Buying Quality Businesses (Megan: Part VIII)

IF you are an investor, do you believe in buying quality businesses at reasonable prices (excellent article by Chetan Parikh )?

Let's do an actual case study... on.. err.. err....LOL... let's use Megan Media Holdings. (aiseh... all the data posted oredi mah..)

So what's a Quality Business? According to the article posted by Mr. Parikh:

Defining a Quality Business. A cheap price alone does not justify buy­ing a company. A corporation may sell at a bargain price for good rea­sons, such as incompetent management or waning demand for the company's products. You should disqualify the firm as an investment candidate if company-specific factors that are structural in nature drive its depressed price.

Superior businesses possess certain common characteristics, in­cluding robust profit margins, strong earnings and revenue growth, a clean balance sheet, and competent management.

Make sense?

Profit Margins. High profit margins help a business weather nega­tive circumstances. Such circumstances may be economy-wide, such as a recession; industry-wide, such as airlines after 9/11; or company specific. Poor margins have forced many corporations to fold or sell to competitors during business downturns, as low-margin firms can easily generate bottom-line losses when their revenues take a hit.

Let's look at Megan: Part V

Sales 248.323 million
Net profit 3.957 million

Net profit margin is a mere 1.5%.
Is this a good profit margin, average profit margin or a simply poor profit margin?
Does Megan pass the high profit margin test?

Ok, maybe one could argue that this could be a one-off event, a hiccup in performance.

See Megan: Part IV. In that blog article, I have noted Megan's past 6 quarterly earnings since 30th April 2004. Look at each quarterly earnings net profit. At best, Megan's quarterly net profit margins is a 7.8%. (is this 7.8% a good or an below average profit margin?) Now it's profit margin is a mere 1.5%.

So would you rate this as a quality business?

Next we look at the issue of earnings growth. Now as per the article...

Projected Earnings Growth. Strong historical growth does not guar­antee a healthy expansion in a firm's future income. New technologies make older products obsolete, demographic changes alter consumers' purchasing habits, and buyers' preferences shift over time. Before in­vesting, make sure you understand a company's products well enough to develop confidence in its future demand. Ask yourself if the firm's products are trendy, or if they exhibit growing demand regardless of changing fads. You want businesses that can sustain their earnings growth.


See Megan: Part IV.

What do we have? What growth? We now have continous quarter of serious earnings decline. Given such indications, how would you rate Megan's growth story?

Is Megan's growth story still bang-bang sound so geng?

If the answer is a clear NO, then what about the possibility of Megan sustaining their earnings growth?

Next we look at the composition of the company. The balance sheet. As per the article.

Balance Sheet. Producing a unique product with a strong demand will not ensure a company's success. A weak financial situation can prevent a firm's management team from executing its business plan effectively. Two factors dominate when determining the health of a company's balance sheet: liquidity and debt level. A strong balance sheet with plenty of liquidity and low debt gives a company flexibil­ity and fortifies it against business downturns.

Liquidity refers to the amount of assets a business can convert to cash in a relatively short period of time. A company may have lots of assets, but if they cannot be converted to cash, the firm may not be able to pay its bills. Liquid assets are referred to as current assets. Bills that come due within a year are known as current liabilities. The ab­solute amount of liquid assets a business has on hand does not matter as much as its current assets relative to its current liabilities. There­fore, you compute a key measure of a company's liquidity, known as its current ratio, as current assets/current liabilities.

Excessive debt has plunged many corporations into bankruptcy because steep payments strangled the firms' cash flows. High fixed expenses also reduce a company's ability to adjust to changes in its operating environment.

Let's look at Megan's Current Assets (taken from Megan's latest quarterly earnings)


Inventories...................................................... 73,543
Trade receivables.............................................. 333,357
Other receivables,deposits & prepayments...............18,505
Fixed deposits with licensed banks........................ 3,589
Cash and bank balances....................................... 93,998
Tax recoverable................................................. 410
Total............................................................... 523,402

Inventory. I had not mentioned the warning sign here. A year ago, Megan's inventory is about 36 million. And if one does some research, 2 quarters ago (29th June 2005)), Megan's inventory was also around 36 million. Now it is 73.543 million. A huge increase of 37.543 million. Worrying issue? What caused the inventory level to jump soooooo much? Overstock of not-so-laku inventory such as them CD-R?

Cash and bank balances. This 93.998 million is painting a false picture. Megan's piggy bank was inflated via the recent loan.

Biggest worry i reckon is Trade Receivables. 333.357 million. That works out to 63% of Megan's current asset.

Now trade receiveables is the same as trade debtors.

This is what Megan's customers owes to Megan.

Now as mentioned sooooooo many times b4, this amount kept on increasing each single quarter.

Consider this.

In 30th April 2004 earnings report, Megan had only trade debtors amounting to 190 million.

Now? 333.357 million.

And this was just 7 quarters ago.

Isn't this strange?

Now if these accounts cannot be collected or perhaps one day, Megan's auditors would even deem it as doubtful, then the next move is Megan has to write-off these debts.

And if and when it does write-off... the investor greatest worrry is how much of this portion of debts is doubtful?

Put things into perspective.. Megan's current quarter net profit is a mere 3.957 million. However, trade debtors increased by 63.357 million.

Is this even possible?

And when you consider that the trade receivables now represent a whopping 63% of Megan's current asset, don't you think that if any reclassification of Megan's trade receivables would to happen, then wouldn't it cause a severe damage to Megan's balance sheet?!

So what do we have? Well, Megan's current assets value appears to be high but this high is boosted by 3 questionable issues. Piggy bank cash is inflated via borrowings. Inventory build up is worrying and the built-up in trade receivables is simply freightening.

And the ballooning trade receivables raises a huge question mark on Megan's ability to convert their sales revenue into liquid cash to pay for their bills

Excessive debt has plunged many corporations into bankruptcy because steep payments strangled the firms' cash flows.

Megan's debt issue? LOL... :P

How?

Does Megan even pass the Balance Sheet issue?

How has Megan fared so far? Do we even need to run the rest of the tests?

Anyway what do we have?

We have a company which had a below average profitability (7.8%) suffering two very poor quarterly earnings. With the declining earnings, the company does not even have a growth story anymore. And the company balance sheet is so poor.

Isn't it not crystal clear that Megan does not represent a quality business?

Or is my assesment delusionary?

This is just a mere mock-up exercise if i were to use Mr.Parikh's article as a guide to picking out Quality Businesses.

How?

Your say?