Institutionalised Quirks for Analysts to Ponder
by Nandini Vijayaraghavan, CFA – Finsights Research
Independent insight posted on Smartkarma 21st November 2017
Read more of Nandini’s work by clicking here!
Blessed are those who can laugh at themselves, for they shall never cease to be amused.
As an analyst, five analytical practices that are common place but need to be changed, in my view are:
- Focussing on accounting profits as opposed to cash flows
- Inconsistent treatment of on-balance sheet and off-balance sheet debt
- Deducting readily marketable inventory from debt, thereby under-stating financial leverage
- Focussing on share of net income rather than dividends from associates and
- Companies maintaining investment portfolios that are opaque and which often generate lower returns than that of the core business and weighted average cost of capital
Read the unabridged insight for an analysis of and real-life examples of the above-mentioned issues.
Detail
The objective of a Smartkarma insight is usually to help investors make optimal decisions. But I thought I’ll use this platform to solicit responses from fellow analysts and astute investors to five issues that I have not been able to get my head around through my analytical career.
Issue #1: The Income Statement Fixation
One of the parameters of a company’s performance analysts are expected to opine about is a company’s profitability. Financial statements across the globe consist of the income statement, balance sheet and cash flow statement. The funny thing about income statement is that revenues represent sales income that is contractually due to a company but not necessarily collected as cash during the period of reporting, expenses that a company has contractually incurred to generate the revenues it has reported but has not necessarily paid, interest expenses payable on account of the existing businesses and not on account of the capital projects underway…The list goes on.
The income statement does have its utility in terms of “smoothing” a company’s performance, enabling a company to set aside funds for the replacement of plant and machinery that is subject to wear and tear due to the normal course of business aka depreciation, determining tax liability etc.
But what the income statement does not tell you is how much cash the business is generating. A much ignored gem and a more useful tool for analysts (in my view) is the cash flow statement. The list of companies that generate accounting profits (usually EBITDA and net income) but marginal to negative cash flow from operations (CFO) is endless. The financials of Singapore-based Olam International Ltd (OLAM SP) and Hong Kong-based Noble Group Ltd (NOBL SP) illustrate the disconnect between accounting profits and cash flows.
Figure 1
Issue #2: On and Off Balance Sheet Debt
Some companies opt to fund purchases of plant and machinery through debt, cash or a combination of the two. Other companies lease their assets. Several companies operate using a combination of owned and leased assets. The lease rentals are recorded as an expense. Why is there a tendency to estimate financial leverage using on balance sheet debt and ignore the off balance sheet debt i.e. the debt equivalent of leases. There is a wide spread misconception of Singapore Airlines being in a net cash position, as is evident in this article and this one.
As demonstrated in my insight “Singapore Airlines FY17 Results: The Myth of Net Cash”, Singapore Airlines Ltd (SIA SP) has been a moderately leveraged entity if the off balance sheet debt is included while computing financial leverage.
Issue #3: Readily Marketable Inventory
The businesses of companies whose business models integrate upstream and downstream operations and commodity traders tend to be working capital intensive. These companies may also hold high levels of readily marketable inventories (RMI). The companies in question and certain analysts argue that RMI, on account of its liquid nature, ought to be deducted from consolidated debt and hence, net financial leverage is lower.
This argument puzzles me. Are we evaluating companies as going concerns or in a liquidation scenario? As long as company is treated as a going concern,
- The company requires those inventories to render its services,
- Avails of inventory financing through banks, and
- Pays interest on the consolidated debt, and not on consolidated debt less RMI.
Hence, is the high ratio of RMI to inventory a source of financial strength?
The spike in Noble Group’s CFO margin to 22% in Q3 2017 (Figure 1) from negative territory during six of the seven preceding quarters was driven by asset disposals including Noble Americas Corp that resulted in:
- A working capital release of USD508.29 million driven by
- An 86% decline in Q3 2017 revenues to USD1.47 billion over Q2 2017, and
- Consolidated debt as of September 30, 2017 declining to USD3.59 billion, around USD1 billion lower than USD4.56 billion as of June 30, 2017
Asian commodity traders like Olam International and Noble Group and agri-business companies like Golden Agri Resources, Wilmar International and IOI Corporation seem to have a higher risk appetite than the global majors like Archer Daniels Midland Co (ADM US) and Bunge Ltd (BG US), who manage their working capital cycles efficiently. Hence, Archer Daniels Midland Co and Bunge Ltd maintain moderate financial leverage, i.e. the ratio of lease adjusted debt to EBITDAR (the sum of EBITDA and operating lease rentals) despite earning wafer thin EBITDA margins.
The following insights demonstrate how leverage may be understated by deducting RMI from consolidated debt.
- Golden Agri Resources: Robust Q1 2017 Operating Performance; High Financial Leverage Sustained
- Wilmar International: A Hold Based On Stable Margins & Agricultural Commodity Prices
- IOI Corporation Berhad: Why Sell This Investment Grade (?) Issuer’s Stock?
Issue # 4: The Emperor’s New Clothes aka Acquisitions
Expensive, debt-funded, and unremunerative acquisitions have contributed to the weakening, if not downfall, of several well-regarded corporates. If companies treated such acquisitions (which companies have an amazing knack of making, at the peak of the price / business cycle) as associates, then the share of net income is reported in the income statement (once again…) and the dividends from associates in the cash flow statement.
While we analysts comment about the trend in the share of net income from associates and its impact on accounting profits, we seldom document the dividends these expensive acquisitions generate.
Issue #5: Opaque Investment Portfolios
Blue chip corporates and conglomerates including Genting Bhd (GENT MK) and Tata Group (1396Z IN)grow their financial investment portfolios over time. While the accounting policies of these companies comply with the requisite accounting standards, the disclosure regarding the composition and returns from these investment portfolios is inadequate. My guestimates indicate that the return from these investment portfolios may at times be lower than the CFO margin and weighted average cost of capital.
“Genting Berhad: GITP & Las Vegas Projects Offer Upside Potential To This Stable Stock” highlights this gaming focussed conglomerate’s loss making investment portfolio.
We analysts could sharpen our analysis in several other areas. Do highlight such issues by commenting on this insight. I’ll be happy to write a sequel to this insight analysing these topics.
Institutionalised Quirks for Analysts to Ponder
by Nandini Vijayaraghavan, CFA – Finsights Research
Independent insight posted on Smartkarma 21st November 2017
Read more of Nandini’s work by clicking here!
