The Power of Float

This is Amazon.

Assumptions: 10 Year forward growth at half the trailing 10-year growth rate. 8% cost of capital, in line with Walmart.

Emeco Holdings -- Equipment Leasing

Emeco Holdings buys earth moving equipment and leases it to businesses in the mining sector: iron ore, gold, coal, and copper in Australia, Chile, Canada and Indonesia. The company was founded in 1972 and, after a period when it was owned by a private equity firm, was floated on the ASX in 2005.

The business model should be familiar by now: like Silver Chef, Northbridge, and Northgate, the name of the game is specialization, risk spreading, niche market domination, and balance sheet flexibility.

Like Northgate, it over-depreciates. See here:

Or here, in figures provided by the company itself for the period 2009-2012:

Maintenance capex is therefore about 47% to 48% of depreciation. Knowing this allows us to build an accurate economic picture of the company:

So Emeco is worth AUD $1.43 per share (if we use the average operating profit over the last business cycle), or AUD $2.48 per share (if we use the average return on net operating assets and apply it to Emeco’s current installed capacity). The stock is trading at $0.47 – i.e. at either 1/3rd or 1/5th of its intrinsic value.

It is free cash flow positive and there are no covenant or liquidity issues. Hell, at $0.48, it is trading below liquidation value.

If you can break Emeco, hats off. I can’t.

Disclosure: No position.

Cybergun Part 2

The problem with dumpster diving is that one is occasionally faced with having to work in the service of one’s capital. Break out the pencil, fill in the missing information, do some sums, and make a decision. Grubby stuff, far removed from the more patrician activity of investing in high quality issues.

Still, I asked for it by taking a position in Cybergun, so here goes.

The premise:

At the beginning of the calendar year, Cybergun was a fast-growing business, generating an average return of 13% on its net operating assets and 44% on its incremental investments. It buys the right to use brand identities from all major gun manufacturers and makes its money from converting those brand licenses into replica weapons that it sells on to the consumer market. A 3% spread between returns and investment, therefore, is a quite reasonable estimate of its economic worth; and, since licenses are fixed and sunk costs, it makes some sense that increased sales should generate higher incremental returns. 

So, valuing Cybergun at (13% ROIC / 10% Cost of Capital) x Net Operating Assets of € 54 Million, giving it no credit for future growth, and subtracting net debt, sums to a lowball equity intrinsic value of €8 per share. And indeed, at the beginning of the year, that’s where Cybergun’s shares were trading.

Subsequent developments:

Since then, Cybergun’s share price has fallen by 85%, which would seem to suggest that either the initial valuation was wrong or that something has changed over the course of the year. 

I am confident that the initial analysis wasn’t wrong. There are, nevertheless, some things to think about:

Gross Margin compression: The gross margin that the analysts following Cybergun use to model their estimates and valuations is 40%. In fact, Cybergun’s gross margin has varied between 38.1% and 48.8% in the period 2003 to 2010. So, their idea is that Cybergun’s baseline gross margin is 40% with anything above that as a bonus. So, when gross margin fell to 34% in the year ending March 2012, it triggered a wave of downgrades and, presumably, sell orders. 

Liquidity: A 34% gross margin is unsustainable. At that level, Cybergun’s ability to cover its interest charge is called into question.

Dividend: Cybergun is accustomed to paying out a dividend at the half-year mark – that is, at the end of September. The dividend is usually in the order of 50 cents per share, which would have yielded, at the Sept 2012 stock price, 20%. For the above reasons, it opted not to pay a dividend this year. That decision accelerated the sell orders.

Year-on-Year fall in revenue: H1 2012 sales (in the period ending Sept 2012) fell by 12% over H1 2011 sales. Since Cybergun is a growth story – actual long-term growth has exceeded management’s long-term growth guidance of 20% CAGR – a fall in sales now, when it had powered through the 2008-2010 period unaffected, looks ominous.

My take:

Between March 2011 and March 2012, China’s CPI inflation rate was running at 6.5% which likely approximates the increase in input costs facing Cybergun. The company was likely to have passed on almost half of this inflation, absorbing 3.5% in reduced gross margin. By contrast, in the period September 2011 to September 2012, China CPI rose at 1.8%, so we should see TTM gross margin expand back to its normal 40% level.

At a ~40% gross margin and €79.5m revenue, we’re looking at €2.44 million in cash from operations before changes in working capital. The company tells us that it has worked down its inventory by €4.9 million in the TTM, so operating cash flow, after taxes, interest and reduction in working capital, should be in the region of €7.3 million. After €3 million in previously committed capex, TTM free cash flow should be €4.3 million. (The company tells us in its latest quarterly statement that there will be a pause in growth capex as it uses cash flow to pay down debt). So dividend and interest cover are not – if I’ve done my sums right – an issue: Cybergun should be in a better financial position today than it was a year ago, when its shares were trading at €11.

Between H1 2010 and H1 2011, revenue (in dollar terms) grew by 45%, far above the long term trend. It was inevitable that H1 2012 would suffer in absolute terms as distributors’ inventory was worked down to normal levels. There is nothing to suggest that the long term trendline of 20% growth has been broken.

Note: As should be plain from the discussion above, the TTM figures are of my own devising. I have pieced together the information provided by the company re: revenue, inventory levels, capex and net debt to piece together a complete cash flow schedule that it doesn't provide.

Revenue trends

Geoff Gannon sensibly advises that one should relive one’s experience of buying the stock rather than one’s experience of owning it. This has been my attempt to do just that. I feel no differently toward Cybergun than I did 5 weeks ago. It’s worth €8 to €12. Or so I say. Time will tell.

Disclosure: I have a position in Cybergun and may double or triple it at prices below €1.20

Update

An update on a stock I’ve praised.

Instem’s Provantis suite is the de facto standard in preclinical software. In the last 20 years, half the world’s pre-clinical software data has been collected using it. 80% of the top 20 pharmaceutical companies use it. Its user base is twice that of its nearest competitor.

So, today's news should come as no surprise:

“National Institute of Allergy and Infectious Diseases (NIAID), part of the National Institutes of Health (NIH), has selected Instem's integrated Provantis® preclinical software suite to help advance research programs against infectious, immunologic, and allergic diseases.”

NIAID funds $30 billion in research at hundreds of organizations. That Provantis is now the preferred preclinical software suite for NIAID-funded preclinical research means future market share gains. Market share gains in a business model dependent on a loyal installed base and on its status as de facto standard means a wider and deeper moat. And a wider moat will mean more market share gains. That’s the logic of sustainable competitive advantage. 

Remember, this is a software business, so incremental revenue will fall unmolested to the profit line.

Of course, the market for small capitalization companies is often perverse in the short term, and Instem’s stock price fell modestly on the announcement of this contract win.

Disclosure: No position

Northgate Plc -- Vehicle Rentals

Northgate buys vehicles (vans, overwhelmingly) and rents them out, on a monthly and yearly basis, to small and mid-sized businesses in the UK and Spain. 

Fleet management is done centrally, and sales are generated through a network of local offices.  

The advantage of this kind of operational structure is that (1) rental pricing, based as it is on intimate, local knowledge of the customer base, tends to be sensitive to demand, ensuring a high fleet utilization rate (90%) with very little variation.; and (2) fleet size and distribution across locations can be optimized with very little trouble – it is not hard to reduce the size of the fleet (the market for used white vans is liquid and robust) and it is not hard to move  vehicles from one rental location to another .

Add to this (3) the purchasing power derived from buying tens of thousands of identical vehicles from the same manufacturer (Ford, in this case), and (4) the benefit to credit risk management from local knowledge of the customer base, and one can anticipate that Northgate earns returns on its operating capital that are some 3 or 4 percentage points above its cost of capital – perhaps 13% as against a cost of capital of 9%.

In fact, the profit spread is a little higher, an almost 8 and a 1/2 point spread – 17.5% against a cost of capital of 9%.

The extra, unanticipated value is derived from the tax benefits of the excess depreciation that Northgate is able to record.   Northgate reports depreciation of its vehicles that is some 37% higher than its actual maintenance capex requirement. The tax benefit of this over depreciation amounts to an extra 1.8% return on invested capital.

  

So, Northgate can be expected to earn 17.5% returns on operating assets of 780 million. Discounting at a cost of capital of 9%, this places the value of the business at 1,514 million, and subtracting the non-operating items leaves us with equity that has an intrinsic value of 892p per share. Which means that Northgate is trading at almost a 1/3 of its value.

One would think that Northgate is an attractive acquisition candidate – it could be bought by either a private equity firm or by one of the large vehicle rental companies at a price halfway between price and value (say 575p) and satisfy both parties. The Times reports on rumors of just such a possible purchase, but at a price of 400p. It seems to me that this is the worst case scenario.

The Northgate writeup at Expecting Value and at Share Sleuth  are well worth your time.

Disclosure: No Position 

Postscript: 

I calculate maintenance capex as follows (follow along in the 2nd graphic, above):
The average dollar cost of fixed assets required to support a dollar of sales is $1.68

Sales have risen from 338 to 646 million over the last 10 years, which therefore implies that growth capex is approx (1.86 * (646 - 338)) = 687 million

Since total actual capex in that time period is 1,735, it follows that maintenance capex is total capex less growth capex = 1,735 - 687 = 1,048 million.

Now this 1,048 million in maintenance capex is substantially less -- almost half -- than the 1,985 million reported as depreciation over the same time period. 

I therefore adjust annual depreciation expenses downward by 52.7% in order to arrive at a more accurate maintenance capex and annual profit figures.

These adjustments get us much closer to the true economics of the business. I credit the company for tax shield from the excess depreciation that it is able to record because it is a permanent feature of its strategy.