You don't need hindsight to be wise

Hindsight is a wonderful thing, but if we look at some of the big share price blow-ups that we have seen then I think it's fair to say that, in many cases, the signs of trouble were already well entrenched. I am going to look at some recent examples and show you that the red flags were already waving all over them.

If you want to read more about spotting signs of trouble then I thoroughly recommend picking up a copy of Tim Steer’s excellent book The Signs Were There.

Kier Group

Businesses that are backed by contracts are supposed to offer some peace of mind to investors. Provided the contracts are won at the right price and managed well then they are supposed to give rise to predictable profits and cash flows – something that investors tend to like.

The experiences of Carillion and Interserve show how a contracting business managed badly can end in tears for its shareholders. It seems that Kier Group (KIE) is following suit and its share price is down by more than 80 per cent since the start of 2019.

Yet arguably, all the warning signs of potential trouble ahead were there and that the risks were very high. First and foremost, Kier has long been a low profit margin business. Profit margins represent a buffer between profit and loss. Good businesses tend to have high profit margins and poor ones do not. A low-margin business can quickly become a zero or negative margin business if trading takes a turn for the worse.

Kier also tried to grow by buying companies. This is often a big red flag and can be used to mask weak underlying growth.

The money spent on acquisitions led to a big increase in Kier’s total borrowings. Even though the company had substantial cash balances on its year-end balance sheet these are often not representative of cash on hand throughout the year and can be used as window dressing.

A consistent red flag has been Kier’s volatile operating and free cash flow performance.

In some years the business has not produced any trading cash flow at all, which is not good when you have interest bills to pay and investments to fund. Free cash flow per share often lagged earnings per share (EPS) by a significant margin – a key sign that something is often amiss.

These warning signs were all hallmarks of a poor quality business. I was not shocked when the company announced this year that its strategy had backfired and that high debts, poor acquisitions and weak cash flow had landed it in a mess. The dividend has been scrapped, the share price has collapsed and shareholders have had to provide more cash to try to get the business back on an even keel.

Ted Baker

Ted Baker (TED) shareholders have had a year to forget. Its problems have been related to the conduct of its founder and increasingly difficult trading conditions. This week, the company announced that the value of its stock (inventories) has been overstated to the tune of £20m-£25m.

Again, this should not have surprised anyone who had looked at its accounts in recent years and performed the simple calculation of comparing its stock levels with its revenues or turnover.

A rising stock-to-sales ratio is often a sign of a business in trouble and of one that is struggling to shift its stock. The risk is that if stock stays unsold for too long it has to be written down in value. Ted Baker’s ratio in recent years was a big red flag that something was not quite right.

Aston Martin Lagonda

It’s difficult to know where to start with Aston Martin Lagonda (AML). I wrote about its IPO in October last year and raised several red flags. Most notable was its extremely frothy valuation, which was at a big premium to Ferrari and implied expectations of rapid profit growth that was always going to be difficult to achieve.

Aston Martin Lagonda

Sources: Aston Martin, Investors Chronicle

The company had a chequered history, having been declared bankrupt many times and was losing money as recently as 2015. Yet somehow this business was going to transform itself from a niche manufacturer into more of a volume business in markets it hadn’t been in before, such as SUVs.

A close look at its accounts in the IPO prospectus and you could see that the company was capitalising virtually all its research and development expenditure, which looked a little bit aggressive. This meant that while appearing to be profitable, the company was not generating any free cash flow but would apparently generate shed loads of it very soon.

Throw in the fact that private equity investors were selling out – and with none of the IPO proceeds being reinvested in the business – and the foundations were being laid for much disappointment.

And so it has proved. Despite rallying hard over the past month, the company’s share price is down 58 per cent in the year to date. Aston Martin is selling fewer cars than it was a year ago and the 9600-9800 cars it was aiming to sell in 2020 according to the prospectus look a little way off. The company has lost money over the past year and is expected to do so for 2019 as a whole. Analysts’ forecasts for rapid profit growth in the years ahead need to be treated with lots of caution.

How much money is a company actually making?

One of the clearest red flags that investors should be able to quickly pick up on is when there is a big gap between a company’s adjusted profits and its reported profits and free cash flow.

When a company reports its financial performance, it’s not unreasonable for investors to expect that the profit number has some resemblance to reality. Sadly, for some companies this is not the case.

For years, many companies have wanted investors to focus on their adjusted profits. This is supposed to be a profit number that most accurately reflects the true underlying performance of their businesses. It does this by stripping out one-off costs and gains that are not expected to happen again so that we can have a better feel for what is really going on.

There’s nothing actually wrong with doing this. Investors should welcome this kind of openness when it helps them to better understand a company.

My gripe is that the use of adjusted profits by some companies has been abused. It seems that certain costs that are supposed to be one-offs – such as redundancy costs associated with a business restructuring – actually tend to be regular occurrences. Here is a list of common costs we are told we should ignore:

• Amortisation of intangible assets.
• Share-based payments.
• Restructuring costs.
• Bidding costs for contracts.
• Acquisition costs.
• Losses on selling businesses and assets.
• Impairment of assets.
• Pre-opening costs or start-up losses.
• Provisions for onerous leases and contracts.

We are told that if employees are paid in shares we should ignore it. Share-based payments are in reality like wages, they are a cost that represents a reduction in value to the shareholders.

Amortisation of intangible assets can in some cases be ignored, but items such as software costs, which actually require regular outlays of cash, should not. The costs of bidding for contracts are just a cost of doing business. We are expected to count the profits made from them if they are won, but not the costs of winning them in the first place. If contracts are not won then why should the costs be ignored?

Even items such as a reduction in the value of assets or a business – known as an impairment – should not be ignored. Yes, the reduction in value is not an outflow of cash, but a reduction in asset values can reduce future depreciation expenses and boost future profits. We are told to ignore the impairment but accept the boost to future profits. Cash flows in both cases are unchanged and this is what we should concentrate on if we have the information to do so.

I think it’s a very good idea for investors to keep a very close eye on the difference between a company’s reported profits – which include all costs and gains whether they are one-off or not – and its adjusted profits and compare them over a number of years. If there is a big gap between the two numbers and where adjusted profits are a lot higher you should start asking questions as to whether the truth may be being stretched somewhat.

Bus and rail operator FirstGroup (FGP) is a company that I used to follow closely when I was a transport analyst in the City many years ago. Back then I raised concerns that the gap between adjusted and reported profits was too big and that perhaps investors should pay closer attention to what was going on behind the scenes.

In the 15 years or so since I used to write research reports on the company not much seems to have changed. In its recent half-year results, it reported a loss before tax of £187m and a loss per share of 14.3p for the six months to September 2019. However, if we were to ignore all the adjusting items, the company actually made a profit before tax of £28.8m and EPS of 2p. This was still lower than the £42m and 2.9p from a year earlier.

FirstGroup adjusted and reported profits

Sources: FirstGroup, Investors Chronicle

The issue I have with this is that FirstGroup has considerable form when it comes to the differences between its adjusted and reported profits. I have taken a look back at its financial results for the past 15 years and virtually every year sees big adjusting items and a big gap between adjusted and reported profits.

FirstGroup: Differences between reported and adjusted profits and free cash flow per share

Sources: Annual Reports, SharePad, Investors Chronicle

A better sanity check is to compare free cash flow per share with adjusted earnings per share, but this is not without its complications. This is because FirstGroup is quite a complicated business. Its rail business sees big swings in cash flows when franchises are won and lost, whereas investment in parts of its bus business can be lumpy.

All this being said, between 2004 and 2019, FirstGroup has told its investors that its cumulative adjusted EPS has been 418.7p, but its cumulative reported EPS has been 249.8p. The cumulative free cash flow per share has been 284.5p, which is almost a third less than its cumulative adjusted EPS, but much closer to the cumulative reported EPS. 

Which profit figure you choose to believe is ultimately up to you. I have no doubt that some of FirstGroup’s adjustments have been perfectly above board, but I do think there are grounds for questioning whether all of them have been.

Its accounts are a fascinating study for those of you who like to scrutinise these things. The self insurance provision on its US bus business is a particular source of interest when trying to work out how much money the company actually makes as the cash paid out to settle insurance claims has been more than expensed in its income statement for a few years now. The recent increase in the provision essentially tells us that the company has been overstating its profits in the past, but the increase has been treated as an exceptional item. Analysts and investors should not ignore this.

In the long run, the stock market is rarely kind to companies with messy accounts and FirstGroup has been no exception to this.