cof cof cof !, page-16

March, me ol' fishy on a dishy, don't worry about time. I've got lots of it...some people restore old cars, some do woodwork, some garden; I enjoy nothing more trawling through annual reports and company announcements. It's my passion. Tragic, I know.

I'm somewhat confused by your posts: an earlier post has you fretting about the company's health from the standpoint of lenders ("...its balance sheet with negative nta must be worrying to its bankers and financially literate creditors."), while your later post has you in not only ambivalent - but in opposition - to the banker's view ("I would not like to think that my approach to investment analysis is from a banker's perspective, quite the opposite").

No matter, I've tried to address any concerns about solvency, whether you harbour them or not. "Gearing", whether defined as Net Debt to Equity, Net Debt to Total Capital, or Net Debt to Tangible Equity are irrelevant for measuring the creditworthiness of intellectual property businesses such as COF. Interest coverage ratios is what counts, believe me.

Your focus on EPS is noted, but bear in mind that EPS is a direct outworking of NPAT, which is the item right at the bottom of the Statement of Profit and Loss. My considered observations have taught me that the further down the P&L one goes, the greater the propensity for accounting creativity and financial oddities. EPS is a good ready reckoner as a distillation of company financial performance, but it needs quite a lot of scrubbing and sanitising. For often, EPS can be completely useless as an investment tool.

Take for example, some of the most famous investment disasters: Babcock and Brown (BNB), Allco Finance Group (AFG), Centro Properties (CEN), and HIH.

In BNB's case, during its four-year listed history, EPS looked nothing short of stellar:
2004: 5.1cps,
2005: 77cps,
2006: 115cps, and
2007: 172cps.
Impressive, evidently. Problem was, cash flow per share told a totally different story:
2004: minus 32cps,
2005: minus 4cps,
2006: minus 21cps, and
2007: minus 136cps.
Between 2004 and 2007 BNB reported a cumulative total of $1.35bn in NPAT, yet cumulative operating cash flow over that period was negative $757m. Had investors who lost money in BNB simply undertaken a crude reconciliation of EPS to OCF per share, they might have avoided the losses.

Similarly for AFG:
2004: EPS = 20cps, OCFPS = 4cps;
2005: EPS = 32cps, OCFPS = 30cps;
2006: EPS = 49cps, OCFPS = 29cps;
2007: EPS = 64cps, OCFPS = minus 91cps; and
2008: EPS = 9 cps, OCFPS = minus 43cps
So total EPS over that period = 174cps, total OCFPS = minus 71cps. Investment Result: Unmitigated disaster.

And the reason for that was not hard to see, had the P&L been compared to cash flows. In AFG's case, most of its NPAT came from interest it "earned". Yet per the cash flow statement, physical interest income was far less that the P&L reflected, and interest expensed in the P&L was far less than the cash interest actually paid. And because it was a finanical engineer by nature, these interest items were by far the dominant feature of the P&L. The capitalisation of interest expense combined with premature recognition of interest earnings, had the combined effect of grossly overstating the P&L, renedering EPS absolutely meaningless. Yet the auditors signed off on the accounts, and investors bought the stock on those very shonky EPS numbers. Again, investment disaster.

HIH: As far as 3 years before HIH went belly-up, the indicators of trouble were clearly there to see, without having to conduct an exercise in complex forensic accounting:
1998: EPS = 11 cps, OCFPS = minus 15 cps;
1999: EPS = 12 cps, OCFPS = minus 66 cps; and
2000: EPS = 8 cps, OCFPS = minus 124cps

There are many more examples where EPS gives the wrong investment signal, and while not all cases lead to outright failure, they do ultimately result in poor investment outcomes. I can list many so-called "Blue chip" stocks that I believe fall into this category, for eg, QAN, DOW, AWC, IPL, NUF, BXB, ALL, SUN, GFF, PRY, CEU, CMJ.

All I'm arguing is that, if EPS is what one looks at, why not just undertake a quick cross check of "P&L Earnings" with cash flow. It's not an onerous exercise at all; indeed the reward-to-effort ratio is extremely high, in my view. I mean, you're going to the trouble of looking at the rate of change of debtors with revenue, which is sensational, so why don't you take a similar simple step of rigour and take a look at cash flows. In isolation, earnings don't underpin enterprise value, its the stuff that you can touch and taste and see that does: cash flow.

Back to COF, if Debtor Growth versus Revenue Growth is what matters deeply to you, then I assume you've done the exercise yourself and drawn the logical conclusions from the recent trends in COF's Receivables-to-Revenue ratio, namely:
DH2004: 18.7%
JH2005: 17.4%
DH2005: 21.5%
JH2006: 22.7%
DH2006: 24.7%
JH2007: 23.8%
DH2007: 22.7%
JH2008: 20.0%
DH2008: 16.1%
JH2009: 15.3%
DH2009: 14.1%
(all figures based on annualised revenues)

As for the thing that you say provides you consolation, namely "there was a 'becoming a substantial holder' filing by a new shareholder, who we assume did their homework!" I'm afraid I've got some bad news for you. That shareholder had been buying the stock in January and February this year, when the share price was well over $2.00 (refer to website: http://www.celestefunds.com.au/home.aspx. Go to "Offer documents and reports" and download the January 2010 and February 2010 reports under the heading: "Celeste Australian Small Companies Fund"). Sorry, but you really shouldn't believe evrything you read.

Never forget that if tortured hard enough, EPS will say whatever management and the auditors want it to say.
But cash flow never lies.

Cheers

Cameron