HomeBusiness DigestOf phoney earnings and negative cash flows

Cotton price 42% lower

ON a quick glance the recent financial results from Hippo Valley Estates are impressive.

The income statement for the fiscal year to December 2009 shows net profits of US$21million from revenues of US$58, 9million. Earnings per share stand at US11c giving a historic price to earnings ratio of 7, 7x using the current price of US85c. Operating margins at 28% could make other local companies grin with envy as very few are able to cover operating expenses from their revenues.
The future for the company is supposedly good considering that the recent performance was achieved under more difficult conditions with capacity utilisation at 29% (88 122 tons produced against mill capacity of 300 000 tons). Currently the mill is “undergoing extensive maintenance and refurbishment” which is expected to improve productivity starting from the 2010 crushing season.  Capacity can be ramped up to at least 50% which could push up revenue, further improve the overhead absorption rate and consequently grow operating margins to above 28%.  On the basis of this analysis, the company can easily earn enough profit to yield a forward PE of 5x or less. This would make Hippo dirt-cheap at current levels. But is it?
Well it depends. On a purely income statement basis and the future projections highlighted in the management discussion and analysis (MD& A), the answer could be yes. But a closer look at the cash flow statement would paint a different picture. Hippo did not make as much money as shown on the income statement. In fact the company could have lost some money! The net profit of US$21,1 million is only paper money generated by accountants. Take out the income tax credit of US$4 million from the net earnings — which is a net position resulting from a deferred tax rate adjustment of minus US$8,6 million on US$4,1million deferred tax — what is left is US$17,2 million.
The operating profit of US$16,6million includes a biological adjustment of US$17,4 million for sugarcane which, if stripped out, would leave Hippo in an operating loss position. Cost of sales and operating expenses exceeded the revenue of US$58,9million. This is evidenced by the net cash from operations of minus US$444 000 compared to the operating profit of almost US$17 million. The two metrics are normally expected to be more or less the same with the difference usually being changes in working capital. 
What is also critical to note is that the sugar business is predominantly a cash business and this should also apply to Hippo’s operations. Between 2008 and 2009 trade receivables increased by only US$6,3 million which implies that in 2009 approximately US$52,6 million or 89% of the total revenue was cash. All that cash was used up in the business to cover expenses and part of the working capital leaving the net cash flows from operations in red.
More cash will be required in the current year to refurbish the mill and to fund growth in working capital. Without the fair value adjustments on the cane, operating income in 2010 is unlikely to be anywhere closer to the reported US$16,5 million even if capacity increases to 50%. Does that make the share cheap?
On the same issue about generating cash flows but at Colcom, this writer wonders why this company decided to pay a dividend when the cash flows do not seem to support that. The income statement looks good with revenues of US$21 million, operating margins of 17% and net margins of 11,3%.  But the net cash from operations was US$39 000 after working capital used up US$3,3million. The dividend payment of US$700 000 is then not coming from cash generated from operations.
It is being paid out of proceeds from sale of investments and biological assets plus short-term debt. In a market where companies are not currently under pressure to pay dividends as it is known that they are rebuilding capacities, is it reasonable to borrow and dispose assets to pay shareholders? Well, unless the major shareholder, in this case Innscor, ordered that payment.
Arguably better results this week came from Turnall which reported turnover of US$16,5 million with gross, operating and net margins of 36,9%, 15,6% and 9,3% respectively. Borrowings were restricted to US$1m (US$400 000 short term from local banks and US$600 000 drawdowns on the US$5m PTA facility) with working capital being funded largely from internal sources.
Operations generated net cash flows of US$1,7 million which is commendable bearing in mind that operating income was US$, 6 million. Unfortunately such a strong performance might pass unnoticed as many investors seem to consider company size rather than profitability when making investment decisions. 
This writer understands that businesses in the country are funding working capital using internal resources and expensive loans. Cash is spent and net cash flows from operations are bound to be negative as companies currently prioritise growing the business to building cash piles. But large earnings such as those shown on the Hippo income statement have to be backed by cash flows for them to be credible.


Ranga Makwata

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