QUALIPORT
Five Cash-Flow Nightmares
By Maynard Paton (TMFMayn)
August 2, 2005
"Any business with a severe working capital cash haemorrhage is likely to disappoint."
That was the warning given in this Qualiport article way back in February 2002. The feature highlighted five companies whose working capital movements spelled T-R-O-U-B-L-E. Three years on, all five have suffered cash-flow nightmares -- with one going bust.
To recap: earnings are opinion, cash is fact. And so, 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 (debtors) refuse to pay and suppliers (creditors) demand earlier payment. Importantly, customers and suppliers can cause difficulties at a company long before management admits to problems. (More on working capital can be found here and here).
Here are the five companies that were highlighted, alongside their subsequent share price performances:
| Company |
Price (p)
25/02/02 |
Price (p)
01/08/05 |
Change
(%) |
| Health Clinic |
186 |
0 |
-100 |
| Innovation (LSE: TIG) |
194* |
35 |
-82 |
| Minorplanet (LSE: MPS) |
308 |
2.38 |
-99 |
| Sanctuary (LSE: SGP) |
66 |
20.75 |
-69 |
| Warthog (LSE: WHOG) |
48 |
1.3 |
-97 |
|
|
|
|
| FTSE 100 |
5,101 |
5,290 |
+4 |
(*adjusted for rights issue)
Importantly, these companies did not seem to be in trouble in early 2002. Indeed, all had improved their turnover dramatically in previous years and had upbeat earnings forecasts supported by optimistic boardroom comments. However, closer inspection of the accounts would have revealed big problems:
Here's a rundown on what subsequently happened at each company, with tables comparing reported underlying operating profits with movements in working capital:
1) Health Clinic
| Year to April 30 |
2000 |
2001 |
2002 |
2003 |
2004 |
| Operating Profit (£m) |
1.7 |
2.0 |
0.1 |
- |
- |
| Net change in working capital (£m) |
(1.4) |
(1.7) |
(6.4) |
- |
- |
Health Clinic, owner of around 20 private clinics catering for laser eye surgery, went downhill quickly in 2002. Full-year results were delayed due to 'certain non-cash accounting issues', which when they did arrive revealed sales up 25%, a sizeable outflow of working capital cash and (ominously) a new finance director. The new FD quickly discovered Health Clinic needed more cash to fund 'peak working capital requirements', the demand for which increased two just weeks later. The banks called it a day during October 2002 and shareholders walked away with nothing. Read more.
2) Innovation
| Year to September 30 |
2000 |
2001 |
2002 |
2003 |
2004 |
| Operating Profit (£m) |
3.1 |
14.8 |
9.6 |
3.5 |
7.7 |
| Net change in working capital (£m) |
(7.7) |
(12.6) |
(7.1) |
(7.8) |
(1.4) |
Things turned sour in 2002 at software specialist Innovation. Mishaps included a change of accounting policy that sliced off a chunk of past revenues and an admission that there was a 'material risk' of losing up to 40% of second-half sales. It all caused profits to contract and working capital to remain dire. During early 2003, the shares hit 5p prior to details of a £10m rights issue and fresh management emerging. Those developments appeared to get the group out of a hole, though working capital movements in 2003 and 2004 weren't anything special. Read more.
3) Minorplanet
| Year to August 31 |
2000 |
2001 |
2002 |
2003 |
2004 |
| Operating Profit (£m) |
0.3 |
0.7 |
0.8 |
(17.5) |
(12.4) |
| Net change in working capital (£m) |
(1.7) |
(14.1) |
(21.1) |
(8.5) |
7.6 |
Results from Minorplanet, a fleet management/telematics business, continued to look worrying in 2002. Despite sales up 136% and talk of 'enormous' market potential, the company barely broke even and a further working capital haemorrhage was experienced. By early 2003, however, the company was embarking on 'a year of significant transition', which included a change in revenue recognition and a new boss. With working capital still terrible and debts more than doubling to £27m, 2004 heralded a £13m cash call. A profit warning required bridging finance in late 2004, with trading problems and ongoing losses prompting further bridging funds in 2005. Read more.
4) Sanctuary
| Year to September 30 |
2000 |
2001 |
2002 |
2003 |
2004 |
| Operating Profit (£m) |
7.4 |
14.3 |
18.2 |
21.9 |
21.7 |
| Net change in working capital (£m) |
(13.3) |
(9.2) |
(19.4) |
(25.2) |
(29.3) |
Of the five shares highlighted, music business Sanctuary managed to last until 2005 before striking real trouble. Yet in 2003 and 2004, working capital was abysmal, with horrendous outflows of cash causing borrowings to zoom from £40m to £74m. In June of this year, events finally caught up with the company. Delays to record schedules prompted a profit warning and the management admitted there was a particular emphasis on 'looking at ways to improve cash generation and profitability and reduce long-term debt levels'. Recent interim results showed no respite from the general bookkeeping trend, with a profit of £1m supporting additional working capital of £30m and net borrowings at a mega bad £109m. Read more.
5) Warthog
| Year to April 30 |
2000 |
2001 |
2002 |
2003 |
2004 |
| Operating Profit (£m) |
0.2 |
0.3 |
0.4 |
1.3 |
(4.6) |
| Net change in working capital (£m) |
(0.1) |
(1.3) |
(2.9) |
(2.2) |
6.0 |
Warthog, a computer games developer, continued to exhibit worrying working capital traits in 2002 and 2003, with annual operating profits of about £1m totally absorbed by £2-3m of yearly working capital requirements. By late 2003, net cash had turned to net debt and profits had turned to losses. Early 2004 witnessed the company raise £5m, but things obviously deteriorated badly as the core operation was sold on late last year. It appears Warthog is now a shell whose only asset is a stake in the parent of its former business. Read more.
Summary
Although many smaller companies suffered during the bear market, the five shares listed above had their troubles magnified by poor cash conversion. To re-iterate, shareholders back in 2002 would not have realised the forthcoming problems from just reading the boardroom's view on the company's progress and industry growth prospects.
It's significant to note Health Clinic owned up to accounting 'issues' while Innovation and Minorplant eventually adopted more conservative accounting polices -- which suggests all three were rather cavalier with their bookkeeping. That operating profits were largely consumed by working capital requirements should have suggested reported earnings were unduly rosy.
Indeed, Innovation, Minorplanet and Warthog were forced to go to shareholders and raise more cash, with Health Clinic apparently looking at that option just before the plug was pulled. Should current preliminary bid talks come to nothing, a cursory inspection of Sanctuary's accounts suggests it too is likely require an equity fund-raising exercise.
So the key messages are simple:
* Businesses should always generate 'cash profits' as opposed to just 'accounting profits'. One way or another, any business with a severe working capital cash haemorrhage is likely to disappoint.
* Cash flow speaks louder than words. Customers and suppliers can cause difficulties at a company long before management admits to problems.
More: Shares That Could Lose You Money | Fool's Guide To Working Capital: Part 1 and Part 2
Portfolio value
| Holding |
Number
of shares |
Closing price
01/08/05
(p) |
Value
(£) |
| Associated British Ports |
681 |
474 |
3,227.94 |
| Emap |
372 |
841 |
3,128.52 |
| Halma |
1,920 |
144.5 |
2,774.40 |
| Johnston Press |
1,608 |
486.5 |
7,822.92 |
| London Stock Exchange |
2,018 |
539.5 |
10,887.11 |
| Cash |
|
|
408.24 |
|
|
|
|
| Total |
|
|
28,249.13 |
