#8 Warning Signs That Flashed Before PC Jeweller Stock Crash
PC Jeweller is a jeweler based in New Delhi, India. It manufactures and sells gold and diamond jewellery.
PC Jeweller had humble beginnings in 2005 with just one store inaugurated in Karol Bagh, Delhi. The founders of the company are two brothers namely Padam Chand Gupta and Balram Garg.
The stock of PC Jeweller had a meteoric rise from approximately 40 Rs a share in 2013 to 600 Rs a share in Jan 2018, leaving the investors craving for more.
But who knew that after hitting a high of 600 Rs a share on 16th Jan, 2018, stock of PC Jeweller was waiting to commence its downward spiral.
All it took was an IT firm Vakrangee Ltd buying shares of PC Jeweller worth 112 crore (a .51% stake in PC Jeweller) on 25th Jan, 2018.
As Vakrangee itself was under SEBI lens for stock manipulation, there was speculation that PC Jeweller may have business relationship with Vakrangee.
A lot of retail investors, and big funds like Fidelity were caught off guard in PC Jeweller stock crash. As an investor, we should always look for ways to learn from such episodes.
Folks. The objective of this post is to see if there were any warning signs that should have alerted an investor before PC Jeweller stock crashed in 2018.
Hence in this post our focus will be on the financial statements, annual reports, conference calls and other data available to investors of PC Jeweller.
We will see if the data available to us as investors could have warned us against investing in shares of PC Jeweller.
1. Haphazard Cash Flow From Operations
As an investor we should always look for companies that generate a positive and healthy cash flow from operations.
A negative cash flow from operations may be indicative of cash being stuck in inventory or trade receivables.
A company may sell its goods and receive the payment on a later date. The amount of sales on credit are termed as receivables which reflect under assets in balance sheet.
While on the profit/loss statement a firm will record the entire sales made but as the money is yet to be received from its customers, it will not be counted on cash flow statement.
That is why profit after tax and cash flow from operations can differ from each other. Ideally, we should look for companies whose cash flow from operations is more or equal to profit after tax over a period of time.
As this would mean that the company is able to collect its payments in cash and its cash is not stuck in inventory or receivables.
Now let us look at the cumulative cash flows and profit after tax of PC Jeweller from Mar 12 to Mar 17.
Please note that we are focusing only on numbers till Mar 17 as the article is focused on warnings signs before the stock crash in Feb 18.
Looking at the sum of cash flow from operations and sum of profit after tax from Mar 12 to Mar 17, we see that while PC Jeweller reported a profit of 2075 crore, its cumulative cash flow from operations was only 540 crore.
This means that while the company reported profit after tax of 2075 crore from Mar 12 to Mar 17, it was only able to generate 540 crores of cash leading to a deficit of 1535 crore.
The main reason for this difference is majority of cash being stuck in inventory and trade receivables. Below is a snapshot of data from screener.in
We can clearly see in the table below, that the main reason for negative or low cash flow from operations in Mar 12, Mar 14 and Mar 16 are the working capital changes (accounting for change in trade receivables, inventory and trade payable).
An investor should always invest in companies with positive cash flow from operations.
If the cash flow from operations is negative as in case of PC Jeweller in some years, then company will have to either borrow money or dilute equity to raise capital.
Based on the parameter of cumulative Cash flow from operations being less than cumulative Profit after tax from Mar 12 to Mar 17 by a large amount of 1535 crore, I would have clearly avoided this stock.
Most Of The Cash Is Used To Service Debt
Continuing our discussion on cash flow above, I have provided a detailed cash flow statement for PC Jeweller. We can draw the following inferences from the table below:
1. Most of the capital of PC Jeweller is used for either repayment of borrowings or in interest payments as can be seen under cash from financing activity (repayment of borrowings and interest paid)
2. Since their cash flow from operations is insufficient or negative in some years they have to resort to diluting equity or borrowing capital (marked in green as proceeds from shares or proceeds from borrowings)
Please note that negative numbers represent cash going out of the company while positive numbers indicate cash flowing in to the firm.
2. Cash Stuck In Inventory
PC Jeweller has a high number of days inventory outstanding as per the data below (src: morningstar)
Please note that days inventory outstanding refers to the average number of days needed by a firm to sell its inventory.
A high number of inventory days also indicates that cash remains tied up in inventory for a long period of time.
So far example, PC Jeweller took around 170 days to sell its inventory in the financial year 2012. Inventory in case of PC Jeweller consists of gold and diamond jewellery.
This means that PC Jeweller needs to wait around 6 months to realize cash by selling its inventory. I think this is quite a high number.
As per the data from morningstar above, days inventory increased from 170 days in Mar 12 to 198 days as of Mar 17.
This rise in days inventory outstanding should be a concern for an investor.
Inventory days outstanding suddenly jumped to hit a high of 232 days as of Mar 2019.
CARE Ratings & CRISIL Ratings Report Highlight The Large Inventory Requirement
High days inventory outstanding is also highlighted by various rating agencies in their ratings report from time to time.
For example, in the ratings report published on 8th Aug, 2017, CARE Ratings highlights the working capital intensive nature of the business.
It states that company has to maintain high inventory levels in the form of raw gold and also as stock at each retail outlet of various designs. It also needs to maintain adequate stock of diamond.
Almost a year later, after the PC Jeweller stock crashed in Feb 2018; CRISIL ratings report dated 26th June, 2018, highlights the fact that PC Jeweller requires a large amount of inventory.
Report stated that the group had 222 days inventory outstanding as of 31st Mar, 2018.
It also states that PC Jeweller inventory days will continue to remain around 200 – 210 days as company planned to open around 22 stores
As the days inventory kept increasing, the amount held as inventory by PC Jeweller kept increasing as can be seen in the data below.
Inventory increased from 1172 crore as of Mar 2012 to 4187 crore as of Mar 17, before peaking at 5012 crore as of Mar 2019.
As an investor such high levels of inventory and rising inventory days outstanding as of Mar 17 are enough to make me uncomfortable as an investor.
3. Low Margin Export Business With Sales Mostly On Credit
In various conference calls held by PC Jeweller, management has stated that majority of the trade receivables on the balance sheet are due to export sales. Receivables linked to domestic sales are negligible.
In addition to export sales being on credit, the export business is a low margin business having gross margins almost half of that of domestic business.
For example, a snapshot from the FY15 annual presentation below clearly shows the gross margins for domestic business were 15% to 16% while for exports gross margin stood at nearly 8%.
Therefore as an investor, one needs to think if it advisable to keep a low margin business with mounting receivables and margins half that of domestic retail sales. Think about it.
Irrespective of this, management insisted on continuing the export business. Following is a snapshot of Q4FY17 presentation confirming the same.
As an investor I really cannot understand the rationale for running an export business with big chunk of sales on credit. For me receivables raise suspicion.
Even in case of Gitanjali Gems receivables were a problem. You can read more about Gitanjali Gems by visiting the link below:
PC Jeweller Stock Crash Was Enough To Change The Management's Export Strategy
After the PC Jeweller stock crash in 2018, management wanted to suddenly reduce the export business and also wanted to demerge this business from domestic business.
Have a look at the snapshot from Q4FY19 presentation below. A complete U-turn to what they said earlier about exports.
Suddenly the management thinks that exports is a credit driven business with > 6 months long export credit lines and they are trying to reduce this business.
In fact below excerpt states that they voluntarily reduced export business by nearly 47% in FY19.
4. Increasing Receivables To Exports Sales
Please note that in the data provided below, export receivables are assumed to be 97% of the total receivables.
This assumption is based on a statement from the management in FY15 annual presentation.
“Receivables for our export business in FY 15 were 756.07 crore (reduced from 46.3% in FY 14 to 41.8% in FY15)”
756 crore is approximately 97% of total receivables (780 crore) in Mar 15. Hence the assumption.
As per the data above, the receivables to sales ratio (considering only export sales as they form the bulk of receivables) has been increasing from 41.47% in Mar 15 to 48.63% in Mar 17 (around a year before the stock crash in Feb 18).
An increasing receivables to sales ratio indicates that company is making more number of export sales on credit to its customers which is not a good sign.
Firms may try to report higher sales in profit/loss statement by showing more sales on credit (receivables)
PC Jeweller Provides A Discount To Its Export Customers in 2019. Confirming The Problem With Receivables
As pointed out above, PC Jeweller’s was making around 41.47% of sales on credit as of Mar 15. This number increased to 48.63% as of Mar 17 and continued to deteriorate further.
In Q4FY19 (more than a year after the PC Jeweller stock crash), company reported a loss of 376.8 crore on account of one time discount against outstanding export trade receivables amounting to 513 crore.
In short shareholders should forget about these 513 crores as the management decided to give a voluntary discount to their export customers.
Were we wrong in our hunch about increasing receivables to sales ratio on export sales?
Were we not right in doubting management’s intention on trying to increase a low margin, high credit sales export business?
Although the given excerpt from the financial results uploaded for Q4FY19, states that the ongoing credit crunch in India and imposition of 5% import duty and 5% VAT by UAE government disrupted their exports business.
So in order to address the so called genuine operational issues as well as to ensure that receivable payments are not delayed further, company extended 25% discount on outstanding export receivables.
As an investor, I am forced to think how by offering a discount will the company ensure that its receivable payments are not delayed further?
5. Large Bank Balance In Current Accounts With Sudden Increase in Mar 17
A look at the annual report of FY17 reveals that there was a sudden increase in cash in current account.
Please find below an excerpt from annual report of FY17 which reflect a jump in bank balance in current accounts to 326.47 crore from 88.28 crore.
Further balance with current account of 197.62 crores was declared in FY18 annual report.
As an investor this raises suspicion. The purpose of holding such large amount in current account should have been clarified with the management in conference calls.
I have already discussed in one of my previous posts, how wary I am of companies keeping large sums of cash in current accounts.
You can read more about cash in current accounts in point 4 of the below article posted earlier.
9 warning signs of fraud or financial distress in a company
Although it could be a business requirement but what intrigues me is the sudden increase in cash in current account.
6. Decline In Promoter Shareholding From Mar 16 To Dec 17
The table below provides the promoter shareholding percentage of PC Jeweller.
Please note that PC Jeweller issued compulsory convertible preference shares and compulsory convertible debentures in 2016. These instruments must be converted to ordinary shares after a specified time.
Hence the second coloumn in the table below reflects the diluted shareholding.
For our reference we will consider the diluted shareholding assuming full conversion of convertible securities.
Please note that data below has been taken from PC Jeweller’s website
We can see that promoters kept diluting their stake in the company from Mar 16. In Mar 16 the promoter holding was at 70.55 which gradually declined to 60.5% by Dec17 (a drop of 10%).
As an investor we should be investing or increasing our stake in companies where the promoter is increasing his/her stake.
While if the promoter is decreasing or diluting his/her stake significantly then an investor should become cautious.
After all no one knows the business better than the promoter.
Diluting Stake To DVI
Just to add to our discussion on promoter diluting stake in PC Jeweller. The company issued compulsory convertible debentures to DVI Fund (Mauritius) Ltd. On the date of signing the investment agreement DVI held 3.42% shares in PC Jeweller.
After conversion of these debentures to securities, DVI’s stake would increase to 9.4%. The debentures carried a premium of 13% per annum. Please have a look at some of the terms of the agreement:
1. Right to appoint one nominee director on the board of directors of the company
2. Company could not issue any shares at terms more favourable than DVI, without prior consent of DVI
3. PC Jeweller could not take additional debt except a) in the ordinary course of business an to support its business b) without the consent of DVI
4. Firm is not suppose to declare dividend which is more than the dividend payout ratio as of Mar 31, 2015 without the consent of DVI.
In fact they also signed a non disposal undertaking with DVI which led to promoter encumbering their shares to the extent of 70.87% as can be seen below.
In my opinion this agreement with DVI lends too much control to DVI. In my personal view I would not like the management of a company to go to such extent for borrowing capital.
7. Interest Coverage Ratio Hovering Near The Threshold of 3
In my previous posts I have highlighted that a firm should have a minimum interest coverage ratio of 3. In fact higher this ratio the better.
A low interest coverage ratio indicates a reduced ability of the firm to make its interest payments.
You can read more about the interest coverage ratio in the following post:
In case of PC Jeweller, interest coverage ratio has been hovering around the lower range of 3 since Mar 2016 and briefly dipped below 3 in Mar 17.
Although PC Jeweller passes our threshold test of 3 on most occasions but as an investor we should aim to invest in companies with a much higher interest coverage ratio.
8. Spike in Trade Payable & Receivables From Mar 16 to Mar 17
Just as we saw in case of cash in current account, the trade receivables and trade payable for PC Jeweller spiked from Mar 16 to Mar 17.
Please note that trade receivables are sales made by a firm on credit for which money is received on a later date.
For example, PC Jeweller made 686 crore sales on credit in FY12 which are recorded under assets in balance sheet as trade receivables. PC Jeweller is yet to collect payment for these sales.
Essentially trade payable are short term debt obligations or money owed by the company to its supplier or vendor. Trade payable are recorded under liabilities in the balance sheet.
For example, PC Jeweller is due to pay 857 crore to its vendors as of 31st, Mar 2012.
Now coming back to the spike observed in trade receivables and payable for PC Jeweller.
As per the data below we can see that trade receivables jumped by 562 crore from Mar 16 to Mar 17. Likewise the trade payable increased sharply by 820.37 crore over the same period.
In both cases the spike seen in Mar 17 was the highest. As an investor such sharp jumps in cash, receivables or payable need to be verified with the management as they raise suspicion.
Although in Q3FY17 presentation (as can be seen below), management stated that there was a spike in export sales as UAE imposed an import duty on jewellery imports w.e.f from 1st Jan, 2017. This led to preponing of export orders.
May be due to this there was a spike in receivables and payable. But this sudden surge should have been verified with the management in conference call.
As an investor we could have avoided investing in PC Jeweller by looking at the following parameters:
1. Insufficient cash flow from operations with some years having negligible to negative cash flow from operations. Most of the cash of PC Jeweller was getting stuck in inventory and receivables
2. High days inventory outstanding which indicates a large amount of time required to sell inventory and collect cash from customers
3. Low margin export business with sales mostly on credit raises suspicion as an investor
4. High receivables to sales ratio for export related sales
5. Sudden spike in cash balance in current account, trade payables and receivables from Mar 16 to Mar 17. Such sudden spikes should have led an investor to verify the reason from the management via conference calls
6. Interest coverage ratio hovering near the minimum threshold of 3 indicating a lot of profit of the firm is going towards interest payments.
7. Reduction and dilution of stake by promoters from Mar 16 to Dec 17
I hope you liked the article and I wish these warning signs will save my readers from potential stock market declines like PC Jeweller.
Whenever you see a warning sign please make use of the conference calls arranged by the management to address your queries. Please do not hesitate to ask questions from management.
Please share if you liked this article and don’t forget to subscribe. That’s all from my side. Happy Investing Folks.
Disclaimer: Any views or opinions represented in this blog are personal and belong solely to the blog owner. The views represented above are based on data available to investors. Any views or opinions are not intended to malign any company or individual
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