This article is about a company that looks attractive at face value. Once you go deeper, you will see big potential pitfalls. I will talk about the need to study the business before you start working with the numbers. You will also see some interesting accounting tricks that you should be aware of.
Why did I look at SRF Ltd.?
I looked at this company a few months back. It had a high dividend yield (dividend divided by market capitalization). If one gets a dividend yield of 6-7% in a stock and if the dividend will not be cut in the future it is almost like putting your money in a fixed deposit of around 10% (for someone in the 30% tax bracket). Dividends are tax free.
This does not take into account the possible capital appreciation if the company’s outlook is good.
If you see something like this, it is worth investigating.
What does SRF Ltd. do?
- Tyre Cord
- Belting Fabrics
- Coated Fabrics
- Industrial Yarn
- Laminated Fabrics
SRF Ltd.’s corporate presentation is a good starting point to understand the business.
SRF manufactures industrial products. Usually in industrial products it is not easy to generate high return on capital unless you have some compelling competitive advantages which are sustainable. As Warren Buffett calls them, you need moats.
I recalled that SRF had been a “hot” stock in 2004-06. The stock had a huge run-up because of the carbon credits story.
What are carbon credits?
Under the Kyoto Protocol, many nations came together and decided to deal with the problem of carbon emissions. These emissions contribute to the greenhouse effect and global warming. Nations agreed to cut down on emissions in two ways.
One is where some nations asked their industries to cut down emissions by upgrading to better technology or closing down polluting plants. The other is where polluters could “pay” for emission reductions done by someone else.
The intermediate currency for this “payment” is carbon credits.
Polluting industries from developing nations have cut down emissions in a large way (also in a distorted way, more about that in this article). In return for cuts, they receive carbon credits.
These carbon credits are sold on exchanges. Usually buyers from developed nations buy these carbon credits. In a way, without actually reducing emissions at their end, they are “paying” for reduction done by someone else.
One important point to note is that carbon credits does not imply only carbon dioxide (CO2) emission reduction. It is applicable to multiple different processes and gases which can cause global warming. In fact, there are many gases which are more harmful than CO2 in terms of their potential to trap heat in the atmosphere.
Why did SRF Ltd. get carbon credits?
SRF manufactures fluorochemicals. Think of refrigerants as an example. If you remember there was a lot of controversy over chloro-fluoro carbon (CFC) gases long back. These were used in refrigerator and AC compressors.
SRF manufactures a fluorochemical called HFC -22. HFC-23 is a by-product of HFC-22 production. This is a greenhouse gas, which is 11,700 times more potent than a similar quantity of CO2 in the atmosphere.
SRF used to release the by-product HFC-23 into the atmosphere without any treatment. Around 2004, SRF started incinerating HFC-23. This was an example of reduction of greenhouse gases. They applied under the Kyoto Protocol and got carbon credits for their project.
How did SRF account for these carbon credits?
This is where the story gets more interesting.
I opened the annual report (AR) for FY12. This was a few months back and the AR for FY13 had not been released at that point.
If you go into Note No. 19, you will see the sales breakup.
Notice anything atypical?
Carbon credits are a source of income for SRF. Why are they not listed as a separate income head? Common sense says that they should be in other income (it is not a core activity, it is incidental). That is a separate discussion since accounting standards are still not clear on this topic.
Anyway, we need to ask is carbon credit income substantial?
Read the note at the bottom of the table. Certified Emission Reductions (CER) is the technical name for carbon credits. The amount generated from sale of CERs is Rs. 43972 lakh. This is around 12% of the company’s sales in FY12.
Why is CER hidden away in notes when there are much smaller sales items than CER?
What is the impact of CERs on profits of SRF Ltd.?
CER’s would not have a large manufacturing expense associated with them like other manufactured products. My understanding is that the bulk of the money generated from the CER head in the breakup will be directly contributing to the Profit before Tax (PBT).
If I take this assumption, it contributes to a relatively large 77% of PBT.
If you read the annual report, the biggest takeaway is that underneath the hood, there is a completely different engine. The bulk of profits are coming from CERs and not the core manufacturing business.
What has been the performance of SRF in the past if we go by the books of accounts?
|Return on Equity||14%||26%||29%||21%|
At face value, it looks like a decent set of figures. One may call it capital efficient.
What is the performance of SRF if we adjust and remove the impact of CER sales?
Figures are in Rs. lakh
|Total Sales(as per accounts)||224,923||310,665||355,827|
|Total Sales(adjusted for CER)||198,967||303,384||311,854|
|Tax (assumption – 30%)||5,831||18,140||3,784|
|Return on equity||11%||26%||5%|
I subtracted the CER sales (remember the figure I saw in the notes, I had to pull more of them from old annual reports, they are not presented directly) from the Total sales.
I kept the expenses same (recall the assumption I made about the CER expenses)
I re-calculated tax. This is important because if I consider that there is no CER income, tax outgo should reduce with lesser taxable income.
Notice the return on equity figure now captures the manufacturing business only. CERs are not in the picture. RoE is fluctuating and not steady at all.
Worse, RoE of 5% means the shareholders’ funds are earning less than they would if kept in a bank.
This clearly proves that this company looks attractive on the face of it. If it has to continue having good RoEs and good dividend payouts we have to check the CER sales.
Are they sustainable?
It was worth checking how the market for CERs is behaving.
Source: Intercontinental Exchange
CER prices have fallen badly over the last few years. As of October 2013, they are trading around EUR 0.34 per CER on the futures market. Possible reasons that I read included, the oversupply of CERs from developing countries including India and China combined with general slowdown in the Eurozone (less pollution) which leads to less demand in terms of the CDM mechanism. The Eurozone is a big market for CERs under the CDM process.
So, clearly price is not in SRF’s favour.
SRF’s CER volume
If you revisit the UN CDM link I have given above, you will see that the period for the project under the UN CDM is July 2004 to June 2014.
Back of the envelope calculation will tell you that SRF can earn around Rs. 20 crore till June 2014 for the balance CERs, at today’s rates of CER. In comparison in FY12, they clocked Rs. 439 crore in sales.
Between Sep 2012 and Jan 2013, SRF generated 1.38 mn CERs. They have “claimed” only 0.1 mn. This may be because of low prices in the CER market. This is the only time in the last 29 periods from the 2004 that they have claimed less.
Can SRF renew their project and sell CERs again in the future?
To put it crudely, will the hen that laid the golden eggs continue to be kind?
I dug up some more data on HFC-23 and the CDM process.
In Sep 2012, the UNFCC released this statement,
Source: Report of the High-Level Panel on the CDM Policy Dialogue, under the UNFCC
European Commission speaks out
- Allowing credits from the destruction of HFC-23 can create a perverse incentive to continue to produce or even increase production of it and of HCFC-22, a gas which both depletes the ozone layer and is also a powerful greenhouse gas.
- The environmental integrity of the credits is therefore questionable.
- These projects do not provide value for money as they could have been funded and implemented more cost-effectively by other means. Because of the credits they receive, the rates of return are exorbitant – revenues from the sale of HFC-23 credits to EU ETS participants can represent up to 78 times the initial capital investment and operational costs of the project.
- The EU considers that emission reductions which can be achieved relatively cheaply – as with destruction of HFC-23 from HCFC-22 production and N2O from adipic acid production – should not be financed through the international carbon market. They should be undertaken by developing countries themselves as part of efforts to reduce their own emissions. Alternatively, the actual per-tonne cost of reductions could be directly funded.
In plain speak,
- People are producing HFC-22 not because there is a good market for HFC-22.
- They are selling it for the by-product HFC-23.
- Perverse incentives are at play.
Read this article from DNA – Are toxic gases being created just to earn carbon credits?
Let me be clear that I am not pointing fingers at SRF specifically. It is HFC-22 which has come under pressure.
Whatever be the case, it does not look like there are going to be golden eggs after June 2014.
What does a CER-less future mean for SRF?
|Operating cash flow||45,406||60,699||76,299||83,062|
|Adjusted operating cash flow adjusted for tax||24,386||18,169||5,097||30,781|
|Free cash flow||(14,160)||(17,470)||(15,104)||(18,756)|
I adjusted the operating cash flow downwards for the past few years. The results are not surprising. Without CER sales, they could not have enough cash to grow the core business, without taking on debt or raising equity. And that too, for a business which has low return on equity.
Without CER sales in the future, how can they grow? How can they generate sufficient free cash to pay dividends to shareholders?
This is the reason why my article had this title. I get the feeling that I am walking towards the edge of a cliff.
- First, try to understand the business in depth.
- Go beyond the usual profit and loss statement, balance sheet and cash flow statement. Sometimes they are like veils.
- The notes give the true picture in many cases.
If you have come across any other case relating to accounting, please share it using the comments below. It would be useful to the Capital Orbit Community.