Actuant (ATU), an equipment and solutions company serving a diversified group of industrial and energy end users, has been rated as high risk (<40) for the last 2 year ends and latest fiscal quarter. It falls squarely in Quadrant C, where you definitely don't want to see your key partners!
While this is a pretty clear indicator that you'd want to look into them a bit more if they were one of your key or critical suppliers, a high risk score isn't the only thing that should stand out. Besides a score of 34, High Risk, for the trailing twelve months ended Q1 2018 (for Actuant, that's 12 months ending November 30, 2017), there are some other flags that would make Actuant worth a second look:
- Core Health scores that are just over 1/2 the FHR scores for the same periods
- A consistent pattern of decline (low risk up to 2014)
- A big delta between actual and simulated FHR
So with a whole suite of reports available, and limited time, where do you start?
To immediately pinpoint relative weakness and strengths, provide historical context and give you the "lay of the land", Section 2 of the FHR is a quantitative overview of performance category scores.
Let's get a few things straight...all of these scores are based on 12 months of financial data. FHR is associated with an estimated probability of default, while core health can be thought of as medium-term profitability and efficiency.
Remember those 68 ratios that go into our methodology? Well, the last two tables show different buckets that those 68 have been split into. Core Health comes first - 62 ratios, divided into Operating Profitability, Net Profitability, Capital Structure Efficiency, Cost Structure efficiency. These groups of ratios are scored from 1-100.
Depending on how good (or not good) these scores are, Resilience Ratios are less (or more) important. Here's the ratios that give a company credit for a good balance sheet divided into Leverage, Liquidity and Earnings Performance. We score them on a letter grade system.
Looking at that first table, you see that declining trend - Actuant went from low risk in the early part of the decade, to fluctuating between medium and high risk (depending on the quarter). This is clearly a declining pattern, and something to ask them about (or dig into deeper).
Moving down, you can see where the problem is immediately! Apparently Actuant's capital structure hasn't been great since 2010, but the real drop in Core Health is due to a decline in operating and net profitability. Today, their profitability scores stand at an abysmal single digit value! Another item to add to our "dig deeper" list.
So now you know, poor trend, poor profitability - it must mean the balance sheet is important! Looking at the last table, you see that Leverage is classified as weak, Liquidity and Earnings performance are Adequate, but nothing is strong enough to push that score into medium risk currently. The relative strength of Liquidity (cash on hand) and earnings however, accounts for the FHR being almost twice as large as the core health scores - for this level of core health, Actuant's balance sheet doees mitigate some of the default risk and exposure to shocks.
Now that we have some initial thoughts, where can you find more detail?
A good starting point is Sections 9 and 10 of the FHR, the Balance Sheet and Income Statements of the company you are looking at. This is available for all publicly rated companies, as well as private companies that have allowed for full disclosure.
From the income statement, you will learn what you already suspected - Actuant's profit margins went from positive to negative in 2016, and have remained below 0 ever since. Separately, you can also see that revenue growth over the same time period has also been negative, with TTM ending 11/30/2017 the first period with positive revenue growth.
Looking a little closer, you might notice some large abnormal items, further details of which can be found in Section 4 of the FHR:
And you can dig into that balance sheet a little more - noting that while Gross Debt to Total Assets hovers around 40% (give or take) from 2015 onwards, the cash flow and liquidity stories are quite good.
From this quick analysis of the FHR report, you now have some solid questions to speak with Actuant about (or research yourself):
- What is the revenue and profitability story? Is there a specific business unit responsible for the the declining revenue and the switch from positive to negative profitability?
- These abnormal losses are pretty large, especially in the periods that Actuant is rated high risk. In 2017, the abnormal item was 15% of sales, while in 2016, it was 19%. For the latest period, it's 11.4%. What do these items consist of, and why are they so frequent?
- Debt has remained mostly consistent from the more profitable days, but it's more risky to have such a high leverage ratio now. What are Actuant's thoughts on this?
- What are the characteristics of the balance sheet and operational structure that lead to such a less than ideal capital structure efficiency?
- Actuant has some strengths going for it - cash flow is positive, working capital for the 2016, 2017 and Q1 2018 is positive (and in the hundreds of millions!) and other liquidity ratios (think cash / current liabilities as an example) are high (around or above 50%). How does Actuant plan to use these strengths to improve its financial risk?
So, before we spoil the surprise for you, we do have to point out that these questions look an awful lot like those in our Financial Dialogue for Actuant.
While we've shown you how to analyze the FHR Report in the most efficient way, you can always take the easy route, and grab that Financial Dialogue solution instead.
And now, it's the part you've been waiting for! We didn't actually have a conversation with Actuant on the questions above, but we did do some of our own research, and the high risk rating and declining trend has a very interesting story behind it!
Actuant has 3 Business Units: Energy, Industrial, Engineered Solutions. We are not sure if "Energy" set of some bells in your head, but, not surprisingly, it is Actuant's Energy business has been dragging revenue down - project cancellations, deferrals and scope reductions. Actuant's outlook for Energy remains negative to flat for the fiscal year 2018. Combined with this, they saw some lower than expected growth in their Industrial segment, due to increased competition.
Looking into that switch from positive to negative profitability, since 2015, Actuant has had abnormal losses every year. These can be chalked up to all the corporate activity they have been deliberately carrying out - their stated strategy is to achieve a significant portion of growth through M&A and spin-offs. Of course, with M&A, a large part of their asset base is now goodwill....which, you guessed it, is subject to large impairment charges (also known as abnormal losses!). Combine these impairments with various internal restructuring plans such as a cost reduction program that began in 2016, and we have found the source of the decline in profitability. Actuant themselves admitted in their latest earnings released that they will need to fix their margin issues.
An unexpected twist is that the debt ratio and capital structure is also affected by all this M&A. Total Debt to Total Assets was around 35% in 2015. Actuant's debt consists of a term loan and senior notes, the latter of which has been around since 2012. However, while Actuant didn't take on more debt, writing down all that intangible goodwill meant that the Total Debt to Total Assets ratio jumped up to closer to 50%. The same level of debt at lower levels of profitability is much riskier. Meanwhile, with M&A, Actuant's balance sheet has Intangibles making up 50% of Total Assets.
We will note that Actuant indicates that there will be future payoffs to all these moves now, that lead their financials to show elevated risk.
So where would you go from here?
This is the part where your teams and processes come into play. We've given you all the information - it's now up to you to decide if the risk posed by Actuant (given the backstory, facts and strategic vision) is acceptable, based on your internal parameters and deliverables. In cases like this, where there is a stated strategy that is deliberately leading to risky-looking financials, we would encourage significant discussion with your partner or supplier, to ensure you understand (and believe) in their vision.
Actuant's Annual Report for FY 2017
Actuant's Q1 2018 Analyst Slides
Transcripts of Actuant's earning calls