The Magic Formula and Value Traps

STRATEGY
October 2015
Apollo Tyres
Inox Wind
Aurobindo Pharma
The Magic Formula and Value Traps

Analysts: Saurabh Mukherjea, CFA Ritu Modi
saurabhmukherjea@ambitcapital.com ritumodi@ambitcapital.com
Nitin Bhasin
nitinbhasin@ambitcapital.com Bhargav Buddhadev Aditya Khemka
Tel: +91 22 3043 3241 bhargavbuddhadev@ambitcapital.com adityakhemka@ambitcapital.com
Gaurav Mehta, CFA Deepesh Agarwal Paresh Dave, CFA
gauravmehta@ambitcapital.com deepeshagarwal@ambitcapital.com pareshdave@ambitcapital.com
Prashant Mittal, CFA Ashvin Shetty, CFA Consultant: Anupam Gupta
prashantmittal@ambitcapital.com ashvinshetty@ambitcapital.com anupam.gupta@aavanresearch.com
Strategy
CONTENTS
The Magic Formula and Value Traps ….........................................................3
Section 1: Value and value traps ……………………………………………………4
- Screening for value - The magic formula……………………………………...4
- Current ‘value’ plays on this screen ……………………………………………5
Section 2: A framework to identify ‘value traps’ ………………………………….7
- Filter 1: Accounting quality ………………………………………………………8
- Filter 2: Corporate governance………………………………………………..10
- Filter 3: Capital allocation ……………………………………………………..10
- Filter 4: IBAS framework………………………………………………………..12
COMPANIES
Apollo Tyres (NOT RATED)…………………………………………………………. 15
Aurobindo Pharma (SELL)………………………………………………………….. 29
Inox Wind (SELL)……………………………………………………………………...43
October 06, 2015 Ambit Capital Pvt. Ltd. Page 2

Strategy
THEMATIC October 06, 2015
The Magic Formula and Value Traps Value traps discussed in this report
Apollo Tyres NOT RATED
The recent correction in the stockmarket has prompted investors to
search for stocks with deep value. We ran the ‘Magic Formula’ screen, Target Price: NA Upside NA
ranking companies on return ratios and earnings yield. From this list, Aurobindo Pharma SELL
we flag three names – Apollo Tyres, Aurobindo Pharma and Inox Wind –
which appear to be value traps. Our deep dive into these three stocks Target Price: `414 Downside: 46%
reveal concerns around issues such as lack of sustainable advantages
Inox Wind SELL
and risk of capital misallocation. We provide a four-filter framework to
help investors assess the deep value in stocks and thus to avoid stocks Target Price: `370 Upside: 2%
that look attractive but are, in fact, value traps.
The hunt for value… Top-50 firms on ‘magic formula’
The BSE200’s 8% correction from its March 2015 high has prompted investors to score
hunt for value stocks. Our Magic Formula – a modification of Joel Greenblatt’s NMDC Tech Mahindra
screen – has delivered excellent results in the past (click here for our Hero Motocorp Guj.St.Petronet
13th September 2013 note). When we ran the screen on the current market, the Apollo Tyres Oracle Fin.Serv.
results included some of our top BUYs such as ITC, Lupin and Coal India.
Engineers India BPCL
However, even as the approach works well in general, like any other ‘value’
screen, this approach reveals some ‘value traps’ that need to be avoided. Indraprastha Gas Mphasis
Sun TV Network Tube Investments
...has some pitfalls
Bajaj Auto Essar Oil
From the list of the top-50 stocks under the ‘Magic Formula’ screen, we
PC Jeweller Cyient
highlight three midcap value traps – Apollo Tyres, Aurobindo Pharma and
Inox Wind. All three stocks appear attractive on the ‘Magic Formula’ after the HCL Technologies Ajanta Pharma
recent correction. However, we recommend that investors should avoid these Infosys Lupin
stocks given that each of them has issues pertaining to lack of sustainable Supreme Inds. Balkrishna Inds
competitive advantages and risk of capital misallocation. ITC UPL
Defining a value trap Welspun India CMC
MRF P I Inds.
In general, value stocks remain cheap for prolonged periods of time,
irrespective of the overall direction of the markets. Our core thesis is that Mindtree Castrol India
companies with poor management (tracked on capital allocation, corporate TCS Inox Wind
governance and accounting quality) and businesses without sustainable Coal India Bajaj Corp
competitive advantages (tracked on our IBAS framework) are prime candidates Hind.Zinc Oil India
for becoming value traps.
JSW Energy Aurobindo Pharma
Building a framework
AIA Engg. Motherson Sumi
Using our core thesis, we build a four-step filter to help investors identify value Tata Motors Hind. Unilever
traps. We believe that value traps would fail on at least two of these filters.
Hexaware Tech. Arvind Ltd
These filters are: (a) Accounting Quality: 11 ratios focusing on highlighting
key issues in published accounts; (b) IBAS: Assessing sustainable competitive Wipro Colgate-Palm.
advantages, a key success factor for any business; (c) Capital Allocation: SJVN GSK Consumer
Evaluating management’s ability to efficiently use capital to fund growth; and Natl. Aluminium Titan
(d) Corporate Governance: Commitment of promoters to protect all interests,
including minorities. Analyst Details
Value trap summary Gaurav Mehta, CFA
Company
Accounting Corporate Capital
IBAS Hypothesis
+91 22 3043 3255
Quality Governance Allocation gauravmehta@ambitcapital.com
Modest franchise with core business
Apollo Tyres
under threat from rising competition Prashant Mittal, CFA
Auro Key issues in corporate governance +91 22 3043 3218
Pharma and lack of moated revenues
Absence of any sustainable prashantmittal@ambitcapital.com
Inox Wind competitive advantage; issues in
accounting quality Consultant
Source: Ambit Capital research. Note: = rating of 4/4; =rating of 3/ 4 and so on. Anupam Gupta
anupam.gupta@aavanresearch.com
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital
may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
Strategy
Section 1: Value and value traps

The BSE200 Index has corrected by almost 8% from its 3 March 2015 highs. This
has prompted investors to hunt for ‘value’ in the Indian stockmarket especially in
small-mid capitalisation stocks. The quest for value, however, can also lead to
‘value traps’, i.e., stocks that appear cheap but actually aren’t. In this note, we
provide investors with a framework to identify ‘value’ traps and we discuss three
stocks that, in our view, are offering a false sense of ‘value’ today.
Screening for value - The magic formula

A credible way of screening for ‘value’, we believe is Joel Greenblatt’s ‘magic’
formula. Our detailed note on this approach, dated 13th September 2013, had
shown that such an approach works in the Indian context.
The approach is premised on finding stocks that offer a good blend of return on
capital employed and earnings yield. In particular, the formula ranks firms on a
combination of the following two ratios: (1) EBIT as a proportion of Net Fixed
Assets plus Net Working Capital (this ratio is akin to an adjusted RoCE); and (2)
EBIT as a proportion to Enterprise Value (this ratio is akin to a firm’s earnings
yield adjusted for capital structure).
We have historically used a slightly modified version of the formula with the
following two measures for return ratio and earnings yield:
 Our ‘return ratio’ is pre-tax RoCE which includes interest and dividend
income along with EBIT in the numerator and total capital including cash in
the denominator.
 Our ‘earnings yield’ has the same numerator as pre-tax RoCE and the
denominator is market value of capital (debt as well as equity without
excluding cash).
Firms are then ranked on both these parameters individually. The two ranks are
then added to arrive at the cumulative ranks for each firm; a firm with a better
cumulative rank should have a good blend of high return ratios and inexpensive
valuations.
The performance of quintiles constructed using this approach for the BSE200
universe over the last 18 years (1997-2015) is presented in Exhibit 2 below and
suggests that the magic formula does work.
Exhibit 1: The magic formula over the past 18 years on average return basis*
Performance of 'magic' quintiles

4,000
Growth of INR 100 invested in
3,500 CAGR
Q1
3,000
22%
2,500 Q2 21%
2,000
'97
Q4 16%
1,500
1,000 14%
500 Q3 8%
-
Q5
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Year
Source: Capitaline, Bloomberg, Ambit Capital research. * Within each quintile, we take the raw average of
the quintile’s constituents to calculate the return for the quintile as a whole. These quintiles are based on an
annual rebalance on June 30th

Strategy
Exhibit 2 clearly shows that the ‘magic formula’ does work over a long-term
horizon. Further, the yearly performances of these quintiles suggests that the
highest quintile, Q1, has outperformed the BSE200 in 12 of the last 18 years (see
Exhibit 3), thus validating the approach’s utility from a more tactical standpoint as
well.
Exhibit 2: Yearly quintile performance over 1997-2015*
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 CAGR
Q1 46% 46% 7% -19% 82% 24% 42% 54% 33% 38% -9% 8% 49% -1% -9% -8% 55% 15% 22%
Q2 21% 39% 56% -26% 17% 16% 59% 72% 37% 34% -13% 9% 44% -3% -14% -6% 59% 31% 21%
Q3 -19% 39% 12% -34% 19% 9% 46% 71% 49% 44% -9% -9% 33% 0% -3% 10% 35% 19% 14%
Q4 -16% 51% 26% -35% 34% 4% 47% 86% 30% 43% -7% 8% 26% -13% -16% 5% 64% 17% 16%
Q5 -20% 34% 35% -36% 31% -1% 29% 79% 24% 52% -8% -6% 15% -23% -21% -15% 58% -5% 8%
BSE200 -19% 26% 26% -31% 10% 15% 38% 48% 38% 42% -9% 7% 27% 3% -8% 9% 33% 12% 12%
Q1minus
BSE200 65% 20% -19% 12% 72% 9% 4% 6% -5% -4% 0% 1% 22% -4% -1% -17% 22% 3% 10%
Source: Capitaline, Bloomberg, Ambit Capital research. * Within each quintile, we take the raw average of the quintile’s constituents to calculate the return for the
quintile as a whole. These quintiles are based on an annual rebalance on June 30th .Yearly performance in calculated from 1st July every year. For e.g. the 2014
performance is from 1st July 2014 – 30th June 2015. Years in which the magic formula has underperformed are marked in Red
However, it is important to note that the performances shown here are the
average of all stocks in the quintile, and individual stocks within a quintile may
have varying performances scattered around these averages. Thus, even as the The top quintile has outperformed
approach works well in general, like any other ‘value’ screen, this approach too the BSE200 in 12 of the last 18
will throw up some ‘value traps’ alongside a bunch of ‘value’ picks. years over 1997-2015
Current ‘value’ plays on this screen

The magic screen in the current context can be seen in Exhibit 4 on the next page,
which plots the best 50 stocks on a blend of ‘earnings yield’ and ‘return ratio’
from a universe of Indian companies with a market-cap in excess of `60bn.

Strategy
Exhibit 3: Top-50 firms ranked in descending order (best firm first) on the basis of the ‘magic formula’ score
Mcap 6M Adv FY15 Earnings FY16E FY16E FY16E
Company Name Sector Ticker
(US$ mn) (US$ mn) RoCE Yield P/E (x) P/B (x) EV/EBITDA (x)
NMDC Mining & Mineral products NMDC IN 5,762 3.7 31% 26% 9.4 1.0 4.8
Hero Motocorp Automobile HMCL IN 7,713 23.1 55% 7% 18.0 5.7 12.0
Apollo Tyres Tyres APTY IN 1,499 8.6 27% 15% 8.4 1.6 4.8
Indraprastha Gas Gas Distribution IGL IN 1,013 3.4 31% 10% 14.1 2.7 7.7
HCL Technologies IT - Software HCLT IN 18,323 27.3 40% 8% 15.5 4.0 11.5
PC Jeweller Diamond, Gems and Jewellery PCJL IN 1,021 1.6 28% 11% 14.7 2.8 8.2
Sun TV Network Entertainment SUNTV IN 2,177 12.6 35% 8% 15.9 3.8 7.1
Engineers India Infrastructure Developers ENGR IN 1,023 2.0 28% 10% 19.4 2.4 15.2
Bajaj Auto Automobile BJAUT IN 10,462 14.3 42% 7% 17.8 5.3 12.9
Infosys IT - Software INFO IN 40,572 71.7 36% 6% 19.9 4.5 14.2
Supreme Inds. Plastic products SI IN 1,234 0.7 36% 6% 25.0 5.9 13.6
ITC Tobacco Products ITC IN 40,830 35.7 48% 5% 25.4 7.5 16.3
Coal India Mining & Mineral products COAL IN 32,609 27.6 27% 9% 13.5 4.9 9.0
Hind.Zinc Non Ferrous Metals HZ IN 9,081 2.3 19% 13% 7.9 1.2 4.1
TCS IT - Software TCS IN 80,915 49.7 51% 5% 21.9 7.8 16.2
MRF Tyres MRF IN 2,781 8.5 27% 8% 11.3 2.6 6.2
Welspun India Textiles WLSI IN 1,396 3.4 25% 9% 14.2 4.8 7.8
Tata Motors Automobile TTMT IN 16,359 53.2 19% 14% 7.3 1.4 3.3
JSW Energy Power Generation & Distribution JSW IN 2,343 3.8 19% 13% 11.4 1.8 5.9
AIA Engg. Castings, Forgings & Fastners AIAE IN 1,434 1.5 30% 6% 21.6 3.9 13.9
Hexaware Tech. IT - Software HEXW IN 1,170 6.2 34% 6% 19.3 5.5 13.1
Mindtree IT - Software MTCL IN 1,970 4.5 37% 5% 21.5 5.3 14.8
SJVN Power Generation & Distribution SJVN IN 1,607 0.3 17% 16% 8.0 1.0 4.6
Natl. Aluminium Non Ferrous Metals NACL IN 1,407 0.9 16% 22% 11.1 0.7 3.5
Wipro IT - Software WPRO IN 22,746 15.0 26% 7% 16.1 3.2 11.7
Guj.St.Petronet Miscellaneous GUJS IN 1,008 1.3 18% 11% 13.0 1.6 7.3
Cyient IT - Software CYL IN 963 0.8 25% 7% 16.4 2.9 11.6
UPL Agro Chemicals UPLL IN 3,007 19.8 22% 9% 13.8 2.8 8.2
Tech Mahindra IT - Software TECHM IN 8,279 26.0 28% 6% 17.8 3.6 11.9
Oracle Fin.Serv. IT - Software OFSS IN 5,162 3.4 29% 5% 24.0 7.4 16.4
P I Inds. Agro Chemicals PI IN 1,337 2.3 41% 4% 29.0 7.6 19.4
B PC L Refineries BPCL IN 9,677 21.2 18% 10% 11.1 2.4 7.3
MphasiS IT - Software MPHL IN 1,331 1.1 17% 10% 11.9 1.5 7.4
Tube Investments Miscellaneous TI IN 1,167 0.5 15% 11% 61.3 DNA 23.3
Essar Oil Refineries ESOIL IN 4,317 6.0 18% 9% 14.7 4.5 9.2
CMC IT - Hardware CMC IN 942 1.0 27% 6% 21.0 3.9 13.3
Balkrishna Inds Tyres BIL IN 976 0.9 18% 9% 11.8 2.3 7.5
Ajanta Pharma Pharmaceuticals AJP IN 2,037 5.1 57% 4% 33.2 11.5 22.0
Bajaj Corp FMCG BJCOR IN 1,034 1.1 50% 4% 26.9 12.3 22.1
Inox Wind Capital Goods INXW IN 1,211 N/A 29% 5% 15.2 4.3 10.0
Motherson Sumi Auto Ancillaries MSS IN 4,704 15.9 25% 6% 22.4 7.3 9.0
Castrol India Chemicals CSTRL IN 3,413 2.0 117% 3% 37.4 38.7 23.4
Oil India Crude Oil & Natural Gas OINL IN 4,063 2.7 13% 11% 7.9 1.1 5.4
Hind. Unilever FMCG HUVR IN 27,162 20.8 147% 3% 39.0 38.9 27.6
Lupin Pharmaceuticals LPC IN 14,355 46.6 40% 4% 37.0 8.5 23.0
Aurobindo Pharma Pharmaceuticals ARBP IN 6,843 28.4 28% 5% 22.2 6.0 15.4
Arvind Ltd Textiles ARVND IN 1,118 9.4 16% 8% 16.3 2.4 9.2
Titan Company Diamond, Gems and Jewellery TTAN IN 4,701 5.8 34% 4% 34.8 8.4 25.7
Colgate-Palm. FMCG CLGT IN 3,987 6.7 114% 3% 42.5 29.8 27.8
GlaxoSmith C H L FMCG SKB IN 3,889 1.3 41% 3% 36.1 10.2 27.7
Source: Capitaline, Bloomberg, Ambit Capital research. Note: * RoCEs and earnings yields based on FY14 financial statements for Engineers India and MRF;
arranged by ‘magic’ score; RoCE is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in
the denominator; earnings yield has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity including cash).
FY16 estimates have been sourced from Bloomberg, updated values as of 05 Oct 2015.
From the list above, it is clear that not all of these names have ‘value’. Whilst
many do have ‘value’, quite a few fall into the ‘value trap’ category. Whilst some
of these names are obvious, we highlight three non-obvious ones in the next
section.

Strategy
Section 2: A framework to identify ‘value

traps’
In a September 2013 blog post, Aswath Damodaran, a Professor of Finance at
the Stern School of Business at New York University, described value traps as
“companies that look cheap on every metric but stay cheap forever” (source:
http://goo.gl/Mzr9TP).
Value traps have many things in common beyond appearing cheap after every Value traps have many things in
market fall and looking good on reported financials. In our view, these stocks are common beyond appearing cheap
businesses without any sustainable competitive advantage which have benefited after every market fall and looking
from a market cycle or exit of competition or a temporary factor that makes them good on reported financials
look good. Chance, rather than merit or skill, has propelled the management
that is likely lucky at best and mediocre at worst.
In our view, a great company – one with proven, sustainable competitive
advantages – can survive bad management. But a company without any
sustainable competitive advantage, irrespective of management quality is at high
risk of value destruction, more so if it is saddled with poor management. These
are the value traps that investors must avoid irrespective of how attractive
valuations appear after a stock price correction. In all probability, there is further
downside to the stock price.
In this section, we provide a framework to help investors identify value traps. We
base our framework on proprietary filters that have held us in good stead in the
past in identifying winners and avoiding losers.
To summarise: Companies with poor management
and businesses without sustainable
 Our core thesis is that companies with poor management (as captured by
competitive advantages are prime
capital allocation, corporate governance and accounting quality) and
candidates for value traps
businesses without sustainable competitive advantages (as tracked by our
IBAS framework) are prime candidates for turning out be value traps.
 Therefore, our filters include all four issues: accounting quality, IBAS
framework, capital allocation and corporate governance.
 Our filters will assign red flags, as applicable, for value traps on each of the
parameters.
We summarise our filters in the table below before delving into each filter in
detail.
Exhibit 4: Summary of value trap filters
Filter Methodology Purpose
Analyse overall published accounts for
Accounting Stocks with weak accounting quality
quality in general and misstatements
Quality tend to underperform
and irregularities in specific
Analyse data such as insider trading,
Corporate Evaluate management's attitude
board composition and related party
governance towards minority shareholders
transactions
Measure management's effectiveness in
Capital allocation Critical for superior RoCEs
allocating capital for growth of the firm
Assess sustainable competitive
advantages across Innovations, Brands Helps in sustaining growth over long
IBAS framework
and Reputation, Architecture and periods
Strategic Assets
Source: Ambit Capital research

Strategy
Filter 1: Accounting quality

Accounting quality is not just one of the many factors affecting investment returns
but rather a critical hygiene factor, the lack of which can be detrimental to
portfolio returns. In our 22 December 2014 thematic report,
“Forensic Accounting: Identifying the Zone of Trouble”, we established a model
that looks at the following key categories of accounting irregularities: balance
sheet misstatement, profit & loss misstatement, cash pilferage and audit quality.
We use 11 ratios to score our universe (excluding, banks and financial services We use 11 ratios to score our
firms) based on their accounting qualities. These ratios can broadly be universe based on their accounting
categorised into four buckets. quality
Exhibit 5: Key categories of accounting checks
Category Ratios
(1) CFO/EBITDA, (2) change in depreciation rate, and (3)
P&L misstatement checks volatility in non-operating income (as a percentage of net
revenues)
(1) Cash yield, (2) change in reserves (excluding share
premium) to net income excluding dividends, (3) provisions
Balance sheet misstatement checks for doubtful debts as a proportion of debtors more than six
months, and (4) contingent liability as a proportion of net
worth
(1) Non-operating expenses as a proportion of total
Cash pilferage checks revenues, (2) CWIP to gross block, and (3) cumulative CFO
plus CFI to median revenues
(1) CAGR in auditor’s remuneration to CAGR in consolidated
Audit quality checks
revenues
Here is a brief description of the accounting ratios:

I - P&L misstatement checks
1 CFO/EBITDA: This ratio checks a company’s ability to convert EBITDA (which A low CFO/EBITDA raises concerns
can be relatively easily manipulated) into operating cash flow (which is more about the company’s revenue
difficult to manipulate). A low ratio raises concerns about the company’s recognition policies
revenue recognition policy (because this may imply aggressive revenue
recognition through methods such as channel stuffing). We use a six-year
median for this measure.
2 Change in depreciation rate: We calculate change in depreciation rates for Our model penalises high volatility
each of the past six years (FY09-14). We then calculate the median of in depreciation rate
absolute changes and then sort the companies on this ratio such that the
company with the smallest change in its depreciation rate receives the best
score. The rationale is to penalise companies that have high volatility in their
depreciation rate on a YoY basis.
3 Volatility in non-operating income: We calculate change in non-operating High volatility in non-operating
income (as a percentage of net revenues) for each of the past six years (FY09- income is a cause of concern!
14). We then calculate the median of absolute changes and then sort firms
on this ratio such that the company with the least volatility receives the best
score. The rationale is to penalise firms where volatility in non-operating
income is unusually high, as this could imply intent to inflate profitability in
years of low profits by resorting to such means as sale of assets, investments,
and so on.
II - Balance sheet misstatement checks

4 Cash yield: This ratio is calculated as the yield earned on cash, investments A low cash yield may imply
and deposits. A low ratio could be a cause for concern, as it could mean that balance sheet misstatement or that
either the balance sheet has been misstated or that the cash is not being the cash is not being used in the
used in the best interests of the firm. We use a six-year median for this firm’s best interest
measure.

Strategy
5 Change in reserves (excluding share premium) to net income A ratio of less than one on this
excluding dividends: This ratio is calculated by dividing the change in check may denote direct write-offs
reserves (excluding share premium) on a YoY basis and dividing it by that through the balance sheet
year’s PAT excluding dividends. We then take a six-year median of this ratio.
A ratio of less than one indicates direct write-offs to equity without routing
these through the Profit & Loss account and may indicate aggressive
accounting policies.
6 Provision for doubtful debts as a proportion of debtors more than six A low provisioning raises the
months: This ratio checks the conservativeness of a company’s provisioning spectre of earnings being boosted
policy. A low ratio raises the spectre of earnings being boosted through through aggressive provisioning
aggressive provisioning practices. We use a six-year median for this measure. practices
7 Contingent liabilities as a proportion of net worth: This is a check on a A very high proportion of
company’s off-balance-sheet liabilities. If this ratio is high, it raises concerns contingent liabilities to net worth
regarding the strength of the company’s balance sheet in the event that the indicates disproportionately high
contingent liabilities materialise. Given that contingent liabilities also include off-balance-sheet risk
genuine items such as letters of credit, bill discounting and capital
commitments, we seek to eliminate as many of these items whilst computing
the figure for contingent liabilities. We use a six-year median for this
measure.
III - Cash pilferage checks

8 Non-operating expenses as a proportion of total revenues: This ratio A high proportion of non-operating
checks a company’s expenditure policy. A high ratio raises concerns expenses raises concerns regarding
regarding the authenticity of such expenses. We use a six-year median for the genuineness of such expenses
this measure.
9 CWIP to gross block: The idea here is to penalise firms that show A high CWIP to gross block ratio
consistently high CWIP relative to the gross block, as this may either indicate may either indicate
unsubstantiated capital expenditure or a delay in commissioning (which may unsubstantiated capex or delay in
in turn be motivated by a delay in the recognition of the related depreciation commissioning
expense). We calculate the proportion of capital work in progress to gross
block for each of the last six years and then take the 25th percentile
observation (instead of a simple six-year median like in most other ratios).
The reason for using the 25th percentile over the last six years for this
measure as opposed to the median (which would be the 50th percentile
observation) is to allow the benefit of doubt to firms that have invested wisely
during the recent downturn. Hence, we are penalising companies only if the
ratio has been consistently high over most of the last six-year period.
10 Cumulative CFO plus CFI to median revenues: We calculate the Our model penalises firms that
cumulative CFO (cash flow from operations) plus cumulative CFI (cash flow have not generated positive cash
from investing activities) over the last six years and divide this by the last six- flows even on a six-year basis
year median revenues for the company. The higher the ratio, the better our
perception of the company’s accounts. The idea is to penalise firms which
over such large periods have been unable to either generate positive cash
flows from operations or alternatively where cash flow from investments have
consistently eaten away cash generated from operations.
IV - Audit quality checks

11 CAGR in auditor’s remuneration to CAGR in consolidated revenues: We penalise firms where growth in
We calculate CAGR in standalone auditor’s remuneration and consolidated auditor’s remuneration has been
revenues over FY08-14. A lower ratio of CAGR in auditor’s remuneration higher than the growth in the
relative to CAGR in consolidated revenues receives a high score. The firm’s revenues
rationale is to penalise companies whose growth in auditor’s remuneration
has exceeded the growth in the firm’s revenues.
Implications for value traps: We highlight that not all value traps will have
poor accounting quality. However, investors must use the above filters to carefully
assess those stocks that show up on their value screen and only consider those
companies whose ratios provide a high level of comfort on accounting quality.

Strategy
Filter 2: Corporate governance

Finally, we believe that high corporate governance standards are a measure of High corporate governance
the company’s commitment to all shareholders, not just promoters. Whilst our standards are a measure of the
first filter in ‘Accounting Quality’ will capture irregularities in published accounts, company’s commitment to all
more subjective filters are required to gauge the intent of management and their shareholders, not just promoters
attitude toward minorities. These filters include, but are not limited to, the
following:
 Related party transactions: Ideally, transactions between related parties
should be at arm’s length. An arm’s length transaction would mean that both
the parties seek to execute the transaction in their best interests. However, in
several cases, related party transactions are conducted in a manner that is
not in the best interests of one party. Overpaying for an asset purchased from
a related party, sale of goods or other assets to related parties at a significant
discount to their fair market values, loans given to related parties at
exceptionally concessional rates or loans taken from related parties at
exorbitant interest rates are just a few examples of how these transactions
might not be in the best interests of minority shareholders. Likewise,
unwarranted transactions with related parties should raise a red flag.
 Insider trading: Investors should watch out for excessive insider trading in
the company’s stock. These trades are required to be reported to the
exchanges and anything suspicious – especially surrounding big
announcements – should raise red flags to investors.
 Board independence: The company’s Board should be visibly independent
and contribute in a meaningful manner to key decisions. Boards where the
number of independent directors is lower than the statutory limit or where
independent directors have no merit or connection with the company’s core
business should raise red flags for investors.
 Questionable transactions that benefit promoters: These include
transactions such as merger of unlisted entities at exorbitant valuations and
transfer of profitable divisions at cheap valuations, which should immediately
raise concerns for investors on the intent of the promoters.
Implications for value traps: Whilst companies with a track record of poor Whilst companies with poor
corporate governance should raise red flags in general, it is more important to corporate governance should raise
identify these companies as value traps. In such cases, even if the core business red flags in general, it is more
performs well, there is no guarantee that the benefits will be shared with all the important to identify these
shareholders alike. companies as value traps
Filter 3: Capital allocation

Efficient capital allocation is at the core of great companies. More importantly, Efficient capital allocation is at the
effective capital allocation is not just about growing but growing profitably. Thus, core of great companies
capital allocation is perhaps the single most important decision through which a
management adds value to the firm’s shareholders.
The exhibit below outlines the various choices that managements face towards
allocation of capital.

Strategy
Exhibit 6: Capital allocation choices
Organic: Inorganic:
Capex Acquisitions
Expand
Do nothing
Capital Cash builds up
allocation
choices
Return
Share buybacks/
Dividends debt repayment

A firm should either use its capital for business expansion (capex/ acquisition) or Letting cash accumulate on
return the surplus cash to its stakeholders (dividend/ share buyback/ debt balance sheets reduces return
repayment). However, we often see firms opting for a third choice of doing ratios and hurts shareholder
nothing and letting cash accumulate on their balance sheets. This clearly reduces returns
return ratios and hurts shareholder returns.
We have explored capital allocation in great detail over the years, starting from RoCE is the single biggest driver for
our Greatness Framework in 2012 that analysed capital allocation decisions of stock price performance
India Inc to our thematic report dated 31st July 2013, “The Cashflow Conundrum
for India Inc” that established RoCE as the single biggest driver for stock price
performance. Capital allocation is the key to superior RoCEs.
Thus, in this report, we carry forward our focus on capital allocation as a key area
for identifying value traps. Growth creates value only when it helps generate
return on capital in excess of cost of capital. Using this measure, we analyse the
trends in sources and utilisation of capital in the past decade.
Implications for value traps: Inevitably, value traps falter in any one or all of Investors must convince themselves
the areas of utilisation: excessive capex and/or acquisitions to fuel global of the management’s ability to use
ambition plans, which eventually hurt return ratios or refusal to return excess capital judiciously
cash to shareholders or pare debt. Investors must convince themselves of the
management’s ability to use capital judiciously to avoid falling for a value trap.

Strategy
Filter 4: IBAS framework

In our 22nd May 2014 thematic report, “Great Indian Midcaps”, we used the “IBAS
Framework” to analyse how a select group of stocks sustained high levels of
growth whilst maintaining return ratios. “IBAS” stands for Innovation, Brands and
Reputation, Architecture and Strategic Asset. This framework was first enunciated
by John Kay, the British economist and Financial Times columnist, in his 1993
book, “Foundations of Corporate Success”.
John states that “sustainable competitive advantage is what helps a firm ensure Strategic assets can be in the form
that the value that it adds cannot be competed away by its rivals”. He goes on to of intellectual property, legal rights
state that sustainable competitive advantages can come from two sources: or a natural monopoly; distinctive
distinctive capabilities or strategic assets. Whilst strategic assets can be in the capabilities are more intangible in
form of intellectual property (patents and proprietary know-how), legal rights nature
(licenses and concessions) or a natural monopoly, the distinctive capabilities are
more intangible in nature.
Distinctive capabilities, says Kay, are those relationships that a firm has with its
customers, suppliers or employees, which cannot be replicated by other
competing firms and which allow the firm to generate more value additions than
its competitors. He further divides distinctive capabilities into three categories:
 Brands and reputation
 Architecture
 Innovation
We summarise the four aspects of IBAS below. For a more detailed reading,
including case studies and examples, please refer to our report,
“Great Indian Midcaps”, which has exhaustive analysis on six stocks using the
IBAS framework.
Brands and reputation

In many markets, product quality, in spite of being an important driver of the
purchase decision, can only be ascertained by a long-term experience of using
that product. Examples of such products are insurance policies and healthcare. In
many other markets, the ticket price of the product is high; hence, consumers are
only able to assess the quality of the product only after they have parted with
their cash. A few examples of such products would be cars and high-end TVs.
In both these markets, customers use the strength of the company’s reputation as Reputation tends to be difficult and
a proxy for the quality of the product or the service. For example, we gravitate costly to create, making it a very
towards the best hospital in town for critical surgery and we tend to prefer world- powerful source for a competitive
class brands whilst buying expensive home entertainment equipment. Since the advantage
reputation for such high-end services or expensive electronics takes many years
to build, reputation tends to be difficult and costly to create. This in turn makes it
a very powerful source for a competitive advantage.
For products that we use daily, we tend to be generally aware of the strength of a
firm’s brand. In more niche products or B2B products (such as industrial cables,
mining equipment, municipal water purification and semiconductors), investors
often do not have first-hand knowledge of the key brands in the relevant market.
In such instances, to assess the strength of the brand, they turn to:
 Brand recognition surveys conducted by the trade press.
 The length of the warranties offered by the firm (the longer the warranties,
the more unequivocal the statement it makes about the firm’s brand).
 The amount of time the firm has been in that market (eg. “Established 1905”
is a fairly credible way of telling the world that since you have been in
business for over a century, your product must have something distinctive
about it).

Strategy
 How much the firm spends on its marketing and publicity (a large marketing
spend figure, relative to the firm’s revenues, is usually a reassuring sign).
 How much of a price premium the firm is able to charge vis-a-vis its peers.
Architecture
‘Architecture’ refers to the network of contracts, formal and informal, that a firm ‘Architecture’ refers to the network
has with its employees, suppliers and customers. Thus, architecture would include of contracts, formal and informal,
the formal employment contracts that a firm has with its employees and it would that a firm has with its employees,
also include the more informal obligation that it has to provide ongoing training suppliers and customers
to its employees. Similarly, architecture would include the firm’s legal obligation
to pay its suppliers on time and its more informal obligation to warn its suppliers
in advance if it were planning to cut production in three months.
Such architecture is most often found in firms with a distinctive organisational

style or ethos, because such firms tend to have a well-organised and long-
established set of processes or routines for doing business. So, how can an
investor assess whether the firm they are scrutinising has architecture or not? In
fact, whilst investors will often not know the exact processes or procedures of the
firm in question, they can assess whether a firm has such processes and
procedures by gauging the:
 extent to which the employees of the firm co-operate with each other across
various departments and locations.
 rate of staff attrition (sometimes given in the Annual Report).
 extent to which the staff in different parts of the firm give the same message
when asked the same question.
 extent to which the firm is able to generate innovations in its products or
services or production processes on an ongoing basis.
At the core of successful architecture is co-operation (within teams, across various At the core of successful
teams in a firm and between a firm and its suppliers) and sharing (of ideas, architecture is cooperation and
information, customer insights and, ultimately, rewards). Built properly, sharing
architecture allows a firm with ordinary people to produce extraordinary results.
Innovation
Whilst innovation is often talked about as a source of competitive advantage, Whilst most talked about,
especially in the Technology and Pharmaceutical sectors, it is actually the most ‘Innovation’ is also the most
tenuous source of sustainable competitive advantage, as: tenuous source of sustainable
 Innovation is expensive. competitive advantage…
 Innovation is uncertain - the innovation process tends to be a “hit or miss”.

 Innovation is hard to manage due to the random nature of the process.
Furthermore, even when the expensive innovation process yields a commercially

useful result, the benefits can be competed away, as other firms replicate the
innovator and/or employees who have driven the innovation process tend to
extract the benefits of innovation through higher compensation.
In fact, innovation is more powerful when it is twinned with the two other
distinctive capabilities we have described above – reputation and architecture.
Apple is the most celebrated example of a contemporary firm which has clearly
built a reputation for innovation (think of the slew of products from Apple over
the past decade which first changed how we access music, then changed how we
perceive our phones and finally, how we use our personal computers).

Strategy
Strategic assets
In contrast to the three distinctive capabilities discussed above, strategic assets …’strategic assets’ on the other
are easier to identify as sources of competitive advantages. Such assets can come hand are easier to identify
in different guises:
 Intellectual property i.e., patents or proprietary know-how;
 Licenses and regulatory permissions to provide a certain service to the public;
 Access to natural resources such as coal or iron ore mines;
 Political contacts either at the national, state or city level;
 Sunk costs incurred by the first mover which result in other potential
competitors deciding to stay away from that market; and
 Natural monopolies i.e., sectors or markets which accommodate only one or
two firms.
All value traps will face key hurdles
Implications for value traps: In our view, all value traps will face key hurdles on the IBAS framework
on the IBAS framework. If the business has not developed and maintained
sustainable competitive advantages, then the company – irrespective of superior
financials and attractive valuations – will eventually get de-rated in terms of stock
price.
Apollo Tyres, Aurobindo Pharma and Inox Wind – Three midcap value
traps
We filtered the top-50 value stocks as per the Magic Formula in Exhibit 4 on the
four filters mentioned in this section. Our filters throw up three stocks: Apollo
Tyres, Aurobindo Pharma and Inox Wind. We summarise the key thesis that
qualify these stocks as value traps.
Exhibit 7: Summary hypothesis for value traps
Earnings
Mcap 6M ADV FY15
Company Name Ticker Yield (FY15 Hypothesis
(US$mn) (US$mn) ROCE
earnings)
Modest franchise with core business under threat from rising
Apollo Tyres APTY IN 1,404 8.9 27% 16%
competition; aggressive capex in Europe is a cause for concern
Key issues in corporate governance such as sub-par financial
Aurobindo Pharma ARBP IN 6,251 28.5 28% 5% reporting; core business lacks moat and susceptible to competitive
threats
Absence of visible sustainable competitive advantage, key issues
Inox Wind INXW IN 1,274 N/A 29% 5%
in accounting such as nil expenditure on warranties and R&D
Source: Capitaline, Bloomberg, Ambit Capital research. Note: RoCE is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator
and total capital including cash in the denominator; earnings yield has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt
as well as equity including cash)

Apollo Tyres
NOT RATED
COMPANY UPDATE APTY IN EQUITY October 06, 2015
Apollo Tyres has a relatively modest franchise with no clear dominance
Auto & Auto ancillaries
in any domestic segment. It faces threats in its core domestic truck tyre
franchise from Chinese imports and global majors (Michelin and
Bridgestone). We also have concerns around it capital allocation Recommendation
decisions (acquisition of Cooper Tire which did not materialise) and Mcap (bn): `93/US$1.4
aggressive capex in Europe which would impact FCF/return ratios over 3M ADV (mn): `617/US$9.3
the next few years. Whilst Apollo scores relatively well on accounting CMP: `182
quality, there is lack of rotation of independent directors and numerous TP (12 mths): NA
share purchases by promoters/promoter-owned entities (mainly in Downside (%): NA
depressed markets). Given these challenges, we expect its discount to
MRF (35% on FY17 consensus P/E multiple) to persist. Flags
Value trap summary Accounting: AMBER
Parameter Result Comment Predictability: AMBER
Above average score on accounting quality driven by Earnings Momentum: AMBER
Accounting quality higher provisioning vs peers, lower contingent
liabilities and strong FCF generation.
No major corporate governance issues but What will change our view?
Corporate governance inadequate rotation of independent directors and
significant insider transactions are worrying.  Any government regulation which
Aggressive and ambitious management as indicated significantly curtails truck tyre imports
Capital allocation by its attempt to acquire Cooper Tire and big capex
bets in Europe. Mixed track record of acquisitions.  Significant demand recovery in e
IBAS
Average domestic franchise, significant threats from domestic or European replacement
Chinese and MNC competition in the truck segment. tyre market
Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on.
Apollo scores above average on accounting quality Performance (%)

Apollo Tyres receives the second best score on accounting quality as compared 120
to its peers. The above-average ranking is primarily driven by: (a) higher 110
provisioning of debtors vs peers; (b) lower contingent liabilities; and (c) strong 100
FCF generation. Apollo scores relatively lower than its peers on cash yield and 90
non-operating expenses as a percentage of revenues. 80
Reported number do not reveal the true picture of capital allocation 70
Nov-14
Apr-15
Jun-15
Aug-15
Jan-15
Feb-15
Jul-15
Sep-15
Oct-14
Dec-14
Mar-15
May-15
Apollo’s historical RoCE and funds deployment do not capture the attempted
acquisition of Cooper Tires (2.5x Apollo’s size), which if consummated, would
have thrown the company’s debt levels/cash flows out of gear. The firm has a Sensex Apollo Tyres
mixed track record of acquisitions (Vredestein Banden was a success but Dunlop
South Africa was a failure). Today the company has big-ticket capex planned in
Source: Bloomberg, Ambit Capital research
Europe (€475mn) which appears aggressive given the lack of experience in the
European truck bus radial market. This capex would result in a negative FCF (at
the consolidated level) over the next 2-3 years.
Modest franchise facing threats in the core domestic truck tyre segment
Apollo has an average franchise in the domestic market without a dominant
market share in any segment. Its peers (such as JK Tyres) are catching up on
dealer network and capacities. With rising competition from Chinese imports
and global majors, Apollo faces significant threat in its core truck tyre business.
The JV break-up with Michelin in FY06 appears to be a big missed opportunity.
Stagnant independent directors; significant insider transactions
Four of the eight independent directors have been on the Board for at least the
last eight years. Further, there have been several transactions in the company’s
Analyst Details
shares over the last five years by promoter/promoter entities mainly pertaining
to share purchases during periods of low share prices. Ashvin Shetty, CFA
Discount to MRF to continue +91 22 3043 3285
Apollo is currently trading at 7.8x FY17 consensus net earnings, which implies a ashvinshetty@ambitcapital.com
discount of 35% to MRF’s multiples. Given significant threats to its domestic truck
Ritu Modi
tyre franchise and ambitious management (which increases risks of adverse
+91 22 3043 3292
capital allocation), Apollo should continue to trade at such discounted multiples.
ritumodi@ambitcapital.com
Apollo Tyres
Exhibit 1: Whilst EBITDA margins have recovered over the Exhibit 2: Significant volatility in return ratios depending
last 4 years, revenue has stagnated on the business cycles
140,000 16.0% 35%
120,000 15.0%
30%
100,000 14.0%
25%
13.0%
80,000
12.0% 20%
60,000
11.0%
15%
40,000 10.0%
20,000 9.0% 10%
- 8.0% 5%
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
Revenue (Rs mn) EBITDA margin - RHS RoE RoCE (post-tax)
Source: Company, Ambit Capital research Note: Consolidated accounts Source: Company, Ambit Capital research Note: Consolidated accounts
Exhibit 3: Free cash generation over the years has led to Exhibit 4: Apollo’s funds over FY06-15 have been mainly
reduction in net debt levels deployed for capex and interest payments
17,000 1.1 Dividends
` mn
4%
14,000 0.9 Interest
11,000 0.7 19%
8,000 0.5
5,000 0.3 `16.7bn
2,000 0.1
Investments
(1,000) (0.1)
7%
`56.6bn
(4,000) (0.3)
Capex
(7,000) (0.5)
64%
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
Decrease in
CFO FCF Net debt:equity (x) - RHS debt 6%
Source: Company, Ambit Capital research; Note: Consolidated accounts Source: Company, Ambit Capital research; Note: Consolidated accounts
Exhibit 5: On P/E, Apollo is currently trading at a 6% Exhibit 6: On EV/EBITDA, Apollo is currently trading in line
premium to the historical five-year average with its historical five-year average
11.0 6.0
10.0 5.5
9.0 5.0
8.0 4.5
7.0
4.0
6.0
3.5
5.0
3.0
4.0
3.0 2.5
Sep-10
Jan-11
May-11
Sep-11
Jan-12
May-12
Sep-12
Jan-13
May-13
Sep-13
Jan-14
May-14
Sep-14
Jan-15
May-15
Sep-15
Sep-10
Jan-11
Jan-13
May-11
Sep-11
Jan-12
May-12
Sep-12
May-13
Sep-13
Jan-14
Jan-15
May-14
Sep-14
May-15
Sep-15
Apollo 1-yr fwd P/E Avg 1-yr fwd P/E Apollo 1-yr fwd EV/EBITDA Avg 1-yr fwd EV/EBITDA
Source: Bloomberg, Ambit Capital research. Note: P/E bands arrived at using Source: Bloomberg, Ambit Capital research. Note: EV/EBITDA bands arrived
Bloomberg consensus estimates for respective periods at using Bloomberg consensus estimates for respective periods
Exhibit 7: Explanation for our flags

Segment Score Comments
Accounting AMBER Apollo Tyres scores the second best on accounting quality in the peer set comprising MRF, JK Tyres and Ceat.
Quarterly earnings reported by the company tend to be unpredictable. Given the high level of fixed costs (including
Predictability AMBER depreciation and interest expenses), any marginal outperformance/underperformance at the topline level tends to have a
magnified impact at the net earnings level. However, this is an industry-wide phenomenon.
Treatment of We have not come across any significant corporate governance concerns surrounding the company. However, certain
AMBER
minorities decisions such as acquisition of Cooper Tire were significantly detrimental to the interests of minority shareholders.

Apollo Tyres
Accounting quality
Apollo scores above-average on accounting quality
Apollo Tyres is the second best on accounting quality in the peerset (comprising MRF,
JK Tyres and Ceat). The above-average ranking on accounting quality is primarily
driven by: (a) higher provisioning of debtors vs peers; (b) lower contingent liabilities
relative to competitors; and (c) strong FCF generation. Apollo’s scores are relatively
lower than its peers on: (a) lower cash yield; (b) higher non-operating expenses as a
proportion of revenues vs peers.
Exhibit 8: Apollo’s performance on accounting parameters vs peers
Apollo Tyres JK Tyres Ceat MRF
P&L Misstatement
CFO/EBITDA 91% 91% 104% 97%
Change in depreciation rate 41 62 14 74
Volatility in non-operating income as % of sales 14 43 23 29
Balance sheet Misstatement
Cash yield 1.5% 5.0% 3.6% 2.4%
Change in reserves to net income excluding
1.0 0.8 1.0 1.0
dividends
Provision for doubtful debts as % of debtors more
98% 30% 82% 49%
than six months
Contingent liabilities as % of networth 3.3% 4.4% 30.2% 16.5%
Cash pilferage checks
Non-operating expenses as a proportion of total
2.5% 1.8% 1.9% 0.7%
revenues
CWIP to gross block 0.04 0.06 0.05 0.10
Cumulative CFO plus CFI to median revenues 0.17 (0.00) 0.13 0.00
CAGR in auditor’s remuneration to CAGR in
(0.38) (0.59) (0.49) (0.38)
consol. Revenues
Overall
Source: Company, Ambit Capital research. Note: = ranking of 1; = ranking of 2 = ranking of 3
P&L misstatement checks

Cash conversion – Remains strong but behind peers
Apollo’s CFO as a percentage of EBITDA over FY10-15 is 91%, which is lower than its
peers like Ceat (104%) and MRF (97%). Apollo’s working capital days have been
higher than Ceat (53 days in FY15 vs 49 days for Ceat). This has impacted Apollo’s
cash conversion ratio.
Depreciation rate – Stable over the years except in FY11
The median volatility in the average depreciation rate (excluding land and goodwill
from the gross block) over FY10-15 is 41bps, marginally lower than other tyre
companies (average of 50bps). The average depreciation rate for Apollo has
remained stable except in FY11, when the depreciation rate dipped to 4.5% from
6.6% in FY10. Whilst the proportion of ‘Plant and Machinery’ in overall fixed assets
remained broadly stable in FY11, the depreciation rate on Plant & Machinery for the
year declined, which led to the overall depreciation rate declining by 214bps YoY. A
potential reason for this could be the timing of the capitalisation of plant and
machinery. The average depreciation rate since then has remained largely similar to
the FY11 levels.
Non-operating income – Stable in the last six years
Apollo’s non-operating income has averaged around 0.6% of revenues over FY10-
15. This is marginally lower than the average non-operating income as a percentage
of revenues for other tyre makers (0.8%). Unlike its peers, Apollo’s non-operating
income as a percentage of revenues has remained stable in the last six years.

Apollo Tyres
Balance sheet misstatement checks

Cash yield – Significantly lower than peers
Apollo’s six-year median yield on cash and liquid investments is only 1.5%,
significantly lower than the median yield commanded by its peers (3.7%). Apollo’s
average income rate is low, as nearly 82-92% of its cash/bank balances are lying in
current accounts which do not earn interest. Apollo’s average income rate increased
substantially from 0.7% in FY13 to 4.9% in FY14. This was on account of an increase
in the proportion of cash/bank balances lying in deposit accounts. However, in FY15,
the average income rate once again declined to 1.7% due to the lower proportion of
cash lying in deposit accounts. For FY15, income on cash/cash equivalents accounted
for 1% of PBT and cash/cash equivalent balance accounted for 14% of end-FY15 net
worth.
Contingent liability as a proportion of net worth is not significant
Contingent liabilities accounted for only 1.4% of FY15 net worth. A significant portion
of contingent liability is towards disputes related to income tax issues. At 1.4% of net
worth, we do not expect contingent liabilities to have a material adverse impact on
the company’s cash flows or net worth in case of an adverse outcome on disputed
cases. Moreover, contingent liability as a percentage of net worth has come down
from 7.1% as at FY10 to 1.4% as at FY15.
100% debtor provisioning
Apollo’s outstanding debtors for more than six months as a percentage of overall
debtors have been very low (averaging 3.4%) over FY10-15. The company, unlike its
peers has provided for 100% of debtors outstanding more than six months.
Cash pilferage checks

Non-operating expenses as a proportion of total revenues is high but on a
declining trend
Apollo’s six-year median of non-operating expense as a percentage of turnover was
2.5% of revenues, higher than peers like Ceat (1.9%) and JK Tyre (1.8%). However,
this proportion has been declining since FY10 (from 3.7% of sales in FY10 to 2.5% in
FY15).
Capex efficiency – Strong FCF generation
Over FY10-15, Apollo has incurred a cumulative capex of close to 2.3x the
cumulative depreciation expense. The capex was mainly incurred towards truck bus
radial (TBR) capacity at Chennai. During the same period, the company reported
revenue CAGR of 10%. Despite seemingly high capex spends, Apollo’s strong cash
conversion (as explained above) has led the company to score relatively better
amongst its peers on FCF generation (relative to revenue). Furthermore, over the last
five years, Apollo’s proportion of CWIP to gross block has been relatively low at 4%.

Apollo’s auditor’s remuneration recorded 15% CAGR vs 10% CAGR in revenues over
FY10-15 and accounted for 0.01% of revenues. Apollo ranks the lowest on CAGR in
auditor’s remuneration to growth in consolidated revenues. Apollo’s accounts are
audited by Deloitte Haskins & Sells. The breakup of audit fees between that paid for
statutory audit and other services is reasonable.

Apollo Tyres
Corporate governance
 Board Composition: The Board currently comprises eleven directors, out of
which seven are independent directors, three are executive directors and one is a
non-executive nominee director of the Government of Kerala. The proportion of
independent directors appears reasonable.
 Rotation of independent directors: Best Practices suggest that the maximum
tenure for an independent director should be five years. However, four of the
total seven independent directors have been on the company’s Board for at least
eight years. We assign an AMBER FLAG.
 Attendance of the Board: The attendance of the Board members has remained
reasonable for the Board meetings held in FY13-15.
 Share purchases/sales by promoters/management: There have been several
share purchase/sale transactions by promoters/promoter owned
entities/management over the last five years. It may be noted that most of the
insider transactions appear to be share purchases undertaken during periods of
low share prices. We have not been able to establish any direct correlation
between these transactions and stock price movements. However, the sheer
number of these transactions makes us assign an AMBER FLAG.
Exhibit 9: Snapshot of shares purchase/sales by promoters/management
 No major related party transactions: The related party transactions at the

consolidated level mainly consist of sale of finished goods to Apollo International
Trading LLC, Dubai, and Apollo International Ltd. However, total sales to related
parties are not significant (1.2% of total sales) and have remained more or less
constant over FY12-15.

Apollo Tyres
Capital allocation
“The vision for us is to clock revenues of US$6bn by 2016, which will put us among the
top ten tyre makers in the world" - Neeraj Kanwar (source: Economic times1,
December 2012)
Apollo’s RoCE and RoCE improvement have been in line with its peers. The
company’s consolidated operational cash generation over the past decade
has been healthy, with CFO before tax averaging 90% of EBITDA between
FY06 and FY15. A significant portion of the operational cash flow has been
invested in capex (64%), with the company’s net debt coming down from 0.8x
as at end-FY06 to 0.1x as at end-FY15. However, we believe the reported
numbers do not capture the true picture of capital allocation, as: (i) it does
not reflect the aggressive ambitions of the management – more specifically
the aggressive Cooper Tire acquisition, which if consummated would have
thrown the company’s debt levels and cash flows out of gear; (ii) the
company has a mixed track record as far as acquisitions are concerned
(Vredestein a success, Dunlop South Africa a failure); (iii) the company has
big-ticket capex in Europe (€475mn) where we believe there are strong odds
against the company succeeding (more particularly in truck radials).
Standalone RoCE and RoCE improvement over FY11-15 have been in line with
the peer group average
APTY’s standalone post-tax RoCE for FY15 at 19% is line with the peer group average
of 18% (average of MRF, JK Tyres and Ceat). Its FY15 RoCE is lower than that of MRF
(23%), in line with that of Ceat (19%) but higher than that of JK Tyres (12%). Apollo’s
EBIT margin at 11.9% for FY15 is in line with that of MRF (11.8%) but higher than that
of Ceat (10.0%) and JK Tyres (9.9%). However, APTY’s capital employed turnover is
relatively lower than that of peers (at 2.3x in FY15, lower than the peer group
average of 2.5x). The lower capital employed turnover could be attributable to
challenges surrounding the domestic truck-bus segment of Apollo Tyres.
The standalone RoCE (post-tax) has improved from 10% in FY11 to 19% in FY15 on Apollo’s higher than peer EBIT
the back of the significant decline in commodity prices (mainly rubber). This has margin is offset by its low capital
resulted in EBIT margin jumping from 7.0% in FY11 to 11.9% in FY15. The capital employed turnover
employed turnover has improved from 1.9x in FY11 to 2.3x in FY15; however, note
that FY11 capital employed turnover was impacted due to a strike in APTY’s
Perambra facility which lasted for over a quarter in FY11; as compared to FY12’s
capital employed turnover of 2.3x, there has been no improvement in FY15.
APTY’s RoCE improvement of 2x between FY15 and FY11 is similar to the peer group
average of 2.1x.
1
http://articles.economictimes.indiatimes.com/2012-12-
02/news/35546833_1_neeraj-kanwar-tyre-makers-apollo-tyres-vice-chairman

Apollo Tyres
Exhibit 10: Apollo’s EBIT margin is in line with peers; Exhibit 11: Apollo’s RoCE is in line with the peer group
however, its capital employed turnover is lower than peers average
14.0% 3.0 19.0%
12.0% 2.8 17.0%

15.0%
10.0% 2.6
13.0%
8.0% 2.4
11.0%
6.0% 2.2
9.0%
4.0% 2.0 7.0%
2.0% 1.8 5.0%

FY11 FY12 FY13 FY14 FY15 3.0%
Apollo EBIT margin-LHS Peer EBIT margin-LHS FY11 FY12 FY13 FY14 FY15
Apollo CE turnover Peer CE turnover Apollo RoCE (post-tax) Peer RoCE (post-tax)
Source: Company, Ambit Capital research; Note: Standalone accounts Source: Company, Ambit Capital research; Note: Standalone accounts
Much of Apollo’s internal accruals have been used towards capex (similar to
peers)
Apollo’s consolidated operational cash flow has been strong over the last ten years,
with CFO pre-tax averaging 90% over FY06-15. The cumulative CFO generated of
`83bn has been utilised mainly towards capex (64%), including setting up of
greenfield TBR capacities in Chennai and payment of interest (19%). Furthermore, the
company spent `5.4bn (excluding debt acquired) towards the acquisition of Dunlop’s
South African operations in 2006 and Vredestein in 2009. Apollo’s capital allocation
for the past decade appears more or less in line with that of MRF which similarly
spent most of its cash generation towards capex (74%).
Exhibit 12: Apollo Tyres uses funds mainly for capex and interest payments
Source: Company, Ambit Capital research. Note: Size of the pie represents cumulative funds raised (through
various sources such as CFO, equity, debt, etc) and spent (on capex, debt repayment, interest, dividend paid, etc)
over FY06-15.
However, reported numbers do not reveal the true picture on capital

allocation
(a) Mixed track record of acquisitions
Apollo has made two major acquisitions in the past ten years. The company
acquired Dunlop’s South African operations in 2006 in an all-cash deal
amounting to `2.9bn. Similarly, Apollo acquired the Netherlands-based
Vredestein Branden B.V. from Russian company Amtel in May 2009 for `2.5bn
(Enterprise Value of `10bn implying EV/sales of 0.5x). Whilst the South African
operations catered to all vehicle categories, Vredestein is a niche player in the
passenger car radial segment with specialisation in ultra-high performance tyres,
especially winter tyres.

Apollo Tyres
South African acquisition finally sold/ wound down

Whilst the South African operations reported a relatively stable performance until
FY10, the operations faced significant challenges since FY11 in the form of a
general slowdown in the South African economy, labour problems, high power
costs and cheap Chinese imports swarming the market. These problems
manifested in the form of muted revenue growth – CAGR of only 2% over FY11-
14, EBITDA margin declining from 18.4% in FY10 to 3.4%% in FY13 and EBIT-
level losses in FY12 and FY13. This prompted Apollo’s management to
substantially scale down its South African operations by disposing off the
passenger car plant and rights to the Dunlop brand name use for Africa to
Sumitomo Industries for US$60mn (`3.6 bn) in FY14. The remaining part of the
South African operations which is essentially the truck tyre plant at Durban
continued to face business challenges, resulting in the company eventually
closing down the plant in FY15.
On the other hand, Vredestein has performed well since its acquisition by Apollo
on the back of recovery in the European passenger car tyres and strong growth in
the winter tyre sales (which in part was driven by stronger enforcement of safety
regulations surrounding winter tyres). Vredestein’s revenues have reported a
healthy 12% CAGR and EBITDA have reported a 14% CAGR; this has proved to
be a good investment by Apollo Tyres. Vredestein, though, is a relatively modest
franchise with a market share of only about 3% in the European PCR tyre market.
It, though, has somewhat higher brand recall in the winter tyre segment.
(b) Cooper Tire’s attempted acquisition reflective of very ambitious
management
The Chairman’s letter to shareholders in the FY11 Annual Report outlined the
company’s aim to be ranked amongst the top-ten tyre manufacturers in the
world.
In line with this aim, the company on June 12, 2013, announced the acquisition
of the US-listed Cooper Tire & Rubber Company (Cooper) in an all cash
transaction valued at approximately US$2.5bn. To put this acquisition figure in
perspective: (i) Enterprise valuation ascribed to Cooper was nearly 2x that of
Apollo’s then EV; and (ii) the acquisition was to be entirely financed by debt which Enterprise valuation ascribed to
would have raised Apollo’s consolidated debt levels by a whopping 7.3x to Cooper was nearly 2x that of
`163bn (3.8x net worth). Whilst the combined entity would have become the Apollo’s then EV
world’s seventh-largest tyre maker, even one bad year of operations could have
severely hampered Apollo’s ability to service the interest as well as the principal
repayments.
The acquisition was eventually cancelled due to issues surrounding the control of
Cooper’s Chinese joint venture and agreement with United Steelworkers
representing Cooper’s US workers.
Exhibit 13: Cooper Tire’s acquisition would have significantly elevated the debt levels
Pre-acquisition Post-acquisition
Apollo Tyres’ consolidated balance sheet
(` mn) (` mn)
Share capital 509 509
Reserves & Surplus 39,630 42,276
Networth 40,139 42,785
Net debt 22419 22,419
Add: incremental debt taken for acquisition 140,868
Total net debt 22,419 163,287
Net debt-equity ratio 0.56 3.8
Source: Company, Bloomberg, Ambit Capital research. Note: (1) Assumed INR/USD rate of Rs56 for conversion
of USD into INR

Apollo Tyres
(c) Company’s big bet in Europe…limited upside potential high downside

The company has recently announced plans to set up a new greenfield facility in
Europe (Hungary) involving an investment of €475mn (69% of end-FY15
consolidated net worth) over the next four years. Once ready, this facility will
have a capacity to produce 5.5mn passenger car light truck (PCLT) tyres and
675,000 heavy commercial vehicle (HCV) tyres. The first tyre is expected to roll
out in early-2017 from this facility. Whilst the size of the passenger car expansion
from this facility is nearly similar to that of the existing Vredestein capacity of
6.2mn tyres, a foray into the European HCV market is a completely new venture
for Apollo Tyres. We believe the size of this venture is aggressive particularly
against the backdrop of the lack of experience of the European CV tyre business
and given that APTY will compete against the likes of formidable players like
Michelin, Bridgestone and Continental. The company has not outlined any
strategy on how it plans to compete against the well-entrenched peers in this
geography/segment. On the positive side, the demand for both PCR and TBR tyre
is witnessing a growth in Europe (August replacement segment volumes up 4%
and 13% respectively).
As a result of this huge capex in Europe, consensus expects Apollo Tyres
to post a consolidated negative FCF of `2.47 bn over FY16 and FY17 as
against positive FCF of `26 bn over F13-15.

Apollo Tyres
IBAS framework indicates a moderate

franchise
Exhibit 14: Summary of IBAS framework
Level of
IBAS Parameter Comment
strength
 No technical tie-up currently
Innovation  R&D spends higher than peers but does not reflect in superior
SKU strengths
 No clear leadership across any segment
Brand  No significant pricing premium over peers
 Brand spend marginally higher than peer group average
 Dealer network second largest/above average but no
Architecture significant gap with the third largest player (JK Tyres)
 Dealer commission levels not much different from peers
 Highest capacity in the growing TBR segment but peers like JK
Strategic Asset
tyres catching up fast
Source: Company, Ambit Capital research. Source: Company, Ambit Capital research. Note: = Strong; =
Moderate; = weak
Innovation: No technical tie-up

The company had entered into a partnership with Michelin in FY04. This partnership
resulted in Michelin picking up a 14.9% equity stake in Apollo and the formation of a
JV Michelin Apollo Tyres Private Limited. The JV aimed to manufacture TBR tyres in
India with the dual brands of Michelin and Apollo, with Apollo retaining the right to
exclusively distribute both the brands in India. Both parties intended to make an Apollo currently does not have any
investment of US$75mn in the ratio of 51:49 for the plant in Ranjangaon technical tie-up for technology
(Maharashtra). However, Apollo exited from this JV in FY06 citing poor adoption of
radial tyres in the Indian CV market. The company recovered almost its entire
investment in the JV through sale of its 49% stake back to Michelin. In hindsight,
given rapid radialisation in the truck-bus tyres in the recent years, we believe break-
up of JV with Michelin was a big missed opportunity for the company.
Apollo currently does not have any technical tie-up for technology. The company’s
R&D spends (standalone) is much higher than that of its domestic peers. However, the
positive effect of the same is not visible in terms of innovative advantage over peers.
Exhibit 15: Apollo’s R&D spends have been higher than its peers’
1.40%
1.20%
1.00%
0.80%
0.60%
0.40%
0.20%
0.00%
Apollo Tyres MRF JK Tyre Ceat
FY14 FY15
Source: Company, Ambit Capital research
Brand: No clear advantage in any domestic segment

Apollo has a market share of around 27%2 in the TBR and 25%3 in the TBB segment.
In the TBR segment, the company is the second-largest player behind JK Tyres (which
claims a market share of around 31%4). The company has a smaller market share in
the domestic PCR tyre segment of around 17%. Furthermore, the company is absent
from the lucrative two-wheeler tyre segment.
2
http://www.apollotyres.com/uploads/IRPresentation-Aug-2015/
3
http://www.apollotyres.com/uploads/IRPresentation-Aug-2015/
4
http://www.jktyre.com/Investor%20Presentation.pdf

Apollo Tyres
Exhibit 16: Truck-bus sales contribute close to 65% of Exhibit 17: Apollo does not have dominance in any tyre
Apollo’s standalone revenues segment
Light truck, 27%

28%
8%
Farm & 26% 25%
OTR, 11%
24%
TBB, 37%
22%
20%
PCR, 17% 18% 17%
16%
14%
12%
TBR, 27% TBB TBR PCR
Source: Company, Ambit Capital research. This data is as of FY14. Source: Company, Ambit Capital research
Our discussions with dealers do not indicate any significant difference in the pricing
of Apollo’s and peers’ brands. Apollo’s advertisement spends
At the standalone level, Apollo spent 1.6% of its revenues on advertising and sales are marginally higher than
promotion (excluding commission and discounts). This is only marginally higher than peers
the peer group average of 1.4%. % of revenues
Apollo 1.6%
Architecture – Second-largest dealer network but no significant gap with the MRF 1.1%
third largest Ceat 1.7%
JK Tyres 1.4%
Apollo has around 4,900 dealers across India (of which 1,600 are exclusive). Whilst
the exact dealership figures for MRF are not readily available, out discussion with Peer group average 1.4%
industry sources indicate that MRF has the largest dealership numbers. Apollo’s gap is Source: Company, Ambit Capital
also not significant as compared to the third-largest player i.e. JK Tyres which has research. Note: all financials pertain to
standalone entity
around 4,000 dealers (1,000 exclusive). Our discussions with industry sources do not
indicate any significant difference in dealer commissions between Apollo and peers.
Exhibit 18: Apollo has the second higher dealer network; JK Tyres not far behind
Apollo Tyres JK Tyre Ceat
Total dealerships 4,900 4,000 3500+
of which exclusive 1,600 1,000 300+
Strategic assets: Peers catching up on TBR capacities

Apollo currently has the biggest truck bus radial capacities in India of 360MT/day
located in Chennai (based on/assuming 360 operational days per annum and weight
of 60kgs/TBR tyre). This is bigger than that of JK Tyres which has 244MT/day at its
facility in Chennai, 150MT/day for MRF and 81MT/day for Ceat. This has helped
Apollo take the first mover advantage in the rapid radialisation of the truck bus tyres
in India. Whilst Apollo has plans to double its TBR capacity with a total investment of
`27bn over the next 3-4 years, other players such as JK Tyres too have large TBR
expansion plans of adding 133MT/day at its Chennai. This is likely to be
commissioned in 2016.

Apollo Tyres
Modest franchise facing threats in the core domestic truck tyre

segment
Apollo has significantly higher proportion of revenues from the truck bus
segment
We estimate the truck bus tyre segment (including OEM and replacement) to
contribute to nearly 60-65% of Apollo’s domestic revenues. This proportion is
significantly higher than domestic peers such as MRF and Ceat (40% of revenues).
Only JK Tyre has a similar level of concentrated revenues, with truck tyres constituting
nearly 68% of its FY15 revenues.
Going forward, we find this core domestic segment of Apollo Tyres coming under
threat from the following factors:
 Rising Chinese imports impacting truck bus tyre segment
Driven by the slowdown in the Chinese automotive industry, relaxation in anti-
dumping duties and significantly cheaper pricing, India has seen a substantial rise
in the level of Chinese imports since the last one year. According to Apollo’s FY15
Annual Report, Chinese tyre imports grew 138% YoY to 555k units in FY15 for
the truck radial segment and accounted for 11% of the total truck radial market.
These imported radials are not only 30% cheaper than domestic radial tyres, they
are priced even at some discount to the domestic bias tyres. The share of these
cheap imports is mainly concentrated in the replacement market accounting for
nearly 20% of the TBR replacement market (FY15). This growth in Chinese
imports has only accelerated in FY16 with nearly 30% increase QoQ in 1QFY16.
As a result, the market share of Chinese imports has jumped to around the mid-
to-high 20s which is nearly equivalent to the leadership position in the domestic
TBR replacement market.
Furthermore, the acceleration in slowdown in the Chinese automotive market
and the devaluation of Yuan in the recent months pose risks of further rise in the
level of Chinese truck tyre imports.
 Increasing focus of MNCs with technological advantages
Global major tyre makers have been absent in the Indian TBB segment, except for
Continental Tyres which has some TBB tyre capacity owing to the acquisition of
Modi Rubber in July 2011. However, with radialisation reaching a respectable
level (from 8% in FY09 to 22% in FY13 and further to 33% in FY15) in the Indian
truck-bus tyre market, several international players have recently forayed to set
up TBR tyre capacities in India. Michelin has already commenced commercial
production of TBR in 2014 from its greenfield Chennai facility and is planning to
increase the production by nearly 45% from 11k tons in 2014 to 16k tons in
2015, which implies a market share of 3-4% in TBR (OEM and replacement put
together) market5.
Our discussions with industry sources (dealers, domestic tyre companies and fleet
operators) indicate that MNCs have clear technological/quality advantages over
their domestic counterparts in the TBR segment, though they currently trail the
distribution spread and competitive pricing offered by domestic incumbents.
Based on the current announcements available, we believe MNCs would account
for nearly 20-25% of the total TBR capacities by FY18 vs negligible capacity
currently.
5
http://economictimes.indiatimes.com/industry/auto/news/tyres/michelins-chennai-
plant-to-raise-2015-production-by-over-45/articleshow/48235043.cms

Apollo Tyres
Financials
Balance sheet (consolidated)
Year to March (` mn) FY12 FY13 FY14 FY15
Shareholders' equity 504 504 504 509
Reserves & surpluses 27,824 33,397 45,134 49,914
Total networth 28,328 34,009 45,746 50,423
Minority Interest 8 - - -
Debt 28,720 26,507 16,134 11,062
Deferred tax liability 4,025 4,928 5,241 4,912
Total liabilities 61,081 65,444 67,122 66,397
Gross block 80,344 85,219 94,681 90,651
Net block 40,238 41,693 44,558 42,685
CWIP 4,225 3,878 883 2,890
Goodwill on Consolidation 1,338 1,436 1,376 1,165
Investments (non-current) 158 546 637 470
Cash & Cash equivalents 1,730 3,348 6,541 6,946
Debtors 11,458 9,908 10,427 9,589
Inventory 19,991 20,311 20,664 17,782
Loans & advances 4,781 4,136 5,254 4,326
Total current assets 37,961 37,703 42,885 38,644
Current liabilities 17,811 13,928 16,254 12,281
Provisions 5,028 5,884 6,963 7,176
Total current liabilities 22,839 19,812 23,217 19,456
Net current assets 15,121 17,891 19,668 19,187
Total assets 61,081 65,444 67,122 66,397
Income statement (consolidated)

Net Sales 121,533 127,946 134,085 127,778
% growth 37% 5% 5% -5%
Operating expenditure 109,872 113,380 115,365 108,547
EBITDA 11,661 14,567 18,720 19,232
% growth 19% 25% 29% 3%
Depreciation 3,256 3,966 4,109 3,883
EBIT 8,405 10,601 14,611 15,349
Interest expenditure 2,873 3,128 2,838 1,828
Non-operating income 326 944 1,014 612
Adjusted PBT 5,858 8,418 12,787 14,133
Tax 1,444 2,448 2,269 3,532
Adjusted PAT/ Net profit 4,393 5,958 10,518 10,601
% growth 0% 36% 77% 1%
Extraordinary Expense/(Income) (294) 169 (468) (825)
Reported PAT / Net profit 4,687 5,789 10,986 11,426

Apollo Tyres
Cashflow statement (consolidated)

Net Profit Before Tax 5,565 8,586 12,319 13,308
Depreciation 3,256 3,966 4,109 3,883
Others 2,825 2,817 1,111 2,694
Tax (953) (1,134) (2,386) (2,954)
(Incr) / decr in net working capital (3,100) (1,454) 1,302 (2,286)
Cash flow from operations 7,593 12,781 16,455 14,646
Capex (net) (7,895) (5,999) (4,905) (6,201)
(Incr) / decr in investments (43) (13) 3,640 (780)
Other income (expenditure) 58 67 314 142
Cash flow from investments (7,879) (5,944) (951) (6,839)
Net borrowings 3,372 (1,782) (8,897) (4,826)
Issuance of equity - 108 - 349
Interest paid (2,769) (3,085) (2,881) (1,912)
Dividend paid (293) (293) (297) (447)
Cash flow from financing 309 (5,053) (12,075) (6,836)
Net change in cash 23 1,784 3,429 971
Closing cash balance 1,730 3,347 6,541 6,946
Free cash flow (302) 6,782 11,550 8,445
Ratio analysis (consolidated)

Year to March FY12 FY13 FY14 FY15
EBITDA margin (%) 9.6% 11.4% 14.0% 15.1%
EBIT margin (%) 6.9% 8.3% 10.9% 12.0%
Net profit margin (%) 3.6% 4.7% 7.8% 8.3%
Dividend payout ratio (%) 6% 4% 4% 10%
Net debt: equity (x) 1.0 0.7 0.2 0.1
Working capital turnover (x) 10.2 9.0 9.4 9.5
Gross block turnover (x) 1.8 1.5 1.6 1.7
RoCE (pre-tax) (%) 15.5% 17.9% 24.5% 26.0%
RoIC (%) 11.7% 12.7% 20.1% 19.5%
RoE (%) 16.7% 19.1% 26.4% 22.0%
Valuation parameters (consolidated)

Year to March FY12 FY13 FY14 FY15
EPS (`) 8.7 11.8 20.9 20.8
Diluted EPS (`) 8.7 11.8 20.9 20.8
Book value per share (`) 56.2 67.5 90.7 99.1
Dividend per share (`) 0.5 0.5 0.7 2.0
P/E (x) 20.9 15.4 8.7 8.7
P/BV (x) 3.2 2.7 2.0 1.8
EV/EBITDA (x) 8.7 7.0 5.4 5.3
EV/EBIT (x) 12.1 9.6 6.9 6.6

Aurobindo Pharma
SELL
COMPANY UPDATE ARBP IN EQUITY October 06, 2015
Aurobindo has corporate governance issues such as inferior financial

reporting, less than ideal disclosures and taxation issues relating to Healthcare
promoters. Moreover, the company also faces structural issues around
absence of ‘moated’ revenue/profit streams and long-term growth Recommendation
drivers. Also, it faces potential revenue/margin erosion as incumbents Mcap (bn): `418/US$6.4
return and regain market share post FY18 through competitive pricing in 6M ADV (mn): `1854/US$28.2
complex injectables, controlled substances and cephalosporin. CMP: `716
Value trap summary TP (12 mths): `414
Parameter Result Comment Downside (%): 42
Low cash flow generation and high loans and
Accounting quality
advances as a percentage of net worth
Flags
Corporate governance Opaque tie-ups with relatively unknown companies
Accounting: RED
Vertical integration and improvement in product mix
Capital allocation Predictability: AMBER
is a positive; gross block turnover in line with peers
Lack of investment in innovation and no moats Treatment of minorities: RED
IBAS around its business; revenues exposed to return of
competition
What will change our view?
Accounting quality – Poor cash flow generation  Better cash generation

Aurobindo has poor cash flow generation (CFO/EBITDA of 56% vs peer average  Investment in long-term growth
of 85%) led by an extended working capital cycle (93 days vs peer average of 65 drivers / moated business
days). Its accounting practices have raised issues before, leading to undisclosed  Clarification / visibility in third-party
income of `300mn during raids by income tax authorities in 2012 (click here). agreements and / or promoter issues
Capital allocation – Improvement in product mix and vertical integration
Aurobindo moved up the value chain from an API manufacturer to a formulation Performance (%)
manufacturer. Its acquisition track record is yet to be established; though the 250
Actavis acquisition looks promising, we would wait before giving too much credit 200
as pharma companies have struggled with profitability in Western Europe. 150
Corporate governance – Distribution agreement impairs upsides 100
Mr. Nithyanand Reddy (Chairman, ex-MD) appears to be a connected person. 50

Aurobindo Pharma was named in a charge-sheet filed on a disproportionate -
Sep-14
Oct-14
Dec-14
Jan-15
Mar-15
Jun-15
Aug-15
Jul-15
Apr-15
asset case for which court proceedings are underway. Also, Aurobindo’s
distribution agreement with Citron Pharma and Celon Labs for the US market is
opaque and impairs upsides from product-specific opportunities. Sensex Aurobindo
IBAS – Lack of spending on innovation; no moats in its business

Aurobindo incurs 4.4% of R&D as a percentage of sales vs peer average of 6.3%.
Out of these, some/none of the investments are longer-term growth drivers like
NCEs, biosimilars and NDDS-based products. Also, the company has a limited
presence in the branded business (moats), which provides sustainable revenue
as compared to the lumpy business from US generics.
Expect discount to front-line peers to expand as earnings growth abates
Aurobindo’s earnings deserve a lower multiple vs peers due to corporate
governance issues and lack of moats. Valuations of 16.3x FY17E EPS are
expensive vs being optically cheap and may begin to de-rate, as incumbents
return to the US, and revenue/margins/RoCE starts declining from FY18E.
Analyst Details
Key financials
Year to March FY14 FY15 FY16E FY17E FY18E Aditya Khemka
Net Revenues (` mn) 80,998 121,205 136,808 161,507 184,744 +91 22 3043 3272
Operating Profits (` mn) 21,328 25,637 30,499 40,098 47,528 adityakhemka@ambitcapital.com
Net Profits (` mn) 11,737 15,758 19,733 27,268 32,336
Diluted EPS (`) Paresh Dave, CFA
40.3 27.0 33.8 46.8 55.5
RoE (%) 36.9 35.4 31.9 32.7 29.2 +91 22 3043 3212
P/E (x) 22.3 27.3 13.2 9.6 12.7 pareshdave@ambitcapital.com
P/B (x) 7.0 8.3 3.7 2.7 3.3
Aurobindo Pharma
Exhibit 1: EBITDA margins and revenue growth over the Exhibit 2: RoCE and RoE over the last ten years; poor cash
last ten years conversion not reflected here
50% 30% 50% 50%
40% 25%
40% 40%
30%
20% 30%
20% 30%
15% 20%
10%
10% 20%
0% 10%
-10% 5% 10% 0%
-20% 0% 0% -10%
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
FY15
Revenue growth EBITDA margins, RHS RoCE RoE, RHS
Source: Company, Ambit Capital research Source: Company, Ambit Capital research
Exhibit 3: Sources of funds over the last ten years; if cash Exhibit 4: Utilisation of funds over the last ten years was
conversion had mirrored industry average, debt would primarily towards capex and acquisition of Actavis brands
have been lower
Interest Increase in
paid, cash and
Debt 11.3% cash
Proceeds raised, equivalent,
from 42.3% Interest 5.2%
received, Dividend
shares,
2.0% paid, 6.6%
2.9%
CFO,
52.7% Purchase
of Net Capex,
investment 62.9%
, 14.0%
Exhibit 5: Forward P/E evolution over the past ten years Exhibit 6: Forward P/B evolution over the past ten years
25 6.0
20 5.0
4.0
15
3.0
10 2.0
5 1.0
0 0.0
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Aug-11
Aug-12
Aug-13
Aug-14
Aug-15
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Feb-12
Feb-13
Feb-14
Feb-15
Mar-06
Oct-06
May-07
Nov-10
Oct-13
Jun-11
Aug-12
Mar-13
May-14
Dec-07
Dec-14
Jul-08
Feb-09
Sep-09
Apr-10
Jan-12
Jul-15
PE 4 yr avg 6 yr avg P/B 6 yr avg 4 yr avg


Segment Score Comments
Aurobindo’s accounting practises raise RED flags on: (a) admission of undisclosed income in the past; (b) continuation of the
Accounting same auditor despite undisclosed income issues; (c) lower than peer EBITDA/CFO ratios; and (d) higher than peer working
RED
capital cycle.
Overall, the management has made timely announcements in its earnings calls, meetings and interviews regarding product
Predictability AMBER filings, acquisitions and business outlook. However, the unpredictability of segments like ARV sales, RoW formulation sales and
API sales make us assign an AMBER flag on predictability.
Treatment of Apart from concerns raised in our accounting analysis wrt undisclosed income and low cash generation, the company has
RED
minorities entered into partnerships with unknown/small companies to market/develop high value products, thus impairing profits.

Aurobindo Pharma
Accounting quality
P&L misstatement + revenue pilferage checks
 Revenue recognition: Aurobindo’s pre-tax CFO/EBITDA ratio has consistently
been significantly lower than the peer average over the past few years mainly on
account of higher working capital requirements. Aurobindo’s working capital days
have deteriorated from 186 days in FY10 to 217 days in FY14. Given Aurobindo’s
lack of material exposure to the branded generic markets where terms of trade
are more benign, its working capital days remain ahead of peers.
Even in years when EBITDA growth was healthy, CFO/EBITDA has deteriorated, Perpetually low cash flow
as working capital needs have expanded. For instance, in FY11, whilst EBITDA generation due to higher working
improved by 17%, CFO declined by 9% owing to higher working capital (205 days capital investment
in FY11 vs 186 days in FY10) on account of a significant jump in inventory and
debtors during the year (32% and 29% respectively).
In FY13, pre-tax CFO/EBITDA deteriorated significantly again due to higher
working capital. We highlight that the working capital in FY13 at 49% of EBITDA
was higher than 23% of EBITDA in FY12. Not only is the FY13 cash conversion
lower than peers but it is also at a 7-year low. We assign a RED FLAG.
Exhibit 8: Revenue recognition checks
YoY change in CFO as Volatility
Pre-tax CFO as a % of EBITDA
Company/Metric a % of EBITDA (bps) (measured
FY11 FY12 FY13 FY14 FY15 FY14 FY15 by SD*)
Aurobindo 55% 65% 46% 46% 68% 67 2,113 10%
Cadila 81% 64% 82% 98% 80% 1,621 (1,746) 12%
Torrent 124% 118% 41% 91% 85% 4,919 (538) 33%
IPCA 74% 85% 77% 82% 100% 498 1,818 10%
Lupin 88% 60% 79% 92% 102% 1,337 914 16%
Average(ex-
92% 82% 70% 91% 92% 2,094 112 18%
Aurobindo)
Divergence -37% -16% -24% -44% -24% (2,026) 2,001 -7%
Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity. * SD refers to
standard deviation.
 Working capital days: Aurobindo’s high debtor and inventory levels can only Higher working capital days due to
be partly explained by Aurobindo’s business model, which is predominantly that business of generic drug supply
of a generic drug supplier with relatively lower negotiating power (hence longer
payment cycles). This is in comparison with peers that have a mix of generic as
well as branded drug businesses. Both API and generic finished dosages in the
Western markets are highly competitive.
Whilst the higher debtor days can also be justified for new entrants trying to
break into the business, Aurobindo has had a presence in the generic business
for nearly a decade. Hence, we raise a RED FLAG on Aurobindo’s overall cash
conversion cycle.
Exhibit 9: Working capital days
Average Working Capital
Average Debtor days Average Inventory days Average Creditor days
Company/Metric days
FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15
Aurobindo 97 88 95 93 118 108 97 90 56 51 52 51 160 146 140 132
Cadila 57 53 53 57 66 66 65 61 48 35 40 42 76 84 78 76
Torrent 61 69 78 106 73 83 84 81 104 110 109 128 30 42 53 59
IPCA 63 49 48 47 88 92 88 103 32 33 34 38 118 108 103 112
Lupin 77 74 75 73 76 70 66 66 74 66 58 66 79 78 83 74
Average(ex-
64 61 64 71 76 78 76 78 64 61 60 68 76 78 79 80
Aurobindo)
Divergence 33 27 32 22 43 31 21 12 (8) (10) (8) (17) 84 68 61 51
Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity.

Aurobindo Pharma
 Expense manipulation: The average depreciation rate for Aurobindo was

almost constant in FY11-14. The depreciation rate has been in line with the peer
average. We do not have any significant concerns on the depreciation rate and
hence we assign a GREEN FLAG.
Exhibit 10: Expense manipulation checks - Depreciation
YoY change in
Average depreciation rate
Company/Metric depreciation rate (bps)
FY11 FY12 FY13 FY14 FY15 FY14 FY15
Aurobindo 7.1% 7.3% 7.3% 7.9% 6.9% 60 (96)
Cadila 4.8% 4.8% 4.6% 4.3% 6.0% (21) 161
Torrent 7.1% 7.6% 6.6% 6.4% 7.7% (23) 130
IPCA 6.0% 6.3% 6.0% 6.0% 8.1% (6) 216
Lupin 6.9% 7.2% 8.4% 5.9% 9.0% (252) 305
Average(ex-Aurobindo) 6.2% 6.5% 6.4% 5.7% 7.7% (75) 203
Divergence 0.9% 0.8% 0.8% 2.2% -0.8% 136 (299)
 Investment income analysis: Aurobindo’s investment income as a percentage

of cash is low vs its peer group. However, the primary reason for this appears to
be that a significant portion of Aurobindo's cash/bank balances are kept in
current accounts, on which no interest income is earned. Over FY10-15, current
accounts averaged 75% of total cash bank balances (except FY11 when it was
34%). Interest income calculated on pure bank deposits work out to 7.3% for
FY13 which appears reasonable. The significant jump in FY12 was on account of
cash of `1.2bn (63% of FY11 cash) which was temporarily parked in interest-
bearing securities. Aurobindo does not have any significant investments in
marketable securities, resulting in negligible dividend income over the years.
Exhibit 11: Investment income analysis
Change in investment income as
Investment income as a % of cash and
a % of cash and marketable
Company/Metric marketable investments
investments (bps)
Aurobindo 0.3% 4.4% 2.1% 2.0% 4.8% (14) 285
Cadila 4.1% 8.7% 4.8% 5.5% 5.7% 74 18
Torrent 6.1% 6.5% 5.9% 4.6% 3.4% (125) (127)
IPCA 14.4% 17.1% 20.4% 21.6% 22.7% 115 109
Lupin 1.8% 2.2% 2.8% 2.4% 5.0% (36) 261
Average(ex-
6.6% 8.6% 8.5% 8.5% 9.2% 7 65
Aurobindo)
Divergence -6.3% -4.2% -6.4% -6.6% -4.4% (21) 220
Source: Company, Ambit Capital research. Note: (a) All financials pertain to the consolidated entity; (b)
Investment income comprises interest income, dividend income and profit on sale of current investments
 Cash manipulation: Aurobindo’s loans and advances as a percentage of net

worth have been volatile over the years under consideration. The increase in
FY14 was on account of: (a) Export rebate claims receivable at `1.4bn vs `0.9bn
in FY12 and `1.2bn in FY13 (accounting for 12% of FY14 loans and advances) Loans and advances schedule
and (b) MAT credit entitlement amounting to `2.5bn vs `.1.3bn in FY13. Apart includes high percentage of
from these, the loans and advances schedule includes Advances recoverable in advances recoverable in cash or
cash or kind. Whilst the proportion of such loans has decreased substantially from kind with no disclosures
36% in FY11 to 10% in FY14 and 1% in FY15, no disclosures have been provided
with regard to these advances. We believe these require further probing and
hence we assign an AMBER FLAG.

Aurobindo Pharma
Exhibit 12: Cash manipulation checks

Loans and advances as a % of networth
Company/Metric
Aurobindo 31.2% 20.3% 21.8% 18.1% 22.1% 31.1% 19.9%
Cadila 20.5% 19.2% 20.9% 22.4% 25.3% 24.3% 20.6%
Torrent 29.5% 18.1% 24.5% 23.4% 24.5% 28.1% 31.7%
IPCA 13.2% 14.6% 11.2% 18.2% 15.3% 15.8% 14.7%
Lupin 19.5% 18.5% 18.9% 20.5% 18.4% 13.1% 9.1%
Average(ex-Aurobindo) 20.7% 17.6% 18.9% 21.1% 20.9% 20.3% 19.0%
Divergence 10.5% 2.7% 2.9% -3.1% 1.2% 10.8% 0.8%
Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity; we have
excluded capital advances from loans and advances to calculate the above ratio.
Provisions for debtors: Aurobindo’s debtors over 6 months as a percentage of
gross debtors declined from 5.7% in FY12 to 3.8% in FY15 (in absolute terms it has
increased by 75% in FY15). Aurobindo’s debtors over 6 months are in line with its
peers. Whilst Aurobindo’s debtor days are higher (see Exhibit 9), percentage of
debtors over 6 months is at par with its peers, implying better realisation/certainty on
a relative basis. Also, Aurobindo has higher and stable provision for doubtful debts as
a percentage of debtors over six months. We assign a GREEN FLAG.
Exhibit 13: Provisioning for debtors
Provision for doubtful debts as Provision for doubtful debts Debtors over 6 months as a
Company\Metric % of debtors over six months as % of gross debtors % of gross debtors
FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15
Aurobindo 40.2% 42.7% 41.1% 51.3% 2.3% 1.7% 1.2% 1.9% 5.7% 4.0% 2.9% 3.8%
Cadila 50.9% 51.0% 40.4% 13.4% 1.2% 1.3% 0.8% 0.2% 2.4% 2.5% 2.1% 1.6%
Torrent 45.3% 32.5% 58.5% 69.8% 2.9% 1.8% 2.6% 2.3% 6.3% 5.4% 4.4% 3.3%
IPCA 3.7% 0.0% 4.8% 4.2% 0.1% 0.0% 0.1% 0.2% 2.4% 2.7% 3.0% 4.6%
Lupin 42.3% 24.1% 48.2% 31.0% 0.5% 0.6% 1.5% 0.9% 1.2% 2.4% 3.2% 2.9%
Average(ex-Aurobindo) 35.5% 26.9% 38.0% 29.6% 1.2% 0.9% 1.3% 0.9% 3.1% 3.2% 3.2% 3.1%
Divergence 4.7% 15.8% 3.1% 21.6% 1.1% 0.8% -0.1% 1.1% 2.7% 0.7% -0.2% 0.7%
Source: Company, Ambit Capital research. Note: All financials pertain to the consolidated entity
 Contingent liability as a proportion of net worth: As compared to its peers,

contingent liabilities not provided for by Aurobindo are below the peer average.
We assign a GREEN FLAG.
Exhibit 14: Contingent liabilities for Aurobindo vs its peers
Contingent Contingent
Net Worth
FY15 liabilities as % of liabilities
(` mn)
networth (` mn)
Aurobindo 2.4% 1,231 51,559
Cadila 5.8% 2,467 42,516
Torrent 1.4% 337 24,906
IPCA 1.1% 237 22,084
Lupin 11.6% 10,270 88,741
Average(ex-Aurobindo) 4.95%
Divergence -2.56%
Exhibit 15: Contingent liabilities not provided for by Aurobindo

Contingent liabilities Contingent liabilities
Description (` mn) as % of networth
FY13 FY14 FY15 FY13 FY14 FY15
Claims arising from disputes not
acknowledged as debts
-Indirect taxes 196 223 772 0.5% 0.6% 1.5%
-Direct taxes 105 105 309 0.3% 0.3% 0.6%
-Other duties / claims 493 150 150 1.3% 0.4% 0.3%
Total disclosed disputed liabilities 794 478.6 1231 2.1% 1.3% 2.4%

Aurobindo Pharma
Auditors
Accounting practices of the company have raised issues in the past: Media
reports (http://goo.gl/zLaLsp) suggest that the company had declared `300mn of
undisclosed income for FY12 post an income tax raid on its premises in February
2012.
The fact that company acknowledged undisclosed income during the tax raids in
February 2012 calls into question the independence of both the statutory auditors (S
R Batliboi & Associates) as well as the internal auditors. This issue itself makes us
raise a RED FLAG.
The statutory auditors of Aurobindo Pharma are S R Batliboi & Associates who were
appointed in 2008-2009, replacing Batliboi & Company who had been auditors of
Aurobindo at least since FY01. Both the statutory auditors are essentially a part of
Ernst & Young auditors and the auditors have remained unchanged for more than 12
years now. AMBER FLAG
S R Batliboi and Associates are statutory auditors of 46 companies including Adani Lack of rotation of auditors;
Ports, Bharti Airtel, Biocon, Cairn India, GMR Infra, GVK Power, Lanco Group, Sobha undisclosed income found in tax
Developers, Spice Jet and Sun TV among others. The signing partner Mr Vikas Kumar raids was not checked by auditors
Pansari (Membership No. 93649) is also a signatory to the accounts of ILFS
Engineering, GVK Power, and Hyderabad Industries.
The internal auditors of Aurobindo Pharma are currently KPMG who were appointed
only in FY10-11. Prior to KPMG, M/s K Nagaraju & Associates were the internal
auditors of Aurobindo Pharma. M/s K Nagaraju also happens to be the statutory
auditors of Axis Clinicals and Trident Chemphar, which are the holding companies of
the promoters of Aurobindo Pharma. AMBER FLAG
“The Audit Committee”, as on 31 March 2015, comprises three members (all of
whom are non-executive independent directors of the company). Mr. M. Sitarama
Murthy took over the chairmanship from Dr. K. Ramachandran wef 3 May 2011. Prior
to taking the chairmanship, Mr. M. Sitarama Murthy was a member of the audit
committee. Most members of the committee attend meetings, and we do not have
any major concerns in this regard.
Aurobindo’s payment to auditors is in line with its peers and its audit fees as a
percentage of sales are also close to the peer group average. For the purpose of
calculation of audit fees, we have included fees for tax audit, out-of-pocket expenses
and other audit expenses. GREEN FLAG

Aurobindo Pharma
 Board Composition: The Board currently comprises ten directors, out of which
four are independent directors and four are executive directors. Although the
percentage of independent directors is higher than the 30% prescribed by Indian
company laws, it is lower than global best practices of 50%. AMBER FLAG
In the past, former employees have been classified as independent
directors and have occupied positions on critical Board committees such
as the Audit Committee. Mr Srinivas Lanka who was on the company’s Board
between 2002 and 2007 was classified as an independent director; he was Former employees classified as
overseeing the company’s operations in manufacturing and marketing up to independent directors
early-2002 until he resigned from his executive duties and was inducted as a
non-executive independent director on the Board. Moreover, Mr Lanka was also a
member of the all-important Audit Committee until his resignation in 2007.
We believe that the purpose of the independent directors on the Board is to
safeguard minority interest. A former employee holding an ‘independent’ director
designation on the Board is not ideal practice, in our opinion. AMBER FLAG
 Rotation of independent directors: Over the past 10 years, Aurobindo’s Board
has seen significant churn amongst the independent directors. The Best Practices
Code suggests that the maximum tenure for an independent director should be
five years. Note that there was significant churn amongst independent directors
during 2006-2008 when Aurobindo Pharma’s financial performance was poor
and it also had a stretched balance sheet and poor cash flows. We highlight that
a number of independent directors resigned from the Board in FY06-08, as per
annual report, which was not articulated either in the media or in the company’s
press releases.
 Attendance of the Board: The attendance of the Board members has remained
reasonable for the Board meetings held in FY11-13.
 Insider trading closer to key events: Several stock transactions by insiders
raise questions over corporate governance practices. For instance, towards the
end of CY10 and early CY11, there was selling by insiders. This was shortly
followed by issues relating to US FDA strictures against an injectable facility
becoming public, which lead to significant correction in the stock price. Similarly
towards the end of CY11, there was heavy insider buying which was followed by
news flow on regulatory issues gradually getting resolved. We assign an AMBER
FLAG.
 Promoter involved in legal issues due to political connections: Aurobindo
Pharma has also been haunted by legal issues in the past due to alleged political
connectivity. The Central Bureau of Investigation in India (equivalent to the FBI in
the US) had charge sheeted the former MD and current Board member, Mr. Promoter named in charge sheet
Nithyanand Reddy, in a case involving disproportionate assets. However, the filed against a politician for
company disclosed that the investments were made by the promoters (if any) and disproportionate asset case
the listed entity had nothing to do with the case. The charges were also later
dropped by the CBI, as per management. Though media article suggest
otherwise.
Media reports regarding this issue are http://goo.gl/3N8OXo
Click the link for media reports suggesting that the case is still pending trial
(http://goo.gl/hbklMG).
 Accounting practices of the company have created issues in the past:
Media reports also suggest that the company had declared `300mn of
undisclosed income for FY12 post an income tax raid on its premises in February
2012.

Aurobindo Pharma
 Upsides from interesting products impaired due to partnerships:

Aurobindo’s distribution agreement with Citron Pharma on at least 39 oral
products and 12 injectables for the US (possibly other emerging markets as well)
would impair the upside for Aurobindo from these products, as it would have to
pay distribution margins. Further, Aurobindo’s agreement with Celon Labs for
hormones and oncology product manufacturing for the US (a 60:40 JV called
Eugia) would also impair the potential upside from these ventures.
Exhibit 16: Snapshot of insider transactions
 Managerial remuneration: Aurobindo’s managerial remuneration as a

percentage of PBT is low vs its peers except for FY12. In FY12, the company
reported lower PBT due to the INR depreciation, resulting in forex losses in
foreign currency loans. We assign a GREEN FLAG.

Aurobindo Pharma
Capital allocation
Average
Positives – Improvement in product mix and vertical integration albeit
temporary
 Aurobindo scores high on sales improvement and pricing discipline under our
‘greatness’ framework. Whilst improvement in product mix (move from API to
formulations) has led to a higher score in pricing discipline, gaining traction in
oral solids due to vertical integration has helped the score on sales improvement. Improvement in product mix has
We highlight that both these advantages seem temporary, as the decline in led to a higher score in pricing
contribution from API sales would be more gradual, and Aurobindo is not discipline
vertically integrated in injectables, which form a large chunk of its pipeline. The
management may have to rethink the portfolio strategy once scale becomes an
obstacle to growth.
 We have to credit the company for achieving sales growth in a short span of time
post resolution of issues with FDA at Unit VI. Also, gross block turnover of ~3x is
in-line with its peers. Whilst Cymbalta has been a major contributor to sales and
EBITDA in FY14, the resumption of cephalosporin sales and controlled substances
along with general injectables has been within a very short span of time,
exhibiting excellent execution.
Exhibit 17: Aurobindo Pharma - Relatively poor score on our ‘greatness’ framework
Scores out of 0.17 for each measure
Total Score-using
Company Sales Pricing EPS and Bal Sheet Ratios Rank
Investment Adj PAT
Improve discipline CFO increase Discipline improve
IPCA 17% 17% 17% 17% 17% 17% 100% 1
Sun Pharma 17% 17% 17% 17% 8% 17% 92% 2
Cadila 17% 17% 17% 17% 17% 8% 92% 2
Lupin 17% 8% 17% 17% 17% 8% 83% 4
Strides 17% 8% 17% 17% 8% 17% 83% 4
Torrent 8% 17% 17% 13% 13% 17% 83% 4
Cipla 17% 4% 17% 17% 17% - 71% 7
Dr Reddy's 8% 8% 17% 17% - 17% 67% 8
Aurobindo 8% 13% 17% - 8% 8% 54% 9
Glenmark - 8% - 8% 8% - 25% 10
In Exhibit 17 above, we have shown how Aurobindo Pharma stacks up on our

proprietary ‘greatness’ framework relative to its other Pharma peers.
The framework essentially hinges on using publicly available historical data to assess
which firms have, over a sustained period of time (FY09-14), been able to relentlessly
and consistently:
(a) Invest capital;
(b) Turn investment into sales;
(c) Turn sales into profit;
(d) Turn profit into balance sheet strength;
(e) Turn all of that into free cash flow; and
(f) Invest free cash flows again.
For each of these parameters, we look at both the absolute improvement as well as
the consistency in improvement over the last six years. Thus, a score of 17% on
Investments would mean that the company does well on both absolute investment in
Gross Block as well as the consistency with which it has invested in its Gross Block.

Aurobindo Pharma
In case of Aurobindo Pharma, whilst the company scores high on pricing discipline
and sales improvement, it lags in cash flow increase, balance sheet discipline and
investments.
Negatives – Working capital dampens cash flows

 The ever-expanding working capital cycle for Aurobindo has had an adverse
impact on balance sheet improvement and cash flows (please refer to Exhibit 9 –
working capital table)
 Whilst the company has guided towards a meaningful decrease in debt levels, we
would wait and watch for the improvement in balance sheet before giving credit
to the management, given the patchy track record on this front.
Aurobindo Pharma’s acquisition track record yet to be established

The company’s acquisition of Actavis looks promising, but given that most pharma
companies have struggled with profitability in Western Europe, we would wait and
watch before giving much credit to the company.
Exhibit 18: History of clustered acquisitions by Aurobindo
Name of Joint venture /
Nature Year Geography Particulars
Acquisition
Acquired Milpharm (UK), engaged in generic formulation manufacturing,
Milpharm Acquisition 2006 UK mainly in the UK market. Milpharm had over 100 products approved from
the UK regulator and it helped Aurobindo to tap the UK generic market.
Sandoz manufacturing, R&D and Purchased fully integrated R&D, formulation manufacturing and
Acquisition 2007 US
distribution facility distribution facility from Sandoz in the US.
Acquired Pharmacin International BV to help reduce Aurobindo's time to
Pharmacin International BV Acquisition 2007 Netherlands
market and build portfolio in the generic value chain.
Acquired majority stake in the group company, Trident Life Sciences, which
Trident Life Sciences Acquisition 2009 India provides Aurobindo with additional capacity in non-oncological and non-
infective injectables.
Acquired Hyacinths Pharma, an API manufacturer; strategic location of
Hyacinths Pharma Acquisition 2013 India
land ideal and convenient for expansion plans for the company.
Acquired Actavis's operations in 7 European nations, which includes
Actavis's Europe operations Acquisition 2014 Europe personnel, commercial infrastructure, products, marketing authorisations
and dossier license rights.
Acquired Natrol to enter the OTC market in the US. Natrol manufactures
Natrol Inc. Acquisition 2014 US
and sells nutritional supplements.

Aurobindo Pharma
IBAS framework
IBAS Level of
Comment
Parameter strength
We credit the company for moving up the value chain from API to formulation
Innovation
manufacturing, but it lacks investment in innovative pursuits.
No presence in branded generic markets and vulnerable to competition in the
Brand US market from incumbents that have been absent from the markets due to
cGMP issues.
Credible business heads with rich experience in MNC pharma companies but
Architecture
issues with the bottom of the pyramid employees, resulting in frequent strikes.
Vertically integrated with 19 manufacturing facilities but the company does
Strategic
not have intellectual property nor has it made any investments to develop the
Asset
same.
Innovation
Moving up the value chain - From domestic API to formulation exports:
Aurobindo initiated operations in 1986 by locally trading antibiotic molecules. In
1988, the company started manufacturing and marketing on its own in India and
began exporting APIs in 1992. The company began manufacturing formulations in Aurobindo has moved up the value
2002 and discontinued its Indian formulation business (50/50 JV with Citadel Fine chain from API to formulation
Pharmaceuticals) in February 2006 due to continued losses. The company entered the exports
US formulations market in 2003 when it filed its first ANDA and it has been investing
heavily in manufacturing and R&D capabilities ever since. The business appears to be
snowballing in the US with a 178 ANDA strong pipeline pending final approval and
with a 201 currently approved portfolio. The company harbours ambitions of
becoming a large generic player in the US and the regulated markets of Western
Europe.
Lack of investment in innovative pursuits: As on FY15, Aurobindo incurs 4.4% of

R&D as a percentage of sales vs the peer average of 6.3%. Out of these, some/none
of the investments are in longer-term growth drivers like NCEs (New Chemical Entity),
biosimilars, NDDS (Novel Drug Delivery Systems) based products. Investments are
largely in less complex products like oral solids, general injectables, controlled
substances and cephalosporins, which have yielded significant revenues owing to
excellent execution in the US driven by vertical integration.
Brands/Reputation
Aurobindo does not have any branded business in India. The company withdrew from
the India business in 2006 due to loss-making operations, implying an inability to
establish its brands. Aurobindo earns most of its revenues from me-too products in
the US, for which no branding is done.
Also, lack of differentiation in its currently marketed portfolio makes Aurobindo more Lack of branded business and a
vulnerable to incremental competition from incumbents like Hospira (general beneficiary of absence of
injectables), Ranbaxy (cephalosporins) and Nesher (controlled substances), which incumbents
have been out of the market due to FDA-related issues. As the incumbents return to
the market, we expect them to regain market share through competitive pricing. Also,
as compared to Aurobindo, these incumbents have a broader product basket to offer
to the channel partners thus having higher bargaining power to negotiate. Therefore
we believe, recent stellar revenue and EPS growth has been primarily a function of
luck due absence of incumbents and expect revenue/margins/RoCE to decline
materially as these companies return to the market post FY18E.

Aurobindo Pharma
Architecture
Credible business heads: Aurobindo has in place credible business heads for
important markets. Mr. Robert Cunard (CEO at Aurobindo Pharma, USA) and Mr.
Ronald Quadrel (CEO at AuroMedics Pharma LLC) have worked with established
MNC pharma giants like Glaxo, Mylan and Pfizer. Recently, the company appointed
Mr Sanjeev Dani (former senior executive with Ranbaxy; COO and head of the
formulation business) as the head of front-end operations of emerging markets and
Europe. Mr. Sanjeev Dani had spent over a decade in managing emerging markets
like India, Middle East and Africa.
Regular employee unrest in its

However, issues with bottom of the pyramid employees: In three different manufacturing facilities
instances, workers at the Aurobindo facility have gone on strike to protest against the
policies of the management. In November 2014, the management suspended 1,500
employees at its Unit XI facility in Srikakulum, Andhra Pradesh, which manufactures
~50% of the company’s overall production. The strike was to seek salaries at par with
neighbouring pharma units like Dr. Reddy, Mylan and Hetero Drugs.
August 2012 - Strike at Aurobindo Pharma's unit (http://goo.gl/ZSZMJp)
November 2104 - Suspension of 1,500 employees cripples Aurobindo unit operations
(http://goo.gl/HafUic)
September 2015 - Tension prevails at Aurobindo Pharma in Srikakulam
(http://goo.gl/bFxhwJ)
Strategic assets
Aurobindo’s operations are vertically integrated with a network of 19 manufacturing
facilities (eight formulations and eleven API and intermediates) in India and abroad.
Whilst the company faced cGMP issues with the US FDA in 2011-12, the issues stand
resolved and all its facilities are approved by the regulator.
The company does not have any intellectual property, as it produces ‘Me Too’ Lack of investment in innovative
products. Further, no R&D investment is incurred on innovative pursuits to create pursuits
patented/proprietary products.
In terms of licences and regulatory permission to provide certain service, Aurobindo is
enrolled with WHO/NACO (National Aids Control Organisation) to submit tenders for
ARV products in the Africa region.

Aurobindo Pharma
Financials
Revenue mix
Year to March (` mn) FY14 FY15 FY16E FY17E FY18E
Formulations
USA 34,028 48,317 55,495 74,175 92,337
ARV 8,402 9,639 11,029 12,132 13,346
Europe 6,721 31,947 34,060 37,204 39,064
ROW 4,634 5,683 5,566 6,122 6,734
Total formulations 53,785 95,586 106,149 129,633 151,480
API
SSP 9,778 8,640 11,210 11,770 12,359
Cephs 8,755 9,300 10,500 10,500 10,500
ARVs and others 10,110 9,122 11,591 12,750 14,025
Total API 28,643 27,062 33,301 35,020 36,884
Dossier Income 165 77 150 150 150
Total 82,593 122,725 139,600 164,803 188,514
Income statement
Net revenues 80,998 121,205 136,808 161,507 184,744
Material Cost 36,060 55,056 62,238 68,857 75,287
General Expenses 21,059 35,058 37,914 45,284 53,615
R&D Expenses 2,551 5,454 6,156 7,268 8,313
Core EBITDA 21,328 25,637 30,499 40,098 47,528
Depreciation 3,125 3,326 4,226 4,264 5,314
Interest expense 1,087 843 846 621 395.742
Adjusted PBT 15,334 21,679 25,627 35,413 41,994
Tax 3,635 5,966 5,894 8,145 9,659
Reported net profit 11,737 15,758 19,733 27,268 32,336
Balance sheet
Total Assets 77,503 98,386 101,450 118,826 140,824
Fixed Assets 30,314 41,253 35,887 41,623 51,308
Current Assets 64,386 87,647 92,070 107,830 124,019
Investments 198 198 198 198 197.9
Total Liabilities 77,504 98,386 101,450 118,826 140,824
Shareholders' equity 292 292 292 292 291.5
Reserves & surplus 37,210 51,267 70,656 95,532 125,030
Total networth 37,502 51,559 70,948 95,823 125,321
Total debt 37,691 44,511 28,191 20,691 13,191
Current liabilities 16,037 28,286 25,347 29,467 33,343
Deferred tax liability 2,054 2,058 2,054 2,054 2,054

Aurobindo Pharma
Cash flow statement

PBT 15,334 21,679 25,627 35,413 41,994
Depreciation 3,125 3,326 4,226 4,264 5,314
Tax -3,440 -4,956 -5,894 -8,145 -9,659
Net Working Capital -10,591 -8,417 -4,207 -10,002 -9,409
CFO 6,471 12,368 20,398 21,952 28,460
Capital Expenditure -3,741 -7,459 -7,500 -10,000 -15,000
Investment -236 -6,860 - - 0
Other investments -4,211 234 200 200 176.794
CFI -8,187 -14,085 -7,300 -9,800 -14,823
Issuance of Equity 35 68 - - 0
Inc/Dec in Borrowings 1,737 2,669 -8,346 -8,121 -7,896
Net Dividends -596 -1,805 -1,732 -2,393 -2,837
Other Financing activities - - - - 0
CFF 1,176 932 -10,077 -10,514 -10,733
Net change in cash -540 -785 3,021 1,638 2,903
Closing cash balance 1,786 4,691 5,291 6,929 9,833
FCFF -1,481 5,143 13,098 12,152 13,637
Ratio analysis
Year to March FY14 FY15 FY16E FY17E FY18E
Revenue growth 38.3 49.6 14.1 18.1 14.4
Core EBITDA growth 139.9 20.2 21.7 31.5 18.5
APAT growth 236.5 34.3 25.1 38.2 18.6
EPS growth 234.9 34.3 25.1 38.2 18.6
Core EBITDA margin 13.2 15.2 26.3 20.9 22.3
EBIT margin 20.3 18.6 19.4 22.3 22.9
Net profit margin 14.4 13 14.4 16.9 17.5
ROCE (%) 24.2 26.3 28.2 33.4 25.6
Reported RoE (%) 36.9 35.4 31.9 32.7 29.2
Debt Equity ratio (X) 1.0 0.9 0.4 0.2 0.1
Current Ratio 4.0 3.1 3.6 3.7 3.7
Valuation parameters
EPS 40.3 27.0 33.8 46.8 55.5
Book Value ( per share) 128.7 88.3 121.7 164.4 215.0
P/E (x) 22.3 27.3 13.2 9.6 12.7
P/BV (x) 7.0 8.3 3.7 2.7 3.3
EV/EBITDA(x) 13.9 18.3 9.3 6.9 8.7
EV/Sales (x) 3.7 3.9 2.1 1.7 2.2
EV/EBIT (x) 18.1 20.9 10.7 7.6 9.8
CFO/EBITDA (x) 0.3 0.5 0.7 0.5 0.6
Gross Block turnover (x) 2.8 3.8 4.0 4.2 4.0
Working Capital Turnover (x) 1.3 1.5 1.4 1.5 1.4

Inox Wind
SELL
COMPANY UPDATE INXW IN EQUITY October 06, 2015
Although Inox Wind is a new entrant, it has captured a market share of Capital Goods
12% in FY15 (vs NIL in FY10) with an EBITDA margin of 17% which is the
highest amidst its peers. Lack of any sustainable competitive advantage Recommendation
alongside the rebirth of Suzlon (thanks to its recent balance sheet re-
Mcap (bn): `80/US$1.3
capitalisation) and shift in the Indian market from wind towards solar
3M ADV (mn): `92/US$1.4
should cap future revenue growth. The high probability of warranty
provisions and competition from solar should impact margins. The CMP: `359
promoter’s poor capital allocation coupled with sub-par corporate TP (12 mths): `370
governance is likely to remain an overhang on multiples. Upside (%): 3
Value Trap Summary Flags

Parameter Result Comment Accounting: RED
Accounting quality Several unanswered questions over industry-highest EBITDA margin Predictability: AMBER
Capital allocation Weak return ratios of Group companies Treatment of minorities: RED
Corporate governance Lack of independence of Board; related party transactions
IBAS Lack of innovation; dependence on vendors for critical components What will change our view?
Source: Company, Ambit Capital research. Note: = rating of 4/4; = rating of 3/ 4 and so on.  Inox streamlining its accounting policy
in line with its peers by providing
Accounting quality - Several questions remain unanswered warrant provisions
Although Inox is not an integrated manufacturer, its average gross margin over
 Inox building a credible in-house R&D
FY11-15 at 27% was higher than an integrated manufacturer’s 24%. Also, Inox
team to update/upgrade its
pays significantly lower royalty (highest paid was 1.8% of revenue in FY14) vs technology
R&D spend incurred by peers at 3.1% of revenue over FY11-15. Moreover,
unlike its peers, which provide 4-5% of revenue as warranty provision, Inox does
not provide for any warranty provision. Performance (%)
Capital allocation – Unrelated diversification by group companies 140
Inox has limited history of capital allocation as it was incorporated only in FY10. 120
However, the capital allocation history of the Group isn’t impressive with both
Gujarat Fluorochemicals (GF) and Inox Leisure reporting sub-optimal RoCE. 100
Furthermore, diversification into non-related businesses is a concern. The group 80
Jun-15
Jul-15
Jul-15
Aug-15
Sep-15
Sep-15
Apr-15
Apr-15
May-15
has diversified into air products, entertainment, chemicals, cold storage

products, renewable and capital goods.
Corporate governance - Lack of independence of directors Sensex Inox
Two of the four independent directors are on the Board of Inox’s promoter (GF).
Inox’s non-promoter CEO is not a part of the Board. Moreover until FY13, a Source: Bloomberg, Ambit Capital research.
significant part of Inox’s business was coming from the Group and promoter-
owned-entities (34%/100%/100% in FY13/FY12/FY11). All the wind sites for
future development in Rajasthan, Gujarat and Kerala are held by GF.
IBAS - Lack of spending on innovation; lack of strategic assets
Inox stands out as a weak player on our IBAS framework due to lack of in-house
innovation, dependence on AMSC (a financially fragile company) for technology,
a weak brand (due to a limited third-party execution track record), weak
architecture (due to lack of decentralisation) and high dependence on vendors
for critical wind turbine generator (WTG) components.
Attractive valuations, but what after FY17? Analyst Details
Inox’s valuation of 13.2x FY17E P/E looks attractive given its strong EPS CAGR of Bhargav Buddhadev
40% in FY15-17E and impressive 36% RoE in FY17E. However, Inox’s revenue +91 22 3043 3252
growth seems likely to plateau beyond FY17E, as we believe wind power will go bhargavbuddhadev@ambitcapital.com
out of favour with the Government withdrawing incentives such as generation
based incentives (GBI) and feed-in-tariff (FIT) post FY17-end. Poor YTD poor Deepesh Agarwal
order inflow at 310MW (vs our estimate of 913MW) imply a likely cut in revenue +91 22 3043 3275
and PAT by 8%-10% for FY17 making the current multiple expensive. deepeshagarwal@ambitcapital.com
Inox Wind
Exhibit 1: Whilst revenue increased at 147% CAGR over Exhibit 2: …and RoIC is likely to decline by 290bps over
FY11-15, it is likely to stagnate post FY16 with 11% FY16-18E
revenue CAGR over FY16-18E…
60,000 26% 140.0
50,000 24% 120.0
40,000 22% 100.0
20% 80.0
30,000
18% 60.0
20,000 16% 40.0
10,000 14% 20.0
- 12% -
FY11
FY12
FY13
FY14
FY15
FY16E
FY17E
FY18E
FY11
FY12
FY13
FY14
FY15
FY16E
FY17E
FY18E
Revenue (Rsmn) EBITDA margin (%) on RHS RoIC RoCE RoE
Exhibit 3: Debt and equity capital raise accounted for 66% Exhibit 4: …and investment in working capital accounted for
of cash inflows over FY11-15… 63% of cash outflows over FY11-15
Others, Interest
Inter-
IPO 0.8% payment,
Corporate
proceeds, 9%
deposits,
29.0% Borrowings
12%
, 36.8%
Capex,
WC
15%
investment,
CFO 63%
before
WC, 33.4%
Exhibit 5: Inox is trading at a 4% discount to global peers

EV/EBITDA
Mcap P/E (x) P/B (x) RoE (%) CAGR over FY15-17E
Company Country (x)
(US$mn)
FY16E FY17E FY16E FY17E FY16E FY17E FY15 FY16E FY17E Revenue EBITDA EPS
Inox Wind India 1,314 17.4 14.5 5.5 4.9 11.1 9.2 32.6 33.0 35.6 40.2 49.0 46.9
Indian WTG players
Suzlon India 1,505 NA 16.5 NA NA 25.9 13.2 NA 8.3 (13.5) (19.8) 46.3 NA
Divergence with Inox NA -12% NA NA -57% -30% NA NA NA NA 270bps NA
Global WTG players
Gamesa* Spain 3,669 14.8 12.8 1.9 1.7 6.0 5.5 11.5 13.1 13.6 8.9 9.5 17.3
Vestas* Denmark 11,181 16.2 17.4 3.1 2.8 6.8 7.2 21.8 20.9 17.0 0.4 0.8 1.3
Nordex* Germany 2,137 19.6 17.4 3.4 2.9 7.6 7.0 17.6 19.6 18.1 3.5 14.0 19.4
Xinjiang Goldwind* China 5,537 11.5 9.6 1.9 1.7 9.9 8.2 16.7 16.9 17.8 9.8 19.5 17.3
Median 15.5 15.1 2.5 2.2 7.2 7.1 17.2 18.3 17.4 6.2 11.7 17.3
Divergence with Inox 12% -4% 117% 119% 54% 30% 1540bps 1470bps 1810bps 3400bps 3730bps 2960bps
Source: Bloomberg, Ambit Capital research; Note: Prices as on 29 September 2015, * - calendar year ending

Field Score Comments
In our accounting analysis of capital goods companies, Inox's scores are similar to the median score due to its
Accounting RED
stretched conversion cycle at 106 days in FY15 and high related party transactions.
Lack of availability of historical quarterly financial and extremely bullish management commentary renders limited
Predictability AMBER
predictability on the numbers.
Lack of independence of independent directors (two independent directors are also directors of Inox’s promoter
Treatment of Minorities RED i.e. GF) and ownership of wind sites for future development in the states of Rajasthan, Gujarat and Kerala in the
name of promoters (GF) and other group company (Inox Renewables) are matter of concern.

Inox Wind
Accounting quality
Although Inox is not an integrated manufacturer, its average gross margin
over FY11-15 at 27% was higher than an integrated manufacturer’s 24%.
Also, Inox pays far lower royalty (highest paid was 1.8% of revenue in FY14)
vs R&D spend incurred by peers at 3.1% of revenue over FY11-15. We wonder
why other players are not emulating Inox Wind, as R&D costs impacts their
EBITDA margin and in-house manufacturing impacts RoCE. Moreover, Inox
does not provide for warranty expenses vs an average warranty provision of
4-5% by peers over FY11-14. This is a risk as several warranties are provided
by the equipment supplier, which includes performance guarantees of WTGs,
machine availability, etc. Lastly, Inox’s cash conversion cycle at 106 days
(second-worst in industry) remains a concern; peers reported cash conversion
cycle of -10 days in FY14 (FY15 data not available).
 Cash conversion cycle: Inox has the second-worst cash conversion cycle given
its high receivable days of 141 in FY14 (FY15 data not available for peers) vs
Inox has the second worst cash
peers’ 89 days. Moreover, the cash conversion cycle deteriorated from an
conversion cycle in the industry
average of 23 days in FY12 to 104 days in FY14 and to 106 days in FY15. Whilst
Inox’s poor cash conversion cycle can be attributed to the higher share of turnkey
projects (88% of projects executed in FY15), industry participants highlight that
Gamesa is also an aggressive player in turnkey projects but still its cash
conversion cycle stood at -33 days in FY14 (FY15 data not available). Note that a
comparison with Suzlon does not depict a true picture, as Suzlon’s negative cash
conversion cycle is due to its inability to pay its creditors. Hence, we raise a RED
FLAG on Inox’s cash conversion cycle.
Exhibit 7: Inox cash conversion at 104 days in FY14 is second highest amidst peers
Customer advance Cash conversion
Receivable days Inventory days Payable days
Company days cycle
FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15
Inox Wind 22 99 141 144 48 31 41 47 46 58 76 77 0 0 2 8 23 71 104 106
Suzlon 152 520 187 251 66 313 136 109 197 761 391 494 11 140 86 35 10 (68) (155) (169)
Vestas 35 137 93 NA 112 395 172 NA 22 90 56 NA 25 117 78 NA 100 325 130 NA
Gamesa 59 92 39 NA 79 231 86 NA 92 201 93 NA 17 84 66 NA 29 39 (33) NA
Regen 78 113 84 NA 39 59 52 NA 57 96 99 NA 20 16 23 NA 41 60 14 NA
Median (excl. Inox) 69 125 89 NA 72 272 111 NA 75 148 96 NA 18 100 72 NA 35 49 (10) NA
Divergence (47) (26) 52 NA (24) (241) (70) NA (28) (90) (20) NA (18) (100) (70) NA (12) 22 114 NA
Source: Company, MCA, Ambit Capital research; Note: FY15 figures for Vestas, Gamesa and Regen are not available
 Revenue recognition: Consequent to deterioration in the cash conversion cycle

from 23 days in FY12 to 106 days in FY15, Inox’s CFO has been negative over
FY12-15. The management is guiding for an improvement in the working capital Inox’s CFO has consistently been
cycle to ~80 days by FY17 led by better credit terms in recent contracts. Our negative over FY12-15
recent interaction with industry expert suggest that credit terms are improving as
IPPs are desperate to get the WTG projects commissioned before FY17 given
uncertainty beyond FY17. However, post FY17, we expect the cash conversion to
deteriorate, as IPPs start shifting towards solar.
Exhibit 8: Inox’s CFO over FY13-15 has been negative due to rising investment in
working capital
`mn unless specified FY11 FY12 FY13 FY14 FY15
CFO before change in WC 110 1,160 1,652 1,509 3,548
WC investment (68) (664) (2,862) (2,389) (4,607)
CFO 42 495 (1,210) (880) (1,060)
Revenue growth NA 764% 70% 48% 73%
Cash conversion cycle 23 71 104 106

Inox Wind
 Inox’s gross margin is similar to global peers even though Inox is not an
integrated manufacturer: Although Inox is not a fully integrated manufacturer;
its gross margins are higher than the average margins of global peers. Inox Although Inox is not a fully
outsources WTG design, gearbox, generator, electrical control systems and towers integrated manufacturer, its gross
(partial outsourcing policy for towers). Inox’s higher margin is incomprehensible, margins are higher than the
given the industry thumb rule of manufacturers earning higher gross margin than average margins of global peers
aggregator companies. This is also corroborated from the data given in the
exhibit below where Gamesa and Suzlon, which are virtually fully-integrated
manufacturers, make gross margin of more than 30% vis-à-vis an aggregator like
Vestas which makes gross margin of 14%. We raise a RED FLAG on this
unexplainable high gross margin.
Exhibit 9: Inox’s gross margins are significantly higher for an aggregator company
Average over
Gross margin (%) FY11 FY12 FY13 FY14 FY15
FY11-15
Inox 29% 32% 27% 23% 25% 27%
Suzlon India# 34% 36% 19% 23% 36% 30%
Gamesa*^ 27% 32% 29% 33% 32% 31%
Vestas*^ 17% 12% 11% 15% 17% 14%
Nordex*^ 27% 26% 22% 25% 23% 24%
Goldwind*^ 23% 16% 14% 20% 26% 20%
Average (excl. Inox) 25% 24% 19% 23% 27% 24%
Source: Company, Ambit Capital research; Note: * We taken the financials of the global entities, as the gross
margin data for the Indian arm of these companies are not available; ^ Calendar year ending, # we have taken
Suzlon India’s financials for Suzlon, as the consolidated business includes the operations of Senvion
Exhibit 10: Inox is less integrated vis-a-vis global peers and Suzlon…
Criticality Inox Suzlon Gamesa Vestas Nordex
Design Outsourced In-house In-house In-house In-house
Rotor blades In-house In-house In-house Partial in-house Partial in-house
Towers Partial in-house In-house In-house Partial in-house In-house
Hubs In-house In-house In-house In-house In-house
Nacelle In-house In-house In-house In-house In-house
Generator Outsourced In-house In-house In-house In-house
Gearbox Outsourced Partly In-house Outsourced In-house
Electrical control system Outsourced In-house In-house In-house In-house
Source: Company, Industry, Ambit Capital research
Note: - Highest; - High; - Moderate; - Low.
Exhibit 11: …which is also corroborated by Inox’s lowest fixed asset per MW sold
FY15 figures Inox Gamesa Nordex Goldwind Vestas Suzlon
Fixed Assets (US$mn) 40 682 163 1,772 3,898 101
Sales (MW) 578 2,623 1489 4,728 6,053 454
Fixed asset (US$mn per MW) 0.07 0.26 0.11 0.37 0.64 0.22
Exhibit 12: Gearbox and generator are regarded as critical components; both
together account for ~84% of WTG failure (as per WindInsider)
Nacelles, 2% Others, 3%
ECS, 3%
Rotor blades, 8%
Generator, 25% Gearbox, 59%
Source: WindInsider, Ambit Capital research

Inox Wind
 Several questions over EBITDA margins: Inox reported the highest EBITDA
margin vs its peers, both domestic and foreign. Whilst Inox reported 17% EBITDA
margin in FY15 vs Suzlon’s -17% and MNC peers’ average of 8% for FY14 (FY15 Compared with average warranty
financials not available for MNC peers), its average EBITDA margin over FY11-15 provision at 4.5% of revenue over
at 17.1% was also higher vs average EBITDA margin of -20.8% for Suzlon and FY11-14 for its peers, Inox’s
5.5% for MNC peers (FY11-15). Inox’s superior EBITDA margin can be warranty provision was NIL.
attributed to NIL R&D expenditure (see Exhibit 16 below) and NIL
provisioning on warranties (see Exhibit 14 below). Compared with average
warranty provision at 4.5% of revenue over FY11-14 for its peers, Inox’s warranty
provision was NIL.
Exhibit 13: Inox’s EBITDA margin at 17% in FY15 is the highest amidst peers, as it
does not spend on R&D and also does not provide for warranties
EBITDA margin (%)

20.0%
15.0%
10.0%
5.0%
0.0%
-5.0% Inox Vestas* Gamesa* Suzlon Regen*
-10.0%
-15.0%
-20.0%
Source: Company, MCA, Ambit Capital research; Note: * We take FY14 EBITDA margin for Vestas, Gamesa and
Regen, as their FY15 financials are yet not available on MCA
 NIL warranty provisioning: The lower provisioning cost is a risk, as several

warranties are provided by the equipment supplier, which includes performance
guarantees of WTGs, machine availability, etc. Inox provides its WTG customer
with a warranty of about two years against all defects in components, materials
and engineering from the date a WTG is commissioned. Whilst Inox has back-to-
back warranties with its vendors, in some cases, the warranties provided by
suppliers may be for shorter periods than the warranties provided to the
customers. In other cases, the extent of losses can exceed the limits of that
provided by the vendor/insured by the insurance company. We raise a RED
FLAG.
Exhibit 14: Inox’s highest EBITDA margin vs its peers is led by lower provisioning cost
Warranty provision as a % of revenue FY11 FY12 FY13 FY14 Average*
Inox 0.0% 0.0% 0.0% 0.0% 0.0%
Gamesa 3.7% 4.7% NA NA 4.2%
Suzlon 6.8% 3.9% 10.4% 9.0% 6.3%
Regen 2.2% 0.5% 0.8% 1.3% 1.1%
Average (excl. Inox) 4.2% 3.0% 3.7% 3.4% 4.5%
Source: Company, MCA, Ambit Capital research; Note: Warranty provisioning for Gamesa in FY13 and FY14 and
Vestas over FY11-14 is not available in their MCA filings; * we have calculated average warranty claim on
cumulative warranty claim made and cumulative revenue
 NIL R&D expense: Inox has a perpetual licence from AMSC Austria GmbH to
manufacture 2MW WTGs in India based on AMSC’s proprietary technology.
Inox’s technology partner AMSC
AMSC is a Nasdaq-listed company (mcap of US$84mn), offering a host of
has been facing financial
electronic controls and systems as well as wind turbine designs and engineering
difficulties since FY03
services which aid in maximising turbine availability. However, AMSC has been
facing financial difficulties since FY03 (and has made profit only once in the last
13 years) given the potential loss of a key customer and changes to its senior
management. Its stock price has corrected by ~69% in the last one year and by
~98% in the last five years. Inox procures Electronic Control Systems (ECS) from
AMSC and its affiliates. We raise a RED FLAG on NIL R&D spend.

Inox Wind
Exhibit 15: AMSC’s sustained losses are a worry

US$mn unless specified FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Operating performance
Revenue 112 183 316 287 77 87 84 71
Gross Profit 32 52 115 (22) (6) 15 11 3
EBITDA (17) (7) 39 (89) (101) (55) (43) (46)
PAT (25) (17) 16 (186) (137) (66) (56) (49)
Financial position
Net worth 208 222 281 293 165 125 112 80
Debt - - - - - 18 13 8
Cash 106 110 142 240 52 39 43 20
Ratios
Revenue growth YoY (%) 115% 63% 73% -9% -73% 14% -4% -16%
Gross margin (%) 29% 28% 36% -8% -8% 18% 13% 4%
EBITDA margin (%) -16% -4% 12% -31% -132% -63% -51% -65%
RoE (%) -16% -8% 6% -65% -60% -46% -47% -51%
RoCE (%) -11% -3% 16% -31% -44% -36% -32% -43%
Source: Bloomberg, Ambit Capital research, Note – March year ending
In the event, of any bankruptcy at AMSC, there can be no assurance that Inox will
continue to update and upgrade the technology that it licenses from them. Whilst
If AMSC goes bankrupt, there is no
Inox’s agreement with AMSC provides that the source codes for ECS will be
assurance that Inox will be able to
released to Inox, there can still be no assurance that Inox will be successful in
update and upgrade the
updating and upgrading technology to keep pace with its competitors that use
technology
other technology for their WTGs. Given Inox’s NIL spend on R&D over FY11-14 vs
average of 1.7% of revenues for its peers like Suzlon, Regen, and Gamesa, it
remains to be seen how Inox will be able to compensate for the loss of AMSC.
Exhibit 16: Inox’s R&D spend is the lowest amidst peers
Particulars FY11 FY12 FY13 FY14 Average*
R&D spend (`mn)
- Inox NIL NIL NIL NIL
- Gamesa NA NA 93 5
- Suzlon 764 1,023 2,172 390
- Regen 195 53 58 52
R&D spend as a % of revenue
- Inox - - - - -
- Gamesa NA NA 0.8% 0.0% 0.2%
- Suzlon 1.7% 1.5% 12.4% 1.3% 2.7%
- Regen 1.7% 0.2% 0.3% 0.2% 0.5%
Average (excl. Inox) 1.7% 0.9% 4.5% 0.5% 1.7%
Source: Company, MCA, Ambit Capital research; Note: R&D spend for Gamesa in FY11 and FY12 and Vestas
over FY11-14 is not available in their MCA filings; we have calculated average on cumulative R&D spend and
cumulative revenue
 Royalty paid by Inox is negligible vs R&D cost incurred by global peers: If
one assumes that the NIL R&D spend for Inox is due to royalty payment to AMSC, Highest royalty paid by Inox is 1.8%
note that the royalty expense of Inox is significantly lower than the R&D spends of of revenues which is much lower
the global WTG peers. The highest royalty paid by Inox in its limited existence has than the 3.1% of revenues paid by
been 1.8% of revenues in FY14. This is really surprising, as globally the R&D its global peers
spend incurred by players is much higher at 3.1% of revenue over FY11-15.
Even domestic players like Suzlon, Gamesa and Regen have spent 1.7% of
revenue on R&D over FY11-15. Further, Inox now does not need to pay any
royalty on WTG models of 93 meter and 100 meter rotor diameter with hub
height of 80 meters and 80/92 meters respectively, as the royalty was to be paid Inox also has a unique
only on the first 450 WTGs supplied. It is surprising that other players have not arrangement of not paying
entered into similar arrangements as Inox, as R&D costs impact EBITDA margins royalty beyond a certain number
of WTGs supplied
by 2-4% across various players.
Height Royalty condition
Upto 110 meters On first 450 WTGs

Above 110 meters On first 245 WTGs

Inox Wind
Exhibit 17: Inox’s royalty and R&D spend is inferior to foreign peers
As a % of revenue FY11 FY12 FY13 FY14 FY15 Average over FY11-15
Inox's royalty spend 1.6% 1.2% 1.3% 1.8% 0.8% 1.3%
R&D spend
Gamesa* 1.4% 2.3% 2.8% 1.9% 1.9% 2.1%
Vestas* 5.4% 3.4% 3.5% 4.0% 2.3% 3.7%
Nordex* 5.0% 6.8% 7.5% 3.6% 3.1% 5.2%
Goldwind* 0.5% 0.9% 2.2% 2.4% 1.5%
Average 3.9% 3.2% 3.7% 2.9% 2.4% 3.1%
Source: Company, Ambit Capital research, Note: * We have taken financials of the global entities; ^ Calendar
year ending, data for royalty payments by Inox in FY15 is not available
 Contingent liability as a proportion of net worth: Inox’s contingent liabilities

as a percentage of net worth at 8.3% is not alarming, as it is entirely contributed
by tax-related disputes and unexecuted capital contracts.
Exhibit 18: Contingent liabilities as a percentage of net worth at 8.3% in FY15
`mn FY14 FY15
Tax related 131 206
Unexecuted capital contracts 108 949
Total Contingent liability 239 1,154
As a % of net worth 5.6% 8.3%
Auditors
Inox’s accounts are being audited by M/s Patankar & Associates since FY14 (prior to
FY14 M/s Deewan PN Chopra & Co were the auditors) and Mr SS Agarwal is the
signing partner. M/s Patankar & Associates is a less known firm; The Inox group of
companies are their large clients. We believe a company of Inox’s size (FY15 revenue
at `27bn) should be audited by one of the big-4 auditing firms. Moreover, SS
Agarwal is the signing auditor for Inox’s group companies as well i.e., GF and Inox
Leisure, which we believe poses a risk to the auditor’s independence, as GF is the
promoter of Inox Wind. Thus, we raise a RED FLAG.
“The Audit Committee”, as on 31 March 2015, comprises four members (three of
whom are independent director and one is non-executive director). Mr Shanti Prasad
Jain is the chairman of the audit committee. The attendance of one member i.e. Ms
Bindu Saxena was only 20% in FY15.
Exhibit 19: Composition of Audit Committee
Name Position in Audit Committee Directorship Attendance
Shanti Prasad Jain Chairman Independent 5/5
Deepak Asher Member Non-executive 5/5
S Rama Iyer Member Independent 4/5
Bindu Saxena Member Independent 1/5
Inox’s payment to auditors at 0.01% of FY15 is in line with the industry practice. For
the purpose of calculation of audit fees, we have included fees for tax audit, out-of-
pocket expenses and other audit expenses.
Exhibit 20: Audit fees as a percentage of revenue is reasonable
Audit Fees (`mn) As a % of revenue
Particulars
FY14 FY15 FY14 FY15
Audit fees 0.9 1.1 0.01% 0.00%
IPO related 2.0 2.0 0.01% 0.01%
Other matters 1.0 0.8 0.01% 0.00%
Total 3.9 4.0 0.02% 0.01%

Inox Wind
 Board Composition: Are independent directors independent?
The Board currently comprises eight directors, out of which four are independent
directors, two are executive directors and two are non-executive directors. Mr
Devansh Jain and Mr Rajeev Gupta are the executive promoters on the Board.
The proportion of independent directors is reasonable at 50%. However, Mr
Shanti Prashad Jain and Dr S Rama Iyer cannot be said to be
independent, as they have a presence on the Board of the group
companies including GF which is the promoter of Inox Wind.
The CEO Mr Kailash Lal Tarachandani is not a part of the Board of
directors. Consequently, we assign a RED FLAG.
Exhibit 21: Snapshot of Board of directors
Director Designation Education Other directorship Summary
Directors
He joined the group as a member of corporate
management group at GF in March 2008. He has been
Bachelor’s in economics
Whole-time leading the group’s foray into the wind equipment
Devansh Jain and BA from Carnegie None
Director business. He is on the National Council of the Indian
Mellon University, USA
Wind Power Association and he is the Secretary of the
Indian Wind Turbine Manufacturers Association.
He has more than 35 years of experience in various
management and operational areas. He was involved in
Whole-time B.Tech (Chemicals) from
Rajeev Gupta None setting up GFL’s chemical complex at Dahej and
Director IIT, Delhi
production plants for Aditya Birla Group and TOA Group
of Companies.
Inox Leisure, Inox Leasing,
He has been associated with the Inox Group since the
Inox Motion, Inox
past 25 years. He is the founding president of the
Non-executive Bachelor’s in commerce Infrastructure, Inox
Deepak Asher Multiplex Association of India and a member of the FICCI
director and law, CA, ICWA Renewables, Frame Motion
Entertainment Committee. He has also been awarded the
Pictures, Shringar Films, Fame
Theatre World Newsmaker award in 2002.
India, GF
Inox Leasing, Inox India, Inox
Bachelor’s Degree in
Air Products, Inox Leisure,
Mechanical
Siddhapavan Trading & He has been associated with the group since the past 12
Non-executive Engineering from the
Siddharth Jain Finance, Devnansh Gases, years. Currently he is looking after product development
director University of Michigan;
Rajini Farms, Kingston Smith, at Inox Air products.
MBA from INSEAD,
Megnasolace City, Crysogenic
France
Vessel Alternative
He is the former CMD of NTPC. He had been the
ILFS Energy, ILFS Infrastructure
Chandra Independent chairman of the Standing Conference of Public Enterprises
CA, Bachelor’s in Law Development Corporation,
Prakash Jain Director (SCOPE) for FY03-05. He has also served on the advisory
Adani Power, PCI
committees of RBI, CAG and CII.
He has more than four decades of experience as an
Shanti Prashad Independent Inox Renewables, Inox
CA auditor and tax consultant. He is the senior partner of M/s
Jain Director Infrastructure, GF
Shanti Prasad & Co.
He has over five decades of experience in
BE (Chemicals) from L&T Infotech, Thirumalai the engineering, chemical, petrochemicals and
Independent Jadhavpur University; Chemicals, GF, Inox oil and gas industry. He is a member of the Indian
Dr S Rama Iyer
Director MTech and PhD from IIT, Renewables, Deepak Institute of Chemical Engineers. He has been awarded the
Mumbai Fertilisers ‘Business Leader of the Year Award’ by the Chemtech
Foundation in 2005.
She has over 25 years of experience as a corporate
Independent Bachelor’s in Law and
Bindu Saxena None attorney. She is a partner at Swarup & Company (New-
Director Commerce
Delhi-based law firm).
Other key executives (non-director)
He has more than 22 years of experience in strategy
management, global project
execution, product management and business
Kailash Lal Chief Executive BE (Electricals), IIT development; he was instrumental in
None
Tarachandani Officer Kanpur; MBA, INSEAD building organisations, setting up their plants,
acquiring technologies and developing their
management teams. Prior to joining Inox Wind in 2013,
he worked with Kenerseys, Vestas, Alstom Power and L&T.
Prior to joining Inox Wind, he was the CFO of Punj Lloyd.
Chief Financial
Raju Kaul CA; MBA, FMS (Delhi) None He has also worked with SAE India, Blue Star
Officer
and Hotel Corporation of India.

Inox Wind
 Since Inox was incorporated in FY10 and went public in FY15, the rotation of
independent directors is not comparable.
 Attendance of the Board: The attendance of the independent directors at the
Board meetings has been poor in FY15 (details for FY14 are not available). Apart
from Mr Shanti Jain who attended all the Board meetings, the attendance of
other three independent directors was not more than 50%. Mr Chandra Jain
attended only one out of the eight Board meetings. We assign an AMBER FLAG.
Exhibit 22: Attendance of independent directors at the Board meetings has been poor
Director Designation FY15
Devansh Jain Whole-time Director 8/8
Rajeev Gupta Whole-time Director 7/8
Deepak Asher Non-executive director 8/8
Siddharth Jain Non-executive director 1/8
Chandra Prakash Jain Independent Director 1/8
Shanti Prashad Jain Independent Director 8/8
Dr S Rama Iyer Independent Director 4/8
Bindu Saxena Independent Director 3/8
 Insider trading: No insider transaction has taken place since the listing of Inox
in March 2015.
 Managerial remuneration: Inox’s managerial remuneration as a percentage of
PBT at 0.92% in FY15 is reasonable.
Exhibit 23: Managerial remuneration is reasonable
Salary & As a % of
FY15, in ` mn Designation Sitting fees Total
Commission PAT
Directors
Devansh Jain Whole-time Director 12.1 - 12.1 0.31%
Rajeev Gupta Whole-time Director 5.9 - 5.9 0.15%
Deepak Asher Non-executive Director - 0.3 0.3 0.01%
Siddharth Jain Non-executive Director - 0.0 0.0 0.00%
Chandra Prakash Jain Independent Director - 0.1 0.1 0.00%
Shanti Prashad Jain Independent Director - 0.3 0.3 0.01%
Dr S Rama Iyer Independent Director 1.2 0.2 1.4 0.04%
Bindu Saxena Independent Director - 0.1 0.1 0.00%
Key executives (Non-
director)
Kailash Lal Tarachandani Chief Executive Officer 12.6 - 12.6 0.32%
Raju Kaul Chief Financial Officer 3.0 - 3.0 0.08%
Total 34.8 1.0 35.7 0.92%

Inox Wind
Capital allocation
Capital allocation strategy appears reasonable
Per MW capex low but not comparable
 Inox has spent `1.5bn on capex over FY14-15 for its capacity expansion from
800MW currently to 1,600MW (expected by end-FY16). Whilst this capex appears
low on a per MW basis (`2mn-2.5mn per MW vs peers’ `4-5mn), note that Inox’s
facility is not integrated and hence to that extent it is not comparable. Although
capacity expansion appears rational, given its opening order book of 1,178MW in
FY16 vs current installed capacity of 800MW (we calculate capacity on blade Inox has not undertaken any
manufacturing capacity), we believe industry growth should stagnate at 3.5GW acquisition since its incorporation
after FY17, which means that Inox may be left with excess capacity. in FY10
 Moreover, Inox has not undertaken any acquisition since its incorporation in
FY10.
Negatives – Working capital dampens cash flows; group companies
capital allocation strategy questionable
 Deteriorating cash conversion cycle from 23 days in FY12 to 106 days in FY15
coupled with 63% revenue CAGR over FY12-15 has meant that CFO generation CFO generation has been negative
has been negative over FY13-15 (see Exhibits 7 and 8). Whilst the company is over FY13-15
guiding for an improvement in its cash conversion cycle to ~80 days in two years,
we are not enthusiastic about its guidance, as Inox’s peers are operating at
negative cash conversion cycle (FY14 median cash conversion cycle for peers
stood at -10 days).
 Since Inox has been incorporated only six years ago (in FY10), we also analyze
the capital allocation history of the other group companies; GF and Inox Leisure.
As per our Chemicals analyst, amidst fluorine players, SRF is a much better play
than GF, given its product portfolio, scale, management bandwidth, and R&D
capability. Whilst SRF has a dominant share of the fluoro chemicals business Other group companies earn
(commercialised 20 modules so far), a large portion of GF’s revenues are driven returns lower than their peers.
by the commodity product, caustic soda. Also, whilst SRF has been investing 6-7%
of PBT into R&D, GF has not focused much on specialty chemicals and has largely
focused on commodity fluoro products such as Teflon. Whilst GF’s FY15 EBITDA
margin at 21% is superior to Navin Flourine’s 12% and SRF’s 18%, GF earns
lower RoE than both (as seen in the exhibit below).
Even the Inox Leisure business (entertainment business) lacks a competitive edge
vs its peers. Despite its revenue at `9.7bn in FY15 being similar to PVR’s `14.7bn,
its FY15 EBITDA margin/RoE at 12%/5% was lower than PVR’s 14%/6%.
Exhibit 24: GF’s RoE is lower than its peers Exhibit 25: Even Inox Leisure’s RoEs and margins are lower
than its peers
Average Average
FY11 FY12 FY13 FY14 FY15 FY11 FY12 FY13 FY14 FY15
over FY11-15 over FY11-15
EBITDA margin EBITDA margin
(%) (%)
- GF 34.4 35.8 44.0 16.6 21.4 30.4 - Inox Leisure 9.7 12.9 12.8 14.0 12.0 12.3
- Navin Fluorine 26.2 35.5 15.3 13.5 11.6 20.4
- PVR Cinema 17.7 14.0 13.8 15.2 13.8 14.9
- SRF 28.2 22.7 17.4 14.8 18.2 20.3
RoE (%) RoE (%)
- GF 16.1 22.2 17.2 3.0 14.2 14.5
- Inox Leisure 0.5 7.7 6.2 8.7 0.8 4.8
- Navin Fluorine 23.0 56.7 8.7 9.6 8.9 21.4
- SRF 33.2 22.2 13.4 10.4 13.5 18.5 - PVR Cinema 0.1 8.1 9.6 9.7 3.2 6.1
Source: Ace Equity, Ambit Capital research; Note: We have taken standalone Source: Ace Equity, Ambit Capital research; Note: We have taken consolidated
financials for GFL, Navin Fluorine and SRF financials for PVR

Inox Wind
IBAS framework
IBAS Level of
Comment
Parameter strength
It is dependent on AMSC for technology support. Despite the high probability
Innovation
of AMSC going bankrupt, Inox has yet not spent on in-house R&D.
Limited execution history with non-related party and lack of manufacturing of
Brand
critical components has meant a moderate brand name for Inox.
Inox is a promoter-driven company with lack of decentralisation of decision-
Architecture making (which is evident from lack of representation of a professional CEO on
the Board).
Inox does not manufacture critical WTG components such as generator,
Strategic
gearbox, and electrical control system. High dependence on vendors is a
Asset
concern.
Innovation
Lack of in-house R&D alongside weak financial position of technology
partner is a concern:
Inox Wind forayed into WTG equipments post the technical collaboration with AMSC
for design and electrical control systems in FY10. Over the past six years, technology
support from AMSC for 2MW wind turbines has helped Inox to improve its market
share from NIL in FY10 to 12% in FY15.
However, the continuity of technology support from AMSC remains a question mark, Continuity of technology support
as AMSC has been facing financial difficulties since FY03 (and has made profit only from AMSC remains a question
once in the last 13 years) given the loss of a key customer and changes to its senior mark, as AMSC has been facing
management. Its stock price has corrected by ~98% in the last five years. In the event financial difficulties since FY03
of bankruptcy at AMSC, there can be no assurance that Inox will continue to update
and upgrade the technology that it licenses from them.
Whilst Inox’s agreement with AMSC provides that the source codes for ECS will be
released to Inox, there can still be no assurance that Inox will be successful in
If Inox fails to update technology
updating and upgrading technology to keep pace with its competitors that use other
in-house then it may fall behind in
technology for their WTGs. Given Inox’s NIL spend on R&D over FY11-14 vs average
the fast-changing technology curve
of 1.7% of revenues for its peers like Suzlon, Regen, and Gamesa, it remains to be
of the WTG industry
seen how Inox will be able to compensate for the loss of AMSC. If Inox fails to update
technology in-house then it may fall behind in the fast-changing technology curve of
the WTG industry.
Brands/Reputation
Limited execution history with non-related party has meant moderate brand
recall for Inox
Inox’s turbines (commenced operations in 2010) have a moderate track record Until FY13, a significant part of
beyond its captive consumers. Whatever third-party business has gone to Inox Wind Inox’s wind business was coming
may be attributed to the reputation enjoyed by its group companies, GF and Inox from the group and promoter-
Leisure. Until FY13, a significant part of Inox’s wind business was coming from the owned companies
group and promoter-owned companies (34% in year-ended 31 March 2013, 100% in
year-ended 31 March 2012 and 100% in year-ended 31 March 2011).
Also, until FY13, Inox had executed projects only in Rajasthan and Tamil Nadu, with
~83% of the projects being executed in Rajasthan. Suzlon’s financial woes during
FY11-15 allowed Inox to gain market share during this period, as only Suzlon,
Gamesa and Inox provide turnkey solution. However, with Suzlon back in the market
given the recent equity infusion of `18bn by Dilip Sanghavi & Associates and stake
sale in Senvion for `70bn, Inox is losing ground to Suzlon.

Inox Wind
Exhibit 27: Limited track record of turbines from third parties, as majority of sales
happened to related parties until FY13
Sales in MW FY11 FY12 FY13
Related party sales
- GFL 2 52 -
- Inox Renewables - - 134
Others - - 130
Total 2 52 264
Sales to related parties as % of total 100% 100% 34%
Architecture
Promoter-driven company
 Our discussion with Inox’s customers and visit to job portals like Glassdoor
Inox’s CEO is not even a part of the
suggest that Inox is a promoter-run company which lacks decentralisation. This is
Board of Directors
corroborated by the fact that Inox’s CEO is not even a part of the Board of
Directors.
 All the wind sites for future development in the states of Rajasthan, Gujarat
and Kerala are held by the promoters (GF) and by Inox Renewables (IRL, a
group company). In the event, the framework agreement entered into with the All the wind sites for future
promoters does not hold up, the company may lose all the wind sites. development in the states of
Management’s view on this happening is very limited as GF and IRL are not Rajasthan, Gujarat and Kerala are
engaged in wind equipment manufacturing. Further there is no possibility of GFL held by the promoters and by
and IRL allowing any other developer other than Inox to use these sites. Lastly, group companies
the brand Inox is not owned by the company. It belongs to the Jain family
(represented by Pavan Kumar) which are the promoters of GF.
Strategic assets
Inox is not a fully integrated manufacturer, as it outsources critical WTG equipment
such as design, gearbox, generator, electrical control systems and towers (partial Inox outsources critical WTG
outsourcing policy for towers). Dependence on vendors for critical components equipment from vendors
suggests weak control over strategic assets.
Exhibit 28: Inox is less integrated vis-a-vis the global peers and Suzlon
Criticality Inox Suzlon Gamesa Vestas Nordex
Design Outsourced In-house In-house In-house In-house
Rotor blades In-house In-house In-house Partial in-house Partial in-house
Towers Partial in-house In-house In-house Partial in-house In-house
Hubs In-house In-house In-house In-house In-house
Nacelle In-house In-house In-house In-house In-house
Generator Outsourced In-house In-house In-house In-house
Gearbox Outsourced Partly In-house Outsourced In-house
Electrical control system Outsourced In-house In-house In-house In-house
Source: Company, Industry, Ambit Capital research
Note: - Highest; - High; - Moderate; - Low.

Inox Wind
Exhibit 29: Gearbox and generator are regarded as critical components; together
they account for ~84% of WTG failures (as per WindInsider)
Nacelles, 2% Others, 3%
ECS, 3%
Rotor blades, 8%
Generator, 25% Gearbox, 59%
Source: WindInsider, Ambit Capital research
Attractive valuation but what after FY17?

Inox’s current valuation of 14.5x FY17E P/E looks attractive given strong EPS CAGR of
40% over FY15-17E and impressive RoE of 36% in FY17E, an improvement of 310bps
over FY15-17E. However, we believe Inox’s revenue growth would flatten out from
FY18 onwards, as we believe wind power would go out of flavor with the
Government withdrawing incentives to support solar power. We believe Inox will not
foray into solar, as there are no competitive advantages for domestic solar equipment Inox’s poor YTD poor order inflow
manufacturers. Our recent discussions with consultants suggest that the WTG industry at 310MW (vs our estimate of
ordering may fall to 1.5-2.0GW in FY17 from ~3.5GW in FY16E given the shift 913MW for FY16) implies a likely
towards solar at rapid pace which implies a material downside risk to our FY17 cut in revenue and PAT by 8-10%
industry ordering assumption of at 4.1GW. Moreover, Inox’s poor YTD poor order for FY17E
inflow at 310MW (vs our estimate of 913MW for FY16) imply a likely cut in revenue
and PAT by 8%-10% for FY17 which makes the current multiple even less attractive.
Exhibit 30: Inox is trading at 4% discount to global peers
Mcap P/E (x) P/B (x) EV/EBITDA (x) RoE (%) CAGR over FY15-17E
Company Country CMP#
(US$mn) FY16E FY17E FY16E FY17E FY16E FY17E FY15 FY16E FY17E Revenue EBITDA EPS
Inox Wind India 379 1,314 17.4 14.5 5.5 4.9 11.1 9.2 32.6 33.0 35.6 40.2 49.0 46.9
Indian WTG players
Suzlon India 20 1,505 NA 16.5 NA NA 25.9 13.2 NA 8.3 (13.5) (19.8) 46.3 NA
Divergence with
NA -12% NA NA -57% -30% NA NA NA NA 270bps NA
Inox
Global WTG players
Gamesa* Spain 12 3,669 14.8 12.8 1.9 1.7 6.0 5.5 11.5 13.1 13.6 8.9 9.5 17.3
Vestas* Denmark 44 11,181 16.2 17.4 3.1 2.8 6.8 7.2 21.8 20.9 17.0 0.4 0.8 1.3
Nordex* Germany 24 2,137 19.6 17.4 3.4 2.9 7.6 7.0 17.6 19.6 18.1 3.5 14.0 19.4
Xinjiang Goldwind* China 13 5,537 11.5 9.6 1.9 1.7 9.9 8.2 16.7 16.9 17.8 9.8 19.5 17.3
Median 15.5 15.1 2.5 2.2 7.2 7.1 17.2 18.3 17.4 6.2 11.7 17.3
Divergence with
12% -4% 117% 119% 54% 30% 1540bps 1470bps 1810bps 3400bps 3730bps 2960bps
Inox
Source: Bloomberg, Ambit Capital research; Note: Prices as on 29 September 2015, * - calendar year ending, # Local currency prices

Inox Wind
Financials
Income statement
Operating income 15,668 27,099 45,035 53,303 55,867
% growth 48% 73% 66% 18% 5%
Gross Profit 3,537 6,753 12,097 14,538 14,982
EBITDA 1,953 4,298 7,994 9,546 9,407
% growth -1% 120% 86% 19% -1%
Depreciation 116 204 245 345 391
EBIT 1,837 4,094 7,749 9,201 9,016
Interest expenditure 460 622 1,293 1,758 1,717
Non-operational income / Exceptional items 91 143 355 723 749
Exceptional Items
PBT 1,468 3,615 6,810 8,165 8,048
Tax (45) 927 1,973 2,365 2,331
PAT 1,513 2,688 4,837 5,800 5,717
% growth 0% 78% 80% 20% -1%
Balance sheet
Cash 40 7,096 14,453 14,981 15,346
Debtors 7,096 14,322 16,809 18,873 19,475
Inventory 2,707 4,238 5,552 6,572 6,888
Loans & advances 2,030 3,436 4,565 5,403 5,663
Investments 450 0 - - -
Fixed assets 1,993 2,519 3,719 3,719 3,719
Other Current assets 482 337 1,144 609 1,228
Total assets 14,798 31,948 46,243 50,157 52,319
Current liabilities & provisions 4,802 9,300 11,767 13,887 14,606
Debt 5,567 8,743 19,073 19,073 19,073
Other liabilities 151 (14) (14) (14) (14)
Total liabilities 10,520 18,029 30,825 32,945 33,664
Shareholders' equity 2,000 2,219 2,219 2,219 2,219
Reserves & surpluses 2,278 11,700 13,199 14,992 16,435
Total networth 4,278 13,919 15,418 17,211 18,655
Net working capital 7,512 13,032 16,304 17,569 18,647
Net debt (cash) 5,526 1,647 4,620 4,091 3,726

Inox Wind
Cash flow statement

PBT 1,278 3,891 6,810 8,165 8,048
Depreciation 116 204 245 345 391
Interest 460 622 1,293 1,758 1,717
(Incr) / decr in net working capital (2,389) (4,607) (3,271) (1,265) (1,078)
Tax (334) (800) (1,973) (2,365) (2,331)
Others (11) (370) (355) (723) (749)
Cash flow from operating activities (880) (1,060) 2,749 5,916 5,997
(Incr) / decr in capital expenditure (440) (1,039) (1,445) (345) (391)
(Incr) / decr in investments (454) 465 0 - -
Others 474 (909) 355 723 749
Cash flow from investing activities (420) (1,483) (1,090) 378 358
Issuance of equity - 6,923 - - -
Incr / (decr) in borrowings 1,789 3,255 10,329 - -
Others (465) (593) (1,293) (1,758) (1,717)
Cash flow from financing activities 1,324 9,585 9,036 (1,758) (1,717)
Net change in cash 25 7,042 10,696 4,535 4,638
Ratio analysis
Year to March (%) FY14 FY15 FY16E FY17E FY18E
EBITDA margin 12.5 15.9 17.7 17.9 16.8
EBIT margin 11.7 15.1 17.2 17.3 16.1
Net profit margin 9.7 9.9 10.7 10.9 10.2
RoIC 24.1 25.8 32.7 33.1 29.8
RoCE 23.0 19.2 19.3 18.5 17.3
RoE 36.1 32.6 33.0 35.6 31.9
FCF / Capital employed (15.9) (12.9) 4.6 15.7 15.1
Pre-tax CFO/EBITDA -28% -6% 59% 87% 89%
Valuation parameters
EPS (`) 6.82 12.11 21.80 26.14 25.76
Book value per share (`) 19.3 62.7 69.5 77.6 84.1
P/E (x) 50.8 28.6 15.9 13.2 13.4
P/BV (x) 17.9 5.5 5.0 4.5 4.1
EV/EBITDA (x) 42.1 18.2 10.2 8.5 8.6
EV/Sales (x) 5.3 2.9 1.8 1.5 1.4

Inox Wind
Institutional Equities Team

Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 saurabhmukherjea@ambitcapital.com
Research
Analysts Industry Sectors Desk-Phone E-mail
Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 nitinbhasin@ambitcapital.com
Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 aadeshmehta@ambitcapital.com
Abhishek Ranganathan, CFA Retail / Mid-caps (022) 30433085 abhishekr@ambitcapital.com
Achint Bhagat, CFA Cement / Roads / Home Building (022) 30433178 achintbhagat@ambitcapital.com
Aditya Bagul Consumer (022) 30433264 adityabagul@ambitcapital.com
Aditya Khemka Healthcare (022) 30433272 adityakhemka@ambitcapital.com
Ashvin Shetty, CFA Automobile (022) 30433285 ashvinshetty@ambitcapital.com
Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 bhargavbuddhadev@ambitcapital.com
Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 deepeshagarwal@ambitcapital.com
Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 gauravmehta@ambitcapital.com
Girisha Saraf Mid-caps / Small-caps (022) 30433211 girishasaraf@ambitcapital.com
Karan Khanna Strategy (022) 30433251 karankhanna@ambitcapital.com
Kushank Poddar Technology (022) 30433203 kushankpoddar@ambitcapital.com
Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 pankajagarwal@ambitcapital.com
Paresh Dave, CFA Healthcare (022) 30433212 pareshdave@ambitcapital.com
Parita Ashar, CFA Metals & Mining (022) 30433223 paritaashar@ambitcapital.com
Prashant Mittal, CFA Derivatives (022) 30433218 prashantmittal@ambitcapital.com
Rakshit Ranjan, CFA Consumer (022) 30433201 rakshitranjan@ambitcapital.com
Ravi Singh Banking / Financial Services (022) 30433181 ravisingh@ambitcapital.com
Ritesh Gupta, CFA Oil & Gas / Chemicals (022) 30433242 riteshgupta@ambitcapital.com
Ritesh Vaidya, CFA Consumer (022) 30433246 riteshvaidya@ambitcapital.com
Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 ritikamankar@ambitcapital.com
Ritu Modi Automobile (022) 30433292 ritumodi@ambitcapital.com
Sagar Rastogi Technology (022) 30433291 sagarrastogi@ambitcapital.com
Sumit Shekhar Economy / Strategy (022) 30433229 sumitshekhar@ambitcapital.com
Utsav Mehta, CFA E&C / Industrials (022) 30433209 utsavmehta@ambitcapital.com
Sales
Name Regions Desk-Phone E-mail
Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 sarojini@panmure.com
Dharmen Shah India / Asia (022) 30433289 dharmenshah@ambitcapital.com
Dipti Mehta India / USA (022) 30433053 diptimehta@ambitcapital.com
Hitakshi Mehra India (022) 30433204 hitakshimehra@ambitcapital.com
Krishnan V India / Asia (022) 30433295 krishnanv@ambitcapital.com
Nityam Shah, CFA USA / Europe (022) 30433259 nityamshah@ambitcapital.com
Parees Purohit, CFA UK / USA (022) 30433169 pareespurohit@ambitcapital.com
Praveena Pattabiraman India / Asia (022) 30433268 praveenapattabiraman@ambitcapital.com
Shaleen Silori India (022) 30433256 shaleensilori@ambitcapital.com
Singapore
Pramod Gubbi, CFA – Director Singapore +65 8606 6476 pramodgubbi@ambitpte.com
Shashank Abhisheik Singapore +65 6536 1935 shashankabhisheik@ambitpte.com
USA / Canada
Ravilochan Pola - CEO Americas +1(646) 361 3107 ravipola@ambitpte.com
Production
Sajid Merchant Production (022) 30433247 sajidmerchant@ambitcapital.com
Sharoz G Hussain Production (022) 30433183 sharozghussain@ambitcapital.com
Joel Pereira Editor (022) 30433284 joelpereira@ambitcapital.com
Nikhil Pillai Database (022) 30433265 nikhilpillai@ambitcapital.com
E&C = Engineering & Construction

Inox Wind
Aurobindo Pharma Ltd (ARBP IN, SELL)
1,000
800
600
400
200
0
Oct-12
Oct-13
Oct-14
Jun-13
Aug-13
Jun-14
Aug-14
Aug-15
Oct-15
Jun-15
Dec-12
Feb-13
Apr-13
Dec-13
Feb-14
Apr-14
Dec-14
Feb-15
Apr-15
AUROBINDO PHARMA LTD
Apollo Tyres Ltd (APTY IN, NOT RATED)
300
250
200
150
100
50
0
Oct-12
Feb-13
Apr-13
Jun-13
Aug-13
Oct-13
Feb-14
Apr-14
Oct-14
Jun-14
Aug-14
Feb-15
Apr-15
Aug-15
Oct-15
Jun-15
Dec-12
Dec-13
Dec-14
APOLLO TYRES LTD
Inox Wind Ltd (INXW IN, SELL)
600
500
400
300
200
100
0
May-15
May-15
Jun-15
Jun-15
Aug-15
Aug-15
Sep-15
Sep-15
Apr-15
Apr-15
Jul-15
Jul-15
Jul-15
INOX WIND LTD

Inox Wind
Explanation of Investment Rating

Investment Rating Expected return (over 12-month)
BUY >10%
SELL <10%
NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation
UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events
NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock
Disclaimer
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Additional information on recommended securities is available on request.

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The Magic Formula and Value Traps - Ambit

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STRATEGY

Section 1: Value and value traps ……………………………………………………4

- Screening for value - The magic formula……………………………………...4

- Current ‘value’ plays on this screen ……………………………………………5

Section 2: A framework to identify ‘value traps’ ………………………………….7

- Filter 1: Accounting quality ………………………………………………………8

- Filter 2: Corporate governance………………………………………………..10

- Filter 3: Capital allocation ……………………………………………………..10

- Filter 4: IBAS framework………………………………………………………..12

Apollo Tyres (NOT RATED)…………………………………………………………. 15

Aurobindo Pharma (SELL)………………………………………………………….. 29

Inox Wind (SELL)……………………………………………………………………...43

October 06, 2015 Ambit Capital Pvt. Ltd. Page 2

THEMATIC October 06, 2015

Section 1: Value and value traps

Screening for value - The magic formula

Performance of 'magic' quintiles

October 06, 2015 Ambit Capital Pvt. Ltd. Page 4

Current ‘value’ plays on this screen

October 06, 2015 Ambit Capital Pvt. Ltd. Page 5

October 06, 2015 Ambit Capital Pvt. Ltd. Page 6

Section 2: A framework to identify ‘value

October 06, 2015 Ambit Capital Pvt. Ltd. Page 7

Filter 1: Accounting quality

Here is a brief description of the accounting ratios:

II - Balance sheet misstatement checks

October 06, 2015 Ambit Capital Pvt. Ltd. Page 8

III - Cash pilferage checks

IV - Audit quality checks

October 06, 2015 Ambit Capital Pvt. Ltd. Page 9

Filter 2: Corporate governance

Filter 3: Capital allocation

October 06, 2015 Ambit Capital Pvt. Ltd. Page 10

Exhibit 6: Capital allocation choices

Source: Ambit Capital research

October 06, 2015 Ambit Capital Pvt. Ltd. Page 11

Filter 4: IBAS framework

Brands and reputation

October 06, 2015 Ambit Capital Pvt. Ltd. Page 12

Such architecture is most often found in firms with a distinctive organisational

 Innovation is uncertain - the innovation process tends to be a “hit or miss”.

Furthermore, even when the expensive innovation process yields a commercially

October 06, 2015 Ambit Capital Pvt. Ltd. Page 13

October 06, 2015 Ambit Capital Pvt. Ltd. Page 14

Apollo scores above average on accounting quality Performance (%)

Exhibit 7: Explanation for our flags

October 06, 2015 Ambit Capital Pvt. Ltd. Page 16

Source: Company, Ambit Capital research. Note: = ranking of 1; = ranking of 2 = ranking of 3

P&L misstatement checks

October 06, 2015 Ambit Capital Pvt. Ltd. Page 17

Balance sheet misstatement checks

Cash pilferage checks

Audit quality checks

October 06, 2015 Ambit Capital Pvt. Ltd. Page 18

Source: Bloomberg, Ambit Capital research

 No major related party transactions: The related party transactions at the

October 06, 2015 Ambit Capital Pvt. Ltd. Page 19

October 06, 2015 Ambit Capital Pvt. Ltd. Page 20

14.0% 3.0 19.0%

12.0% 2.8 17.0%

2.0% 1.8 5.0%

However, reported numbers do not reveal the true picture on capital