Cash flow and paper profits

The Transmile debacle has reminded investors to get back tobasics in placing priority on the quality of earnings growth. Companies are expected to produce free cash flow, not just profits on paper. 

IT was a pleasant surprise that even though Transmile Group Bhd's share price fell 33% on Friday, it did not shake sentiment in the overall market. It was right to treat it as an event specific to that stock only.  

The Kuala Lumpur Composite Index rose almost 1% although there was turbulence not only in the local air freighter company but also in China where stock markets continued to swoon. The benchmark index fell 2.6% at the Shanghai Exchange and 4.9% at the Shenzhen Exchange on Friday.  

The interim findings of Moores Rowland Risk Management Sdn Bhd that Transmile's revenue for 2006 and 2006 could have been overstated by RM530mil took everyone by surprise. The list of its largest shareholders reads like a who's who of foreign institutional investors, and as recent as February, there was a target price of RM18.00 a share by an analyst.  

No one suspected that something was amiss. After all, Transmile has been reporting increasing levels of profits for more than two years. 

One figure that may have put investors at ease was that the bottom line of Transmile's cash flow statement was in the black in the last two years. Its cash increased by RM97mil in 2005 and RM155mil in 2006. All of that came from sale of new shares, but that was considered a smart thing to do since its share price was rising.  

Even its increased receivables of RM380mil in 2006 compared with RM110mil in 2005 did not raise eyebrows because its revenue rose even more - by RM440mil. The problem now is that most of that revenue may have to be expunged. 

Receivables are often where the early symptoms show up. This was observed before in more acute affairs in the last two decades, mainly in smaller companies where high receivables were eventually written off as bad debts. The companies then faded away, and got de-listed. 

This time, there was so much more publicity, even though the situation was not as grave as those earlier cases, because Transmile had become a big company with a market value of RM3.5bil at its peak.  

More importantly, there was a relatively new major shareholder, the Kuok group, which played the role of whistle blower.  

In many cases, problematic numbers show up as receivables because increases of revenue and profits on the profit and loss (P&L) account have to appear somewhere on the balance sheet which states the assets and liabilities.  

Increases in revenue and profit should show up as cash on the balance sheet. If they did not show up as cash, they would appear as receivables.  

This episode in Transmile is a wake-up call for investors to pay more attention to the balance sheet and cash flow statements, instead of entirely on the P&L account in valuing a stock.  

Obviously, the quality of a company is higher the greater its ability to generate cash, which raises its potential to increase dividends.  

Taking it a step further, if the value of a company is the total amount of free cash flow it can generate over the years, after deducting a discount for getting the cash in future instead of now, it is free cash flow that determines the value of a stock and not its profits on paper. If a company perpetually declares profits but no free cash flow, it can be argued that there is no value in its business.  

As an accountant was heard telling a distressed creditor why his profitable company could not settle its bills, “profit is not cash flow, you know.” A rule of thumb, fund managers said, is that receivables should not rise faster than revenue, and over time, the cash position should roughly track that of revenue growth.  

A complication arises if it involves a growth stock. Companies that are rapidly expanding tend to have negative cash flow, or even losses, in their early years. It is important that cash flow was negative because of investment in productive capacity, and not increases in receivables.  

Ultimately, the accounts of listed companies must be reliable or no valuation - and no investment - can be done.  


Growing with giants 


This may not be the right week to talk about high growth stocks, in the midst of the Transmile episode, but high growth reflects proficient management in an industry experiencing favourable economics.  

Two companies that stood out with exceptionally high growth were Coastal Contracts Bhd and RCE Capital Bhd.  

Coastal Contracts was listed in 2003 as a builder of tugs and barges. It is owned by the Ng brothers who are mechanics by training, with no airs about them. It is probably the only listed company in which executive directors are described in the annual report as having completed only Lower Certificate of Education (LCE), or Form Three.  

These directors are the type who can fix or build anything mechanical. In other words, they were grease monkeys, not corporate guys. For many years, some fund managers have said the country needs more technicians than graduates.  

Proving that thesis right, Coastal Contracts is one of just a few successful shipbuilders for the oil and gas industry.  

Soon after their company was listed, the Ng brothers learned to build anchor handling tugs (AHTs) that are far more expensive than ordinary tugs and barges.  

Their ability to scale up the value chain just before a boom in the oil and gas industry enabled the company's net profit to increase by 122% to RM35.5mil last year.  

In its latest results, Coastal Contracts reported a 119% increase in its first quarter (Q1) earnings to RM15.1mil, with cash rising by 49% to RM43mil. The company is expected to continue to register very high growth rates, even if not as high as last year.  

Its order book continues to expand, which indicates that business is still brisk. Coastal Contracts said in its Q1 results that deposits from vessel buyers amounted to RM96mil, up from RM36mil six months before.  

The company was listed less than four years ago. It had a market value of RM170mil in early 2004 that has since increased to RM850mil.  

Given a few more years, it may get to the size of one of its Singapore peers, Labroy Marine Ltd, which has a market value of S$2bil or RM4.6bil.  

RCE Capital gives small loans, without collateral, to civil servants through co-operatives with which it linked. The company saw its fourth quarter net profit rising 118% to RM15.9mil while earnings for the full year ended March 31, 2007, surged 220% to RM63.4mil.  

RCE does not have to look very far to see the current size of the market. Bank Rakyat, the co-operative bank which is engaged in the same business, made a net profit of RM561mil last year.  

There is one major difference, however, between the two. Bank Rakyat can collect deposits for its lending activities whereas RCE does not have a deposit base.  

RCE raises funds from the money market. It raised RM420mil in 2005 through an issue of medium-term notes with which it on-lent at higher rates to its customers. Thus, it has high borrowing levels that stood at two times its equity, which is not high for a lending institution. Banks typically lend up to about seven times their equity.  

Furthermore, RCE faces much less risk in its debt assets than banks because civil servants repay the loans through salary deduction. RCE experiences a very low default rate. It is therefore safe for it to expand and that is seen in its loans growth, with receivables rising 40% from Q4 last year to RM369mil in Q4 this year. Goldman Sachs saw this potential too and, with additional share purchases at the end of last month, raised its stake to 8.3% in RCE. 

 TRANMIL :  [Stock Watch]  [NewsCOASTAL :  [Stock Watch]  [NewsRCECAP :  [Stock Watch]  [News]

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