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QUALIPORT
Shares That Did Lose You Money

By Maynard Paton (TMFMayn)
September 2, 2002

"Any business with a severe working capital cash haemorrhage is likely to disappoint."

That was the warning given in this Qualiport article from February. The feature highlighted five companies whose working capital spelled T-R-O-U-B-L-E. Just six months later, the shares of all five firms have fallen substantially. In fact, two of the companies have blown-up big time.

To recap, cash is fact. And so, businesses should always generate 'cash profits' as opposed to just 'accounting profits'. A crucial aspect of determining whether accounting profits are underpinned by cash flow is checking movements in working capital. Companies heading for trouble often have terrible working capital characteristics, as their stock goes unsold, customers (debtors) refuse to pay and suppliers (creditors) demand earlier payment. Importantly, customers and suppliers can cause difficulties at a company long before management admits to problems. (More on working capital can be found here and here).

Here are the five companies that were highlighted, plus their six-month share price performances:

Company               Share price        Share price      Change
                        25/02/02          02/09/02          (%)
                           (p)                (p)

Health Clinic             186                16.5           -91
Innovation                236                14             -94
Minorplanet               308               117.5           -62
Sanctuary                  66                40.25          -29
Warthog                    48                21.5           -55

FTSE 100                 5100.7            4195.4           -18

Of the five, it's worth focusing on Health Clinic (LSE: HEC) and Innovation (LSE: TIG). Shareholders of both groups have heard terrible news over the past six months.

Health Clinic

Health Clinic operates 19 city centre clinics providing eye treatment, dentistry and other healthcare services. Almost all of Health Clinic's operating profits were absorbed into working capital during 2000 and 2001:

Year to 30th April                         2000   2001          

Operating Profit (m)                       1.7    2.0
Net change in working capital (m)         (1.4)  (1.7) 

Here's what happened in the last six months

June 21: Health Clinic delays publication of its annual results, pending resolution of "certain non-cash accounting issues". The issues came to light towards the end of the audit process and mean the 2002 results could show a pre-tax loss (brokers had been expecting a 4-5m pre-tax profit).

July 1: Full-year results published, showing operating profits falling from 1.7m to just 0.1m. The introduction of accounting standards UITF 34 and FRS 18 meant anticipated profits were reduced by 3.3m.

Worryingly, the results also showed working capital deteriorating even further...

Year to 30th April                         2002 

Operating Profit (m)                       0.1
Net change in working capital (m)         (6.3) 

... and net debt ballooning from 4.7m to 23.2m. Not surprisingly, the Finance Director quits.

Aug 23: Health Clinic announces the new FD has found errors in the cash flow forecasts submitted to the company's bankers at the time of the annual results. As such, the first quarter now requires an extra 3m of working capital. Revised finance package to "include a strengthening of the balance sheet through an equity issue in the near future". Expansion programme put on hold.

Innovation

Innovation is "the leading provider of high return on investment evolving leading practice solutions to the global financial services industry" -- in other words, a software company. Over 2000 and 2001, all of Innovation's operating profits were absorbed into working capital rather than flowing into the bank:

Year to 30th September                      2000   2001              

Operating Profit (m)                        3.1   14.8
Net change in working capital (m)          (7.7) (12.6) 

Here's what's happened since February:

Mar 25: Trading statement confirms positive second quarter progress with "significant" new contracts being signed. Board remains confident of meeting full-year market expectations (pre-tax profits of 40-50m) under the group's current accounting policies. Company continues to investigate a US listing and a move to US accounting principles.

May 30: Interim results herald move to US accounting standards, the general impact of which defers Innovation's licensing income to later years. For the prior full year, sales are restated from 57.7m to 43.7m and operating profits from 4.2m to 0.9m. However, on the new basis, half-year operating profits surge from 2.1m to 11.1m.

Aug 30: Innovation's third quarter figures warn of a "material risk of up to a 40% reduction in revenues in the second half". Third quarter figures show an adjusted pre-tax loss of 1.4m (versus a 1.7m profit a year ago) and the fourth quarter now expected to generate a 4-5m loss. Net cash stands at just 5m and working capital remains bad:

Nine months to 30th June                    2002 

Operating Profit (m)                       14.1 
Net change in working capital (m)          (8.4) 

News of a 350m goodwill write-off and the part-disclosure of the financial affects of acquisitions only heighten the suspicion surrounding Innovation's past accomplishments.

Conclusion

Both Health Clinic and Innovation adopted new accounting practices that had a dramatic -- and unfavourable -- affect on their reported earnings. There is a definite sense that the two boardrooms had previously used rather cavalier practices when drawing up their accounts. That accounting profits were far higher than cash generated from operations (i.e. cash flow less additional working capital requirements) should have suggested headline earnings were unduly rosy.

With Health Clinic, the delayed annual results certainly contained more signs that all was not well with its cash flow. (Bizarrely, the share price promptly jumped 40% to 99p after the results were published). A follow-up statement concerning funding problems and additional working capital was always on the cards.

And even without looking at the accounts, Innovation's performance looked too good to be true. Numerous acquisitions and an upbeat outlook when the class acts of the sector were struggling should have alerted investors. 

The key messages are simple:

* Businesses should always generate 'cash profits' as opposed to just 'accounting profits'. One way or another, any business with a severe working capital cash haemorrhage is likely to disappoint.

* Cash flow speaks louder than words. Customers and suppliers can cause difficulties at a company long before management admits to problems.

Finally, what of Minorplanet (LSE: MPS), Sanctuary (LSE: SGP) and Warthog (LSE: WHOG)? In short, recent results from each three companies have shown a continuation of poor cash flow. Needless to say, stay well away.

More: Shares That Could Lose You Money | Fool's Guide To Working Capital: Part 1 | Part 2