In my last article on “Profit and Cash Flows: the GOOD and the BAD” in the link below,

http://klse.i3investor.com/blogs/kcchongnz/85655.jsp

I talked about how a bad company looks like by looking at their financial performance.

I showed that Guan Chong Berhad, though with great profit and growth of its profit over a number of years, it “lost” cash as its cumulative cash flows was negative over a number of years. Worse, after spending money on capital expenses, the “loss” in cash over the years was humungous.  

Anyone knows about a little accounting, I mean simple accounting, not complicated accounting jargons, and cares to look at the details of this would have avoided investing in it when its profit appeared to be fantastic at 25 sen a share and its share price was flying high at more than RM2.00 apiece three years ago. It closed at 90 sen today on 6^th November 2015.

The other example is London Biscuits. This stock was even more dangerous as not only its earnings per share was great at 20 sen 10 years ago, its cash flows from operations was as good every year. Its share price flew up to RM2.60 more than 10 years ago.

However, as usual, if one has some knowledge on how to read financial statement, and care to spend some time on the cash flows statement, and know how to do some simple arithmetic, not complicated calculus, he would have notice that it has been losing enormous amount of cash after spending on heavy capital expenses, every year. Yes, it is every year, without fail.

Where is the beef?

London Biscuits closed at 81.5 sen today on 6^th November 2015.

Why do I talk about these two companies so frequently? Isn’t it boring to do so?

No, it is not boring to me, because these are classic case studies for a finance MBA programme on how to spot a lemon in investing. Knowing this thing will avoid investing in many similar stocks at the present which exhibit very similar behaviour.

Okay, let’s go to the more interesting stuff; how to spot GOOD companies. I am using the case of Padini Holding Berhad as an example.

Padini Holding Berhad

Padini Holdings Berhad involves in dealing of ladies' shoes and accessories, garments and ancillary products, children's garments, maternity wear and accessories. The Company principally operates in Malaysia. The Company's subsidiaries include Vincci Ladies' Specialties Centre Sdn. Bhd., Padini Corporation Sdn. Bhd., Seed Corporation Sdn. Bhd., Yee Fong Hung (Malaysia) Sendirian Berhad, Mikihouse Children's Wear Sdn. Bhd., Padini Dot Com Sdn. Bhd., Padini International Limited, Vincci Holdings Sdn. Bhd. and The New World Garment Manufacturers Sdn. Bhd.

The Padini brands of goods are widely known by the consumers and are easily available in major urban shopping malls of Malaysia. In addition, other lesser known value-for-money house brands are offered for sales in its Brand Outlet stores.

What is so good about Padini?

Everybody wear clothes, shoes, and especially women like to look pretty with beautiful handbags, fashionable dresses and shoes. Padini has been in this business for decades. For me, I have bought mostly Padini brand of pants and shirts. Its products are quite good for me, and they are affordable too. Maybe I am a little Ah Pek but I think I am not an exception. Hence I think Padini’s business is durable and likely to last for a long time to come.

The management has proven to be good too, and adaptable to market forces, proactive in improving and providing attractive product offerings in design, quality and affordability.

Let’s look at its past performance and see what the management has achieved.

Financial performance of Padini

Table 1 in the Appendix shows the past 10 years financial performance of Padini. There are a number of things we can look at to make a judgment if Padini is a good company. Once again, these are simple analysis of the financial statements, and using a RM5 calculator to do some simple arithmetic, no complicated and misleading theory or formula, and of course, no accounting jargons.

Growth

One can see there is uninterrupted growth of the top-line for Padini. The revenue grows at a compounded annual growth rate (CAGR) of 14.6% for the last 10 years. The net profit also grow by a high CAGR of 12.5% over the period. Net profit dropped a little in the last three years due to the competitions in this industry, but this net profit is still good.

The growth strategy the management is trying to use is to drive volume to compensate for the reduced margins, for example, the opening up of more affordable merchandise Brands Outlets.

Well I don’t expect the company to grow its revenue and profit in the future at such a high rate as before. It is a bonus if it still does, but I am more focus on the next few things which I place more importance.

Quality

In this respect, I look at the margin, specifically the gross margin, a metric from high up the income statement. A business should have high gross profitability. Padini has a high gross margin which varies from 43% to 51% over the last 10 years. This is a tick.

Return on capital

Padini has a return on equity, ROE of 20% in 2015, down from 28% three years ago. That is also because it equity, especially the cash has grown to RM246m from RM138m 3 years ago.

A better metric would be the return on invested capital (ROIC), which we use to gauge the whole firm, which include the debt holders, rather than just the equity shareholders, and excess cash not needed in the ordinary operations is excluded.

In the most recent year in 2015, ROIC is a whopping 40%. Padini just needs RM2.50 to grow RM1.00 in operating profit. Tell me, how many companies can do that?

Next we look at cash flows and how management makes use of the earnings and cash flows.

Cash flows

Most readers know that I tend to favour companies with high free cash flow relative to their revenue and invested capital.

As shown in Table 1 in the Appendix, cash flows from operations (CFFO) of Padini is always positive. In fact most of the time it is higher than the net profit. On average, it is 122% of its net profit. This signifies the good quality of its earnings which is converted to cash readily.

After spending on capital expenses, there is still abundant free cash flows (FCF) left behind almost every year except for one year in 2008.

It is this internally generated FCF that Padini is able to pay a good and increasing dividend from less than one sen a share 10 years ago to 10 sen per share in 2015. It is this FCF that the cash in the balance sheet is piling up, to give additional confidence that dividends payment will be sustainable in the future.

Capital Allocation

Free cash flow is discretionary spending. The management gets to decide what to do with it. I like the way Padini distributing good dividends, as it is a positive signal that the company is doing well, and I get to choose how I utilize the dividend payment, whether to reinvest in Padini shares, or other better shares, or just to use it for a holiday trip, great dinners etc.

Most of all, after the good dividend pay-out ratio averages 43% over the last 10 years, the company still has plenty of money to open up more stores, come up with new designs and products which sell. It spends an average of 35% doing that. Some of the cash are left in bank account, for example some in Islamic banks to maintain its Syariah compliance.

If the management can carry out some stocks buyback with its huge cash pile when they are selling cheap would be good. It’s because I’ve already decided to invest in this stock. Therefore, I would like the company to make more for me by doing so.

Conclusions

Compare with the previous two companies, Guan Chong and London Biscuits, it is not hard to see Padini is a much better company. It is far ahead of them in terms of past financial performance, and most likely the future too. It has high margin, high return on capitals, good cash flows, and the management has been doing an excellent job in capital allocation.

As usual, don’t get mixed up with a good company and a good investment. A good company is not necessary a good investment and vice versa. It all depends on the price you pay. That will be the next chapter.

To end I would like to bring your attention to this article put up by another i3investor forumer here on Joel Greenblatt’s advice to retail investors.

http://klse.i3investor.com/blogs/oldschool_jaejun/85792.jsp

Joel Greenblatt is one of the greatest super investors in the US in recent years with the magic Formula Investing fame. He argued that if you don’t know the fundamentals of investing, you will lose. This follows closely Graham’s philosophy of value investing.

• Do your own work
• Don’t trust anyone over 30
• Don’t trust anyone 30 or under

Do you wish to learn the fundamentals of investing, the language of business and to know how to carry out valuation so that you can have a feel the value of something to compare to the price it offers to make an informed decision, all by yourself?

Please contact me at

ckc14training2@gmail.com

K C Chong

Appendix

Table 1