Not all related party transactions, even when promoter’s private entities are involved, are bad in nature. It requires deep analysis before commenting whether the transactions seem logical or not.
Case Study: Mirza International
Let’s take an example where sales are being made to a promoter-owned entity, Mirza International. If we open the related party transaction footnote in case of Mirza International, we will see sales being made to an entity named Mirza (UK) Limited, which is not a subsidiary.
All the directors of RTS Fashion Pvt Ltd and Mirza International are 100% same who have been driving the parent company, thus we may safely conclude that it is a promoter-owned entity.
Source: MCA, India
If we track % of Mirza International sales being made to Mirza UK, it's been significant (but decreasing) over the years.
Source: Mirza International AR 2020
Now, to check if these transactions are/ aren’t robbing common shareholders of their wealth, we need to see if Mirza (UK) Ltd is making abnormal profits every year by purchasing these shoes manufactured by Mirza International and selling them! and then, cumulatively judge, and if that profit ideally makes a huge difference for the shareholders of Mirza International or not.
Let’s try and calculate the profits generated from the Mirza (UK) financial statements from their financial statements from the source aforementioned. We get:
Cumulatively, Mirza UK has generated a profit of nearly 26 Cr from 8 years operations in the UK. The Mcap of Mirza International is about 1030 Cr. As one can see, it's insignificant in comparison to the same!
Yes, One may argue that it's a promoter owned entity and it's quite possible that the promoters may not be extracting $$$ through profits, but through crazy salary remuneration? Cumulatively Management remuneration has been 33Cr across 8 years! Yes, though in comparison to the profits the UK entity is generating, its high, but in terms of bigger picture, one may see that a total of nearly ~60 Cr (26 + 33 = 59Cr) has gone to promoters in 8 years of UK business where Mcap of Mirza International has increased from 250 Cr to 1030 Cr (not all attributable to the UK segment) but given the significant revenue contribution by the UK sales, one can-not simply ignore the role Mirza (UK) has played in the growth of Mirza International.
Please note, Mirza UK making profits is not necessarily a bad sign, because its opening up a new market (UK) for Mirza international. Had it not been for Mirza UK, Mirza International would have sold it to some other entity in the UK to grab the market present there/ had to officially launch a business there which would have increased the costs too, right? Even that entity would want to make profits from that business, right?
However, some analysts may also argue that these 60 Cr which went in the pockets of the promoters, could have stayed within the company (if they had created a subsidiary to make sales in UK). This ~60 Cr amount would have boosted the earnings and eventually the valuations of the company too. Assuming a P/E of 15, it would have implied a growth of about 15*60 = 900Cr in Market cap of the company!! That's significant!
So as you can see, An analyst really needs to consider all aspects before making any conclusions regarding these grey areas. Materiality and impact are key metrics before jumping the gun and making any conclusions.
Read our blog 112 - Analysing sources of Revenue Part 6 on understanding the importance of customer concentration as a source of revenue generation