Ellies (ELI) released its H1:12 results today revealing revenues up 11%, PAT up 36% and HEPS jumping 39% to 20.98cps (H1:11 - HEPS of 15.12cps). At first glance, these are very strong results in a tough local economy.

Most of Ellies growth came from its Megatron or "Infrastructure electrification" segment where revenues jumped from R85m to R251m and Profit Before Tax (PBT) grew from R8m to R38m. Ellies founding segment (with brands like Elsat), the "Wholesale distribution" segment, saw revenues come off slightly by c.17% and PBT slip by c.5% to R60m (H1:11 - R63m) as the previous period still included World Cup consumer spend and the current period saw a slight change in the satellite pricing and distribution models.

Overall, good results...until you look at the cash flows and working capital.

In FY 10 Ellies declared a surprise dividend of 5cps (dividend cover of 5.2x HEPS). I chatted to management at this time and they intimated that Ellies would now be paying dividends. This is always a strong sign of optimism in a Group's prospects and I took it as such.

Then, in FY 11 the Group reported HEPS growing by a whopping 21%, yet dramatically cut its dividend due to "due to short term funding requirements to support working capital needs". The logic?

Well, the FY 10 overdraft of R31m had expanded to an even larger overdraft of R46m by the end of FY 11. There was some cash generation, though, in FY 11 and Ellies actually saw its FY 10 net overdraft (i.e. cash less overdraft = net cash/(overdraft)) position of R13m become a small net cash position of R25m.

More recently, though, this R25m cash (net of a R46m overdraft) that was reported at the end of FY 11 has actually gotten worse and at the end of H1:12 Ellies reports that its cash position has slipped to a net overdraft of R24m (with a total overdraft of a staggering R67m). While Ellies H1:12 revenues rose by 11%, the debtors rose by 90% as debtors days expanded from 48 days during H1:11 to H1:12's 83 days and inventories rose by 24% yet creditors only grew by 37%.

In other words, the short term funding requirements needed to support Ellies have gotten more dire.

This is not unique to this reporting period for Ellies either. If you dig around into Ellies listed past, almost every year the working capital requirements for the group expand and the overdraft and cash position deteriorates.

Hence, it is unlikely that anything will change in H2:12, thus it becomes even more remote that Ellies will declare a dividend for FY 12. And, if Ellies working capital does continue to deteriorate (or even remains the same, i.e. net overdraft) for H2:12, yet the Group does declare a dividend, I would have serious (serious!) questions to ask them.

Here is the logic:

It is quite likely that Ellies overdraft is attracting an interest rate of approximately prime (currently 9.0%). If Ellies then declares a dividend, it will have to pay it in cash (ignoring the option for a script dividend, which is even worse for shareholders...). As the Group is in a net overdraft position, it has no cash to pay this dividend. Therefore, Ellies will have to increase its overdraft to pay this cash dividend. At Thebe Stockbroking, we are currently forecasting FY 12E HEPS of 37.98cps, thus assuming a dividend cover of 5.0x, Ellies will be paying a dividend of 7.6cps or a Dividend Yield of c.2.5% on its current share price of 297cps.

In other words, Ellies will be borrowing money at 9% to pay its shareholders a return of 2.5%. I.e. there is a 6.5% cost to its shareholders of Ellies declaring a dividend.

You may point out that based on this logic, the cost to Ellies shareholders gets smaller the larger Ellies dividend is.

Aaaah, but then you are not seeing the bigger picture...

If Ellies declared its full HEPS as a dividend, then a dividend of 37.98cps implies a DY of 12.8%. On the above logic, this dividend actually appears to create value for Ellies shareholders of 3.8% (=12.8% - 9%). But...the dividend is a once-off benefit while the overdraft will still be there in FY 13! Hence, in FY 13, the cost of FY 12's irresponsible dividend would be another 9% interest cost, but there is 0% (nil, nothing, nudda etc etc) benefit to shareholders.

Yes, you can argue for tax deduction and so, but the logic remains: in reality, any dividend of any size declared by a company sitting in a net overdraft position is more than likely to destroy returns rather than create it, unless that company can dig itself out of its net overdraft position quite quickly. And, if you talk to anyone who has been in a large net overdraft position, this is a lot harder you think.

Hence, I think Ellies is a classic case study for how not to manage a business's working capital and how this endangers shareholders' long-term returns.

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