QUALIPORT
How Shares Lose 100%

By Maynard Paton (TMFMayn)
April 5, 2004

With a good record of growth, coach and bus builder Mayflower (LSE: MFW) attracted many followers in the 1990s:

Year to December 31	1994	1995	1996	1997	1998
Turnover (£m)	137.5	202.3	274.6	392.7	495.2
Operating profit (£m)	9.1	15.5	23.9	36.3	49.4
Pre-tax profit (£m)	8.6	7.1	17.9	33.3	68.9
Earnings per share (p)	3.6	5.3	7.0	10.6	12.2
Dividend per share (p)	1.5	2.0	2.3	2.8	3.3

(All figures adjusted for goodwill)

But after sporting a market value of £1b in 1999, Mayflower's worth had collapsed to £24m by last week. Protracted difficulties with debt negotiations then prompted the suspension of the shares, with administrators appointed soon afterwards. Shareholders will almost certainly suffer a 100% loss.

Like medical students, investors should also pass by the mortuary once in a while to aid their learning. Here are some of the signs that spelt T-R-O-U-B-L-E at Mayflower.

1. Onerous debts: Of all Mayflower's problems, debt was the ultimate killer. But the difficulties were clear four years ago.

In 1999, Mayflower recorded a £77m operating profit, though net interest payments were £21m. In 2000, operating profits declined to £69m, yet had to service net interest payments of £19m. Net interest cover in both years was around 3.6 -- far too low, especially as profits (and turnover for that matter) were falling.

To put Mayflower's borrowings into perspective, tobacco companies -- probably the most reliable cash generators around -- operate with interest cover approaching 5 times. Read more on interest cover.

2. Aggressive acquisitions: Following a string of smaller acquisitions (perhaps a bad sign in itself), Mayflower trumped an offer (bid auctions are another bad sign) from Henlys (LSE: HNL) and bought bus and fire engine builder Dennis for £278m during 1998.

According to the 1998 accounts, Dennis had recorded a £13m after-tax profit during the year prior to purchase. But Mayflower did admit: "Accounting policy adjustments of £5.4m are required to align the income recognition policies of the acquired business with the rest of the Group.

So, the purchase price to earnings ratio was at least 20 (i.e. not cheap) and furthermore, the acquisition was funded entirely by additional debt (see above). At the time, the company said: "Having acquired Dennis, Mayflower feels it will prove to be an excellent purchase and will complement our existing companies, as well as enhancing shareholder value." The financial terms of the deal suggested otherwise. Read more on acquisitions.

3. Operational distractions: Beware the struggling company trying to enter different markets. Fanciful new projects are the last thing shareholders want to hear when profits are falling and there's a debt mountain to handle.

Chief executive John Simpson commenced his 2001 review by saying "In this most difficult, turbulent trading year...". Excluding acquisitions, operating profits were down 35% to £46m, which were struck before exceptional costs of £28m.

However, the 'difficult, turbulent' year didn't prevent plans to move into some 'exciting' new areas: "Mayflower has a continuous desire to be at the forefront of innovation... [It has] resulted in exciting progress within Mayflower e3, which is currently developing two projects... Mayflower e3 Energy is contracted to build a unique turbine installation vessel (TIV), for installing offshore wind farms... Wind power is the fastest growing energy source globally and the value of the total market is estimated at over £15.0 billion... Mayflower e3 Engines is developing an environmental variable motion engine..."

4. Regular exceptional items: Become suspicious if companies flatter their results by declaring ongoing costs as one-off. In Mayflower's case, product warranties were a favourite 'exceptional':

2000: 'one-off product warranty costs (£1.9m)'
2001: 'other exceptional items including product warranty costs (£6.4m)'
2002: '£3.0m in respect of warranty costs relating to TransBus chassis that are no longer in production'
2003 H1: 'A £1.5 million charge for warranty provisions on discontinued product'

No surprise then to read a profit warning in February admitting: "The majority of the shortfall in profit since the last announcement has occurred in TransBus and has arisen from a reappraisal of warranty provisions..." Read more on exceptional items.

5. Cosy corporate governance: Executives continually outnumbered non-executives within Mayflower's boardroom. Without the counterweight of independent voices, the chance of a reckless boss ruining shareholders are heightened.

At Mayflower, no senior independent non-exec was recognised as this 'could cause confusion with the role performed by the non-executive chairman.' But the chairman, Rupert Hambro, had been in that position since the company's formation in 1989, which begs the question: did he have too cosy a relationship with chief exec and Mayflower founder John Simpson? Read more on corporate governance.

Summary

Other Mayflower curiosities include the continuation of dividend payments after a £67m rescue rights issue, starting to capitalise certain development expenditure in 2001 and the boardroom holding just two audit committee meetings in 2002.

Taken separately, none of the above factors would have been a clear signal of eventual bankruptcy. For instance, companies have survived onerous debts before and gone on to prosper (e.g. Next (LSE: NXT), while some executive-dominated boardrooms have produced wonderful long-term returns (e.g. William Morrison (LSE: MRW)).

Mixed together though, shareholders had a recipe for disaster. Substantial borrowings, a taste for acquisitions, diversification, funny exceptional items and a questionable boardroom set-up should have told sensible investors to stay well away.

Where next? Revisit The Qualiport Guides To: Interest Cover | Acquisitions | Exceptional Items | Corporate Governance