One of the most important factors in outperforming the market is avoiding the losers.
There are several warning signs you can look out for that may indicate your company is heading for trouble. While companies can still report rising revenues, profits and earnings per share, they may still be on the slippery slope to oblivion.
9 key indicators to watch for are:
- Falling profit margins
- Negative free cash flow – paying out more in capital expenditure than it received in cash from 'business as usual'
- Frequent capital raisings
- Falling returns on equity, assets and capital
- Rising cost of doing business – costs of raw materials, employees and other costs increasing faster than revenues
- Rising levels of debt
- Falling interest cover – the size of a company's profits compared to its interest costs
- Rising or very high levels of intangible assets
- Frequent reporting of negative "one-off" items
The following companies provide ample evidence that these indicators can be used to pick the weeds from amongst the flowers. While a company exhibiting one or two these "symptoms" infrequently may not be heading to the wall, investors would be wise to consider them potential warning signs.
ABC Learning
ABC Learning was a classic example of several of these factors occurring at once. The company was reporting rising revenues, profits and earnings per share but its EBIT margin, net profit margin and return on equity were all falling.
Free cash flow had been negative from 2002 to 2007 and the company raised significant amounts of new equity every year with the share count going from 45m shares in 2000 to almost 400m shares on issue in 2007. Debt ballooned to $1.76b in 2007, eventually bringing the company unstuck.
Timbercorp
Timbercorp is another worthy example. Despite reporting rising revenues, profits and earnings per share for many years, net debt rose every year. The company had negative free cash flow for many years, and the share count doubled from 173m in 2000, to 341m in 2008.
Net profit margins and returns on equity, assets and capital employed all fell. This company stung me personally, because I failed to heed my own advice.
AJ Lucas
In more recent times, AJ Lucas Limited (ASX: AJL), has also fallen into difficulty and looking at a history of its financial statements, it's not hard to see why. The share count has more than doubled from 32m shares in 2000 to over 76m shares currently. EBIT & profit margins have been very low in a number of years, offering no protection against any bumps the company might experience.
Debt has been at uncomfortably high levels since 2005, and combined with net losses, interest cover has been dangerously low. Shares in AJ Lucas are currently trading at $1.25, down from over $6 in 2008.
Neptune Marine
Neptune Marine Services Ltd (ASX: NMS) is another recent candidate. Since listing in 2004, Neptune has never reported positive free cash flow; the company has raised equity every year, and ended up with 74% of its net assets as intangibles. The company has also had to issue more equity – it now has 1.75b shares outstanding, and each share is currently worth about 3 cents; quite a fall from its highs of over $1.50 in 2005.
Billabong
Billabong International (ASX: BBG) is another classic example. Frequent "one-off" negative items as my colleague Scott Phillips mentions in this article. Billabong has exhibited falling return on equity, assets and capital employed ratios, falling margins, rising intangible assets (106% of net assets) and rising levels of debt. The company is now in a position where it is at the mercy of predators and its bankers and either needs to sell assets, raise debt and/or equity, (or all of the above), or accept an offer from one of the bidders.
The Foolish bottom line
Reported profits, revenues and earnings per share can misrepresent the real underlying performance of the company, so it pays to read company announcements and financial reports with a grain of salt. Here at The Motley Fool, we'll try and guide you around these pitfalls.
Tomorrow, I'll run through a few companies currently exhibiting these warning signs.
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Motley Fool contributor Mike King doesn't own shares in any of the companies mentioned. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy
