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No short cuts or silver linings for Ellies

Road to recovery is long and tough.

This article was first published in Moneyweb Investor. To read the magazine click here.

Ellies recomm

Ellies table 1

It is a tumultuous time for Ellies which is in the thick of a restructuring exercise to establish a new operating equilibrium, with particular focus on its cost base. It has split into two divisions, each to be listed separately.  

Management’s immediate objectives are to cut overheads, collecting on debts, de-stocking, completing projects that are burning cash and disposing of its property portfolio. The group still has a huge working capital burden but some of these moves are expected to improve its liquidity position. If liquidity does not improve significantly, another capital raising exercise might be in the offing which results in further earnings dilution or increased interest charges.

Against this backdrop it is difficult to use historical or current financial information to make future inferences on free cashflow-generating capacity. Our assessment still supports the view that any value to accrue to this share in the short to medium term is more meaningful to those who already own it. 

Furthermore, Ellies has adopted the international financial reporting standard (IFRS) 5 in preparing these results, which compounds the problem in interpreting them. Because of the possible separate listing of the consumer goods division, IFRS 5 recommends that the division be treated as a discontinued operation. The implication is that the consumer division’s performance is only shown below the line (after-tax profit) as a discontinued operation which does not truly reflect the economics of Ellies because the division is still a going concern and generates the bulk of group business.

We have therefore employed certain ratios and other tools to get a sense of how management has addressed the more pressing issues of liquidity, gearing, sales and costs. But the method is limited due to lack of a comparable history. We also adjusted the financial statements to reflect the economic substance of the business more accurately by treating the consumer goods division as a continuing operation.

Ellies share price performance (rebased)

Ellies graph

The net debt-to-equity ratio has improved drastically to 8% from 34% thanks to capital raised, resulting in the net interest cost falling by 49%. This shows a dramatic improvement in group solvency but Ellies’ immediate needs require us to pay particular attention to its liquidity.

Both the current ratio – current assets divided by current liabilities – and the quick ratio – (current assets -inventory)/current liabilities – have improved only marginally to 2.1 (1H15: 2.0) and 1.2 (1H15: 1.1) respectively. Although still low, a more strict measure of liquidity, the cash ratio (cash/current liabilities), shows commendable improvement to 9% from 6%. Its drive to reduce the fixed cost base is also paying off with the Ebitda margin (earnings before interest, tax, depreciation and amortisation) recovering remarkably to 4.5% from -1.4%.

The infrastructure segment, regarded as a continuing operation, grew revenue 27.5% to R205.1 million and returned a small operating profit of R0.96 million from a previous loss of R21.2 million. Capital raised helped improve liquidity, with more benefits expected in 2H16. The division is cutting overheads and streamlining fixed costs so that project costs are mostly variable. All South African contracts were completed and the division is now export-focused with future revenues denoted in foreign currency, which is a positive given the rand’s woes.

Labelled a discontinued operation, the consumer division’s revenue edged up 3.3% to R737.1 million and operating profit rose to R28.7 million from a previous loss of R8.7 million. This was driven by a drop in overheads, through a lower staff count and increased efficiencies. Furthermore, the division reduced its inventory levels although it says this is not reflected monetarily due to significant exchange rate movements. It has cleared all OpenView HD (OVHD) inventory and significantly reduced corporate lighting inventory.

It is encouraging that a modest revenue increase of 7.6% was accompanied by an improvement in working capital. The group managed to reduce both stock and debtors, with creditors also decreasing. Although a decrease in creditors means eating into cash holdings – an unlikely move for a company with liquidity challenges – we view it as an improvement in operations. The cashflow statement is particularly difficult to dissect given that it is overly condensed, along with awkwardly classifying the consumer goods division as a discontinued operation. But it is apparent that the company is generating negative operating cash flows.

Although there are signs of life in Ellies’ operations, the macro outlook is too bearish to support its sales growth. And the negative operating cash flows leaves the company with little ability to self-fund both its working capital and capex. However, some projects which launched towards the end of 1H16 are promising for 2H16 and as such we think any value to be created in the short to medium term is more valuable to investors already holding the counter. Therefore we maintain a hold recommendation.

Bull Factors

  • Streamlining of cost base is paying off
  • Gearing profile has improved and company can take on more debt
  • Infrastructure division experiencing encouraging sales growth

Bear factors

  • High customer concentration
  • High working capital base coupled with negative operating cash flows
  • Poor economic outlook
  • Consumer division experiencing lethargic sales growth

Nature of business: Ellies Holdings has restructured into two divisions, each to be listed separately. The consumer division will be spun off from the holding company and listed as Ellies Electronics. It will be a diversified manufacturer and distributor of electronic products related to television reception, including satellite and terrestrial aerial products. It is also involved in the manufacture and distribution of domestic and industrial audio electronic and electrical equipment under the Ellies brand, and satellite and associated equipment under the ElSat brand. The infrastructure division will be housed under Ellies Electronics Holdings. Through subsidiary Megatron Federal, Ellies is involved in infrastructural power in the fields of power generation, transmission and distribution. It also has interests in the renewable energy and internet connectivity markets.

Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view.

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