In a fragile world it's important to select only the very best...

In a fragile world it's important to select only the very best companies when buying. One important criteria is a strong positive cash flow generating from the companies usual operations. IMD 1HFY12 report shows that OCF (pre-tax) of 33.2m up 121% from PCP. So clearly things looked good at 31/12/11.

However, as R. Montgomery and many other analysts have noted: 'Even a business that generates positive net operating cash flow has other hurdles to jump. Businesses have plant and machinery that needs to be replaced or purchased to accommodate growing sales. Some businesses need to acquire new premises when they grow, and some grow by acquiring other businesses. Owners also like to receive dividends and a company may also need to repay loans (although our preference is for businesses that don’t have any loans).

In the cash flow statement, these items are accounted for in the net investing cash flows and net financing cash flows sections. If net investing activities consume more cash than generated from operations, the company is like a shopaholic with a maxed-out credit card and the company will have to undertake borrowing or capital raising's to fund the gap. As an aside, the accounting for acquisitions muddies the water for the calculation of cash flows and it can be particularly difficult to determine what cash has been spent to maintain (rather than grow) property, plant and equipment.

If a company has a negative cash flow year, after money was spent on property, plant and equipment (PP&E), but the balance sheet shows that PP&E or intangibles have been growing, then you should look at the return on equity. Provided return on equity is being maintained at high levels and borrowings are not at or growing towards worrying levels, then you might look past the negative cash flow. But that is one of the few exceptions and it should be temporary.'

R.M. also notes: 'Finally, a company must also fund dividends. Ideally, a company that generates positive net cash flow from its operations uses some of that cash generated for the purpose of maintaining and perhaps expanding its PP&E, and then uses some to pay dividends. If it pays more for PP&E and dividends than it generates from operations, it will have what we call a funding gap. This indicates the company’s management have bitten off more than they can chew in that year, and they must have filled the gap by borrowing, raising fresh equity or dipping into their bank account.'


IMD made a big acquisition in early CY2012. This follows several other acquisitions made during the previous 24 months. The exceptional rise in sales combined with strong profit margins have allowed Imdex to buy-out others... but the Vaughn Energy Services was bought at a higher PE than others and at a time when world economy is looking increasingly precarious. At last year's AGM i raised my concerns that the company was acquiring too many firms and the problems and costs of consolidating these into the IMD culture etc is not to be under estimated. The Chairman raised how well Cardno had been in acquiring other companies. I agreed that Cardno (a share i have held in the past) had done every well.... but it was the exception and far from the norm. (As an aside Cardno was exceptionally fortunate that it bought a US enviromental company based in Gulf of Mexico just a fortnight before the huge offshore oil well manned by BP blew!!)


So come August 20 all eyes will be on the balance sheet. In particular: OCF, net DEBT level, ROE, gearing and interest cover. Plus i hope to see in some detail how well DHS in US is performing, along with 'System Mud' in Brazil. The CEO has made some big calls and had a busy 12 months. He'll need to keep a sharp eye on how each acquisition is performing for quite a while before market can become confident.

The 55% drop in SP over past 4 months shows market has not ruled-out a capital raising. A CR is the very last thing shareholders want. It will confirm IMD has bitten off more than it can handle. Let's hope the news is good and balance sheet in good shape. I'd rather sacrifice some divs and get debt down as fast as possible... along with a promise of no more acquisitions for next 2 years at least.