Portfolio Update

I have taken a small position in Unitek Global Services. It's messy, this one. I'll write it up over the weekend.

Portfolio Update

I'm out of Precia with a 17.4% gain (8.1% from share price, 2.2% from the dividend and 4,9% from the exchange rate effect) which is well below the returns from the index (pick one, it doesn't matter much). 

It's still inexpensive, though (like GEA SA) it requires more patience than I am able to muster, especially with some interesting names reporting over the next few days.

I suspect that I'll circle back to it at some later date.

Portfolio Update

Reduced Hawaiian a little and picked up some more Northgate with the proceeds

Silverdell

This is what I saw when I looked at Silverdell a few months ago:

Reinvesting capital that costs 10% in order to earn 2.31% returns is an unhealthy practice.

Emeco's Downside

What will happen to Emeco’s valuation if there’s a material, permanent slowdown in mining activity?

It will reduce its inventory of equipment and shrink its working capital needs, thereby generating increased free cash. If revenue falls by 15% a year between now and 2016, the free cash flow schedule, at more or less 80% utilization and 36 days of working capital, will look like this:

Doesn’t this assume an orderly liquidation?

Yes, it does and for a number of reasons:

(1) Emeco is more exposed to mining operations than to mining capex (and therefore more exposed to commodity supply than to commodity prices);

(2) Under conditions of commodity price uncertainty, the benefits of leasing v. ownership are brought into sharper relief;

(3) Emeco is exposed to thermal coal (with its blue-chip customers themselves operating under long-term supply agreements with Japanese, Korean and Chinese buyers) as well as to gold, iron ore, oil, and civil construction;

(4) Emeco’s used equipment holds its value well, reselling at 15% above book value even in 2009;

(5) Pressure in the Australian rental equipment market will squeeze out smaller players first, thereby stabilizing rental rates somewhat;

(6) Oversupply of heavy equipment will shrink the supply of new equipment first, thereby cushioning the resale market from the effects of a sharp downturn in mining activity;

(7) Emeco’s fixed operating costs amount to ~$48 million, or 8.5% of current revenue, meaning that expectations of heavily negative operating leverage in case of a fall in revenues are misplaced;

(8) Emeco management’s incentive pay is structured around ROIC and share price which leads one to believe that the company will attempt to (a) reallocate existing equipment to more productive uses, (2) shed equipment at attractive prices, and/or (3) repurchase its shares at attractive prices;

(9) Three and six months ago, with the same information available to them then as we have now, the company was repurchasing a material number of shares at $0.53.  

Why does this opportunity exist?

My best guess is that the market has lost sight of Emeco’s place in the mining value chain, has overstated its fixed cost base, and has underestimated its cash flow levers. The Indonesian contract dispute has served up a profit warning that was perfectly timed to reinforce the market’s assumptions about its business.  

I am sometimes wrong but almost never in doubt so, as always, please do your own research.

Disclosure: I am long Emeco

Northgate's 2013 Results

Northgate  reported its FY 2013 results todays The company incurred a £54 million charge in order to reduce its interest expense from 7.1% to 2.8% . The lower interest charge translates into $20 million in additional annual after-tax cash flows to equity.

Here’s its free cash flow history:

Here’s what its valuation looks like:

Corrected:  July 9th

This is how I arrive at 700p:

Disclosure: I am long Northgate

More on Emeco Holdings

Some things it is helpful to know about Emeco:

“A large part of our sustaining capex is the replacement of machines at the end of their useful life. We can therefore naturally contract certain asset classes within our fleet where we see lower demand for them over the medium term and use the cash to retire debt. I refer to this as “right sizing” the balance sheet to the earnings of the business through the cycle.”

and

and

And a long presentation by the CEO here.

Disclosure: I am long Emeco

Portfolio Update

I’ve bought some shares in Emeco Holdings at ~AUD 0.310 (or <2x trough FCF). 

Epicentre Holdings

Epicentre Holdings is a Singapore-listed “Apple Premium Reseller”: it retails Apple products and third party accessories (iPad covers, speakers, etc) in Singapore and Malaysia.

Longer videos featuring the CEO are here and here

The business model is simple enough: pull people into one’s stores by offering Apple products at a slim margin and make one’s money on the accessories, the after-sales service, and so forth. Not complicated and there are probably only three ways to muck it up: (1) People no longer like Apple products; (2) Apple decides to sever its relationship with Epicentre; (3) the Singapore Dollar takes a nosedive.

The last of these is, for our purposes, the item of interest. The USD has appreciated against the Singapore dollar. Since Epicentre buys its Apple-branded inventory in USD,  its gross margins on Apple products have nosedived, turned negative, and made their effects felt all the way down the income statement. Plunging earnings, plunging share price.

Epicentre has now negotiated an arrangement with Apple whereby its Singapore operations (80+% of revenue) may now buy Apple-branded inventory in Singapore dollars. Its Malaysian operations (<20% of revenue) will continue to buy in USD.

The upshot is that gross margin should improve by a minimum of ~3.6% and that the earnings margin should therefore improve to a minimum ~4.0% .  A 4% net income margin on SGP $180 million translates into an earnings yield of ~41%. And, since Epicenter pays out 85%+ of its earnings, it seems reasonable to expect a forward dividend yield of 35%.

There are some other factors that justify more upside to the valuation – the announced exit from the loss-making presence in PRC, immature new stores in Malaysia, investments in “customer-centricity” that have been expensed – but these are immaterial to the investment case at the current share price.

The shares are illiquid and any buyers will be competing with the company itself.

Disclosure: I am long Epicentre and intend on buying more shares.

ConscienceFood Holding (Continued)

So, what’s going on?

The dirty shop window: It’s hard to see what’s on offer unless one actually reads CSF’s quarterly and annual reports. The financials, as reported, look like this (give or take some minor rounding errors):

The notes to the financials and management’s discussion and analysis add the following information:

First, CSF had tried to make a go of adding snack noodles to its repertoire. But the demand for snack noodles just wasn’t there. The gross margins were thin or negative, the opportunity cost of using the production lines for snack noodles rather than for instant noodles were therefore high, and CSF stopped making them.

Second, CSF invested in, and opened, a factory and warehouse complex 30km from Jakarta in order to serve western Java. Soon after, however, that complex was subject to a major fire, causing Rp. 27 billion in damage to property and inventory and slowing production to 30% of what had been its capacity. In addition, an additional Rp. 11.6 billion in G&A expenditure was tied to that plant and that spending was therefore mostly unproductive in 2012. The factory should be up and running at full tilt in the second half of 2013. 

Third, CSF’s marketing and distribution costs rose by 84% in 2012 partly for the purpose of establishing a distribution system to service Western Java and partly to promote the full launch, in 2013, of its line of beverages. Capital spending also rose. These increased expenses and capital investments had little or no corresponding revenues in 2012, and margins and asset turns were therefore crushed:

So, as I say, that’s part of it. No-one likes to see such a steep collapse in margins and turns and, if one hasn’t read the filings and if one is also of the view that big is beautiful everywhere and every time (that, for example, Coke will see off Irn-Bru) then one will read in these numbers cause for alarm: this is just the start and it’s going to get worse; “reversion to the mean” and all the rest of it.

What else?

The custom in the Singapore exchange is for listed companies to pay dividends. It is so much the custom that it is quite normal for companies go public and pay out dividends in their first quarter of being listed.  Following this norm, the declared dividend policy in CSF’s IPO prospectus was 20% of earnings.  CSF paid out dividends in 2010 and 2011. But in 2012 it amended its dividend policy: henceforth it would pay dividends in the absence of capex claims on cash. In 2012 it didn’t pay out a dividend.

And these two overall factors – dirty windows, dividend policy – are the long and short of it. I don’t think that they add up to an enterprise yield of 30% but the market apparently does.

There’s a lot more to say – about the cup noodles and beverages, about CSF’s prospects in the Jakarta market, etc – but I’ll leave it at that. If you’re reading this and are interested in researching it further, you should know that the market for the stock is not as illiquid as it may appear: there are days when no shares trade and there are days when 600,000 shares change hands; it wouldn’t take a month to buy $100,000 worth.

Disclosure: I am long Consciencefood Holding

ConscienceFood Holding

Consciencefood Holding (CSF) is a Singapore-listed Indonesian company that makes and sells  just under a billion packs of instant noodles annually in Aceh, North Sumatra, Riau, Jambi, West Sumatra and South Sumatra.

Its sales in Aceh and North Sumatra account for half of its revenues and its market share in these two northernmost provinces of Sumatra exceeds 50%. In Sumatra overall, its market share is 30%. (At 50 million, Sumatra is as populous as England and more populous than California).

Which is nice because instant noodles are an Indonesian staple: its population consumes more of it per person than any people but the Koreans. (As a point of comparison, Americans eat 46 slices of pizza per person per year).

Indonesian consumers often buy instant noodles by the carton, each carton containing 40 packs.

Whereas CSF's position in Sumatra (and Northern Sumatra, especially) is strong, it is nevertheless a midget in the overall Indonesian instant noodle marketplace:  it operates in the shadow of the two giants of the instant noodle business in the country – Indofood CBP Sukses Makmur and Wingsfood – whose market shares in Indonesia overall are ~75% and 15% respectively

Indofood CPB’s “Indomie” brand, in particular, is so popular that “Indomie” is synonymous with "instant noodles" in much of the country. In the diagram below, pulled from an analyst report on Indofood CBP, “Alhami”, CSF’s principal brand and accounting for half its sales, doesn’t even merit a mention. (CSF’s national market share is, in fact, 4.5%).

Instant noodle brand share in Indonesia.

At first glance, this situation looks ominous: what chance does CSF have in defending its market share against a goliath like Indofood CBP and at what cost? And yet, the history of the instant noodle market in Indonesia points to an altogether more optimistic outlook for CSF.

Indofood’s market share in 1999 was actually 20% higher than it is today. You need wheat flour to make instant noodles, and Indofood had a lock on wheat flour imports and wheat flour milling; no wheat flour for anyone else, no competition. Deregulation in the aftermath of the “Asian crisis” of that period, however, meant the end for Indofood’s control of wheat flour and this, in turn, allowed other firms to contest the instant noodle market.

No wheat flour, no noodles.

Now, it seems to me that there are two very different ways to enter the market. The first way, available to deep-pocketed entrants, is to launch in Java and wage a very expensive price war with Indofood, imposing serious losses on Indofood and oneself, taking market share, and then calling a truce. This is the approach that Wings Group took and the four year (2004-2008) price war between Indofood’s “Indomie” and Wings Group’s “Mie Sedaap” – a Javanese cockfight, if you like – is a celebrated episode in recent Indonesian business history. The unofficial terms of the truce? Indofoods sets the prices and Wings Food matches it. It's been that way since late 2008.

The other way, of course, is to focus on a niche: pick your geography and demographic; develop, test, market, and launch products for that demographic; build a dense distribution system (Makro, Carrefour and Hypermart; mini-marts, wet markets, and neighborhood grocery stores); and let local economies of scale and brand habit do the rest 

An analyst checking out the Carrefour in Median: the shelf space occupied by Alhami was 60 to 70 meters across. 

CSF’s instant noodle offerings are positioned as healthy and certified halal (hence “Consciencefood”), and are flavored to correspond to the range of popular north Sumatran dishes. In addition, all of its fixed costs – the production lines, the warehouses, the trucks, the TV/radio/promotional spending – are all concentrated on sales within a 300 km radius of Medan. 

This latter approach, therefore, takes market share without imposing losses on oneself since one’s average unit cost is lower than Indofood’s. In fact, one can price the noodles at 10% below Indofoods and make a fatter profit. 

To see why, one can run the numbers in full or one can take a shortcut. Consider the box of 40 packs of noodles pictured above. That box of instant noodles retails for about ~US$5.50 in local currency. How many boxes fit in a truck that can navigate Indonesian roads? How much would it cost for a truck to transport those boxes from Java to Medan and back? Multiply that problem by a 25 million boxes a year and one can appreciate the scale of the problem.

Local scale is important enough that the retail price of imported (Japanese, Korean, etc) brands of instant noodles is 10x to 30x that of Alhami, CSF’s premium product. 

Between 1999 and 2010, then, CSF had taken more than half the north Sumatran market away from Indofood, was growing at 18.6% a year, had maxed out its production capacity and, in order to extend its reach into Java, had hired a third party manufacturer to make its noodles in Jakarta.

At the same time, it had big plans for the future: it wanted to take control of manufacturing in Java; and it wanted to leverage its brand by entering the markets for cup noodles and health drinks. Cup noodles and soft drinks sell for 5x and 3x the price of a pack of instant noodles so the margin prospects are that much more attractive.  

So CSF went public in 2010, with the owner-operator Djoesianto Law selling ~45% of his stake.

Let’s pause here for a moment and consider the value of CSF’s instant noodle business.

Note: The marketing, distribution and G&A expenses are unallocated. Total corporate marketing expense in 2012 was 32.6 billion Rupiah, an 83% increase over 2011: this increase in very large part represents groundwork for the launch of CSF’s line of cup noodles and soft drinks in 2013.

Instant noodles are a cheap, fast, convenient alternative to rice. Consider Indonesia's long term per capita GDP growth rate (6%), its rate of urbanization (44%, growing at 1.7% per year), and the participation of women in its labor force (51%). Next, consider Medan's relative proximity to Kuala Lumpur and the cultural affinities between Indonesian Malays and Malaysians. Now, what's the correct multiple for this business? I'd feel lucky to buy the whole business at 8x earnings. 

Now consider how the market is pricing it: 

A P/E of less than 1.5x for a growing, branded consumer staple with some moat-like properties? What’s going on? I’ll turn to that in my next post.

Amended: June 8 2013

Disclosure: I am long Consciencefood Holdings.

Portfolio Update

I have sold out of my position in Cybergun's 8% 2016 bonds. They still offer a 19% YTM at this price.

Portfolio Update

I've reduced my position in Northgate by 40%.

Half-term Report Card - II

Cybergun announced today that it had signed agreements with its banks extending the maturities of its term loans. The agreements will be signed this month. It has also sold two noncore subsidiaries, SMK Sportsmarketing (rifles) and I2G (video games), for €5 million in cash and a possible extra €1.3 million in contingent consideration. Separately, it will issue 4.7 million new shares at €1 each, effectively doubling the share count.

The upshot of all this is that the liquidity risk is reduced. €34.7 million in bank debt will now come due in smaller installments spread out over a 6 year period; €9 million in bond maturities over the next year (€6 in July, €3 next February) seem to be well covered by cash on hand, subsidiary sales, and the equity raise (~€ 15 million) before accounting for any cash flows generated by the businesses as it continues to work down its inventory to normal levels.

The prices of the 8% bonds and the equity have therefore both risen a bit – by 32% and 25% respectively.

The 8% bonds have been altogether de-risked, in my view, and the yield to maturity at the current price is about 25%.

The equity is more troublesome: if one thinks the underlying business deserves an enterprise multiple of greater than 7x, the shares are quite good value; if one doesn’t, they are uninteresting. The equity raise appears to be already quite well subscribed.

Disclosure: I am long the bonds and the equity

Half-term Report Card - I

Six months in, a quick round up of developments. I am lagging the S&P 500 by 7.5%, the International Small Cap Index by 9.6%, and my own picks by 23.4%.

I’ll start with a review of Hawaiian Holdings.

Hawaiian has reported its 2012 results. The last five years have seen its franchise stress tested: fuel prices have ranged from $1.93 to $4.67 per gallon; the domestic market has fallen into, and has come half-out of, a recession; its major international market, Japan, has suffered a nuclear event causing a calamitous drop in the number of Japanese visitors to Hawaii; the yen has appreciated and depreciated against the dollar, and so on.

And still the franchise remains intact, as it was bound to: it’s a low cost airline with full service amenities; it’s a toll road to a honeymoon, anniversary, and once-in-a-lifetime destination; it’s the transport network for residents who need to hop from island to island to get to meetings, to shop, and to visit relatives; and it’s the network into which all other airlines carrying passengers and cargo venturing beyond O’ahu must feed their traffic.   

The strategic control point of Hawaiian’s franchise is its monopoly position in interisland transportation and significant events are those that threaten that position, including end-runs. In that light, 2012 saw some US carriers increase their direct flights to Maui in an attempt to circumvent that control. Hawaiian responded in an appropriate way, creating a hub in Maui and flooding it with excess capacity. It was, in hindsight, a bit overdone but a sign, nevertheless of competence at work in the executive offices: the integrity of the inter-island monopoly matters, everything else is mere noise.

These are the last five years (you will remember that Hawaiian's fortunes were transformed when Aloha Airlines was liquidated in 2008):

It is a bigger, better diversified, more efficient airline than it was a year ago, and it is still the lowest cost and best performing scheduled passenger service airline in the United States.

There had been some indications that Southwest was considering entering the West Coast-to-Hawaii market. I had thought that unlikely since that market is probably the most brutally competitive market in the United States, a market in which one has to price an available seat mile at 7.5 cents just to break even. Only Hawaiian and Alaska Air Group, both favored with high margin regional monopolies (Alaskan in the Pacific Northwest, Hawaiian in the Islands), could and would compete effectively there. And, in fact, it now seems that Southwest has turned its attention to other, softer markets. 

What, in any case, is Hawaiian worth?

We know the rate at which its net operating assets will grow over the next two years and, since we know that its margins and asset turns are increasing as it grows, applying the past average ROIC to those assets implies a degree of welcome conservatism.

The above implies an expansion of the various market multiples currently accorded to Hawaiian.

At a constant total enterprise multiple (TEV/EBITDAR, where TEV = EV + Capitalized Operating Leases + Pension Liability – Cash – NOLs), Hawaiian’s share price should follow a progression that looks something like this:

When an intrinsic valuation is so much higher than the current market price it doesn’t hurt to do a sanity check by comparing one’s valuation to the market’s valuation of other, “similar” businesses.

Therefore:

The market clearly doesn’t agree with the above rather smug review. It's not that it hates airlines as a group; it just really doesn’t like Hawaiian. 

I’ll be adding to my position as price and cash availability permit.

Dsclosure: I long Hawaiian Holdings

Portfolio Update

Bought a few more shares of Hawaiian Holdings at an average cost of 5.77. I'll post some commentary later.

Trust Deficit

Judges Scientific and Elektron Technologies are so similar that they could easily be confused for each other.

Well, except for this:

Got that? Owning 13.4 million shares makes one’s interests more aligned with that of all shareholders than does owning 9.7 million shares.

Who says that irony is dead?

Valuing Howden Joinery Group

My posts on Howdens Joinery tried to understand its business model: how and why does it make money? That must be the very first question that a prospective investor asks of any business that s/he invests in. The arithmetic of valuation is the second step, and I’ll turn to that now.

A Rough Cut:

Howdens was once twinned with a low quality furniture retail business. Howdens sold that business to a private equity firm in 2006 and, when that business went bust in 2008, the legacy store lease obligations of the bankrupt business were, for one reason or another, put to Howdens.  Since 2008, therefore, Howdens had been both paying rents on properties it doesn’t use and paying breakage costs in order to rid itself of these legacy properties. These extraordinary payments are now almost entirely in the past; annual payments of only £2 million remain.

Also, Howdens’ pension fund assets once enjoyed assumptions that perhaps would have seemed reasonable at the time: an 8.4% rate of return on equities and a 4.5% rate of return on government bonds. As these assumptions crumbled in the face of the downturn, the net pension liability ballooned, and the trustee insisted on large cash infusions to eliminate the deficit. As it stands today, the deficit amounts to 154 million, the weighted average expected return on pension assets has contracted from 7.39% to 5.07% (Equities: 6.25%; Bonds: 2.55%) and Howdens has agreed to inject a further 45 million a year for the next three years. By 2015, the net liability should be eliminated: I doubt that there’s a reasonable basis for suggesting that expected long term returns on equities or bonds ought to be lower than they are now  and the cash payments will therefore be enough to make the retirement plan whole.  

We’re ready, now, to make a rough estimate of the lower bound of Howdens’ ability to generate free cash. We add back the legacy rent payments, the lease breakage costs, the cash contributions to the pension fund, and we are left with 23p in free cash per share, or, at the current market capitalization, an 8% FCF yield.

This is a rough cut and it’s wrong: we know that Howdens is growing, so that free cash flow doesn’t represent earnings; and we know that the years 2008-212 are exceptional ones, such that earnings in these years understate the company’s long-term earnings capacity.

So what is Howdens’ true earning power?

Approximately Right, from the Bottom Up

Let’s start with sales. We know that Howdens’ sales per square foot is a function of cyclicality and store maturation. The combined effect of these two factors can be seen below:

Average sales per square foot between the top and bottom of the cycle, i.e. between 2005 and 2012, is £199.4.

We know also that the depots mature with time. We can isolate this effect by calculating the CAGR in sales per square foot between the two bottoms of the cycle, 2002 and 2012. It’s not a perfect approach – that would take more information that we have available to us – but it’s good enough. The maturation effect is 1.4% per year.

Put these two factors together and look out to 2016 and we can estimate that sales will amount to something like £1,475 million: 700 stores, 10,000 sq ft per store, £211 in sales per sq ft.

We know that adjusted operating margin is 17.45%, that depot rents approximate £5 per square foot, that the business needs 30 days of noncash working capital, and that it costs £170,000 to build out each new depot so, at this point, we can estimate earnings and cash flow:

The business will generate about £650 million in cash over the next four years. Of this, 180 million will be contributed to the pension plan, £46 million will be tied up in increased working capital, and £30 million will represent cash capex for 171 new depots.

This leaves £390 million in free cash which, for the sake of simplicity, I choose to keep on the balance sheet. In reality, some of it will be paid out in dividends but it makes little difference to the valuation whether it is or isn’t.

A 2016 equity valuation of £2,775 sees the shares being worth 655p each, representing a return of 29% a year.

I’ll pause here to re-emphasize a couple of points:

·      This estimate of Howdens’ intrinsic value would be impossible without confidence in the robustness of Howdens’ business model.  One can’t do this for some teen fashion retailer or low-grade home supplies distributor and reasonably expect to be close: tastes change, and anything that can be disintermediated will be, sooner or later; forecasting revenues and profits for these kinds of businesses is, in my view, a fantasy.

·       The above valuation is dependent on two assumptions only, neither of which is fanciful: (a) things stay as they have been; and (b) management’s 700 depot target is proved reasonable.     

      If you'd like to take a stab at breaking my valuation, I’d welcome it in the comments below.