Richard Beddard: pandemic results feed into Decision Engine

The latest changes reflect company figures investors would never normally expect.

As companies publish their results after a full year of the pandemic, investors are squinting at figures they might never have expected.

Erstwhile stalwarts such as 4imprint (LSE:FOUR) and Churchill China (LSE:CHH) are producing negligible profits and cash flows. Because I’m pretty average at maths this has caused me to do a considerable amount of head-scratching.

The decline in the profitability of these companies is readily understandable. As I wrote last week, 4Imprint is a manufacturer of promotional goods and peculiarly exposed to the pandemic.

Not only do businesses cut their spending on marketing during tough times, but the pandemic ensured that the kind of marketing that requires promotional goods, trade shows and meetings was stymied. Even 4Imprint switched what was left of its marketing budget into TV advertising, instead of sending freebies to prospective customers.

Churchill China manufactures dinner plates for restaurants, which were closed or half open for most of the year, and I will elaborate on the impact of the pandemic on the company soon.

The reason for my head scratching is not the cause of these negligible returns, which is apparent, but the impact on the two companies’ cash conversion ratios.

Cash conversion conundrums

Cashflow measures how much money a company has earned during the year before all the adjustments accountants make to determine profit. Cash conversion is cashflow as a proportion of profit.

I use it as a confidence measure. High cash conversion, when cashflow is more than, say, 75% of profit, is reassuring. It means it is less likely that accountants are taking liberties with the numbers to arrive at a higher profit figure.

But there are many legitimate reasons cashflow can be substantially lower than profit. For example, companies that are investing heavily tend to have poor cash conversion because the entire cost of an investment is deducted from the company’s cash flow, whereas in the profit and loss account the cost is spread out over many years as the asset bought by the company, a machine say, is worn out (depreciated).

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Annual cashflow can vary a lot, so I tend to pay more attention to cash flow over longer periods.

Hitherto I have averaged cash flow, taking the mean over many years. But when I updated my 4Imprint and Churchill China spreadsheets with their latest results I got some “interesting” average cash conversion ratios.

To explain why, I will use the last two years for simplicity:

In 2020 (actually the company’s year end was 2 January 2021), 4Imprint only made $4.1 million (£2.89 million) in adjusted operating profit. Cash flow (operating cash flow minus capital expenditure) was -$2.1 million, so cash conversion was -50%.

To put that year’s result into perspective, in 2019 4Imprint made a $54.4 million profit and cashflow was $46.4 million, giving cash conversion of 86%.

The average of these cash conversion ratios, 86% and -50%,  is 18%, which gives equal emphasis to the returns made by the company in 2019 and the very small ones of 2021 (2021 was a 53-week year, which is why there is no 2020).

But a $2.1 million cash outflow is immaterial to a company that routinely rakes in many times that much cash. It only looks big in relation to profit, because profit is so small.

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There is similar weirdness at Churchill China, which made £1.2 million profit, compared to £11.8 million the previous year, and experienced a cash outflow of £800,000, giving cash conversion of -69%.

To avoid the disproportionate impact of these essentially meaningless cash conversion ratios, I have decided to calculate them in a different way, by dividing the sum of the annual cashflows over many years by the sum of the profits earned over the same period (rather than adding the cash conversion percentages and dividing by the number of years).

Sticking with the simplified two year example, 4Imprint made a cumulative $58.5 million profit and  a cumulative $44.3 million cash, giving a two year cash conversion ratio of 76%.

Making this change for all 39 firms in the Decision Engine has only changed the average/long-term cash conversion ratios for a handful of companies by more than a few percent.

Churchill China and 4 Imprint are two of them, but Jet2 (LSE:JET2) illustrates that averaging cash conversion can also put too little emphasis on years when the numbers are very large.

Until the pandemic, Jet 2, which is a holiday airline and package tour operator, had been growing profit for over a decade, but from 2015 it stepped up spending to refresh and grow its fleet with new aircraft.

Capital expenditure peaked at £474 million in 2016, which when deducted from operating cash flow resulted in a cash return of -£136 million. In subsequent years cash flow has been positive but suppressed.

Buoyed by earlier years in which cash returns were above 100%, Jet2's 12 year average cash conversion based on averaging each annual cash conversion figure remains a very healthy 87%.

The new cash conversion ratio is just 52%.

This does not mean Jet2 is a basket case. Far from it. But were I investigating Jet2 for the first time I would need to explain why I am happy to invest in a business that has only earned half its profit in cash flow.

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Of course, we know the answer: Cash flow is depressed because in recent years it has bought lots of new planes. They should last decades and generate lots of cashflow in future.

That leads to two more questions: will they generate lots of cash flow, and was the money well spent?

Due to the impact of the pandemic on the travel industry that question has become somewhat imponderable. But I expect that when I write my annual review of Jet2, the answer will be the same as it was last year, and the year before: Jet2 is rolling out its distinctive format of family-friendly holidays from UK airports and no other company serves that particular market as well. Of course it is worth it.

I would rather cite the lower cash conversion figure and have to explain it, than partially obscure weak cash flow in the average of the ratios and potentially misunderstand or miscommunicate what is going on.

This month’s scores

Since the last Decision Engine update, I have re-scored three companies: Howden Joinery (LSE:HWDN), Next (LSE:NXT), and 4Imprint.

Click on the links in the table below to see how I scored them. As usual the shares are ranked by their scores, with the highest-scoring companies at the top.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.

For more information about my scoring and ranking system (the Decision Engine) and the Share Sleuth portfolio powered by this research, please read the FAQ.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard