Explore the power of a strong balance sheet when it comes to analysing a company's financial health
19-Mar-2019 •Jugal Harpalani
Many a time, investors pay little heed to balance sheets. Probably, it is because they aren't as exciting as income statements, which depict earnings growth. Nevertheless, when it comes to analysing the liquidity and financial health of a company, the importance of analysing a balance sheet cannot be overlooked. After all, a resilient balance sheet has the potential to navigate a company through cyclicity and unpredictable events like demonetisation or the recent liquidity crisis.
We have identified four such companies with spectacular balance sheets that could take any storm in their stride without making a dent in their operations.
At the core of the resilient balance sheets of these four companies was the fact that they had incurred zero net debt (total debt less cash) for the past five years. It signified that these companies had used internal sources to fund their capex requirements (if any), thereby generating positive free cash flows. Also, they maintained a negative cash conversion cycle, which again indicated their strong bargaining power. This would imply they are receiving cash upfront and paying their suppliers later.
Contingent liabilities are restricted to a maximum of four per cent of their net worth. There were no cases of changes in their accounting policies, with all of them having reputed auditors. Further, they were able to give a return on equity of more than 20 per cent in the past three years. Finally, all these companies cleared the Z score and the C score.
At present, these four companies are trading at valuations below their five- year medians. However, this certainly does not mean that they are available at lower valuations.
The following are detailed insights into the four companies:
GSK Consumer Healthcare
GSK Consumer Healthcare owns some of the most iconic brands in the malt beverage space, such as Horlicks and Boost. It was recently acquired by FMCG major HUL. GSK's revenue is largely dependent on these products, which have been losing market share. As compared to GSK, HUL has a wider distribution channel. So, following the acquisition, HUL's distribution channel will now be used to spread GSK's malt-based beverages in markets like North India where they have not performed well so far. However, it is too early to comment whether these synergistic benefits with Hindustan Unilever will ultimately be realised by GSK.
The share swap deal has been finalised at 1 share of GSK for every 4.39 shares held by HUL, which as on date gives an arbitrage profit of around 5 percent before tax to someone buying a share of this company. The combined revenue of the company can be expected at upwards of Rs 40,000 crore. Trading at a PE of 32 times, it is now well below its two biggest competitors (Nestle and Britannia) who are trading at a PE above 60 times.
Indian Energy Exchange (IEX)
This company has a market share of 98 per cent in energy exchanges in India. This has been possible mainly because of the absence of any real competitor in the market. However, the monopolistic hold of IEX may change with the entrant of a new power exchange-which is being promoted by BSE, PTC India, and ICICI.
On the other hand, under the new amendment that came into effect from January 1st 2019, the linking of DSM (one of the modes of settling short-term contracts) prices to exchange traded prices, is expected to drive volumes at least by 25 per cent, as more than 50 per cent of the total DSM volumes shall shift on the exchange.
According to IEX management, the total DSM volumes is estimated to be 16-17 billion units. Furthermore, the cross-border trade of energy between India and countries like Nepal and Bangladesh is likely to drive volumes further. Trading at a PE of 31 times, the company is reasonably priced given its growth prospects.
Dr Lal PathLabs
With its asset light model, Dr Lal PathLabs has gained a foothold in a highly fragmented market having very few barriers for new entrants. Its wide network built on operating a franchisee model gives it a strong bargaining power with suppliers. Furthermore, the hub and spoke model followed by the company helps it keep costs to a minimum. As projected by CRISIL, the diagnostics industry will grow at a CAGR of 16-17 per cent per cent over the next three years to over Rs 860 billion by 2020-2021 and Dr Lal PathLabs is well positioned to benefit from this growth.
Nevertheless, the brand name of the company can be adversely affected by any negligence of its franchisees or a deterioration in the quality of the tests. Besides, an increase in taxes by the government on healthcare services can affect its margins, as there is very little room for this diagnostic chain to increase prices.
Despite all these factors, it trades considerably higher (at a PE of 45 times) than its competitors like Thyrocare, which trades at 29 times.
Swaraj Engines derives most of its revenue from the sale of diesel engines used in tractors under the brand name of Swaraj, which is owned by Mahindra & Mahindra (M&M)-who is a industry leader in the farm equipment space (market share 42.9 per cent) and run by a highly experienced management, along with a capital efficient business model. Backed by M&M, this company is well positioned to gain from various government incentives allocated for the rural sector.
M&M-being the only major customer of these engines-comes with a high bargaining power, which it can leverage to squeeze the margins of Swaraj Engines. The tractor industry, which is essentially their end-customer and the steel industry, which provides them with the main raw material, are both cyclical in nature. An increase in steel prices can further squeeze Swaraj Engine's margins.
At a PE of 21 times, Swaraj trades in line with its peers.
Disclosure: The companies mentioned above are not our recommendations. If you intend to invest in any of them, do thorough research.