Return on Equity: Errrm? Help!

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

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

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

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

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

A Basic analysis looks like this:

	BASIC		Opening	Yr 1	Yr 2	Yr 3	ROE			"Value"
	PAT (£'m)			10	10	10				120
	DIVIDENDS (£'m)			0	0	0
	NET ASSETS bal b/f			50	60	70
	NET ASSETS bal c/f		50	60	70	80				30
							Ave
	ROE			20%	17%	14%	17%			150

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

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

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

	DIVIDENDS		Opening	Yr 1	Yr 2	Yr 3	ROE			"Value"
	PAT (£'m)			10	10	10				120
	DIVIDENDS (£'m)			10	10	10				30
	NET ASSETS bal b/f			50	50	50
	NET ASSETS bal c/f		50	50	50	50
							Ave
	ROE			20%	20%	20%	20%			150

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

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

	BUY-BACKS		Opening	Yr 1	Yr 2	Yr 3	ROE			"Value"
	PAT (£'m)			10	10	10				152
	BUY-BACKS (£'m)			10	10	10
	NET ASSETS bal b/f			50	46	42
	NET ASSETS bal c/f		50	46	42	39
							Ave
	ROE			20%	22%	24%	22%			152

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

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

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

Conclusion

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

Any thoughts or comments are most welcome

10 Up! Taking Stock...

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

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

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

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

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

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

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

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

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

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

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

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

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

Next stop: 100.

T.Clarke - Constructing the Future?

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

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

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

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

Background

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

Westfield Shopping Centre
Source: T.Clarke website

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

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

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

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

Risks & Challenges

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

Investor Relations can be found here - T Clarke IR

The Rules

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

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

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

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

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

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

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

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

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

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

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

Update

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

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

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

Conclusion

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

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

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

Building Value at MJ Gleeson?

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

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

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

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

Background

Potted History

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

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

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

Business Model

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

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

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

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

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

Risks & Challenges

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

The Rules

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

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

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

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

2 - Market Value - £64m. Pass

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

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

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

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

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

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

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

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

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

The interim results are due in February 2011.

Conclusion

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

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

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

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

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

Book Review: Genius Greenblatt

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

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

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

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

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

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

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

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



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

Muck and Brass at Drax?

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



Beautiful? Source: Drax website

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

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


Source: Drax website


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

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

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

Background

Potted history

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

Business Model

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

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

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

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

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

Risks & Challenges

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

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

The Rules

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

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

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

2 - Market Value - £1.39bn. Pass

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

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

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

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

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

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

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


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

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

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

Update

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

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

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

Conclusion

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

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

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

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

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

Foot on the Gas or Hot Air at Ecofin?

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

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

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

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

Source: London Stock Exchange

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

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

Background

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

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

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

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

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

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

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

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

The Rules

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Update

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

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

Conclusion

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

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

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

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

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

Happy New Year!