Tongaat Hulett in ICU: too sweet to fail
The outstanding measure for companies with high debt is return on capital employed
FUND MANAGERS, analysts and the general investment public will continue to wonder how they could go so wrong on Tongaat Hulett and Steinhoff. Were there any red flags popping up that should not have been ignored?
It is important to measure a company’s profitability and the efficiency with which the company’s capital is used. Furthermore, the trend in profitability and efficiency is essential as it gives an indication to where the company might be heading.
Various measures are used, but to me the outstanding measure for companies with especially high debt levels is the return on capital employed metric, which consists of two metrics: earnings before interest and tax or operating profit, and capital employed with the latter being the sum of shareholders’ equity and total borrowings.
When analysing any company with significant operations offshore such as Tongaat with operations in Zimbabwe and Mozambique, working capital and the company’s overall capital are often skewed by currency movements.
After “normalising” Tongaat’s capital with the foreign currency translations it is evident that the company’s return on capital employed dropped from its range in 2010-2014 around 12 percent in 2014 to 6 percent in 2016.
While the trend was similar to that of industrial companies as measured by Iress’ Financial Analysis System the quantum or impact on Tongaat was more severe.
It meant that Tongaat’s profitability and efficiency fell by nearly 50 percent compared the aggregate of industrial companies’ 40 percent from 2010 to 2016. Tongaat’s return on capital employed edged up briefly in 2017, but continued the down trend in 2018 while the market’s return recovered.
The interim results for the 2019 financial year, published in November last year revealed that, on an annualised basis, the return on capital probably fell below 5 percent.
A company’s financial position or financial health is reflected in the shareholders’ interest and consists of share capital, share premium, retained income and other reserves. It is also the comfort zone for lenders to the company.
I do not want to speculate whether accounting policies or other possible wrongdoings may have inflated Tongaat’s shareholders’ interest, only time will tell, but it is evident that the company’s shareholders’ interest, excluding minority interests and adjusted for foreign currency translations, saw healthy growth from 2012 to 2017, but tanked thereafter. So much so that, as I call it, the “debt death cross” happened. When the company’s 2019 interim results were announced it was evident that Tongaat’s short- and long-term borrows exceeded the adjusted shareholders’ interest.
When I compare the trend in Tongaat’s adjusted shareholders’ interest with the share price, it is evident that the market did not buy the company’s financials since 2013. The 2018 financials were the final straw that broke the camel’s back as their scepticism came to fruition. The debt death cross was the final nail in November last year.
It is unlikely that Tongaat can service the debt with borrowings exceeding the adjusted shareholders’ interest, while the return on the adjusted capital employed is below 5 percent.
It is clear that there were red flags, but so we all learn in an ever-changing environment.
I have no doubt that Tongaat will survive, they just have to. If the PIC and other lenders could rescue Edcon, there is no justified reason why Tongaat should be the exception. Tongaat needs to be allowed to sort things out, but most importantly, management and labour need to buy into new or changed business models.
Thousands of jobs are on the line and the ripple effect can be enormous – not only in South Africa, but also our neighbouring countries, Zimbabwe and Mozambique. The socio-economic impact of such lay-offs is vast.
According to studies in the mining sector at least 10 people are affected for every job lost. Not only are direct dependants affected, but also the micro-economic environment, such as shops and transport where those people live. The entire workforce, including management and directors, have lost significant assets as share incentive schemes effectively went bust. The socio-political fallout could be even worse as despair and desperation have no boundaries.
Yes, there is hope. Tongaat will most definitely survive the storm. What is true, though, is that the market is never, or at least most of the time, wrong. What happened at Tongaat and others recently should be a lesson for all – analysts, fund managers and individual investors as well, not even to mention company directors. Listen to what the market says!
My sources are based on company reports, own calculations and research.