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What HNA Can Learn from Steinhoff

 A chief executive officer quits amid a probe of accounting irregularities; the stock falls 72 percent in a day; a results announcement is delayed by criminal and tax investigations. You wouldn't think there's much in the experience of the acquisitive retail conglomerate Steinhoff International Holdings NV that would be of use to its deal-hungry Chinese peer HNA Group Co.

Yet the crisis at the South African group that controls Mattress Firm and the U.K.'s Poundland offers a salutary lesson to any company that's grown mighty through a voracious appetite for takeovers: When you're in a tight spot, operating cash is king.

With the proviso that the books of a company facing an accounting inquiry might be taken with a pinch of salt, a comparison between the cash flows of the two groups is instructive. Here's Steinhoff's:

One thing that's notable here is that, while the company has clearly been heavily dependent on financing, it could have paid for a substantial share of its investments from operating cash flows alone. Over the past three years, 1  operating cash has been sufficient to cover about 70 percent of group investments. As a result, free cash has only rarely dipped into negative territory.

HNA provides a markedly different picture. Operating cash here looks more like an afterthought — over the same three-year period, the company would only have been able to cover 12 percent of investment spending. The last time free cash flow was positive was when HNA posted a 9.11 million yuan ($1.38 million) inflow with its 2007 annual results, according to data compiled by Bloomberg. In 2016, the result was a negative 61 billion yuan.

There's a simple reason that few companies spend long on the sort of shopping spree that Steinhoff and HNA followed in recent years: Takeovers tend to destroy shareholder value. You have to pay over the odds to prise a business away from existing shareholders, and touted synergy and integration benefits rarely meet expectations.

As a result, companies on such a trajectory generally run out of acquisition cash at some point. At best, their lenders will then give them several years to digest the businesses they've taken on and start generating returns. At worst, they risk a swift appointment with administrators.

With HNA's core business, Hainan Airline Holding Co., canceling a bond sale and another unit scrapping a share offer as borrowing costs rise and credit companies cut their ratings on the debt of group companies, Steinhoff's troubles represent a potent warning sign.

After all, the South African company's accounts always looked relatively solid, if racy: Net debt at its most recent financial year-end in 2016 was 2.96 times Ebitda, and the interest bill was covered a handsome 9.32 times by Ebit. Return on invested capital came in at 5.8 percent in the most recent year, but had been in manageable territory north of 8 percent in both of the two previous years.

At HNA, those metrics don't look nearly as good. Leverage was more than twice as high, with net debt at 7.8 times Ebitda, while Ebit was just 0.8 times the interest bill, meaning that HNA has only been able to pay its old debts by taking on new ones. Returns on invested capital of just 1.6 percent suggest that HNA's cash would have performed better invested in one-year government bonds.

It's hard to be sure how far to trust Steinhoff's numbers, given the accounting cloud over the company. But if hypocrisy is the homage that vice pays to virtue, then rubbery accounts at least recognize the importance of sound accounting in building a sustainable business. 

Should Steinhoff's troubles spiral out of control, the scandal will be about what was hidden behind its published numbers. Should the same thing happen to HNA, the scandal would be over what's been out in the open.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Actually three years and a quarter: Steinhoff changed its balance sheet date in 2015 and only reports cash flows half-yearly.

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