Quality of earnings is an important component of due diligence before investing.
In our study of PPHB, the objective of that examination is to verify if the amount of earnings is attributed to artificial profits created by accounting anomalies.
I dare you
To achieve that, we examined the growth rate of (1) revenues, (2) inventories, (3) trade receivables, and (4) trade payables using FY11 as the base year.
It becomes clear, if we follow textbook teaching, that:
- Revenue has grown faster than Inventory, implying the practice of recording Revenue too soon;
- Trade Receivables has grown faster than Revenue, implying aggressive Revenue recognition and extended credit terms given to customers; and
- Trade Payables have grown faster than Revenue, implying longer period paying back to creditors.
I dare you, again
Their quick summary was done without consulting the cash conversion power.
Let's look at how quick PPHB could collect cash from its business.
The analysis of cash conversion cycle above reveals that:
- Days Inventory Outstanding has reduced, suggesting that it takes PPHB lesser days to holds its inventory before selling it;
- Days Sales Outstanding has increased, implying that it takes PPHB more days to collect its Trade Receivables through extended credit terms;
- Days Payable Ourstanding has increased, suggesting that it takes PPHB more days to pay creditors.
Missing points
It seems like PPHB has poor quality of earnings. But, we have missed two big pictures - Cash Conversion Cycle and the business of PPHB.
#1 Cash Conversion Cycle
Cash Conversion Cycle describes how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash.
The concept of Cash Conversion Cycle is very much like Operating Cash Flow and, in turn, is the most important metric.
It turns out that, as indicated in the table above, PPHB has a stable Cash Conversion Cycle.
Nevertheless, if based on its breakdown, PPHB is still seen as practicing aggressive revenue entry. To clear that up, it relates us to the business of PPHB (see my previous post on One Up on Competition).
#2 The business of PPHB
We have learned from Mr Koay that PPHB will only begin producing paper packaging products after receiving a purchase order. Thereafter, finished goods are delivered to customers or used to pack customers' products at PPHB's plants at the customer's predetermined time over a period (e.g., once a week for a few months).
It is just a different way that PPHB creates additional value to customers through inventory holdings services in comparison to its peers.
Revenue is recognized at the first delivery or use, and is turned into Trade Receivables for a credit term between 30 days and 120 days.
In view of the inventory holdings services for increasing number of customers (see our previous post on customer acquisitions), it is reasonable to observe increased Trade Receivables.
Then why Inventory has always been around RM19m?
Carrying finished goods for customers comes with a cost and requires special care to manage that in addition to PPHB's own inventories.
PPHB has maintained that through the strategic geographical locations of its plants in proximity to its sources of raw materials.
In Penang, its plants are surrounded by more than 10 paper mills (see the map below).
In addition, due to considerable supply sources, PPHB can purchase raw materials at competitive prices.
Customers of PPHB, on the other hand, are also located in the same area, thereby reducing delivery lead time and costs.
Takeaways
It is important to conduct due diligence prior to investing in a stock.
When issues are spotted, intelligent investors ask why and seek answers preferably from a business perspective.
Otherwise, we would have missed PPHB being an effective compounding machine as will be illustrated by its returns on incremental invested capital (we will discuss this in the next series).
Importantly, up next, we will sum up all we learned from this and previous series in order to have a clearer view on PPHB's outlook.
Stay tuned.
http://valueveins.blogspot.my/2017/07/still-on-pphb-making-sense-of.html
