DEBT RISK Mediclinic,
DEBT RISK Mediclinic, Tongaat, Famous Brands, Aspen… Discovery? When cash flow signals risk Royce Long, Portfolio Manager, Obsidian Capital 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: Source: Discovery 2019 Interim Results 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 FY 2017 FY 2018 H1 2019 Profits from Income Statement 4,495 5,735 2,326 Non-cash items (648) 782 472 IFRS to EV adjustments (3,419) (4,182) (2,222) Cash flow before Investing & Financing 428 2336 576 Cash conversion ratio 10% 41% 25% 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. ■ 24 www.bluechipjournal.co.za
ADVERTORIAL A culture of respect Obsidian is invested in its investors Investment returns are driven by many different factors, some predictable, some not. Knowing what works in the long run, and how to make provision for what you can’t control, comes from spending years engrossed in the fascinating machine that is financial markets. Richard Simpson and Royce Long, who founded Obsidian Capital in 2007, have been managing money together for 25 years. Prior to the entrepreneurial leap to start Obsidian, they were both an integral part of the team that built RMB Asset Management into an institutional business. Their journey at RMB was an experience they both treasure deeply because of the varied investment strategies they were exposed to, setting the foundation for the multi-asset investment philosophy that they live by today. Testament to their belief of diversifying across asset classes is their significant personal wealth invested in the funds they offer to investors. The Obsidian team that supports Richard and Royce share this belief and are also invested alongside those who have partnered with us. We are first and foremost an investment business concerned with generating returns in excess of inflation for our investors. However, our desire to protect capital means that we place substantial weight on managing the risk we have in our portfolios, remembering always that what happens to investors’ money, happens to ours. Our culture is one defined by respect – respect for our investors, for the market, and for each other. ■ Strictly speaking, they’re both birds. Hedge funds are often treated as one homogenous group yet one fund is to another what a pigeon is to an eagle. At Obsidian Capital, we choose to focus less on titles and more on track records. For 11 years our Multi Asset Hedge strategy has not had a negative calendar return, delivering on its objectives to protect capital, even when losses were common. To discover more about what makes our hedge funds a viable option, visit us at www.obsidiancapital.co.za or call us on +27 (11) 219 6311. Obsidian Capital is an authorised financial services provider.
