NIB P&L continued

We saw in my last post that the bottom line is not always the bottom line - by removing just a few no-recurrent items what on the surface looks like a good result can, in reality, be a poor results.

So, after removing costs associated with listing on the ASX, setting up the NIB Foundation and net results from investing, the indicated earning power (IEP) for nib in FY2008 was $36.4m and dropped to $25.6m in FY2009.  I have performed the same exercise on the FY2010 results and again the (NPAT) falls by one-third, down to $17.1m.

So things are not looking so good for nib, but having three years worth of data makes the trends clearer.  In terms of their basic business - selling insurance policies and paying claims - the results are all good. The "underwriting result" has increased from $60.5m in FY2008 to $63.5m in FY2009 to $72.0m in FY2010.  So why is the underwriting result going one way and the IEP going the other way?  There are two aspects to this:

1. tax, and
2. investment result

Tax

In my last post, I did not adjust for tax in my assessment of IEP.  I did this on the basis that tax is an expense that reduces returns to shareholders.  However, looking at it again, the IEP result is being obscured by the fact that the loss due to non-recuring costs FY2008 has provided a tax benefit, the FY2009 tax paid is more typical of a standard year, and the FY2010 tax paid is higher due to the profit made on investments.  So, if I apply the company tax rate of 30% to the before-tax-IEP, I end up with new results as follows:

• FY2008 - $21.7M
• FY2009 - $23.4M and
• FY2010 - $29.8m

In short, a little knowledge is a dangerous thing.


Investment Result

Looking at the P&L, I'm going to use the term "Investment Result" to refer to the sum "Investment Income" minus "Investment Expenses".  I originally excluded Investment Result from my calculation of IEP for the years FY2008 and FY2009 because it represented such a small part of the results.  Obtaining the FY2010 results however, highlights the importance of examining as many years of results as you can when assessing a potential investment.  Here are the Investment Performance results for the last three years:

• FY2008 - $7.5m
• FY2009 - ($1.8m) loss
• FY2010 - $44.5m 

Suddenly, in 2010 the investment result is as important as the underwriting result. You would think that this would make the investment result an important topic of the shareholder review, however, in both the FY2009 and FY2010 shareholder reviews there is only a couple of paragraphs which merely set out a few facts.  Disappointingly, as we have no basis for estimating the investment result for future years, we have no way of assessing a IEP for this side of the business.

This is getting tricky now

I've started reading "Chapter 31: Analysis of the Income Account" of Graham & Dodd's Security Analysis, or rather, I started reading it again.  The date on my last post informs me that it has been six months between drinks (I can't believe its been six months) and I'm not sure how many times I've started Chapter 31. 

As I've discovered with other chapters, Graham & Dodd's relaxed style of writing makes reading the book deceptively easy.  Its when you try to apply the concepts for yourself that you discover how much information the book imparts.  To overcome this, I've decided to "divide and conquer", as they say in the IT world and tackle this chapter over several posts (hopefully in intervals shorter than six months, or I will have died of old age before finishing the book).

The "Income Account", or "Income Statement" or "Profit and Loss" or (as I prefer) "the P&L" is perhaps the most important of the three financial statements provided in a company's annual report.  This is because it is generally accepted that a share's worth is the discounted value of future dividends and the P&L contains the most relevant information to determine this. (Refer to the last couple of paragraphs of my post "What is a share?" for an explanation of discounting.)

One of the questions to be asked when examining a P&L is "What are the true earnings for the period studied?".  In a simple world, one would be able to look at the bottom line of a P&L and if it showed a profit of $23.8m, we could say that the true earnings for the period studied were $23.8m.  Unfortunately, we live in a very complex world with very complex accounting standards developed to deal with very complex things that people do with money, hence, we need to do a bit more work that this.

There are three elements of a P&L that "require critical interpretation and adjustment":

1. Nonrecurrent items (ie things that are one-off's and won't happen again)
2. Operations of subsidiaries or affiliates - particularly tricky as you may not be given any details about them other than their profit or loss
3. Reserves

Non-Recurrent Items

Graham and Dodd list nine types of non-recurrent items and point out that they need to be taken out to determine the "ordinary operating results". By doing this, we can get a better idea of the "indicated earning power", which is what you would expect the company to earn each year if business conditions remained the same.

To apply this concept I am going to examine NIB Health Fund's financial result for the year ending 30 June 2009 [specifically the pdf file titled Appendix_4E_Preliminary_Final_Report_30_June_2009.pdf, which I downloaded from NIB's website]. For the time being I'm going to only look at the Consolidated results and ignore the Parent Entity results. I have chosen NIB because I have had a health insurance policy with them for several years and, as a result, when they listed on the ASX they gave me some shares.

NIB's Income Statement is on page 41 of the annual report. NIB's profit for the previous year FY2008 was only $404,000, but increased to $23.8m for FY2009. Coincidentally, a large part of the difference is due to non-recurrent items and so proves a useful example when considering this chapter.
In looking for non-recurrent items the first thing I do is run down the list of figures and compare last year and this year.  Any items which differ significantly are likely due to non-recurrent items.

The most obvious thing that first stands out are the two items:

• Other underwriting expenses - demutualisation and listing costs: which was $10.8m in 2008 and $0 in 2009; and
• Other expenses - demutualisation and listing costs: which was $7.6m in 2008 and $0 in 2009.

These costs resulted from the demutualisation of NIB Health Fund and its listing on the Australia Securities Exchange in November 2007.  Obviously, this is an event that will likely only happen once in a company's existence, so we should exclude them entirely as they only serve to obscure NIB's "indicated earning power".  In doing so, the profit for FY2008 lifts from $404k to $18.9m.

The third expense that occurs in FY2008 and disappears in FY2009 is a $25m payment to the NIB Foundation. There is no discussion of the Foundation in the FY2009 financial statements, however, the media releases on the NIB Foundation website state that this donation established the Foundation using funds raised for the purpose as part of the ASX listing. The NIB Foundation aims to distribute $2m in grants each year, so presumably they are using the $25m as capital to raise the $2m each year. There is no mention made regarding whether NIB will provide ongoing monetary support to the Foundation, so I’m going to assume that we can exclude it for the purposes of determining NIB's "indicated earning power". As a result, the FY2008 profit lifts to $43.9m and suddenly what on the surface seemed an extraordinary improvement in performance from FY2008 to FY2009 is looking like a dramatic decline.


The next items to look at are Investment Income and Investment Expenses. If we add these two items together they represented on 1% of costs in FY2008 and 0.2% of costs in FY2009, so the temptation is to just ignore them all together. But as this is a learning exercise, we are going to delve in and see what we can find out about them. This will involve reading the dreaded Note 1. Every set of financial statements has a Note 1 - Summary of Significant Accounting Policies. Note 1's set out how the financial statements are put together. Note 1's always consist of several pages of single spaced type in a small font that contains a lot of accounting jargon. This is why I have never before read a Note 1, but I suppose there is a first time for everything.

So, on the third page of NIB's 14-page Note 1, we learn:

• changes in the value of financial assets are put on the profit and loss statement.
• dividends from subsidiaries are put on the profit and loss when the right to receive the dividend has been established - so even though they might not yet have recieved the cash, NIB will report the income as earned on the P&L.
• rent from building they own and lease out is put on the P&L for the period when it should have been received.

All these items are annoyances when it comes to determining a company's "indicated earning power".

Firstly, an increase in value of some shares you own (financial assets), doesn't put money in your pocket - at least, until the time you sell them, when the value would have changed again. So on the one hand, this should be excluded from assessment of indicated earning power (I'm going to go ahead and start calling this "IEP") on the other hand, over the long term, this will come into play.

Secondly, we do not have the financial statements of the subsidiaries so we have no way of assessing their IEP's and therefore no way of assessing likely future dividends and their contribution to NIB's IEP.

Thirdly, we have no details on the rental properties so cannot assess whether the rent is representative of a typical year or whether, for example, a significant tenant is about to vacate and leave 60% of the buildings empty for an indefinite period.

Fourthly, there is no breakdown of the investment income and given it has gone from a positive $8.8m in one year to a negative $1.2m the next, it could do anything in the third year. It may well be that when we examine the balance sheet we will get a better handle on this, but in the mean time, I'm going to fall back on my earlier comment and say that this is such a small part of NIB's IEP and exclude it.

With all these non-recurrent items excluded FY2008 profit becomes $36.4m and FY2009 profit becomes $25.6m and what looked like a good year has turned into a bad year with a 30% drop in profit from FY2008 to FY2009.

For the next post I will read through NIB's annual report and see what they have to say about their results. I will also run this exercise on the FY2010 results and see how the next year has been.

What a difference a P&L makes

State of Play: I have a shortlist of five companies I want to analyse to determine whether I should invest my hard-earned cash into them. I have “The Motley Fool Investment Guide” (‘MFIG’ / “the book”) by David and Tom Gardner. It’s time to get into some serious number crunching, starting with Nomad Building Solutions.

Nomad shares were trading at 17.5 cents when I first checked their price on 30 January 2009. They closed at 75 cents on Friday 14 August 2009. An increase of 429%. That’s equivalent to around 800% per annum. Phenomenal, so what do the financials tell us?

As per the blog I wrote way back on 26 January 2008, Chapter 14 of the MFIG looks at how to analyse a company’s income statements (otherwise known to oldies like me as the Profit and Loss Statement, or just the P&L).

D&T’s first piece of advice is to “make sure margins remain at consistent levels if they are not actually rising”. Nomad’s net profit margin for the financial years ending 30 June 2007 and 2008 are:

FY2007 7.8%

FY2008 7.1%

Oh dear. They have failed the first test.

Net profit margin is net profit after tax divided by revenue. The book explains that shares trade off expectations and those expectations are based on trends. This trend is going the wrong way. We want the net profit margin either to stay the same or go up.

We also need to look at what is going on to get this result, so first to revenue:

FY2007 $208.7m

FY2008 $335.7m

Yes, you’re reading right. Nomad lifted their revenue by $127m or 61% in only one year.

An extraordinary result.

How did they do it?

They did it by buying two businesses. So actually, we have no idea whether it is extraordinary or not. They don’t tell us how much revenue was derived from the parts of the business that was in place at 30 June 2009 and how much came from the new businesses. We don’t now how much revenue the two new businesses made last year, so we have no way of judging whether this is good or bad. Damn, that is annoying.

Moving on, lets look at the net profit after tax (‘NPAT’ or “the bottom line”) in both years:

FY2007 $16.3m

FY2008 $24.0m

An increase of 47%, which by itself again you would think is impressive, but we just have no way of judging. We also see why net profit margin has fallen. If revenue has increased by 61% but profit has increased by only 47%, then the increase in costs must have eaten up the difference.

So what can we conclude from this? Either, the two businesses bought are not as profitable as Nomad in its original form or Nomad in its original form has not performed as well over FY2008 or both.

I don’t like it.

The market did not seem too fussed about it, however. The 30 June 2008 results were released on 24 September 2008. On that day, 2.8m Nomad shares changed hands, over ten times the daily average for the year prior. In spite of this, the price only changed by 2c per share on the day, closing at $1.65, compared to $1.67 the day before.

D&T’s second piece of advice is “make sure research and development expenditures aren’t getting shortchanged”. Unfortunately, we can’t check this because Australian companies don’t itemise research and development expenditures on the P&L. So we just have to move on.

D&T’s third piece of advice is “make sure the company is paying full income taxes. They say to do this by dividing the tax paid by the earnings before tax.

For Nomad, these rates work out at:

FY2007 31%

FY2008 32%

Which is a tad odd given the Australian company tax rate is 30%. Fortunately, they have a note in the financials which reconciles the tax paid back to a straight 30%. The issue is there are some expenses which are not deductible for the purposes of calculating taxable income. These include “Share based payments”, “entertainment” and “other”. These total less than 0.2% of all costs, so I’m not going to worry about them.

The book explains that the point of this is that if a company has carry-forward losses which are diminishing their tax rate, then these need to be taken into account when examining margins. This does not apply here.

D&T’s last piece of advice is “keep an eye on growth in shares”. This is because its not so much the net profit after tax that counts, it the net profit after tax divided by the number of shares, because that’s what its worth to you as a shareholder.

There’s a whole note in the financial statements about this and it looks more complicated that I would like, but lets wade through it.

At 30 June 2007, the balance of the number of shares issued was 116,466,124. So, with a NPAT of $16.3m, the earnings per share (‘EPS’) were 14 cents.

This seems a fairly straightforward calculation to me, so why do Nomad report the EPS as 18.9 cents per share?


At 30 June 2008, the balance of the number of shares issued was 135,273,708. So the profit is being shared between 16% more shares and the EPS on my calculation was 17.7 cents per share.

So why do Nomad report the ‘basic’ EPS as 19.7 cents per share and the ‘diluted’ EPS as 19.5 cents per share (the ‘diluted’ figure takes into account options).

Nomad’s calculation is based on using the weighted average number of shares over the year, rather than the number outstanding at the end of the year. I’m sure this has been the topic of countless papers and committees on accounting practice and numerous very learned people have determined this is the best method, but I don’t see how this helps me. If I was holding 100 shares at 30 June 2009, unless the company gave me more shares for free over the year, I will still hold 100 shares at 30 June 2010 and if the company had made the exact same profit, my profit would be down almost 14% on the year before.

So lets look at what the changes are over FY2008 and see what happened.

- 6 Sep 07: Issued 673,401 shares in part payment for one of the businesses they bought

- 26 Oct 07: Issued 457,042 shares under the dividend reinvestment plan, ie some shareholders elected to give back the cash they received as a dividend in return for more shares.

- 4 Mar 08: Issued 5.6m shares in part payment for one of the businesses they bought and on the same day, issued 105,076 shares under a share purchase plan

- 24 Apr 08: issued 706,992 shares under the dividend reinvestment plan.

So no-one got free shares (which is a good thing), and the EPS have increased 3.7 cents over the year for a person who held x shares at the start of the year and the same number at the end. This seems a good result to me, and quite a bit better than the 0.8 cents increase calculated under the weighted average method.

So the lesson here is, do your own EPS calculation.

What can we say at the end of it all. The company is generating slightly less revenue for the amount of money it is spending (return on cost has fallen), but in buying the new businesses, it took account of this in the price, so the net result to shareholders is positive? But how will this affect things going forward? Will Nomad bring the new companies up to speed or will they drag things down? Hard to say at this point.

Chapter 14 goes on to talk about P/E ratios. With an EPS of 17.7 cps (my calculation, lets call this the ‘spot EPS’) the P/E ratio at the sound of the closing bell on 24 Sep 2008 would have been 9.3. The book makes the point that the P/E ratio really doesn’t tell us much, but there is a rule of thumb that the P/E ratio should equal the percentage of the company’s earnings per share growth rate. So you can use this rule of thumb to determine whether a share is under- or over-valued. Unfortunately, you need to have a view on the growth rate. I don’t have a view, at least not yet. I also don’t have access (yet) to any analyst views, so I will just stick this in the back of my mind for now.

It all needs to be considered with a grain of salt, in any case. Going back to a year earlier, the 2007 results were released on 26 Sep 2007. With a closing price of $2.81, the P/E ratio based on earnings of 14 cps was 20. The actual growth in spot EPS was 26%. So using the rule of thumb, the shares were undervalued then at $2.81 and interestingly the shares reached a high of $3.40 on 31 October 2008, which gives a P/E ratio of 24. Unfortunately, it then started a steady decline, reaching a low of 15 cents on 27 January 2009, co-incidentally, just a couple of days before I checked the price. So, I don’t think this rule of thumb is going to be of great use to me.

Lets jump ahead and look at the 31 December 2008 results, where we find things have all gone horribly wrong. Firstly, there is a new expense item on the P&L called “Impairment of Goodwill”. Not being an accountant, just these words send shivers down my spine – what the hell is “impairment of goodwill”? Then it gets worse, the figure against it is $6.852 million. This is a big whack, leaving a bottom line of only $1.3m compared to $10.3m for the same period last year.

Looking through the note on this, it has to do with the valuation of goodwill, which they reassess every six months and as a result have come up with this figure of $6.852m. This says to me that they paid too much for the businesses they bought. But the share market was falling steadily during this same six months, so I'm not sure how much I can blame them for this.

Reading further we find out the even before the impairment of goodwill, profit is down 21%. The Net Profit Margin before the impairment of goodwill is 4.8%, quite a fall from 7.2% for the same period last year. Now this really is a big issue.


The fall in profit is attributed to “problems in the Nomad Modular Building division in WA” and the CEO of this division has “tendered his resignation”. Nomad Modular is not one of the new businesses they bought during the year, this is part of the original business, so it should be running like clockwork. The departure of the CEO just raises more questions than it answers. Is this just scapegoating for an event that was beyond anyone’s control? Are they letting required knowledge and experience walk out the door? They don’t provide enough detail to make an assessment.

So, in summary:

* the headline presentation of Nomad’s 2008 annual results, ie "we’ve made a 48% increase in profit", was misleading, it should have mentioned that the acquisition of two businesses contributed to this rather than leave it for the fine print, and

* based on the admittedly small window of performance I have assessed, I have no evidence that they can manage their business successfully. They made acquisitions that lead to write-offs and their costs have blown out cutting one third off their net profit margin.

These issues no doubt contributed to the fall in their share price from a high of $3.40 on 31 October 2007 to the low of 15 cents on 27 January 2009. But given the growth in the share price since then, something must now being going right for them. I will delve into this in a future post, however, in the next post I will go through their balance sheet.