Arvind+Mi lls+Ltd&quarter=MC2006-2007&type=53.5 http://www.moneycontrol.com/india/stockpricequote/textilescottonblended/arvindmill s/13/39/profitloss/marketprice/AM Ratio Analysis: Look for the following: 1. Debt/Equity Ratio – Lower the better 2. Long term Debt/Equity Ratio – Lower the better 3. Current Ratio – Close to and higher than 1. Not very high 4. Operating profit margin – Higher the better 5. Return of Net worth – higher the better 6. Sales per share – Higher the better Retained earnings = Earning per share – Dividend per share If we look at these figures for the past five years, the following table will draw up: Year EPS Dividend per equity share Retained earnings / share Mar’02 2.89 0 2.89 Mar’03 6.97 0 6.97 Mar’04 4.47 0 4.47 Mar’05 6.14 19.54 -13.4 Mar’06 5.72 22.34 -16.62 The table above shows that for a total EPS (for five years) = 26.19 and the total retained earning = -15.79. The negative sign indicates the dividend has not been paid out from the company operations but from an alternative source. This alternative source can either be equity or debt and since there’s no sense in paying back dividend from equity, the dividend has been paid by taking debt. This is a significant negative on the company books. http://investmentinfoline.blogspot.com/ [email protected]

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Investment Basics

P/E ratio: This ratio is considered the thumb-rule check of any investment and hence needs some understanding before use. P/E is the market price of share divided by EPS. The fundamental behind this is that the price of the share should reflect the growth in EPS. The sectoral P/E average of Arvind Mills and related companies are as follows: Company P/E ratio Arvind Mills 36.69 Phoenix Mills 102.12 Vardhaman Textiles 6.23 Forbes Gokak 46.78 Nahar Industrial Enterprises 5.28 Abhishek Industries 8.46 This shows that the P/E of the sector is marked by different P/E ratios commanded by different companies, and a sectoral P/E comparison is not feasible here. P/BV ratio is 0.63 which is favourable for a buy, as the share price does not fully represent the fair book value (accounting value). Recent news: The recent news and press releases can be found here: http://www.bseindia.com/qresann/announcecom.asp?scrip_cd=500101&scripname=A RVIND%20MILLS%20LTD. http://www.arvindmills.com/ The news items can be classified as information, expansion, capacity enhancement, new orders, change in management, etc. and the stock needs to be analysed based on the publicly available news items only. The news items are subjective and need reader discretion and comprehension to fully identify any financial impact of the news item and hence is left to the reader. Summary: Looking at all the above factors, the company: 1. Is not even using a close 90% of its installed capacity - Negative 2. Inefficient inventory management - Negative 3. Stable cotton price – Positive 4. P/E ratio to the higher side – Neutral 5. Dividend payment through borrowings – Strong negative 6. Results are not very good and does not show a strong growth momentum – Negative 7. P/BV < 1 signifies market price of share not fully accounted by market – Strong positive. 8. Operating revenue put into investments instead of growth of operations – Negative The company is NOT recommended for a buy.

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