Provisions & Prakash Industries

On the face of it, Prakash Industries seemed a good bet. The company has embarked on a number of cost saving initiatives and has improved profitability in multiple areas. The P/E of the scrip is around 4. The company has diversified into various businesses like power, wind energy etc. There is also a lingering news of a de-merger which could unlock more value for stockholders (which is primarily promoters).

However, the announcements page of BSE had one section which caught my attention. It seems the company has a penchant for "ignoring possible risks". Here's some important items the auditors pointed out -
1. No provision has been made in respect of doubtful / disputed debts, loans and advances aggregating to Rs 109 lacs
2. No provision has been made in respect of lease rental liabilities due to pending cases and settlement of disputes with the lessors, the amount whereof is not ascertainable.
3. No provisions for gratuity and leave encashment has been made, the amount whereof has not been ascertained. (Refer Note 7)
4. There is a lower charge of interest of Rs 563 lacs for the quarter (Rs 1668 lacs for the nine months period) ended December 31, 2006 for which the settlements with the concerned lenders are yet to be concluded.
5. No adjustment has been made in the accounts for the amount waived under settlements entered into during the year with financial institutions.
6. Adjustment has been made in the books of account towards Minimum Alternate Tax which may be set off against future tax liability of the Company. However, the auditors are unable to express any opinion on the Company’s ability in future for this set off. (Refer Note 13)
7. Provision for Deferred Tax Liability has not been made. Consequently, the profit for the quarter & the period ending December 31, 2006 has been shown higher by Rs 1387 lacs and Rs 3702 lacs respectively. (Refer Note 14)
8. No amount has been amortised towards Deferred revenue expenditure incurred during the year by the Company. (Refer Note 15)

These provisions can have a huge impact on the profitability of any company. Let's take two examples here -

1. Consider an insurance company. The perfect recipe for insolvency is the combination of aggressive (under) pricing and low reserving. The two underlying motives for this are - 1. expansion & increasing market share and, 2. inflating the profits. These short-term moves can really hurt the company when a serious claim hits them - and they find themselves out of money to settle the claim (Read the article on Insurance Company Failures for more info on this)

2. Frequent flyer miles given out by Airline companies. Currently, around 14 trillion miles have been unclaimed - this is a risk faced by all airline companies where they, as a group, have to quantify these 14 trillion miles and accommodate this liability in their accounting statements as a provision (reserves). American Airlines carries a USD 1.6 billion liability in it's books, in unclaimed miles. Interestingly, 7.5% of all customer who flew in the US, were on free trips. That's 7.5% less income for all airlines.

Im not comfortable with ivesting in Prakash Industries given these provisions. This is quite typical of a promoter-led organisation (promoters in the company have over 2/3rd ownership and public holding is just 15%).