Following on from a previous excursion into Return on Equity, and the very good debate which ensued on this blog and on Stockopedia, I have been pondering further on how to identify and recognise what constitutes a great company.
Why Great?
It sounds like a redundant question, but why the interest in great companies?
To paraphrase the likes of Buffett and Co, they would rather buy a great business at a fair price, rather than a fair business at a great price. This makes perfect sense as the stronger a business is (and is likely to remain so in the future), the stronger the likelihood that future profitability will increase. Get the quality business at a discount and then you can make a killing a la Greenblatt.
I may have come to it a bit late, but there seems to have been a lot of excellent analysis and discussion around the subject recently, particularly with UK Value Investor's screening based on ROE and other attributes, and Richard Beddard's Herculean efforts in attempting to apply Greenblatt's Magic Formula to the UK with ROA being a key component.
I have been taking a closer look at other ratios that are commonly used alongside ROE.
Useful Tools for the Tool-kit?
1 - Return on Assets (ROA)
ROA = Adjusted Net Income / Total Assets
Adjusted Net Income = PAT + Interest (and the tax effect) - to show (kind of) operating profits without the cost of the capital base (ie interest)
Total Assets = Net Assets (opening or average)
Observations. Trying to adjust for interest and the tax effects is fiddly (Sharelockholmes in its ROTA calculation gets around this by using EBIT (I think)). Net Asset Value will include book values of intangibles and goodwill, and fixed assets, all of which may be very detached from market value.
2 - Return on Capital (ROC)
ROC = EBIT / (Net Working Capital + Tangible Assets )
NWC = net current assets/liabilities - ie stock + debtors + cash - current liabilities. Cash should be operating cash
TA = opening or average book value of Tangible Assets
Observations. This is very similar to Greenblatt's Magic Formula measure, although adjusting for surplus cash remains problematic. At least intangibles and goodwill are excluded from Assets, but there is still the issue of tangible assets at book cost. Maybe a high ROC is a sign that the assets could be undervalued?
3 - Return on Capital Employed (ROCE)
ROCE = EBIT / (Total Assets - Current Liabilities)
Very similar to ROC but includes long-term debt.
So What?
They all sound fine and dandy and they have particular strengths and weaknesses, but it is too easy to get hung up about the finer details of these ratios in isolation. Every man and his dog seem to tweak each definition, and each sector has different drivers which will influence the outputs when compared to other sectors. Formulas are useful, but should not be the 'be all and end all' and do not remove the need to understand the movements in a company's finances. At the end of the day, we're all try to find good quality companies at an appropriate price, and I'm going to use them as an early stage screening tool.
I am in the process of re-writing/tweaking my Rules, but am considering using the following measures for screening purposes:
1 - ROE > 15% average over 10 years
2 - ROC > 25% (as suggested by Greenblatt - ROA equivalent)
3 - ROCE > 15%
4 - PER < 14
5 - Yield > 2.5%
6 - Gearing < 50%
7 - Mkt cap > £20m
A first pass has thrown up 19 interesting companies, including the likes of Astrazeneca and Unilever. In an ideal world, I would want to back-test these parameters so see what the results are like, but for the time being I will judiciously select a few targets and take them to the next level of analysis. Watch this space...
Thursday, 3 March 2011
Tuesday, 1 March 2011
Virtuous Vertu and HMV the Dog
A flurry of activity this morning when I switched on my Blackberry to see trading updates from HMV and Vertu. Let's start with the bad...
HMV Group
The two pieces of news this morning were short and pithy, but no less significant.
The first announcement was a trading update since the last one a mere seven weeks ago. In that period, profits will now be "moderately" below market expectations (which were £45m of PBT based on the median expectations - there must be some crazy stuff out for them to use median) due to "challenging" trading conditions.
To compound matters, debt will not be less than £130m due to changing product mix and adverse working capital, and it now expects to breach certain banking covenants based on the full-year tests. The Company has commenced discussions with its lenders, who "continue to be supportive".
In the second announcement, the Chairman has stepped aside (to focus more on M&S presumably) and Philip Rowley has picked up the mantle with immediate effect.
The shares dropped over 20% to 16.5p in early morning trade, giving the Company a market value of £88m.
Before I starting writing this, my mind-set was to ditch HMV along the lines of 'run the winners and cut the losers'.
It's easy to paint a very bleak picture: tough trading, profits below expectations, covenant breach on the cards, debt higher than forecast, reduced cash generation, big sector/cyclical issues playing themselves out and the Chairman stepping aside.
Is there any Value here?
I have no idea what "moderate" means in terms of black and white (or red) numbers, but let's assume PBT comes in at £30m (two-thirds of median expectations - sounds moderate to me)
Tax this at 28% and EPS equates to about 4p per share. The current share price of 16.5p equates to a PER of 4.1x.
The dividend policy is to aim for say 3-4x times cover, so a theoretical dividend of 1p per share would be possible. The interim dividend was 0.9p, so rule out any further dividends in the short-term from an earnings perspective and in any event, the banks will not permit it if the Company has breached covenants or will breach covenants on a look-forward basis.
EBITDA looks interesting given that that DA was about £45m in FY10 (I would expect it to be higher in FY11) and Interest will be, say, £10m (v £7m in FY10). This gets us to an underlying EBITDA of £85-90m for FY11. Based on an EV of £220m (£130m debt and £90m equity), this represents an EV/EBITDA ratio of 2.5 times.
We would want to look at the rent-adjusted position given that it is a retailer, but I am not sure how much sensible analysis can be undertaken given that they are on a store closing programme.
HMV is priced for failure based on a PER of 4x and an EV/EBITDA of 2.5x. The two aspects that worry me most are (i) cash generation - is the adverse working capital temporary or permanent (if the former, then the level of debt is higher than normalised and cash should come back in) and (ii) the size of the 'exceptionals' and the extent to which these are cash items (eg redundancies and unexpired lease costs).
The other interesting aspects are: the Russian Mamut waiting in the wings and/or the potential disposal of Waterstone's. If Waterstone's was valued at £50m (figure plucked from the air via "media sources"), this would equate to a fully-taxed gain of about 7p per share - from what I can see, this is not reflected in the share price. I would not be surprised to see a Rights Issue appear sooner rather than later too.
HMV is one sick mutt, but is it terminal? Not yet; I can still see some value here, but the next few months are going to be very interesting indeed. Stick or twist?
Vertu
Vertu is the Ying to HMV's Yang (if that's the right way around).
Trading has remained strong and results are likely to be ahead of FY11 expectations (EPS of 2.7p as per Digital Look) . Market share has grown, cash generation has been good and a final dividend of 0.3p has been disclosed (full year DPS 0.5p; yield of 1.8%).
On the down-side, there will be exceptional costs in relation to asset write downs and financing costs.
I am topping up my holdings in HMV and Vertu.
The two pieces of news this morning were short and pithy, but no less significant.
The first announcement was a trading update since the last one a mere seven weeks ago. In that period, profits will now be "moderately" below market expectations (which were £45m of PBT based on the median expectations - there must be some crazy stuff out for them to use median) due to "challenging" trading conditions.
To compound matters, debt will not be less than £130m due to changing product mix and adverse working capital, and it now expects to breach certain banking covenants based on the full-year tests. The Company has commenced discussions with its lenders, who "continue to be supportive".
In the second announcement, the Chairman has stepped aside (to focus more on M&S presumably) and Philip Rowley has picked up the mantle with immediate effect.
The shares dropped over 20% to 16.5p in early morning trade, giving the Company a market value of £88m.
Before I starting writing this, my mind-set was to ditch HMV along the lines of 'run the winners and cut the losers'.
It's easy to paint a very bleak picture: tough trading, profits below expectations, covenant breach on the cards, debt higher than forecast, reduced cash generation, big sector/cyclical issues playing themselves out and the Chairman stepping aside.
Is there any Value here?
I have no idea what "moderate" means in terms of black and white (or red) numbers, but let's assume PBT comes in at £30m (two-thirds of median expectations - sounds moderate to me)
Tax this at 28% and EPS equates to about 4p per share. The current share price of 16.5p equates to a PER of 4.1x.
The dividend policy is to aim for say 3-4x times cover, so a theoretical dividend of 1p per share would be possible. The interim dividend was 0.9p, so rule out any further dividends in the short-term from an earnings perspective and in any event, the banks will not permit it if the Company has breached covenants or will breach covenants on a look-forward basis.
EBITDA looks interesting given that that DA was about £45m in FY10 (I would expect it to be higher in FY11) and Interest will be, say, £10m (v £7m in FY10). This gets us to an underlying EBITDA of £85-90m for FY11. Based on an EV of £220m (£130m debt and £90m equity), this represents an EV/EBITDA ratio of 2.5 times.
We would want to look at the rent-adjusted position given that it is a retailer, but I am not sure how much sensible analysis can be undertaken given that they are on a store closing programme.
HMV is priced for failure based on a PER of 4x and an EV/EBITDA of 2.5x. The two aspects that worry me most are (i) cash generation - is the adverse working capital temporary or permanent (if the former, then the level of debt is higher than normalised and cash should come back in) and (ii) the size of the 'exceptionals' and the extent to which these are cash items (eg redundancies and unexpired lease costs).
The other interesting aspects are: the Russian Mamut waiting in the wings and/or the potential disposal of Waterstone's. If Waterstone's was valued at £50m (figure plucked from the air via "media sources"), this would equate to a fully-taxed gain of about 7p per share - from what I can see, this is not reflected in the share price. I would not be surprised to see a Rights Issue appear sooner rather than later too.
HMV is one sick mutt, but is it terminal? Not yet; I can still see some value here, but the next few months are going to be very interesting indeed. Stick or twist?
Vertu is the Ying to HMV's Yang (if that's the right way around).
Trading has remained strong and results are likely to be ahead of FY11 expectations (EPS of 2.7p as per Digital Look) . Market share has grown, cash generation has been good and a final dividend of 0.3p has been disclosed (full year DPS 0.5p; yield of 1.8%).
On the down-side, there will be exceptional costs in relation to asset write downs and financing costs.
I am topping up my holdings in HMV and Vertu.
Thursday, 24 February 2011
Vroom Vroom Vertu...
Why Am I Interested?
1. The shares are trading at a 37% discount to reported net assets
2. Directors have been buying in the last 12 months
3. Declared a maiden dividend in its interim results in October 2010
4. I have a holding at a break-even cost of 31p per share (acquired before my blog started)
Background
History & Operations
VTU was formed in 2006 as a new vehicle to consolidate UK motor retailers, raising £25m and listing on AIM in December 2006. Since then, the Company has made numerous acquisitions and raised £56m through two Placings and has £45m in debt facilities (£12m drawn).
In essence, the strategy involves buying dealerships at reasonable prices and getting more out of them through applying "consistent business processes and systems" - ie increasing profits through harmonising and standardising as part of a larger corporate organisation - the whole is worth more than the sum of the parts kind of thing.
The Company is now present in over 70 locations, via 84 franchised and 3 non-franchised sales operations.
Activities include: new and used car sales, fleet contracts, commercial vehicles and 'after-sales' (servicing, repairs and parts). After-sales has by far the highest gross profit margins (41%) compared to new car sales (8%) and used car sales (10-12%).
The main brands sold include: Ford, Honda, Vauxhall, SEAT and Peugeot.
Investor Relations can be found here
Share Price & Value
The current share price of 28.5p (mid-point as at 23 February) gives the Company a market value of £57m. Based upon the 2010 basic EPS of 2.2p, this represents a PER of 12.8x. The Company is listed on AIM.
In the past five years, the shares have hit a high of 101.5p (Dec 2008) and a low of 10p (Feb 2007).
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| Source: London Stock Exchange |
- execution risk in a buy and build strategy - need to buy the right things at the right price;
- the motor "trade" is littered with the dead bodies of snake-oil salesmen. Anecdotally, the industry seems to have cleaned itself up a bit in the past decade, and maybe the consumer responds more favourably to a quality, corporate offering. One thing for sure, a profit is only a profit once it turns to cash;
- the sale of new (and used) cars is tied to some degree to economic well-being. The industry received some support via the government scrappage scheme, which ran from May 09 and was equivalent to the US's Cash for Clunkers scheme, but it remains a challenge. On the plus side, new car sales do not generate a huge amount of gross profit for the dealers, unlike servicing and maintenance, although you cannot have one without the other; and
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| Fancy a new motor? |
The Rules
The following analysis is based on the 12 months to 28 February 2010 (FY10) unless otherwise stated
1 - Assets - the NAV at February 10 was £90m compared to a market cap of £57m, equating to a discount of 37%. Better still, there was net cash of £23m, which if valued at par, means that you can buy £67m of assets for £34m - a discount of 50%.
Even if Goodwill of £21m and Cash are excluded, you can buy £46m of assets for £34m, which still represents a discount of 26%. The bulk of these assets are in relation to freehold and long leasehold sites. Pass
2 - Market Value - a market cap of £57m. Pass
3 - Cash Flow - (a) net current assets of £18m and (b) operating cash of £15m after working capital movements. Out of this, we need to cover replacement capex (£3m - est), interest (£1m) and tax (£1m - FY10 P&L), meaning that there is £10m "left over". Cash generation was also good in FY09 and it gives some comfort to see profits turn to cash. Pass
4 - Debt - (a) net cash of £23.5m and (b) Adjusted EV/EBITDA of 10x, which is a full valuation and probably reflects the asset nature of the business. This assumes that EBITDA is adjusted by £3m for replacement capex, which may be harsh for a growing business
Also, a word of caution in the FD's review re the cash balances:
The positive net cash balance at 28 February 2010 reflects the seasonal reduction in working capital, typical of the industry, which arises at the period end prior to a plate change month. Consequently, the year end net cash balance is higher than the normalised cash balances throughout the remainder of the year.
Unfortunately, he does not say what the normalised position would be.
5 - PER - based upon FY10 EPS of 2.23p, the current PER is 12.8x. The Company has only been listed for three financial years and has been growing through acquisition each year. The three year average EPS is 1.1p, but I do not consider this to be a representative level of earnings. Pass(ish)
6 - Yield - no dividend was declared in FY10. However, they intend to embrace a modest, but progressive, dividend commencing with the FY11 interims (see below). Fail, but potential to Pass
7 - ROE - was 7% in FY10. Given that the Company has been acquisitive in the past couple of years, there will be a time lag in seeing profits come through at the appropriate levels. Whilst the current level of profitability is not as high as we would like, it is important to remember that it does not represent the finished product. As work in progress, it gets a Marginal Pass.
8 - Directors - the two executive directors held 8.2m (£2.3m) of shares between them at February 2010. The directors had reasonable basic salaries, but generous bonus arrangements, linked to PBT targets, which will be good for shareholders if set at the right levels. Pass.