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Looking Beyond a Company’s Profits: Why It’s Important

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Everyone immediately gravitates towards a company’s announcement of their profits and losses when speculating whether or not they are going to do well in the stock market. What usually ensues after is the strangest display of irrational human behaviour known to the thinking man in terms of buying and selling shares. But ignore that for now, and listen to what The Motley Fool has to say about focusing on a company’s profits.

Cordlife Group (SGX: P8A) reported its second quarter results yesterday and posted great head-line numbers. For the six month period ended 31 Dec 2013, the company had managed to grow its revenue by 31% from S$17.9 million a year ago to S$23.5 million. Meanwhile, Cordlife’s profits did even better with a 53% year-on-year jump to S$12.9 million.

Based on its earnings per share of S$0.072 over the last 12 months, the company’s now valued at 16.5 times trailing earnings which is almost a third higher than the valuation of the Straits Times Index (SGX: ^STI). The index is selling for close to 12.8 times its historical earnings at its current level of 3,041 points according to data from the index-tracker, the SPDR Straits Times Index ETF (SGX: ES3).

 

Looking Deeper

With such a strong record of earnings growth – for more background, profits at Cordlife had more than doubled from S$8.5 million in June 2011 to S$17.9 million over the last 12 months – it might seem that Cordlife’s valuation might even be understated if we were to just look at things on the surface.

But as they say, the devil’s in the details, and if we look beneath the hood, things aren’t quite as rosy with Cordlife.

The company’s main business lies in the provision of stem cell banking services in countries including Singapore, Hong Kong, India, Indonesia, The Philippines, and China. If the profit growth in its recent earnings release had been due to rising customer numbers and/or the ability to raise prices, it would have been great for its investors.

But even though Cordlife did do more business in the six months ended 31 Dec 2013 – client deliveries went up from 4,500 to 7,4000 – costs increased disproportionately resulting in the bulk of its profits coming from one-off gains that totalled S$11.6 million before taxes.

The one-off gains came from two events:

1) Cordlife had shifted its investment in China Cord Blood Corporation from the ‘’investment in associate” category to the “long-term investment” category on its balance sheet, and somehow awarded an accounting gain of S$6.17 million to the shift.

2) There were positive fair value changes for the company’s long-term investments.

The two events were likely one-off in nature because firstly, Cordlife can only shift its investments in other companies to different categories on the balance sheet that many times; and secondly, fair value changes (which can be thought of as the adjustment of the value of an investment to reflect prevailing market conditions) are hard to fathom if Cordlife’s shareholders can’t get hold of the details of what these long-term investments are.

Either way, both events brought with it accounting profits that couldn’t show up in actual cash. Cordlife’s cash flow statement for the six months ended 31 Dec 2013 showed that operating cash flow had dropped drastically from S$4.71 million in the previous year to just S$208,000. In other words, the company’s profits for the period were of low quality given the lack of cash brought in.

 

What You Should Be Looking At

Investors have to bear in mind that cash is what ultimately allows a company to strengthen its balance sheet, pay the bills, and grow the business. Profits, as important as they are, are just an accounting construct.

At this juncture, it’s good to note that the point of all this is not to single out Cordlife as a good or poor investment. Rather, it’s meant to illustrate how important it is that investors look beneath the surface of seemingly ‘cheap’ companies with strong earnings growth.

For what it’s worth, Cordlife did highlight macro-trends in its earnings release that might benefit the company and ultimately, its investors. For instance, there are the strong historical growth rates in storage units for private cord blood banks in countries like Indonesia, Philippines, and India that signals growing demand in the region for cord blood banking services. There’s also the China story to look forward to, with private cord blood banking having a low single digit penetration rate for births in the country, suggesting a large headroom for future growth.

All told, an investment into Cordlife might yet turn out to be successful five to 10 years down the road. But, that would depend on its overall corporate performance and on that front, investors have to look beyond just its reported-profits to have a better gauge of its actual performance, just as it is with any other company.

 

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