By JASON BOOTH
Creative Computers Inc. of Calabasas is the most profitable company in Los Angeles, based on average return on equity over the past five years.
But before being too impressed, note that the computer retailer posted a net loss of $17.8 million in 1998, resulting in a negative ROE of 26 percent. In a bid to survive, the company has closed most of its stores, and is attempting to shift its sales to the Internet.
It just goes to show that relying too heavily on any single measure of company performance can be, at best, misleading and potentially even disastrous for investors.
“You don’t ever know for sure that a company will remain profitable. That’s why an investor has to diversify their portfolio,” said Jim Mair, executive vice president at Pasadena-based money management firm Roger Engemann & Associates Inc.
Some L.A. companies clearly seem steadier performers than others. Hilton Hotels Corp., for example, was L.A.’s most profitable public company last year, and it’s the area’s eighth-most-profitable company over the past five years, based on average annual ROE.
But even long-term ROE performance can be misleading, analysts and money managers warn.
“Theoretically, high ROE should translate into high profitability, but in truth it can be skewed in a number of ways,” said Bryant Riley, president of Westside brokerage B. Riley & Co.
ROE is a percentage calculated by dividing net income into common shareholder equity. So it is boosted, obviously, by an increase in net income. But net income can be artificially inflated by one-time gains and other factors that have little or nothing to do with a true improvement in company performance.
Likewise, ROE can be boosted by reducing common shareholder equity, through the issuance of debt, buying back shares or other such maneuvers.
Part of the reason that Guitar Center Inc. managed to be ranked as the third-most profitable L.A. public company last year, based on ROE, is because it leveraged itself through debt offerings, analysts said.
John Lee, president of Century City-based Hollister Asset Management, said he considers net profit margin to be a more reliable gauge than ROE.
“You can’t manipulate net margins,” he said. “It tells you what percentage of each dollar of sales goes to the investor.”
The best way to determine if a company will remain profitable over the long term, Lee said, is to look at how much of its earnings are being plowed back into the company.
“They may be making a profit,” he said, “but the question is, what are they doing with that money for the future?”
Another indicator is what company insiders are doing with their own money. If executives and directors are loading up on their company’s stock, that is clearly a bullish sign, while a sudden, high volume of insider sales can be a sign that trouble is around the corner.
One way to avoid relying on misleading financial indicators, of course, is to look deeper into a company’s competitive position and assets.
For example, some Hilton shareholders may have become spooked by the Asian meltdown last summer, because Hilton has several properties in that continent. But a closer look would have revealed that Hilton also has strong brand-name recognition and well-placed facilities in key destination cities such as New York and Las Vegas. As a result, Hilton has benefited from the strong U.S. economy in recent years.
“They have solid assets, a good game plan and solid execution,” said Denise Warren, senior industry analyst at Merrill Lynch & Co.
And having a strong brand name like Hilton can go a long way toward ensuring long-term profitability.
Mair said he looks for companies that have established a strong brand name, established dominant market share or have a monopoly in a certain product category or niche. “The less you have to invest into establishing your brand, the more profitable you will be,” he said.
Lee looks beyond the brand name to the product itself.
“I look for companies whose product is easily understood, which is essential to the public, which can easily be transported to other cultures, and which is unique enough that you can charge a premium for it,” he said.
While Hilton has protected itself by having assets in a strong-performing market (the United States) to offset assets in a weak market (Asia), other L.A. companies are not so well protected.
Hawker Pacific Aerospace Inc., a Sun Valley-based company that handles maintenance for commercial jet aircraft, was hurt by slower business in Asia. And even its expansionary moves depressed profitability, at least in the short term, due to higher-than-expected costs associated with an acquisition in Great Britain.
As a result, Hawker Pacific’s robust 34.3 percent ROE in 1997 (10th highest among local public companies) dropped to -6.0 percent in 1998.
Discerning a company’s business structure also can be key to determining its profit outlook.
Take Tarrant Apparel Group, the second most-profitable local company over the past five years, and the 10th most profitable last year.
Such a steady performance would seem highly unlikely from a company in a highly volatile industry like apparel manufacturing, in which fickle consumer fashion tastes can send profits soaring or plunging virtually overnight.
But Tarrant has developed a business model that helps shield it from risk. The company manufactures clothes to order for department stores. So, unlike brand-name apparel manufacturers, which often fall prey to shifting tastes, Tarrant is able to maintain a steady cash flow.
“They are effectively putting the risk on the retailer,” said Jeanne Kraus, an analyst at First Security Van Kasper in San Francisco.
One local high-flier that remains largely unshielded from the vagaries of changing consumer tastes is Natrol Inc. of Chatsworth.
The company, which produces herbal remedies and other personal care products, was the third most-profitable company in L.A. last year, with ROE of 50.3 percent. And that performance has been largely driven by a nationwide explosion in the popularity of herbal products.
But over the past three years, Natrol has an average annual ROE of negative 106.7 percent. Of course, its recent soaring fortunes could continue, but such rapid reversals of fortune may be reason for concern.
“A swing like that is likely to be a red flag,” said Jack Kyser, senior economist at the Los Angeles County Economic Development Corp. “You have to ask what made them swing so quickly from red to black, and whether they could go back again.”
Vulnerability, of course, can come from sources other than changing consumer tastes. For example, the fortunes of Newhall Land & Farming Co. are inextricably tied to the health of the California real estate market. And with the local real estate in an up cycle in recent years, Newhall Land has posted an impressive 29.6 percent average annual ROE over the last five years. But if property values drop, and historically they always have hit down cycles, Newhall’s ROE will follow suit.
Such macro forces are why companies hoping to remain profitable over the long haul can’t afford to rest on their laurels.
“In the long term, in order to maintain profits you have improve productivity, and that’s not easy,” said Tom Lieser, senior economist at the UCLA Anderson School Forecast.
Another hard hit local company was by Imperial Credit Industries.
The investment firm posted very strong ROE of 27.8 percent in 1997, making it the 17th most profitable company in L.A. that year.
By 1998, the company had fallen on hard times, losing $59 million dollars amid the downturn on the stock market and posting negative ROE of 25.3 percent, placing it 210th on the list.
And just as companies can swing from good to bad, some of this year’s winners were in the dog house not so long ago.