Cash flow check on accounting

Cash flow from operations or free cash flow?

Pardon the technical post and the prosaic title, but I hope it will explain why I rejected Smith & Nephew but retain Castings in the Thrifty 30. Smith & Nephew makes human parts (replacement knee joints for example) and Castings makes car parts, like steering knuckles.

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Frustration

One month in the life of the Thrifty 30

November was such a frustrating month. Every new idea crumbled into dust. The result: £7,500 of the Thrifty 30 portfolio in cash and one demoralised investor.

I started with high expectations. The addition of Smith & Nephew would be a departure. Valued by the market at £500m, it’s ten times bigger than any the companies in the Thrifty 30. It’s also expensive, trading at nearly three times book value.

Investing in a company like Smith & Nephew requires supreme confidence in the business, because it must remain highly profitable to justify its price. Assuming the accounting value of the company is accurate and we require a 10% return, we can say that a company must earn a return on equity of nearly 30% in a typical year to be worth paying three times book value.

It’s possible. Smith & Nephew’s median return on equity over the last ten years is 28% and it’s a market leading supplier of endoscopy devices used in minimally invasive surgery and devices to manage wounds like pressure sores. Its biggest division supplies replacement joints, like hips and knees, a competitive but still lucrative market. Since its products are targeted at the elderly and people with sports injuries, it has growth credentials.

Although Smith & Nephew is having to cut costs and relocate manufacturing to low-wage economies to stay competitive, the resulting concern of investors, might, I hoped, be an opportunity to buy shares Warren Buffett style, in a great company at a fair price.

But it failed at the final hurdle; free cash flow. Profits are adjusted and can vary dramatically from the amount of money that flows into a company’s bank accounts in a particular year. Over long periods though, the differences between net profit and free cash flow should roughly even out as, for example, the cost of plant and machinery bought in one year is depreciated, deducted year-by-year as it is used.

In fact, Smith & Nephew’s median free cash flow return on equity (13%), although improving, is far lower than the 28% accounting return on equity and although my measure underestimates free cash flow, published accounts rarely contain all the information required to calculate it, the size of the discrepancy is sufficient to worry me.

I’m also nervous about profitability at three other stars of the ‘naughties’, shipbrokers Clarksons and Braemar Shipping Services.

I don’t usually allow the parlous economy to put me off an investment, often that’s why shares are cheap, but the 2000’s was a period of unprecedented globalisation fuelled by Chinese production and Western consumption that in turn fuelled a huge boom in shipping.

It seems most unlikely the next decade will be as profitable for shipbrokers. Their profits are already under pressure as a glut of ships forces charter rates down and makes shipowners and shipbuilders more cautious. History shows that down swings in shipping can last decades, which would test even my patience. That said, Braemar is encroaching so deeply into bargain territory that the new reality may be factored in the price.

And that’s really the positive ending I’ve been searching for as I’ve been writing this depressing dirge. They’re all good companies, so time spent researching them now is not wasted. They may not be cheap enough to add to the portfolio today, but they probably will be one day, and if that’s the case, the payoff is merely delayed.

Smith & Nephew out on a technicality

Screens well…

I’m fed up of companies that screen well but don’t stand scrutiny. The latest is Smith & Nephew, which looked like a shoe in, but, having painstakingly plucked the numbers from its last nine annual reports I feel, well, puzzled, and lacking in confidence about the quality of its earnings.

Skipping over shareholders’ wealth, which has compounded lucratively over a decade at an average rate of 23% a year:

And the breakdown of return on equity, which shows net profit margins consistently around 16% and variable, but currently relatively low levels of indebtedness:

To the chart that’s convinced me not to invest in Smith & Nephew for now. It shows return on equity, and the troublesome line is the thin blue one:

Free cash flow return on equity is the statistic that potentially undermines all the others because free cash flow is a check on net profit, and net profit is a key factor in all of the other statistics I’ve just mentioned and the earnings yield I use to gauge the company’s valuation.

In any single year net profit and free cash flow can differ enormously since cash flow measures the movement of money into and out of the company’s bank accounts but profit is adjusted so that revenues and costs fall in the periods over which they impact the company. For example the cost of expensive machinery is depreciated, or spread over the period in which the equipment will earn the company money. If it were not, and the entire cost was born in a single year, the company’s results would give a false impression of its underlying performance.

Over a long period of time, free cash flow should be roughly equivalent to net profit. If it’s not, then there may be something suspect about the accounting adjustments and its prudent to assume average free cash flow is a more accurate measure of the company’s returns.

Do that and Smith & Nephew’s earnings yield is 7% if we assume last year’s free cashflow return on equity of 20% is typical, and just 4.5% using the median free cashflow return of the last ten years.

Suddenly Smith & Nephew looks less attractive. The earnings yield implied by its return on equity is closer to 11%.

The moral of this story is to check a company’s free cash flow history before going to the trouble of profiling the company in more detail. I didn’t think that was possible, but I’ve just noticed Sharlockholmes has added free cash flow per share to the ten year history of each company.

This can easily be compared to earnings per share to see if the former is consistently and significantly below the latter.

Free cash flow joins operating leases and pension deficits as factors that, by their omission, can fool my screens into ranking a company as cheaper, and stronger than it really is.

Smith & Nephew needs transplant

Half hidden, half champion

In its third quarter results last week Smith & Nephew reported shrinking margins in its Orthopaedic division, the result of tightening healthcare budgets in developed countries and selling highly specified products in developing countries when cheaper products would be more profitable.

Since Orthopaedics earn the company just over half its revenues, it’s a serious problem, and the company’s response is to cut $150m in annual costs, partly by transplanting some manufacturing to low-cost economies, and partly by combining the Orthopaedic division with its Endoscopy division.

With the company under pressure, I think there may be an opportunity to add it at a relatively cheap price to the Thrifty 30 portfolio.

I hesitate to utter the words ‘competitive advantage’ after my recent scepticism , but Smith & Nephew has many of the credentials of a hidden champion. It’s big, but not massive, focussed on specific market niches, global, and claims to be a market leader in some respects.

The numbers, straight from one of my screens (data source: Sharelockholmes.com, 1 Nov) are:

So, consistently high return on equity (the company targets 24%) and relatively low gearing. Exactly what you’d expect from a Nifty share at first glance. Maybe it’s worth 2.7 times book value, the implied 11% earnings yield puts it in the buy zone, just.

The Smith in Smith & Nephew is Joseph Smith, who opened a Chemists shop in Hull in 1856. The Nephew was his nephew, he took over forty years later. The company grew into a medical conglomerate and in the 1990s it rationalised. Today it’s a medical device company specialising in:

1. Orthopaedics (2010 revenues over $2bn): for example knee and hip implants and therapies
2. Endoscopy (2010 revenues $855m), minimally invasive surgical devices.
3. Advanced wound management (2010 revenues $912m), devices that speed healing and prevent infection.

Although Orthopaedics is the biggest division, it operates in by far the biggest market so, according to Smith & Nephew its market share is just 11%. It competes against big names, Zimmer, Stryker, Biomet, and DePuy, a Johnson & Johnson company. Hermann Simon identified all four as hidden champions in his book Hidden Champions of the Twenty First Century.

Zimmer, DePuy  and Biomet are based in Warsaw Indiana (pop. 12,145), the ‘orthopaedic capital of the world” and Stryker is 80 miles away in Kalamazoo, Michigan. Strong local competition can drive companies, like athletes, to greater performance and give the cluster a competitive advantage over rivals further afield. Smith & Nephew’s orthopaedic division in Memphis is 600 miles away, and there can’t be too many champions since market leadership is a criteria.

The bad news is even the orthopaedic champions are struggling. Stryker recently announced a 5% cut in its workforce, which it blamed on a soft market for orthopaedic joints and a new medical device excise tax.

Smith & Nephew’s relatively weak position in what appears to be an increasingly commoditised market may help explain why it’s succumbing to pricing pressure in Orthopaedics, but not in Endoscopy and Advanced Wound Management, markets in which it claims 22% and 18% market share respectively.

All three divisions operate in what are conventionally regarded as growth markets. Hip replacements and devices for treating pressure sores, for example, benefit the aged, and its endoscopy products target sports injuries.

On its web pages describing the Endoscopy and Advanced Wound Management divisions, the company emphasises training, product support, and collaboration with medical staff in product development, which are typical hidden champion strategies to add value and embed products in their niches.

If I add this half-hidden half-champion to the Thrifty 30 it will be a rare occasion. The first time I’ve added a company valued at more than £500m by the market (its market capitalisation is nearer £5bn – and that’s not a typo Mr Monevator), and only the second or third time I’ve added a company at more than twice book value.

But I’m getting ahead of myself. I want to have a closer look at the last ten years.