Thursday, 30 March 2017

Associated British Foods (LON:ABF): Nice company, shame about the valuation

Associated British Foods is a diversified consumer conglomerate incorporating a large sugar business, grocery products, an ingredients business, agricultural interests and the retail operation which is Primark.

ABF is a really good business. This is a good quality, diversified company with some outstanding  interests most notably Primark which has been a huge success in the last 10 years. I tend to get a feeling before I even start really analysing a company as to whether I will find value - just looking at the basic metrics and considering its popularity and drivers. I wanted to look at the valuation of ABF as an example of a quality company currently trading at a valuation which generally implies suboptimal returns going forward.

Amiable Minotaur ABF Model: Good returns on capital

The long run CAPE for the FTSE 100 is 12-14x, the S&P 500 around 14-16x or the FTSE 250 around 20-24x. This equates to earnings yields of around 8%, 7% and 4.5% respectively. I would imagine the difference between say the FTSE100 and the FTSE250 is earnings growth expectations as some of the biggest FTSE 100 stocks are very mature businesses like BP, Shell, HSBC, Glaxo and Vodafone. 

Considering that the long run return used by most pension funds for equities is 6-7% we should expect P/E ratio average of 14-16x assuming earnings are relatively stable. Now you may pay less than 14x for a lower growth company where most of the return is from the dividend e.g Shell or you may pay more than 16x for a growing company with usually a lower yield but better internal returns whose earnings may grow more quickly giving capital gains and converging in the medium term toward your 14-16x price to earnings. This is all theoretical and a bit simplistic but if gives you a guideline target value for most stocks that grow by between say 3% and 15% at ~15x P/E. You might pay 10x for a stock growing 3% or 20x for one growing 15% it all varies a bit and depends on the cycle. (Note: Stocks with extraordinary growth rates north of 15% require a different metric - but we are focusing on value.)

Obviously some of the P/E expansion in the market since 2008 is due to lower interest rates driving down required returns and therefore driving up P/E ratios. However at present this relationship looks overextended.

So back to ABF. ABF traded around 15x trailing earnings between 2007 and 2012 by my estimates. Then between 2013 into 2015 the multiple went up. A lot. before dropping down toward 25x where it sits today in 2016. This is explained in part by Sugar prices and in part by Primark I believe. Sugar prices boomed during the period 2009-2012 significantly raising the profitability of that division. This coincided with excellent growth in the period 2008-2015 for Primark. Essentially the market got way ahead of itself bidding up ABF on the basis of that period of rapid growth. 

If you had held the company back in 2010 when the multiple was about 15x you would have seen a 200%+ rise in the value of your shares to 2014. Yet earnings in the period 2010 to 2014 rose just 45%. Therefore the PE multiple expanded from a sensible 15x in 2010 to a lofty ~30x in 2014. This would appear to be a classic example of over exuberance as investors bid up the shares assuming this excellent growth would accelerate in future rather than decelerate. 

Google Finance: ABF vs FTSE 100 vs NXT

Typically, it decelerated. Earnings slumped 29% in 2015.

Sugar prices dropped. Substantially. Operating margins in sugar collapsed from 15% to 2% in 2015: 

Amiable Minotaur Model: Operating Profit Breakdown

Primark margins remained strong but the growth rate started to slow. This should be expected because as a company like Primark grows bigger it inherently should grow more slowly:

Amiable Minotaur Model: Revenue Breakdown

The point of this hindsight analysis is that even today ABF trades on 25x trailing P/E. The 10 year Earnings growth CAGR is 8.4%. This means ABF will trade at ~15x P/E multiple around 2022 if it sustains that growth rate (which is hard to do). As I stated before Next Plc with a 7.2% earnings growth 10yr CAGR will be - by my model - (includes decelerating earnings growth) - trading at 8x P/E in 2022. It already trades at 9.5x today! Therefore what I think this demonstrates is that either ABF will grow earnings substantially faster than Next into 2022 or Next will struggle to grow earnings at all but will shrink into 2022 to converge on our theoretical 15x multiple. Or the alterative hypotheses; Investors are overestimating the future growth rate of ABF and underestimating that of Next (essentially that Next EPS will be > 30% lower in 2022).

Now qualitative considerations need to be taken into account. ABF has a more diversified and less cyclical business (Grocery, Ingredients) so may command a higher multiple on average. ABF also would benefit from earnings growth if sugar prices normalise a bit and margins rise. 

However these companies are more similar than you think - or at least the bits investors want. I think ABF trades at such a high multiple due to Primark. Now if Next are guiding down retail sales as are M&S and Debenhams are in trouble I struggle to see how Primark, a high street retailer, cannot also be effected. Even if Primark is super low cost a general trend away from clothes purchases must hurt the business. The 10 year operating profit growth CAGR of Primark is 13.2% but due to a dip in 2015 and 2016 the 3 year CAGR is only 10.3%. Still healthy and a moderation in the growth rate is expected as the business matures.

Primark has more retail outside the UK (~50% space and stores are UK based) so is less effected by Brexit concerns. But Primark is not online like Next, it is solely high street retail. It seems surprising how much value investors place on Primark when it doesn't have an internet business- look at the crazy valuation of ASOS by comparison. Still Primark does have the advantage of being a real cash business. A lot of the excess margin of Next comes from their finance offering which is declining a bit.

ABF has low debt with ~£900m in debt (just to improve capital efficiency I presume) and plenty of cash on hand. The debt is only 1x profit and this is a low risk to equity holders. 

The pension scheme is more of a problem. The scheme has a gross liability of £4.3bn which is ~5x the 2016 annual profit. There is currently a £303m deficit on the scheme so this does present a bit of concern that additional cash contributions could be required. The liability is due for triennial valuation in April 2017 which could see it increase due to lower long term discount rates as rates have fallen further since 2014 (10yr GILT down from around 2.5% to less than 1.5% today.) I expect additional cash contributions being made over the next three years to the scheme but these should be manageable for ABF given the strong cash flow position of the group and low debt. This could however reduce medium term earnings and free cash flow.

I really struggle to square the circle on valuation for ABF. For instance they have a low dividend yield of 1.3% due to their strong internally generated returns. But it grows well and the payout could be increased in future as the business matures (albeit the growth rate would likely fall). Now given the 10 year CAGR of the dividend has been a healthy 6.4% this results in a DDM valuation of £22 at a Ke of 8.1% (Rf 1.5%, MRP 6%, Beta 1.1) with that 6.4% growth rate. At that price of £22 the trailing P/E of ABF would be 21x. 

I get a similar price of £21.70 a share on my DCF with the growth rate dropping from 6% in 2023 to 3% by 2043 and 3% for my Terminal value (WACC 7.65% due to low debt.)

Maybe the company trades at a premium following the Unilever bid (which has a similar grocery business.) But I struggle to see any impact on the shares around the Unilever bid newsflow. Besides the ownership structure of ABF does not lend itself to takeovers given it is controlled by a private family company.

I estimate the fair value of ABF to be around the £20 per share mark. Slightly less than my DCF/DDM because I think growth will struggle to be that strong, and I want some upside to fair value as a margin of safety. That is the price that if I were Warren Buffet I might consider buying ABF being a 'fair price for a wonderful business.' 

At £26 I think the stock is 30% overvalued as investors are overestimating the future growth rate of ABF. This is the sort of company that one wants to buy during a generalised market selloff/panic and  not at the end of a protracted bull market like the one we seem to be in.

Disclaimer: I have no interest in ABF shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Tuesday, 28 March 2017

Why Debenhams (LON:DEB) has all the hallmarks of a Value Trap

Given the general downturn in the fortunes of high street retailers at this point (both in the UK and the US) I noticed Debenhams is trading rather cheaply. I had a quick look through the Annual Report on my hunt for value. My conclusion is Debenhams is most likely a classic 'value trap.'

Debenhams is a mid market department store chain. They mostly sell clothes but also a variety of other home wares and items. They have neither the exclusivity of special stores like Harrods and Selfridges nor the middle class popularity of the John Lewis partnership. They are unfortunately a bit like BHS - just a bit better.

Debenhams have no particular sustainable competitive advantage to my mind - they have neither the top end brand equity of the aforementioned department stores nor the bottom end low costs of say Primark (part of LON:ABF) or H&M. They also have a weak online presence unlike one of my top picks Next (LON:NXT) or  the rather overpriced growth story that is ASOS (LON:ASC). 

So essentially Debenhams exist in a sort of mid market no man's land. So this begs the question; if the company is not a Buffet style 'moat' business could it be a Graham style 'cigar butt' ? Maybe.

The way I see it Debenhams shareholders have a problem because they are too far down the end of the trough to be adequately compensated for the risk of holding the shares. Here is my pecking order for the economic returns that Debenhams generates;

1.       Commercial Lessors
2.       Pension Fund
3.       Debenture holders and Bank
4.       Debenhams shareholder

Now let me explain.

Debenhams first problem is it leases its stores - no big deal Next does this too, it can enhance flexibility - except Debenhams has £4.58bn future lease payments over the next 20+ years and from what I can see the weighted average lease term must be longer than 10 years given that more than half the contracted lease payments fall in more than 10 years time. By comparison Next discloses the weighted average lease term is 7.5 years. If we capitalise the £216m lease cost Debenhams paid in 2016 with a simple factor of x7 and treat it as debt (it is debt like due to raising operating leverage) then Debenhams would have around £1.5bn in additional debt. That is a lot of leverage for a company struggling to generate £100m in profit per annum. Debenhams is paying out £200m+ a year to its landlords:

Debenhams Annual Report 2016
Now the next thing is the Pension Fund. Debenhams has a defined benefit legacy pension fund. This closed to future accrual in 2006. It is currently a small net deficit on the balance sheet of £4m. But this is the tip of the iceberg as that deficit is made up of £1.062bn in liabilities and £1.058bn in assets. That means the pension liability is more than 10x profits (Next for instance is 1x profits). So imagine a scenario where assets fall 10% or liabilities rise 10% (they even disclose that a 0.5% increase in inflation all things being equal would increase the deficit by £117.8m!); now Debenhams are potentially on the hook for more than 1x annual profit to make up the shortfall. This company is therefore a pension scheme with a retailer attached:

Debenhams Annual Report 2016

Debt holders are the third in line to the returns of Debenhams. The debt holders will always rank above equity in capturing returns. Debenhams has a modest debt of £335m as at Sept 2016. This is composed of £200m of debentures due 2021 paying 5.25% - junk bond coupons in this low rate environment - and £135m of bank credit. This debt is offset by £56m in cash. Interest payments appear manageable 8.5x operating profits but if you factor in adjustment of lease payments as interest (with no adjustment for depreciation) this ratio rises to 1.5x -  a very tight fixed expense base!

Debenhams Annual Report 2016

Now all of this would be manageable if Debenhams were a growing business able to expand profits. But unfortunately Debenhams is a shrinking business! Revenue growth has flat-lined which is somewhat cyclical but margins have been falling for years. Distribution and admin costs keep eating into the profitability of the company.

Amiable Minotaur Model

Amiable Minotaur Model

Therefore when investors look at Debenhams it may look cheap on 8x trailing P/E (12.5% earnings yield) with a 6.3% dividend yield but that P/E is likely to expand due to falling earnings over the long term and that dividend yield is heavily under threat if any cash flow has to be redirected to the pension scheme, higher borrowing costs or escalating rents. 

The dividend is a lure to investors who are presently chasing yield. The dividend looks unsustainable in the medium term if profits continue to shrink along with the flat to down operating cash flow. The dividend probably explains why the share price has not collapsed more completely as it is currently, but precipitously, covered by cash flow and earnings. 

Taking a quick dividend discount model with 3.40p a share in dividends at 6.3% cost of equity (Rf 1.5%, MRP 6%, beta 0.8) and with a growth rate of 0% gives a fair value of 53.97p - exactly the price it trades at today. Risks to the dividend are to the downside though not the upside.

Is there one puff left of this 'cigar butt'? I would say no at the present share price value. The company trades at a discount to book but too much of the book value is essentially illiquid and worthless (leasehold fixtures, software etc) and the company has net current liabilities not assets!  Debenhams could be a trade if the whole sector starts to improve but unlike Next Plc you are not acquiring a quality business at a low value - you are acquiring a speculative leveraged option on a better overall retail environment in the future. And that option is not cheap enough as this is a company whose margins have been declining during the entirety of the last cycle.

Debenhams in the long run is going the way of Sears without some miraculous turnaround in its offering. They have no financial flexibility due to all the different claims on their earnings detailed above. This is a classic value trap. NXT offers a relatively similar valuation level (div yield, P/E) with far healthier metrics and better growth and margins. I would not short Debenhams as it is cheap anyway and may take many years to reach zero.

If I were an employee or ex employee with a DB pension with Debenhams I would be very worried.

Disclaimer: I have no interest in Debenhams plc shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Monday, 27 March 2017

IG Group (LON:IGG); What is the case for the Value investor?

Want to be the next Paul Tudor Jones?
IGG is a CFD and spread betting platform offering trading across the UK, Europe, Australia and other international markets. 

The company offers a wide range of markets to trade including indices, forex, shares and options. This is a spread business and the primary revenue is from acting as a broker and trading platform.

The company has grown strongly in recent years but in November the industry faced several regulatory enquiries which have substantially dented the share price. So does IGG have a price below intrinsic value for the value investor?

Google Finance

The regulatory actions seem to be off the back of sterling flash-crash in October - the issue being people stopped out of positions with negative balances due to meteoric midnight drop in GBP. Positions were liquidated and bad debts left outstanding. Many clients will feel aggrieved at losing more than their posted margin in such an extreme event - and also being stopped out of positions which then recovered somewhat. Action has been the pipeline for longer than this though and the situation is both complex and interesting.

When Japan implemented a similar regulatory inquiry and major limits on leveraged products in the 2010-2012 period the impact on revenue meant it fell from May 2009 year end of £28m to  £16m by May year end 2013. (There was a slight strengthening of the Yen in that period.) So revenues fell ~50% on that basis from leverage limits. At the time IGG wrote off >£100m in goodwill related to the acquisition of the Japanese business only a few years before.

Amiable Minotaur Model: Base case model
 (Note the exceptional 2011 result includes impairment of Japanese goodwill)

This Japanese revenue drop of 50% sets a base case bearish scenario for the CFD/Spread bet market going forward. Note this is not a parliamentary legal issue but rather a regulatory enquiry so regulatory capture is probable. The FCA are so good at being captured they had to change their rebrand from the FSA a few year back after they went 'light touch' and let all the banks run riot in the run up to 2008. The regulators have an interest in retaining some form of onshore industry if they want it to exist at all for UK clients - as more unscrupulous operations like to locate in places like Cyprus. IG and CMC seem to be the most engaging with regulators probably because they have the most to lose as the bigger and generally more responsible incumbents.

This is now a low growth business -only so many people have the capital and mindset for this kind of trading. Or at least only so many people should. I.e professional traders and market participants. The business makes small amounts of revenue on every trade through the spread - this accounts for the vast majority of revenue. Unfortunately the company do not break does a stratified analysis of their client book by revenues only an average revenue per client across the whole business so it is difficult to assess the impact of curbs around retail/small accounts on the overall revenue picture. 

The new Limited Risk Accounts should provide some security for new clients as these prevent a client losing more than their posted margin through extreme movements. To be fair to retail clients how can one learn to trade and gain experience other than by actually trading. Still I would imagine growth in customers will slow dramatically in future in part due to regulation and likely some curbs on advertising (I see a lot of advertising everyday for financial betting which is targeted at the general public.) 

Amiable Minotaur Model: Base case revenue and growth

IGG are already diversifying into lower risk areas such as share-dealing - IG now offer very competitive share commission rates of £8 which is below most other brokers who offer around £10-£12 commissions (this is making me reconsider my broker choice). This is another way to leverage the power of your existing platform and diversify away from the regulatory risks associated with leveraged trading. CMC markets have been doing a similar thing recently announcing a share dealing tie up in Australia. Note though that currently share dealing is 0.25% of revenue and CFDs are 40%. There is a long way to go.

IG has scale - this means more people and tighter liquidity in your closed spread bets market. Also this allows for market leading SG&A ratios due to the dilution of centralized costs. The model is also capital light (Capex inc intangibles  is 2% of sales!) and easy to scale globally as it is internet based. So this is definitely a business which lends itself to scaling. That is always an interesting kind of business. It also means if revenues drop costs scale down as the company can cut headcount and marketing costs quite easily in proportion to a fall in client numbers and order sizes. 

Barriers to entry are relatively low hence why small specialist operations keep cropping up. Such high returns with such low risk to capital invite competition so it pays to market aggressively, tie up referring partners and buy out small operations. All things IGG do to protect their market share. IG also have the barrier of a large and well researched platform. More size means more trading options and better research and PR. This also means they can more easily extend their platform into areas like share dealing or even data analytics in future. I have an IG Index account myself for periodic shorting of bad value propositions - and I find it a useful tool for general market data and analysis.

The equity value screens super well on DCF/DDM due to low volatility and super low beta (0.2! I adjust to 0.8 in my model) - depends on your view of cost of capital. I think CAPM is fairly useless in reality but handy as a concept. CAPM gives a 6.3% cost of equity so at 2.7x P/B a 6.3% Ke implies a 17% sustainable ROE. If Ke is 6.3% and the sustainable ROE is above 20% investors should pay 3.2x book for this business or a ~18% premium over the price today. Presently one is paying 2.7x price to book for an ROE of 24.7% trailing - which is pretty cheap.

Amiable Minotaur Model: Base case ROE vs P/B

This assumes of course underlying absolute profit doesn't shrink hugely after regulatory action. In the event of a major drop in trading activity the company would likely still get a > 20% ROE they would just pay out a special dividend in the interim (probably around 50p-60p per share to gain a 20% ROE) to realign the required capital position with the size of their trading book (excluding any impairments - which do not effect regulatory capital as goodwill is inadmissible). But future earnings in aggregate would be smaller going forward despite  maintained ROE which would substantially reduce the value of the shares.

Valuation wise I set up three models with a Bad, Base and Positive regulatory outcome from recent events in the UK and Europe:

Bear Case; Revenue drops 50% in Europe and in the UK. The company scales down costs in proportion. I make a valuation range of £5.40 - £3.50 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E. Let us say floor value is £3.50.

[Why 15x? I think 15x is as much as I would want to pay for a company with stable cashflow, an acyclical market leader in its sector and excellent returns on capital - assuming it will fail to grow much beyond the current time]

Base Case; Revenue drops 25% in Europe and 20% in the UK. The company scales down costs in proportion. I make a valuation range of £7.00 - £4.75 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E. Let us say floor value is £4.75 or just below the current share price.

Bull Case; Revenue drops 12% in Europe and 10% in the UK. The company scales down costs in proportion. I make a valuation range of £9.00 - £5.75 - the upper being a DCF and DDM model where the low cost of equity flatters the share and the latter being a target 15x P/E.

IGG is a supreme cash machine. A classic story of owning the casino. The issue of course is anything offering such high returns on capital attracts (a) competitors and (b) regulators and this issue is linked because smaller and more unscrupulous competitors entering the market make the regulators much more interested in the industry. So the outcome of the various regulatory proposals will ultimately determine the future value of the company. 

I see a risk reward scenario skewed to the upside. The stock is down around 50% from its peak last year and the company has no secular or cyclical issues to contend with (except a recent period of low volatility which can weigh on revenues.) Therefore should regulatory action be particularly bad we could see a value around £3.50 a share or 30% downside. 

However my base case suggests a more modest proposal with a value around £5 per share. No real upside but it acts like on option on the best case scenario of > £5.75-£9.00 a share. In the meantime one can expect cash dividends of 5% or so which is not a bad return at all. 

Disclosure: I have modest long positions in LON:IGG and LON:CMC. This analysis does not constitute investment advice. I also hold a trading account with IG Index. Read my disclaimer.

Sunday, 26 March 2017

Why UK Home builders are an amazing cartel!

"Then something awoke me.
The old man laid down his hand to light a cigar. He didn't pick it up at once, but sat back for a moment in his chair, with his fingers tapping on his knees.
It was the movement I remembered when I had stood before him in the moorland farm, with the pistols of his servants behind me.
A little thing, lasting only a second, and the odds were a thousand to one that I might have had my eyes on my cards at the time and missed it. But I didn't, and, in a flash, the air seemed to clear. Some shadow lifted from my brain, and I was looking at the three men with full and absolute recognition.
The clock on the mantelpiece struck ten o'clock.
The three faces seemed to change before my eyes and reveal their secrets. ////
'Whew! Bob! Look at the time,' said the old man. 'You'd better think about catching your train. Bob's got to go to town tonight,' he added, turning to me. The voice rang now as false as hell. I looked at the clock, and it was nearly half-past ten.
'I am afraid he must put off his journey,' I said."
 - 'The 39 steps' by John Buchan

Sometimes you just know something and can't explain it - until it reveals itself and you realise it has been standing there all along and you could not see it. This same thing happened to me today whilst looking at the UK Home builder Persimmon. I realised the UK home building sector is a cartel and it is a very British version of corruption. But it is corruption nonetheless. I don't mean the companies actually collude to restrict supply, they don't have to, the planning system does it for them.

Firstly; Persimmon is a great business! A really great business. The company has had stellar earnings growth and amazing returns on capital since 2012. This company has no debt, a £2.6bn landbank & WIP, a small gross pension liability and really high cash flow. I am questioning my short now (based on macro) and this is because all the other home builders have similarly low leverage, high returns businesses!

Now Persimmon is a home builder. Ordinarily construction is a bad business. Why? Well it is cyclical, capitally intensive, has no pricing power - due to competitive tenders and then the companies tend to carry huge debt loads to finance projects and generate some return on equity. So what gives Persimmon such high returns on capital employed?

Well principally they have pricing power and they also control their own pipeline of construction. This functions so well because of the strict and complex UK planning laws and the very nature of 'land' as an inexhaustible and finite resource. 

But Persimmon and the others are generating the high ROCE pricipally from the planning system; i.e having the clout and expertise to see larger tracts of land turned over from low value agricultural or other uses into high value development land - then you simply pop some homes on it and call yourself a 'home builder.' The returns are I would argue principally generated through land use change not construction.

In any business such high ROCE would be causing a huge influx of competitors and it would be driving down prices as supply floods the market to satisfy high demand. 

Persimmon Annual Report: Look at that ROCE!

But instead we have the big 6 home builders hoovering up profits at the expense of the common British serf. The UK press jabbering on about the big six energy companies are really missing the show here. The big six energy companies might cost a few hundred pounds a year from their activities, the home builders are costing people thousands.

Google Finance

The UK home builders are like the OPEC of house prices. They control the flow and price of new homes coming onto the market and they are aided in doing this by the planning system itself. Acquiring and developing land through the planning system takes years - so as a home builder you steadily control your pipeline of land projects to ensure you can tease out homes at the minimum rate thus commanding the maximum price due to their scarcity. Now throw in some well intentioned stimulus for the sector during the rough post 2008 period and then continue the stimulus for way too long (I wonder what the home builders political donations looked like since 2008) and you have a massive boom.

So why aren't more homes being built? Well small developers can acquire the odd site but most construction companies and builders are tradesman not businessmen and construction doesn't lend itself to scale. Therefore they are unlikely to gather together and lay their hands on enough capital to be able to acquire significant sites to move the home building needle. Even if one did start a new company today it would take years to develop the scale to be profitable waiting for land to gain the necessary permissions to even start the process of building.

Therefore the home builders have a huge barrier to entry.

This means UK home builders can sit on the finite supply of land, tease it out slowly in the form of finished houses and gain maximum price for each unit - much as OPEC tries to do by not pumping too fast - you only get the oil once.

Now of course the home builders do compete with all the existing houses in the UK for a market. Thus the general actions of central bank stimulus on interest rates and the fiscal stimulus to the wider economy and the home lending segment in particular has created a total bonanza of profits for the sector.

So what is the upshot from the OPEC comparison? Now this is my crucial point. Listening to Diego Parilla on the RealVision podcast pointing out how OPEC fails to control prices when oil prices fall is the key warning for the UK home building sector. Let me explain:

When oil prices fall OPEC nations need to sell more volume to make up the lost revenue (for example those generous Saudi social transfers) - they don't care if the price is $50 a barrel they just need to sell 2 barrels to get their $100. So supply increases - thus exacerbating the problem of falling prices. Well what happens when the background house price in the UK drops; these UK home builders then start to produce more homes to keep up earnings and returns, at lower prices, driving up supply when prices are falling. The current market structure is causing supply to be more constrained by high prices. Thus the risk of a housing bust is being exacerbated by the cartel structure of the UK home builders. Therefore a generalised 'healthy correction' fall in the wider UK house price level could kick off a dangerous cycle of oversupply - this is such an amazing paradox as it explains why with record high house prices we have record low house construction!

[Obviously oil supply is more easily increased than housing and the structures of the two markets are different but the oil collapse in 2014 is indicative of the turmoil created in a 'tight' supply controlled scenario. Therefore the sector is at risk of a generalized race to the bottom to sell inventory accompanied by land bank impairments as values fall. At least this time they aren't carrying huge debt loads like 2008.]

Why is it corrupt? Well a better planning system, more pressure on the sector to actually develop sites and increased incentives and competition could all disrupt this cosy arrangement. But to date I just see it being further perpetuated. It is a special sort of corruption we have in the UK. We don't do Latin style 'cash in the briefcase' corruption. Rather we keep it endemic - between the 'have land' and that 'have not land.' Who said the aristocracy are gone?

My previous argument is that put simply these companies are facing a cyclical peak in their earnings due to the likely deterioration of the wider macro from current levels simply because the current rear view mirror economic data has been so good. But structurally this is one amazing business and the person picking up the tab is the common homeowner.

Economics suggests the market should be flooding with new supply but the flawed regulatory and market structure in the UK means it won't be - and outsized profits remain for the home builders. Another risk is such outsize profits tend to attract government hungry for revenues (remember those oil windfall taxes!). 

However I can't see that happening as I fear the press would be too short sighted to perceive the benefit of taxing the sector when the popular narrative is 'we need to build more homes.' Maybe a rolling 'land bank' tax would work well to incentivise maximum development of land and disincentivise the sector from teasing out homes so slowly. Until then, what a stitch up for investors at the expense of the public!

Disclosure: Disclosure: I have a small short position in Persimmon Plc. These are opinions only, not investment advice. If in doubt read my disclaimer.

Saturday, 25 March 2017

Easyjet Plc (LON:EZJ): Does it constitute a value investment?

Does the old joke hold true 'how to make a billionaire a millionaire; buy an airline' or does Mr Buffet's recent foray into the industry show we have moved on from having an industry which has  "eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labor unions and you've got commodity pricing."

Remember this guy?
Well in this example I want to do a bit of an overview of Easyjet. The company has some advantages over Buffet's old view because labour unionisation is less of a problem as are legacy costs. Easyjet is more like a flying bus service. The company has excellent routes and is a good operator.

I always fly Easyjet over Ryanair for two reasons (a) it has a website a normal human can use [which secures a booking] and (b) it flies to places I actually want to go on holiday (who flies to Poznan? Or Dinard?). 

However is Easyjet a good investment?

Well I got to looking at it due to the share price fall with the shares down 50% from their 2015 peak and 33% down since the 'Brexit' vote. Trading at 9.4x trailing P/E with around a ~5% potential yield things look relatively attractive.

The reason for the poor price performance is a combination of (a) deteriorating fundamentals (b) political risk. 

The driver of (a) is principally weaker sterling following on from (b). Margins are falling, demand is lower and with a mismatch between a sterling dominated revenue base (of Brits trying to escape terrible weather) and a Euro exposed cost base and Dollar denominated fuel puts a crunch on Easyjet. So the macro factor most likely to influence Easyjet is the strength of the Sterling. Which is at a 30 year low vs the dollar and significant low vs the Euro at the moment. 

The problem with (b) is Easyjet is exposed to the fallout from Brexit via (a) but also via regulatory impediments. Just this week ;

"EU chiefs have warned airlines including easyJet and Ryanair that they will need to relocate their headquarters or sell off shares to European nationals if they want to continue flying routes within continental Europe after Brexit.
Executives at major carriers have been reminded during recent private meetings with officials that to continue to operate on routes across the continent – for instance, from Milan to Paris – they must have a significant base on EU territory and that a majority of their capital shares must be EU-owned." -The Guardian 
So there is risk here beyond the merely operational problems associated with the currency devaluation and weaker consumer confidence. Moving your HQ is not too hard but moving your share capital might be a bit trickier. Still Easyjet may be able to fiddle it if the founder's shares are classified as EU, in fact Ryanair have more shares held by UK nationals at the moment.

Value investments tend to arise during these periods of regulatory or other uncertainty. This can make an attractive entry point into a good quality business but not if the feared catalysts prove to be worse than expected of course!

These two hangover are likely to continue to weigh on the shares in the medium term from a qualitative perspective. Easyjet becomes the 'maybe Brexit won't be that bad' sentiment proxy (alongside GBP trades).

What about the fundamentals?

Well Easyjet appears to be a structurally sound business facing a cyclical downturn. I would hazard a guess that going concern is not an issue as Easyjet runs net cash (albeit leases act a bit like debt). Rather investors are essentially abandoning the stock due to a weaker medium term earnings outlook.

Thinking like Mr Buffet; Does this company have a durable competitive advantage? I would say yes due to lower costs than legacy carriers and the barrier to entry of slots across the best EU airports - but loss of continental Europe business could mean loss of slots and a permanently impaired growth trajectory and fleet reduction. I will assume the company adapts to the new environment rather than just let's this happen to them.

My main issue is simply valuation and the cycle. Easyjet margins and return metrics hit their peak in 2015 and funnily enough so did the share price at around £19 a share! Margins and returns have since been trending down following Brexit and presumably a weaker consumer confidence. Those margins have also been boosted by lower fuel costs since 2014:

Amiable Minotaur Model: Margins comparison

Now looking at the performance of margins in the 2008/9 crisis period Easyjet is still way more profitable (and a lot larger) than it was then - so I see a limited downside risk to those levels. Still I feel that looking at it cyclically we are only one year into Easyjet's downturn and I think it will take at least another 6-12 months before the comparison basis with a weaker sterling washes out and potentially earnings could start to improve again.

Valuation guideline; A 10 year average ROA is 6.3%. This is a bit pessimistic as Easyjet ROA peaked at 11.4% in 2015 but troughed at 1.9% in 2009. However I feel in future returns will be more  moderate due to potentially higher jet fuel costs and a lower growth trajectory for the company as there are only so many slots you can fill, routes you can fly and sky space you can take up. 
Amiable Minotaur Model: Returns comparison

Revenue growth has stagnated and slowed rapidly since 2013 which illustrates my point about future growth opportunity: 

Amiable Minotaur Model: Revenue Growth & Absolute

So ROA will likely be lower in future than the peak - to give Easyjet some leeway let us say it will be 8% as they are better operators now than 10 years ago. Well at the £5.5bn total assets of Easyjet at year end 2016 I suggest a normalised earnings of around £440m across the cycle. If we put today's  10x earnings multiple on that level I estimate an intrinsic value around £11 per share which offers a 10% upside from today's levels. 

[Why 10x earnings? I would not want to pay a lot more than that for a company with high operating leverage, high capital intensity and low future growth prospects - i.e a commodity business albeit an operator with a low cost advantage.]

So does this make me want to buy Easyjet. Maybe. But not yet. I think regulatory headaches and Brexit noise could drive the stock lower. I dont see a recovery in earnings growth in the medium term and I dont think the shares give enough of a margin of safety at these levels to offer out sized future returns. I think around the £8.50-£9 a share level the risk/return would be more promising. If I were an Easyjet shareholder I would probably keep the shares for their healthy dividend yield in the ~4 to 5% range - but as a potential new entrant I would bide my time.

Essentially on a 'Buffet style' view Easyjet seems to offer a fair price today at these levels for an average business i.e a glorified commodity. If I am buying an average business I want to pay a discounted price.

Disclosure: I have no position at present in the shares of Easyjet Plc.

Friday, 24 March 2017

Tullow Oil (TLW): When your long term holding becomes a bit more long term

So aside from my position in Diamond Offshore (NYSE:DO) I also have the pleasure of owning quite a few shares in Tullow Oil (LON:TLW). It is funny as just two weeks ago I was thinking 'I really need to revisit Tullow Oil and their leverage ratios as they might do a capital raising.' I didnt get around to it and then 'oops' they just announced a $750m cash call with heavy dilution. 

TLW is not exactly a classic 'value' stock - it is more of a special situations investment.

I have been a buyer of TLW since early 2015 and just like with DO I was too early to the cycle and it has gone on longer than expected. My first entry prices were around the 400p - 350p per share mark. The stock bottomed in January 2016 at around 130p per share (fortunately I traded some here for a very tidy gain by March 2016). It has seemed to be on the path to recovery trending up with oil prices over 2016. Until now. The prolonged depression in prices has made TLW a slave to its huge debt load so the company announced a rights issue to bring back financial flexibility.

So the main question is; should I subscribe, sell, buy more? 

The first consideration is the oil cycle. I was clearly too early into TLW thinking it looked good value if the drop in oil was a blip - but it wasnt - so much like DO I have been sticking it out through the bad times. I expect in the next few years the cycle will turn as the chronic underinvestment of 2014-2017 starts to lead to a supply crunch and kicks off a new cycle of investment.

The second consideration is; will TLW still be here when the next cycle starts its virtuous path? I think yes, certainly after this cash call. I estimate that with the~ $735m in net rights proceeds alongside FCF generation of ~$400m net debt should reduce to $3.6bn by end of 2017. This would bring 2017E net debt/EBITDAX down from 5.2x to 3.2x. This should bring the net debt levels back below the required 3.5x of the covenants which was breached previously. If FCF generation is Nil for the year then debt sits at the 3.5x limit. I would imagine the company and their bankers thought about this metric ahead of the rights issue.

FCF generation should be driven higher in 2017 by operating cash flow due to rising production from TEN with total production +24% at 88.6k boe (including Jubilee field insurance) and higher oil prices on average against 2016. (Note that around half the 2017 production is hedged with a floor at $60.23bbl.) This combined with a huge cut in capex following the completion of TEN from $0.9bn to $0.5bn should drive up FCF and enable TLW to pay down debt.

How to play the cycle? TLW has a very interesting market position as a play on higher oil prices - unlike some of the minors (Premier, Rockhopper, GKP) TLW has the ability to raise equity (albeit at a steep discount) because they have the size and clout of a FTSE 100 company (at least for now). But interestingly TLW also stands to benefit by orders of magnitude from high oil prices due principally to its financial leverage and operating leverage as a pure play E&P. This also explains why TLW has hugely underperformed the majors; Shell and BP over the period since 2014. They have the balance sheets to whether the downturn and the upstream assets to fall back on.

Google Finance

TLW shares are unlikely to gain in value in the near term without an improvement in the earnings department. Earnings have been depressed due to heavy impairments of assets and capitalised exploration expenditure. TLW will always have a reasonable level of written off exploration due to the nature of the business but in 2014-2016 the company has written off and written down a total of $4.8bn in capitalised assets and expenses, hence the losses. Impairments peaked in 2014 and with a much leaner business losses have narrowed into 2016 and EBITDAX margins have actually improved to the highest level since 2013. 

Margins including EBITDA ex impairments/write offs

Now clearly impairments are a real cost they just aren't a present cash cost (representing past cash outflow) - therefore what we can see here is that underlying profitability has improved. 

SG&A driven by Impairments - note the 2014 spike

This is due to a well executed cost cutting plan and focus on core low cost production principally finalising the TEN oil field. Operating cash costs per barrel are competitive and have been falling; these assets are cheaper than US shale for instance which is currently the swing producer.

TLW Annual Report

So much like DO the story of TLW is a story of leveraging up to increase capacity at exactly the wrong time - but back in 2013 nobody foresaw the precipitous drop in the oil price. With that leverage now on its way down and underlying profitability improving TLW should survive to play the waiting game on higher oil prices.

A rights issue usually has the medium term impact of drawing a line under poor share price performance and given the magnitude and high dilution of this issue it seems that management have 'kitchen sinked' it. No management wants to have to do a second cash call so they tend to overestimate the requirements for the first one.

Based on this analysis I most likely will subscribe for the rights and buy my allotted shares. I have sold some TLW since the announcement at a significant loss with a view to buying them back in my tax free ISA account should the price drop much below the 200p TERP in the interim.

The long term remains the long term oil outlook and it appears likely now TLW will be around to see it following this capital raising.

Disclosure: I have an established modest long position in LON:TLW. This is not a solicitation and does not constitute advice for investors considering the TLW corporate action. These are opinions only, not investment advice. If in doubt read my disclaimer.

Thursday, 23 March 2017

Why UK Homebuilders look like bad value...

The UK home builders seem cheap on a trailing P/E basis all valued around 8-11x P/E. But there is a reason for these relatively low valuations and that is the cyclical nature of the businesses. The stocks are all posting record earnings (except Bovis) at the moment boosted by the UK housing market growth which in turn is driven by (in order of importance):

(1) Cheap money (funny how the media never mentions this)
(2) Economic growth and low unemployment
(3) Lack of available housing (due to planning + empty/2nd homes + speculation driven by (1))

Now with all housing affordability metrics at record unaffordable levels, interest rates on the floor and peak employment it seems like cyclically things can only go one way from here. That would be down.

So we are at peak cycle from the look of the data. Maybe not this year, maybe not next year, but soon enough the housing market will take a wobble in the UK and these guys are vulnerable. Data is great for these companies as there are lots to choose from and all have been around at least 10 years. 2016 reported Earnings are way above the 10 year or even 5 year averages:

UK Homebuilders Earnings Per Share - (Bovis estimated; 2016)
This means you are paying more than 20x 10 year average earnings to own these stocks today (except TW who have negative 10 year average earnings). Even on an 8 year average basis only Bovis trades below 20x;

Share price performance has been limited over a ten year period as this fully captures the massive effect of the last crisis on the homebuilders (TW never really recovered) and then the boom to date:

However the 5 year chart shows you where the returns have been, nothing like some government subsidies and a wall of cheap money to drive demand and keep your land bank appreciating;

Caveat Emptor for these shares.

I will do a more in depth analysis soon on this sector.

Disclosure: Disclosure: I have a small short position in Persimmon Plc. These are opinions only, not investment advice. If in doubt read my disclaimer.

Results are what counts; Next Plc (NXT)

Well Next published their 2016/7 results and their first decline in annual earnings since the 2008 crisis. And the shares went up 8%. Classic value. Something of a relief rally then. The results were presented with doom and gloom across the press but that is because Next and M&S offer 'bellwether' outlooks on the UK economy and the press loves some gloomy news.

There were a few key takeaways for me from the press release;

UK retail sales declined 2.9% and remains the headline weak spot for Next. This is why most UK retailers are suffering low valuations.

But Next are a long term shareholder's dream! They are guiding down the difficult conditions in the retail market and even provide a sensitivity analysis of how they would wind down leases on stores if the LFL sales trend deteriorates...they do the job for you;

Next Plc Annual Results

Next's stormy guidance and outlook should be worrying shareholders of Debenhams - they are behind the curve and could go the way of BHS with their bricks and mortar model and large pensions gross liability (yes it is a net asset today but the total liability is 10x net profit - Next pension liability is 1x). One bright spot for high street stores is Next note declining rents on new openings (-24% yoy!); that is the nature of supply and demand people. What I wouldn't want to be right now is a commercial landlord or shopping mall.

Second the Directory business is still doing rather well. Next were well ahead of the curve building this business and they have not been resting on their laurels. They set out a clear and concise plan for further improvements. UK Directory sales rose 1.2% and overseas rose 18.5% (4 year CAGR is  23.4%) which provides essentially the glimmer of hope for growth for Next in the future. Operating margins also rose to 25.7% from 24.4% but much of this (100bps) came from one time effects of realigning the credit offering. 

Now on those overseas sales - it is much easier and less capitally intensive to distribute goods from the web platform than their small European store base (which had weak results but is <2% profits). And the CAGR for this business is showing excellent growth. A la ASOS. But the margins are much better at Next because ASOS has a 4-5% operating margin. That is right, Next have a 2000bps better margin than ASOS. And as I mentioned before Next are much cheaper.

The one thing that seems odd is the expressed guidance that the company won't be buying back shares. This seems rather bizarre given the drop in the share price and the previous buyback ceiling of ~£67 per share. I just find it incoherent. Frankly I would rather have the cash and reinvest the dividends as I feel buybacks are 'muddy' and I have all my investments in tax free wrappers so welcome the dividends. On the subject of Dividends the specials are back in again this year with 4 x 45p announced plus a 105p final to be paid in the summer. Next will therefore likely distribute £3.38 per share over the next 12 months. That is a yield of 8% at the closing price today! Not only that it is fairly sustainable given the FCF generation and lack of buybacks. They only call them 'special' so they don't get accused of cutting the dividend later if they change policies. (You get a 3.7% yield ex-specials)

Net debt looks like fine with debt covered by the customer credit portfolio and recent refinancing at lower rates bodes well for the future. The company remains investment grade.

Next Plc Annual Results

In summary I think these results are what any long term investor wants to see. A company refocusing on its core business, committed to effective use and return of capital, and managing intelligently a cyclical downturn. The market certainly agrees today. But who knows in the future.

Disclosure: I have established a modest long position in NXT. These are opinions only, not investment advice. If in doubt read my disclaimer.