QUALIPORT
More Shares That Could Lose You Money

By Maynard Paton (TMFMayn)
February 25, 2002

Carburton Street, London -- Following on from this feature, today's Qualiport highlights another group of shares that investors should treat with caution. Last time, the companies involved had rich stock market ratings but did not have a proven competitive advantage to support shareholders' growth expectations.

This time however, the company's cash flow profile comes into focus. That's because businesses should always generate 'cash profits' as opposed to just 'accounting profits'.

A crucial aspect of determining whether accounting profits are underpinned by cash flow is checking movements in working capital. Companies heading for trouble often have terrible working capital characteristics, as their stock goes unsold, customers refuse to pay and suppliers demand earlier payment. In general, shareholders should want to see working capital assets converted into cash as quickly as possible.

As Independent Insurance and the companies described in this post show, any business with a severe working capital cash haemorrhage is likely to disappoint. (More on working capital can be found here).

So, here are five businesses whose working capital cash flow characteristics give much cause for concern. All are fast growing companies and have valuations that don't leave room for disappointment.

Health Clinic

Health Clinic (LSE: HEC) operates around 20 clinics for eye treatment and other healthcare services. Funds raised from the group's 2000 flotation will help Health Clinic open six new outlets a year. The company's recent interim results highlighted sales growth of 42% and like-for-like sales growth of 14%.

Year to 30th April           1998   1999   2000   2001   2002*  2003*

Turnover (£m)                11.2   13.2   16.3   20.3 
Pre-tax profits (£m)          1.1    1.1    0.9    1.7
Earnings per share (p)        0.1    0.3   (0.8)   1.9    3.6    9.7

(* estimates)

At 186p per share, Health Clinic is worth £93m. Although the shares stand on a forward price to earnings (P/E) ratio of 52, almost all of Health Clinic's operating profits are absorbed into working capital.

Year to 30th April                         2000   2001              

Operating Profit (£m)                       1.7    2.0 
Net change in working capital (£m)         (1.4)  (1.7)

Innovation Group (LSE: TIG) is almost unique amongst software companies at the moment. The provider of IT systems for the insurance industry recently stated it expected to report "strong" first quarter numbers. The upbeat statement followed full year results that highlighted "no slow down in demand" for Innovation's products.

Year to 30th September       1998   1999   2000   2001   2002*  2003*

Turnover (£m)                 0.3    0.0    9.6   57.8 
Pre-tax profit (£m)           0.2   (0.6)   3.7   17.4
Earnings per share (p)        0.1   (0.5)   2.7    8.4   18.4   27.1

(* estimates)

At 236p per share, Innovation is worth £451m. And although the shares stand on a forward P/E of 13, brokers are expecting earnings to more than double this year. Over the past two years, all of Innovation's operating profits have been absorbed into working capital rather than flowing into the bank.

Year to 30th September                      2000   2001              

Operating Profit (£m)                        3.1   14.8 
Net change in working capital (£m)          (7.7) (12.6)

Minorplanet (LSE: MPS) is another 'tech' company seemingly doing well at the moment. The group claims to have "world leadership" within the vehicle management information industry, with "further significant progress" to be made in the current financial year.

Year to 31st August          1998   1999   2000   2001   2002*  2003*

Turnover (£m)                 3.4    6.5   17.3   52.9 
Pre-tax profits (£m)         (1.3)  (1.0)   1.2    2.2
Earnings per share (p)       (3.5)  (2.1)   1.5    3.5    8.7   19.6

(* estimates)

Year to 31st August                        2000   2001             

Operating Profit (£m)                       0.3    0.7 
Net change in working capital (£m)         (1.7) (14.1)

(It's also worth noting that within Minorplanet's latest results, the company said it had "recruited a number of accountants to report on and control the finances of every part of the Group".)

Sanctuary

Sanctuary (LSE: SGP) owns "the world's largest independently owned catalogue of music and visual rights". Artists within the Sanctuary stable range from Dolly Parton and Elaine Page to Megadeth and Guns N' Roses. Sanctuary also produces two 'teen drama' serials for Channel 5. Acquisitions have been a notable driver of growth, with near-term profits to be enhanced by the purchase of "one of the world's leading merchandising companies".

Year to 30th September       1998   1999   2000   2001   2002*  2003*

Turnover (£m)                17.5   23.1   44.1   82.3 
Pre-tax profit (£m)           1.7    2.3    4.5    7.7
Earnings per share (p)        1.4    1.4    1.9    2.3    4.8    5.7

(* estimates)

Year to 30th September                     2000   2001           

Operating Profit (£m)                       7.4   14.3 
Net change in working capital (£m)        (13.3)  (9.2)

Warthog

Floated a year ago, Warthog (LSE: WHOG) is one of the many quoted computer game developers. Rally Championship Xtreme and Bounty Hunter are two of the group's past successes, with games based on Looney Tunes and X-Men characters currently in the pipeline. The imminent launch of new gaming consoles gives Warthog much enthusiasm for the future.

Year to 30th April           1998   1999   2000   2001   2002*  2003*

Turnover (£m)                 0.3    0.9    2.4    3.8 
Pre-tax profit (£m)           0.0    0.0    0.2    0.3
Earnings per share (p)        0.0    0.0    0.4    0.5    0.8    4.6

(* estimates)

At 48p per share, Warthog is valued at £22m. Brokers are presently expecting profits to jump 50% this year, and quintuple the year after next. At the moment, the shares are valued at 63 times current year earnings. Yet it too has seen recent profits all absorbed into working capital, rather than converted into cash in the bank.

Year to 30th April                         2000   2001         

Operating Profit (£m)                       0.2    0.3 
Net change in working capital (£m)         (0.1)  (1.3)