MARKET COMMENT
Hangover From Hell Awaits SFI

By James Carlisle
November 12, 2002

Today's statement from SFI Group (LSE: SFI) wasn't pulling its punches regarding the previous management. According to the new finance director, aided by PriceWaterhouseCoopers, "the Group has operated for some time with a particular focus on its profit and loss account but with less attention being paid to its cash flow statements and balance sheet".

Apparently this has caused "significant over-statement of current assets and under-statement of liabilities", while the fixed assets "are still the subject of the financial review". It looks like it'll be the hangover from hell for SFI investors when (and if) the shares resume trading.

When you look at the cash flow statements and balance sheets for the last few years, you can see where Tim Andrews and PWC are coming from. Operating profits have expanded at the same sort of rate that cash has been leaking out of the group and debt has been expanding quickly.

SFI Group "Numbers"             2002     2001     2000
                                 (£)      (£)      (£)

Operating profit                27.2     21.5     12.4
Operating cash flow             33.2     26.7     13.2
Capital expenditure            (43.6)   (39.1)   (30.4)
Cash paid for acquisitions      (7.2)   (28.4)    (9.5)
Cash outflow before financing  (16.0)   (49.0)   (33.2)
Net debt                         121      105       57

Everything looks pretty rosy at the operating level, with the cash inflow exceeding operating profits, but the problems soon arrive with the massive wedges of capital expenditure. If we try to remove our hindsight spectacles for a moment, there are two ways an investor might have looked at all this before everything went wrong.

One view would have had the company expanding very rapidly, as apparently evidenced by its growing profits, and the capital expenditure as "growth capex" to drive its profitable growth into the future. Tiny depreciation charges of £8.5m, £6.2m and £3.4m, implying a small amount of "maintenance capex", might have lent weight to this conclusion.

The other way to see things would have been that the company was spending oodles of cash refurbishing its existing pubs, that is "maintenance capex", but just not depreciating the assets created by that expenditure fast enough. Looking at the accounting policies, 'Plant and Equipment' (which I take to mean pub refurbishment) is depreciated over anywhere between 5 and 12.5 years. I don't know about you, but the Slug and Lettuce near me seems to have a face lift every year or two.

So how could you have decided which it was? The answer is that you probably couldn't have, for sure, although you'd have got yourself a long way by thinking about the nature of the business and the frequency of the maintenance capital expenditure. The bottom line, however, is that when you come across cash flows and profits in apparent contradiction, then you'll save yourself a lot of headaches if you start by believing the fact of the cash, rather than the hope of the profits. You should need some extreme persuasion -- far more than the directors say-so in the accounts -- to decide that a company bleeding cash might be turning a profit.