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Against the flow

Writing this particular spreadsheet was prompted by the demise in 2009 of Aero Inventory, a much-adored company that purported to be growing like stink. It claimed a 20-fold growth in operating profits in four years, but suddenly ceased to exist when the banks that funded it woke up to the truth that they were pouring loans into a black hole.

The liquidity risk that did for Aero Inventory is highlighted simply by juxtaposing – over the previous five or six years, if possible – a company’s operating profits against its operating cash flow. In other words, it compares two measures of profit before financing costs and tax get in the way, one of which is subjective, the other based on cash flow and harder to manipulate.

This is a familiar enough adjustment. Analysts call it ‘cash conversion’ – the extent to which accounting profits also exist as cash. One difficulty is that companies often fail to compare like with like when – very conveniently – they don’t deduct capital spending from cash flow. My spreadsheet rectifies that omission. It also highlights where any deficit between notional profits and hard cash is made good. That can be done by rigorous management of working capital. More likely, the gap will be filled by new debt or equity.

It should be obvious why I am writing about companies that run a mismatch between profits and cash flow. It’s to do with the fun and games at litigation financier Burford Capital (BUR). It wouldn’t surprise me if Burford is a can of worms. Yet the point isn’t to pass judgement on it. That’s why a PDF of the Muddy Waters research sits unread on my desktop, lest it influence me. Rather, the aim is to draw investors’ attentions to the type of company that Burford might be, or Aero Inventory was.

That said, the ‘safety’ spreadsheet could have been written with Burford in mind. The company may set records for the gap between accounting profits and cash flow (see table). While operating profits rose almost eight times in the four years to end 2018, cash flow resolutely went in the opposite direction. As a result, over the five years 2014-18, $363m (£295m) of cash left the group before interest and taxes while the income statement simultaneously totted up $863m of operating profit. And in the most recent year – 2018 – the gap between profit and cash flow is a mind-boggling $543m.


Burford's profits and cash flow
year end Dec20142015201620172018Cumulative 
Case load ($m)2673385621,0921,636na
Operating profit ($m)4478124272345863
Operating cash flow ($m)-89-911-79-198-363
Divergence ($m)133871133505431,225
Net new debt ($m)1480190138180656
Net new equity ($m)0000250250
Source: S&P Capital IQ; company accounts


Add on the cost of interest, taxes and dividends, and total outflows over the five years were close to $550m, an amount that sucks up almost all the extra debt that Burford raised. In that sense, only new debt was keeping the group afloat and shareholders happy.

True, companies with vast needs for cash are not necessarily bad, particularly if they are growing rapidly. It is reasonable to expect that increasing amounts of cash will be sucked into the expanding business. And, as the top row of the table shows, Burford’s case load – what it calls its investments – rose six times to $1.64bn in four years to end 2018. That’s expansion.

A related concern is the rate at which Burford has plucked accounting profits from that case load, which it does when it assesses changes in the guesstimated end-value of cases still running. From the outside, it is pretty well impossible to judge the veracity of Burford’s assessments; as its own bosses say: “It is very difficult for research analysts to project accurately the likely investment income of the business.” Yet it relies hugely on these ‘fair value movements’ for its accounting profits – $230m in 2018, $192m in 2017 and so on.

The investment moral is that even just basic checking can hoist warning flags about companies such as Burford. Which is not to say their shares should be ignored; after all, a certain sort of investor just loves these situations. But they should be seen for what they are – ultra high risk. The presence of serene accounting profits marvellously undisturbed by the force of torrential cash outflow should tell us that.

These are the sort of shares that I would only consider buying at a steep discount to net assets, whose value – almost by definition – is tentative. In Burford’s case, the latest net asset figure is 573p a share. So, even at the current 808p (down 60 per cent from its 12-month high), the share price would have to halve, then drop some more before I would take an interest. Even then there is the issue of its corporate governance – idiosyncratic or risible? Has anyone noticed that next month all four of its four-man board solely comprising non-executive directors will cease to be independent? Still, as I say, it’s not really about Burford.