Stars, cows, dogs and problem kids

Wednesday 1st August 2001

Are you holding cash cows or dogs? Finance guy Alan Robb explains the difference So, you've got a stock portfolio and you dutifully scan every financial statement to determine how each company's doing. But are you looking at the right figures? Profits might seem fine, but what if there's so much going out in dividends that there's nothing left to grow the business? Assets look strong, but have those assets got real market value or are they simply expectations?

It's amazing how one-eyed some investors are when it comes to evaluating performance. They focus only on earnings. They forget the ultimate bottom line in business is not profit - it is the ability to earn a profit on a transaction, collect the cash, and to do this repeatedly. Remember this basic truth and you'll be well on the way to spotting undervalued shares. You'll also get an early warning of which companies are performing poorly.

The two best measures for really understanding what's going on in a company are cumulative retained earnings and cumulative operating cash flow after interest and dividends. Take the first. Cumulative retained earnings are basically what the company ploughs back into its business in terms of profits. Don't pay any attention to such distractors as "profit before abnormal items", "normalised earnings" or "earnings before interest, tax, depreciation and amortisation". Go for "total recognised revenue and expenses" (normally found in the second block of figures on the company's financial statement) and deduct the dividends (or "distributions to shareholders"). That will give you the retained earnings (the amount of profit that has been ploughed back) for the current period. Do the same calculation for each year of the period that you are looking at.

Now for the cumulative operating cash flow after interest and dividends (OCFAID). Start with the reported operating cash flow figure in the statement of cash flows (normally called the "net cash flows from operating activities"). Then deduct the dividends paid. These will have been reported as a "financing outflow". The result is OCFAID for that year. Do the same calculation for each year of the period that you are looking at. If the reported operating cash flows don't cover the dividends paid that's probably not a sign of financial strength.

If the company has capitalised any dubious debits on its balance sheet you will need to adjust both the reported results and the operating cash flow. It's quite within current accounting standards to call something an asset as long as the auditor agrees that it is an "expected future benefit". But a company can't pay its bills with expected benefits, only from resources that have an actual market value. So anything that isn't a real financial resource should be treated as a dubious debit, and deducted from the reported results and reported operating cash flow.

It's also important to look at performance for more than just the latest quarter. Look at cumulative figures covering several periods. You'll see things most clearly if you plot the cumulative figures on a graph - any standard spreadsheet package should let you do that.

If all is going well, the graph should look like the "star" performers below. Both cumulative retained earnings and cumulative OCFAID are trending upwards. If the company is making profits but not generating enough cash from operations, its trajectory is known as the "problem child" (retained earnings up, OCFAID down). Conversely, a company generating positive OCFAID but not ploughing back profits is a "cash cow" (OCFAID up, retained earnings down). A company that fails to generate both profits and OCFAID is a "dog".

This technique is being used by a number of companies to monitor progress. It's also being used by one major firm of auditors to help them make decisions regarding clients. History shows that the companies that have struck financial trouble in the past have been the dogs and the problem children. If detected early enough they can be turned around. Cash cows also need action to ensure that too much money isn't taken out, potentially causing a collapse later on.

We applied the technique to nine well-known companies - Advantage Group, Brierleys, Baycorp, Designer Textiles, PDL, Ryman Healthcare, Sky City, Smiths City and The Warehouse - to see how they are performing.

The stars

Baycorp

There is a definite star quality about Baycorp. With no dubious debits on its balance sheet and great disclosure of key performance indicators in its annual report, it's one of the best generators of both profits and OCFAID I have seen.

Ryman Healthcare

Listed in June 1999, Ryman has shown a strong star performance in its first three years of results. The downturn in operating cash flows in the most recent year was caused by the slowness of some solicitors in paying over client's money - since balance date nearly $11 million of debt has been received. The company has a solid bank of sites for future development and appears to be focused on profits and operating cash flows.

Smiths City

Smiths City faces the most risky future of the three stars. Its revenue largely comes from sales on extended credit, thus producing a greater risk of bad debts. It carries significant inventories, thus facing the risks associated with inventory replacement as exchange rates fluctuate. Retained earnings have deteriorated since dividend payments were resumed in 1999.

Cash cows

Designer Textiles

Annual reports from this company have regularly reported "difficult conditions" and profits "well short of forecast" and "well below company and shareholders' expectations". Changes at board and management levels in July 2000 were claimed to foreshadow "a fresh direction to business development", while other major changes in shareholdings occurred in November 2000 and January 2001. The profit for the six months to December 31, 2000 (at $850,000) was marginally up on the corresponding six months in 1999, but operating cash flow fell by nearly two-thirds (to $538,000). The full year's results are usually signed off around the first week in September, so investors will have to wait to see whether the company's new initiatives are paying off. The graph, based on the interim results, shows cash cow-style trajectories since 1997.

PDL

The last three years at PDL have seen good performance in terms of operating cash flow, although profits took a tumble in 1999 and no final dividend was paid. Only an interim dividend was paid in 2000, which helped restore both trajectories on the graph. This strong cash flow has undoubtedly been an attraction to the French company Schneider Electric, which is purchasing the Stewart family's 60% holding and aims to take a 100% stake. Recent moves to shift low-value production to China should contribute to improvements in profits. When Schneider takes total control and PDL vanishes from the scene, minority shareholders should look for another cash cow, frequently attractive to large competitors.

Sky City

Sky City has been a strong generator of cash flows since it was listed five years ago, but when an adjustment is made for deferred costs carried forward and cumulative retained earnings are calculated, the picture is less impressive.

The cumulative retained earnings have yet to become positive, although the company has a very strong OCFAID. Investors will be watching the next reports to see how quickly the company's recent investments in the Adelaide Casino, Sky Alpine Casino Queenstown and now Force Corporation contribute to bottom-line profits.

The Warehouse

The Warehouse continues to be a major player in retailing throughout the country and has now moved into Australia, acquiring Clint's Crazy Bargain Stores and Silly Sollys a year ago. The company expected its Australian expansion to be "moderately earnings positive … even after goodwill amortisation in the year to July 31, 2001". In April, however, the chairman announced that "unsatisfactory inventory management and other integration issues" had caused sales and gross margins to be significantly below plan. Clint's is no longer forecast to produce any positive earnings this year, against previous expectations of $A8 million.

The Warehouse has paid dearly for goodwill in its acquisitions. Clint's Crazy Bargain Stores cost $148 million and goodwill comprised $77 million of that total. Writing this off will increase expenses by between $7.7 and $15.4 million a year, but will not affect OCFAID.

New Zealand sales remained strong, at over $900 million in the half-year to January 31, 2001. In recent years its reported performance has been enhanced by its practice of capitalising losses on the sale of mobile phone handsets; a practice that has audit approval because the company expects to receive future benefits from the sale of pre-pay phone cards. After adjusting for these capitalised losses, its retained earnings and OCFAID changed significantly in 1999 and 2000, losing its star status of 1997 and 1998 and becoming a cash cow.

The dogs

Advantage

For the past three-and-a-half years Advantage has followed a strategic path set by now ex-managing director Greg Cross. The emphasis was on earnings and "normalised profits". Sales grew spectacularly, but profits and operating cash flows were a different story. There have been some questionable assets on its balance sheet; intellectual property was capitalised at $834,000 in 1999 and $4.6 million in 2000. If that is treated as an expense, it shows the company's performance as distinctly "doggy".

Brierleys

Since 1999 Brierley Investments (BIL) has been undertaking major restructuring. Non-core assets have been sold but the contributions from some remaining key investments, such as Air New Zealand, continue to be minimal. The company's recent history has been dogged by downward trajectories for retained earnings and OCFAID.

In the March 2001 interim report BIL announced that it is unlikely to report a profit for the full year. The release of the annual report around September will show whether the company's restructuring is paying off in terms of profit and operating cash flow.

Problem children

Problem children are likely to be found in inflationary times, when companies report profits but have negative operating cash flows because of the rising cost of replacing stock. They can be found today among the telcos, where collection of revenue often falls far behind their earnings. Telemedia, which collapsed on June 5, is a classic example. Its receivables a year ago (at June 30, 2000) were equal to 415 days of sales. Its OCFAID for that year was a negative $7.83 million, followed by a further outflow of $7.5 million over the next six months. A problem child indeed.

Alan Robb is a senior lecturer in accountancy at the University of Canterbury and a commentator on financial reporting

Alan Robb

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