When Will Century Properties Group Wean from her Dependence on Debt?

I have been pointing out that even in the Philippines, publicly listed companies have been increasing their exposures on unnecessary risks via increasing debt loads in the hope of extracting yields or earnings grounded in the belief that good times lasts forever.

I have pointed to SMC[1] and SM Investments[2] as examples.

Before I proceed I would like to restate my objectives for the following discussion

The following doesn’t serve as recommendations. Instead the following has been intended to demonstrate the shifting nature of business models by major firms particularly from organic (retained earnings-low debt) growth to aggressive leveraging or the increasing use of leverage to amplify or squeeze ‘earnings’ or returns, the deepening absorption of increased risks in the assumption of the perpetuity of zero bound rates, and how accrued yield chasing by the industry induced by zero bound rates has pushed up property prices

The flow of my analysis has always been patterned after “follow the money trail”. This is why I have opted to use free cash flow relative to debt as measure for risks.

Free cash flow is the lifeblood of any business[3]. The importance of free cash flows as highlighted by Q Finance[4] (bold mine)

Unlike earnings, free cash flow represents real cash. It is a very useful way to assess the financial health of a company as it is what is left after all the accounting assumptions built into the earnings have been stripped away. A company may seem to be generating high earnings, but only free cash flow indicates whether any real money has been generated in a designated period. Ultimately, the stock market’s estimate of how much free cash flow a company will generate in the future is reflected in the share price.

Benjamin Graham’s value investing[5] has essentially centered on debt, profit margins and cash flows.

It is not my intent to flaunt financial gibberish—to paraphrase Warren Buffett (the value investor and not the crony), by doing equations with Greek letters on them—just to look sophisticated. Superficial knowledge in numbers really represents negative knowledge or knowledge that is wrong and don’t work.

As the late economic historian Peter Bernstein warned[6],

Our lives teem with numbers, but we sometimes forget that numbers are only tools. They have no soul; they may indeed become fetishes.

My concern today is the growing use of leverage by elite property developer Century Properties Group [PSE: CPG]

CPG is easily one of the high profile standouts in the Philippine property development sector with signature projects tied to American celebrities such as the $150 million (Donald) Trump Tower and the Paris Hilton designed amenities of Century's Azure Urban Resort Residences—a beach club[7].

According to the CPG’s profile at the PSE

As of December 31, 2012, the Company completed 21 condominium and commercial buildings (5,530 units) with a total of gross floor area of 669,857 square meters. Among CPG's developments include the Essensa East Forbes and South of Market in Fort Bonifacio, Taguig City; SOHO Central in the Greenfield District of Mandaluyong City; Pacific Place in Ortigas, Pasig City; and a collection of French-inspired condominiums in Makati City called Le Triomphe, Le Domaine and Le Metropole.

According to CPG’s second quarter[8] cash flow statement, while income grew by 15.96% from last year, interest expenses ballooned by 416.07%. This resulted to negative cash flow from operations of 173 million pesos compared to last year’s 1.823 billion (net of interest and taxes). This year’s improvement may have been due to increased collections from sales. But still a deficit.

And in addition to the negative cash flows from operations, mostly due to investment properties, CPG generated a cash deficit of 539.7 million pesos from investing activities this first semester, as compared with 262.5 million pesos over the same period last year.

The combined deficits have been more than offset by cash flows from sale of equity shares (1.584 billion pesos) and by increasing debt (222.1 million pesos).

The same dynamics can be seen from last year sale of equity shares (2.187 billion) and by increasing debt (284.1 billion pesos)

In CPG’s 2012 annual report[9], in 2012 CPG’s income almost doubled. However interest expense jumped by 20%.

Since 2010, CPGs ‘cash used in operations’ (before interest and income charges) have been in a deficit.

In 2012 CPG added 800 million pesos worth of investments which compounded cash deficits from investing to 863 million pesos.

So how did CPG finance the 2012 cash deficit from operations of 3.077 billion pesos (before interest and taxes) and deficit from investing activities of 863 million pesos? By borrowing money 2.78 billion pesos and sale of shares worth 2.19 billion pesos.

So far CPG’s core business has been inadequate to service the company’s debts and thus has resorted to borrowing aside from relying on cash proceeds from the company’s listing in the PSE in 2011.

The company’s long term debt of 3.367 billion pesos have mostly been in bank loans and partly on CTS (contract to sell) financing.

CPG has 1.794 billion pesos in cash and cash equivalent. This represents around 53% of the total debt. This also means CPG has a significant cash cushion to burn while waiting for the core business to turn positive.

Nonetheless if the vacancy rates in the high end property sector as noted last week[10] continue to rise, which likely means the slowing of top line figures, then CPG’s cash hoard will eventually be consumed. CPG will then have to rely on more debt or further sale of her assets (or inventories at lower prices).

Of course CPG debt exposure (3.367 billion pesos) to the financial system is minute compared to San Miguel (324 billion pesos adjusted for the sale of Meralco) or CPG hardly poses as systemic risk.

But again the point here is that zero bound rates has prompted aggressive leveraging and risk taking by companies such as SMC, SM and CPG.

So yes stocks may continue rise, but if these companies continue to absorb more risks via more debt without improving core businesses, and if economic conditions change enough to expose their vulnerabilities whatever gains today may be lost in a snap of finger.

[Updated to add: correction on two numbers: 539.7 billion and 222.1 billion altered to million]

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[1] See Why San Miguel Corporation Looks Vulnerable September 23, 2013

[2] See Phisix: Moody’s Sees Bubbles as Structural Shift to Higher Growth October 7, 2013

[3] Wikipedia.org Cash flow forecasting

[4] Q Finance Understanding Free Cash Flow

[5] Investopedia.com The Greatest Investors: Benjamin Graham

[6] Peter L. Bernstein Against the Gods: The Remarkable Story of Risk John Wiley and sons p.7.

[7] Rappler.com From Paris Hilton to Donald Trump, Century Properties' celebrity ties June 26 2012

[8] PSE.com.ph CENTURY PROPERTIES GROUP INC 2^nd quarter report (as of June 30, 2012) SEC Form 17Q Report August 14, 2013

[9] CENTURY PROPERTIES GROUP INC Annual Report SEC FORM 17-A April 16, 2013

[10] See Cracks in the Philippine Property Bubble? October 7, 2013