Insights

Recently, while working on the Indian arm of a global engine manufacturing company (hereinafter referred to as SIL), we found some potential Corporate Governance issues mainly with regards to the Capital allocation of the Company which minority shareholders may want to be aware of. In this piece, we summarise some of the issues we found pertinent.

1. Substantial Divergence in performance of listed and unlisted entities. SIL has many other group companies operating in India. The largest one is STIL – A wholly owned subsidiary of the global parent. Over the last decade, the parent has been shifting manufacturing operations to low cost countries like China and India. A lot of export business was supposed to come to India under this organisational rejig, which was expected to come to SIL, being the group’s flagship company in India. However, as evidenced from the data below, STIL has significantly outgrown SIL.
   
   Similarly, analysing the export revenues of SIL and STIL, we can see that STIL has substantially outgrown SIL during this manufacturing shift to India.
   
   It is important to note that there is no stated bifurcation between the operations of these entities w.r.t their product lines. These seem to be assigned to the Companies on a somewhat ad hoc basis. Comparing operating margins of the two entities also show that on average, STIL has been more profitable than SIL.
   
2. Discrepancy in allocation of business lines: As seen from table 1 above, STIL’s revenues have grown by 73% in 2018 compared to a small de-growth in SIL. This growth is mainly due to the Emissions Services business wherein they have provided after treatment services post the introduction of products for BS IV vehicles.
   This growth in 2018 has mainly emanated from the domestic market. It is interesting to note that SIL’s previous annual reports have mentioned these ‘after-treatment’ technologies as products wherein they have been innovating to meet environmental standards. They have also mentioned the fact that the Company exhibited these products at industry exhibitions. However, as per the 2018 Annual report of STIL, it seems that this business has been shifted to their domain.
3. Investment in R&D Center: SIL has invested a fairly significant amount of money in developing a new tech center.
   
   This tech center is for the use of both SIL and the parent company. The Company had previously claimed that of the total capex of Rs 10,000 Mn of which 5000Mn would be borne by SIL. However, as seen, the actual investment was upwards of 7,700Mn. As per the management of SIL, 70% of the R&D activities conducted here would relate to the parent company and the balance would be forSIL. However, SIL’s R&D expenses have not shown much change since this has come into use.
   
   The Company has given this center on rent to various promoter entities and is earning a post tax yield of around 5-6% before indirect expenses. Incurring expenditure to the tune of 27% of total historical gross block for a tech center for related parties where the post-tax yield is 5-6% seems suboptimal in terms of capital allocation.
4. Management Remuneration: The top management of SIL are given ESOP’s in the global parent entity and not in SIL. This may be detrimental to the interests of SIL shareholders as the focus of the management may be diverted towards the performance of the group and not SIL. At Multi-Act, we believe that quality is defined by actions and not reputation. An exceptional track record in business may not guarantee fair treatment to minority shareholders in the future. Investors who do not delve deeper into the numbers may be exposed to more risk, or in line to gain lesser return than what they bargained for.