Mediclinic, Tongaat, Famous Brands, Aspen… Discovery?

When cash flow signals risk

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One of the upsides of being a hedge fund manager is that excessive risk can be viewed as an opportunity, rather than a perennial enemy as it is in the long only space. Too much risk and we can take a bet against the share price. These risks come in many shapes and sizes, but one in particularly has risen to infamy of late. Its name is debt.

The first four companies that comprise the heading of this piece have all suffered as a result of over-gearing. To be sure, debt is often a necessary cog in growing a business. It only becomes problematic when the earnings needed to service it are insufficient. Eventually that hole needs to be plugged via rights offers or asset disposals – don’t hold the equity under this scenario.

SA corporates have done exceptionally well to grow their earnings in what has been an anaemic economic landscape for some years now. But one by one, these businesses are converging to the growth rate of our economy. We’re on the lookout for companies that are facing these earnings headwinds, coupled with elevated debt levels. If they happen to be highly rated, even better.

Mentioning Discovery and "short" in the same sentence may be bordering on blasphemy for some people. But there is nothing emotional about our trepidation around their earnings, and more specifically, their cash flow. In their most recent set of results, they included a shareholder cash-flow statement that illuminated our concerns. Alongside are the cash-flow figures before investing and financing activity:

The weak cash conversion ratio is what intrigues us. The valuation of Discovery clearly indicates that investors expect vigorous growth, but that magnitude of growth requires capital expenditure, and if you’re not generating enough cash then you must borrow to finance it. You can’t pay people with profits; only cold hard cash will do.

Because Discovery’s cash generation is so poor, they are having to borrow more. At the end of the 2017 financial year, Discovery’s debt-to-equity ratio stood at 26%, which has climbed to 37% as per their first half of 2019 results. If one adjusts the ratio for issues such as capitalised expenses and reinsurance – as we feel is prudent – the debt levels as per traditional measurements can be materially higher than the figures mentioned above.

There is considerable discourse among investors as to the appropriateness of how Discovery recognises its earnings. Simply put, the Discovery bulls are betting that nascent ventures like the Discovery Bank and Ping An will spit out enough cash, in the near future, to make the debt problem go away. The aggressive accounting may, under this scenario, pass by like a ship in the night.

The question the bears are asking is will these white knights arrive before investors start paying attention to what is unquestionably and unemotionally a cash-flow problem? Add to that the elevated valuation and the recent implosion of other debt-burdened SA equities that ran into earnings problems, and you have yourself what we would deem a risky situation. 

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