Tuesday, July 12, 2011

Lessons from Southern Cross

The collapse of Southern Cross offers a lesson for investors of all stripes: do not enjoy the story so much that you forget to look at the numbers. The management team at the care home operator, which announced on Monday that it would close its operations, offered an enticing narrative after the intial public offering in 2006: here was the biggest residential care provider in a country that was getting older. Demand would outpace supply, so fees would always go up. The elderly were such an important demographic that politicians would never reduce funding. Investors lapped it up: by the middle of 2007 the shares were trading at 30 times earnings.

If only they had studied the accounts. The biggest red flag was the company’s off-balance sheet liabilities. There were £390m of liabilities on the 2007 balance sheet – a fairly racy 2.7 times shareholders’ equity. But the footnotes showed about £5bn in off-balance sheet liabilities, mostly 30-year operating leases on the company’s properties, which included fixed annual rent increases.

There were other numerical warning signals: the proportion of earnings before interest, tax, depreciation, and amortisation that showed up as cash fell by one-quarter between 2006 and 2007; in 2007 bed capacity increased by 25 per cent, yet revenues grew only 20 per cent; the company’s staff turnover was high; returns on invested capital were low; 80 per cent of revenue came from one customer (the government).

Finally, even the laziest of investors should have been alarmed when the chairman, chief executive, finance director and chief operating officer all sold their entire stakes in the company at the end of 2007. When even the people who told the story acted as though they did not believe it, it was time to stop listening.

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