High-risk business model exposed

Intellidex says Ellies shares are a ‘hold’.

Valued at less than half of its book value, this company has fallen out of favour with investors and not without cause. However, Ellies has taken a big bath and will thus report from a very low base in the next season, providing potential for a bounce.

The company is trading on a negative PE due to an unprecedented headline loss. It has realised significant non-recurring expenses in implementing a new operational structure (see ‘Nature of business’ below).

Its woes started about two years ago when two of its major lumpy projects hit problems – the digital terrestrial television (DTT) migration and Eskom’s residential mass rollout programme. Ellies’ high-risk business model, characterised by transactional-type revenue generated largely from very few customers, was exposed. This was compounded by a high fixed-cost structure at both operating and financing levels. This high degree of combined leverage (operational and financial) works nicely when revenue is growing but inflicts severe pain when it falls.

Essentially, Ellies is in the process of reversing a trend of deteriorating fundamentals over the past five years. It had no choice but to tap pockets of its owners twice during FY15 and once afterwards. The balance sheet is in bad shape even after incorporating the rights offer that took place post the FY15 balance sheet. Net debt:equity now stands at 22%, an improvement from 36% at year-end. A significant part of working capital is still tied in debtors and stock, which implies that liquidity problems may persist in FY16.

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Cash now stands at 9.6% of working capital, up from 4.5% recorded on the FY15 balance sheet. This is on the back of an average of 9% for the past five years. Other indicators have also deteriorated in the last five years (after incorporating the post- FY15 balance sheet rights issue):

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The surge in degrees of operating and financial leverage explains the position that Ellies finds itself in. In essence, a slight change in sales will have a disproportionate effect on operating income and ultimately on headline earnings. This is a good thing if sales are rising but for Ellies sales are nosediving and that can only mean pain and more pain. Return on equity, which grew to 24% in FY13, has fallen to below zero – shareholders are actually losing money.

Generally, management seems to be on track in addressing these challenges, but we reckon the business risk profile is still high. It is a share to avoid but if you already own it, it seems to have hit rock bottom and is likely to rise off a low base.

Overall, the group recorded a headline loss of 81.34c/share (FY14: profit of 24.66c/share). Even if we add back non-recurring charges, Ellies remains in the red at operating profit level. This is quite worrying. Two things come to mind: the group needs to aggressively increase its top line and reduce its operating costs. Further, it also needs to drive down the interest charges.

What we see is a risky business characterised by high gearing and stagnant sales growth. Capital raised has improved liquidity, albeit marginally, and as such sales may start to improve. Management says liquidity, or lack thereof, dented sales growth in the period under review.

Ellies’ fortunes are tied to its infrastructure segment order book; its ability to drive down fixed costs; the successful roll-out of the DTT migration programme; its inverter trolley generator sales; and the resolve by Platco to subsidise OVHD set-top boxes.

What will help is management’s commitment to improving liquidity by disposing of the property portfolio, reducing abnormal inventory levels and recovering outstanding debtors – areas in which most of the group’s capital is tied. In addition, the separation of the company into two distinct business units, each to be listed separately, has the potential to improve the overall group cost of capital.

Bull factors

  • Expansion into Africa reduces exposure to SA market
  • Restructuring exercise and deleveraging efforts are continuing

Bear factors

  • High business risk characterised by high gearing
  • High and more liquid working capital requirements
  • Slow sales growth

Nature of business
Ellies Holdings has restructured into two divisions, each to be listed separately. The consumer division will become Ellies Electronics, a diversified manufacturer and distributor of electronic products related to television reception including satellite and terrestrial aerial range. It is further involved in the manufacture and distribution of domestic and industrial audio electronic and electrical equipment under the Ellies brands 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.

Analyst: Phibion Makuwerere; Editor: Colin Anthony

COMMENTS   1

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This used to be a very good investor company, but when they became so wrapped up with Eskom and set top boxes and inventories went through the roof, and there was a noticeable deterioration of the quality of their products I sold out totally. Today I won’t buy Ellie products as a matter of course as their products are inferior to others on the market. I can’t see investors rushing off and buying into this share in a hurry – even the rights issue was poorly supported especially at a price higher than the trading price at time of closure. So for me Ellies made certain decisions which were fundamentally investor averse

End of comments.

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