Comments on HIH’s financial statements

Note
In order to make the financial analysis as accessible as possible to
ordinary investors, I have simply “spread” the HIH financials onto a
spreadsheet format, and derived ratios and a fairly straightforward cash
flow analysis from them. With a relatively small amount of studying, the
average investor could probably carry out the same analysis. References
to the attached schedules are in red.

Before looking at the detailed numbers, I have a number of general

comments to make:

1. A number of commentators have made the point that insurance

companies generate investment income to complement the low returns
from underwriting. That’s all very well, but HIH made underwriting losses
in each of the past 5½ years Page 2, marked (i). How was this sustainable,
particularly as the investment climate turns down?

2. Why, when the company was unprofitable and cash flow negative in
1999, did it pay over $95 million in dividends? Page 2, marked (ii)

3. And why did HIH dramatically restate profits for 1996 and 1997 in
the 1999 and 2000 accounts without an explanation? There are very
significant discrepancies in the P&L between the published results and the
results in the prior year financial summary in the 2000 accounts. The
reported underwriting profit for 1997, for example, goes from $41.7
million to $28.3 million, a fall of 32%. Page 6, marked (iii)

Now let’s look at HIH’s cash flow (by my analysis, not the published cash
flow statement). The following figures Page 4, marked (iv) (in $mn) are
revealing:

1997 1999 2000

Net operating cash flow 8.6 307.3 99.5
Interest expense 9.3 27.0 36.0
Cash debt service cover 0.925 11.4 2.8

These look reasonable, although the fact that the cash debt service ratio
fell from 11 times to less than 3 times inside 12 months periods is a worry.
However, what is more revealing is to look at HIH’s cash generation
capacity with the impact of the very substantial acquisitions stripped out:
Page 5 marked (v)

1997 1999 2000

Net operating cash flow 8.6 -125.2 99.5
Interest expense 4.9 27.0 36.0
Cash debt service cover 0.925 2.8

In other words, in 1999, were it not for the additional working capital
provided from acquisitions (principally FAI), HIH’s net operating cash flow
would have been severely negative-to the tune of $125 million. Surely, if
this had been disclosed, it may have precipitated earlier intervention into
HIH?
Moreover, what these figures demonstrate is that, over 3½ years, HIH
generated a negative $17 million of net operating cash flow from its own
operations, and was obliged to find funds from elsewhere to meet a total
of nearly $68 million in interest. Even allowing for the $82 million in
increased creditors arising out of the 1999 acquisitions, this is a poor
performance.

So where did HIH find the funds?

The analysis of where this came from is also revealing (before accounting
for the acquisitions): Page 4, marked (vi)

1997 1999 2000

Funding need 135.5 425.0 223.7

Funded by:
Lenders 13.2 423.8 23.7
% 6.6% 136.2% 10.6%
Shareholders 50.9 280.5 23.4
% 37.6% 66.0% 10.5%
Changes in cash balances -75.1 +435.0 -177.1
% 55.4% 102.4% 79.2%

So, like squirrels, HIH set money aside in good times to fund times when
there were greater funding needs. But even in good times, the kindly
lenders provided the great majority of the funding: when a company is
growing as fast as HIH proclaimed itself to be, the shareholders would
normally expect to be called on to shoulder a larger proportion of the
funding needs.

 Another interesting question is the extent to which the financial

warning signals discussed in “Corporate Collapse” might have
provided warning of the deterioration in HIH’s financials. The
following table applies a series of warning signals to HIH’s
financials.

Warning signals from financial statements

1997 1999 2000

Net operating cash flow >25% less than stated operating
profits ∙
> 25% deterioration in net operating asset position
(Receivables & inventory/Accounts payable &
accruals)
Net operating cash flow positive because of material
reduction in receivables & inventory and/or growth of ∙ ∙
trade creditors & accruals
Non-operating income >25% of net operating cash flow
> 25% deterioration in cash interest cover
∙
Cash interest cover <3:1
∙ ∙
External sources provided >50% of net funds needed
during year ∙
Intangible assets >25% of shareholders’ funds
∙ ∙ ∙
There are a number of alarming signs here, including:

 The extent to which net operating cash flow was dependent on

growth in claims receivable, to offset the dramatic increase in
receivables Page 4, marked (vii);
 The dramatic deterioration in cash interest cover; and
 The fact that intangibles (largely goodwill) made up more than 75%
of shareholders’ fund Page 1, marked (viii)

It’s also worth while taking a look at HIH’s financial ratios, to see if there
was anything alarming in them Page 3. A number of issues are
immediately apparent:

 The rapid deterioration in gearing1 page 3, marked (ix);

 The rapid deterioration in “normal” (i.e. not cash) interest cover
page 3, marked (x);
 The continued negative insurance margin page 3, marked (xi);
 The deteriorating return on assets page 3 marked (xii);
 The dramatic deterioration in HIH’s cash conversion cycle page 3
marked (xiii);

All of these suggest a company whose financial position was deteriorating

rapidly, Indeed, t is the fact that ratios addressing a range of different
concerns-debt service, gearing, performance-were all deteriorating
simultaneously that suggests that HIH was already in a significantly
weakened state by the 2000 financial statements.

Finally, some data that is often overlooked by investors when reading

financial statements. The company’s segment reports, when set out in a
table and analysed (Pages 7-9) give some interesting additional
indicators, including the following:

 Losses in US were escalating, and, by 2000, were equal to 30% of

the Australian operations, even though revenues were the equivalent of
only 20% of Australian assets, and assets only 13% of Australian assets.
 The second largest generator of revenue (UK) and New Zealand
were both generating losses and declining returns on assets.
 The dependence of HIH on its Australian operations for profits grew
over the past 5 years, even as its contribution to total revenues declined.
This gives quite a different picture to the purple prose at the front of the
annual report.

All of the above suggests that HIH was inconsiderably less than robust
good health well before its collapse. Obviously, there were those analysts
who were aware of the real picture of HIH, but were the general investing
public aware? Were the employees aware? Were Governments aware?
The reaction since HIH’s collapse suggests not in each case.
1
It could be argued that this gearing ratio is a little aggressive, given that I
have treated all HIH’s convertible and converting notes as debt, where the
company showed some of them as equity. I argue that, so long as HIH had to pay
interest on them, the notes had the character of debt.