“Earnings, dividends and growth rates are useful figures in investment analysis. However, like water to humans, there is an underlying element essential to the survival and success of any firm—cash flow.”

Somewhere at the end of February 2013, Success Transformer Corp Berhad (Success) announced its end of year 2012 results. Revenue and net income both jumped by 16% to RM296m and RM30.6m respectively. Earnings per share was 22.5 sen, while its share price was trading at around RM1.00 apiece as shown in Figure 1 below. At that price, it was selling at less than five times earnings.

Its share price went up with this good profit growth by 40% to RM1.40 within a year, and continues to rise after that to RM2.00 another six months later, with another profit growth to EPS of 24 sen for the financial year ended December 2013. Success is quite an illiquid stock and with some recommendations in the cyber space because of this seemingly great results, the retail investors “suddenly” realize its value and many of the transactions were done around the RM1.75-RM2.00 level. After that Success’s revenue continues to rise, with its revenue growing another 15% to RM371.4m, but net income dropped by 20% for the financial year ending 31^st December 2014. Its share price retreated as a result and closed at RM1.35 last Friday on 4^th September 2015.

If an investor has invested in Success 5 years ago at the adjusted price of about RM1.00, the total return after 5 years is still okay at about 30% now, or a compounded growth rate of 5.8%, comparable to the return of the broad market during the same period. It is still far ahead of the return of many lemons as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/67199.jsp

However, if you were to compare with the return of many good second liners companies during the same period, the return of Success falls far behind. For those who were chasing its high growth story a year ago and bought close to RM2.00 would have suffered considerable loss of about 30%.

Business background

Success is engaged in investment holding and provision of management services. The Company, through its subsidiaries, operates in two segments: transformer, lighting and related products, which is engaged in manufacturing and marketing of electrical apparatus, industrial lighting and metal products focusing on metal casing and stamping parts, and process equipment, which is engaged in the fabrication of process equipment and metal structures and the provision of maintenance, repair and shutdown works.

Past Performance

Success appears to be a successful story since its listing about 10 years ago at RM1.00. It is a high growth company no doubt with its revenue growing from RM74.3m 9 years ago to RM371.4m in 2014, or a compounded annual growth rate (CAGR) of 20% as shown in Table 1 in the Appendix. Net Income, however, grows at a CAGR of 11% from RM10.4m to RM25.8m, or 20.6 sen a share, way below its revenue. At this price of RM1.35 apiece, it is still trading at a relatively low 6.6 times its earnings. Why isn’t Success trading at a double digit PE ratio with such a high growth story? One of the answers was given by the legendary Warren Buffett.

 “Customarily, most investors measure annual company performance by looking at earnings per share (EPS). Did they increase over last year? Are they high enough to brag about? For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record EPS. There is nothing spectacular about a company that increases EPS by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way below its borrowing costs.

The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS. To measure a company's annual performance, Buffett prefers return on equity or ROE. -- The ratio of operating earnings to shareholders' equity.”

Return on Capitals

Figure 2 below, however shows a clear trend of deteriorating return on capitals.

As early as beginning of 2014 before the share price of Success shot up from about RM1.50 to RM2.00, diligent investors could already see the ROE of Success has been deteriorating unabated from 18.8% in 2009 to 13.1% as at end of December 2013, barely meeting its cost of equity, and avoided investing in Success, even though its PE ratio is about only 6 at a price of about RM1.40 then. Despite of that, the share price continued to shoot up following the high growth story.

Actually the deteriorating ROE is just part of the story, and the low PE ratio is just a smokescreen. In my opinion, it deserves that low PE valuation due to its cash flow from operations.

Cash is King

Look at Enron’s four years financial performance and cash flow from 1997 to 2000 as shown in Table 4 below with its net income galloped by 832% from $105m to $979m before it went belly up. This was one of the most talked about corporate scandals in the US in 2000s, an excellent MBA case study. Focussed on net income, profit growth and PE ratio, Enron became a darling stock and Wall Street sent Enron’s stock price soaring from about $30 to $100 from 1997 to 2000. However, from 1997 to 1999, the company burned all its revenues and required an additional $3b of capital expenses just to open its doors.

Table 4: Enron cash flow, $m

Few businesses can survive long without the ability to generate cash.

I have written a similar article before using another company as an example.

http://klse.i3investor.com/blogs/kcchongnz/78262.jsp

Basically, a business needs to pay all the expenses such as administration, marketing, workers, plant and equipment, materials etc. to produce goods and services. After deducting cash to pay for all these stuff, and sold or executed the services and receive cash, you get some cash left over from the operations, termed cash flows from operations (CFFO). The net income/profit (NI) or earnings figure, the income statement’s “bottom line,” is based on the principles of accrual accounting. Accrual accounting attempts to match expenses with revenues regardless of when the cash transactions that deal with the creation of the goods being sold and the receipt from the sale occurred. In essence, accrual accounting is not entirely concerned with when “cash trades hands.” However, over a long period of time, the profit figure should match closely the net profit figure, i.e. the ratio of CFFO/NI should average close to 100%, generally with increase in net working capital along the years, and neutralized by the adding back of the non-cash depreciation charges.

Table 2 below shows it is not the case for Success.

Table 2: Cash flow of Success

The CFFO has been always way below NI. The average of CFFO is only 43% of NI for the last 5 years, very poor CFFO indeed. What has been the problem? Let us examine Table 3 below.

Table 3: Growth in revenue and inventories of Success

The culprit as you can see is the inventories build up, mush faster than revenue growth. Compare last year and 5 years ago, revenue grows by 87% while inventories grows at a much faster pace of 309% as shown in Table 3 above. A lot of cash has been tied up in inventories, which explains its persistent shortage of cash all these years.

Another big headache is Success’s business requires relatively huge amount of capital expenses (capex) to embark on its high growth as shown in Table 2 above.

What is left from CFFO after capital expenses is the free cash flow (FCF) in the year. As you can see from the Table above, Success has not been successful at all in this respect. It has negative FCF practically every year for the last 5 years. Without positive FCF, there is no money left from the business for distributing dividends to shareholders, to invest in other profitable ventures, pay down debts, or buy back shares when they are selling cheap. Without FCF, a company has to resort to issuing more shares and hence dilute its EPS, or borrow more from the banks and making the company more risky in times of economic downturn. That is precisely what Success has been doing for the later; keeps on borrowing.

Most smart and proven successful businessman and super investors looks at more tangible metric when investing, a good cash yield, rather than the obscure earnings yield, the inverse of PE ratio.

http://klse.i3investor.com/blogs/kcchongnz/76875.jsp

Cash yield CY = Free cash flow (FCF) / Price.

Success’s CY is negative as a result of negative free cash flow (FCF) practically every year for the last 5 years.  Hence it was never a good candidate for investment since listing.

How do you like when you invest in a business, it reports profit but losing hard cash every year?

Second quarter 2015 interim report

Success has just announced its second quarter results ending 30^th June 2015. Its net income increased again by 20% to RM12.6m, or 10.2 sen per share, from the corresponding quarter last year. The company has been announcing many share buybacks recently. Were all these good news? Not until you see its CFFO deteriorated further to a negative value of RM16.3m for the two quarters, and with a further RM5.2m in capex, FCF is at a negative of RM21.5m. Not until you see the major shareholders keep on dumping their shares?

Conclusions

It is always not easy to predict if a company would do well in the future and that its share price would rise. It is much easier to see if a company is likely not to do well. Normally the writing is all over the walls in its financial statements, if you know how to spot red flags. Although investing is about the future, not the past, the economics of the business are usually clearly reflected from its past performance and the actions of the same management. It seldom changes unless the business model changes, and/or the management changes.

Investing just basing on the simplistic growth and PE ratio works sometimes, and sometimes it doesn’t work. There are more important things to look for, some of them mentioned above, which have higher predictability on your return of investment. This has been proven again and again in many academic research and from the investing experience of many truly super investors all around the world.

Do you wish to learn how and what to look for in investing in the stock market in order to have a higher probability of success in building long-term wealth? Do you wish to scout for some good stocks to invest at cheap prices now using some plausible and proven investing strategies? Please contact me for an online course for a small fee at

ckc14training@gmail.com

In Bursa, there aint no tooth fairy. The only person whom you can depend on is none other than yourselves. Nothing comes easy and without having to spend time and effort, and nothing good comes free. That is the golden rule in investing.

Happy investing.

K C Chong (5^th September 2015)

Appendix

Table 1: Revenue and net income for Success Transformer