Investors learn a lot of lessons from their mistakes, but that’s a pretty costly way to learn. One of my preferred methods of learning is from the mistakes of others, and that’s why I like to write case studies about investments that have been subject to interesting events.
One of these investments is Silverdell plc (LSE:SID). Investors in this company, including at least one professionally managed value investment fund, thought they were getting good value for their money, until they suddenly without warning lost their entire investment. Don’t think this can’t happen to you, learn from their mistakes and improve your chances.
Silverdell works globally with organisations to help them protect people, assets and reputation. It “provides peace of mind through a unique portfolio of end-to-end specialist environmental support services.” Working in highly hazardous regulated environments, it delivers asset maintenance and recovery, decommissioning, asbestos management and consulting services to the built environment, industrial and energy sectors.
Doesn’t sound particularly exciting and a bit risky, but you could be forgiven for liking this company if you saw its 2011 financial statements in early 2012. This research report was published too, and said the shares were undervalued, and they certainly seemed so at 8.3x earnings with those earnings forecast to keep rising.
What happened next?
A year later things were still looking good. Here are the 2012 financial statements. Revenue was up massively thanks to an acquisition and although headline profits were down, adjusted profits were almost double what they were in 2011. The good news continued as the company posted the order book was up 70% later in the year and a number of new contract wins. And then followed, again, another good trading update with revenue up 100%. All this from a company that could have been bought at 8.3x earnings just a year ago.
Then on 2nd of July the company released this news item.
“Silverdell has requested a suspension of its shares from trading pending clarification of the Group’s financial position. Further announcements will be made as and when appropriate.”
To say this came out of the blue is an understatement, the company had given no prior indication it was having any financial troubles, and was in fact still claiming to be doing well and winning new business only 12 days before this!
What had happened was a supplier had taken one of Silverdell’s subsidiaries to court for the monies it owed. The company had not disclosed this, until of course the court had judged against Silverdell and put its subsidiary into administration (bankruptcy). With its subsidiary effectively bankrupt Silverdell finally had no choice but to notify the market and suspend its shares.
This was followed by some other minor events, but for the purposes of this case study they aren’t important. All that matters is that in the end, the shareholders were wiped out.
What were the warning signs?
The point of a case study is to find out how a similar disaster can be avoided in the future, so lets dissect Silverdell’s financials. The very first place I look when I want to check a firms financials is the cash flow statement. It is the most difficult statement to falsify or manipulate (it is possible, see my Enron piece, but rare) and so is the best place to find signs of financial trouble.
A quick glance at the 2011 statements doesn’t raise any immediate red flags. Free cash flow was positive in 2010 but negative in 2011. Cash flow is often volatile so that isn’t an immediate sign of trouble, but what is concerning is the enormous increase in trade receivables and inventories. In business this is a classic warning sign that sales could be about to deteriorate.
When a business struggles it tends to give more generous terms to its customers, gives them big quantities of goods and allows them not to pay for a long time. Also inventory build up suggests they aren’t selling as much as management had predicted and to reduce inventory they will likely discount.
Silverdell itself doesn’t sell goods, it sells a service, but these are still warning signs. But trade receivables alone don’t tell the whole picture, they can increase when sales increase, so instead it is best to look at trade receivable days, which is trade receivables / (revenue / 365). For Silverdell this went from 89 days in 2010 to 112 days in 2011.
Moving onto the 2012 financial statements, free cash flow is again negative (note interest isn’t including in operating cash) but not large, so investors may have not thought this a big deal. But lets take a look at our friend trade receivable days again, which jumped from 112 days to a whopping 161 days.
This wasn’t the only warning sign. The company was rapidly expanding by acquisition and so was debt. Net debt was about £4m in 2010 but had ballooned to £11.3m in 2012. To make matters worse free cash flow and unadjusted profits were non existent. Debt becomes a big problem when you don’t have the cash flow to service it, and in the end this was the reason for the demise of Silverdell. Their cash flow couldn’t cover the payments needed to suppliers and as a result, the supplier took legal action.
Of course it is easy to see these things with hindsight, and I could probably find an example of another company with the same warning signs that didn’t lose investors all their money. But the point of value investing isn’t to catch all the winners, it’s to preserve capital, and extreme care should be taken when investing in companies that show these patterns of increasing trade receivable days. You need a good reason to overlook them.
I’m no accounting guru, I have only a basic understanding from what I have read in books, so anyone is able to check these things and they are important. I have set out my own Investment Checklist which checks more detailed and unusual characteristics than most basic checklists, and the point is to find exactly situations like these where investors are caught off guard because the headline financials have been lying to them.