No. of Recommendations: 30
I'm surprised there has been no further comment on this share as it's quite an interesting case and has garnered a lot of recs. The story looks good, the profits look good and the potential looks even better.

However, I'm now going to argue that not everything is as rosy as it currently seems. I'm a bit old fashioned in that I think the value of a business is the present value of the future cash flows it can generate. EROS, as it currently stands, does not generate any cash flow. It burns cash at a pretty sizeable rate and has done for the past five years.

So why then is it churning out such impressive profit growth? If I had to title this post, it would be 'Not all earnings are worth the same'. Investors would be well served by paying more attention to the cash flow statement to understand what's happening to their money.

All the 'profits' of the last five years have just been due to a gigantic build up in intangibles, my least favourite asset. If the accounting were to be more conservative and they expensed all this asset build up directly they'd have made no profit at all. The company has only been cash flow generative in one year of the last five and needs to keep tapping the equity and debt markets to keep up with this cash burn. Not only that, the huge capex spends haven't even been all that successful in producing growth even with the generous accounting, with return on equity having dropped every year in the last five.

I try and view the cash flow like I would if I were a private owner of the business, so I ask myself 'what cash am I left with, after taking in all my revenues and paying out all my expenses?'. Due to the way EROS capitalise a large proportion of their operating expenses, it takes costs out of the operating cash flow line and in to the investing cash flow line. For example, here is what they showed for last year:

Net Operating cash flow (After Interest & Tax): £62,947

Investing cash flows (Capex): -£85,432

Combined cash flows from operating and investing lines: £-22,485

This is what I mean by cash flow negative - the activities of the business, so operating and investment, burn cash rather than generate it. They've done this in every year of the last five apart from 2010. The reason operating cash flow is positive is due to the large capitalisation of their expenses. An alternative accounting treatment would be to not capitalise any costs at all, in which case the cash flow statement would look like this:

Net Operating cash flow (After Interest & Tax): £-22,485

Investing cash flows (Capex): £0

Combined cash flows from operating and investing lines: £-22,485

Which looks far less rosy! Profits would also be negative if this alternative accounting treatment were used. In fact, here's what the profits would have been if the company didn't do any capitalisation at all over the past five years:

2007: -£23,032
2008: -£46,677
2009: -£37,866
2010: £18,121
2011: -£22,485

Now, it might be that this huge capitalisation is justified by the cash flows these intangible assets will generate in the future but the issue is that they aren't justified yet in terms of the cash flow they currently do so any valuation of the business needs to be based on what the business looks like when it reaches maturity.

I'm concerned that this investment in the future has been going on in a cash flow negative manner for five years now, so I'd want to see the proverbial light at the end of the tunnel i.e. the business is generating considerably more cash flow than it consumes and I just don't see it right now. It's especially worrying that given the business managed to turn cash flow generative in 2010 to then take a step backwards and go back to consuming cash. New and start-up businesses will have a cash consumption period, I accept that, but I'd expect this business to be in a cash generating stage and it just isn't.

I'd be very interested in seeing the assumptions underlying the projected future cash flows of the business and how the back catalogue valuations were arrived to try and determine if they are reasonable but right now I'd need something very convincing to justify an investment. In fact, given that the management have been deliberately using very aggressive accounting techniques to boost profits in order to show wonderful 'growth' I'm now incredibly sceptical of anything they'd tell me.

I've read too many stories about financial manipulation to know that when management try to tell a story with the numbers that doesn't reflect the real, underlying economics of the business that you should avoid them like the plague.
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