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

Cybergun -- Replica Firearms

Cybergun, listed on the French exchanges, is an interesting situation.

It makes replica air guns, under licence to brands such as Beretta, Smith & Wesson, Colt etc., for the benefit of the collector, toy, and paint-ball game markets. These are not large markets, and Cybergun dominates them. Naturally, its sales are concentrated in the United States.

Up until the year ending March 2010, things were going as one would expect: growth (22.5% CAGR), healthy RONIC (44.5%), and all the rest of it.

And then, for some reason known only to the CEO, whose family owns 44% of the business, Cybergun decided that it might as well branch out into shoot-‘em-up video games, too. Of course, any link between physical guns and video games is extremely tenuous – the markets, distribution channels, manufacturing processes, supply chains, are all different. Inevitably, therefore, the capital invested in this drive into software was wasted – heavy capex in 2010 and heavy goodwill write-downs in 2012.

The company has now rethought the rush of blood to the head and is, contra Hornby, washing its hands of its noncore activities. Unpleasant for longstanding shareholders  (the equity raise that financed the foray into video games came at their expense), but, now that the lesson has been learned the hard way, perhaps an attractive opportunity for new shareholders.

At a 10% discount rate, the underlying earning power value of the replica gun business is about EUR 11 per share, four times the current share price. Growth should add substantial additional value. The leverage is worth thinking about, however.

Dsclosure: No position

Precia SA -- Measuring instruments

Precia Molen ("Precia") is a supplier of instruments that measure, weigh, count, and dose in contexts where exactitude matters a great deal – pharmaceuticals, chemicals, agro-industry, mining, construction, railroads, and many others. Its instruments “weigh anything from a grain of wheat to a sea-going vessel”.  

In support of the design, manufacture, and marketing of these instruments, Precia provides a number of pre- and post-sales services: instrument selection advice, application engineering, pre-installation visits, calibration and commissioning, on-site training, repairs, spare parts, and so on.

Industrial weighing is important, and in some circumstances mission critical: imperfect weighing of pig iron will cost someone a lot of money; imperfect measurement in flavors and fragrances will lead to the manufacture of unusable batches; imperfect measurement of pharma dosages may cost lives. 

What matters most, therefore, is not going to be price, but service and reputational quality. 

This means that measurement instrumentation is a business suited to specialists – in established markets, one can’t easily buy in to the business: one has to wait a long while before a reputation is built, distributor relationships forged, service personnel reach appropriate levels of excellence and reliability. 

For incumbents, therefore, gross margins should be very high, and corporate financial health – operating margins, return on capital, cash conversion -- should follow from that. As the incumbent's business grows, overhead should constitute a smaller share of costs, replacement parts and services should constitute a larger share of revenues, and the return on incremental investment should therefore outstrip ROIC.

Like so:

Precia is currently yielding 18% and is worth approximately €135 – without growth, just doing maintenance business and servicing its current client base.

In recent years, however, Precia has sought to expand internationally, i.e. beyond the European Union. International sales now account for 34% of sales and 31% of profit.

While the company has identified Brazil, Australia, Indonesia, and Eastern Europe as promising markets for its products, its activities in these markets is still embryonic. 

Those international markets in which it has already established a presence, however – India and Morocco, in particular – are growing at 14%, helping to drive overall revenue growth by 4.5%. The client list of Precia's India subsidiary is illustrative of the potential:

It's not out of the question that international sales (and profits) will constitute 50% of both revenue and profit within three years. In fact, it seems unlikely that it won't: India alone contributed 2.8 million to revenue in 2010, 3.65 million in 2011, and is on track for something like 4.55 million in 2012. Brazil is a similar opportunity to India, in terms of both size and market characteristics. 

Barring exceptional events, therefore, one can peer into Precia's future:

If one assumes that an ex-cash P/E ratio of 1.77x is unreasonable for a quality business, one can envisage two paths to share price appreciation by 2015 -- via multiple expansion and via growth in earnings power:

Precia, then, has all the characteristics of the kind of investment that I have had success with: a solid competitive position, a clear pathway to growth, increasing economies of scale, a clean balance sheet,  free cash flow generation, significant insider ownership, and a history of increasing payouts. It is the safest way that I can think of to earn annual returns of 25% or more.

I am in debt to Nate at Oddball Stocks for the lead. His recent post on every stock he's ever written about is a treasure chest.

Disclosure: I have a partial position in Precia and intend to accumulate more shares in the near future.