Creston Plc – business model & valuation
Yesterday, I “introduced” Magic Sixes stock Preston Plc, which based on first check is worth a closer look.
One of the improvements in my “investment process” which I try to achieve in 2012, is trying to understand better the respective business models of the companies I am analyzing. This is something where I do not have a lot of experience but let’s see if this adds some value.
Creston PLC business model
As mentioned, I am neither an expert in business models nor in the advertising agency business, but in my opinion the busienss model can be ccharacterized the following way:
+ very low fixed asset requirements (which is good)
The company does not have any fixed assets which is understandable because you only need some PCs and rent office space to run such a business.
+ limited working capital requirements
The company had in the last 2 business years almost zero net working capital, however as mentioned before, in the last 6 months receivables had increased to a certain extend. Still, we can conclude that the busienss itself does not require significant amounts of capital
+ People’s business
Jan Hendrik commented that this might be a typical “people’s” business. Based on a simple metric one can conclude that this is cleary the case here. Employe expenses for the 2011 financial year are 46.5 mn GBP, or ~80% of total expenses.
From what I know, salaries pretty low in the junior levels because a lot of people want to get into the “creative business”, however on a senior levelö salaries tend to be pretty high as companies have to make sure that the most creative employees don’t just switch companies (and take their clients with them…).
+ barriers to entry
Based on my understanding, the barriers to entry into the ad/pr agency markets are pretty low. Evidence is the large number of ad agencies. Contracts are tendered by corporate clients on a regular basis. I would assume that the company posseses some sort of proprietory data & information as well as customer relationships, but nothing which would count as a “real” barrier to entry against any competitor.
Maybe Creston as a mostly UK based player has some niche advantages, but overall this seems to be a very competitive market. Further proof for this are relatively low NI margins (~5%, fluctuating between 1.5% and 8.5) over the last few years. I also doubt that the business is really scalable.
Summary business model: Creston seems to be in a very competitive industry with low barriers to entry, however the business requires only a minimum of capital. Nevertheless, it would be quite aggressive to really assume significant growth for the future. So the “investment thesis” would be rather a “reversion to the mean” theme.
As indicated before, the net income margin averages at around 5% over the last 10 years, however with some volatility. Much more interesting is the low return on invested capital. With 6.1% this is clearly below any cost of capital number. Before I said that the business model doesn’t really require assets, so why is this number so low ?
The answer is relatively easy: Goodwill. ROIC includes goodwill and the low single digit return tells us one thing: Creston just spent too much on those acquisitions, so the returns on puchase price are not really good.
If one looks at the company history in the 10 year report, one can see that every second year companies were bought and sold. Much of the free cashflow generated did go into those acquisitions, only a small amount was distributed to shareholders. Usually, small M&A transaction can be positive, but the track record for Creston is not great. We also don’t know if this is going to change in the future.
Another disturbing issue is the fact that numbers of shares increased significantly in the past:
I could only find one “straight” capital increase in 2002 (5.6 mn shares at 0.60 GBP), so they seem to have paid a couple of their past acquisitions with stocks. So at the end of the day, Management seems to have been quite easy on increasing the numbers of shares in the past, which is not good for the shareholders.
Without any real assets, the downside for Creston Plc is basically unlimited. If things go south and key people leave, I highly doubt if there would be any value left. I have no idea how much the goodwill is worth, but my worst case assumption would be zero.
Earnings Power Value
If we assume a “reversion” to the mean approch, we can think about 5% net income margin for Creston going forward. As there are no interest payments, depreciation is neglectible, net income might be a good proxy for Free cashflow.
Based on current sales of annualized 70 mn GBP, expected profit in a steady state would be 3.5 mn GBP, discounted with 10% would give us a market capp of 35 mn GBP, slightly above the current 31 mn GBP.
At that point, we can stop. Without a downside protection, the “steady state” valuation is around the current price level. Without any competitive advantages and general economic headwinds, the stock looks unattractive, despite qualifying under the “Magic Sixes” criteria.