Intellectual Thoughts by Sanjay Panda: July 2007

Free cash flow: Is it free after all?????

The best things in life are said to be free and the same holds true for cash flow! Investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to repay debt, pay dividends, buy back stock and facilitate the growth of business all important undertakings from an investor's point of view.

How and what of FCF
The formula for calculating Free Cash Flow (FCF) is as:

Net Profit + Depreciation - Capital expenditure - Changes in working capital - Dividend

FCF takes into account not only the earnings of the company but also the past (depreciation) and present capital expenditures, capital inflows and investment in working capital. Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF due to revenue growth, efficiency improvements, cost reductions, share buy backs, dividend distribution (from subsidiaries) or debt elimination can reward investors in the future. Better free cash flows are therefore a reason for the investment community to cherish. On the other hand, an insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business

From a companys point of view
A better FCF definitely indicates better efficiency on the part of the company. But what is pertinent for investors to note is that simply assessing the FCF on the basis of its absolute value is not prudent. It is imperative to also assess as to what components have contributed to the same.

Let us take a hypothetical example of two companies, A and B, both of which have garnered the same FCF for the current financial year.

Estimated free cash flow
(Rs) Company A Company B
Net profit 75 120
Add: depreciation / amortisation 20 5
Less: Capital expenditure 5 15
Add/ (Less): Decrease /(Increase)
in wkg capital
10 (10)
Less: Dividend 20 20
Free cash flow 80 80

Prima facie although appearing similar, if you delve a little deeper there is a stark difference in their performances. While company A, despite having lower earnings has benefited by adding back depreciation and decrease in working capital, company B has invested in capex and working capital. This indicates that while company B is investing for future growth, company A is not sufficiently geared up for the impending challenges. This also means that investors in company B can expect rewards in future while those in company A should sit up and take notice of what is ailing it.

From a sectors point of view
As explained earlier, cash flows are dependant on the capital expenditure and working capital liabilities borne by the company. This however, differs as per the dynamics of the sector in which the company is operating and should be seen in that light. While sectors like banking require minimum expenditure on capex (as a % of their turnover) those in pharma, engineering, FMCG or commodity sectors require to invest a substantial amount in R&D and capacity expansions.
To conclude...
FCF is not only a mirror image of the present but also a sneak preview into the future. The implications of the components of cash flow may not be explained in the annual reports, but is left to the investors prudence to diligently scrutinize the same and try to read between the lines. The legendry investor Benjamin Graham once said, The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.

Free cash flow, is not free after all!

The educated terrorist

Doctors are supposed to heal, not kill. And architects are supposed to build, not destroy. But they have started doing just that. Mohammad Atta, the man who led the attack on the World Trade Towers, was an architect, and those who attacked the airport at Glasgow are doctors. This suggests that education is no longer a restraining influence on the use of violence. Indeed, amongst the many things that 9/11 demonstrated, the least commented upon or debated, relatively speaking, is the educated terrorist. Time was when it was only the semi-educated, brainwashed young man or woman who, wearing a belt of bombs, went and became a martyr. Not any longer. In recent years the world has seen several other instances of men and women whose education should tell them otherwise, indulging in acts of terrorism. It is instructive to examine the phenomenon.

In 2003, two Princeton economists, Alan Kruger and Jitka Maleckova, in an academic paper published in the Journal of Economic Perspectives, had said, with full support from cross-country data, that a lot of modern terrorism had nothing to do with poverty and income levels. In fact, their data showed that the suicide bombers of the Hezbollah were as likely to come from economically well-off families as from poor ones. There was also a 50 per cent likelihood of them being relatively well-educated. Similarly, members of the Israeli Jewish Underground, a terrorist group active in the late 1970s and early 1980s, were mostly well-educated and had jobs that were held in high esteem. Other studies of terrorist groups in different areas of the world, including the Red Army in Japan, the Irish Republican Army in Ireland and the People’s Liberation Army in Turkey, confirm this.

Two other economists, Charles Russell and Bowman Miller, who conducted one such study, say, “The vast majority of those individuals involved in terrorist activities as cadres or leaders, is quite well educated. In fact, approximately two-thirds of those identified terrorists are persons with some university training, university graduates or post-graduate students.” They also said that more than two-thirds of the arrested terrorists came from the middle or upper classes of their respective countries or areas. Yet another economist, Jessica Stern, who conducted a study in Pakistan, said that the madrasas are funded by many big industrialists. She also said that many of these schools trained their students to become part of extremist movements from a very early age. Thus, there seems to be little reason to believe that the alleviation of poverty and/or the education of more people will reduce the threat of terrorism. Why, they might increase it. It also seems to be the case that there is always a sub-set of the educated population that believes the end justifies the means, even if these are violent. This is not new. History is very revealing in this regard. There are scores of instances where highly-educated people have engaged in different degrees of violence and terrorism to achieve their aims. The best known was Vladimir Ilyich Lenin. A scholar in at least five languages, not including his mother-tongue, he had no qualms about using violence.

Closer home, India has had the likes of Charu Majumdar and Kanu Sanyal, the heroes of Naxalbari who enticed so many young men and women from even the stuffy Delhi University. Many members of ULFA are graduates; and so on. In the end, it would seem that some people, when they feel aggrieved at what they see as injustice, decide that violence is the answer. The problem is systemic and systematic injustice. When all else fails, violence becomes an attractive option. But is this option, really needed??? And who are to blamed fort his option ??। The indivisuals or society or who??.


Dishman buys Solvay fine chemicals

Dishman Pharmaceuticals & Chemicals has made another incursion into European assets by signing a memorandum of understanding to acquire the fine chemicals, vitamin D and vitamin D analogues business of Solvay Pharmaceuticals at Veeenendaal, Netherlands। The deal is expected to close within four months। Dishman added that the acquisition”will not only increase the basket of products of Dishman but also bring in new customer relationships”.

Indications are that vitamin D3 production will be transferred to India, thus bringing more fine chemicals expertise there, while the other products will remain in the Netherlands. For Solvay, the sale of the two businesses will enable it to focus more on its core areas of cardio-metabolic and neuroscience treatments.

More importantly, Dishman’s existing contract under to supply about 90 tonnes/year of the API for Teveten (Eprosartan Mesylate), Solvay’s anti-hypertensive drug, will not change. The contract expires in December 2008, but can be renewed annually until its patent protection ends in 2013. Since an FDA inspection at its Bavla site in 2006, Dishman has been able to supply this API for use in the US as well as Europe.Separately, Dishman has announced the integration of another of its previous European acquisitions, SynProTec DCR of the UK, into CarboGen-Amcis.

SynProTec DCR specialises in process research and custom synthesis of pharmaceutical intermediates and has capacity of up to 4,500 litres for production of early phase APIs and large-scale intermediates. Griffiths said that capacity combined capacity will increase and material produced at SynProTec DCR can be further processed at CarboGen Amcis’s Swiss facilities.