Do we have a company here that is trading below its net current asset value, NCAV, while also meeting Benjamin Graham’s criteria of:
1. Good management 2. Good prospects for the business 3. Stability? (see The Financial Times Guide to Value Investing for summary of criteria) Market capitalisation is £2.7m. Current assets are £4m (which includes £2.6m of cash). If we deduct all the liabilities we arrive at a NCAV of £3.1m, significantly greater than Mr Market currently values the company. A further adjustment might be to reduce the receivables as recommended by Graham. Let’s remove 20% of receivables which amounts to £0.29m bringing NCAV to only slightly above market capitalisation. However, an argument can be made for adding to the NCAV the £0.5m classified as non-current ‘available-for-sale investments’ (actually stakes in three property investment syndicates run by FK). A further consideration is that the NCAVs shown on recent balance sheets have consistently been above £3m for at least three years. What about the indicators of a well-run stable company? 1. Good management. There are 18 members of staff. The three leaders have been with the company for a minimum of 14 years. They each have decades of experience in commercial property management. They have seen recessions come and go. David Fletcher, founding director and chairman, has 40 years of experience. He also owns 14.6% of the shares. The managers have formed good relationships with clients, some over decades. Seemingly honest and realistic appraisal of the business prospects through the recession years: using words/phrases such as ‘challenging’, ‘keep a steady eye on overhead costs’ ‘it will take all our ingenuity and resource to maintain turnover’ 2. Good prospects. Profits before tax for the last three years have not fallen below £0.29m pa and dividends have consistently been 1.5p. With a share price of 31p the dividend yield is just under 5%. This performance has been achieved at a low point in the property cycle. At the last high point (2007) dividends amounted to 4.75p pa. Given the company’s balance sheet strength there is every reason to believe that what remains of the current recession will be survived. Could dividends then go back to 4.75p? If they do then the Mr Market might push up the share price. Of the reasons Benjamin Graham gives for a turnaround in the prospects of a NCAV company perhaps the most compelling for this case is that the earning power will be lifted to the point where it is commensurate with the company’s asset level. This will not come about through either the benefit of competitor exit from the industry or from the replacement of the senior managers, but by an improvement in the property market combined with tight management practices (honed in the recession). FK has high operational gearing: with high fixed costs, small percentage increases in revenues should feed through to large percentage increases in eps. Another possibility is a merger, as another firm may value the brand name and the long-standing relationships with property fund managers, but this is unlikely given the sense of continuity of the existing managerial team. The final alternative of liquidation would be wasteful given the profitability and the reputational competitive advantage enjoyed by this firm. 3. Stability Positive profits have been achieved year-in-year-out through a difficult period (satisfying Graham’s high average past earnings power requirement) and the balance sheet has remained robust. Much of the income comes from collecting rents on buildings for client quarter-afterquarter, providing a solid source of revenue. I cannot detect manipulation of earning numbers and sense that such a conservatively run firm is unlikely to play accounting tricks. Some negatives 1. Much of the value created is taken by staff. Of the £3m of so of annual revenue more than half is taken in employee benefits. Two directors each take about 10% of annual turnover in remuneration. While experienced and capable executives in the City can expect high rewards a Board that takes 25% of revenue and 250% of the profit before tax can legitimately be asked: Are you really operating this business for the benefit of all shareholders? 2. Are they too small? Will the larger property investors consider using a firm with so few surveyors? 3. Illiquidity of shares. Might shareholders be trapped? It is important in investments of this type to buy on a portfolio basis
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The share price of this credit hire company has fallen 95% over five years to 5.6p (market cap of £85m). Profits were non‐existent for four years and it was on the point of insolvency when it eliminated all debt by persuading its banks to accept 187m shares in return for most of the debt in Spring 2013 (they now have 12% of the equity). It also raised £23m in a placing and open offer selling a further 860m shares. This was used to pay off £32m of debt. Even before the transformation of the balance sheet the turnaround was already taking effect. This can be seen by comparing the interim results to 31 Dec 2012 and those to Dec 2011. We’ll use this comparison for a Piotroski analysis (the annual report comparison with its year end at June 2012 and 2011 is terribly out of date and therefore not appropriate):
(1) Profits compared with losses the previous year (2) Net cash flow from operating activities of £12.1m (3) Improvement in ROCE year on year (4) Cash flow is greater than profit (5) The debt to capital employed ratio improved from 66% to 59% (following share issues and debt for equity swap it is now zero) (6) The current ratio has improved year on year (7) There were no equity issues in the half year (but very large issues in Spring 2013) (8) Trading profit margin has changed from negative to positive (9) Sales to total assets ratio has improved from 55% to 65%. Thus the Piotroski score is 8. In the process of repairing the balance sheet the number of shares has risen almost 5‐fold to 1,561m with some dilution for the previous owners and some enrichment of directors with generous incentive schemes. It seems that business is looking up. A major competitor exited the market in December 2012 and ‘the Group’s trading results through to 31 May 2013 continue to show a considerable improvement over the corresponding period last year’. Debtor days have been further reduced to 127 days (177 in April 2012). Operating profit target for the year is £7.5m, with a dividend target of £2.5m. Questions: 1. The regulators are coming down heavily on this industry; in addition to bans on referral fees there is a Competition Commission enquiry into the car insurance industry. Could this result in loss of markets? 2. Will the insurance companies move away from using credit hire firms? I would value your comments on the following ideas. Earlier this year I analysed Mallett, the antique dealer, after a numerical‐only screen showed it to have a market capitalisation lower than the value of the current assets minus all liabilities on the balance sheet – at first glance a NCAV investment. However NCAV requires more than a superficial analysis.
We also need to be: (a) reassured that the prospects for the business are good (b) that the managers are both competent and act with integrity, particularly with regard to shareholder interests (c) the business is financially stable. It was put on the rejection pile because it had produced years of losses on a turnover of £14m to £10m (declined over 5 years) combined with a management that thinks sucking £750,000 or more out of the firm each year is suitable reward for a job well done. I was also nervous about placing so much weight on an inventory of antiques valued either by cost/net realisable value or by ‘external independent valuation’ subsequently adjusted by the directors based on ‘market movements’ (which is used is not entirely clear to me). But the facts have changed over the last nine months and so the strength of the case for investment has improved. I’m grateful to ‘Rainmaker’ (posts on ADVFN) for his well‐reasoned arguments which encouraged me to take a second look at the company. Mallett has a market capitalisation of £10.7m at 80p. Based on the accounts for the six months to the end of June 2013 it has inventory of £11.46m, receivables of £5.2m and cash of £0.95m. Current liabilities are £6m and non‐current liabilities (all pension deficit) are £1.5m. Thus NCAV is £10m, which is less than MCap. However one of the facts that has changed is that a freehold building has been sold with planning permission for flats. When the receipts come in, the cash on the BS will be boosted by around £2.5m. This helps alleviate worries over the ‘flexibility’ in valuing such slippery items as furniture. Furthermore Mallett holds a 23.75% stake in a prestigious annual antique fair, Masterpiece, which had a successful fourth year with visitor numbers rising by 20% to 34,000 this year spread over 8 days. While Mallett’s share of the profits is a mere £85,000 (2011: £82,000) this business has potential to provide a low‐capital‐input‐with‐high‐upfront‐receipt‐of‐cash income for many years to come (Rainmaker points to high operational leverage given the fixed cost nature of the business; negative cash conversion cycle; absence of bad debt risk; and ‘toll‐gate’ characteristics). Once established as an annual fixture there are good reasons to think that a business like this has a quality franchise (If it is well managed). Which brings me to reasons for cautious optimism concerning managerial competence and shareholder orientation. Peter Gyllenhammar, the activist investor, has taken more than 29% of the equity and has entered discussions with the managers on matters of importance to shareholders (he withdrew an attempt to get elected to the Board in March 2013). Whether his suggestions/pressure have stimulated pro‐shareholder action or whether the senior team woke from their five year slumber (while asleep they draw millions in remuneration and blamed the economic climate for costs exceeding revenue) and decided spontaneously to take action we do not know. But action has been taken: (a) Director remuneration totalled £0.58m in 2012, down from £759,000 in 2011 (It was over £1m in 2008 when large losses were made!). No executive is receiving more than £160,000. (b) The expensive showroom in New Bond Street has been vacated after a sale of the lease. By moving to Ely House the company saves £0.7m in costs per year and increases square footage by 50%. Given that losses last year were only around £0.3m a rental saving of £0.7m is highly significant. Note also that turnover appears to be unaffected by the lowered property costs. (c) A plan is under way (or is it? – the latest interims suggest that the plan may be ‘reviewed’) to ‘reduce substantially fixed costs in New York by subletting two floors of the Madison Avenue showroom’. The sublet rental income is expected to equal the rent currently being paid on the whole building. Background: the USA operations lost £1.2m in 2011 and £275,000 in 2012 (d) The FD is in the process of leaving (the date has recently been put back to December 2013. He will not be replaced. This should save over £100,000 per year ‐ significant for such a small company. I agree that company of this size needs merely a competent accountant rather than a finance director. (e) Over the past five years staff costs have fallen from £2.4m to £1.8m while numbers have decreased from 53 to 35. Turnover has dropped as well, but the staff reduction remains an indicator of managers cutting cloth according to their means. (f) The loss‐making JHBA subsidiary has been sold off. More recognition that unprofitable activities should not be allowed to continue? (g) I’m led to believe that the recent liquidation of major competitors has left Mallett as the ‘go‐to’ place to deal in high‐value antiques. Perhaps they can develop an economic franchise on the back of this to allow acceptable ROCE? (h) In the last three years they have built up the showroom offering by displaying antiques held on assignment rather than owned by Mallett. This is smart: low cash requirements but exploiting extraordinary resources of name, retail position and expertise. (i) An innovation: a website for selling antiques. (j) Peter Gyllenhammar says that the company has “superb reputation, skills and infrastructure”. Respected in the market place but managers promoted beyond their competence to run a business for shareholder wealth maximisation? (k) Managers have made efforts to establish the company in China, Brazil and other developing economies. Where might share returns come from? The four possible areas of improvement for NCAV firms are: 1. Earning power is lifted due either the industry economics improving, e.g. exit by competitors improves the returns for the survivors, or due to managerial change when a spirit of revival emerges or they are replaced. In the case of Mallett we have some evidence of both these effects being underway. Competitors have gone to the wall and (under pressure) the directors are cutting costs. 2. A sale or merger. A possibility that is in the wings, but I cannot see it yet. 3. Complete or partial liquidation. Highly unlikely given the potential recovery in antiques, the strong balance sheet and the potential of Masterpiece. Questions 1. Is the managerial conversion to shareholder wealth pursuit real, imagined or put on for show? 2. How valuable is Masterpiece? 3. Will Gyllenhammar encourage a greater proportion of professional managers (rather than antique experts) in the Boardroom? 4. How cyclical is the antiques business? Will the economic upturn result in significantly greater sales? 5. Director shareholdings are at laughable levels – are their interests really aligned with shareholders? 6. Very high levels of receivables outstanding, for example at year end 2012 those outstanding for more than 120 days were over £1m. Do these well‐heeled customers not pay on time? If not, why not? Is there a danger of high bad debt? The share price (now 5.75p) of this small explorer, developer and producer, with a focus on oil and gas prospects in and around Italy, Malta and France, has fallen over 90% in five years to leave a market capitalisation of £24m. It thus qualifies as a return reversal share on this filter. I have also examined it for Piotroski factors:
1. The last full year of accounts to 31 December 2012 show a profit from operations of €4.1m. 2. Net cash flow from operations was €6.5m 3. The change in ROCE year‐on‐year is positive because the previous year showed a loss 4. Cash flow was greater than profit 5. There is no debt 6. The current ratio has improved from the previous year’s level 7. An absence of large equity issues 8. Trading profit margin has improved 9. Sales to total asset ratio improved Thus all nine Piotroski factors are positive based on the full year accounts. However, there are dangers. Output from the main gas field already in production has declined in the past few months due to technical problems. This will probably result in a large decline in turnover (from €16.3m in 2012) and a fall in profitability to barely breakeven. Also there are profound geological risks combined with political risks with such a small company taking calculated but extreme punts on oil and gas bonanzas being found. On the positive side they have a very experienced managerial team and a diversified collection of prospects. They are also debt free. Given that they fulfil the criteria laid out in the ‘Return Reversal’ academic paper and the ‘Financial Statement analysis’ academic paper, I have bought a few shares to add to the portfolio. Northamber appears to qualify as a Net Current Asset Value, NCAV, share. However, Benjamin Graham and I both like(d) an NCAV company to also have ‘good prospects for the business’. This is where the doubts creep in. Any help would be appreciated.
Market capitalisation is £7.7m. Based on the last (interim) balance sheet to 31 December 2012 the company has current assets of £22.4m including £3.2m of cash (no debt). To calculate NCAV we deduct current liabilities (£7.4m) and non-current liabilities (£0.05) to give an NCAV of just under £15m – almost double the current market cap. Of course, we cannot take the receivables and inventory at face value but need to reduce them to build in a margin of safety. Even taking an ultra-pessimistic approach NCAV is greater than market cap. A further consideration is the shift in the balance sheet over the past two years. Whereas it used to have over £11m of cash (resulting in the net cash being greater than NCAV) the directors decided to stop paying rent on its warehouse. They had been trying for years to buy the freehold and they finally got a chance to do so. They paid £6.7m. Rent expense will now fall to zero from £0.6m (a 9% return on the spare cash rather than virtually zero). The company also owns its office building. In total there are around £9m of property assets. These have a reasonably stable market value. So, if worst came to the worst the company could run down its inventory (£6.6m) and its trade receivables (£12.7m). The proceeds, after paying off creditors (£7.4m), could be added to the cash of over £3m to provide a very nice cash pile (even if the amounts received for inventory and receivables are much less than the BS value). On top it could sell or rent out its £9m of property. There could be a company consisting of property plus cash of £3m? £10m? or £15m? Thus, there is reasonable hope that market capitalisation is covered by either (a) NCAV, or (b) property assets. If both turn out to be as valuable as the BS makes out we have a potential trebling in market price. The fly in the ointment Northamber trades in an industry with some of the worst economic characteristics I have come across. It is a medium sized player in an industry in which entry is wide open (there is little customer captivity/loyalty). Suppliers hold a great deal of power. Customers can quickly obtain alternative prices from competing wholesalers. Substitute methods of getting the product (e.g. computer) to the end-user are viable (e.g. manufacturer selling direct). Furthermore, the year on year product price falls and manufacturers on wafer thin margins expect wholesalers to also operate with low gross profits (in Northamber’s case 7.7%). So what can save this company from cash burn and continuous slide? NCAV shares have serious problems but they usually improve their positions in one or more of the following ways: (1) Industry economics change as result of competitors exiting the industry. The last man (men) standing gains in pricing power to return to reasonable profitability. This is possible with Northamber, but unlikely. It will be one of last standing because of its strong BS and its ability to reduce overheads as sales fall to remain close to breakeven, but I cannot rely on there being a sufficient number of competitors exiting to make a material difference to profitability. There is a good chance that new competitors will emerge. (2) Earnings power will be lifted. Management will stop the slide by returning the company to fair ROCE through excellence in operations or by stopping the head-against-brick-wallbanging and reallocating assets to areas of business with better returns. Here we have some hope. The senior team are very experienced and have shown a willingness to drop low margin products. (3) Liquidation. This is a possibility. It seems to be happening to some degree by stealth: Over the past 6 years turnover has declined from around £200m to around £80m, and with that there has been the release of cash from working capital and quite high dividends and share buy backs. (4) Takeover. Perhaps another industry player will bid for it, but how valuable is the client list when buyer switching cost is so low. Managerial quality and commitment Directors have sensibly withdrawn from the most unprofitable activities rather than chase after sales in a highly competitive industry. There is always a worry that majority share controlling directors will behave dishonourably and suck money out of the company while it is in decline. However here is evidence of a sense of responsibility and duty to fellow shareholders and workers: Chairman and CEO, David Phillips, again waived a large portion of his salary in 2012. It was reduced to only £15,000. The annual reductions in workforce shows grit, but has also resulted in reported low morale on the shop floor. The sound financial position is used as a competitive weapon in negotiating with both customers and suppliers. Lost vendors such as IBM, Fujitsu and Allied Telesis in the past 2 years, often due to failure to push through enough volume. High degree of realism in assessing the business and the industry economics, e.g. ‘it is not possible to be positive about the immediate future’. (Interim Statement 2012) Stability Over the last five years profits average out at just above zero. However, this must be seen in the context of very poor sales in the industry and a halving of sales for this company. There seems to be an ability to stabilise the roughly breakeven position by improved overhead control (down by £0.6m in 2012), improved stock turnover ratios (9.9 times in 2011 and 13.8 times in 2012 resulting in £4.7m of cash being released), shift to higher gross margin product lines (gross margin in 2010: 6.69%, 2011: 6.8%, 2012: 7.7%) and directors waiving of salary. The saving of £0.6m rent each year will again help stabilise. Solvency is not an issue, nor is pension fund obligations (there are none) nor rent obligations (none). Dividend yield is currently 4.5% (1.3p/29p). Given the BS strength, this should be sustainable. Despite the high dividends (2008: 2.2p, 2009: 1.6p, 2010: 1.6p, 2011: 2p) NAV has declined only a small amount: 2008: 90.1p, 2009: 89.4p, 2010: 88.5p, 2012: 85.7p December 2012: 82.7p. It is thus treading water rather than collapsing in a heap. David Phillips, the founder and 61.47% shareholder, is now 68 years old and has shown some signs of wishing to hand over responsibility to others. The transition phase may lead to some instability. Peter Hammett was brought in as a senior operations manager (not on Board) in 2013, but left after just 6 months ‘to save costs’. He is on ‘holiday’ – classed as a consultant. Questions: (1) Will they get swamped by the competitive pressure in this industry, resulting in perennially low profits but continued high capital commitments? Or will the industry economics improve sufficiently to allow acceptable ROCE? (2) Alternatively, will they increasingly see themselves as ‘property plus cash firm’ with an irritating appendage of a wholesaling business draining managerial attention and other resources for little reward? If so will ROCE potential outside of wholesaling become the guiding light? Or will outright liquidation or liquidation by stealth be attractive options? If so will the directors treat the minority shareholders decently? (3) Are they capable of weighing up the alternative uses of the capital at their disposal rather than automatically stick with what the activities they know and love regardless? Is there sufficient clarity on the future industry economics for them to work out the best uses of shareholder capital? Are they true to the fundamental meaning of the statement in the Dec 2012 interims: ‘we are best placed to benefit from any commercial viable opportunity that becomes available that do not overly risk our custodianship of our shareholder asset base’. Titon Titon, manufacturers of house ventilation products ranging from simple ducts to heat recovery systems, has a balance sheet which suggests a net current asset value investing (NCAV) bargain. However, we need some reassurance with regard to (a) the industry economics, (b) managerial quality and (c) financial stability.
Market capitalisation is £3.9m at a share price of 39p. The interim results to March 2013 show inventory of £3m, receivables of £3.2m and cash of £2.1m. There is no bank debt and only £3m of payables and £0.2m of deferred tax to deduct to arrive at NCAV of £5.1m. Even if inventory and receivables are marked down as suggested by Graham M.Cap is less than NCAV. Also consider that £3.3m of property, plant and equipment is shown in the BS, over £2m of which is freehold land and buildings. No pension deficit. (a) Industry economics. Titon operates in a very competitive industry and I see no reason for this to change. There is easy industry entry by new firms and little customer captivity. It is largely a commoditised sector. This is reflected in the poor profits over five years: roughly breakeven on average. However, even commoditised sectors can improve and allow leading players to raise ROCE to an acceptable (or even above acceptable) level in a rising demand situation. The highly cyclical house building and construction sector may allow this to occur over the next three years or so. In addition, Titon have developed products (R&D budget of c. £400,000 pa) for the whole house ventilation with heat recovery market. This is likely to be a growth sector as building regulations get ever tighter regarding air-tightness (buildings are almost air sealed, therefore oxygen has to let in from somewhere; opening a window seems wasteful so heat-exchanged fresh air makes sense for many (currently too expensive to install for the houses I’m building though). There is a high degree of free entry to even this industry, but at least Titon are established. The recent improvement of the company’s fortunes in its overseas markets might indicate what happens to profits in an economic upswing to commoditised cyclical business. (b) Managerial quality. In the recession costs were cut and senior managers/directors pay was restrained with the highest paid director receiving £108,000 pa: not evidence of scamming the shareholders there. A younger team of directors is now leading the company with advice from the founder and other old hands. All the directors have many years of experience in this industry in this firm. The CEO joined in 1988, joined main board in 1997 as FD, becoming CEO in 2002. While over the past five years the combined record is merely break-even, the company stayed sufficiently financially strong and cash generative to pay for over £1m of dividends, £0.5m of new computer equipment and £0.4m pa of R&D. And yet, throughout this period PPE only declined from £4.4m to £3.5m, cash declined from £2.6m to £2.1m, net current assets (as defined by firm) declined from £5.8m to £5.1m, and shareholder’s funds declined from £10.2m to £9m. If this managerial team are simply managing decline then this has to count as very slow decline – and at a time of enormous general economic pressure. (c) Financial stability. With no debt other than payables and a very high NCAV this company does not seem like a candidate for solvency or liquidity trouble. Profits (or rather break-evenness) is also stable. WHAT MIGHT CAUSE A RECOVERY IN SHARE PRICE? (a) General economic/industry improvement? Most likely of the four. (b) Managerial turnaround? Possible. Still investing in innovation. Still cost cutting. Korea and other overseas performances are encouraging. (c) Takeover? Possible (management control around 40% of shares) (d) Liquidation. Unlikely Questions (1) Will margins recover? (2) Will cash/NCAV/shareholder equity remain a downward course year after year while director continue to offer jam tomorrow? (3) Will they be competed out of existence by a bigger beast in the industry? |
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