Corporate landmines - Part 3

In Part 2, we discussed the fact that corporate insolvencies aren’t normally the result of a sudden misfortune. Instead, they tend to be the gradual and inevitable result of poor underlying economics. These poor economics are typically revealed by a low return on equity and weak cash flow (which were discussed in the Investor’s Colleges of issues 170/Mar 05 and 171/Mar 05 ). But as the end draws near, there are some signs of more immediate trouble and these ‘landmines’ are the topic of this issue’s article.

If poor economics are the long-term cause of most insolvencies, then debt—and the interest on it—is the short-term cause of almost every single one. So rising debts over several years are a bad sign, but the omens are more immediate when those debt levels start to look uncomfortable. Companies prefer to operate with a lot of headroom, so you have to be sceptical when that headroom starts to evaporate.

So what’s enough headroom? One thing to look for is deteriorating interest cover. This is the amount of times that a company’s earnings before interest and tax covers its net interest bill. Three times might be OK for the most reliable businesses, but you should expect cover of at least five times for most companies. For cyclical companies, you’d hope to see no debt at cyclical high points and cover of at least five times towards the bottom of the cycle.

If the operations can’t be relied upon to cover debts, then the next step might be the sale of quality assets. You’d hope that a company would keep its best assets and sell its worst, but when they get into trouble it can be the other way around. After all, the dreadful assets that are burning through cash are probably not saleable, so a fire-sale of the better ones may be used to keep the show on the road. HIH Insurance was a case in point; it sold a substantial part of its most profitable local insurance business to German insurer Allianz in 2000, only months before falling into administration.

If a company’s operations aren’t producing cash and there’s nothing left to sell, then management will have to turn to shareholders to plug the gap and the first stop will normally be dividend cuts. A reduced payout is often a sign of trouble, but it’s even worse when it happens repeatedly because it may indicate an endemic problem. Underwritten dividend reinvestment plans (DRPs) are a subtle means of achieving the same thing: a company will declare a juicy dividend, but then satisfy it by issuing shares rather than handing over cash. There’s a fuller explanation in the Investor’s College of issue 152/May 04, but it’s safe to say that companies with bountiful cash flows don’t usually indulge in this trickery.

Another way that shareholders can plug the hole is through share issues. Equity fundraisings can be great for a company that has perhaps dropped a one-off clanger or has a sudden need to take a major step forward. But they can be a disaster where the only reason for the lack of cash is a poor business, and the only thing that will remain after the fundraising is the same poor business with a bit more cash to squander.

If the cash can’t be found then the final phase—whether through dishonesty, desperation or simple blind optimism—may involve overstated profit figures, with assets being recognised incorrectly or liabilities being ignored incorrectly. A sudden expansion of inventory, relative to sales, can be a sign that management isn’t taking its lumps by writing off dud stock. For example, a less-than-conservative retail manager might stick that pallet of lime green miniskirts in a warehouse, leaving it on the accounts as a bona fide inventory ‘asset’, rather than write it off as obsolete stock. Leading up to the collapse of department store retailer Harris Scarfe, inventory blew out from 15.6% of sales in 1996 to 23.2% in 2000, its last full year of financial solvency. A sudden expansion of debtors can also be a worrying sign, perhaps suggesting that debts are being recognised as an asset when they’re unlikely to be collected.

A mismatch between capital expenditure and depreciation—with no commensurate growth—can also be a means of hiding real losses. And you can run into problems when profits are recognised upfront on long-term contracts, but the costs involved in delivering these contracts are understated. This was specifically the case with telecommunications company WorldCom in the US. An aggressive approach to accounting on anything is a worrying sign: if it makes no difference to the cash position, management is obviously trying to kid someone.

Investors should be on the look-out for these various accounting shenanigans, but one golden rule will keep you away from most of the problems: be very alarmed when profits aren’t backed by real cash flow. HIH reported negative operating cash flow in 1999, which then worsened the following year. It was an ominous sign.

It’s the coming together of these landmines that will indicate real problems. Companies occasionally hit a number of them and live to fight another day, such as Southcorp and AMP, but few perish without setting off a couple. One exception was Pan Pharmaceuticals, where a regulatory event resulted in its manufacturing licence being revoked—forcing bankruptcy. But for general circumstances, if a situation looks finely balanced, it normally pays to think again about the underlying economics. A company with a strong business franchise can get away with a lot more than a me-too company selling commodity products.