Category Archives: Fundamentalanalyse

Boss score harvest part 6: Reply SpA (ISIN IT0001499679) – Quick check

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Cheap Italian companies are ” a dime for a dozen” at the moment. Cheap Italian companies with rising sales, improving margins and solid balance sheets are however as common as the common “black swan”.

One Italian company which looks good under my Boss Score model is Reply SPA from Italy.

Reply SPA looks relatively cheap based on traditional metrics, especially P/E and EV/EBITDA

Market Cap: 160 mn EUR
P/B 1
P/E Trailing 5.9
Div. yield 2.85%
EV/EBITDA 3.6

What really raised my interest was their half year update, which shows nicely improving figures:

The Board of Directors approves the Half-yearly Report as at 30 June 2012
2 August 2012

“Double digits” growth for all economic and financial indicators:

Consolidated turnover of 244.2 million Euros (+11.6% compared with H1 2011);
EBITDA of 30.7 million Euros (+15.9% compared with H1 2011);
EBIT at 27.6 million Euros (+19.8% compared with H1 2011);
Earnings before taxes of 26.8 million Euros (+18.9% compared with H1 2011)

This is even more astonishing, as they have 3/4 of their activities in Italy. So how are they doing it and what are they doing anyway ? Bloomberg says the following:

Reply S.p.A. specializes in the design and implementation of solutions based on new communication channels and digital media. The Company’s services include consultancy, system integration, application management, and business process outsourcing. Reply S.p.A. provides services to business groups within Telco & Media, Industry & Services, and Banking & Insurance sectors.

If I understand correctly, they seem to be a kind of IT systems integration company. In their annual report, they use all the “buzzwords”, like cloud computing, mobile payments, big date business security etc.

Similar to German IT company Bechtle, Reply seems to have grown through acquisitions in the past and is more a “collection” of smaller IT companies than one monolithic company.

Balance Sheet

A quick look into the balance sheet:

Reply has relatively low debt (they had zero debt in 2010) which is good. However we can see a significant amount of Goodwill. This is a problem if profitability would go down.

So far it looks OK. With ROE of 16.5% and ROIC in the double digits (including Goodwill, 13.7%) it looks like they did not overpay for acquisitions.

One thing which caught my attention was the high amount of receivables, with almost 50% receivables compared to sales. However looking at the past, this seems a “normal” amount for reply. If we look at historic numbers, they were always in that range:

Receivables Sales  
2007 121 230 52.6%
2008 144 277 52.0%
2008 144 330 43.6%
2009 153.7 340 45.2%
2010 189.1 384.2 49.2%
2011 219.0 440.3 49.7%

German IT company Bechtle AG, which seems to have a similar business model however has only 10-15% receivables compared to sales. So this is definitely something to explore further.

Stock price, shareholders etc.

Although the stock is clearly below 2007 highs, the stock has clearly outperformed the Italian index as one can see in the following chart:

Typically for Italian companies, the majority yof the company is is controlled by a family, in this case by Mario Rizzante through his Alika Srl holding. Hi daughter Tatian is CEO of the company.

Among the other shareholders, I found the “Franfurter Aktionfonds für Stiftungen” very interesting. I am not sure how succesful they are but in their portfolio are many stocks I find interesting as well. For them, the 4.83% stacke is one of the largest fund positions.

Special stuff

I overlooked almost one very interesting detail about Reply: Reply owns 78.6% of German listed “Reply Germany”, the former Syskoplan AG (ISIN DE0005501456).

Reply Germany is interestingly valued much much higher, at around 11.7x EV(EBITDA and 1.6x P/B. and a P/E of 13. A quick back of the envelope calculation shows the following

– value of the stake 37 mn EUR
– trailing 12 m earnings 0.72 cents per share or 3.5 mn EUR

If we deduct this from Reply’s 140 mn market cap and Reply’s profit, we can see that Reply’s business ex Syskoplan is actually valued at a P/E below 5.

Quick summary:

Reply SpA looks like a really interesting stock. However I do not have a lot of experience with investing in IT service companies, despite having started by professional carreer in one. So I will have some more work to do with Reply, especially a comparison with companies like Bechtle. The one thing to watch out is clearly the receivables issue.

KAS Bank NV (NL0000362648) – Specialist banking opportunity ?

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DISCLAIMER:
This is not meant to be an investment advice. Please do your own work. The author might have bought or sold the stock already prior any discussion. Don’t trust ANYONE with stock tipps or other easy ways to make money.

In general I try to stay away as far as possible from banks. However KAS Bank NV (NL0000362648) might be interesting.

KAS Bank itself describes its business as follows:

KAS BANK N.V. is the independent European specialist in securities services and risk control and reporting services for professional clients in the pensions and securities industry.

KAS BANK pursues a ‘pure play’ strategy, underlining the bank’s absolute neutrality and independence. A low risk profile is integral to its services and is reflected in the quality of its balance sheet and its high solvency ratio.

So this is important why it is technically a “bank” effectively it is a sort of service company with a banking license.

Based on traditional metrics the company looks relatively cheap although technically all the banks are cheap.

MArket Cap: 100 mn EUR
P/B: 0.6
P/S: 0.2
P/E Trailing 10.0
Div. Yield 7.2%

Before diving into the details one should always ask the question: Why might KAS Bank be an interesting investment ? My thesis (which will then have to be tested) is the following:

+ Service based business model should show less volatility than credit based bank models
+ as client base etc. is Netherlands and Germany fundamental fall out from EUR crisis should be low
+ stock price might have been punished by overall issues with banking industry
+ business should be cash generative increased cap. requirements should be not a big problem
+ no risk of dilutive capital increases
+ small market cap and low analyst coverage might further nake stock unattractive

Earnings history & volatility

As a financial stock with mark to market accounting KAS bank doesnt look that good in my “boss” model but this is to be expected for any financial stock with mtm assets and liabilities.

If we look at 5 year figures provided by KAS Bank we can clearly see that the overall results were less stable than I would have assumed:

2007 2008 2009 2010 2011
net asset value 14.19 11.49 13.27 12.83 11.36
basic earnings per share 3.41 -2.7 1.69 1.27 0.7
dividend 2.6 0.45 0.73 0.73 0.5

On the plus side they paid a dividend each year however earnings were quite volatile with a big loss in 2008 caused by impairments.

Looking into the 2008 annual report one quickly sees the following comment:

Impairment losses on loans, including Lehman and one Madoff-related investment, bonds and equities in the available-for-sale portfolio, goodwill and two exceptional charges reduced the net result for 2008 by €58.7 million.

On a gross basis those impairment charges were ~5 EUR per share so quite significant. Further on they give more details on the losses:

As a result of this exercise, the bank has recognised impairment losses on loans and advances totalling €35.3 million (2007: nil). This item is made up of impairment losses on receivables in respect of securities lending positions with Lehmann Brothers Inc as client (€9.6 million) and in respect of an investment indirectly caught up in the serious fraud case involving Bernard L. Madoff Investment Securities LLC (€11.8 million). The rest of
the impairment losses (€13.9 million) relates to loans and advances to clients who are expected to be unable to repay their loans in full and, based on objective evidence, in connection with which the securities provided as collateral have fallen sharply in value.
Available-for-sale investments
The portfolio of available-for-sale investments is made up of shares and bonds and, with regard to both, there is objective evidence of impairment losses of €21.9 million (2007: €1.5 million) and €11.0 million (2007: nil), respectively. The difference between the cost and the current fair value has been transferred from the revaluation reserve to the income statement.
Intangible assets
The deterioration in market conditions has led the bank to make a downward adjustment in the future profit projections for the subsidiary in Germany acquired 1 July 2008, involving the recognition of an impairment loss of €5.2 million in respect of goodwill. This goodwill impairment loss is not allowable against tax.
Other equipment
In connection with the vacating of leased premises in 2007, all the previously capitalised costs of alterations to the building, totalling €3.2 million, were written off.

So all in all it was a combination of different financial crisis related write-offs which caused those impairments. We can clearly see that the business model includes at least some credit risk so its not a “Pure” service function. Going forward I guess the whole industry has learned from the “Lehman moment”.

Business model

At this point it makes sense to look at how the business model of a custodian looks like. Simply speaking a custodian manages the technical aspects of a security portfolio. The custodian executes trades records and receives interest coupons and dividends on behalf of the investor and sometimes offers “add on services” like reporting accounting cash management securities lending programs etc.

Some more background of the custodian business can be found for instance here or for a real deep dive this 100 page + overview of the industry.

In general one could asay that the custodian business is an interesting growing business however it is not clear if specialists or universal banks will profit most. Personally I think that after the crisis a specialist with “untarnished” reputation might have a certain reputation advantage.

In principle one can simplify the custodian business into 2 parts:

1. Transaction and service fees
2. Spread on “float”

The first part is relatively easy and is depending on the size of the administrated portfolios and the frequency of transactions. The second part is more difficult.

Custodians are a typical “float” business. If we look at KAS Bank’s 2011 accounts we can see at first a huge amount of leverage:

We have 5.2 bn EUR of liabilities against only 170 mn equity. However if we look at the funding side we see the following split:

Of the ~5 bn EUR financial liabilities around 0.5 bn are deposits from other banks so called “wholesale” funding. 4.5 bn are from non banks. Of the non-bank money again 0.7 bn are time deposits and 3.8 bn are “demand deposits”.

The non-bank demand deposit is the interesting part. Although this amount is fluctuating significantly a large part of this is “float”. usually every day some of the securities either pay interest dividend or mature. So KAS bank has a constant cash inflow from its client portfolios. Only few clients manage those cash flows on a day-to-day basis. Normally they only act if a certain amount accrues.

Custodian banks sometimes offer interest for those accounts at usually well below market rates. In normal times the custodians than invest those funds into the “normal” money market and earn a nice spread.

However at the moment, with short term interest rates at zero this “spread” is almost zero to. So for custodian banks the “float” part of the business is at its worst point in the cycle. KAS Bank (as many others) even took this further in investing part of the float into a security portfolio which at times can produce some mtm changes as we all know.

Looking at the pure “net interest result” without derivatives we can clearly see that KAS Bank could generate even in 2008 around 30 mn net interest result whereas in 2011 this amount dropped to 20 mn EUR pre tax.

Net commission income at the moment is around ~70 mn EUR this used to be ~90 mn EUR p.a. in the good days.

So we can see that both pillars are at the moment at a depressed status. Another interesting aspect is that custodians scale quite well. More transactions do not require a lot of more expenses if the infrastructure is in place. So if business (and interest rates) pick up profits will increase over proportionally.

Potential “Moat”

Custodian business in principle is a kind of “commodity” business. However there are some significant switching costs associated with changing custodians especially with more complex institutions like pension funds and insurance companies.

Within total costs for managing financial assets custodian fees are a relatively small cost block however in the overall process the custodian is very important.

So many institutions will think twice before changing an existing custodian relationship because any cost advantage will not be very big compared to the potential hassle.

I would call this a “weak” moat.

Current developement:

KAS Bank doesn’t issue quarterly reports only short “trading updates”. The Q1 update was Ok in line with 2011. However they mention a special positive effect of 4 mn EUR:

The half year report is scheduled for end of August in a couple of days

Non-operating result in Q1 2012 comes to €2.0 million and is chiefly attributable to the revaluation of a number of perpetual loans from banks. The proceeds of the planned sale of the shareholding in LCH.Clearnet will contribute €4.3 million net to the result in 2012.

So this seems to be a realization of a “Hidden asset”.

Dividend policy:

The stated dividend policy seems to be quite shareholder friendly:

Dividend policy
In accordance with the dividend policy discussed with the General Meeting of Shareholders, our target is to distribute 60-80% of the net result, where the profit permits and unless prevented by exceptional circumstances.

Shareholders

Interestingly KAS Bank does not have a dominating shareholder. LArge shareholders according to the annual reports are:

5% holdings
The following institutions have given notification of holdings of 5% or more in KAS BANK pursuant to the Financial Supervision Act and the Decree on Disclosure of Control and Major Holdings in Listed Companies.
– Delta Lloyd N.V. 12.2%
– APG Algemene Pensioen Groep N.V. 8.8%
– Delta Deelnemingen Fonds N.V. 8.6%
– ING Groep N.V. 7.9%
– All Capital Holding B.V. 5.3%
– KAS BANK N.V. 5.1%

Historically ING held more than double the current amount and sold down half of their stake in 2007 and 2008.

Some smaller positions are held by funds the only known value investor is Sparinvest with a 0.17% share. However the seem to have a “Poison Pill” in place for unfriendly take overs. So this limits any take over (and short term catalyst) “fantasies to a certain extent.

The stock is followed only by a few Dutch analysts 4 of 5 analysts have a buy rating with target prices between 10-13 EUR per share.

Management:

Management owns smaller positions in the stock and some options but compared to salaries (which ar Ok by the way) stock exposure of management is relatively small.

Balance Sheet quality

Overall balance sheet quality seems to be Ok. intangibles are ~14 mn EUR or less then 10% of equity. Disclosure for the AFS portfolio could be better. They only publish rating categories with the disclaimer

* No sovereign exposure on the PIIGS countries

So there would be some room for improvement.

Valuation

For me KAS bank is one of the few financial institutions where I would see a good “reversion to the mean” opportunity. They currently trade at an approximated “normalised” bottom of the cycle P/E of 7 and P/B of 0.6.

Average EPS over the last 14 years was 1.74. If we assume that conservatively They can achieve the 1.75 at some point in time in the future and a “fair P/E would be 10 then the share could be worth ~17,50 EUR. Average Price/Book over the last 14 years was about 1.2 so this would imply a double on current P/B of 0.6 if things return to “Normal” for KAS Bank.

Looking at the two profit pillars one could come up with the following valuation approach:

1. Pretax income on “float” ~25 mn EUR over a cycle
2. Fee income trading income etc. 100 mn EUR p.a. over a cycle
Minus 100 mn cost would be 25 mn EUR pre tax or ~ 20 mn EUR p.a. post tax of annual profit

Discounted by 10% this would again give us a value around double the current market price.

So from a valuation point of view I would say that KAS Bank should be worth double before any growth and excluding any future catastrophes.

Stock Price

The stock chart looks relatively ugly:

From a momentum point of view one shouldn’t touch the stock. In contrast to most other banks the stock didn’t rebound at all in the past few weeks. This might reflect that KAS Bank has not a lot of PIIGS exposure. Positively one could say that at least based on the last few months the stock price has found a floor at around 7 EUR.

Personally I think that KAS Bank now has reached a “fundamental” floor so in this case i will again ignore stock price “momentum” to a certain extent.

Interestingly, Beta to the AEX is only 0.62, which fits very well into my “low vol” strategy. What is very strange but interesting is the fact that Kas Bank is not really correlated to anything. Just for fun I looked at the 1 year correlations against the Dutch Index the Stoxx Banking index and ING:

SX7E↑ KA INGA AEX
SX7E 1.00 0.27 0.86 0.83
INGA 0.86 0.28 1.00 0.89
AEX 0.83 0.32 0.89 1.00
KA 0.27 1.00 0.28 0.32

Although this is not the most important decision point for me, the low correlation of KAS Bank makes it very attractive from a portfolio risk point of view.

Summary:

KAS Bank for me looks like a very interesting opportunity within the banking sector due to the following reasons:

+ attractive specialist business model (custodian)
+ cheap valuation even based on current “bottom of the cycle” earnings
+ valuation depressed because of overall hostility against banks
+ low or no analyst coverage
+ reversion to the mean speculation a lot less risky than with normal banks as virtually no risk of dilution (even Basel III standards are met by a wide margin)
+ potential upside ~100% over the next 3-5 years plus dividends+ low correlation / beta good portfolio diversifier

For the portfolio I will start as usual with a half position (2.5%) and then decide after the half year report if I want to increase.

Boss Score Harvest part 5: – L.D.C. SA (ISIN FR0000053829)

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In the fifth part of analysing the results of my Boss Score model, i want to look at the French company L.D.C. SA next.

The reason is not that LDC has the best score, but it is relativley comparable two 3 other companies I have analysed so far, Cranswick and French companies Tipiak & Toupargel.

According to Bloomberg,

L.D.C. SA processes and sells a wide range of specialty poultry products ranging from fresh prepackaged chicken to more elaborate prepared dishes. Those products are sold under brand names including “Loue,” “Bresse,” “Landes” and “Le Gaulois.”

So will French chicken be a good fit to British Pork ? Let’s look at traditional fundamentals:

Market Cap 690 mn EUR
P/E Trailing 12.2
P/B 1.1
P/S 0.2
EV/EBITDA 4.2
Debt/Assets 9.5%
ROE 9.5%
ROC 8.1%
Dividend yield 2.1%

At a first glance, relatively unspectacular. Not overly cheap but not expensive. EV/EBITDA looks attractive, almost no debt is normally a good sign. Market cap a little high but still ok.

What makes the company score quite well in my model is the very constant Comprehensive income yield on equity. This 10 year history:

12M EPS BV/share Div
31.12.2002 4.19 33.50 1.15
31.12.2003 4.11 36.05 1.23
31.12.2004 5.48 42.288 1.15
30.12.2005 5.76 47.4188 1.25
29.12.2006 5.30 51.8404 1.25
31.12.2007 6.63 56.4853 1.25
31.12.2008 5.29 60.7223 1.50
31.12.2009 7.83 67.144 1.30
31.12.2010 5.9 71.1595 1.93
30.12.2011 6.97 75.8072 1.80

creates an average 11.5% CI Yield on Equity with only a 3.2% standard deviation.

Looking at some further metrics we can see that unlike Tipiak and Toupargel, LDC is growling nicely however margins have been eroding somehow since 2009:

Sales p.s. NI margin  
31.12.2002 191.7 2.19% 10.69%
31.12.2003 186.4 2.21% 10.63%
31.12.2004 170.8 3.21% 19.07%
30.12.2005 193.2 2.98% 14.00%
29.12.2006 195.0 2.72% 11.43%
31.12.2007 226.8 2.92% 10.88%
31.12.2008 242.1 2.18% 9.36%
31.12.2009 256.6 3.05% 12.39%
31.12.2010 315.5 1.87% 7.69%
30.12.2011 342.7 2.03% 8.95%
       
avg   2.54% 11.51%

The stock chart shows a very boring but steady developement since 2004:

Beta to the French CAC40 is an incredibly low 0.46. 10 Year performance for the stock is 7.53% p.a. against 4.11 for the CAC

Business model:

Other than Cranswick, LDC is actually producing a significant part of their own poultry as we can read on their website:

Supply
The acquisition of Group Huttepain enabled the LDC Group to become closer to its farmers and make sure that they felt closer to the upstream part of the business. The companies belonging to Group Huttepain operate in cereal collection, feed manufacture and poultry farming (chicken, turkey and duck). This live poultry represents 55% of the group’s entire supply.

So as a first thesis compared to Cranswick I would argue that

– LDC should be more capital intensive
– more exposed to cost pressure (animal feeds)

than Cranswick.

So let’s have a quick look at some capital metrics:

Cranswick LDC
  2010/2011 2011
Sales 758.3 2,774.0
NI 35.3 56.7
NI in % 4.7% 2.0%
 
Inventory 35.7 178.3
Receivables 78.7 343
Trade liabil- -84.9 -308
 
Net WC 29.5 213.3
In % of sales 3.9% 7.7%
 
PPE 123.3 421.6
in % of sales 16.3% 15.2%
Goodwill 127.8 164.1
 
Net WC+ PPE in % of sales 20.2% 22.9%
     
Net WC +PPE+GW in % of sales 37.0% 28.8%
 
 
 
Inventory / Sales 4.7% 6.4%
 
Depr. 12.44 80.9
Depr /Sales 1.6% 2.9%

So we can see that Cranswick is better in working capital management, whereas LDC has slightly less PPE than Cranwick. interestingly, LDC deprecates a lot faster than Cranswick, almost a fifth of their PPE whereas Cranswick deprecates a tenth of PPE.

This faster depreciation explains 1.3 % of the Margin difference.

Some other notable differences are:

– LDC has to spend ~22% of sales on salaries vs. 13% at Cranswick, so LDC’s business model is clearly more labour intensive.

Due to the significant depreciation, LDC’s Cashflow before investments is around 2.3 times net income compared to Cranswick’s 1.2 times. However LDC is investing back all the depreciation plus some into the business. This explains the tripling of sales over the last 10-12 years, however at a decreasing rate of return on capital.

Similar to Cranswick they move strongly into processed and packaged food.

Looking at the English language annual comments, the processed food part seems to be in difficulties (same as Tipiak and Toupargel), whereas the Poultry business itself seems to run quite well. Representing around 20% of sales, the convenience food actually produced a loss.

Unfortunately, they do not publish segment numbers, so we do not know how much capital is used by the convenience segment. However my assumption would be that the “pure” poultry business looks a lot better stand alone and might be comparable to Cranswick’s.

management & Shareholder structure

The company is majority owned by a couple of families, with the executive board recruiting only members form the different families. This is not necessarily bad, but implies that there will be no real change going forward.

Value Shop Sparinvest has a little position as well.

Summary:

LDC SA is a very steady company with a rock solid business model. Unfortunately,the convenience food business seems to be in some kind of trouble. Stand alone, the company looks interesting as a very defensive “Boss” investment, but in comparison to Cranswick it looks like the inferior business.

The company seems to “overinvest” especially looking at the diminishing returns on capital in the past few years.

For the time being, I will not invest but put it on my watch list. If they manage to turn around the convenience segment, I might consider an investment.

Bad research example: FT’s John Dizard and the Greek GDP linker

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I was quite surprised that my old Greek GDP warrant post got hit a lot in the last few days.

By coincidence I just saw that on Monday, a guy called John Dizard recommended the GDP linker as a “great bet on Greek long-term growth”.

You have to register in order to read the article online, but although its almost a half page in the print FFm supplement, the essence is the following:

– the Argentinian linkers were a great deal
– the Greek linkers are cheap (30 cents)

In my opinion, he makes some plain wrong statements like:

“The Greek GDP warrants could begin to pay out in 2015, based on the country having experienced a minimal recovery by then”

.

As I have mentioned in the post, Greece needs to hit the 2011 nominal GDP (in EUR) by 2014, to get any payout in 2015. In 2012, I think Greece is running at around -7%. So Greek needs nominal increases in GDP by at least north of 3.5% both in 2013 and 2014 to hit this trigger. I am not sure if this could be called a “minimal” recovery.

I am not sure what happens if Greece leaves the EUR, but I would assume that the Linkers would only pay if EUR GDP is triggered, not “new Drachma” GDP.

He then goes on and says the following:

“Right now they trade at about 32 or 33 cents, which means that is what you pay for the possibility of receiving one euro in 2015”.

Again, no points. The 33 cents represent the chance that you get any cash flow over the next 30 years. I am pretty sure that Mr. Dizard never really to bothered reading the prospectus, he will be busy writing his next “analysis”.

Finally he quotes a trader who says “the discount rate on future payments is just to high”. This is of course bullshit as well. Normal “non optional” Greek Government bonds trade at 20% yield p.a. If one discounts the cashlofs without taking the options into account, one ends up with a “bond equivalent” value of 3.28%. So you are paying at 33 cent an option premium” of 10% for the bond equivalent market value which is not cheap in my opinion.

Summary: So maybe it turns out that the Greek linker is a good investment. But if it does, it is certainly not for the reasons this genius has identified. My advice would be for people who want to speculate on Greece’s future to buy the GGBs instead. At 15% of nominal, they have enough “optionality” and upside in the good case. Or you buy shares like OPAP if you want to mitigate the Sovereign default risk. Optionality wherever you look.

Edit: At least the article moved the price up by 10-15% for the linker. This is the advantage of writing for the FT.

Idea generation: Shorting Luxury stocks

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This is an idea which I am contemplating for some time.

Coneventional stock market wisdom says: Chinese / Asians love luxury goods, therefore this is the safest bet to buy Luxury stocks who sell to the Chinese consumer.

As a result, many luxury companies had great runs intheir stock price, for instance:

LVMH

Boss

or Ralph Lauren

However up until now, I did not really no where a “catalyst” would come from. So switch to the brilliant John Hampton at Bronte who really nails it down with Richemont, the Swiss luxury group:

Swiss Watch exports have been increasing, as the Chinese really dig expensive watches:

It is the Rococo stuff that is winning. The Federation of the Swiss Watch Industry publish export data from Switzerland (not sales to end consumers). June data shows a 4.1 percent reduction in volume, a 21.7 increase in value. The average price of a watch is going up sharply. This has been the case for years. The Federation published this graph which shows that (relatively accurate) electronic watches have been flat in value for years – but that mechanical movements (inaccurate but reassuringly expensive) have gone skyward:

Although exports to Hong kong are still increasing strongly, sales seem to have stalled:

There are several data sources I watch to keep tabs on spending by Chinese elite. The Swiss Watch data is obvious.

Exports to Hong Kong in June were up 21.2 percent. It was about the same in May (but the monthly data has disappeared from the web). It was about the same every other month this year. They keep upping the exports to Hong Kong.

But Hong Kong also has sales tax data which comes from the sales tax receipts. There is in the data a series for “Jewellery, watches, clocks and valuable gifts” by both value and volume. The value series – relatively flattering, has monthly sales (versus previous corresponding period) for the last six months as:

+18.3%
+14.1%
+18.4%
+15.1%
+2.9%
+3.1%
Sales growth stopped. However exports to Hong Kong kept up (note that 21.2 percent figure above).

John Hempton is not a guy who would short such a share because of date, he needs a real reason and this is the following:

have a theory given to me by a China watcher. The theory – it turned bad sharply with the ouster of Bo Xilai and now the murder charge on his wife Gu Kailai. Gu Kailai is going to have a hard time avoiding a mobile execution unit. This changes the stakes and it is structural. A half million dollar watch no longer says “look at me”. It says “look at me, I am a kleptocrat”. Thoughts of that beautiful Van Cleef and Arpels hair clip become the last thing that runs through your brain before the bullet.

And he can prove his theory with the example Brazil in the 80ties and 90ties:

We know what a completely collapsed luxury good market looks like. Brazilians like a bit of bling. But in the late 1980s and into the 1990s the kidnapping rate in Brazil went skyward. (There is an horrific documentary about that called Manda Bala which translates “send a bullet”.) After kidnapping became a major industry (particularly in São Paulo) carrying a $3000 handbag no longer said “look at me”, it said “kidnap me”.

Two other data points in the recent weeks show that maybe the Chinese consumer might be (for any reason) a little biut more cautious:

– Sales at Sand’s Chinese casinos disappointed strongly

– and even McDonalds announced that same store sales in China fell

For me, such company news are much more reliable than any Chinese Government statistics.

Let’s quickly look at Richemont:

The stock price ist still below its 2008 highs:

The stock doesn’t look so expensive either:

Trailing P/E 16,6
P/B 2.8
P/S 2.9
EV/EBITDA 9

is not that expensive for a stock with a 17% profit margin and 20% ROIC, a very conservative balance sheet with no goodwill and net cash. Even mean reversion would support current levels. 10 year average net margin is 20%, only 10 year average ROIC is “only” around 10%.

A much more interesting short candidate might be Boss.

Boss is more expensive

Trailing P/E 17.3
P/B 11.9
P/S 2.4
EV/EBITDA 11.5

and 10 year avg. profit margin is 8.6% against current 13%.

Still, I would prefer to short luxury shares with aggressive accounting, but I have to dig a little bit deeper for this.

And do not forget: Luxury sales in Europe are bad anyway and as Coach shows, even the US is not “an island” with regard to luxury sales.

Summary:

I guess shorting Luxury stocks might be an interesting idea at some point in time. I wouldn’t short Richemont, as this is really one of the rock solid companies, but other candidates might be more interesting. Preferably with aggressive accounting and US / Europe exposure.

Mapfre SA (ISIN ES0124244E34) – LatAm “pearl” hidden under PIIGS cover?

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Mapfre SA is THE Spanish Insurance company.

The stock used to be a “star performer” in the past, but suffered from the PIIGS crisis and is now back at 2009 lows:

As many financial companies based in the PIIGS countries, the stock looks relatively cheap:

Market Cap: 4.6 bn EUR
P/E trailing 5.4
P/B 0.65 (Tangible 2x)
P/S 0.2
Dividend Yield 10.4%

Well known problems include:
– ~50% of the premium income is from Spain (market leader with 20% market share)
– of course large PIIGS exposure (~8 bn EUR in Spanish Govies alone)
– Tangible book still lower then stock price (Tangible book is the main criteria used by many insurance investors like Berkowitz)
– Spain is “toast” anyway (current genreally accepted wisdom)
– Troubled bank Bankia is 15% shareholder of Mapfre (and cooperation partner)
– Mapfre has a majority shareholder, take over is highly unlikely

However if one looks more closely at Mapfre, some very interesting points can be identified:

+ Mapfre is mostly a Property and Casualty insurer, which means that the underlying insurance business is not directly affected from the financial crisis

An interesting fact about motor insurance and crisis: When times are bad, people tend to drive less miles with their car and use public transport more often or stay at home. This means that fewer accidents happen and insurers have to pay less claims. A pretty countercyclical business.”

+ Mapfre has something, most other insures don’t: Strong growth !!! Even in the first 6 months 2012, premiums increased more than 10% yoy, despite decreases in the Spanish home market

+ this leads us to the second point: Mapfre’s Business is increasingly international. In the first 6 months in 2011, the split of Spain/Non-spain was 50/50, it is now 30% Spain and 70% international.

+ Mapfre is market leader or in the top 3 in most Latin american countries, most notable they have 20% market share in Brazil and 10% in Mexico.

+ using market multiples, the Brazilian and Mexican subsidiary could be worth more than Mapfre’s market cap

Margin of Safety ?

The big question for anyone who wants to be a “Value Investor” is the question: Is there a margin of safety, or more precise, if there is a haircut in Spain, will I lose money ?

In my opinion, the possibility to lose money PERMANENTLY is relatively small even in a haircut scenario medium and long term due to the following facts:

1. Mapfre is the Spanish market leader an Insurance regulation is complex. So if Spain would really haircut its bonds, I would assume that the regulation would be adjusted so that Mapfre will not need to use a lot of new capital. So dilution risk is relatively low comapred to banks.

2. In contrast to the banks, an insurer is normally not forced to sell “underwater” assets, as the policy holders cannot easily demand their money back.

3. Even in the case of a capital requirement, Mapfre could sell minority shares in its LatAm subsidiaries to rich locals (Carlos Slim anyone ?) and easily raise money, one needs only to look at EDP from Portugal.

4. Especially in its home market and in its major LatAm operation, Mapfre has a strong “Moat” due to established sales channels and economics of scale

So yes, this will definitely be a very volatile future for Mapfre, but I am pretty sure that they will survive even a Spanish Haircut despite the relatively high “gearing” towards Spanish Sovereign bonds.

One of the short term risks will be that they might cut their very generous dividend at some point in time like Telefonica, but as in the case of Telefonica, this might be already included in the current stock price.

Sum of part Valuation:

I will do this very “quick and dirty”, just to show the potential:

Spanish business:

There is one “pure play” Spanish competitor with a similar business mix, Grupo Catalana Occidente (ISIN ES0116920333). Their comps look as follows:

P/S 0.4
P/B 1.0
P/E trailing 6.4

If we use P/S as the simplest multiple, Mapfre’s domestic business based on 2011 premiums of 7.8 bn EUR would be worth 3.1 bn EUR
International business:

For Brazil, Mexico Chile and Colombia (the most attractive LatAm countries) , I would use a P/S multiple of 1.0, for all the other Lat Ams a multiple of 0.5 which results in 5.9 bn EUR market value of the LatAm ops.

For 2 bn “international” premiums (US, Turkey, Portugal) I would use a 0.4 premium multiple, adding a further 0.8 bn EUR

From the 4.2 bn other international businesses, I would value the attractive Assistance business with a multiple of 1, the rest with a 0.4 multiple. This adds another 2 bn .

This results in a total sum of part value (before liabilities) of 11.8 bn EUR. I have identified around 2.5 bn EUR financial liabilities at a quick glance, so this would result in a business value of 9.3 bn EUR or ~3.20 EUR per share based on current multiples for the Spanish business, without taking into account market leadership etc.

LT2 Bond

As an alternative to the stock, Mapfre has also an interesting LT2 bond outstanding (ISIN ES0224244063). The bond has a 30 NC 10 structure, which means that for the first 10 years since issuance (until 2017) it pays a fixed coupon and then changes into a floating rate.

LT2 means that coupons could be deferred but are cumulative.

The bond has a 5.921% fixed coupon and trades around 60%, which would translate into a 19% yield p.a. if Mapfre calls in 2017. YTM would be 9.4%.

Summary:

MApfre SA is an interesting way to speculate on a Spanish recovery. The long term Margin of Safety comes from the value of the LatAm business which is profitable and still growing strongly. Although it is not likely at the moment, a sale or spin off of the LatAm subsidiaries could unlock the “real” value of the stock.

As the stock will be very volatile going forward, I will “scale in” for the portfolio over the next 10 days up to an 2.5% position (0.25% per day) with a limit of 1.50 EUR per share.

Dart Group – Follow up on fuel hedging and comprehensive income

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As proposed in the last Dart Group post, I wanted to take a better look at the impacts on fuel hedging.

Quick summary (or spoiler): During writing the post, I got less and less sure of what to do with the fuel hedges, so the post got very long without a satisfying end. If you are not interested in the process and accounting details, the result is: I am not sure.

Let us start with a “accounting refresher” first.

Accounting for Cash flow hedges

Dart Group uses “cash flow hedges” for their fuel hedges. What does that mean ? Normally, any derivative financial instrument would be considered a “trading instrument” and would have to be marked-to-market directly through P&L.

If a company however wants to hedge a future cashflow (doesn’t matter if in- or outflow) one can apply a technique called “cash flow hedging” which requires basically two things

1) one is able to predict future cashflows with a reasonable accuracy
2) one uses a heging instrument which is “efficient” i.e. tracks the value of the hedged

If one achieves “cash flow hedging” treatment, then the hedge will treated in the balance sheet (under iFRS) the following way:

A) the value changes in the derivatives can be recorded under “OCI” (other comprehensive income)
b) in the future, when the cashflow actually happens, the corresponding hedging gain or loss will then be added or subtracted from the then realised spot price

This is what Dart Group is doing with its fuel hedging and as Wexboy commented fully aligned with accounting standards.

However my argument was that you shouldn’t ignore those movements in OCI but try to understand them and make adjustments if necessary. In order to understand this better, we have unfortunately step beck a little bit and ask the following question:

What is a hedge anyway and when is a hedge a speculation ?

In the case of Dart and airlines in general, this question is quite difficult to answer. In an ideal world as a company, you would like to pass on all your changes in costs directly to your customers and just earn a fixed fee on your products. As we all know, prices on tickets are relatively volatile, however many clients prefer to fix a price well before they start a trip in order to be able to control their budget.

An airline could also, if they were really really good speculators, create a big competitive advantage if they for example could hedge their fuel at low prices while the competitors have to buy much more expensive fuel on the spot markets if prices are rising. However, this is clearly speculation, not hedging as it could go the other way as well.

accounting wise however, one does not distinguish between “economic” hedging and what I call speculation.

So let’s look at Dart Group.

First step: READ THE ANNUAL REPORT

Before one starts to speculate how and what Dart is hedging, it makes sense to look at the annual report to find out what they are actually saying.

On Page 21 of the 2011 report they give us the following information:

2011 2010
Average hedged Price per ton $ 870 786
Percentage of estimated annual fuel requirement hedged for the next financial year 91% 90%

So we know now, that they have hedged ~90% of ALL fuel requirements according to this and we know the price.-

On page 67 we can look at fuel costs (in GBP):

2011 2010
Fuel Cost 122.8 95.3

On page 57 we can see the fair values of the fuel hedges, both an the asset and liability side:

2011 2010
Fair value Assets Forward jet fuel contracts 55.9 16.4
Fair value Liabilities Forward jet fuel contracts -17.8 -8.7
 
calc net Fair Value 38.1 7.7
Delta yoy 30.4

On page 58 we can see that in 2011, none of the fair value movements have been recorded in equity, we can also look at the total fair value movement of the ALL hedges (including currency) which were

2011 2010
Fair value Assets all hedges 59.4 21.7
Fair value Liabilities Forwardalll hedges -24.7 -9.7
     
calc net Fair Vlaue 34.7 12
Delta yoy 22.7

So basically, fuel hedges increased by ~ 30 mn GBP in vALue, FX hedges lost ~ 8 mn GBP

On page 61 they give us another interesting piece of information:

2011 2010
Impact on Profit and Loss 10% change in jet fuel prices 3.8 0.8
2011 2010
     
Profit for the year 17.3 15.6
Exchange differences on translating foreign operations 0 0
Effective portion of fair value movements in cash flow hedges 23 10.6
Net change in fair value of effective cash flow hedges transferred to profit -1.8 0.1
Taxation on components of other comprehensive income -5.2 -3
Other comprehensive income and expense for the period, net of taxation 16 7.7
Total comprehensive income for the period all attributable to owners of the parent 33.3 23.3

One important final piece of information:

Prepayments or “deferred income” stood a 177 mn GBP against trailing sales of 540 mn GBP.

So how to interpret those numbers ?

A) as the hedges seem to qualify almost completely as “cashflow hedge”, we can assume that they use “traditional hedges” like forwards or (tight) collars to hedge

B) IMPORTANT: Dart Group “hedges” 90% of next years fuel prices, but only 177/540 = 32% of (trailing) sales are prepaid. So one could argue that in order to “truly” hedge, Dart should only hedge a third of next year’s fuel consumption as for the rest, the final sale price of the tickets is still variable.

If the competitors don’t hedge, than Dart would have locked in potentially different fuel prices than the competition for 60% of next years fuel consumption and therefore run the risk of being uncompetitive if fuel prices fall.

So coming back to the initial question: What are we going to do with the change in value in OCI for dart Group ?

I have to say I am not sure anymore. I am oK with “ignoring” the part that is covered by deferred income but I honestly don’t know what to do with the part which is “speculation”.

I have quickly checked Ryanair’s latest statements and Easyjets last annual report.

While Ryanair similar to Dart seems to hedge 90% of next years fuel cost, Easyjet only hedges 65-85% of next years fuel charges and 45-65% of the costs in 2 years time.

Ryanair interestingly said that increasing fuel prices were responsible for a 29% profit decline. That sounds strange as they were supposed to be 90% hedged. Interestingly, fuel prices for Jet fuel decreased strongly in Q2, so the problem for Ryanair seem to have been locking in high fuel costs whereas some competitors were able to buy cheaper fuel in the spot market and compete better on ticket prices.

Bloomberg even compiles hedging ratios across companies:

Jet Fuel Hedging Positions for Europe-Based Airlines (Table)
2012-07-30 07:46:25.103 GMT

(Updates with Ryanair.)

By Rupert Rowling
July 30 (Bloomberg) — The following table shows the amount
of jet fuel consumption hedged by European airlines to guard
against price fluctuations.
Data is compiled mainly from company statements and is
updated as it becomes available. Hedges are for prices per
metric ton of jet fuel, unless otherwise stated.

*T
Company/ Percent Hedging Period Price
Disclosure Date Hedged
————— —— ————– —–

Ryanair Holdings Plc
7/30/12 90% July to Sept. 2012 $840
7/30/12 90% Oct. to Dec. 2012 $990
7/30/12 90% Jan. to March 2013 $998
7/30/12 90% April to June 2013 $985
7/30/12 90% July to Sept. 2013 $1,025
7/30/12 90% Oct. to Dec. 2013 $1,005
7/30/12 90% 2013 $1,000
7/30/12 50% Jan. to June 2014 $940

EasyJet Plc
7/25/12 85% Three Months to Sept. 2012 $983
7/25/12 79% Year to Sept. 2012 $964
7/25/12 77% Year to Sept. 2013 $985

Air Berlin Plc
5/15/12 82% April to June 2012 Not Given
5/15/12 92% July to Sept. 2012 Not Given
5/15/12 61% Oct. to Dec. 2012 Not Given

International Consolidated Airlines Group SA*
5/11/12 80% April to June 2012 Not Given
5/11/12 69% July to Sept. 2012 Not Given
5/11/12 55% Oct. to Dec. 2012 Not Given
5/11/12 55% 12-month forward Not Given

Vueling Airlines SA
5/10/12 76% 2012 $1,023
5/10/12 71% April to June 2012 $1,008
5/10/12 83% July to Sept. 2012 $1,035
5/10/12 74% Oct. to Dec. 2012 $1,042
5/10/12 28% 2013 $1,027

Air France-KLM Group
5/4/12 60% April to June 2012 $1,081
5/4/12 53% July to Sept. 2012 $1,081
5/4/12 50% Oct. to Dec. 2012 $1,078

SAS Group
5/3/12 50% April to June 2012 Not Given
5/3/12 49% July to Sept. 2012 Not Given
5/3/12 48% Oct. to Dec. 2012 Not Given
5/3/12 50% Jan. to March 2013 Not Given

Aer Lingus Group Plc**
3/29/12 62% 2012 $972
3/29/12 7% 2013 $991

Deutsche Lufthansa AG
3/15/12 74% 2012 $107/barrel
(Brent crude)

NOTES:
*Hedging breakeven for 2012 at $1,003 a ton, according to May 11
presentation.
**Aer Lingus figures as of Dec. 31

Summary:

To be honest, I am not sure what to do with the fair value movements in OCI. To simply ignore them and assume mean reversion would be very naive. The extent of the movements is just too large. However the impact of the fuel hedging is difficult to estimate as it depends on the behaviour of the competitors.

In general, a positive movement in fair value should be positive for the company and vice versa. nevertheless, the whole fuel hedging issue exposes Dart to quite substantial business risk, especially for the part which is not covered by deferred income.

However, this exercise made it clear to me that running airlines is a quite difficult business, especially in times of volatile fuel prices.

For the time being, I will stick with my half position and try to learn more about it.

One technical remark with regard to hedging:

In the “good old times”, fuel hedging could be done without cash collateral. A bank would happily “step in between” the airline and the futures market and only require cash at settlement of the contract.

As one of the consequences of the finanical crisis, every bank now requires cash collateral on a short term basis from the airlines for the fuel hedging contracts. For the airlines this means a significant increase in reuqired working capital. Lufthansa et al are lobbying strongly against this, but especially for smaller carriers this is a problem.

As a proxy I would use 25% of the notional as working capital requirement for fuel hedges. For Dart this would mean that 25% of around 150 mn GP or 40 mn GBP of Dart’s liquidity should be considered as “locked” for fuel hedging cash collateral.

Red flags for investments: “Transformational” acquisitions – Example Walgreen

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Walgreen is one of the few large US stocks which looks good on my “Boss” Screen, with a consistently high ROE and low volatility. So I put it on my “priority” research to do list.

However,last week I dropped them from the list because of this.

Pessina had already hinted that his preferred exit would be via another merger rather than a fresh stock exchange listing: “If you do an IPO, you create financial value,” he said. “If you do a transformational deal, you create financial value and industrial value.”

Firstly, it is interesting that the seller makes this quote. Clearly, for him it was transformational as he transforms himself financially into a billionaire.

Secondly, if we look at some big “transformational deals in the past, we see that many of them fail.Some well known examples:

Daimler Chrysler
AOL Time Warner
RBS ABN Amro (Fortis, Santander, my all time favourite. everyone involved got screwed in the end))
Allianz Dresdner
Travelers Citicorp
Kraft cadbury
Vodafone Mannesmann

The list is endless. I actually don’t remember large “transformational” deals which actually worked well.

This aspect has not been unnoticed. A famous study by Bain showed that around 70% of large mergers fail:

Bain & Company M&A team leaders David Harding and Sam Rovit challenge the most common deal presumptions in Mastering the Merger: Four Critical Decisions That Make or Break the Deal (Harvard Business School Press, November, 2004) and found that while 70% of large deals fail to create meaningful shareholder value, 80% of the Fortune 100 companies have relied on mergers and acquisitions to fuel their growth over the past two decades.

The reasons are stunningly simple:

Bain examined over 50 case studies, analyzed 15 years of M&A data and surveyed 250 CEOs and senior executives about real-world successes and failures. They found that the top three reasons deals derailed were:

1. Ignored potential integration challenges (67%)

2. Over-estimated synergies (66%)

3. Had problems integrating management teams and/or retaining key managers (61%)

If we look at this article, Walgreen seem to rely heavily on point 2:

The deal will lead to cost and revenue benefits across both companies of $100 million to $150 million in the first year and $1 billion by the end of 2016, according to the statement.

Back to the Bain study. They identified a few critical success factors:

— Frequent acquirers outperform the pack – the more deals a company made, the more value it delivered to shareholders; the “frequent acquirers” outperformed the “never-evers” by a factor of two

— Frequent acquirers buy in good times and bad – frequent acquirers that bought constantly through both tough economic environments and boom times outperformed those that bought primarily in growth periods by a factor of 2.3; they also outperformed the “recession buyers” by a factor of 1.4

— Most successful dealmakers start small then ramp up – firms that focused on small deals on average outperformed those that made big bets by a factor of almost 6

In my opnion, Walgreen is unfortunately a very infrequent acquirer, to my knowledge it is the first acquisition outside the US and they only made one other acquisition in the US in the past few years. It rather looks like a desperate move to counter shrinking business in the US, which is never a good motivation to do a deal.

So despite the low valuation of Walgreen, this acquisition is definitely a “red flag” for any investor, as the chance for a positive outcome seems to be very low. However it looks like a great deal for KKR and Mr. Pessina. If you think about this, KKR and Pessina bought at boom prices in 2007 and seem to at least double their money after 5 years.

An additional remark on international expansion from retailers:Two of the best retailing companies of the world, Walmart and Tesco found out the hard way how difficult it is to transform local cometitive advantages into international markets. Walmart for instance failed in Germany, Tesco is still struggling in the US. As Bruce Greenwald said in “competition demystified”: All competitive advantages are local.

Summary:

Based on historical numbers, Walgreen would look like an interesting “Boss” investment. However the large acquisition completely changes the picture. As outlined above, the success rates of such “transformational” acquisitions are 30% or lower. And historical numbers do not not ho
ave a lot of predictive power in such situations.

So without any special insider knowledge, one should generally stay away from such stocks which in my case would also be the advise for Walgreen.

Sure it can work out, but the odds are strongly against a positive outcome.

How to correctly calculate Enterprise Value

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After all that heavy macro stuff, back to the nitty-gritty world of fundamental analysis.

Let’s have a look at Enterprise Value, which as concept is gaining more and more attention, among others famous “Screening guru” O’Shaughnessy has identified Enterprise value as the most dominant single factor in his new book. Also a lot of the best Bloggers like Geoff Gannon and Greenbackd prefer EV/EBITDA

Interestingly many people seem to just use and accept the “standard” Enterprise value calculation.

How to calculate standard Enterprise Value

Investopedia has the “normal” definition of Enterprise Value:

Definition of ‘Enterprise Value – EV’
A measure of a company’s value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

Investopedia also offers an interpretation

Investopedia explains ‘Enterprise Value – EV’
Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company’s debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm’s value. The value of a firm’s debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.

So this is a good hint how to understand Enterprise Value: It originates from take-over valuation, most prominently from Private Equity investors or “old style” corporate raiders.

How to UNDERSTAND Enterprise Value

The private equity / Raider business in principle is relatively easy: You buy a company (or achieve full control) and then in a first step you extract all existing cash and/or assetswhich are not necessary to run the business from the company. In a second step, the corporate raider will then put as much debt onto the target company’s balance sheet and let it pay out as a dividend or capital reduction.

The more the Raider can get out quickly either as excess cash or as a “dividend recap” (short form for a debt financed dividend) the higher the return on investment.

The first important aspect: Excess cash OR excess assets

As I have written above, a raider of course likes best plain cash lying around. On the other hand, the raider will happily sell anything which is not really required to run a business and pocket this cash as well. However mechanical screeners will only capture cash on the balance sheet, not any “extra assets”.

A good example is my portfolio company SIAS. Their EV/EBITDA decreased strongly because the “exchanged” their extra asset in the form of a South American minority stake into cash. Another “extra Asset” company would be EVN with its Verbund stake.

Including the Verbund stake, EVN looks quite expensive at EV/EBITDA 8.3 (EV ~ 4 bn, EBITDA ~ 500 mn) against 5-6 EV/EBITDA at RWE and EON. However if we deduct the “extra asset” of 25% Verbund (~1.6 bn EUR) from the 4 bn EV, we suddenly end up with an EV/EBITDA of <5, a lot cheaper for this very conservatively run utility company.

In my experience, it is much more interesting to find companies with extra assets which don't show up as cash on the balance sheet. This was mentioned before as favorite technique of value legend Peter Cundill.

Next step: What to add to Enterprise Value

So its pretty clear that the less debt a company has the more a PE/raider will be willing to pay.

But it is also important to understand, how the capacity to put debt into a company is determined. Especially in the US, the debt will be put into the target in the form of corporate bonds. In order to sell them, you need to have a rating.

The lower the rating the more expensive the debt. In practice, raiders will try to achieve a BB rating as this is usually the “sweet spot” before bond spreads go up dramatically.

Rating agencies have relatively simple ratios to determine maximum debt loads within a certain rating category, however the most important point is this one:

Rating companies add additional items to determine debt capacity which are:

– pension deficits or unfunded pension liabilities
– financial and operating leases (capitalised)
– any other known fixed payment obligations (cartel fines, guarantees etc.).

Economically, those items are very similar to financial debt which is usually included in the EV calculations, as they represent fixed payment obligations which sometimes (like pensions) even rank more senior than debt.

It is therefore no wonder that with a “standard” EV/EBITDA screener, often UK retail companies with huge (underwater) operating lease and pension commitments show up as “cheap” and then people are surprised that they go bankrupt soon (Game Group anyone ?).

Special case: prepayments

Prepayments are an interesting feature of some business models, among other for instance at Dart Group.

Normally, a company produces its goods first and then sells them again receivables until cash is then finally collected. In the case of prepayments, cash comes first in against a payable and the good gets produced at a later stage and then delivered with no further cash inflow to the customer. If the prepayments do not carry any formal restrictions, the company in theory can use the cash for whatever it wants. So for instance if a company can finance inventory out of payables, the prepayment cash could be used to finance even machinery or to reduce financial debt. So to make a long story short: cash from prepayments without formal restrictions should be considered “free cash” and deducted from enterprise value.

How to calculate Enterprise Value correctly:

So now we have all ingredients to correctly calculate Enterprise Value:

a. Equity Market cap
PLUS
b. Financial debt (long + short term)
PLUS
c. minorities, preferred
PLUS
d. financial leases and operating leases
PLUS
e. pension deficit or unfunded pension liabilities
PLUS
f. any other fixed liability which has to be repaid independently of the business success

MINUS
g. cash or cash equivalents
MINUS
h. “extra assets”, assets not required to run the business

Of course, EBITDA has to be adjusted as well in order to make usefull comparisons.

Basically we have to add back leasing expenses and pension expenses to EBITDA in order to compare the ratio against other companies.

Summary:

Standard screening EV/EBITDA does omit various relevant elements of an “economical” Enterprise value. Adjusting it for relevant items will prevent an investor to end up with relativ obvious value traps.

I am willing to bet that a back test on the adjusted EV/EBITDA ratios would generate even better results than the “standard” EV/EBITDA calculations.

Quick check: Cairo Communication (ISIN IT0004329733) – 12% dividend “wonder” or liquidation ?

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A reader pointed out that Italian company Cairo Communciations might be an interesting investment.

Company description per Bloomberg:

Cairo Communication S.p.A. carries out its activities in the communication field as an advertising broker for a variety of media, such as commercial television, analog and digital pay television, press, and the Internet. The Company also publishes magazines and books and operates an Internet portal through its own search engine, Il Trovatore.

Cairo looks relatively cheap on an earnings basis (2011):

P/E 8.5
EV/EBITDA 4.5
P/S 0.7
P/B 3.13

The company doesn’t have any debt but significant net cash (0.70 EUR per share against a share price of 2.56 EUR).

ROCE and ROE are both above 30%, so is this a value investor’s wet dream ?

Cairo is listed since 2000, so let’s look at some figures from the past:

BV Sh EPS DPS NI Margin Sales pS ROIC
29.12.2000 1.62 0.09 0 5.6% 1.5348 3.03%
31.12.2001 1.70 0.08 0 4.8% 1.7509 2.84%
31.12.2002 1.73 0.07 0.04 4.7% 1.5929 1.93%
31.12.2003 1.72 0.07 0.24 3.8% 1.7299 2.74%
31.12.2004 1.65 0.09 0.16 3.6% 2.3745 3.54%
30.12.2005 1.58 0.08 0.16 3.5% 2.3161 3.81%
29.12.2006 1.19 0.15 0.30 0.0% 2.7983 7.74%
31.12.2007 1.11 0.15 0.25 5.4% 2.9956 11.34%
31.12.2008 0.91 0.17 0.40 5.6% 2.9527 14.22%
31.12.2009 0.86 0.16 0.20 5.3% 2.9259 15.12%
31.12.2010 0.90 0.27 0.20 8.3% 3.2273 27.67%
30.12.2011 0.82 0.30 0.40 8.3% 3.6192 31.81%
             
Total   1.67 2.35    

The numbers look really interesting. On the one side, it looks like a liquidation, with dividends being constantly higher than earnings. On the other hand, Cairo managed to more than double their sales with almost half of the equity and at the same time increase their margins to a healthy 8%.

Together, this of course leads to a dramaticv increase in ROE and ROIC.

Interestingly the stock price hovers only slightly above the post internet bubble prices:

Summary:

I think this really looks interesting and worth a deeper look into the drivers of the sales increase and profitability development. If this would be “sustainable” then Cairo might indeed be an attractive opportunity.

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