Checking for quality

This perfect form comprises a company with lots of customers, all of whom make comparatively small cash transactions of, preferably, non-discretionary goods or services. This makes for virtually-assured repeat business and it leads to beautifully simple accounts where accounting profits bear a close resemblance to cash profits and the balance sheet is largely free of the obfuscating items – such as pre-paid expenses, unearned revenues or accounts payable – that cloud the figures produced by less fortunate companies.

By contrast, the unfortunate ones rely heavily on a small number of big capital projects where progress payments are lumpy and true profitability may not be known for years after a project has started. True, such companies may be able to give the impression of enviable success early on. And possibly they can preserve the illusion longer than is healthy. But, in the long run, the day of reckoning will arrive when the cash that came into the business needs weighing up against the cash that left it.

The contrast between these business models comes to mind as I contemplate three miserable investments that followed closely on one another and afflicted the Bearbull income portfolio last year, costing about 9 per cent of its value. Last week I said I would discuss whether common weaknesses linked the three – oil-industry engineer Petrofac (PFC), gold miner Pan African Resources (PAF) and satellite communications provider Inmarsat (ISAT) – even as a fourth in the income fund, air-travel broker Air Partner (AIR), fell to earth.

Hence the table, which shows, in condensed form, three measures of corporate health applied to the four companies; ‘condensed’ because the single figure for each metric is an average of the most recent five years. Thus, in the case of Air Partner, the figure showing cash conversion of 120 per cent means that for the five years to January 2017 operating cash flow averaged 120 per cent of operating profits.

Of all the rough-and-ready metrics that indicate the quality of a company’s profits – and, by implication, the merit of its business model – cash conversion is the one I calculate first. Naturally, it’s a volatile figure chiefly because capital spending – a deduction against operating cash flow – bounces around. Given that, expressing five years in a single figure may give a distorted view; although, equally likely, only by averaging is the underlying cash-generating capacity revealed.

Take Petrofac, almost an identikit of a company locked into long-term projects whose real profits are difficult to gauge. If the table showed a figure for Petrofac’s average cash conversion it would have been 174 per cent of operating profits. Yet that apparently-astounding rate of conversion largely resulted from 2015’s freak performance. Cash flow – boosted by turning debtors into cash – was almost seven times operating profits shrunken by write-downs on contracts. Remove 2015 and the average for the other four years was just 51 per cent – more consistent with Petrofac’s business model and problems with old contracts.

True, when I bought shares in Petrofac I knew of the lumpiness of its cash conversion – ditto the purchases of Inmarsat and Pan African. In other words, I chose to ignore this risk, judging that other merits would make the investment worthwhile. The question is whether that was wise, assuming – of course – that poor cash conversion was, indeed, a factor in the subsequent miserable share price performance? That may depend on whether you think cash conversion can drive share prices or whether it is just an effect of things going awry elsewhere. Certainly at each of Inmarsat, Pan African and Petrofac – especially the first two – progress has fallen short of management’s plans.

The other two factors in the table, which quantify a company’s need to raise new debt and new equity, complement cash conversion. That is, when progress is poor then management can – to an extent – disguise that by raising new capital. In effect, the capital substitutes for cash profits. But that’s bad, so it pays to be aware of the extent to which a company needs to tap new capital. No alarm bells ring loudly here, although Inmarsat has steadily added to its debt over the five years and it is questionable whether Petrofac should have been raising so much new debt while it was buying in equity.

So, with these four, company-specific factors not easily distilled into a few bits of data may not have been responsible for their poor share price performance. And, in Air Partner’s case, whose share price has bounced back to 102p, the hope is that illiquidity did much of the damage to the price.

Still, health-checking the quality of a company’s profits and its possible addiction to new capital is a crucial part of the stock selection process. Which is not to say that only companies fitting the ideal business model end up in an income portfolio. Income-orientated investors just can’t be that choosy.