QUALIPORT
The Signs Of Smallcap Strife

By Maynard Paton (TMFMayn)
September 30, 2002

SFI (LSE: SUF) is proving to be a costly lesson for many private investors. A few years recording 20%-plus earnings growth gave the pub group many a devotee. However, the smallcap growth story now looks to be unravelling.

A trading statement earlier this month cast a shadow over the company's finances and the shares have fallen by two-thirds since January. Importantly, the share price decline wasn't exacerbated by a racy price to earnings (P/E) multiple; SFI had been valued on a single digit forward P/E prior to the bad news breaking.

SFI was reviewed -- and rejected -- for Qualiport suitability last year. Looking back at that review and a subsequent Market Comment, there were clear signs that all was not well. Here are the key points:

Cash flow

SFI's recent statement said:

"In addition to the 46 new openings last year we have opened eight new sites since June making a total of 22 in the past six months. Whilst this has put short-term pressure on creditors the Group is actively managing the situation.

The company continues to trade within its existing bank facilities and is in the process of making amendments in keeping with the objective announced on 30th July 2002 of reducing gearing to below 100% within 18 months."

Remarks of "short-term pressure on creditors" sound very ominous. Funnily enough, SFI's working capital cash flow characteristics have never looked up to scratch:

SFI
Year to 31st May             1998    1999    2000    2001    2002

Operating Profit (£m)         6.3     8.6    12.4    22.0    27.9

Change in working
capital (£m)                  0.0    (1.9)   (2.7)   (1.6)   (3.2)

In terms of stock, debtors and creditor movements, pubs ought to be to be fountains of cash. Customers pay immediately at the bar while suppliers are paid on credit. However, regular outflows of working capital cash were reported by SFI. By contrast, rival JD Wetherspoon (LSE: JDW) consistently reports substantial inflows of working capital cash:

JD Wetherspoon
Year to 31st July            1998    1999    2000    2001    2002

Operating Profit (£m)        28.4    36.2    46.3    58.4    70.0

Change in working
capital (£m)                  3.4     8.7     8.9     5.0     7.3

Management

With plenty of competition in the pub game, management talent plays a very important role. But recent changes in the SFI boardroom indicated danger.

For starters, SFI has had three different finance directors over the last three years -- not a good sign. Then there's Tony Hill, SFI's founder. After overseeing the firm's rapid growth, he relinquished his executive duties in February to become non-executive chairman. He also confirmed he's leaving the firm in 2003.

Also of interest was the way Hill's successor was appointed. In September 2001, Hill stated that an external candidate would be given the chief executive's job. Five months later, and SFI Retail boss Andrew Latham got the nod.

Why all the Finance Director changes? Why is the company founder leaving? Why make an internal appointment when it was stated a search for an external candidate was being made? Does Latham have Hill's executive talent? Plenty of questions, not many answers.

Formats

As well as questions over cash flow and management, SFI's numerous retail formats and acquisitions also gave cause for concern. Simply put, the more brands and diversity throughout a pub/restaurant estate, the more thinly management talent will be spread, and the more logistical and operational hiccups that will occur. It's fair to assume the assortment of formats has played some part in the current cash flow predicament.

Then there's SFI's £125m of borrowings. Interest payments were covered a rather thin 3.4 times during 2002. If the creditor problems are in fact a prelude to a profit slump, the banks will surely be in touch with SFI. Not surprisingly, 'non-core' assets are presently being sold off.

Summary

Questionable cash flow, the boardroom upheaval, operational diversity and large borrowings -- togther, they all indicated SFI hitting big trouble. Importantly, all the 'features' were evident at the start of the year, months before the bad news officially broke.

As mentioned earlier, the shares also traded on a P/E of under 10 at the start of the year. So the final lesson is straightforward: 'Value' doesn't help if the underlying business takes a nosedive. With all the concerns still in force at SFI, those who look for long-term business quality should continue to stay well away.

More: Is SFI A Qualiport Share? | SFI: Beware Getting Hooked On PEGs | Growth Share Danger Signs