The Final Word- Checklist

The Final Checklist: Contacting Company Management, Dealers And Distributors

The book concludes with Chapter, which includes a detailed point-by-point questionnaire that investors can use when speaking with management, dealers, distributors, or conducting their own research. These questions are divided into different categories and are aimed at analyzing the business model, industry scenario, government regulations, management, strategy, income statement (revenue, raw material, labor, administrative costs, margins, taxes net profit), and balance sheet (liabilities, assets, working capital and capital employed).

The Checklist:-

BUSINESS MODEL:

• Nature of the business; source of competitive strength whether through brands, patents, costs, distribution, network effect etc.
• Whether the business is capex light or needs a lot of investment to grow?
• Does the company outsource its production? If so, does it plan to stay just as a design and marketing company? If not, what are the plans for further expansion in production?
• Are the vendors capable of scaling up and supporting the company by growing at a rate equal to the targeted rates of growth?

INDUSTRY:

• Whether the company is a sector leader of this industry? If not then the difference in revenues between this company and the sector leader.
• Major competitors, organised vs. unorganised; break up, if any, market share of the top five companies in the sector?
• Trend in the market share over the last few years. Whether this company has gained or lost market share from Its competitors.? Reason For the loss in market share, if any.

GOVERNMENT:

• Impact of government regulations in terms of duties and restrictions on imports and exports. Does the company have the ability to shift the burden of taxes on its customers? Here, it is important to mention that a company like La Opala started to do well from the time the government imposed anti-dumping duty on the cheap Chinese imports. An astute investor should be aware of such catalysts and risks to stock price performance.
• Does the company enjoy excise duty, sales tax, income tax or any other exemption which can go away with time, either because of imposition of these taxes or completion of the tax holiday period?
• Do the excise payments conform with the amount of reported revenues? if a company is under the 896 excise duty rate and the excise paid in the accounts does not conform to this rate it would need clarification.
• Whether The Size of The Industry is Large or small? Generally, the government does not actively regulate very small industries for raising taxes because the overall impact on its finances is minimal. For example,tobacco is more likely to see a tax change than a low calorie sweetener.
• The extent of government control on pricing as is the case in fertilizers, oil marketing companies, sugar and other sectors.
• Environment and other bottlenecks if any?  This is relevant mostly for mining, industrial and other government regulated companies.

MANAGEMENT:

• Does the management bandwidth extend beyond the top level?  Is there a divorce in ownership and management? If not, are the promoters managing the company as a professional enterprise?
• In the case of secular growth companies, Is the management satisfied with a 15% to 20% growth or will they strive for more if the opportunity presents itself. No company answers this question clearly but stÏIl an investor will have to use his question to get this answer. Pointers to this are the ROE and the past operating history and the presence of an economic tailwind.
• Management’s take home competition either in cash or stock options as percentage of net profit.
• If there is a promoter issue of shares or warrants at discount then why not a rights issue for all shareholders?
• Management's intention to handle free cash, either through dividend payouts, business diversification or expansion of existing facilities.

STRATEGY:

• Any new products or services that the management intends to add? Minimum threshold RoCE that the company has in mind while thinking of new ventures.
• Are the existing products as good as those of the competitors, if not is the company innovating fast enough?
• If the management is keen on acquiring a new business then the RoCE of the new venture in comparison to the RoCE of the existing one.
• In case of a PSU Bank or any other company owned by the government an investor should find out when the chairman is going to retire. This is because the new chairman of a PSU company is always eager to start from a low base and hence resorts to large scale provisioning so as to suppress the profitability number.
• Whether the management intends to generate growth by:
  • Selling more of existing products to new customers- Volume growth through new geographies or new distribution.
  • Selling more new products to existing customers- Innovation.
  • Selling more new products to new customers - Diversification.

REVENUE:

• The past one, three, five and ten year sales growth and if they can be maintained, increased or decreased with reasons for change if any. Check for the inflection point from this past data if any, and reasons or catalysts for this Inflection point whether it was changing regulations, changing demographics or an overall change in economic set up.
• Differentiating the revenue growth above into volume and price. Can the company raise prices without losing sales and market share? How sticky are consumers to rising prices?
• Whether customers are up-trading or down-trading on their purchases?
• Change in sales mix because of some fast growing segments and repercussions of the same on overall growth. In case of a change in sales mix, the change in revenues could show a non-linear movement to a change in volume.

RAW MATERIAL COSTS:

• If the primary raw material is a commodity cyclical then the management itself will be incapable of estimating future input prices but a point to clarify will be on the ability of the company to shift the burden of rising input costs or retain the gain from falling input prices.
• Percentage of raw material to overall sales and the trend of this ratio over the last few years.

LABOUR:

• The extent of labour costs which is variable and directly linked to production.
• Are there any hiring plans on the anvil? Significant hiring plans as evident from newspapers and magazines will indicate that the company is on an expansion drive.

ADMINISTRATIVE COSTS:

• What is the percentage of fixed administrative costs? A higher proportion of fixed costs gives rise to operating leverage which generates a more than proportionate increase in profits when compared to increase in revenues.
• The revenue level that the company would reach without incurring Additional fixed or administrative costs in terms of new office, new staff etc.

EBITDA MARGIN:

• Whether there exists a scope for margin expansion and if so is it an outcome of :

1. gross margin expansion
2. operating leverage

• A very high EBITDA margin Is a cause of concern for a business that does not have strong entry barriers in which case the measures to protect margins.

TAX:

• Is the company enjoying concessional tax treatment because of:
  A) past accumulated losses
  B) from having its operations in a tax free zone?
   
• The remaining tenure of these concessional treatments or accumulated past losses against which the company can seek a tax shield in the future.

PROFIT AFTER TAX:

• It's the EPS that matters and not the profit after tax. For computing the EPS, the number of shares to be computed should be the diluted equity which is the number of equity shares resulting from an increase in Conversion of  outstanding warrants, ESOPs etc.
• The compounded annual growth rate In EPS for the past one, three, five and ten years and whether that trend can be maintained, Increased or decreased with reasons for change if any. Check for inflection points from this past data, if any?

LIABILITIES:

• What is the nature of equity dilution over the last few years? Whether there is a trend in dilution is the company a serial dilution? Whether the dilution is done through a rights issue or at a discount through preferential allotment to promoters or institutional investors?
• In case of a bank or a NBFC, the percentage of loan book which has been created by dilution of equity and the portion that has been created out of internal accruals. Book values that are created predominantly by issuing new shares are not considered too favourable by the market unless that money is put to use.
• Secured and unsecured loans; trends in the absolute debt structure and also in the debt equity ratio; is the company growing revenues by taking debt on a regular basis? The increase in debt over the past one, three and five years should be significantly lesser than the increase in revenues of the company unless an investor is playing for a turnaround.

FIXED ASSETS

• The trend of increase in gross block for one, three, five and ten years. Whether the increase in gross block is higher, equal to or lower than the growth in revenues?
• The amount of money tied up in investments and if the amount is significant then the reason for the company to retain this amount and not distribute it amongst the shareholders.

NET CURRENT ASSETS OR WORKING CAPITAL:

• Whether the company employs positive or negative working capitals If the working capital cycle is negative then the company‘s expansion can be undertaken with minimum incremental capital employed as increase in scale will throw back lots of cash.
• The rate of growth in working capital and whether the growth in Working capital is greater than equal to or less than the growth in revenues?
• The number of debtor days, inventory holding period and creditor day -trends thereof.

CAPITAL EMPLOYED:

• Whether the capital employed is showing an increasing trend? If so, is it in line with, less than or greater than the revenue growth?
• Return on equity and triggers for increase in RoE thereof through the DuPont Analysis.

The points listed above has to be corroborated with a comprehensive financial analysis of the stock in question which includes the standard items like the P/E ratio, RoE, dividend yield etc and it is only then that an investor can formulate an opinion on the stock.The process of equity research is an ongoing process rather than an one time event and continues as long as an investor holds the stock.