Intelligent Investor Funds Management blogs

Battle lines form at RCU

Steve Johnson - IIF — Thu, 17 May 2012 22:53:26 +0000

That didn’t take long, did it? Just a few weeks after the ink dried on RCU’s capital raising, Greg Woolley has lobbed in a low-ball takeover offer for the trust at $0.46 per unit.

The Coming China Crash: Are We There Yet?

Steve Johnson - IIF — Wed, 16 May 2012 05:24:44 +0000

Commodities related stocks are getting pole-axed today. Fortescue down 5.5%. Mt Gibson down 6.4%. Whitehaven Coal down 8%. And the big daddy of them all, BHP, down 4% and trading at a three-year low.

First Greece was to blame. Now the China slowdown hypothesis seems to be gathering credibility. Has the China crash begun?

‘Hard to say’, as my partner tells me every time I ask her a question that she can’t answer with 100% certainty. But the data is looking scary.

I’ve been tweeting all of the interesting stuff I find but here’s a selection of my favourites:

China investment boom starts to unravel from the Financial Times.

Also on the FT, Alphaville posts about China’s economic data disaster.

And the New York Times says Data signals economic trouble in china. This last one contains my favourite quote:

In a series of interviews over the last week, bankers and senior executives from provinces all over China, in a range of light and heavy industries, cited a broad deterioration in business conditions. Two of them said that some tax agencies in smaller cities had been telling companies to inflate their sales and profits to make local economic growth look less weak than it really was, while reassuring the companies that their actual tax bills would be left unchanged.

There is plenty of fudging going on with Australia’s economic budgeting but this is taking it to a new level!

We’ve been expecting a dramatic slowdown in China’s rate of fixed asset investment and the latest data is consistent with that hypothesis. I don’t know if the Chinese authorities can or will stop the economy from unraveling, but I know the adjustment is an adjustment that needs to happen, either now or some time soon.

For regular readers of Bristlemouth and members of Intelligent Investor, you should be well prepared. If not, it might be time to go back and read The coming China crash, It’s time to buy in the US and Why China’s hard landing is a certainty.

Life as a Fund Manager Podcast

mattr — Fri, 11 May 2012 08:16:24 +0000

This week Steve Johnson and Matt Ryan, from Intelligent Investor Value Fund, join Gaurav to discuss the perils and the pleasures of managing an investment fund.

You can download the podcast here or listen below.

Timeline:

1. Update on the fund

- Introduce Steve and Matt (0:00)

- How has the fund performed recently? Is this in line with expectations? (5:07)

- What role does active fund management play versus indexing? (7:40)

- RNY Property Trust (9:35)

- Photon Group, and what to do when an idea doesn't work out (12:49)

2. Fund manager perspectives

- What is different about running other peoples money rather than research? (18:07)

- Portfolio allocation (23:44)

- Behavioural aspects (27:32)

- Is investing harder today than it used to be? (30:55)

- Investor expectations (35:18)

- Can a consistent strategy work or do you tweak them constantly? (36:57)

- Is Australia a large enough market? (38:32)

3. Long or short?

- Value investing (29:56)

- JB Hi-Fi (44:22)

- Equities (50:10)

Podcast:

DODDSVILLE_2012_EP_9.mp3

Sign the German Up To Spark

Steve Johnson - IIF — Tue, 01 May 2012 05:04:35 +0000

Apologies for the lack of postings Bristlemouth readers, things have been hectic in our little world for the past few weeks.

I have found the ideal CEO for Spark Infrastructure, though. A German who retired a few weeks ago after not lifting a finger for the past 14 years is my perfect candidate. The unnamed government official fired off an email to former colleagues on his retirement saying that, since 1998, he had been ‘present, but not really there’.

That’s exactly what we need at Spark. The newly internalised management team (whose stupid idea was it to vote for that proposal?) is most definitely ‘there’ and seem to have their hearts set on empire expansion. First was this little chestnut in the 2011 annual shareholder review:

“Spark has now put itself in a position where it is able to assess other investment opportunities with a view to diversifying its investment portfolio – by asset class, geography or income stream”.

Since that announcement, the Street Talk section of the Australian Financial Review has been full of speculation about Spark bidding for Sydney’s soon-to-be-privatised desalination plant.

One of two things can happen here. Spark lose, and we owners dust a few million dollars in bid costs. Or Spark wins the bid, and we dust a few hundred million of value on the acquisition. How can I be so sure it will destroy value?

Well, Spark doesn’t have the $600m it’s going to need to pay for the desal plant. It’s going to need to raise equity. That makes the analysis straight forward. By selling shares in what we already own to buy something new, we are simply swapping one investment for another. And I can guarantee you that what we get is not going to be worth as much as what we give away.

The Desalination Plant will sell for between 1.1 and 1.3 times its regulatory asset backing (RAB in the regulatory lingo). With big super funds lining up in alternative consortiums, it’s unlikely to go at the bottom of that range. If you strip out the unregulated business, Spark currently trades at a small discount to its RAB. It also has the obligation to invest billions of dollars over the next five years under a very favourable regulatory regime (effectively buying new assets at one times RAB). So, despite recent price appreciation, Spark still looks cheap. The Desalination Plant will be anything but.

Why would you sell something at RAB to buy something else at, say, 1.2 times RAB? You wouldn’t. Unless your underlying purpose was to grow your empire come what may. (Note to Spark shareholder relations guru, don’t bother sending me all that crap about diversification. I can look after my own diversification, thanks, and at the moment Spark forms a very nice part of a well diversified portfolio.)

Mr Unnamed German Government Employee, here’s the CEO chair. Please come to Australia, sit in it and do nothing, absolutely nothing, and we’ll all be a lot better off.

China Invests In PIGS

Steve Johnson - IIF — Wed, 11 Apr 2012 01:40:30 +0000

No, not Portugal, Ireland, Greece and Spain. I mean real PIGS. This from the FT:

Rent-Try-Buy? You're Better Off With Loan Sharks

mattr — Fri, 30 Mar 2012 00:54:30 +0000

There are a number of successful equipment leasing, or 'rent-try-buy' businesses listed on the ASX. Successful, that is, from a shareholder's perspective. As for the customers; that's a different story.

The whole industry is in the business of offering outrageously expensive financing while convincing their customers they're getting a good deal, so it's probably a little unfair to single out one of them for criticism. That said, this example from hospitality equipment provider Silver Chef (ASX code SIV) is too outrageous to let pass.

Silver Chef provides a 'Rent-Try-Buy' solution pitched at cafe and restaurant owners looking to avoid the upfront cost of kitchen equipment and the like. The lessee pays weekly rent and is given the option to purchase the equipment in one year's time.

Here's how Silver Chef presents the numbers for a $2000 transaction:

According to Silver Chef your net cost of funding is 7% for a year! Try and beat that from a bank.

It's a laughable piece of misleading mathematics. In the example here, you get $2,000 worth of kit, the weekly rent is $23.08, and the equipment can be purchased at year end for $1,300. In addition bond of $300 is required to be posted and a 'documentation fee' of $195 is charged.

To come up with its 7%, Silver Chef takes the $1,200 gross rental cost for the year, deducts 30% tax from this figure, and adds the pre-tax year-end purchase price of $1,300 to arrive at a total purchase price of $2,140. Comparing this to the $2000 pre-tax original cost of equipment, Silver Chef claims that the net cost of funding is $140, or 7%.

Lets have a look at how the numbers really work from Silver Chef's point of view:

Lessor	Date	Equipment purchase/sale ($)	Bond ($)	Fee/rent ($)	Tax ($)	Net cash flow ($)

Initial transaction	1-Jul-12	(2,000.00)	300.00	218.08		(1,481.92)
Rent (51 weekly payments)	8-Jul-12 to 30-Jun-12			23.08		1,177.08
Lessee purchase	30-Jun-13	1,300.00	(300.00)		(208.55)	791.45

IRR	52%

An internal rate of return of 52%. The key differences are that the Silver Chef numbers don't take into account the $195 fee, the time value of the $300 bond, and the tax deducation earned by Silver Chef from the decline in value of the equipment (the lessee would be entitled to this deducation had they purchased the equipment outright).

Not bad for Silver Chef shareholders, but if you're a restaurateur you'd be better of financing your equipment from a loan shark.

Silver Chef and its ASX-listed comrades, ThinkSmart and FlexiGroup, tick a lot of boxes from a shareholder perspective. Good returns on capital, plenty of growth and seemingly undemanding stock prices. But the risk of an ACCC crackdown has to be high. How they get away with advertising like this under Australian consumer protection laws is beyond me.

Unacceptable circumstance at RCU

Steve Johnson - IIF — Wed, 28 Mar 2012 04:58:36 +0000

The Takeovers Panel has declared unacceptable circumstances in regards to RCU's rights issue. Amongst other things, the Panel found that:

1. Frost discouraged RCU or RE from implementing a dispersion strategy in relation to the rights issue, other than allowing the rights issue to be renounceable.

2. All reasonable steps to minimise the potential control impact of the rights issue on RCU were not taken.

3. It appears to the Panel that the circumstances are unacceptable having regard to:

a. the effect that the Panel is satisfied the circumstances have had, are having, will have or are likely to have on:

i. the control, or potential control, of RCU or

ii. the acquisition, or proposed acquisition, by a person of a substantial interest in RCU and/or

b. the purposes of Chapter 6 set out in section 602 of the Corporations Act 2001 (Cth) (Act).

The remedy wasn't quite as favourable as we were hoping but goes a long way towards mitigating the control impact of RCU's raising. The main elements of the Takeovers Panel's orders are that:

- Frost will have to offer all eligible unitholders the ability to purchase any units that they didn't take up in the rights issue at the rights issue price of $0.40

- Importantly, all eligible unitholders will be able to apply for additional units and the shortfall will be allocated to those who applied for extra on a pro-rata basis. For example, if 50% of the unitholders take up their rights (including Frost), and then those same 50% apply for all they can under the shortfall facility, Frost would end up with about 30% of RCU.

RCU has also extended the closing date for the entitlements offer by two days (until Friday, 5pm) but that doesn't make much difference given you have the ability to buy any units you don't take up under the facility that will be provided by Frost. There's no reason to send your money in early when you have a free option to wait and see what happens over the next few weeks.

From here it all depends on how many investors take up their rights and how many apply for additional units.

Cliffing Goodman Fielder

mattr — Mon, 26 Mar 2012 03:43:11 +0000

I took a good look at bread maker Goodman Fielder over the Christmas break. The generally accepted wisdom with this stock is that it owns some good brands but has too much debt and is poorly managed. These are problems worth worrying about but presumably there was some underlying value, and with the share price having fallen to less than 40 cents, it sounded like my sort of investment idea.

We didn’t buy it (today it trades at 68, thanks to the prospect of a takeover offer from Wilmar International), but not because it doesn’t make enough money. As I'll argue below, it makes too much. But before I do, lets look at some facts from my research:

1. This business isn’t as bad as most people think (okay that’s not fact; it’s an opinion). Goodman Fielder’s metrics look horrible at first glance: return on equity of 9.7%; return on assets of 6.9% (post tax); and net profit that has declined an average of 11% per annum over the past three years. Note that these are my numbers adjusted for goodwill writedowns and asset sales. Whichever way you cut it, it looks bad.

The low returns on assets and equity, though, have nothing to do with the quality of Goodman Fielder’s business. If you strip out the intangibles generated when Graeme Hart relisted the company in 2005, the return on tangible capital is a very healthy 24%. Pre-tax, that’s the equivalent of 35%. On these numbers, it’s one of the best businesses on the ASX, which suggests it has some serious competitive advantages, contrary to the perception that it's a marginal business.

2. Using the same logic, it’s a lot more leveraged than it looks. The reported debt/total capital ratio is 45%. Strip out the intangibles and it’s 134% - the debt significantly outweighs the tangible assets. That’s not unusual in a high quality business but with the interest cover dropping to 2.7 at the last full-year results, things were starting to look precarious.

3. The $259m capital raising in October 2011 should have patched things up but I’m not sure that it made enough of a difference. It looks like there might have been some funny business going on with the year-end accounts. Goodman Fielder’s net interest expense was $101m for the year and the hedged interest rate was 8.7%. That would imply an average debt balance of $1.16bn.

The net debt balance was less than $1bn at both the start and the end of the year. Some of the difference is explained by the fact Goodman Fielder only earned 1.42% on its cash (note to CFO, you might want to check out Ubank, Bankwest and ING Direct) but I still reckon there’s a $100m hole somewhere.

4. There has also been an increase in the use of off-balance sheet leverage since listing. The company has been selling assets and leasing them straight back under long-term leases. The committed lease payments have risen from $70m in 2006 to $222m at year end 2011. You don’t see that on the balance sheet, but it increases the operational leverage substantially.

The last three points are interesting but don't make or break the investment case. The first point on return on capital, however, has serious implications for future profitability.

In the early days of the Value Fund, we did very well out of an investment in Sigma Pharmaceuticals. Sigma and Goodman Fielder both receive the bulk of their revenue from customers in very strong bargaining positions. Almost 90% of Sigma’s revenue comes from the Pharmaceutical Benefits Scheme, where prices are dictated by the Federal Government. Two thirds of Goodman Fielder’s revenue comes from Coles and Woolworths, and we all know how they treat their suppliers.

In Sigma’s case, though, it was earning abysmal returns on its tangible capital. That capital, mostly inventory and receivables, was liquid and the shares were trading at a large discount to the tangible asset backing. Strange as it may seem, the low returns gave it leverage over the Government. Cut prices further, Sigma can argue, and we’ll withdraw our capital and leave. That capital is worth more in shareholders hands than earning a 5% return in the business.

Now try the same thing if you’re Goodman Fielder. Let’s say Woolworths wants Goodman Fielder to cut prices such that Goodman Fielder is 20% less profitable. That would cut Goodman Fielder’s return on assets from 25% to 20%; hardly a level of profitability at which it’s rational to walk away.

Worse still, half the tangible capital is property, plant and equipment which couldn’t be liquidated anyway, except at a sizeable discount to book value.

According to an article in today's Sydney Morning Herald (Price war draining life out of suppliers), 'cliffing' is the latest negotiation tactic in Australia's supermarket wars.

'Suppliers are asked to stand at the edge of a cliff and agree to certain discounts and if they don't they are told to look over the cliff and see if they like that better'. Usually, we like businesses generating high returns on capital. But when a customer has the ability to cliff you, it can be a hell of a long way down.

Aussie Unhinged From the US Economy

Steve Johnson - IIF — Thu, 15 Mar 2012 03:34:26 +0000

For the past few years, the correlation between the AUD/USD exchange rate and the Dow Jones Industrial Average has been extremely high (0.89 for the stats enthusiasts, which means 89% of the movement in the exchange rate can be explained by movements in the Dow Jones Industrial Average). Every time the US economy shows signs of life, the Dow Jones rises, and so does the Aussie dollar. The theory being that a strong US economy means a strong global economy and high commodity prices. Good news for Australia.

With a large portion of the Value Fund invested in stocks with exposure to the US economy, every piece of good news on US employment or GDP has been offset by bad news on the currency front.

The strength of the correlation has surprised us. For commodity prices, a strong US economy is minor good news. A slowdown in China is major bad news. As we’ve been pointing out for more than a year, internal infrastructure spending is far more important to China’s economy (more specifically, China’s demand for our resources) than exports. So a strong US won’t offset a slowdown in infrastructure spending in China.

I’ve no idea why it’s taken this long, but the nexus seems to have broken. For the past two weeks, the US stock market has gone up while the Aussie dollar has gone down (you can see this clearly for yourself on the far right of the graph). There seems to be more and more fear about the state of the Chinese economy and, no longer constrained by the correlated dollar, stocks like QBE and Computershare, with significant exposure to the US, have been on a tear.

It is, of course, impossible to say with confidence. But I get the feeling we’re at an important inflection point. One we’re very well prepared for.

Frank's Wrong Focus At QBE

Steve Johnson - IIF — Wed, 14 Mar 2012 00:26:41 +0000

A couple of months back, I doubled our position in QBE Insurance. The $10 share price looked like a bargain. As I said in What are we missing on QBE?, at that price you could make a very good investment case on the back of the envelope.

It wasn’t without some nervousness, though. My assumption was that QBE’s problems were industry wide, not company specific. To be sure, we would have to wait for everyone else to report their results. With the results in, it’s clear that QBE remains at the top of the pack.

As you can see, it was a horror year for the industry. QBE did better than most, just as it has for the past couple of decades.

Some people can’t stand the volatility in insurance. I don’t mind it. Without profit volatility, we wouldn’t get the share price volatility that allows us to pick up bargains. And, unlike many other industries, I’m certain insurance as an industry will be around in 20 years’ time and larger than it is today. If QBE can stay in the top 25% of insurers ranked by profitability, it will do very well despite the ups and downs.

So far, 2012 is looking much better, with substantially less in the way of catastrophe claims and slightly higher interest rates. The share price has bounced almost 30% and, already, 2011 fading into the distance.

I’m a touch more comfortable that there aren’t any hidden company-specific problems. But I’m not 30% more comfortable.

And one thing about this company still irks me. The current CEO, Frank O’Halloran, was almost in tears at the analyst briefing following the announcement that he would retire in August. It’s touching to see a guy care so much for the company he works for, particularly in an era where most CEOs are expensive guns for hire, happy to move on to a better role at the first available opportunity.

It was also nice that one of the analysts (he’s apparently followed QBE for 17 years) made a tribute to Frank’s efforts and the global insurance business he has built during his 14 years at the helm. Then came one of the more interesting questions I’ve heard from an investment banker: ‘If there’s one thing you could change or achieve over the next six months, what would it be?’ Ok, so you don’t need much to make it into the list of top questions asked by investment bank analysts. But I thought it provided a great opportunity for Frank to talk about the opportunities for the business and the change required to make the most of them.

And Frank’s response? ‘All I want is for every analyst to have a buy recommendation on the stock by August’.

Really? That’s it? He went on to say that Tony Jackson, QBE’s new global head of investor relations, was one of its ‘best acquisitions’. O’Halloran is obsessed with the share price and the rest of the board are probably the same. Jackson used to cover QBE as an analyst for Macquarie Group, now he’s on the other side of the fence telling QBE how to rub the rest of the analysts the right way. So now there’s more disclosure, more one-on-ones and more ‘we’ll discuss this offline’. The disclosure in itself isn’t a bad thing. But the company is being led by the analysts when it should be the other way around.

So here’s my final tip for Frank: it ain't going to make a difference. When it’s hailing and flooding, they’re going to sell your stock. When it’s clear skies and high interest rates, they are going to buy it. Nothing you or Tony Jackson can do is going to change that, so you might as well just get on with running the business.