In 2015, I met a client who engaged me for comprehensive financial planning. But I was quite frustrated with the outcome because the client did not take up most of my recommendations. In particular, I recalled he did not take my advice to invest in a diversified portfolio. Instead, he preferred to invest 100% of his investable money in just one company.
Company X1 paid very good dividends and was a favourite among many investors. But investing into a single company is not the right way as the concentration risk is too high.At that time many other financial bloggers had already saw how bad the company was and I warned him to be extremely caution with Company X1 as many were already mentioning it was not a good company.
In this article, I would like to point out why Company X1 was a bad investment. Unfortunately, I cannot disclose the name for fear of negative repercussion. Other financial bloggers stated its name but they can do so because they are not professional financial advisers. Hence, nothing will happen to them. As I am a professional financial adviser, I will get into a big trouble with this company as what I say would carry more weight. In addition, the regulator will deem my disclosure of this company as financial advice to sell or go short on its shares. So I better not mentioned it. Disclosure: I do not have any long nor short position of this company.
I will use 2014 annual financial report[1] .
The first thing that is not right with the company was its high debts as shown below. 92% of its assets were owned by creditors.
| (Page 130) | $m (end of 2014) |
|---|---|
| Total Assets (A) | 1,315.6 (fixed) + 671.6 (current) = 1987.2 |
| Total Liabilities (L) | 1,192.9 (fixed) + 645.3 (current) = 1838.2 |
| L/A | 92% |
The second thing that was not right with this company was that its current assets were lower than its current liabilities. This means it does not have sufficient liquidity to pay off its short term loans.
| (Page 130) | $m (end of 2014) |
|---|---|
| Current Assets | 671.6 |
| Current Liabilities | 1,192.9 |
It had a pretax earnings of $456.10 million. Despite its high debts and poor liquidity, it decided to pay most of its earnings to shareholders as dividends. In fact, in the financial year ended 2014, it paid $345.2 million of dividends. This company should have used its profits to lower its debts or increase its liquidity.
Let’s look at the 2016 financial statements[2].
| (Page 16) | $m (end of 2016) |
|---|---|
| Total Assets (A) | 1,455.3 (fixed) + 741.0 (current) = 2196.3 |
| Total Liabilities (L) | 1,145.9 (fixed) +855.5 (current) = 2001.4 |
| L/A | 91% |
| (Page 16) | $m (end of 2016) |
|---|---|
| Current Assets | 741.0 |
| Current Liabilities | 855.5 |
So it appears that nothing much had changed. It is still a highly geared company and its liquidity was still an issue. Its pretax profit was $410.3 million. A check at the cash flow for financing statement (page 14) shown that it still paid $346.2 million of dividends similar to that in the past. But what has changed was that it borrowed $300 million from the bond market. What this means was that it borrowed money to pay dividends to shareholders!
I am aware that many companies do this because the cost of borrowing is lower than the cost of equity. For this company, the bond it issued in 2016 cost only 3.55% for a 10 year maturity. Indeed, its cost of borrowing is low (strangely). But this was a company that already had 91% of its assets owned by creditors. How much debt will it need to accumulate? I believe X1 is being pressured to meet shareholders’ expectation of a company that pays good consistent dividends. However, such expectation is ruining this company.
The following is a price chart on how this company was doing vs the STI index. The price chart assumes all dividends are reinvested at zero cost since 1 May 2015:
As it can be seen that the share price is going downhill despite the STI index trending upwards.
Lessons:
- Do not just focus on dividends. Total return is more important.
- Check the company’s financials to ensure it is sound.
- Do not put all eggs into a single basket. A diversified portfolio is very important.
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Haha pretty obvious who this former dividend darling is. Actually it’s free cash flow has been less than paid out dividends for past few years already. Hence big red flag for many bloggers to highlight sustainability.
Hopefully your client managed to lighten / cut his holdings during the rumor-filled run up in mid-2016.
There are still people willing to make a punt on it as a deep value / potential turnaround play. But definitely not 100% of portfolio haha!
First thing: The current and fixed liability numbers in table 1 are not correct. Kindly amend accordingly.
Second thing: There are many (some are excellent) companies (e.g. DairyFarm, Breadtalk etc.) operates with current asset>current liability as a going concerns. The reason they can do that, is because they are highly cash generative, and this is to optimize the capital structure. Whether it has “sufficient liquidity to pay off its short”, it cannot be solely judged by just looking at the balance sheet. You need to consider the business itself, competitive situation, its cash-flow and its sustainability etc..
Third thing: You need to go into more details of the company to understand what are stated as asset on the balance sheet. The asset may be understated. I don’t know, cos I did not look at the company myself.
Fourth thing: To use the borrowing to fund capex, while paying the earning as dividend. If the management in 2014/2015 deems this is more optimal use of capital, cash flow is sustainable and competitive situation is management, it may be logical and wise to do it. Though subsequently, due to the changes in the industry and competition landscape (by the regulator), those decisions are more difficult to justify now- on hindsight.
Other thing: the share price decline is probably due to the changes in industry and competition landscape, reduced in dividends etc.and not directly linked to the reasons you gave in your article. In addition, listening to financial bloggers for assessment of a company may not be a good ideas as well.
I’m not your competitor. I don’t work in finance industry. I’m just stating my comments only.
M
This company is likely a telecom company that is green in color. I think the debt isn’t too much. Do note that its group equity is so much smaller than the company equity. the reason is that in the early 2000s there was a merger between the cable business and the telecom business, thus there is much negative equity on the group balance sheet.
An analysis of the net debt to ebitda and net debt to asset might tell a different story.
Numbers don’t disclose everything. Many property companies borrowed to its hilt. Their unrealised gains from their fully sold developments may not yield them current cash flows. Meantime, they need to borrow money to continue developments until completion. It’s is only on completion, can they realise the profits which will cover most of the borrowings for constructions, dividends, and other continuing costs.
This isn’t a property developer.