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Issue 174, 27 April 2005

Investor's College Sweeping for corporate landmines It is not always possible to see a corporate disaster before it strikes, but here are some pointers that should make it easier. Failure and success are the yin and the yang of capitalism: without one, you can’t have the other. And if it was always easy to tell them apart, then you’d only ever have successes. So when we’re asked how to spot companies that are about to go bust, as we frequently are, we have to shrug our shoulders and admit that it can’t be done with any certainty. But it’s the wrong question to be asking anyway. Everything has a price, after all, and the better question is: ‘How do I balance up the odds of a company going broke?’ And this is where we can provide some pointers. So in a three-part series, we’re going to look at some of the ‘landmines’ that can point towards impending corporate blow-ups. We’ll set the scene with some fundamental guidelines, before continuing in the next issue with more specifics. Finally, in the third part, we’ll look at how things stand for some of the current crop of sickly companies. Basic tool The basic accounting tool for assessing liquidity is something called the ‘current ratio’. This looks at how well a company’s current liabilities are covered by its current assets (generally speaking, cash, receivables and inventory). A current ratio of more than one tells you that a company has more current assets than current liabilities and should therefore be able to stay afloat this year— if it sells its inventory, and if it collects its debts. The trouble is that these are very big ifs. So the ‘quick ratio’, which excludes inventory, was introduced. A quick ratio of more than one tells you that a company can keep its creditors happy this year even without selling any inventory (assuming it is able to collect its debts). By following this to its conclusion, you find yourself asking whether a company has enough cash sitting in its bank account right now to pay a year’s worth of debts. But that’s not necessarily very useful information, since most companies will be generating more cash as the year progresses, to a greater or lesser extent, and that’s the real key to them staying afloat. Woolworths, for example, routinely trots along with more in the way of current liabilities than it has in current assets. In January this year, for example, it had a current ratio of 0.83 and a quick ratio of just 0.24. Yet no one is suggesting that it’s about to go bust, because we know it will sell its current inventory many times over in the coming year, generating more than enough cash to pay its debts. Perhaps Woolies is a special case but the truth is that, to some extent, every company will prove to be a special case for the simple fact that these tests are measuring the wrong thing. What matters is not so much the existence of assets on a company’s balance sheet, but rather its ability to turn those assets quickly, reliably and frequently into cash. It’s by focusing on these things that we’ll find our landmines. Not surprisingly, the companies that have the most trouble generating cash are the weak companies in the toughest industries. And that’s your first warning sign. Henry Walker Eltin was a me-too operator in the notoriously tough contract mining and engineering game. In issue 122/Mar 03 (Sell/Switch to Leighton Holdings— $0.69), we contemplated an economic Mr Universe competition, with the likes of Westfield on the podium, and noted that ‘Henry Walker Eltin would stumble in among the very last of the tail-enders’. For the years 2001-2004, it averaged an annual return on capital employed of just 3.9%; and operating margins weren’t much better, averaging 5.2%. If you combine low margins with a capital-intensive business, then you have a recipe for disaster. Another example Ion is another case in point, operating in the formidable vehicle-parts manufacturing sector. As the company implemented its acquisitive strategy, which saw revenue grow from $152m in 2001 to $711m in 2004, the numbers that matter had been going the other way. Operating margins (see Shoptalk below) tracked downwards from 16%, to 13%, 12% and then 2% in 2004, and return on capital employed (see Shoptalk below) came in at 29%, 18%, 11% and finally 2%. This one was perhaps harder to see coming, as businesses with poor economics had been added to the mix,

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revealing a relatively short track record. And we made the mistake of thinking that an impressive management team might turn things around, although we noted in issue 164/Nov 04 (Hold— $1.11) that ‘you should only hold on the understanding that this turnaround is undoubtedly speculative’. With hindsight, we should have paid more heed to Warren Buffett’s view that ‘with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact’. So going bust generally isn’t something that happens suddenly; in most cases it’s more like a death of a thousand cuts. Poor performance combined with poor industry economics just gradually suck the cash and the life out of a company. In the next issue we’ll take a closer look at the death throes— such as capital raisings, dividend cuts and rising inventory levels— which can signal that the end is drawing near. But it’s important to note from the start that the seeds of corporate collapse are typically sown well in advance. When the industry dynamics are poor and deteriorating, desperate last-minute attempts to patch things up are likely to prove nothing more than an exercise in pushing water uphill.

C o p y r i g h t © 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.

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