ValueLine: Flying blind

PORTFOLIO POINT: A company’s profit figure can bear little resemblance to the cash profits or cash flow.

Cashflow is crucial in the valuation of any business, yet it is often overlooked. If you own your own business, you will be only too aware that the profit figure your accountants concoct in the end-of-year accounts bears little relationship to the cash in your pocket.

Thanks to tax-driven asset purchases, disposals and attempts to “estimate” the wear and tear on equipment, among many other things, the accounting profit is often not an accurate reflection of the economic performance of a business.

Perhaps the best example of this in the listed company arena is Qantas. It reports a profit but I would argue that it doesn’t make an economic profit.

Its profit and loss statement for 2010 contains an item called depreciation, and a large chunk can be attributed to aircraft. If the planes are depreciated on a straight line basis over a 20-year useful life then you can be sure the “wear and tear” estimate that the annual amount represents will under-provide for the replacement cost of the aircraft.

A 19 year-old plane’s expense in the profit and loss statement will be much lower than the amount required to replace the aircraft with a brand new one.

A true economic profit figure would have to reflect a provision for the replacement cost of the plane. If Qantas did that in its accounts, there would arguably be a substantial loss.

Indeed, that is why the company has raised so much equity and borrowed so much money over the years. There’s not enough cash coming in from receipts – even including Jetstar’s expired, non-redeemed tickets – to fund the operations and so subsidies are required in the form of capital raisings and increased borrowings.

It is also why the profit figure can be a bit of a joke.

Quite simply, reported accounting profits often bear little resemblance to the cash profits or cash flow of a company.

In business, however, one can only spend cash. Accounting profit is not cash unless you are Woolworths, The Reject Shop or JB Hi-Fi. As my chef friend once told me “cash is sanity, profit is vanity’ '¦ or something like that. Cash is indeed king. And with that in mind I want to explain cash flow using the company TFS Corporation.

TFS Corporation Limited (TFC) is an owner and manager of Indian Sandalwood plantations in the east Kimberly region of WA. If you didn’t already know, Indian Sandalwood is a tropical hardwood that is used in high-quality carving, whose oils are an ingredient in fine fragrances, cosmetics and toiletries, incense sticks and for Chinese medicinal purposes.

TFS Corporation promotes sandalwood lots to investors (and finances those lots), establishes maintains and harvests the plantations and researches uses for the product and establishes sales channels including for its own internally produced oils.

In 2009 and 2010 the company reported profits of $72 million, during that period it actually experienced a cash loss $8.9 million. In 2010, the company reported a record $37.11 million in profits, but cash flow was negative to the tune of $25.09 million.

Many investors and analysts often suggest that the difference between cash and profit can be attributed to a timing issue but that too can be assessed with the help of a longitudinal study.

Between 2002 and 2010 TFS Corporation reported total profits of $141 million, but this is not money it or its shareholders can spend. Feeling warm and cuddly about this profitable company may be misplaced because operating cash flow over the same period was just $23 million.

And what if I now told you that over the same 10 years, the business had spent $77 million on property, plant and equipment, and it then paid $30 million in dividends. How can $23 million of operating cash flow fund all of this? The answer is that it cannot, not without the largesse of very altruistic shareholders and financiers. And that too is reflected in the accounts. Shareholders have contributed $61.14 million and lenders have provided $43.19 million in debt funding.

TFS Corporation is not alone in using accounting standards to present the appearance of a profitable business. But only an analysis of cash flow will tell you whether a company is worthy of your involvement.

It is entirely possible that TFS Corporation won’t head down the same path as Great Southern Plantations or Timbercorp and it may indeed be a “monopoly in the making” with significant increases in positive operating cash flow this year. But I prefer a demonstrated track record of uninhibited cash streaming through the door before I include a company like TFS Corporation in the ValueLine portfolio.

Roger Montgomery is an independent analyst and author of Value.able, available exclusively at rogermontgomery.com.