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QUALIPORT
By
Carburton Street, London -- A comment from Warren Buffett: When learning about investment, plenty of investors focus on past stock market winners. However, one important part of an investor's schooling concerns corporate failures. Spot the warning signs that lead to a company's downfall, and you'll help minimise your investment downside in the future. One of the many companies that have gone bust recently is Photobition (LSE: PHB). Its demise was announced just last week. But while it only became apparent this year that bankruptcy was a genuine possibility, Photobition's past history contained many a sign that spelt T-R-O-U-B-L-E. The table below shows Photobition's financial record:
"You become a better doctor if you pass by the mortuary once in a while."Year to June 1995 1996 1997 1998* 1999 2000
Turnover (£m) 12.0 16.9 23.4 57.7 91.0 146.9
Pre-tax profit (£m) 1.8 2.9 4.1 9.8 15.5 19.9
Earnings per share (p) 3.0 3.8 5.2 11.2 13.3 13.6
Divided per share (p) 0.7 0.8 1.4 1.9 1.6 1.8
(* 15 month period)
On the surface, the record looked great. Indeed, such a "growth stock" attracted many investors to investigate the company, including the Qualiport. But scrape beneath the surface of Photobition's record, and a very different picture emerges.
Go for growth
Photobition's business revolved around supplying photographic and printing services for use in exhibitions and displays. In 1995, the group's activities encompassed electronic imaging services, print typesetting and artwork, photographic processing, display mounting, display system manufacturing, screen printing and selling imaging equipment.
However, the next few years would see acquisitions diversify Photobition's business. Amongst other lines of business, in came photo library services, a radio marketing consultancy, digital sound services, sports event signage, movie film storage and distribution, specialised freight services, film cleaning and the manufacturer of film canisters.
While all the separate businesses could be covered loosely under the "exhibition and display" umbrella (and thus have their synergistic benefits explained by management), the scope for operational and integrational difficulties looked immense.
Acquisition strain
The thirty acquisitions made after 1995 undoubtedly fuelled Photobition's financial record. And as the next table shows, the purchases became more and more important to the group's overall performance.
Year to June 1995 1996 1997 1998* 1999 2000 Turnover Continuing (£m) 10.7 14.9 20.0 37.9 67.0 115.6 Acquired (£m) 0.9 2.0 3.4 19.8 24.0 27.1 Operating Profit Continuing (£m) 1.9 2.8 3.9 6.4 12.8 15.8 Acquired (£m) 0.2 0.2 0.6 4.4 4.6 6.0 (* 15 month period)The strain of the acquisition frenzy began to show during 1998. When tabling £50m for printing group Wace, Photobition's initial offer document contained numerous mistakes and had to be republished. But more disturbing was Photobition's £28m purchase of film services outfit Novo -- it was incorrectly accounted for within the group's 1998 financial statements! With all the corporate activity, the Photobition boardroom looked stretched.
Furthermore, Photobition's acquisitions went beyond these shores and into that graveyard of most UK businesses: the US. The Stateside venture commenced with the £28m purchase of Katz Digital in late 1998, which was followed by a string of other minor purchases. The goal to try and form a US network of graphic production centres looked far too ambitious in hindsight, given Photobition's management had plenty on their plate already.
Photobition's acquisitions certainly provided the first forewarning of shareholder trouble. The risks of buying a bad business, possible integration problems, an implied lack of management imagination and the resulting lack of financial clarity are all shareholder hazards of any acquisition spending spree.
Cash flow
Alongside the acquisitions, another operational warning sign was contained within Photobition's cash flow profile.
Year to June 1996 1997 1998* 1999 2000 Operating Profit (£m) 2.9 4.4 10.8 17.5 20.7 Net change in Working capital (£m) (2.0) (1.1) (6.7) (8.2) (11.1) (* 15 month period)As with Versailles, Independent Insurance and so many other companies that ultimately go bust, large amounts of cash required for working capital became a regular feature at Photobition. Between 1998 and 2000, only 50% of the group's operating profits were converted into cash. The poor working capital profile should have questioned the validity of Photobition's reported earnings and led to enquiries over the group's trading relationships with suppliers and customers.
(In fact, another pointer on the absence of free cash was Photobition's level of dividend payment. Look back at the first table in this feature, and you'll see accounting earnings growth far outrunning dividend improvements.)
Summary
Alongside the acquisition, stretched management and cash flow warnings, there were less obvious danger signs too. Compounding the financial haze created by the acquisitions was the decision to change the company's year-end. The change, made in mid-1998, was due to the company wanting to "reduce the impact" of its final quarter "seasonal bias". There were also constant bullish references to specific one-off events (e.g. Expo 98, the Millennium celebrations, the Sydney Olympics) too, a habit that alludes to management having short-term time horizons.
While neither the acquisitions nor the working capital situation heralded imminent bankruptcy, there was enough evidence for those prepared to look beyond Photobition's earnings growth record to see operational trouble ahead.
And it's important to note that during early 2000, after the accounting difficulties had been highlighted, when the US expansion was in full swing and the cash flow question marks still remained, Photobition's share price reached an all-time high. Significantly, the signs of possible trouble went unheeded by most investors.
Photobition's bankruptcy only looked on the cards earlier this year. The (somewhat inevitable) trading and restructuring problems in the US took their toll on the group's latest interim profits. Operating profits of £7.2m were generated in the six months ending December 2000, compared to a group interest bill of £4.1m. Interest cover was therefore a wafer thin 1.8 times. Any further profit deterioration was always likely to prompt an unwelcome call from the company's lenders...
So, what can investors learn from Photobition?
Simply:
* Beware of acquisition-driven companies. The risks of buying a bad business, possible integration problems, an implied lack of management imagination and the resulting lack of financial clarity are all shareholder hazards of any acquisition spending spree;
* Substantial movements in working capital cash flows, which absorb the large chunks of the company's reported profits, should put investors on red alert, and;
* Don't expect the stock market to agree with you should you have any concerns about a company. For a long time, the stock market never questioned Photobition even when a lot of the danger signals were evident.
More: Danger: Acquisition In Progress | Avoid The Agonies Of Going Abroad | Photobition discussion board | Qualiport discussion board