Margin of Safety

Benjamin Graham had emphasised on margin of safety while making investing decisions. All legendary value investors, including Warren Buffett, Charles Munger, Walter Schloss not only vouch for margin of safety but harp on it.

Why is it so important?

The reason is simple.

History shows that managements of companies, even the best managed ones, often make huge mistakes, harming not only the company’s prospects but seriously impairing the value of investors’ interests.

Besides management mistakes there are many environmental risks – political turmoil, disruptive technologies, etcetera.

When you buy the shares below the intrinsic value, when such a management mistake happens you may exit the investment without a loss or a minimum loss. Whereas the person who had bought the share at a very high premium to the intrinsic value naturally suffers a huge loss.

Investor taking the high risk way

Let us consider the following example:

		Value Investor	High Risk Investor
Intrinsic value of the share	240
Price at		192	434
Price after a serious disastrous event	200
Profit/ (Loss)		8	-234

In investing the golden rule is do not incur a loss.

When one buys a share below its intrinsic value, the gap provides the margin of safety. The price difference of Rs.40 provided a 16.67% margin of safety to the value investor, which helped to exit the investment at a low profit of Rs.8 whereas our high risk taking investor had to suffer a huge loss of Rs.23k!

Related Posts:

• How to Calculate the Intrinsic Value Shares?
• How to Find The Fair Price of A Stock?
• You Only Find Out Who is Swimming Naked When The Tide Goes Out
• Intrinsic Value As Described by Benjamin Graham Video
• Simple Formula to Determine Intrinsic Value of a Stock

CAIRN India Ltd. Investment Research Report

CAIRN India Ltd.

A Brief Value Investing Research Report
14^th January, 2017
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Company history and business:

Cairn India is one of the largest independent oil and gas exploration and production companies in India with a market capitalisation of Rs.49531 crores.

Cairn India had 27% of India’s domestic crude oil production in FY 2015-16. Through its affiliates, the company has been operating for over to 20 years playing an active role in developing India’s oil and gas resources. To date, Cairn India has opened 4 frontier basins with numerous discoveries, 38 in Rajasthan alone.

The Mangala field in Rajasthan, discovered in January 2004, is the largest onshore oil discovery in India in more than two decades. Mangala, Bhagyam and Aishwariya fields, the three major discoveries in the Rajasthan block, together, have a gross hydrocarbons initially-in-place of about 2.2 billion barrels of oil equivalent.

Cairn India has a portfolio of 8 blocks of which 7 blocks are in India - one in Rajasthan with multiple assets, two on the west coast and four on the east coast - and one in block in South Africa. Oil and gas is currently being produced from Rajasthan, Ravva in Andhra Pradesh and Cambay in Gujarat.

The company is headquartered in Gurgaon in the National Capital Region with domestic offices operating across India in Andhra Pradesh, Gujarat, Rajasthan, and Tamil Nadu.

Basic Filtering Criteria:

CAIRN India Share's Market Snapshot

	(Rs. Crore/ Rs. 10 million)	Minimum Required	Actual
1	Turnover	1000	8,625	Pass
2	Market Capitalization	1000	49532	Pass
3	Price to Earnings Ratio	Less than 15	104.8	Fail
4	Price to Book Value	Less than 1.5	1.01	Pass
5	Dividend Yield	4-5%	1.14%	Fail

As per basic value investing filtering criteria Cairn India’s share can be taken up as it passes three out of the five filtering criteria.

A. Company Performance

Profitability Analysis

Consolidated Profit & Loss Account                                   (Rs. Crore/ Rs. 10 million)	Mar ' 16	Mar ' 15	Q2 Sep 2016
Revenue from Operations	8625.57	14646.2	2038.59
Cess on crude oil	2604.95	2799.43	495.06
Share of expenses from producing oil and gas blocks	2093.49	1767.24	464.48
(Increase)/ Decrease in inventories of finished goods	-48.59	-1.14	-18.6
Employee Costs	99.07	110.46	17.81
Exploration costs written off	260.04	1098.04	1.11
Other Expenses	251.75	349.54	39.61
Total Operating Expenses	5260.71	6123.57	999.47
EBDITA	3364.86	8522.63	1039.12
Depletion, depreciation and amortization expense	3107.15	2569.47	781.82
Finance Costs	26.96	20.34	19.28
Earnings Before Tax (EBT)	230.75	5932.82	238.02
Non-Operating Income	2008.42	1809.27	599.31
Profit Before Tax and Exceptional items	2239.17	7742.09	837.33
Exceptional Items	11673.80	2633.00	0
(Loss)/ Profit Before Tax (PBT)	-9434.63	5109.09	837.33
Tax Expenses	-2.75	629.49	58.63
Profit After Tax (PAT)	-9431.88	4479.60	778.70
EBDITA Margin - % of Sales	39.01%	58.19%	50.97%
Interest Cost - % of Sales	0.31%	0.14%	0.95%
EBT Margin - % of Sales	2.68%	40.51%	11.68%
PBT&E Margin - % of Sales	25.96%	52.86%	41.07%
PBT Margin - % of Sales	-109.38%	34.88%	41.07%
PAT Margin - % of Sales	-109.35%	30.59%	38.20%

Highlights:

1. Crude oil prices had a taken hit throughout the world. From about US$ 114 a barrel it had plunged to below US$ 20 barrel briefly.
2. EBDITA has fallen in the financial year 2015-16 compared to the previous year, in the light of price hit but still it is very good at 39%.
3. EBT margin has been pulled down in FY 2015-16 by depreciation, a major non-cash expense of Cairn, being a fairly new player with relatively latest and high cost assets. High price realisation in FY 2014-15 could absorb the depreciation charge and still could produce a very good EBT mark-up. Presently oil prices having stabilised at around US$ 40 a barrel, for the quarter ending 30^th September 2016, CAIRN’s EBT again has gained respectability and stands at a decent 11.68% and PAT stands at 38.20% - better than the results of FY 2014-15.
4. Finance cost is negligible as the company is generally cash-rich and carries no borrowing on the books.
5. CAIRN has a large and significant non-operating income comprising of interest and dividends from current investments created from huge accumulated profits of yester years, that can protect investors dividends even during troubled times as it has done during in last financial year. It had also restored the PBT&E ratio to a very good 25.96%.
6. The huge exceptional item of Rs.11,673.80 crores, which has resulted in a loss represents non-cash write down of  acquisition goodwill in the light of the low crude oil price realisation. This is a good and conservative move by the company, which has effectively wiped off almost all the intangible asset goodwill. Even though the profit and loss account shows a huge hole, the cash flow statement is still very healthy.

On profitability parameter the company’s performance appears poor, accentuated by the huge exceptional write-off,  but it is temporary and as the oil prices gain the company has already come back to profitability and going forward its prospects can only be better.

Balance Sheet Analysis

CAIRN India Ltd. Consolidated Balance Sheet                                  (Rs. Crore/ Rs. 10 million)	Mar ' 16	Mar ' 15
LIABILITIES
Share Capital	1874.86	1874.85
Reserves and Surplus	46917.69	56995.35
Total Net Worth	48792.55	58870.20
Long-term Borrowings
Other Long-term Liabilities (Deferred Tax)	1102.83	1271.83
Long-term Provisions	1824.39	1618.25
Total Long Term Liabilities	2927.22	2890.08
Short-term Borrowings	0.00	0.00
Trades Payable	1038.42	919.23
Other Current Liabilities	3019.42	3098.77
Short-term Provisions	717.97	1056.03
Total Current Liabilities	4775.81	5074.03
Total Liabilities	56495.58	66834.31
ASSEST
Fixed Assets	8165.85	8454.75
Capital Work-in-Progress (CWIP)	1324.07	2352.39
Total	9489.92	10807.14
Non-Current Investments	0.00	0.00
Deferred Tax Assets	0.00	0.00
Long-term Loans & Advances	7754.65	16273.43
Other Non-Current Assets	3032.19	1663.17
Total	10786.84	17936.60
Current Investments	15054.09	15233.42
Inventories	468.29	343.88
Trade Receivables	257.08	1124.97
Cash & Cash Equivalents	2385.45	851.69
Short-term Loans & Advances	10875.63	1576.37
Other Current Assets	382.31	227.52
Total	29422.85	19357.85
Intangible assets	3779.86	15178.44
Goodwill on Consolidation	3016.11	3554.28
Total	6795.97	18732.72
Total Assets	56495.58	66834.31

   

Highlights:

1. The reserves have fallen by about Rs.10,000 crores because of the exceptional write-off. However since the write-off had reduced the intangible asset goodwill, the tangible net worth (TNW) has actually improved and improved the important TOL/ TNW Ratio from 1.74 to 1.41. Value investing requirement is below 3 and lesser the better.
2. The current ratio, which measures the short-term liquidity, has almost doubled to 6.16 from 3.82, the norm being above 2 and higher the better.
3. Long-term debt equity ratio of 0.06 is very, very healthy and indicates that company has not borrowed long-term funds. 

Overall, the Balance Sheet of CAIRN India demonstrates immense strength.

Cash Flow Analysis:

Consolidated Cash Flow Statement                               (Rs. Crore/ Rs. 10 million)	Mar ' 16	Mar ' 15
Net Cash from Operating Activities	4133.88	9520.18
Interest	-34.63	-16.86
Adjusted Net Operating Cash Flows (Free Cash Flows)	4099.25	9503.32
Purchase of Fixed Assets & CWIP	-1649.08	-5574.43
Proceeds from Sale/ Maturity of current investments	596.40	1821.43
Loans given to related party	0.00	-7742.50
Fixed Deposits	-1640.30	5045.66
Interest Received	610.63	545.76
Others	-85.78	-37.27
Net Cash Used in Investing Activities	-2168.13	-5941.35
Long-term Borrowings	0.00	0.00
Proceeds from Issue of Equity Share Capital	0.01	14.69
Buy Back of equity shares	143.13	-1121.76
Repayment of Long-term Borrowings	0.00	0.00
Payment of Dividends	-676.04	-1943.09
Tax on dividend paid	-152.67	-366.34
Net Cash Flow from Financing Activities	-685.57	-3416.50
Net  (Decrease)/ Increase in Cash for the Year	1245.55	145.47
		145.47
Dividend Distribution as a % of PB&ET	30.19%	25.10%

Highlights:

1. The cash flow analysis shows strong generation of free cash flows from operations despite losses. The reasons for this is that the losses are primarily due to non-cash depreciation, amortisation and exceptional write-down charges. As the oil prices improve the cash generation will become even more profound.
2. Though subdued compared to the previous year, cash invested in creation of new fixed assets is decent.
3. Interest received is a welcome and significant cash generation component supporting the almost equal amount of dividend paid.
4. Dividend paid accounts for a very healthy 30% of the profits before tax and exceptional items.

Overall CARN’s cash flows are not only very strong but one of the main attractions of the company.

B. Market Conditions:

Price to Earnings Ratio:

A PE Ratio of 104.80 is not favourable.

The reason for the high PE multiple is more owing to low earnings per share (EPS) rather than high market price.

Market condition on this parameter is not favourable.

Price to Book Value per Share: 

With a price to book value ratio at 1.01 the market condition is below the maximum permitted 1.5 and therefore is favourable. Of course the assets are not available on a discount – they are just available at their full value and there is no premium attached either.

Market condition on this parameter is favourable.

Dividend Yield:

Dividend yield of 1.14% is poor. The low dividend is caused by low oil prices and consequent losses and not on account of high market price. Company has to be praised for shelling out over 30% of profits before tax and exception items even after overall loss.

Market condition on this parameter is unfavourable, but the company can be forgiven for the unusually harsh market conditions.

Distance from 52 week high: 

The share price is far away from the 52 week low and very near the 52 week high.

Market condition on this parameter is unfavourable.   

Five-year price graph:

Graph shows CAIRN India Share Price Movement in the last five years

The price graph clearly shows that after falling steeply the share price started climbing too, steeply. In the middle of January 2016 the price was just Rs.110. In one year it has more than doubled. Still it is nowhere near its peak of Rs.392 seen in February 2012.

Thus even though the price has increased in the last 12 months, there is still a lot of scope for further gains and therefore current market condition is still favourable.

Five-year share price return:

Table shows Returns or Increase in CAIRN India's share price

Table shows that even though the share price of Cairn has appreciated over 100% in the last 12 months, still it is lower by about 20% compared to those prevailing in the last three and five years.

On this parameter the market condition even though is not ideal but is still favourable.

C. Final Conclusions:

1. Cairn India Ltd. is a wonderful company that has been currently struggling to maintain profitability in the face of severe market conditions for crude oil, the product of the company. However the oil prices are stabilizing and the prospects again brighten for the company.
2. Cairn has shown loss in the previous financial year but this is on account of an exceptional write-down goodwill to the huge extent of Rs.11,000 crores (US$ 1.57 Billions). For the second quarter ending 30^th September 2016, Cairn has crawled back into profits on the back of stabilizing crude oil prices.
3. Cairn’s balance sheet is very strong despite losses.
4. Company’s cash flows are robust despite losses because the losses are caused by non-cash write-offs.
5. A robust non-operating income out of investments of accumulated profits is the company’s big strength and attraction.
6. Due to the short period of existence of the company, the uninterrupted dividend paying history is short.
7. The dividend yield is low because the quantum of dividend paid in the financial year 2015-16 is low on account of losses. However the company has paid out an appreciable over 30% of its profits before tax and exceptional items.
8. Market conditions are not highly attractive but not bad either. PE Ratio is too high but the culprit is low profits. Price to book value (P2BV) ratio is in the attractive zone.

D. Final Investment Advice:

CAIRN India Ltd. is a wonderful company. Assets are available at face value – there is no discount or premium.

Start buying and accumulating this stock. If the price falls and P2BV drops below 1, buy more. Similarly as the PE Ratio improves and falls below 15, buy more.

Post Disclaimer: Opinions expressed here are the author’s personal opinions. Market conditions have a great bearing on many end results discussed in this report. No disrespect is intended towards the company, it’s management. Investors are advised not rely blindly on the opinions expressed herein but to exercise their own judgment. Neither the author nor the blog shall be responsible for any loss suffered by either acting or not acting based on the opinions expressed herein.

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