BIT­TER PILL

Yes, there were signs of a dra­matic fall in share price — but there is still hope, writes Nigel Dunn

Financial Mail - Investors Monthly - - Contents -

There were signs of a dra­matic fall in Aspen’s share price

In the past 12 months there’s been a fall from grace of sev­eral in­vest­ment favourites, none more spec­tac­u­lar than Stein­hoff In­ter­na­tional.

It’s dif­fi­cult to fo­cus on Stein­hoff as cred­i­ble num­bers are still out­stand­ing. Suf­fice to say, the root cause of Stein­hoff’s prob­lem lay in ha­bit­u­ally over­pay­ing for as­sets — many of them of ques­tion­able qual­ity.

It may be more prac­ti­cal to fo­cus on phar­ma­ceu­ti­cal giant Aspen, where the price has al­most halved in lit­tle more than a month.

Were there warn­ing signs? If so, what were they, and why did in­vestors miss them?

Leg­endary US in­vestor Warren Buf­fett has noted: “In­vest­ment is most in­tel­li­gent when it is most busi­nesslike.”

This quote is in­ter­est­ing in the con­text of de­vel­op­ments at Aspen, as many in­vestors view the stock mar­ket as an end in it­self. They want to make money quickly — which means price is more im­por­tant than the eco­nom­ics of own­ing the busi­ness you are in­vested in.

By plac­ing price ahead of eco­nom­ics, in­vestors have not only el­e­vated their risk pro­file — but have gen­er­ally short­ened their time hori­zons by in­ad­ver­tently be­com­ing traders as op­posed to in­vestors.

Sec­ond, in­vestors should be look­ing at their in­vest­ments as an owner would — which means fo­cus­ing on the ra­tios they deem im­por­tant, rather than those many in the in­vest­ment com­mu­nity pre­fer.

A key area of fo­cus should be ROAM or re­turn on as­sets man­aged. ROAM is de­rived from two ra­tios: the EBIT (earn­ings be­fore in­ter­est) mar­gin; and as­set turn. In short, this ra­tio mar­ries up the in­come state­ment and bal­ance sheet, which too many in­vestors view in iso­la­tion.

An­a­lysts tend to fix­ate on earn­ings and earn­ings growth (in­come state­ment) and of­ten ig­nore the health of the bal­ance sheet. Armed with a few sim­ple ra­tios, could in­vestors have fore­seen Aspen’s fall?

An­other quote from Buf­fett is rel­e­vant: “It is good to learn from your mis­takes. It is bet­ter to learn from other peo­ple’s mis­takes.”

The ac­com­pa­ny­ing ROAM graph paints a dis­turb­ing trend. It has been down for years and be­low the av­er­age for close on half of them.

Look­ing at the con­stituent com­po­nents of ROAM in the sec­ond graph — namely EBIT mar­gin and as­set turn — it shows a sim­i­lar pic­ture. Of par­tic­u­lar con­cern is as­set turn, which has fallen from 1.04 in 2004 to 0.34 in 2018.

The lifeblood of any re­tailer — be it large, slow-mov­ing cap­i­tal items or fast-mov­ing per­ish­ables — is as­set turn: that is, in­ven­tory bought or man­u­fac­tured must be sold and turned into cash at an ap­pro­pri­ate mar­gin. A fail­ure to do so places pres­sure on work­ing cap­i­tal re­quir­ing fi­nanc­ing.

For­tu­nately Aspen’s mar­gins have re­mained healthy with lit­tle degra­da­tion, while its cash con­ver­sion rate has been con­sis­tently good. This has given it some abil­ity to weather the sharply de­te­ri­o­rat­ing as­set turn.

An aside: Stein­hoff had a re­ported mar­gin of half Aspen’s (but sub­se­quently found to have been in­flated), a sim­i­lar fall in as­set turn and a patchy cash con­ver­sion rate. So it is lit­tle won­der it un­rav­elled so spec­tac­u­larly.

An­other key ra­tio is ROIC (re­turn on in­vested cap­i­tal), which seems to play sec­ond fid­dle to ROE (re­turn on eq­uity). The for­mer cov­ers the re­turn on all meth­ods used to fi­nance the busi­ness, (debt and eq­uity), and the latter eq­uity only.

Aspen’s ROIC (graph) is 6.2% vs an ROE of 27.4% — a marked dif­fer­ence. Not only is 6.2% low, it is a trend that should have con­cerned in­vestors as it has been down for years. The same goes for the large dif­fer­ence be­tween ROIC and ROE — which could only be ex­plained away by high lev­els of debt.

The fourth graph con­firms that the big dis­crep­ancy be­tween ROIC and ROE was at­trib­ut­able to debt. Aspen’s debt lev­els at year-end (June 2018) stood at 94%. In 2004 debt was zero and ROIC and ROE were both 33%. Sec­ond, it high­lights the strong cor­re­la­tion be­tween earn­ings and the debt:eq­uity ra­tio.

Aspen’s earn­ings growth has been largely ac­quis­i­tive rather than or­ganic and fi­nanced pri­mar­ily through debt. And the num­ber of shares

in is­sue in­creased from 376mil­lion in 2004 to 456-mil­lion in 2018.

So it can be ar­gued that Aspen’s largely ac­quis­i­tive earn­ings growth has come at the cost of a bur­geon­ing bal­ance sheet, which is strug­gling to earn a de­cent re­turn on the cap­i­tal in­vested in the busi­ness.

ROIC has fallen from above 30% in 2004 to be­low 7% in 2018. In essence, Aspen over­paid for as­sets, and the marked de­te­ri­o­ra­tion in as­set turn con­firms that.

Aspen’s earn­ings mul­ti­ple has fallen to 11 from over 40 in 2015. Is­su­ing shares to fund fu­ture ac­qui­si­tions on a rat­ing like this is lim­ited … if even con­tem­plated. Rais­ing more debt is also out of the ques­tion, given that the debt:eq­uity level at year-end was 94%.

The mar­ket has fi­nally wo­ken up to the fact that Aspen’s bal­ance sheet has run out of run­way to con­tinue ac­quir­ing earn­ings. So growth in the near term is go­ing to have to be or­ganic — which ex­plains the sharp fall in the share price.

The rul­ing earn­ings mul­ti­ple bet­ter re­flects the growth pro­file of the busi­ness, with the CAGR (com­pound an­nual growth rate) of 21% from 2004 to 2018 un­likely to be re­peated for some time.

The de­te­ri­o­rat­ing trends in ROAM, ROIC and the debt:eq­uity ra­tio have been ev­i­dent to any­one look­ing at the in­come state­ment in con­junc­tion with the bal­ance sheet. To claim it is a re­cent oc­cur­rence is disin­gen­u­ous. Sell­ing at cur­rent lev­els seems to be akin to shut­ting the door af­ter the horse has bolted. What now? Aspen has sev­eral things go­ing for it at th­ese lev­els. The founders, though stung, re­main pas­sion­ate and com­mit­ted to the busi­ness. Stephen Saad and Gus At­tridge still own 16% of the eq­uity. Their track record is re­mark­able: in lit­tle more than two decades they have grown the busi­ness from a sub­ur­ban Dur­ban home to one span­ning con­ti­nents, with a mar­ket cap of R70bn.

Post-year-end the Chi­nese in­fant for­mula busi­ness was sold, and the pro­ceeds will be used to pay down debt. This will re­sult in a drop in the debt:eq­uity ra­tio to 68% (94%).

The cash con­ver­sion ra­tio has been con­sis­tently good, as has the mar­gin. The de­te­ri­o­rat­ing trends in ROAM and ROIC that have pre­vailed for years ap­pear to have sta­bilised.

The com­pany has pen­cilled in or­ganic earn­ings growth of be­tween 1% and 4% this fi­nan­cial year, plac­ing the share on a prospec­tive earn­ings mul­ti­ple of 10. This is not de­mand­ing for a dom­i­nant emerg­ing-mar­ket drug play, and per­haps at­trac­tively enough priced to be­come the stalked rather than the stalker.

There are two main con­cerns. Debt re­mains high in an era where cheap money is com­ing to an end; and in which the de­fla­tion­ary forces of glob­al­i­sa­tion are be­ing chal­lenged by ris­ing na­tion­al­ism (which may well be in­fla­tion­ary).

Sec­ond, good­will and in­tan­gi­bles re­main high, jointly to­talling R78bn (R6bn and R72bn re­spec­tively).

The sale of the in­fant food busi­ness will re­duce this fig­ure slightly — but in­vestors may be more com­forted to see fur­ther steps to ad­dress the two is­sues.

Yes, there were warn­ing signs at Aspen. Many in the in­vest­ment com­mu­nity missed them — choos­ing to fix­ate on earn­ings while ig­nor­ing the health of the bal­ance sheet.

How­ever, it now seems in­con­gru­ous to fur­ther pe­nalise a busi­ness whose earn­ings mul­ti­ple has fallen to a level bet­ter re­flec­tive of its growth prospects, and one that is tak­ing ac­tion to ad­dress the ar­eas of con­cern.

Pic­ture: 123RF — KENG PO LE­UNG

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