Fast asset growth can mask weak margins

Growth for the sake of growth is the ideology of the cancer cell.

– Edward Abbey

A recent Financial Times (FT) article discussed the “great aviation disrupters of the 21st century” referring to Emirates, Etihad Airways and Qatar Airways. The article was analysing deteriorating performance amongst these three once high performing carriers. Of particular interest are two points: The first is that annual growth in scheduled seats for these carriers ranged from low to mid teens from 2012 to 2016 but that current schedules forecast 2% – 3% for the UAE carriers and an actual drop of 1% for Qatar Airways. The second interesting point is that the UAE carriers are reported to have a large negative impact on P/L. Qatar Airways apparently does not provide the same levels of transparency as the UAE carriers. Perhaps they would benefit from reading my articles on the value of transparency and corporate governance.

Why are these points interesting? Well, growth went from strong to about flat and yet somehow this hit P/L hard. If growth stops, then P/L should match that of the previous year. One argument that the FT article gives is that lower oil prices is impacting domestic outbound business. But this doesn’t explain things as lower oil prices reduce operational costs. Let’s look elsewhere for some insights.

One example relates to the tech sector and how growth can become disconnected from P/L. A perfect example is Tesla with a loss in 2016 of USD 675 milllion but it managed to raise USD 2 billion in equity and 1.7 billion in debt. The company has lost nearly USD 2 billion in the last four years and raised USD 8 billion on financing (most of the rest of the cash went into USD 4 billion in capital expenditure). So why is the market throwing cash at a massively loss making, massively leveraged company? The argument seems to be that this is a fast growing company with a great strategy that will eventually pay off. The example given is Amazon that kept growing without any increase in profit. The difference is, of course, that Amazon funded itself with its own cashflow.

A different example is companies for which assets drive revenues and for which revenue recognition leads expense recognition. Let’s say margins on the income and expense sides are equal at 10%, i.e. if there is no growth in assets then the company is break even, but that costs lag income by 6 months. So what happens if assets were 100 and grew straight line to 200 in a single year? The average assets would be 150. But the income margin would be applied to average assets of 175 (this is simplistic but directionally correct), or 10% of 175 = 17.5, and expenses would be applied to average assets of 125, or 10% of 125 = 12.5. The P/L would then be 5, but this would be solely due to high asset growth and has nothing to do with healthy margins.

A major type of company that this applies to is banks. With banks it affects multiple facets, a simple one is non-performing loans (NPLs). Here’s the thing with NPLs, banks talk about them as a percentage of the current loan book. But a loan rarely goes immediately bad. It might take two to three years to do so. So if we assume that NPLs are on average two years old, and that today’s loan book is 500 but that the loan book two years ago was 400, then a bank reporting 4% NPLs it is with respect to today’s loan book which means 20 worth of NPLs, but in actuality the correct denominator is the 400 from two years ago, which would mean a percentage of 5%. That’s a difference of 20%! So you can see how, on this facet alone, a slow down in growth to 0% can have an outsize effect on P/L. Add in things like fees as a percentage of loans issued, and you can see how this can quickly grow.

Back to the airlines. We are not concerned as to why there are challenges, simply with why these challenges seem to have a much bigger effect on P/L than it does on revenue. The two places we might look are at areas with a time lag between revenue recognition and expense recognition as well as fee income time to revenue.

The world of accounting is arcane and fast moving, so please take what I have to say as directional. One idea is that people usually pay for their tickets well in advance of using them. The revenue and expense recognition should happen when the passenger flies. But what if it is a non-refundable ticket? Then the revenue is booked when the ticket is issued and that is the recognition time lag that we are looking for. As an aside, even refundable tickets help, because even though the revenue isn’t recognised until the passenger flies, the cash still arrives early. If growth flattens, then this excess cashflow needs to be replaced, usually by borrowing, which costs money. Finally, as we all know there are plenty of fees on our tickets. When growth flattens, this fee income as a percentage of expenses drops fast, creating further downward pressure on P/L.

What can we learn here? Fast growth can hide financial weaknesses in the income – cost margin gaps. A clear idea of what parts of the income statement are driven by the balance sheet is key. Especially for companies whose parents might have deep pockets.

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