value and opportunity

Bronte on Lululemon

Nate at Oddball Stocks has a post on German Graham net-net 3 U

Great post about accrual accounting at Old School Value

Lavish pay packages at Walmart ? Something to watch.

Must read: FPA Crescent Q4 letter

Good post from Stephan on Adler real estate

Self publishing books seems to be realtively easy these days

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.

Historical profitablity

	NI Margin	ROIC
2001	1.4%	1.2%
2002	3.8%	5.5%
2003	4.9%	6.6%
2004	4.8%	5.1%
2005	3.6%	7.2%
2006	6.4%	7.8%
2007	5.9%	5.9%
2008	7.9%	8.0%
2009	8.4%	6.2%
2010	3.5%	7.7%
avg	5.1%	6.1%

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:

	shares mn
2001	11.2
2002	11.2
2003	21.9
2004	25.2
2005	36.6
2006	54.9
2007	55.6
2008	55.7
2009	61.3
2010	61.3

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.

Quick valuation:

Asset Value
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.

Reader Snapple made some interesting comments with regard to the DJE fund and also published an analysis here.

Also, reveller pointed to some interesting facts. For my own model, the most interesting points are:

– DJE used lower values for problem funds than stated NAVs, so my discounts might be too conservative. Snapple also linked to a article which stated that ALL problem funds have been valued below official NAVs. However, based on the half year report, this was only true for the P2 Value funds whereas the TMW Welt and the Axa were valued at official NAV.

– the ABN Henderson Fund certificate matures in 2012, so one could assume complete payback in 2013.

– real estate stocks are 7.7% of the portfolio as of year end, cass 5.6%

However, this didn’t really change much in my model. As Snapple calculated in a slightly different way, 50% of the NAV might be paid within the next 12 months.

For the portfolio, I will increase the purchase limit to EUR 5,50 EUR, as so far I was not able to purchase a lot at prices below 5.40 EUR.

from the last 2 weeks:

Good post about Eddie Lampert and Sears

David Einhorn Greenlight Q4 letter

Some timeless gems of investing wisdom from Eddie Elfenbein

Wexboy tries to value ALL Irish shares

Phantastic 222 year interest rate chart from Barry Ritholz

Uberguru Klarmann invests in Samchully (Korea). Tweedy Brown is also invested. Looks interesting.