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