10 Value 10

Still Vert for Go

2011-07-10T19:17:00.000+01:00

Jacques Vert announced its full year results on 5 July and showed that there is still life in some retail stocks. The previous analysis is here.

Year to 30 April 2011

In a nut-shell, the Company held its own, which is more than a lot of retailers can claim. Turnover, margin and profits were all there or thereabouts compared to last year. The recently reinstated dividend was increased by 3% (v FY10), which is encouraging.

Cash generation remained strong, although there was a big adverse swing in working capital (stocks up, trade creditors down) and increased capex (IT system), but closing cash balances were over £10m. The full year results are here.

Valuation

Based on a share price of 17.5p, the market cap is £34m. Adjusting for the net cash of £10m, the Enterprise Value is £24m. The PAT, which is the profit attributable to shareholders, was £5m. Put it another way, if you buy a share in the Company, it would take only five years for the Company to generate enough profits to pay back your initial investment. Of course, that assumes that profits do not grow (or fall, as the market may be implying). No doubt, FY12 trading will be tough with increased margin pressure, but given the customer base and the cash cushion, I do not anticipate that it will fall off a cliff. EV/EBITDA is around 3.5x, which is very, very reasonable.

The PER comes out at 6.9x (FY11 EPS of 2.55p), ROE 19.6% and ROCE 23.3%. The current yield is 3.8% (EPS 0.67p).

Source: Digital Look

The shares trade on a 30% discount to the general retail sector, which trades at a PER of 11x, (source: Sharelockholmes) and this (probably) does not even reflect the cash-rich nature of the Company, although the shares have handsomely out-performed the bigger AIM shares in the past three years.

There has been sign of some institutional buying with New Pistoia Income Settlement now up to 5%, whilst Schroders have been trimming their substantial holdings. No sign of director buying since January 2011.

The normalised PER appears to be in the 6 to 9x range based upon the trading history of the past ten years, so I am still maintaining some upside PE arbitrage potential. I'm still aiming for a share price close to 30p (being EPS of ~3 and a PER close to 10x). Seymour Pierce reiterated its price target of 28p.

Conclusion

The Company is probably unloved because it is a small, AIM listed retailer and therefore off the radar of most folk. I still think that the valuation is too stingy for a solid, profitable and cash generative potential, and that there is further upside potential to the share price, so I have topped up some more.

Less is More?

2011-06-29T21:06:00.000+01:00

Having been on an extended holiday and had a change of personal circumstances, I am no longer able to publish blog posts as frequently as I have done previously. To combat this, I have decided to be more selective in the quality of the opportunities that I look at.

I am therefore re-working my rules to screen the population (via Sharelockholmes) and spend time looking at the select few. My new rules have borrowed the thoughts of the great and good, including the likes of Greenblatt, Buffett, Graham and esteemed fellow bloggers. The emphasis is intended to be on 'quality first, price second'. I like the prospect of buying a share and tucking it away for the long-term...and watch it grow and grow.

Hopefully, less will mean more.

10 Ingredients

1 - ROC > 25% - ROC is a proxy for Greenblatt's ROA;

2 - Earnings Yield > 15% - Greenblatt has it as a relative measure, but I'm going for an absolute measure of 15% as this feels aligned with my target return of 15%;

3 - ROE10 > 15% - a Company needs to be be able to demonstrate enhanced shareholder value over the long-term, ideally over a ten year period;

4 - ROCE > 15% - I'm just being greedy now on my financial ratios;

5 - PER < 16x - a la Graham;

6 - PER on EPS10 < 20x - slightly higher to allow for an element of growth;

7 - Yield > 2.5% - I want to hedge my bets and at least get a return as I go along;

8 - Gearing < 50% - a bit of debt is capital efficient, but I do not want too much;

9 - Piotriski >= 6 - a new one for me. Appears to be a interesting snap-shot for balance sheet health; and

10 - EPS 5 year growth >27.5% - this is the equivalent of 5% annualised growth over five years. EPS needs to grow to drive value over the long-term.

And More...

Once I've got my candidates, I will then be looking at:

- quality of earnings - past and future
- cash generation and what happens to it
- director buying and motivation
- relative valuations versus historic trends and peers

Simple!

The First Cohort

Throwing all of the above ingredients into the mix comes up with five candidates which tick all of the boxes.

They are, in no particular order:

1 - Braemar Shipping
2 - Clarkson
3 - JD Sports
4 - RM
5 - Unilever

This is not a recommendation to buy these shares! I have a stake in Unilever at the time of writing, but I am intending to drill down into all of these companies, and more besides, in the coming weeks and months. On the face of it, these look like quality candidates, but time will tell.

Portfolio Matters...

2011-04-06T15:41:00.000+01:00

I had indicated a while ago that I would discuss my portfolio and subsequent performance in more detail. This article starts that journey, but first I want to discuss my investing context (if such a thing exists).

My Approach

To surmise conventional investment "wisdom", one can conclude that 99% of expected return from the stock market is down to asset allocation, dividends and (possibly) timing.

If that is true, then it makes sense to go and buy a few index trackers, ideally in the form of low-cost ETFs, set your dividends to reinvest themselves, and then go off and wash the car, creosote the fence or whatever else is on the 'to do' list. This approach assumes that the market is "efficient" and that it is not worth your while spending effort and energy in trying to finding market-beating investments, because you will not be able to do so sustainably in the long-term.

At the other end of the spectrum, if the market is not so efficient then consistent above-average returns can be made from stock-picking the right companies at the right time a la Buffett, Graham & Co.

I take the middle ground and adopt a bit of both. My portfolio of ISAs and SIPPs is currently structured into three components as set out below.

NB - I did not deliberately set out to create three components, but after considering my rationale and doing some analysis, I realised that my portfolio fell into three camps. For more instructive discussion and analysis on portfolio allocation and passive investing, I would heartily recommend spending some time with Monevator.

Three Components

A - Thematic

Big picture: the global population is growing; resources are finite; food, energy and infrastructure will be in demand; emerging markets are...emerging.

My sphere of knowledge extends to UK listed companies. I do not have the expertise or time to try to understand overseas companies with a degree of comfort. I also believe that emerging markets in particular are less efficient and that a good stock-picker (fund manager) should be able to generate superior returns (in the medium-term at least).

In the past, I have favoured Investment Trusts as these can often be bought at a discount to net assets and tend to have lower charges than Unit Trusts. Going forwards, I will look increasingly at ETFs. On a PE/yield basis, Brazil and Russia look cheap, China and India look more expensive.

Current holdings:

Asia - First State Asia, Scottish Oriental
Emerging - BR Latin American, TEMIT, Aberdeen EM, JP Morgan Emerging Markets Income
Infrastructure - International PP, HICL, Utilico EM, Ecofin Water & Power

B - Global Growth

These are UK listed companies with a global footprint and a track-record of delivering for shareholders over the long-term, usually with a generous dividend. The key to optimising returns will be buying these at the right price.

Current holdings:

Shares - Vodafone, National Grid, Aviva, BP, Unilever and Reckitt
I/T - Hansa Trust, British Empire, RIT Capital Partners

C - Special Situations/Value/Discount/Other

This is really the category for anything that I like which is not covered in the other two categories and where the main thrust of this blog has been so far.

Current holdings:

Drax - UK only, but reasonable value and good dividends
Johnsons - turnaround/recovery play that appears to be on the right track
Jacques Vert - lowly valued, cash rich, retailer with steady growth potential
Vertu - discount to net assets, net cash and growth potential
HMV - double or quits
Gleeson - housebuilder with strategic land - big discount to assets, but needs to clarify CEO and business model
UK Mail - reasonable value, cash rich, good dividend

Others, not yet covered on this blog:

Hansteen - interesting property play with growth potential
Chesnara - long-term holding that has doubled my money in three years
HG Capital and Graphite - private equity players with growth potential and acquired at significant discounts to NAV
Home Retail - Argos and Homebase retailer on a relatively low value, with net cash and a good dividend

Asset Allocation

In terms of allocating funds between the three pots, I am aiming for a 30/30/30 split with +/- 10 deviation either way, and the remainder to be in cash and/or fixed interest. This will force me to think about re-balancing, as well as keeping a pot of cash available for new opportunities.

As at 31 March 2011, the split was as follows:

A - 19% - with a locked-in yield of 3.8%
B - 19% - yield of 5.1%
C - 27% - yield of 4.1%

Cash & fixed interest - 35%

The Future

I am aiming for a pot of 15-20 companies to follow in categories B and C, and am there or thereabouts for that.

My current holding of cash is a bit on the high side and I will drip-feed into certain investments as appropriate, with my focus on categories A and B.

I am looking at re-writing/re-focusing my Rules to accommodate B opportunities as well as C. Richard Beddard and UK Value Investor in particular, as well as some interesting correspondence with other private investors, have really got me thinking more about 'great companies at a reasonable price' rather than 'ok companies at a cheap price' - ie quality first, price second.

Overall, I am still aiming for an annual return of 15% after costs.

Play Time

This will be my last post for a while as I am off for an extended holiday shortly. I will be back in May, hopefully with some modified rules in tow. Happy investing!

My Sun Sets for PVCS

2011-03-30T12:33:00.000+01:00

PVCS announced its results for the year to 31 December 2010 on 24 March and what a comprehensive read they are.

I first bought into the Company in April 2009 (way before this blog started) and reviewed it on this blog in December 2010

Headlines

Volumes of wafers have increased, more than offsetting the continued price fall = revenue + 6%

Gross margins fell from 36% to 29% due to continuing price falls

Operating margins fell from 17% to 13% despite cost reduction measures

EBITDA of £36m, down 8% (v FY09)

Operating cash was £16m, down 56% (v FY09) due to increased stock levels

EBIT of £29m, down 21% (v FY09)

PAT of £20m, down 21% (v FY09)

Free Cash Flow - outflow of £5m v inflow of £4m in FY09, due to investment in capex (without grants)

FY10 EPS of 5.0p, down 21% (v FY09)

FY10 DPS of 2.6p, down 25% (v FY09) and equates to a yield of 4.6%

Chinese and Taiwanese customers accounted for 42% of revenue (up from 12% in 2009)

75% of revenues are now generated in Asia and 25% in Europe & USA

No immediate impact on Japanese customers, suppliers or operations from earthquake and tsunami. A strong Yen has a negative impact on PVCS's results, although the back-lash against nuclear is likely to be positive for solar in the long-term

A strong start to 2011 due to strong growth in global installations - with H1 volumes expected to be 45+% up on H1 2010

Valuation Metrics

NAV of £245m, including Net cash of £48m on balance sheet

Market cap of £238m based on a share price of 57.2p. This represents a PER of 11.4x

EV of £190m. EV/PAT ratio of 9.5x and EV/EBITDA of 5.3x

ROE of 13% in FY10

Thoughts

Whilst PVCS is not particular expensive in terms of valuation and has a strong balance sheet, what concerns me most is the future. As the solar market evolves and the Chinese in particular pick up the pace, PVCS has an increasingly 'commodity' feel to it, with falling prices, squeezed margins and falling shareholder returns looming.

Ok, it is investing in its facilities, the global market is growing and it appears to be a well-run and financed-company, but do I want to invest in a company where they will have to run to stand-still trying to sell ever-increasing volumes in order to combat ever-falling prices? No.

I am struggling to see how I am going to generate my desired return of 15% IRR and think there are more suitable candidates out there. I am selling my holding in PVCS.

Will UK Mail Deliver a Profit?

2011-03-22T12:56:00.001+00:00

UK Mail Group PLC (UKM) claims to be one of the leading independent parcel, mail and logistics services companies within the UK and the main alternative to Royal Mail for business requirements.

Why Am I Interested?

It pops up on my new prototype screen (one of the '19' identified in Financial Ratios);
Reasonable valuation/yield - PER of 13x and yield of 6%; and
Cash generative and net cash on the balance sheet.

Background

History & Business Model

The Business was set up in 1974 by Peter Kane, who acts as Chairman, and grew with the help of his brother, Michael Kane, who stood down as Non-Exec to retire in 2010. The Kane brothers and family hold 59% of the ordinary share capital of the Company.

The Company is organised into four separate divisions:

Mail - 45% of turnover and 7% operating margin - collects up to 17m mail items a day for over 1,000 corporate customers. Mail is sorted, consolidated and handed over to Royal Mail to deliver the final mile. Licensed by Postcomm (= barrier to entry);
Parcels - 43% of t/o, 9% op margin - next-day B2B and B2C parcel delivery services;
Pallets - 8% of t/o, 6% op margin - distribution of palletised goods through a network of 80 suppliers; and
Courier - 4% of t/o, 13% op margin - same day delivery service.

The Business has grown turnover every year since 2001 (except for a flat 2010) and operating profit has been between £12m and £20m each year. Operating margins have fallen as lower-margin Mail has taken an increasingly large share of turnover, and there was a slight blip in 2006 when cost-cutting measures and price increases back-fired. The existing CEO joined at the end of 2005 and has grown PBT three-fold since then.

The Strategy is to strengthen its position as the "UK's leading integrated postal group" through (i) integrating the network (think IT) to make best use of resources (lowest cost) to deliver the breadth of services offered and (ii) increasing market share through new products and services.
The Company changed its name from Business Post Group to UK Mail in October 2009.

Investor Relations is here

Share Price & Value

Source: LSE

The current share price of 305p (mid-point as at 21 March) represents a PER of 13x and gives the Company a market value of £167m.

In the past three years, the shares have hit a high of 390p (Oct 2010) and a low of 255p (June 2009). The shares are 63% off the three year high.

M&G and Schroders hold just under 11% and 7% respectively. These two, the families of the founders and directors therefore control 75-80% of the ordinary shares, so there is not much left over for the open market...hence the large and nasty 3% spread on the bid/offer price.

Risks & Challenges

competitive environment with pressure on revenues and margins likley to persist in short to medium term at least;
the ability to pass on rising fuel and energy costs to customers;
the UK mail market is in structural decline and is contracting at 5% pa - therefore innovation and product development will be important in growing market share (eg imail product - a web-to-print postal service), as well as diversification into new areas (eg April 2010 - signed a new contract with Royal Mail to operate a packet collection and delivery service);
proposed privatisation of Royal Mail; and
succession issues - for management and the share price - if and when the Kanes start to unwind their influence.

The Rules

The following analysis is based on the 12 months to March 2010 (FY10)

1 - Assets - NAV was £59m, meaning that the Company is being valued at 2.8 times asset value. £12m of NAV is in relation to Goodwill and Intangibles and £40m in relation to Tangible Assets, and of this c£18m is freehold land & buildings, which is pretty much the book value (£20m) they had attributed to them back in the 2000 accounts. I cannot see an open market value disclosed in the notes, but suspect that it is significantly higher than the carrying value in the 2010 balance sheet. Refreshingly, I cannot see too many nasties in the balance sheet either. Whilst I do not like a premium to NAV, I can just about live with it given that the premium to actual market value will be lower than 2.8 times. Pass(ish).

2 - Market Value - market cap of £167m. Pass

3 - Cash Flow - (a) net current assets of £16m and (b) operating cash of £29m after working capital movements. Out of this we need to cover: replacement capex (£7m - full capex) and tax (£5m - FY10 P&L), meaning that there is £17m left to cover working capital movements, investments for growth and dividends (£10m). Cash generation appears to have been consistently good, and can be seen by moving from a net debt position (£-9m) in 2006 to net cash (£+16m) - a £25m positive swing. Pass.

4 - Debt - (a) net cash of £16m and (b) Adjusted EV/EBITDA of 7.5x, which is not particularly cheap. For those who are interested, it gets a Piotroski score of 8, which is very good. Pass.

5 - PER - based upon FY10 EPS of 23.4p, the current PER is 13.0x, which is right at the top-end of where I would like it to be.

The 10 year EPS is 18.6p, which equates to PER of 16x, which is neither cheap nor expensive. The PER (based on earnings at the time) has been in the range of 12x to 20x over the past decade. Pass

6 - Yield - FY10 DPS of 18.2p equates to a yield of 6% at the current price. The dividend is covered 1.3 times. Pass

The 10 year average DPS works out at 17.2p, which is covered 1.1 times by EPS10 of 18.6p. Reassuringly, the 10 year average Free Cash Flow (FCF10) is 18.9p which means that the dividend has been covered out of cash (1.1 times) over the past decade.

The two issues I have are: (i) low cover - but I can get comfortable with this to the extent that dividend payments are important to the Company's major shareholders and a yield of 6%, whilst pretty generous, is covered by earnings and cash generation, and (ii) lack of dividend growth - the level of DPS has barely budged in 10 years. However, during this period and in the past five years in particular, the Company has been focusing on reducing debt and building up a cash pile. The 2010 dividend was increased (+6%) for the first time since 2006.

7 - ROE - was 22% in FY10 and ROE10 works out, spookily, at 22% too. The Company has consistently generated 'returns' for ordinary shareholders over the past decade. As an aside, ROCE10 is 35%, which is good. Pass

8 - Directors - executive remuneration is probably reasonable and there are bonuses linked to PBT targets (good for shareholders if set at appropriate levels), plus various options, LTIPs and other bits and bobs. The three executive directors hold c425k shares directly (£1.3m in value) and have options/LTIPs over another c300k (which are not under water). A slightly higher holding would be nice, however, the key drivers in this equation are the Non-Execs, principally the founding Kane brothers, who control 59% of the Company. This should ensure that a generous dividend remains. Pass

9/10 - Buy or Bye? - an EPS10 of 18.6p and a PER10 of 18.3x gives a 'long-term fair value price' of 340p. The current price of 305p represents a 10% discount to this. Pass

Update

The interim results for the 6 months to September 2010 were released in November 2010. These showed modest turnover growth and continuing cash generation (cash balances £5m higher than H1 FY10), although gross margin was down. "The Board intends to pursue a progressive dividend policy". "Market conditions for the balance of the year remain hard to predict and...the final three months of the calendar year represent the key trading period for our business".

A trading update was issued in January 2011 which indicated that volume was slow and had been impacted by the adverse weather conditions, resulting in full-year profit being broadly in line with FY10 profits. These factors were considered to be 'one-off' in nature, but the share price fell by about 10%.

Conclusion

The Company appears to be a profitable, cash generative and well-run family controlled concern. There is a growing cash pile and a growing dividend, albeit in the environment of challenging market conditions. The shares are not cheap, but are not expensive in the context of good and sustained shareholder returns (ROE).

As ever, there will be interesting structural issues to play themselves out, particularly with Royal Mail, but UKM appears to be as well placed as any to face these.

The question is do I add now or wait for the 'fat pitch'? I cannot see these trading at a discount to net assets or becoming a Net Net, so maybe I should live with a PER of 13x, which is towards the bottom of the 'normal' trading range, and wait to be compensated through an increasing dividend and ongoing ROE. I am going to dip my toe in and ADD at around 305p (+10p spread).

FY11 results should be released in May and there could be a further buying opportunity if the market gets spooked by seeing the Janaury 2011 trading update in the cold light of day.

Book Review: Peter Cundill

2011-03-17T15:54:00.000+00:00

Up until his death at the end of January 2011, I had not come across Peter Cundill, the Canadian value-based investor in the ilk of Benjamin Graham.

Cundill set up and ran the Cundill Value Fund, which sought out under-valued global opportunities, and generated an IRR of 15% over a 33 year-period to 2007. This has a nice resonance with my target objective of a long-term IRR of 15%.

Cundill kept detailed diaries and Christopher Risso-Gill, a former director of the Fund, has read, analysed and interpreted them, resulting in this book, which acts an interesting chronological journey though Cundill's investing life.

The Things I Took Away

1. All roads lead to (from) Yorkshire! Cundill could trace his family roots back to 1860s Yorkshire and first worked on the Yorkshire Trust Company, which had been set up with original Yorkshire wealth;

2. "Always change a winning game" - businesses (and investment opportunities) need to be dynamic and constantly working to maintain their competitive advantages;

3. "The art of making money is not to lose it". Which is very similar to Buffett's two rules;

4. "Buy a dollar for 40 cents". Margin of safety and all that;

5. When to buy: lots of things to evaluate (eg price below book value, Net Nets etc), but consider whether the share price is less than 50% off its all-time high. This is something that I have started to factor in;

6. When to sell: sell half of any position when it has doubled;

7. "The most important attribute for success in value investing is patience, patience and more patience. The majority of investors do not possess this characteristic"

----

Whilst there is a not a huge amount of new theory for disciples of Graham (and to a lesser extent Buffett or other value investors), the book provides an interesting and enjoyable summary of one man's successful investing life through his own personal diaries.

There are plenty of anecdotes, case studies and things to think about, which might just provide an objective tonic of sanity in today's volatile markets. I think I shall have patience, patience and more patience ringing in my ears for the rest of my investing days.

Solid Progress at Johnson

2011-03-08T11:47:00.000+00:00

Johnson Services Group plc (JSG) announced its results for the year to 31 December 2010 this morning. I last looked at the Company in December 2010 and decided to continue holding.

The ordinary shares are currently trading at 33.75p, giving the Company a market value of £84m (8 March 2011).

On the face of it, the results seem positive with increased Adjusted Operating profit (+5%), EPS (+20%) and DPS (+9%); good cash flow generation and lower levels of net debt (from £68m at Dec 09 to £60m).

However, revenue was flat (snow and tough trading conditions) and there was £8m of Exceptional costs, mostly in relation to closing 20 loss-making dry-cleaning stores (lease commitments and redundancies)

Rules Refresh

1 - Assets - NAV has hardly budged from last year, remaining at £71m. The shares are now trading a slight premium (12%) to Net Assets given that the share price has edged up from 30p since my December review.

On the plus-side, the pension deficit has reduced from £15m to £12m, and there was a tax rebate of £6m received in February 2011 - ie after the year-end.

3 - Cash Flow - (a) net current liabilities increased from £9m to £15m, with trade creditors being stretched; (b) operating cash was £34m (EBITDA after working capital movements and pension scheme payments). Out of this, the Company needs to cover interest (£4m), replacement capex (£12m - guess), tax (£1m), dividends (£2m) and debt repayments (£6m due in next 12 months). This leaves £9m "spare" and together with the £6m tax cash, covers the trade creditors. The Company appears to be generating enough cash to meets its short-term needs at least.

4 - Debt - (a) debt:equity ratio has fallen from 0.95 to 0.85, which is encouraging, even if higher than I would ideally like; (b) EV/EBITDA ratio has crept up to 7x, which is pricey. However, if Exceptionals are removed, the Adjusted EV/EBITDA ratio is 5x, which is acceptable. Since the year-end, the Company has agreed to acclerate payment of the June instalment and has reduced the overall level of facilities available, which has led to a slight reduction in the future cost.

5 - PER - the 2010 EPS is 1.2p, resulting in a PER of 28x! Stripping out the Exceptionals and the underlying EPS was 4.1p, equating to a PER of 8x.

6 - Yield - 2010 DPS of 0.82p, represents a yield of 2.4% at the current price. As mentioned in my previous post, I cannot see stellar dividend growth in the short-term.

7 - ROE was only 5% due to the Exceptionals, which if removed, results in a ROE closer to 15% as in the prior year.

Conclusion

JSG appears to be making steady progress and is heading in the right direction. Trading conditions remain challenging, but the Company benefits from having a diversified business model with the majority of income coming from corporate customers. Cash generation is good, the debt is decreasing and the dividend increasing. The Exceptional items are slightly disappointing, especially as they are substantially cash items, but if it means spending a sum of money now to remove loss-making stores, it should be positive for earnings in the long-run.

I am going to HOLD and maintain my price target of 42p, representing a ball-park EPS of 4 to 4.5p and a PER of 9-10x.

Lies, Damned Lies and...Financial Ratios

2011-03-03T11:48:00.001+00:00

Following on from a previous excursion into Return on Equity, and the very good debate which ensued on this blog and on Stockopedia, I have been pondering further on how to identify and recognise what constitutes a great company.

Why Great?

It sounds like a redundant question, but why the interest in great companies?

To paraphrase the likes of Buffett and Co, they would rather buy a great business at a fair price, rather than a fair business at a great price. This makes perfect sense as the stronger a business is (and is likely to remain so in the future), the stronger the likelihood that future profitability will increase. Get the quality business at a discount and then you can make a killing a la Greenblatt.

I may have come to it a bit late, but there seems to have been a lot of excellent analysis and discussion around the subject recently, particularly with UK Value Investor's screening based on ROE and other attributes, and Richard Beddard's Herculean efforts in attempting to apply Greenblatt's Magic Formula to the UK with ROA being a key component.

I have been taking a closer look at other ratios that are commonly used alongside ROE.

Useful Tools for the Tool-kit?

1 - Return on Assets (ROA)

ROA = Adjusted Net Income / Total Assets

Adjusted Net Income = PAT + Interest (and the tax effect) - to show (kind of) operating profits without the cost of the capital base (ie interest)

Total Assets = Net Assets (opening or average)

Observations. Trying to adjust for interest and the tax effects is fiddly (Sharelockholmes in its ROTA calculation gets around this by using EBIT (I think)). Net Asset Value will include book values of intangibles and goodwill, and fixed assets, all of which may be very detached from market value.

2 - Return on Capital (ROC)

ROC = EBIT / (Net Working Capital + Tangible Assets )

NWC = net current assets/liabilities - ie stock + debtors + cash - current liabilities. Cash should be operating cash

TA = opening or average book value of Tangible Assets

Observations. This is very similar to Greenblatt's Magic Formula measure, although adjusting for surplus cash remains problematic. At least intangibles and goodwill are excluded from Assets, but there is still the issue of tangible assets at book cost. Maybe a high ROC is a sign that the assets could be undervalued?

3 - Return on Capital Employed (ROCE)

ROCE = EBIT / (Total Assets - Current Liabilities)

Very similar to ROC but includes long-term debt.

So What?

They all sound fine and dandy and they have particular strengths and weaknesses, but it is too easy to get hung up about the finer details of these ratios in isolation. Every man and his dog seem to tweak each definition, and each sector has different drivers which will influence the outputs when compared to other sectors. Formulas are useful, but should not be the 'be all and end all' and do not remove the need to understand the movements in a company's finances. At the end of the day, we're all try to find good quality companies at an appropriate price, and I'm going to use them as an early stage screening tool.

I am in the process of re-writing/tweaking my Rules, but am considering using the following measures for screening purposes:

1 - ROE > 15% average over 10 years
2 - ROC > 25% (as suggested by Greenblatt - ROA equivalent)
3 - ROCE > 15%
4 - PER < 14
5 - Yield > 2.5%
6 - Gearing < 50%
7 - Mkt cap > £20m

A first pass has thrown up 19 interesting companies, including the likes of Astrazeneca and Unilever. In an ideal world, I would want to back-test these parameters so see what the results are like, but for the time being I will judiciously select a few targets and take them to the next level of analysis. Watch this space...

Virtuous Vertu and HMV the Dog

2011-03-01T11:02:00.000+00:00

A flurry of activity this morning when I switched on my Blackberry to see trading updates from HMV and Vertu. Let's start with the bad...

HMV Group

The two pieces of news this morning were short and pithy, but no less significant.

The first announcement was a trading update since the last one a mere seven weeks ago. In that period, profits will now be "moderately" below market expectations (which were £45m of PBT based on the median expectations - there must be some crazy stuff out for them to use median) due to "challenging" trading conditions.

To compound matters, debt will not be less than £130m due to changing product mix and adverse working capital, and it now expects to breach certain banking covenants based on the full-year tests. The Company has commenced discussions with its lenders, who "continue to be supportive".

In the second announcement, the Chairman has stepped aside (to focus more on M&S presumably) and Philip Rowley has picked up the mantle with immediate effect.

The shares dropped over 20% to 16.5p in early morning trade, giving the Company a market value of £88m.

Before I starting writing this, my mind-set was to ditch HMV along the lines of 'run the winners and cut the losers'.

It's easy to paint a very bleak picture: tough trading, profits below expectations, covenant breach on the cards, debt higher than forecast, reduced cash generation, big sector/cyclical issues playing themselves out and the Chairman stepping aside.

Is there any Value here?

I have no idea what "moderate" means in terms of black and white (or red) numbers, but let's assume PBT comes in at £30m (two-thirds of median expectations - sounds moderate to me)

Tax this at 28% and EPS equates to about 4p per share. The current share price of 16.5p equates to a PER of 4.1x.

The dividend policy is to aim for say 3-4x times cover, so a theoretical dividend of 1p per share would be possible. The interim dividend was 0.9p, so rule out any further dividends in the short-term from an earnings perspective and in any event, the banks will not permit it if the Company has breached covenants or will breach covenants on a look-forward basis.

EBITDA looks interesting given that that DA was about £45m in FY10 (I would expect it to be higher in FY11) and Interest will be, say, £10m (v £7m in FY10). This gets us to an underlying EBITDA of £85-90m for FY11. Based on an EV of £220m (£130m debt and £90m equity), this represents an EV/EBITDA ratio of 2.5 times.

We would want to look at the rent-adjusted position given that it is a retailer, but I am not sure how much sensible analysis can be undertaken given that they are on a store closing programme.

HMV is priced for failure based on a PER of 4x and an EV/EBITDA of 2.5x. The two aspects that worry me most are (i) cash generation - is the adverse working capital temporary or permanent (if the former, then the level of debt is higher than normalised and cash should come back in) and (ii) the size of the 'exceptionals' and the extent to which these are cash items (eg redundancies and unexpired lease costs).

The other interesting aspects are: the Russian Mamut waiting in the wings and/or the potential disposal of Waterstone's. If Waterstone's was valued at £50m (figure plucked from the air via "media sources"), this would equate to a fully-taxed gain of about 7p per share - from what I can see, this is not reflected in the share price. I would not be surprised to see a Rights Issue appear sooner rather than later too.

HMV is one sick mutt, but is it terminal? Not yet; I can still see some value here, but the next few months are going to be very interesting indeed. Stick or twist?

Vertu

Vertu is the Ying to HMV's Yang (if that's the right way around).

Trading has remained strong and results are likely to be ahead of FY11 expectations (EPS of 2.7p as per Digital Look) . Market share has grown, cash generation has been good and a final dividend of 0.3p has been disclosed (full year DPS 0.5p; yield of 1.8%).

On the down-side, there will be exceptional costs in relation to asset write downs and financing costs.

I am topping up my holdings in HMV and Vertu.

Vroom Vroom Vertu...

2011-02-24T11:16:00.000+00:00

Vertu Motors plc (VTU) claims to be the eighth largest motor retailer in the UK. The words 'retail', 'motor' and 'investment opportunity' do not always sit easily in the same sentence, so let's see if VTU has enough oomph to get into top gear or whether I've got a lemon on my hands.

Why Am I Interested?

1. The shares are trading at a 37% discount to reported net assets
2. Directors have been buying in the last 12 months
3. Declared a maiden dividend in its interim results in October 2010
4. I have a holding at a break-even cost of 31p per share (acquired before my blog started)

Background

History & Operations

VTU was formed in 2006 as a new vehicle to consolidate UK motor retailers, raising £25m and listing on AIM in December 2006. Since then, the Company has made numerous acquisitions and raised £56m through two Placings and has £45m in debt facilities (£12m drawn).

In essence, the strategy involves buying dealerships at reasonable prices and getting more out of them through applying "consistent business processes and systems" - ie increasing profits through harmonising and standardising as part of a larger corporate organisation - the whole is worth more than the sum of the parts kind of thing.

The Company is now present in over 70 locations, via 84 franchised and 3 non-franchised sales operations.

Activities include: new and used car sales, fleet contracts, commercial vehicles and 'after-sales' (servicing, repairs and parts). After-sales has by far the highest gross profit margins (41%) compared to new car sales (8%) and used car sales (10-12%).

The main brands sold include: Ford, Honda, Vauxhall, SEAT and Peugeot.

Investor Relations can be found here

Share Price & Value

The current share price of 28.5p (mid-point as at 23 February) gives the Company a market value of £57m. Based upon the 2010 basic EPS of 2.2p, this represents a PER of 12.8x. The Company is listed on AIM.

In the past five years, the shares have hit a high of 101.5p (Dec 2008) and a low of 10p (Feb 2007).

Source: London Stock Exchange

Risks & Challenges

- execution risk in a buy and build strategy - need to buy the right things at the right price;

- the motor "trade" is littered with the dead bodies of snake-oil salesmen. Anecdotally, the industry seems to have cleaned itself up a bit in the past decade, and maybe the consumer responds more favourably to a quality, corporate offering. One thing for sure, a profit is only a profit once it turns to cash;

- the sale of new (and used) cars is tied to some degree to economic well-being. The industry received some support via the government scrappage scheme, which ran from May 09 and was equivalent to the US's Cash for Clunkers scheme, but it remains a challenge. On the plus side, new car sales do not generate a huge amount of gross profit for the dealers, unlike servicing and maintenance, although you cannot have one without the other; and

Fancy a new motor?

- the Vertu business model is evolving and we do not have the benefit of a 10 year pedigree to analyse.

The Rules

The following analysis is based on the 12 months to 28 February 2010 (FY10) unless otherwise stated

1 - Assets - the NAV at February 10 was £90m compared to a market cap of £57m, equating to a discount of 37%. Better still, there was net cash of £23m, which if valued at par, means that you can buy £67m of assets for £34m - a discount of 50%.

Even if Goodwill of £21m and Cash are excluded, you can buy £46m of assets for £34m, which still represents a discount of 26%. The bulk of these assets are in relation to freehold and long leasehold sites. Pass

2 - Market Value - a market cap of £57m. Pass

3 - Cash Flow - (a) net current assets of £18m and (b) operating cash of £15m after working capital movements. Out of this, we need to cover replacement capex (£3m - est), interest (£1m) and tax (£1m - FY10 P&L), meaning that there is £10m "left over". Cash generation was also good in FY09 and it gives some comfort to see profits turn to cash. Pass

4 - Debt - (a) net cash of £23.5m and (b) Adjusted EV/EBITDA of 10x, which is a full valuation and probably reflects the asset nature of the business. This assumes that EBITDA is adjusted by £3m for replacement capex, which may be harsh for a growing business

Also, a word of caution in the FD's review re the cash balances:

The positive net cash balance at 28 February 2010 reflects the seasonal reduction in working capital, typical of the industry, which arises at the period end prior to a plate change month. Consequently, the year end net cash balance is higher than the normalised cash balances throughout the remainder of the year.

Unfortunately, he does not say what the normalised position would be.

5 - PER - based upon FY10 EPS of 2.23p, the current PER is 12.8x. The Company has only been listed for three financial years and has been growing through acquisition each year. The three year average EPS is 1.1p, but I do not consider this to be a representative level of earnings. Pass(ish)

6 - Yield - no dividend was declared in FY10. However, they intend to embrace a modest, but progressive, dividend commencing with the FY11 interims (see below). Fail, but potential to Pass

7 - ROE - was 7% in FY10. Given that the Company has been acquisitive in the past couple of years, there will be a time lag in seeing profits come through at the appropriate levels. Whilst the current level of profitability is not as high as we would like, it is important to remember that it does not represent the finished product. As work in progress, it gets a Marginal Pass.

8 - Directors - the two executive directors held 8.2m (£2.3m) of shares between them at February 2010. The directors had reasonable basic salaries, but generous bonus arrangements, linked to PBT targets, which will be good for shareholders if set at the right levels. Pass.

9/10 - Buy or Bye? - N/A given the relatively short-trading history.

Update

The interim results for the 6 months to August 2010 were released in October and were pretty bullish. EBITDA and operating cash came in at c£7m, NAV of 46.8p (of which tangible assets were 38.3p), net cash of £15m and a maiden dividend of 0.2p against EPS of 1.8p. After-sales contributed 43% of Gross Profit and helped to offset the slight fall in used car margins. Volumes in September 2010, outside of these results but the second most important month of trading, was ahead of expectations.

Five directors acquired 337k shares at 29.25p in October 2010. F&C and BlackRock also topped up their holdings to over 10% each on October 2010.

Conclusion

Vertu is not a Net Net, probably does not have a moat and is arguably not one for orphans and widows. However, I like it. There is a discount to net assets, cost control and cash generation, I can see the merits in the business plan (if executed properly), a growing dividend and insider buying. Whilst there will be short-term challenges ahead, I am content to sit and wait to see what the full-year results will bring in May 2011.

I am going to HOLD with a price target of 50p, getting us a lot closer to NAV and also equating to notional EPS of 5p on a PER of 10x.

Drax Delivers!

2011-02-22T17:20:00.000+00:00

Drax Group plc (DRX) announced its full year results (12 months to December 2010 - FY10) today and appears to have picked up where my analysis of 14 January 2011 left off.

At the headline level, turnover and every measure of profit were up on FY09, resulting in a total dividend for the year of 32p and putting DRX on a yield of c8% based on a current market price of 403p.

Whilst gross margin was down slightly and there are some headwinds which will lead to lower profits in FY11 (if market expectations turn out to be correct), this appears to be a strong operational performance.

There is still some uncertainty concerning the further development on biomass, with the Company unwilling to scale up further in this area due to "insufficient regulatory support".

Updated Rules

1/2 - Assets - NAV actually fell in the period from £1.025bn to £958m despite the increase in profits. This appears to be due in part to a £232m "loss" booked when forward contracts are marked-to-market through the hedge reserve. The market value is therefore at a 50% premium to net assets, but my previous comments on the matter still apply.

3 - Cash Flow - (a) net current assets of £92m and (b) operating cash of £466m after working cap and interest, to be used to cover replacement capex (£50m - estimate), tax (£67m - 2010 P&L), debt repayment in next 12 months (£68m) and FY10 dividend (£116m). This leaves £150-170m cash left over. There appears to be enough cash sloshing around to keep everyone happy.

4 - Debt - (a) the net cash position was £101m and (b) Adjusted EV/EBITDA of around 3x, which is very, very reasonable indeed.

5 - PER - is a very modest 7.8x based on FY10 EPS (basic diluted) of 52p

6 - Yield - FY10 DPS of 32p, represents a yield of 8%. This will be under pressure in FY11, but the Company is committed to paying out 50% of underlying earnings in dividends.

7 - ROE - FY10 ROE was 18%, which is more than satisfactory.

Conclusion

I consider these to be a strong set of results, particularly with the good cash generation and net cash balances overall. I still maintain that a long-term price target should be around 576p (at least) and I'm seriously tempted to top up at 400p or below. The shares are marked ex-dividend on 27 April if you want to catch that 17.9p final dividend.

More of the Same at Gleeson

2011-02-22T15:27:00.001+00:00

Grove Village, Manchester

MJ Gleeson (GLE) released its interim results for the six months to 31 December 2010 today.

I reviewed MJ Gleeson on 26 January 2011 and, whilst being underwhelmed in general with what I found, saw some potential upside on the appointment of a new CEO and how they were going to spend their surplus cash (dividend and/or strategic acquisition).

I am not going to dissect the interim results to the same degree, as I am more interested in annual results spanning over a decade, but will give some high level thoughts.

6 Months to December 2010

NB all comparatives are to 6 Months to December 2009 unless otherwise stated

Revenue was down 24% primarily due to there being only one land sale rather than two, although house sales did increase 73%, albeit from a very low base. A second land sale has been agreed but not completed, so that will help FY11 results. Negative comment about the lack of supply in mortgages implies that the glory days of house-builders are far over the hills.

Overheads were slightly reduced, benefitting from the release of a prior provision.

A huge Profit After Tax of £0.1m was recorded, but at least it was in the black.

Cash generation was good, with cash balances increasing by £0.5m to £19m. Net Asset Value was £98m or 186p per share. No interim dividend was declared.

Valuation

The shares reached the dizzy heights of 140p in the last few weeks, perhaps fuelled by speculation that there might be a special dividend or some other favourable news.

At the time of writing, the shares have fallen back to 126p, giving the company a market value of £73m.

Assuming that the cash balances are valued at par (about 19p per share), this means that the rest of the business (strategic land and houses to be sold) are still valued at a 35% discount to book cost.

Frustrations

No update on the CEO and no update on how and when they intend to spend that cash.

It is difficult to see any positive stimulus on the share price without any news. At least they are chugging away with what they've got, covering the overhead and maintaning the cash balance.

GLE will remain in my portfolio for the time being, but if I see an opportunity that is more favourable, I shall not be too sentimental about removing it.

Jacques Vert: Green for Go?

2011-02-13T19:22:00.002+00:00

After the roller-coaster that is HMV (mostly a roller-coaster in the downward direction), I am more suspicious of retail stocks. Jacques Vert Plc (JQV) might just restore the faith and put the fun back into the fairground.

JQV is a retailer of four womenswear brands, aimed at the middle-aged to older lady (aged 30+), sold through its own stores, department stores and the internet.

The current share price of 16.75p (mid-point as at 11 February) gives the company a market value of £32m. Based upon the 2010 basic EPS of 2.5p, this represents a PER of 6.7x. The Company is listed on AIM.

Source: London Stock Exchange

In the past five years, the shares have hit a high of 26.5p (April 2007) and a low of 3.25p (Dec 2008).

Background

The Company was founded in 1972 by two tailors and listed on the stock market in 1977 with the Jacques Vert brand.

In December 2002, the Company acquired William Baird Plc, which came with three further brands and a garment manufacturer in Sri Lanka for £18m.

In late 2010, the Company started to develop its online presence with the launch of two multi-brand sites.

The four brands are now retailed in c900 outlets, including a small presence in Canada and Ireland.

Risks & Challenges

Fashion-led retail, although geared towards older women, which as a group tends to have more disposable income and favourable demographics;
Currency risk / overseas suppliers - there appears to be a hedging strategy in place, but currency movements will have an impact;
There is small pension scheme deficit on the balance sheet (£0.65m) and
An upgrade to the IT infrastucture to support online growth has been announced - budgeted at £3m - but brings with it the risks of not being implemented to time or cost.

The Company website is here

The Rules

The following analysis is based on the 12 months to 24 April 2010 (FY10) unless otherwise stated

1 - Assets - the NAV at the April 10 was £23m compared to a market cap of £32m, equating to a premium of 39%. On the face of it, the balance sheet looks healthy with limited goodwill, lots of cash (£12m) and positive net current assets.

However, when you probe the notes it gets potentially better as you discover that there are £11m of unrecognised deferred tax assets (ie will help to reduce the tax bill when profits are made). Adding in the deferred tax asset and deducting £4.5m out of the cash for the 2010 dividend and a planned IT upgrade, results in an adjusted NAV of £30m or 15.5p per share.

In addition, there is potential upside in the market value of the fixed assets (£3m book value versus cost of £18m) and future costs being lower than provided for (£6m) in respect of dilapidations and claims against the group in respect of industrial diseases (but these will be utilised over the next 20 years).

On this basis, I conclude that the market value is trading at around adjusted asset value, of which around £8m (25%) represents cash. Pass

2 - Market Value - a market cap of £32m is lower than the floor of £50m, but I'm considering dropping this to £20m anyway. Pass(ish)

3 - Cash Flow - (a) net current assets of £23m and (b) operating cash of £9m after working capital and provision movements. Out of this, we need to provide for capex (£1m) and tax and dividends (£1.5m), meaning that there is plenty of cash left over. Pass

4 - Debt - net cash of £12m, resulting in an EV of £20m. With EBITDA of £7m, this results in an EV/EBITDA ratio of 2.9x. Even with adjusted cash of £8m (see #1 above), this still represents an EV/EBITDA ratio of just 3.4x.

Given that it is a retailer, we can have a look at the rent positions. Annual rents of £4.7m, result in EBITDAR of £11.7m. If rents are capitalised at 8x, we have a rent-adjusted EV of £58m. The rent-adjusted EV/EBITDAR ratio is 4.9x, which is acceptable. Pass

5 - PER - the 2010 EPS was 2.5p, implying a PER of 6.7x based on the current price.

The acquisition of Baird in December 2002 transformed the existing Vert business and consequently, I am going to consider FY04 (12 months to April 2004) as my starting point for analysing long-term results to ensure an element of consistency. Also, the current CEO and FD assumed their roles in 2003, so there is a nice overlap with this period. Based on this 7 year analysis, the average EPS falls to 1.6p, equating to a PER of 10x, which is still below the target ceiling of 12x. Pass

6 - Yield - the 2010 DPS was 0.65p, representing a yield of 3.9% and earnings cover of 4.2 times . The dividend is new territory for the company (no dividend has been paid in the past ten years (source: Sharelockholmes)) and lots of warm noises are being made: "The Board believes it is in the interests of the Company and the shareholders to put a progressive dividend policy in place". Pass

7 - ROE - the 2010 ROE was 25% and the average annual 7 year ROE is 21% (source: Sharelockholmes). Pass

8 - Directors - the directors are interested in about 9m shares and (discounted) options (c£1.5m in value). Remuneration is reasonable, although the Execs did get 100% bonuses in FY10, which seems generous. The two Execs and the Chairman acquired 0.5m shares at 15p each in July 2010, which is encouraging. Pass

9/10 - Buy or Bye? Based upon a 7 year average of EPS of 1.6p and a 7 year average PER of 8x, we arrive at a 'long-term fair price' of 13p, which is below the current price. Bye

Update

The interim results for the 6 months to October 2010 were released in January 2011, including a trading update. The results were broadly positive, and despite the tough trading conditions, posted LFL sales +3.1%, although margins were squeezed slightly (-0.3%). Positive cash generation was maintained. Sales were effected in the miserable December weather, but rebounded in January, which is more than most listed retailers have said.

Investors Chronicle tipped it as a BUY in January 2011.

Conclusion

So, Jacques Vert is a small-time AIM listed fashion-led retailer, which should be enough to make me run for the hills. However, it passes all of my Rules, apart from the long-term fair price one, which is miserable. It is not a 'Net Net' nor is it valued at a significant discount to reported net assets, but it appears to be a well run business, valued on a lowly multiple with lots of cash swilling about, and upside potential in its balance sheet (market value of assets), business model (defensive customer base and expanding online presence) and dividend policy (now that it has one).

I am going to BUY the shares at around 17p (note the nasty spread) and aim for a target price of at least 30p, being basic EPS of 3p and a rating of 10x (above the current 7x, but below the retail sector average of 13x). The cash balance and dividends will give me some down-side protection whilst I wait. Green for Go. Hopefully.

Return on Equity: Errrm? Help!

2011-02-09T12:53:00.000+00:00

I do not profess to be an academic or a professional analyst, but I like to understand the numbers and ratios that I am looking at in terms of what they really mean and whether they can be misinterpreted or manipulated (by others!).

Received wisdom seems to have Return on Equity (RoE) as an accepted measure of how good a company is at delivering profits for shareholders, which seems fair enough.

In essence, it is calculated by dividing Net Income (Profit After Tax) by Net Assets (Equity funds (attributable to ordinary shares)) on the opening balance sheet. So, if you started with Net Assets of 100 and generated Net Income of 15, your RoE is 15% for the year (one of my Rules). (Note: I use the opening balance of Net Assets, but I have seen others who take an average of the opening and closing Net Asset position).

Let's consider a worked example and I make no apologies for trying to keep it as simple as possible:

a company generates £10m of PAT each year for three years;
it has opening Net Assets (ordinary shareholders' equity; non-cash) of £50m; and
the Market values the company on a P/E of 12x PAT.

A Basic analysis looks like this:


BASIC	Opening	Yr 1	Yr 2	Yr 3	ROE	"Value"

PAT (£'m)		10	10	10		120
DIVIDENDS (£'m)		0	0	0

NET ASSETS bal b/f		50	60	70

NET ASSETS bal c/f	50	60	70	80		30
					Ave
ROE		20%	17%	14%	17%	150

This assumes that each year's profits are retained by the company. The RoE declines each year as the company is not "sweating" its assets hard enough due to the growing surplus cash pile.

From a valuation perspective, the company would be valued at £150m, assuming earnings are valued at £120m (12x PAT) and surplus cash (£30m) is valued at par.

However, let's throw in some dividends. Assuming that all post-tax profits are distributed as dividends each year, the analysis would look something like this:


DIVIDENDS	Opening	Yr 1	Yr 2	Yr 3	ROE	"Value"

PAT (£'m)		10	10	10		120
DIVIDENDS (£'m)		10	10	10		30

NET ASSETS bal b/f		50	50	50

NET ASSETS bal c/f	50	50	50	50
					Ave
ROE		20%	20%	20%	20%	150

The RoE remains steady each year at 20% as surplus cash is not allowed to build up. From a value perspective, the company would be valued at £120m and the shareholders would have received dividends of £30m, resulting in "value" of £150m (ignoring time value of money and personal tax implications). Same "value", better RoE.

Now let's throw some share buy-backs into the mix. Assuming the company spends all of its profits on share buy-backs, the analysis would look something like this.


BUY-BACKS	Opening	Yr 1	Yr 2	Yr 3	ROE	"Value"

PAT (£'m)		10	10	10		152
BUY-BACKS (£'m)		10	10	10

NET ASSETS bal b/f		50	46	42

NET ASSETS bal c/f	50	46	42	39
					Ave
ROE		20%	22%	24%	22%	152

The RoE goes up each year as the net assets figure shrinks due to the buy-backs. Interestingly, the value increases slightly (could be my maths) even despite the fact that the company is essentially wasting shareholders' money by buying back expensive shares in the open market - ie £10m of year 1 share purchases only reduces the Net Assets by £4m (assuming it would not otherwise be held as surplus cash). However, for each £1 of share capital bought back, there is a multiplier effect on value as EPS goes up (due to profits being spread over fewer shares).

So, which is best? From a big-picture perspective, the same company is producing the same level of profits from what is essentially the same operating capital base, so there should be little difference. From a RoE perspective and "value creation" perspective, scenario 3 appears to be superior with an average RoE 30% higher than the basic scenario, although if I came across this scenario, I would be put off by the market value being at a high premium to net assets and the lack of a dividend! Maybe screening for a high RoE could hide suitable opportunities?

There is also the small issue of leverage (debt) which helps to improve returns to shareholders through the introduction of lower cost funds (compared to equity). There is probably an optimal balance between debt and equity for each company to maximise the impact on its RoE.

Conclusion

RoE is an important, but crude measure of how much profit is being generated for shareholders;
A rising RoE does not mean that a company is generating higher levels of profits per se and vice versa;
ROE can be distorted by dividends, share buy-backs and leverage - for instance, see GlaxoSmithKline which has an unfeasibly high RoE due to leverage and all net profits being distributed through dividends and share buy-backs;
There may be opportunities in finding companies with surplus cash on the balance sheet and an accelerated buy-back policy - an increasing RoE might capture the attention of more investors and drive up the price;
Return on Capital Employed (ROCE) might be a better measure of how much return a company generates through employing debt and equity. (EBIT/(Debt+Equity). I will research some more and see whether that is more appropriate for my Rules; and
I could be barking up the wrong tree!

Any thoughts or comments are most welcome

10 Up! Taking Stock...

2011-02-08T11:16:00.000+00:00

Not quite the first ten-bagger yet or a value-added version of a new soft drink, but 10 Value 10 has reached the ripe old age of 10 posts!

Ok, I'm not quite in a position to look back over a long and illustrious career of successful investing, but it's a good opportunity to take stock. My observations and learning points so far:

1 - This is good fun! Better still, I feel that I am getting value out of the discipline, objectivity and consistency that rules bring;

2 - But lots of work - I need to be more selective in selecting candidates before I launch into the detailed analysis. This has been skewed slightly as I am working through my existing portfolio as well as looking at new opportunities. This will resolve itself as I become more selective as I focus on new opportunities more;

3 - Return on Equity - I know it's important, but I haven't completely got my head around RoE. Watch this space for further discussion;

4 - Free Cash Flow - I need to focus more on this as an alternative to EPS for a measure of quality and sustainability of earnings;

5 - Market cap hurdle maybe too high. I might consider dropping it to £20-25m to increase my hunting ground (although taking note of observation #2). Watch this space;

6 - Avoid specific sectors - Some sectors do not sit easily with me. I will be more discriminating in which sectors I delve into. I will struggle with house-builders, construction and "people" businesses for instance;

7 - Revise Rules - whilst it is good to have some hard and fast rules to abide by, it is important to be fluid. As I read, develop and refine my learning, I will consider refreshing The Rules as appropriate;

8 - Portfolio - a measure of tangible success will be monitoring portfolio performance. From 31 March, I intend to publish quarterly updates of (i) companies covered in my analysis on this blog and (ii) my actual portfolio (which includes more besides) to see how much progress is being made;

9 - Techie skills are basic - apologies, but I'm focusing more on the content rather than the pretty pictures. The blog will become prettier one day...;

10 - Patience is required - I'm in it for the long-term and need to focus on long-term results. Short-term distractions like the recent beating up of HMV have been most unwelcome!

Thank you to all of those who have taken the time to provide feedback and comments.

Next stop: 100.

T.Clarke - Constructing the Future?

2011-02-03T14:41:00.000+00:00

T.Clarke plc (CTO) is a building services group that has the look of a good discount in it. Unlike Gleeson, Clarke does not build houses or acquire strategic land.

The current share price of 93p (as at 1 February 2011) gives the company a market value of £38m. Based upon the 2009 basic EPS of 10p, this represents a PER of 9x. The Company is listed on the Main Market.

In the past five years, the shares have hit a high of 265p (May 2006) and a low of 91p (Jan 2011). A peak-to-trough fall of 65%.

I do not own any shares in CTO at the time of writing.

Background

The Company can trace its roots back to 1889 and listed on the LSE in 1946.

Westfield Shopping Centre
Source: T.Clarke website

The Company acts as main contractor, subcontractor or specialist contractor on a variety of building projects in a wide range of industry sectors, including retail, education and commercial. For example, the Company acted as Principal Contractor on the new Westfield Shopping Centre.

The Company is made up of 13 group companies, trading from 14 locations and has over 1,300 employees.

In the Annual Report, the Company provides an analysis of key KPIs (eg turnover per employee) compared to selected (their selection!) competitors and comes out quite favourably, which is positive. However, the Company's average operating margin over a 10 year period is about 5% (my calculation) which is probably there or abouts in the construction industry, but shows that there is not much fat to cut away when times get tough.

The strategic focus of the Company appears to be: concentrating on particular sectors, tight cost control, harmonising the 'T Clarke' brand and strategic acquisitions as they arise (eg acquisition of D&S in March 2010 for £12m and DG Robson in August 2010 for £6m).

Risks & Challenges

the new CEO, albeit a T.Clarke "lifer", has been in situ for only a year or so. Does he come with a new broom? A new FD (the previous FC) was appointed in August 2010
the construction industry is a tough place to be at the moment
bad debt risk from customers - eg bad debts increased by £1m in 2009 due to customers going into administration
rising commodity prices may squeeze margins if the Company does not have the ability to pass on price rises in full

Investor Relations can be found here - T Clarke IR

The Rules

The following analysis is based on the 12 months to December 2009 (FY09) unless otherwise stated

1 - Assets - the NAV at Dec 09 was £25m compared to a market cap of £38m, meaning that the market value is trading at a 50% premium to net assets. Worse still, is that £12m of net asset value is attributed to goodwill (the premium arising on acquisitions). Also, when you dig a little deeper, you come across a pension scheme deficit (£6m - an increase of £4m in the year) and £11m of 'Construction contracts' which is their estimate of the value of the work that they have provided on live contracts at the balance sheet date. Inherent within this is a fundamental level of certainty as outlined in Note 1 (p67) due to the "difficulty of forecasting the final costs to be incurred on the contract". No surprises really, but it is easy to look over. For all this, I don't like the flavour of the balance sheet. Fail

2 - Market Value - a market cap of £38m is below the floor of £50m. The purpose of the floor is to try and screen out tiddlers, but I'll use my discretion and let CTO through as it normally trades above a £50m market value. Rules are there to be broken occasionally. Pass(ish)

3 - Cash Flow - (a) net current assets of £12m is positive and (b) operating cash of £1.3m after working capital movements and interest (NB this is a huge fall from the £29m in FY08). Out of this, we need to provide for capex (£0.2m), tax (£2m - FY09 P&L) and dividends (£5.2m). Something has to give in 2010/11, and it does (see Update below). The cash flows are lumpy and swing a lot from year to year, which is probably a reflection of the contractual nature of the business. Fail

4 - Debt - there was net cash of £23m as at Dec 09, however acquisitions have been made since the year-end and therefore, I am going to use the £7m net cash as at June 10 for EV purposes. Based on a market cap of £38m and net cash of £7m, the EV is £31m. EBITDA for FY09 was c£8m (adjusting discontinued items), which implies an EV/EBITDA ratio of 3.9 times, which is reasonable. Pass

5 - PER - the 2009 EPS was 10p, implying a PER of 9.3x based on the current price. Based on 10 year average EPS of 14p, the PER falls to 6.6x. Pass

6 - Yield - the 2009 DPS was 13p, representing a yield of 14%. The average dividend over the last 10 years is 10p, equating to a yield of 10.7%. This level of dividend screams "unsustainable" to me.

There was a deficit in earnings cover (0.75 times covered) in 2009 (EPS of 10p v DPS of 13p), but the directors decided to hold the dividend at the 2008 level. Over the long-term a 10 year average DPS of 10p has been covered 1.4 times by 10 year average EPS (14p). Whilst the cover is not quite as high as I would like, it suggests that a high dividend is an important consideration for the directors, which is positive even if the current level is unsustainable. Pass

7 - ROE - the 2009 ROE was 13% and the average annual 10 year ROE is 30.3% (source: Sharelockholmes). This seems high, but is probably explained by relatively high levels of dividends, which keeps the denominator low. Pass

8 - Directors - As at March 10, the directors' interest amounted to 80,000 shares in total, which is trifling. Whilst overall remuneration appears to be reasonable for a company of this size, and the bonus element is linked to generating certain levels of Profit Before Tax (minimum threshold of £7.5m), I am concerned that directors have not put enough of their money where their mouth is by buying "cheap" shares. The new FD acquired a whopping 2,000 shares in December (why bother at this level?). Fail

9/10 - Buy or Bye? Based upon a 10 year average of EPS of 14p and a 10 year average PER of 11.8x, we arrive at a 'long-term fair price' of 165p. The current price of 93p therefore represents a 44% discount to this long-term price. Buy

Update

On the face of it, the interim results released in August 2010 were reasonably positive. The dividend level was held "reflecting the board's confidence in the underlying strength of the business" despite noises about a tough trading environment

A trading update was provided on 14 January 2011, which made reference to the tough trading conditions and margins being under "extreme pressure", resulting in the likely outcome for FY10 to be below current market expectations and for FY11 to be even worse. Although the Company had £7m of cash at Dec 2010, it is the Board's intention to reduce to the final dividend to that of its interim dividend [making 8.5p for the year] and to re-base the dividend thereafter (no details on how). The order book amounted to £190m at Dec 2010. All in all...ouch.

The 2010 results are scheduled to be announced on 18 March.

Conclusion

It's easy to see why the Company is relatively unloved when you throw in the global economy, severe margin pressure and the recent negative case studies of ROK and Connaught. It's not all doom and gloom though as the Company has a good order book (which should turn into £7-10 of operating profit in due course) and cash on the balance sheet, but the immediate future is going to be tough.

Whilst the Company passes more Rules than it fails, what troubles me most is the flavour of the balance sheet and the nature of the business model to give me sufficient confidence of future profitability and when and how it turns to cash. I am unable to get comfortable on hitting my target 15% IRR despite the long-term ROE being good (is this just a function of the 'good' years?). I can't see any moat or margin of safety to give me reassurance.

For these reasons, and although I think T Clarke is a good company with lots of heritage, I am going to pass on the opportunity to invest. Given that my concerns apply to the sector as a whole, I am going to avoid looking at opportunities in the construction and house-building sectors in the future, even despite the large perceived discounts.

Building Value at MJ Gleeson?

2011-01-26T16:55:00.001+00:00

When you go trawling for under-valued companies, you come across lots of property, construction and house-building companies that trade at a discount to published net asset value. This is hardly a surprise given the current economic climate and the recent rise and fall of seemingly anything connected with real estate. MJ Gleeson Group plc (GLE) has interests in land development and house-building, and is currently trading on a 35% discount to reported net assets.

The current share price of 121.5p (as at 25 January 2011) gives the company a market value of £65m. Based upon the 2010 basic EPS of 6p, this represents a not-such-value PER of 20x. The company is listed on the Main Market.

In the past five years, the shares have hit a high of 417p (April 2007) and a low of 58p (December 2008).

For the record, my average cost per share is 147p and, after dividends equating to 15p per share, my break-even cost is 132p per share.

Background

Potted History

The Company can trace its roots back to the entrepreneurial Irish immigrant, Michael Joseph Gleeson ("MJ"), who took on a growing Sheffield building business in the early part of the 20th Century.

The Company was listed on the London Stock Exchange in 1960 (a fifty year pedigree is not to be sniffed at), and has adapted through the times with forays in and out of engineering, construction and land. In 2004/5, the Company to decided to focus on development rather than contracting, and gradually exited its construction and engineering businesses over the next 5/6 years.

The Gleeson family connection remains through Dermot Gleeson, who has acted as Chairman for the past 16 years and holds in excess of 1 million shares.

Business Model

There are three principal business operations: (i) Regeneration & Homes (estate regeneration and housing development on brown-field sites in the North of England); (ii) Strategic Land (options over land with a view to adding value by gaining planning consent), and (iii) Capital Solutions (PFI investments in social housing).

Regeneration & Homes focuses on the social housing / cheaper-end of private housing, with selling prices typically in the £100-140k range. This operation accounted for about half of 2010 revenues (continuing activities), but the volume of houses sold was 60% lower compared to 2009, resulting in a focus on cost control and cash preservation.

Strategic land accounted for about 20% of 2010 revenue, but these revenues by their very nature are going to be lumpy (ie ten-fold increase on 2009).

Commercial Property Developments accounted for c30% of 2010 revenue, but this is in wind-down mode.

The P&L is subject to wild fluctuations in asset value - note the £34m write-down in asset values in 2010 - and going forwards, will not benefit from Powerminster (construction) which was disposed of in 2010 but contributed up to £1m of operating profit.

Risks & Challenges

The planning system in the UK lacks any transparency, certainty and, at times, sense! The Coalition Government has reform of the planning system on its agenda, but 'when' and 'how' remain to be seen;
Social housing has been promised large pots of money for the past ten years to fund development and regeneration, but these pots seem to get constantly 'pushed to the right'; and
The previous CEO, Chris Holt, stood down in September 2010 following the disposal of Powerminster. He has not been replaced as yet, but the FD has had his role expanded to be de facto Ops Director. The lack of a CEO for too long is not a positive sign.

The Rules

The Rules are calculated on the results for the year ended 30 June 2010 (FY10) unless otherwise stated

1 - Assets - the net asset position at June 2010 amounted to £98m compared to a market cap of £65m, representing a 35% discount. In simple terms, you can buy an ordinary share in the Company for 121.5p, which has a net asset value of 186p. Better still, net assets includes £18m of cash as at 30 June which equates to 35p per share; if this cash is valued at par value, you can buy 151p of assets for 86.5p - a 42% discount!

The Company qualifies as a Net Net (current assets less current and total liabilities is greater than than the market value). In theory, if you ran off the current assets and paid off the book liabilities, you would generate £78m of value (less costs), which is greater than the market value of the Company.

However, the majority of these current assets (by value) are inventories (£76m), which represent half-built houses and strategic land for sale. I am unclear as to how close the book value of these assets is to market value, particuarly in a falling market, but even so, a 42% discount gives some headroom. More of an issue is how quickly they can turn to profit and cash. A provisional Pass.

2 - Market Value - £64m. Pass

3 - Cash Flow - the business generated positive Operating cash after working capital of £14m in 2010, which is good. In 2009, there was an outflow of £20m, which is bad. This is a function of a lumpy revenue model. Pass (for 2010).

4 - Debt - none! £18m of cash on the balance sheet as at 30 June 2010. Pass

5 - PER - based upon a 2010 EPS of 6p, the current PER is 20x. Looking at the 12 year average EPS of 4p, the PER is even worse at 30x. This is partly a reflection of an 'asset trading' business rather than looking at it on a multiple of earnings. Fail

6 - Yield - I was first attracted to the Company when it was about to pay out a special dividend (a whopping 15p) in March 2010 as the Board "concluded that the Group had cash in excess of its requirements" (at a cost of £8m). With the cash on the balance sheet at June 2010, they could pay this twice-over, but the Company decided to declare no final dividend for FY10, which was disappointing.

Historically, the Company has been a good dividend payer and increased its dividend year-on-year 1999-2007, with an average DPS of 7p (yield of 5-6% on current price). The world changed at the end of 2007 and regular dividends have disappeared since. Fail

7 - ROE - the 2010 ROE was a miserly 0.6%. This is probably not too bad given that three out of the four previous years showed a negative ROE. Fail

8 - Directors - the directors' remuneration pot seems reasonable as listed companies go and the directors have ownership or interest in 11.6m shares, which equates to 22% of the ordinary share capital. The caveat is that Christopher Mills's holdings are through North Atlantic Value LLP (a JO Hambro fund), which is the largest institutional holder in the Company at 18%, meaning that the other directors control c4% (c£2.5m in value). I am satisfied that the directors' interests are aligned with the ordinary shareholders. Pass

9/10 - Buy or Bye? The 12 year EPS of 4p x the 5 year average PER of 10x (2001-2005; negative EPS thereafter), gives a fair valuation based on earnings of 40p. This obviously takes no account of the asset-based nature of the Company and is, arguably, of reduced relevance. Bye
Update

The trading update issued in November 2010 stated that volumes and average selling prices had improved, but that the availability of mortgages (lack of) was constricting additional growth.

The interim results are due in February 2011.

Conclusion

Before undertaking the detailed analysis, I had expected to conclude with a strong opinion that I should I buy some more. However, I am arriving at the opposite position.

Whilst there is a significant discount to net assets, and even a 'Net Net' position, I am concerned about the lack of earnings visibility, ie the need to 'trade' strategic land and get people to buy houses (most of the drivers for value are outside of the direct influence of the Company).

If the Company had always been this shape, then I could look at the 10 year history and get comfortable that the Company will ultimately deliver through thick and thin, but the Company going into 2011 is in a very different shape to its predecessors (and their financial results). In reality, the Company represents some parcels of land and a few semi-built buildings, all valued at a perceived discount, together with a bit of spare cash but no CEO; I am unclear what I think the true Fair Value is and how their strategy is going to deliver my target returns of 15% pa going forwards.

I am tempted to remove the Company from my portfolio immediately, but I am going to resist and see what the interims bring in February. On the up-side, there is room to appoint a CEO, articulate/demonstrate the strategy more clearly and use the cash to re-instate the dividend or pursue strategic acquisitions. The question that I am wrestling with is: "why is this any better than other discounted builder/land holder?" and we'll see if the interims can shed any more light on this.

HOLD for now, but to re-consider following the February interims.

Book Review: Genius Greenblatt

2011-01-23T22:16:00.002+00:00

This is the first in a quarterly, or occasional, review of a relevant book by a noted author. In time, I intend to work my way through the "classics" (my definition!) and see what I learn along the way with a view to improving my portfolio performance.
-----

Despite the sensationalist title, You Can Be A Stock Market Genius, this book adds the substance to Joel Greenblatt's form.

As a American fund manager, Greenblatt achieved an IRR of 50% between 1985 and 1994 through investing in publicly quoted stocks via his fund, Gotham Capital. To put it in perspective, he (and his team) had effectively grown $1 in 1985 to be worth nearly $52 by 1994. OK, there is the small measure of inflation and the partners' carried interest to erode the real return to external investors, but I'm being churlish...his returns were extraordinary.

In this book (1999 edition), he sets out, often quite wittily and with plenty of real-life case studies, the kind of situations that helped to bring him his stellar returns. In essence, he thrives on special situations where there is a fundamental imbalance between supply and demand which causes price distortion (ie the market undervalues that asset/situation) that, through analysis, he expects to reverse.

The interesting things that I took away and will consider for my own portfolio include:

1 - I am probably over-diversified. "After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an attempt to decrease risk is small". I have the words of Buffett and his diversifying against ignorance ringing in my ears.

2 - Look in the right places - he's a big fan of "spin-offs" in particular.

3 - I shall focus on Free Cash Flow a bit more. Whilst I already include it in my rules, I will consider whether it is appropriate to use FCF as an alternative to EPS when looking at PE ratios.

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

Muck and Brass at Drax?

2011-01-14T11:45:00.002+00:00

There is a saying in Yorkshire that goes along the lines of "where there's muck, there's brass".

Beautiful? Source: Drax website

Drax Group plc (DRX), based in Yorkshire, operates the largest coal-fired power station in the UK, providing some 7% of the UK's energy needs via the wholesale market. Plenty of muck then, but what about the brass? And under-valued brass at that.

The current share price of 380p (as at 11 January 2010) gives the company a market value of £1.39bn. Based upon the 2009 basic EPS of 31p, this represents a PER of 12.3x.

Source: Drax website

In the past five years, the shares have hit a high of 968p (August 2006) and a low of 329p (May 2010). However, there were share consolidations in between, and to have a true comparison, one needs to apply a factor of about 1.15x - eg 1,155 August 2006 shares are equivalent to about 1,000 May 10 shares.

The interesting point to note is that the share price has seriously under-performed the FTSE 100 in the past 18 to 24 months - almost being a mirror image. DRX is listed in the FTSE250 and is roughly the 60th largest company in that index by market value.

For the record, my average cost per share is 384p and, after dividends equating to 18p per share, my break-even cost is 366p per share.

Background

Potted history

1974 - first stage of the plant built (second stage in 1986);
1990 - came under ownership of National Power (following regulation of electricity industry);
1999 - acquired by AES Corp (US) for £1.87bn as vertical integration and a need for divestments came into play;
2003 - ownership transferred to a number of financial institutions following "customer issues" (Drax's largest customer went into administration, leading to severe financial problems);
2005 - refinancing and listing on the London Stock Exchange (December);
2009 - acquired Haven Power as a route into supplying business customers directly; and
2010 - £106m of new equity to pay-down debt.

Business Model

Drax burns coal and sells the electricity onto the wholesale energy market. Its revenues come in three flavours: spot ('Balancing Mechanism' - to meet hourly demand), short-term (demand for next 24 hours) and forward contract (up to several years before).

The prices in the wholesale energy markets are driven partly by the price of oil. Gas prices are typically linked to oil prices, so when oil prices rise, gas prices rise. Gas is the major source for delivering energy in the UK (45% in 2008), and a higher gas price tends to lead to higher wholesale electricity prices. NB coal generated 32% of UK electricity in 2008.

In 2009 (and 2010) wholesale gas prices have been relatively low, despite a more buoyant oil price, which has led to a relatively low wholesale electricity price. Gas-fired generation becomes cheaper and coal-fired generation margins are lower to the extent that the price of coal does not fall as low as gas price. Gross margins fell in 2009 as the average price for electricity on the wholesale market fell by 10% whereas the cost of coal was virtually unchanged versus 2008.

On a positive note, Drax enters into forward contracts to ensure some stability to future revenues, and as at the end of 2009 had two years' worth of future revenues contracted. These contracts are 'marked-to-market' each year (ie profit or less arising on contracts yet to be delivered based on current price are taken into account), which should help to smooth earnings. Furthermore, the Company entered into a five-year supply agreement with Centrica in 2009, which appears to be longer in duration than the norm, and sounds positive as a consequence if the industry is moving this way.

The Company is also developing a biomass-fired generation business (essentially burning straw rather than coal), which will help to reduce CO2 emissions. The Company has been dabbling in bio-mass for about seven years and it represented 3% of the fuel burnt by Drax in 2009. The Company has the facilities in place to develop this further, but this is being held back by issues of how it gets funded and what are the incentives (ie subsidies) for doing so. It appears that the Drax hasn't seen eye-to-eye with the UK government on this...yet.

Risks & Challenges

essentially a single-site operation;
spot prices and resultant margins are driven by the price of oil, gas and coal markets - meaning that the Company is to some degree beholden to the vagaries of world's energy markets, although this is mitigated by hedging and forward contracts; and
geo-political desire to reduce CO2 emissions, but which alternative energies are going to succeed and how will they be funded? (direct investment, subsidies, price of carbon etc)

Check out the website: http://www.draxgroup.plc.uk/aboutus/ for more detail.

The Rules

The starting point for the analysis is the Annual Report for the year ended 31 December 2009 (FY09).

1 - Assets - the NAV at December 2009 was £1.03bn versus a market cap of £1.39bn, meaning that the market value is trading at a 35% premium to net assets.

Virtually all of the NAV (and more besides) is in relation to fixed assets - freehold land, buildings and plant & machinery, which are valued at a book cost of £1.2bn. It is arguable that the market value of the newest, largest and cleanest coal-fired power station in the UK could have a strategic element to it and could be higher (or lower!) than the book value. Given the nature of the asset, there is not a readily available market price. From a value perspective, I am not keen on assets being valued at a premium, but I note the relative uniqueness of the asset and can live with a modest premium to book value. Pass(ish)

2 - Market Value - £1.39bn. Pass

3 - Cash Flow - (a) net current assets of £232m bodes well and (b) operating cash was £306m after working capital movements and interest. Out of this we need to provide for replacement capex (estimate of £50m based on depreciation charge), tax (£50m based on 2009 P&L charge), which leaves the best part of £200m to cover debt repayment (£30m due within 12 months), 'new' capex (new biomass capex and clean energy technology) and dividends (£50m based on 13.7p). After all this, I am content that the Company's capital structure can be serviced and that there is room left over to support an increased level of dividend, although future capex could impact on this. Pass

4 - Debt - (a) net debt as at December 2009 totalled £109m versus balance sheet equity (£1.02bn), resulting in a debt:equity ratio of 1:10 and (b) an EV/EBITDA ratio of 4.9x, based on an EV of £1.5bn and adjusted EBITDA of £305m (EBITDA of £355m less replacement capex of £50m), which squeezes under the 5x ceiling by a smidgen. Pass

5 - PER - based upon a 2009 basic EPS of 31p, the PER is 12.3x.

We would want to look at a 10 year average EPS to look at long-term earnings, but the Company has only been listed for five years. The five year average EPS is 90p, but this does not take account of the share reorganisations in 2006/07. If we look at PBT for each of those five years, apply an average tax rate and divide by the shares currently in issue, we get a five year average EPS of around 80p. Using this, the PER based on five year EPS of 80p is a far more reasonable 4.8x, bring us into value territory. Pass

6 - Yield - the 2009 DPS was 13.7p, which equates to a yield of 3.6% and is above the target hurdle of 3.5%. However, this does not represent the whole story. The Company has paid out bumper special dividends in the last five years and 2009 represents the most measly as far as dividends are concerned.

The Company recently revised its dividend policy to be 50% of underlying earnings. If we take this to be basic EPS, then DPS in 2009 would have been closer to 16p. If we get carried away and consider EPS of 80p to be reasonable, we start getting target dividends in the range of 30-40p, and the dizzy heights of a yield greater than 10% based on the current price.

Based upon basic EPS of 31p, the 2009 dividend was covered 2.25x. Given the stated target policy of paying out 50% of earnings, dividend cover will be in the region of 2x going forwards. Pass

7 - ROE - the 2009 ROE was 16%, which beats the target. The five year annual average ROE comes out at 58% (per Sharelockhomes), which seems high, and is probably a reflection of having a low equity base to start with and paying out high levels of dividends. Pass

8 - Directors - the three executive directors are interested in about 1m shares, of which the CEO is in for 0.5m (£2m) and the FD and Production Director about 0.25m each (£1m). Broadly speaking this represents about 2x annual remuneration, which is not peanuts, but a lot of these 'interests' have been generated through bonuses, options and various schemes...ie the directors have not had to have forked out at the same price/cost as an ordinary shareholder. That said, I am content that their interests are aligned with the ordinary shareholders. Pass

9/10 - Buy or Bye? The five-year average EPS is 80p and the five-year average PER is 7.2x, which gives a five-year 'fair' price of 576p, some 50% above the current price. The rationale for using long-term averages, ideally 10 years, is that it should cover earnings throughout a whole business cycle. It is arguable whether we get that through a five-year average, but, to my mind, we appear to have seen some boom and bust within the last five years to get a flavour of the good and bad years.

Update

The results for 6 months to June 2010 were released in August and pointed to improved margins due to higher demand for energy and an interim dividend of 14.1p (50% of underlying earnings). Repeat: the interim 2010 dividend was higher than the full-year FY09 dividend.

On 14 December 2010, the Company announced in a pre-close statement that EBITDA and underlying EPS will be slightly ahead of current market consensus (EBITDA to be ahead of £376m?).

Two Non-Execs acquired their first shares in December 2010 (c£50k in total)

Conclusion

On a score-card approach Drax does well, meeting all of the rules. The caveats to this are the premium to net assets (not a Graham stock) and the fact that 'long-term' earnings are are only measured over five years. I expect average long-term earnings to reduce when FY10 is added in, but should still represent a significant premium to 2009 earnings.

The Company is always going to be subject to the headwinds of the global economy and the vagaries of the global commodity markets, but at the end of the day, the UK needs a substantial amount of power, and Drax currently provides about 7% of it; this not going to change any time soon. The Company is also positioning itself for the future with a growing switch to 'green' through necessity and choice.

In terms of value, the current price is probably fair value if you believe that the current environment (2009 earnings) will be the norm going forwards. However, I consider that we are at a relative cyclical low point currently (2009 earnings) and that, in time, energy prices will rise as global economic growth continues. For me, the shares are a BUY at 380p, with a long-term fair price of 576p. The added bonus (by design) is that we get bumper dividends thrown in.

In the long-term, the returns might be even more valuable than brass!

The FY10 results due on 22 February, after which I will publish an update.

Foot on the Gas or Hot Air at Ecofin?

2011-01-02T18:55:00.000+00:00

Question: where can you buy £1 for 75 pence? Answer: Ecofin Water & Power Opportunities plc (ECWO) ordinary shares.

Ok, it sounds like the kind of question you might find lurking inside a Christmas cracker, but an ECWO ordinary share has a published net asset value of 174p (as at 31 December 2010) but can be bought at a bargain price of 130p (as at 31 December 2010), representing a 25% discount. Sounds too good to be true.

In a sense this is not unusual as investment trusts (closed-end funds) often trade at a discount to net assets, which is probably due to another layer of management charges and listing costs over and above the costs embedded in the underlying investments. Or maybe the market is discounting managers' abilities to generate above-average performance over the long-term. As an investment vehicle, I like investment trusts as the charges are usually lower, you can buy them at a discount and the performance is usually superior to comparable unit trusts.

The two main reasons that attracted me to ECWO in the first-place are (i) thematic, as I wanted exposure to the water and energy sectors as I believe that demand for these will remain strong as the world's population continues to grow and (ii) potential value, given that ECWO trades at a discount to net assets and those underlying assets may themselves be lowly-valued - ie the potential of buying cheap assets...at a discount!

Source: London Stock Exchange

In the past five years, the shares have hit a high of 196p (January 2008) and a low of 118p (December 2005), remaining pretty much within a 120p to 150p price range within the last two years.

For the record, my average cost per share is 144p and, after dividends equating to 6p per share, my break-even cost is 138p per share.

Background

ECWO was launched as a geared equity vehicle in February 2002 with the intention of delivering a high, secure dividend through investing in utility companies, as well as preserving capital.

As at March 2010, ECWO held investments valued at £553m. In a snapshot:

75% were in the US, UK or Europe, with the remaining 25% in other industrialised economies and emerging markets (China, HK and Brazil = 15%);
53% were in Electricity, 11% Gas and 6% Water; 30% in multi-utility and utility-related;
85% were in listed companies and 15% in unquoted equities and corporate bonds.

For a more detailed analysis, start here: www.ecofin.co.uk/eco/en/products/ewpo/aboutewpo/aboutecofin

The Company is essentially a holding company for the investments its holds. The whole business of making and monitoring investments is conducted by the Investment Manager, Ecofin Ltd, under a management agreement. Ecofin Ltd is paid 1.5% of 'chargeable assets' and is entitled to a kicker should chargeable assets increase by 10% over the previous period (Ecofin gets 15% of any excess over the 10% hurdle), which seems generous to me as there does not appear to be a cumulative component - ie from my interpretation, should assets fall by 25% one year, and then rise 20% in the second year, they Manager would get a 1.5% kicker in year 2 even though net assets would be 5% cumulatively lower after two years. Let me know if I have got the wrong end of the stick.

The Company has had a horribly messy capital structure with all sorts of Capital Shares, Income Shares, Ordinary Shares, Deferred Shares, Subscription Shares, Zero Dividend Preference Shares (ZDPs) and Convertible Loan Stock (CULS) in existence within the past five years. In fact, the two pages in the Annual Report covering the capital structure are enough to send an insomniac to sleep. Thankfully, the Company publishes the net asset value of diluted ordinary shares on a weekly basis, so that acts as a focal point to me.

But for all that, ECWO appears to have delivered. According to the Investment Manager (p6 of 2010 Annual Report), the annualised return (IRR) on net assets since 2002 is 16% and the IRR on the ordinary shares since they came into existence in June 2005 is just under 15%.

The risks that the Company faces include: the utility sector is capital intensive (which can gobble up cash flow), is subject to regulatory intervention (think OFWAT, OFGEM etc) and government spending; the renewables sub-sector is in its infancy and there will be casualties along the way (eg portfolio company, Hansen, has been struggling recently); the Company has relatively high levels of gearing (see below); the Company invests in other Ecofin funds (objectivity?); forex and hedging exposure, and the annual charges (TER of 2.5% in 2010 Annual Report) are slightly on the high side and will act as a drag on future performance.

The Rules

Because ECWO is a closed-end fund, the normal Rules do not apply. I will use them as a starting point, but will tinker as required. The starting point for the analysis is the 12 months to 31 March 2010 (FY10) and any reference to ECWO or the Company is in relation to the ordinary shares unless otherwise stated.

1 - Assets - the net assets of the Company totalled £449m, which is split between ordinary shares £387m and zero dividend preference shares (ZDPs) £62m (see below). The net asset value of the ordinary shares (on a fully diluted basis) is 174p. It is worth noting that 85% of the assets are listed investments, and are thus valued on a market valuation basis.

2 - Market value of the ordinary shares is £275m, so that ticks the box.

3 - Cash Flow - as the Company is essentially managing a big pot of money, out of which it needs to pay dividends and service debt, an analysis of cash flow is not especially relevant. If the Company needs to raise liquidity, it will sell some of its investments, most of which are shares in large, listed utility companies.

4 - Debt - Debt totalled £177m, being £35m of Prime brokerage borrowings (essentially an overdraft), £62m of Zero Dividend Preference Shares (ZDPs) and £80m of CULS (Convertible Loan Stock). The ZDPs have a gross redemption yield of 7% pa and will be redeemed in July 2016 (dividends are rolled-up rather than paid) and the CULS pay interest at 6% pa and will be redeemed in July 2016. That's the beauty of leverage...to borrow at 6-7% pa, invest and generate overall returns of 15% pa after costs and tax.

From a gearing perspective, this equates to gearing of 45% at March 2010 (after cash is deducted), which in English, means that for every £1 of ordinary shareholder equity there is 45p of borrowing. The Company has the ability to increase this up to 60% as a maximum. Note that, for this purpose, whilst preference shares are equity instruments, they are treated as debt.

The Directors believe that this level of gearing is sustainable because "utility companies in which the Company invests provide essential services, have substantial real assets and typically pay dividends".

5 - PER - closed-end investment companies tend not to be valued or measured on a PER basis, but more on a net asset basis. As stated, the current discount to net assets on the ordinary shares is 25%.

In the past 18 months, the discount has ranged from 8.8% (June 09) to 25.9% (Dec 09). The level of discount appears to have increased in line with the economic turmoil as the average discount was 2.6% before mid-2008 and it has been 17.7% since mid-2008 (Source: p2, 2010 AR).

A fundamental part of my analysis on this blog is to identify investments that are under-valued, particularly with reference to long-term earnings and current valuations. Whilst the same methodology does not apply for close-end investment trusts, it is possible to reference the current price against the historic level of discount. ECWO's discount is currently at the high end, implying a low relative valuation.

Another point to mention is that because of the existence of the ZDPs, the Company's ordinary shares are ineligible for inclusion in the FTSE indices. With a fair wind, ECWO might have just about crept into the FTSE 250 based on market value, but it isn't allowed, so this probably helps to keep it under the radar of a lot of investors. That said, there is a big institutional holding with Invesco holding 28.7% of the ordinary shares at March 2010, and the eight institutions that disclosed holdings above 3%, held 63% of the ordinary shares cumulatively.

6 - Yield - the DPS for FY10 was 5.5p, however the Chairman commented that they expect to pay semi-annual dividends of 3p per ordinary share going forwards, which equates to 6p per share and a yield of 4.6% based on the current share price of 130p.

The Revenue return per ordinary share for the past two years has been 5.9p and 6.9p respectively, which gives comfort that a dividend of 5-6p is covered. Furthermore, one of the advantages of the closed-end funds is that they can build up reserves to cover future dividend payments. ECWO has a Revenue Reserve of £15m versus an annual ordinary dividend bill of £10-11m, implying that they have 1.5 times the dividend in the 'reserve bank'. This will help to provide continuity and stability to future dividend payments at the current level.

7 - ROE - the return to shareholders is comprised of a Revenue component (dividends and interest received by the Company) and a Capital component (change in market value of investments, most of which is unrealised). It is difficult to use this as a reference point for ROE as the Capital component is essentially derived from a valuation taken at a particular point in time and does not represent 'earned' income. Consequently, I shall take the directors' statement that they generate post-tax returns of 15-16% pa as my proxy for ROE.

8 - Directors - the five directors hold 320k ordinary shares, £250k CULS and £80k of ZDPs, representing a total investment of c£750k, or £150k each. This is not a huge amount, but the dynamics are slightly different insofar as they are acting more as custodians of the Company, whereas the Investment Manager (Ecofin Limited) does the day-to-day management of the investments. Two of the directors are shareholders in Ecofin (or various holding companies or pension plans) which have an estimated £10m of vested interested in ECWO. Plus the generous performance fee arrangements, of course. All very messy, but enough to probably conclude that the directors interests are aligned with the ordinary shareholders.

9/10 - Buy or Bye? - see above and below re discount.

Update

The interim results for the 6 months to September 2010 were announced at the end of November. Whilst net asset value had fallen in light of the continuing tough economic climate, volatile markets etc, there was good news in the form of a higher interim dividend (3.25p), with the intention that this will be maintained for future payments and will be increased "when conditions permit". Better still, the Chairman commented that there may be scope to increase the yield by focusing more on higher-yielding investments.

As with the Annual Report, there was plenty of reference to the utilities sector being priced at historically low valuations, with high yields, and the last sector to enjoy recovery.

Conclusion

I'll let the Chairman have the penultimate word as he has articulated perfectly my rationale for investing in ECWO (Source: interim report):

"In the public equity markets, however, the sector remains under-owned by investors although valuations are attractive and the dividend yields available in the sector are among the highest available in the equity market. Historically, the utilities sector has been a sector that recovers late in the cycle following a recession and this looks to be the case in the current recovery as the sector has underperformed the broader market in 2010. For the patient investor, however, the sector offers income, low downside risk and the prospects of growth and a re-rating as the global economic recovery gains strength."

On top of that, I think that the shares are a little unloved because of the capital structure as well as not being in the FTSE 250, which keeps them under the radar.

For me the shares are a BUY at 130p. It's difficult to come up with a fair price as there is a bit of a moving target with the discount to net assets and the potential of a general revaluation of the global utilities sector. I'll start to get interested when the discount narrows to, say, 5%, which gets us to a target price of 165p- 170p. However, I am content to sit there for the long-term provided that the directors and managers can continue to generate long-terms IRRs of 15-16%, as this is consistent with my investment hurdle.

I will update once the results for the year to March 2011 are published.

Happy New Year!

Will Johnsons Take Me to the Cleaners?

2010-12-21T10:45:00.004+00:00

Johnson Service Group (JSG) pompously describes itself as a 'leader in managed services'. In the real world, it cleans clothes, hires out linen and looks after buildings. Not the most glamorous of things, but surely not something that can go terribly wrong?

Think again. Looking at the five year share price graph, some shareholders might consider that the Company is so proficient at cleaning that it has managed to clean out their wallets too.

In the past five years, the share price has fallen from a high of 467p in January 2006 to a low of 5p in February 2009.

The current share price of 30p (as at 16 December 2010) gives the company a market value of £75m. Based upon the 2009 basic EPS of 4.7p, this represents a PER of 6.4x.

For the record, my average cost per share is 22p and after dividends equating to 1p per share, my break-even is 21p per share. I am therefore sitting on a paper gain of 41%. I want to understand whether this was luck and/or judgement, and whether I should be topping up or baling out.

Background

JSG is comprised of three main divisions: (i) Textile Rentals (work-wear rentals and laundry services to trade); (ii) Dry-cleaning (Johnsons is the eponymous brand)

and (iii) Facilities Management.

The wheels first started to come off in 2006 when the Company experienced IT, stock and local management issues, all of which conspired to generate exceptional costs, write offs and rising debt levels in 2007/8. A new CEO (Skinner) came and went, the 2007 final dividend was cancelled, £30m of new equity was raised through a Placing, Johnson Clothing (the UK's largest provider of corporate clothes was sold off in an MBO for £82m), the shares were transferred to AIM, the debt facilities were refinanced (following a breach of covenants), and John Talbot, an experienced turnaround professional, became CEO. Talk about a boring and uneventful couple of years...

So where are we now? Based upon a review of the 2009 Annual Report, the Company appears to have found a sense of stability. Net debt was down to £68m (less than half of its peak a few years before), the dividend returned (albeit at modest levels), operating cash flow improved, Textile Rentals (with an element of contracted revenues) accounted for 50% of turnover but over 80% of the operating profit in 2009 should help to provide some robustness to earnings.

The Rules

1 - Assets - the net assets on the 2009 balance sheet total £71m compared to a market cap of £75m, which implies that the Company is essentially being valued at book-value. On the face of it, this looks reasonable. However, one must consider the £88m of goodwill sitting on the balance sheet. It is difficult, if not impossible, to know what the true value of a business is (other than what someone is prepared to pay for it), so one cannot say whether this is a 'fair' value or not. At least the net assets are not being valued at a premium above book value.

2 - Market Cap - at £75m it is higher than the £50m floor.

3 - Cash Flow - (a) there are net current liabilities of £9m at December 2009 (v £1m of current assets at December 2008), which is explained partially by £7m of debt repayment now falling due within 12 months and a reduction in trade debtors and other receivables (net of trade creditors); (b) operating cash of £28m (EBITDA of £48m less interest of £7m and 'replacement' capex of £12m) looks good. Out of this, we need to pay the Tax Man (£6m - 2009 P&L), dividends (£1m), and debt repayments (£11m). This leaves £10m for acquisitions, working capital and pension obligations (note the £13m payment to the defined benefit pension scheme in 2009, but it does jump around).

All this leads me to believe that the Company is generating adequate cash for its current needs, but its £60m of future debt repayments (all of which is due to be repaid in the next 5 years) and £20m pension deficit are going to put pressure on any material growth in the size of the dividend in the short-term.

4 - Debt - (a) with net debt of £68m and balance sheet equity of £71m, there is a net debt:equity ratio of 0.95, which is above my target of 0.5 times (ie 50p of debt for every £1 of balance sheet equity), but does not represent ridiculous over-leverage; (b) there is an EV/EBITDA ratio of 4x, based on an EV of £143m and adjusted EBITDA of £36m (less replacement capex). This is at a perfectly reasonable level.

The other point to note about debt is the defined benefit pension deficit. Unlike other debt, where you have certainty over the costs and repayment schedule, pension debt is baffling, not least because it sprawls over five pages in the 2009 Annual Report. Whilst it is a debt obligation insofar as it will snaffle future cash and profit, it jumps around depending on the vagaries of the market and the outlook of actuaries. Because of the variability, I exclude it from the pure definition of debt, but will keep a close eye on it, especially from a cash flow perspective.

5 - PER - a current PER of 6.4x (2009 basic EPS) is conservative and probably reflects the burnt fingers of institutional investors and the AIM listing (unloved and under the radar). No doubt it's tough out there, especially for a company with High St exposure such as Johnsons dry-cleaners, but I am comforted by the contracted revenues of Textile Rentals.

It's easy to get fixated with what the most appropriate measure of EPS should be (basic, diluted adjusted etc), but as a sense check, EBITDA (a proxy for cash profits) for the past four years (2006-2009) comes out at a healthy and reasonably robust £49m, £36m, £44m and £48m respectively, an average of £44m pa.

6 - Yield - the 2009 DPS was 0.75p, representing a yield of 2.5% based on the current price. This is beneath my target yield of 3.5%. Based on 2009 basic EPS of 4.7p, the dividend is covered a healthy 6 times, suggesting that there is scope to increase the dividend, although probably not too much in the short-term given that cash will be used for working capital and debt repayment.

7 - ROE - the 2009 ROE was 12.7% and is greater than the 10% target.

8 - Directors - the eight directors hold 5.6m shares directly (value of £1.7m), and of these the CEO (Talbot) has 3.8m (£1.1m). Stripping the CEO out, the other directors hold on average c250,000 shares each (£75k), which is a little on the low side. In addition there are an additional 14m share options/LTIPs kicking around, which provide an extra incentive for the directors to improve the share price. In general, the director remuneration looks reasonable for a company of this size.

Post-scipt: the directors added another 2.7m shares in September, following the release of the interims, which takes their direct holding to 8.3m (£2.5m).

9/10 - Buy or Bye? At this stage, I would wish to examine the 10 year record to see how the company is valued in the context of long-term earnings and valuation multiples. Clearly, the Company going into 2011, is in a very different shape to the one that thrived and (just about) survived throughout the last decade, rendering any comparison as troublesome.

The 10 year basic EPS average is 3.4p, although if you strip out 2007 and 2008, it jumps to 23.7p! The average PER is 9.0x, although if you strip out 2007 and 2008 again, it jumps to about 11.2x (albeit on the Main Market).

Recent Developments

In the interims (6 months to June 2010; released in September 2010), the CEO announced progress in line with expectations. Turnover was under pressure, margins held up, net debt had fallen to £65m, but the pension deficit was up, an increased interim dividend (up 8% - or a mighty 0.02p!) and an opportunistic acquisition of some PFI contracts from the remnants of Jarvis. All in all, steady progress, with a focus on cost control (if not reduction), cash generation and revenue protection.

Conclusion

In terms of valuation, I propose that a current EPS of 4.7p feels about right (=£11.5m PAT), but a slightly higher multiple should be reasonable, at say 9x. This gives a target sale price of 42p. If JSG reaches this price by Christmas 2012, I will have generated a return of c100% and an IRR of 25-50% depending on how quickly we get there.

Whilst a jump from 30p to 42p sounds high, the shares have had some momentum recently, climbing from 16p to 30p in the space of 6 months. The directors acquired 2.7m shares in September, which must have helped to stimulate matters.

But should I buy some more given that I believe a further 50% upside is achievable? If the yield was a bit higher, the debt a bit lower and there was a bigger discount to net assets, it would be a screaming buy. However, given my relatively low entry point, I find it difficult to add new shares at a much higher base cost. Maybe it's a psychological thing, or maybe I want to keep my powder dry for other investment opportunities that offer a bigger perceived discount, but in the meantime, I'm going to HOLD, with a TARGET SALE PRICE OF 42p. I will review my analysis when the 2010 final results are published, as a solid set of results, may act as a trigger for a re-rating.

GSK: Hero or Headache?

2010-12-10T14:30:00.006+00:00

The trouble I have with GlaxoSmithKline (GSK), other than the unfeasibly long and contrived name, and that is even after dropping the Beecham part, is that it has done nothing for me.

I first acquired shares back in August 2006, have topped up from time-to-time, and am sitting on a spectacular gain of...wait for it...8%. That's total, not per annum. Potentially worse still, is that all of that gain (and more besides) is a consequence of dividends. What I want to establish is whether I massively overpaid for the share or whether I've backed a cart horse.

The other reason that it has appeared on my radar, is that a lot of commentators have tipped GSK as a worthy, if dull, defensive play, on a yield of c5% and a PER of c10-11x, giving it the notional characteristics of a value share.

For the record, my average cost per share is £13.18 and I've had £1.82 per share in dividends, which brings my break-even price to £11.36 per share. The current share price is £12.42 (as at 10 December 2010).

Background

GSK is a very large and well analysed company, being the sixth largest company (by value) in FTSE 100. It is likely that, whether you realise it or not, GSK touches some part of your life and your share portfolio.

As the long-winded name suggests, the Company is an amalgamation of companies that have been added/merged en route to support whatever strategy was in place at the time.

Revenues are broadly split between Pharmaceutical products (prescription drugs and vaccines) (84% of 2009 revenues) and Consumer healthcare (medicines, healthcare and soft drinks) (16% of revenues).

The current strategy is three-fold: (1) grow a diversified global business (cue emerging markets growth), (2) deliver more products of value (make R&D pay) and (3) simplify the operating model (improve efficiencies).

The threats that the business faces include: 'genericisation' (drugs coming out of patent - this represented lost sales of £1 billion in 2009); the need for R&D - generally around 14% of turnover - to find new drugs as quickly as they fall off the patent cycle, and an ever-growing litigious society.

I am not going to pretend that my analysis is going to add anything new to the volumes of research out there, or that I'm going to be able to find a hidden gem in GSK, but I will be taking a big picture view on current valuation versus a historical perspective in particular.

Source: London Stock Exchange

In the last 12 months, the shares have traded at a high of £13.39 and a low of £10.95.

However, on a 5 year trend, the highest point was £15.74 in March 2006. This shows neatly why, in hindsight, I bought at the wrong time!

The Rules

1 - Assets - net assets of £10.7bn (December 2009) compares to a market cap of c£64bn. The assets are trading at a significant premium to book-value. There is an element of goodwill from acquisitions, but the 'market value' of the product portfolio is reflected in the market cap and not on the balance sheet. I am in no position to estimate the future sales of each product on a DCF basis, so I won't attempt to.

2 - Market Cap - with a market value of £64.5 billion, it just about squeezes past my minimum hurdle of £50m...by a factor of 1,290x.

3 - Cash flow - (a) balance sheet - there are net current assets of £5bn, which is encouraging...(b) operating cash - operating cash of £9.5bn less interest of £1bn (top-end) and £1bn replacement capital (guess) = £7.5bn. Out of this, we need to pay the Tax Man £2bn and dividends of £3bn, which leaves a buffer of £2.5bn for future debt payments and strategic stuff (acquisitions etc). On the whole, the cash side of things looks positive.

4 - Debt - (a) a debt to equity ratio of 0.9 is high (for my rules) but probably reasonable for such a large company with stable cash flows; (b) net debt of £9.4 billion, equates to an EV/EBITDA multiple of 8.5x based on an EV of £74bn and adjusted EBITDA of £8.7bn. This represents quite a full multiple and probably reflects the size and relative stability of the cash flows.

5 - PER - based upon a 2009 basic EPS of 109p and a current price of £12.42, the current PER is 11.4x, which is beneath the target ceiling of 12x.

If we look at long-term earnings and a 10 year basic EPS of 80.3p, the PER rises to a not-so-much-value 15.5x.

6 - Yield - the 2009 DPS was 61p, representing a yield of 4.9%, based on the current share price of £12.42. The cover based on 2009 basic EPS is 1.8 times, which is satisfactory.

The Company has a progressive dividend policy in place and increased its 2009 dividend by 7%. In fact, the dividend has increased every year since 2000 (my starting point), and this equates to annualised increase of 5.4%, which represents real growth in income. Good stuff.

7 - ROE - the 2009 ROE (per Sharelockholmes) was 61.4% and the average 10 year ROE is 62.2%. This appears to be high as the denominator (shareholders funds) never seems to increase much as each year's profit is 'spent' on dividends and share buy-backs.

8 - Directors - as one would expect for a large multi-national (nowadays at least), the directors were rewarded handsomely. The director remuneration bill totalled £11.8m (including leavers), and of this, the three executive directors had an average salary of over £2m each.

In addition, the three executive directors directly hold over 200,000 shares (£2.5m), as well as having various share options over c3m shares (at low exercise prices).

9/10 - Buy or Bye? A 10 year average EPS of 80.7p and a 10 year average PER of 15.6x, gives a 'long-term' fair price of £12.59. Interestingly, this is within a whisker of the current market price (£12.42).

Conclusion

I think that GSK is a well-run company with lots of defensive qualities, nice yield, growing earnings and an acceptable capital structure. For me, the current price is a fair price and reflects the fair value of the business. On this basis, the return that I am likely to get from investing in GSK is below my target IRR of 15%, which means that I will probably sell the shares to release the funds for something that does meet my requirements.

Despite being a big admirer of the Company, I can't see sufficient value at this price and, after all, I'm trying to achieve market-beating returns.

"Price is what you pay. Value is what you get." Warren Buffett

Is the Sun Shining for PVCS?

2010-12-06T10:26:00.006+00:00

I first bought shares in PV Crystalox Solar (PVCS) plc at 91p a throw in April 2009. I remembered being attracted to the perceived discount and growth potential at the time, and have averaged down since, to a cost of 70p, as the share price seems to have been in perpetual free-fall. After cumulative dividends of 4p, my break-even cost is now 66p, which compared to a current market price of 53p (2 December 2010) leaves me sitting on a paper loss of -20%.

I don't like losses any more than I like sun-stroke, so now is the time to evaluate (a) whether I should have bought the shares in the first place (based on my new rules) and (b) whether to buy, hold or sell.

Background

PVCS doesn't adhere easily to the mantra of 'only invest in companies that you understand'.

Big picture: the world's energy requirements are increasing (more people, more middle-classes, more technology etc), the 'dirty' energy sources are neither green nor politically correct (unless you're a Texan), and are expected to run-out eventually, meaning that the gap needs to be filled. I quite like this graphic from the PVCS web-site, which sums it up neatly, although may not be totally unbiased.

There is a dynamic between the point at which the 'dirty' energy sources start hitting a down-ward trend (about 2030 according to this graph) and which alternative energy source will come to dominate thereafter. Solar power is purported to be the answer, according to this graph at least.

So, where does PVCS come into it? For a more detailed explanation, see the website - http://www.pvcrystaloxsolar.com/PhotovoltaicEffect.html ...but in essence PVCS manufactures silicon-based photovaltic cells which convert the suns rays into energy.

There are various stages to the production process/supply chain, but PVCS concentrates on manufacturing the ingots and wafers in the UK and Germany, and making wafers and selling through an operation in Japan.

The Company was founded in 1982 and listed in 2007, raising Euros 73m to help build the new plant in Germany (moving down the supply chain to secure solar grade silicon supplies). Key attractions in the Prospectus included: the IP to produce 'wafer-thin'...er...wafers, and long-standing relationships with the big Japanese boys, although the top three suppliers did account for 73% of sales at time of listing.

So, what has happened since the listing? The German factory has opened and is scaling up to full capacity in 2011, but that has happened against a back-drop of over-supply in all parts of the value chain, which has caused prices to plummet by up to 40%, and there are question-marks over the level and longevity of government subsidies (particularly in Spain, but offset by growth in Germany (higher volumes, lower prices) and Japan). Unsurprisingly, the share price has been heading in one direction only; like a sun-set.

Source: Digital Look, from PVCS website

The shares traded within a whisker of 200p in July 2008 and fell as low as 45p in April 2010. Based on the current price of 53p, the Company has a market cap of £222m, which represents a PER of 8.8 times 2009 basic EPS of 7.2 cents (= 6p). A low PER is the starting point for a bargain share, so let's have a look at the rest ...

The Rules

Based on the accounts for year to December 2009 and assuming I can get Euros 1.2 for my £...

1 - Assets - shareholders equity of £216m on the balance sheet versus a market cap of £222m. Assets valued at par; hurrah. Of the net assets, £100m is in relation to tangible assets (property, plant & equipment) and a very small monetary value is attributed to the goodwill (patents and software). I'll come on to working capital and debt in later sections, but at this stage, am comforted by the sensible market cap in relation to the net assets. A discount would have been nice, but let's not get greedy...

2 - Market cap - greater than £50m. Job done.

3 - Cash flow

(a) balance sheet: current assets less current liabilities = +£125m, looks very healthy. No problems in being able to meet short-term obligations, especially given the net cash position of £+58m.

Better still, there is (almost) enough cash in the bank to meet all liabilities: current and long-term. This favourable position has persisted for the last three years, although is unwinding as the Company has taken on more debt and invested in the building of the factory. It is worth noting that in the last three years, the Company has received grants and subsidies of £19m, which has helped to contribute towards the £71m cost of the German facility.

(b) operating cash: operating cash after working capital movements and interest was £36m, but out of this, we need to pay the tax bill (£33m - high due to bumper profits in 2008), before even thinking about capex and dividends (£20m). If we 'normalise' (I hate that word) the tax figure with the 2010 P&L charge (£11m), we come up with an adjusted operating cash figure of £25m, which helps to cover the dividends. That gets me reasonably comfortable that the Company generated sufficient operating cash in 2010 to support the dividend payment. I have conveniently ignored replacement capex as there is too much going on with the new factory to get a feel for what is replacement and what is required to support future growth.

Below operating cash, the cash flows jump around with increasing capex, offset by grants, new bank debt and forex movements.

4 - Debt

(a) gearing - there is cash on the balance sheet of £83m and debt of £25m, resulting in a net cash position of £58m. The debt has jumped around a bit, but since the refinancing in 2009 with Sumitomo

(b) EV/EBITDA - an EV of £164m (£222m-£58m) versus 2010 EBITDA of £44m, results in a ratio of 3.7x, which is very reasonable. It looks even more reasonable if one takes the average EBITDA of the past three years (£77m), resulting in 2.1x.

5 - PER - 2009 basic EPS was 6p per share, which generates a current PER of 8.8x. Ideally, we would want a 10 year EPS to test, but the Company has been listed for three years only, and due to a bumper 2008, average EPS increases to 13.2p per share, bringing PER down to 4x. There are profit figures contained in the listing Prospectus but these were generated under a different capital structure and therefore are not directly comparable. For interest, if we include these, we get a 6 year average EPS of 7.7p, which results in a PER of 7x.

For the purpose of this valuation, I will suggest that we are trading on a PER of 7-9x, which gets us into value territory.

Whilst 2008 was a good year, it looks particularly good from a comparison point of view with 2009, as profits were inflated by a net £37m currency benefit and a lower depreciation in 2008. This shows the perils in looking purely at a basic EPS calculation. However, ongoing margin pressure and increasing depreciation will put further downward pressure on EPS, and will help to prolong any potential re-rating in the market.

The new borrowings in Yen should provide a natural hedge, and help to stabilise these currency swings a bit.

6 - Yield - the 2009 DPS was 2p, which results in a yield of 3.1% and is as about as low as I'd like to go. The dividend has jumped around dependent upon earnings, but has averaged around 3.7p over the past three years, which would represent a yield of 5.9% based on current price. A note of caution though as the 2010 interim has been halved, which means that the level of dividend is under threat in the short-term.

On the plus side, there is plenty of earnings cover and cash to support payment of future dividends. The 2009 Annual Report makes reference to resuming a progressive dividend policy when conditions allow, which is comforting.

7 - ROE - the average ROE for the last three years is a healthy 26%, which ticks the box. Again, a longer time-frame is required to give a real level of confidence, given that this period covered a boom year in 2008.

8 - Directors - although the directors take nice salaries and bonuses, they still have a hefty investment in shares (largely due to owning a big slug at the time of IPO). The CEO has 44m shares (£23m) and the other directors hold 12m shares (£6m), which leads me to believe that they have enough skin in the game to act in the best interests of all shareholders. Given the size of these large holdings, there is little evidence of director buying, but they can be forgiven for that.

9/10 - Buy or Bye? A three year EPS of 13.2p and a three year-rating of 8.2x (courtesy of Sharelockholmes) gives us a (not very) long-term 'fair' price of 108p.

This is heavily caveated by the short trading history as a listed company, exceptional profits in 2008 and an evolving market.

Recent Trading

The 2010 interims (September 2010) were mixed but the Interim Management Statement (November 2010) was a bit more bullish. Higher volumes and stable prices were positive, but revenues were flat v H1 2009, margins were down, EBITDA down 40% and the interim dividend was halved. On the balance sheet, cash has gone up, net current assets has gone up and net assets have increased (meaning that the market value is now at a discount to net assets), although currency fluctuations have helped. Chinese, Japanese and Taiwanese markets are growing, which should help volumes to continue growing.

Conclusion

After all that, my head hurts. My take on it is that the market probably over-valued the share (mini techno bubble) in 2008 and is now more circumspect about future prospects, probably under-valuing the Company, having been "bitten once, twice shy".

From a valuation perspective, I like this share. Slight discount to net assets, earnings multiples not expensive, lots of cash kicking around, good return on equity, high director stake and a dividend.

What I don't like about this Company is that earnings have jumped around so much in its short history, which is a reflection of the vagaries of an evolving technology in an evolving market in an evolving world. Green is "in", but requires lots of subsidies to make it work, and current growth appears to be fuelled by the Asian economies, but what happens if they slow down? There is also a battle to be had between which alternative energy supply will come to dominate, although that battle might be a way off, and which technology will come out on top within solar.

If I came across this Company anew, I would probably hold-fire on a new investment, purely because of the lack of long-term trading history on the ability to generate long-term sustainable profits, and the sectoral issues that need to play themselves out. I can rationalise why I bought the share in the first place, albeit without the assistance of some rules to test, with evidence of a low valuation and lots of cash sloshing around.

If I am going to hit my aspirations of a 15% IRR, I need the price to hit 110p by December 2013 (assuming a three year window and a 2p dividend per annum) from my current starting point. A price of 110p is well within the range considering the all-time high and would represent an EPS of 12p on a PER of 9x, both of which should be achievable, although a modest re-rating would certainly help. Interestingly, this is within a whisker of my caveated fair price of 108p above.

In the absence of further information, I am going to HOLD, with a price target of 110p. If the price drops below 50p, I will consider topping up.

The sun is shining for now.

HMV: Pedigree or Prize Mongrel?

2010-11-30T11:27:00.002+00:00

HMV Group owns the HMV (surprise, surprise!) and Watersone's retail chains on the high street, as well as a smattering of live events (Mama) and digital (7 digital) businesses, to offer an holistic retailing service (see above graphic).

The plan appears to be developing into growing areas (live events and digital) to withstand the structural pressures in the High St, whilst unlocking synergies and turning Waterstone's around.

On the face it, at a share price of 46p (as at 30 Nov 10) based on FY10 (12m/e 24 April) EPS (basic) of 11.6p, giving an implied PER of 4x, it looks as cheap as chips.

In terms of my rules:

1 - Assets - to be valued at no more than a 10% premium - The Group balance sheet shows net assets worth £100m as at 24 April 10, which compares to a market value of £195m as at 30 Nov 10. A 95% mark-up on assets doesn't seem to be a great starting point for a value-based approach! Worse still, of those assets £122m relates to intangibles, which is comprised, broadly, of £68m for the purchase of Ottaker's (2006) and £44m for MAMA (2010).

Given the nature of the business, high street and digital, I wouldn't have expected it to be asset rich. There is a lot to be said for having leases, notwithstanding the future (off balance sheet) lease commitment of £1.2 billion. On this basis, having low asset cover is not unreasonable.

Not too keen on the £39m pension deficit, but this will ebb and flow with actuarial valuations, and I've seen worse. Ask BT.

2 - Market cap - at £195m is greater than the £50m target. Hurrah.

3- Cash flow - (a) balance sheet - working cap: current assets less current liabilities = -£191m, which has worsened by £40m from the prior year, largely due to the extra debt taken on and increased stock levels. Ouch. This shows that the business is running to standstill -ie future sales (cash) are required to pay the current bills, which is not a nice position to be in.

(b) operating cash - looks healthier, with cash generated from operations of £82m. Out of this we need to deduct a tax bill of £16m and capex of £30m (actually £40m, but have assumed that 75% is replacement capex), which leaves free cash of £36m. Dividends were £31m in the year. With extra debt to service (total of £96.3m) and a negative balance sheet working capital, something is going to have to give...which will probably the dividend (as the market seems to be pricing in)

4 - Debt - (a) net debt of £66m versus equity of £100m = 66% and isn't far over my target ratio of 50%

(b) EV/Adjusted EBITDA - EV of £261m (£195m market cap + £66m net debt); Adjusted EBITDA of £82m (EBITDA of £112m less replacement capex of £30m), results in a multiple of 3.2x, which is below my ceiling of 5x. Hurrah.

5 - PER - I make the 9 year EPS (basic) to be 10.4p (source: Sharelockholmes). Based on the current market price of 46p, this represents a staggeringly low multiple of 4.4x. The market appears to be pricing in World War 3 on the High St.

6 - Yield - a DPS of 7.4p for each of the last six years, which represents a yield of 16%. The market appears to think that this is unsustainable. Interestingly, dividend cover has been less than 1.3x in only one out of the previous eight years (2007), which is a good record.

7 - ROE - Per Sharelockholmes, the average ROE for the last three years is a staggering 56%. This is to do with having a high level of profitability relative to a low value equity base on the balance sheet (due to not being an asset intensive business and having a relatively high level of dividends being paid out).

8 - Directors - the directors hold around 886,000 shares directly, in addition to various share options (most of which are under water), which only equates to £407k in value. Given total director remuneration of £2.3m in 2010, this doesn't seem like a high enough holding to me. Disappointing. There has been a trickle of director buying in October, but this was in the region of 30,000 shares, which is peanuts.

9/10 - Buy or Bye? 9 yr EPS of 10.4p and a 7 year ave PER (per Sharelockholmes again) of 10.5x, gives an implied fair market price of 109p based on L/T averages. I like the look of a 58% discount!

Other stuff ...evidence of a moat? Hmm, subjective, but in my opinion, HMV is the destination for music and Waterstone's for books on the High St. I'm less in tune (ha, ha) with live music and digital, but these appear to be sound businesses. It would be difficult to replicate the High St presence quickly or cheaply. The bigger issue is the long-term structural decline of the High St vis-a-vis online, and whether the strength of the brands can flourish on the web.

The recent acquisitions appear sensible from a diversification/finessing the business model point of view, but they have a come at a price. The hefty price, extra debt and lack of earnings, are likely to hold back the share price in the short-term, but should, hopefully, support medium term growth objectives.

On the negative sides....retail is a dirty word, discretionary expenditure is going down, World War 3 is predicted on the high street, Woolworths/Zavvi/Borders don't provide happy case studies, debt has gone up, the pension deficit has gone up, free cash will get squeezed, the dividend is under pressure...BUT

the business is diversifying, there is potential for turn-around at Waterstone's, the market is valuing the business at 4 times long-term earnings, operating cash flows are healthy, debt levels are reasonable and manageable, and even if the dividend was halved, the yield would still be over 8%, plus there is scope for a re-rating with a FTSE250 promotion.

On my scorecard approach, the biggest short-comings are on the balance sheet valuation, balance sheet working cap and lack of director ownership. All in all, whilst not the finished product, I think the investment opportunity is a pedigree one though.

For me the shares are a BUY at 46p. I will add them to my virtual portfolio (watch this space) today. Watch out for the interims on 9 December too as there could be a buying opportunity if the L-F-L's are a bit too red.

Rules is rules...

2010-11-08T12:46:00.004+00:00

Having spent plenty of time reading around the subject and following the market, now is the time to incorporate a bit of discipline and set up my rules for investing.

I've published them on this blog as: (a) it helps me to think the rules through before I try to articulate them and (b) it's a matter of record as to whether I adhere to them or not!

My general objective is to increase my (family's) wealth through above-average stock market returns. This blog will generally focus on a value theme (ie buy low, sell high), but may cover the occasional bit of arbitrage or hedge-fund shenanigans from time to time.

My target net annual rate of return is 15%. I am expecting this to be achieved through a combination of: (i) dividends (4-5%), (ii) EPS growth (5-6%) and (iii) valuation re-ratings (5-6%). Time will tell.

I will start "proper" from 1 January 2011 to allow me time to reassess my existing portfolio and prune as required. I might even start earlier if I get my skates on...

Because the world works in decimal, I've shoe-horned my rules into 10... give or take a bit around the edges (however see Extra Considerations (a) - (c)!)

The rules (in no particular order):

1 - Assets to be no more than a 10% premium - that is...market cap to be no more than 1.1 times balance sheet assets (shareholders funds). Conventional value wisdom suggests that it should be a discount, if not a deep discount, but for the time being, I'm happy to consider valuations at a small premium to net assets;

2 - Market cap > £50m - companies, I'm focusing on UK listed ones as that's my investment universe for this purpose, need to have a certain size and stability to them. £50m is arbitrary, I did toy with £100m, but £50m feels about right for now;

3 - Cash flow - two measures here: (a) positive working cap on the balance sheet (current assets - current liabilities > 0) to show that the company can meets its short-term obligations, and (b) positive operating cash on cash flow (operating cash after working cap movements, interest and replacement capex, but before discretionary items such as dividends) to show that net surplus cash is made which can be used to grow the business and/or be returned to shareholders in dividends or buy-backs;

4 - Limited debt - a bit of debt is efficient (CAPM and all that), but I don't like too much. Positive net cash is a big plus as this gives a company lots of wriggle room. I look at (a) debt to equity (balance sheet) being no more than 0.5 - ie for every £1 of equity there is no more than 50p of debt. I appreciate a gearing ratio of 33% (50/150) may sound reasonably conservative, but c'est la vie...and (b) EV/Adjusted EBITDA should be no more than 5 times. This shows (generally) that the total worth of an entrprise is valued at not more than 5 times its cash profits (after adjusting for replacement capex). Again, the 5 is subjective, but feels about right. I probably wouldn't kick a 6 out of bed, but we'll see...;

5 - Valuation - the PE ratio should be less than 12 times, which I'm taking as a conservative proxy for where I think the market should be. If it's lower than or higher than 12, then I think that the market is being either a bit bearish or bullish than (long-term) normal. See below for entry and exit points. Earnings should be the fully diluted basic EPS average over a 10 year period (or as long as you can muster) to smooth out any cyclicality;

6 - Yield - dividend yield > 3.5%. As there are plenty of studies which show that dividends account for the vast majority of value creation over the long-term, it would be churlish to ignore them. I'm setting my bench-mark as the 10 year gilt yield, at 3.5%ish . This implies that I will get the same return (ignoring market timings) on equities as gilts, but with the upside equity growth potential thrown in. One word of warning, rather than chasing yield...there needs to be (b) at least 1.25 times dividend cover over the average of the last 3 years to get me comfortable that the dividend is sustainable;

7 - Return on Equity > 10%. This is a new one for me. To get my increase in value, I need a sensible return on equity to be satisfied that management has room to grow the business with existing resources (ie without leveraging the business to the hilt or withering away shareholder value). Therefore, I'll set a target of an average RoE of 10% pa over the last three financial years and see how this gets on;

8 - Directors have skin in the game. It's reassuring, and profitable, to see directors acting as owners rather than just managers, and there is no better way than seeing them dip their hands in their pockets and buy their own shares (legitimately). I much prefer direct share purchases to share options, but want to be convinced that the directors are there for the long-term and are incentivised to grow the company for the benefit of the shareholders. The extent of their 'skin' will be subjective in nature;

9 - Buy, buy, buy! The convention entry point will be looking at a current valuation based on (a) 10 yrs EPS (as #5 above) x (b) the lower of the 10 yrs ave PE ratio or 12x (as #5). If this is 25% below the current market price and all of the other points (#1-8) are met, then fill your boots...;

10 - Bye, bye, bye... If the market price is 25% above the same calculation in #10, then it's time to take profits, subject to hitting my 15% IRR target hurdle.

My Extra Considerations, not formal rules, are:

(a) look for evidence of a moat / sustainable franchise - a la Buffett;

(b) look for net nets and cigar butts - market value is discounted to net current assets - L/T liabilities - a la Graham and Buffett; and

(c) set Buy/Sell price targets, but only reappraise these on final results (not interims), unless the world stops turning, in which case we're all doomed anyway.

Now that I've got my rules, I will retro-screen my existing portfolio and aim to analyse at least one new stock per week. watch this space...